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Forum Post: Wall Street Confidence Trick: The Interest Rate Swaps that Are Bankrupting Local Governments

Posted 12 years ago on March 23, 2012, 6:11 a.m. EST by GildasSapiens (266)
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"The “toxic culture of greed” on Wall Street was highlighted again last week, when Greg Smith went public with his resignation from Goldman Sachs in a scathing oped published in the New York Times. In other recent eyebrow-raisers, LIBOR rates—the benchmark interest rates involved in interest rate swaps—were shown to be manipulated by the banks that would have to pay up; and the objectivity of the ISDA (International Swaps and Derivatives Association) was called into question, when a 50% haircut for creditors was not declared a “default” requiring counterparties to pay on credit default swaps on Greek sovereign debt.

Interest rate swaps are less often in the news than credit default swaps, but they are far more important in terms of revenue, composing fully 82% of the derivatives trade. In February, JP Morgan Chase revealed that it had cleared $1.4 billion in revenue on trading interest rate swaps in 2011, making them one of the bank’s biggest sources of profit. According to the Bank for International Settlements:

[I]nterest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion, up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in June 2009, up from $6.2 trillion in Dec 2007.

For more than a decade, banks and insurance companies convinced local governments, hospitals, universities and other non-profits that interest rate swaps would lower interest rates on bonds sold for public projects such as roads, bridges and schools. The swaps were entered into to insure against a rise in interest rates; but instead, interest rates fell to historically low levels. This was not a flood, earthquake, or other insurable risk due to environmental unknowns or “acts of God.” It was a deliberate, manipulated move by the Fed, acting to save the banks from their own folly in precipitating the credit crisis of 2008. The banks got in trouble, and the Federal Reserve and federal government rushed in to bail them out, rewarding them for their misdeeds at the expense of the taxpayers.

How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”:

In an interest-rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements.

Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean. But the Fed artificially manipulated the rates to the save the banks. After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals. Auction interest rates soared when bond insurers’ ratings were downgraded because of subprime mortgage losses; but the periodic payments that banks made to borrowers as part of the swaps plunged, because they were linked to benchmarks such as Federal Reserve lending rates, which were slashed to almost zero.

In a February 2010 article titled “How Big Banks’ Interest-Rate Schemes Bankrupt States,” Mike Elk compared the swaps to payday loans. They were bad deals, but municipal council members had no other way of getting the money."

Read more: http://webofdebt.wordpress.com/2012/03/22/wall-street-confidence-trick-the-interest-rate-swaps-that-are-bankrupting-local-governments-2/

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2 Comments


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[-] 3 points by shadz66 (19985) 12 years ago

GS : An article which speaks to the gist of your excellent 'forum-post' :

radix omnium malorum est cupiditas ...

[-] 3 points by francismjenkins (3713) 12 years ago

Interest rates swaps are indeed a problem. Unfortunately, this is all completely caused by lack of regulatory oversight by the federal government, which has refused to regulate this aspect of our financial industry. We need to not only restore Glass Steagall, but we need more walls in place. A firm handling bond sales for a state or municipality should not be allowed to also handle derivative transactions based on those underlying assets (problem solved). Or in the alternative, we could get rid of these products entirely, although they do serve a valid function in some contexts.

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