Window Closing to Challenge Wall Street Over Swaps: Muni Credit

Jul 25, 2014 8:18 am ET

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July 25 (Bloomberg) -- The clock is running out on a way for U.S. states and cities to try to recoup payments to Wall Street on bond deals that blew up in the financial crisis.

Six years after credit-market turmoil began hitting local governments with rising bills for bond and derivative deals that backfired, the time limit will soon lapse for issuers to seek to claw back their losses by arguing that banks misled them about the risks, said former Congressman Bradley Miller, an attorney with Grais & Ellsworth LLP in New York.

With a six-year statute of limitations closing, officials in Los Angeles may vote to press Bank of New York Mellon Corp. and Dexia SA to renegotiate or terminate interest-rate swaps costing $4.9 million a year. Harris County, Texas, which encompasses most of Houston, is hiring an adviser to look at whether risks were presented fairly when it entered deals that are costing about $7 million a year.

“It’s one of the things from the financial crisis that keeps reverberating,” said Houston attorney David Peterson, a partner at Susman Godfrey who has handled litigation related to the collapse of the auction-rate securities market. “Municipalities are wondering what they got in return for taking the risk. It’s the issuers who end up suffering, and at the end of the day the taxpayers who end up paying.”

The Unraveling

The costs resulted from complex financings that Wall Street banks pitched as a way to cut borrowing expenses and that unraveled after the 2008 financial crisis. States and localities have paid more than $4 billion to banks to back out of the agreements, while issuers such as Chicago and Baltimore opted to remain in the money-losing trades.

With the transactions, municipalities sold bonds with floating interest rates, then entered into related derivative contracts to protect against the risk borrowing costs would jump. Through the derivatives, municipalities received payments based on indexes such as the London interbank offered rate, or Libor, meant to cover the cost of the bonds. In return, they made fixed interest payments to the banks.

The tactic turned costly in 2008, when borrowers faced soaring interest bills as credit markets seized up. At the same time, the payments they received under the swaps fell as the Federal Reserve pushed its benchmark overnight rate close to zero.

’70s Vintage

Miller, a former North Carolina Democratic representative who sat on the House Financial Services Committee, said banks may have violated rules requiring them to deal fairly with local governments that hire them to arrange bond sales.

He said that under those rules, first put in place in the 1970s, underwriters must explain complex transactions in an understandable way and disclose the material risks. Issuers have six years to bring arbitration cases from the time they determine the deals backfired, under Financial Industry Regulatory Authority guidelines.

While issuers were told of risks of entering swaps sold along with variable-rate debt, the magnitude of what could go wrong may not have been sufficiently explained, Peterson said.

“It appears they rarely, if ever, showed how vulnerable issuers were to the variables,” said Joseph Fichera, chief executive officer of New York-based Saber Partners LLC, which is poised to be hired by Harris County. “Savings were calculated without adjusting for the risks that could affect the savings, which is a core financial principle that should have been followed.”

Uphill Fight

Public officials in cities such as Oakland have tried to pressure banks into breaking the decades-long contracts with little success. In Los Angeles, finance officials already met with at least one swap provider and were told they “will be unlikely to offer a significant discount,” according to a June 27 memo to the mayor and city council from Miguel Santana, the city administrative officer.

A last-ditch effort to fight the contracts through arbitration may also prove difficult.

Miller said he was aware of only one municipal issuer, a nonprofit insurer in Louisiana, that tried to recoup money from banks in arbitration by arguing it was misled. It lost the decision. In other cases, issuers pursued claims in court instead of arbitration, after being challenged by banks, Miller said.

“It doesn’t take a very close reading of the contracts to realize that these kinds of cases are difficult to pull off,” said Robert Fuller, a principal at Capital Markets Management LLC, a Hopewell, New Jersey-based swaps adviser.

Alabama Precedent

Some municipalities may find a road map in a case settled by an Alabama sewer company. In March, Baldwin County Sewer Services LLC was able to recover losses after an arbitration panel ruled that a failed swap deal amounted to “a continuing but hidden fraud.” Arbitrators told Birmingham-based Regions Financial Corp. to pay $7.4 million, the net amount of swaps payments the utility made.

Katrina Cavalli, spokeswoman for the Securities Industry and Financial Markets Association, which represents banks that underwrite municipal securities and in some cases serve as counterparties for swaps, declined to comment in an e-mail.

In Los Angeles, the challenge to the city’s swap deals is being led by Councilman Paul Koretz, who filed an ordinance that may be considered after the council’s recess ends later this month.

Bank Expenses

His proposal was in response to a report by the Fix LA coalition. The group, which includes local labor unions and community groups, found that the city spent $204 million on bank fees in 2013, including swap payments, investment-management fees, the cost of bond insurance and remarketing fees, letters of credit and service fees. That year, Los Angeles spent $163 million on streets, the report said.

Paul Neuman, a spokesman for Koretz, said the swaps have been a drain on the city as it pushed through budget cuts in the recession’s aftermath.

“It is a shame that some financial institutions are benefiting when we face such difficulties, especially when we followed their advice,” he said in an e-mail.

Kevin Heine, a Bank of New York Mellon spokesman, declined to comment on the measure. Phone messages left after business hours at the Brussels and Paris press offices of Dexia, as well as e-mails to the bank’s press address, weren’t returned.

In Harris County, Treasurer Orlando Sanchez said he’s hiring Saber Partners to review swaps and decide whether the county should pursue an arbitration claim. The county will have paid about $31 million to Citibank from 2010 to 2014, according to county documents, plus $19 million in interest on the bonds to which the swaps are attached.

Scott Helfman, spokesman for New York-based Citigroup Inc., declined to comment.

“We need to get to the bottom of what happened with our swaps,” said Sanchez. “I want an independent set of eyeballs to look at it.”