Goldman Sachs and Interest Rate Swaps

Ellen Brown outlines how interest rate swaps by banks and insurance companies cause problems for local governments.  The swaps were used to insure against a rise in interest rates.  These swaps became a problem when the Federal Reserve pegged interest rates at nearly zero percent, their lowest rate ever, in order to save the banks from their financial folly in the crisis of 2008. 

We've already discussed how the city of Oakland signed an interest rape swap with Goldman Sachs here.

Ellen Brown's article explains the use and abuse of interest rate swaps in more detail in the following article:

The Shadow Bailout:  How Big Banks Bilk US Towns and Taxpayers
Wall Street Confidence Trick:  The Interest Rate Swaps that Are Bankrupting Local Governments
By Ellen Brown - Common Dreams

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In a March 15th article on Counterpunch titled “An Inside Glimpse Into the Nefarious Operations of Goldman Sachs: A Toxic System,” Darwin Bond-Graham adds these cases from California:

The most obvious example is the city of Oakland where a chronic budget crisis has led to the shuttering of schools and cuts to elder services, housing, and public safety. Oakland signed an interest rate swap with Goldman in 1997. . . .

Across the Bay, Goldman Sachs signed an interest rate swap agreement with the San Francisco International Airport in 2007 to hedge $143 million in debt. Today this agreement has a negative value to the Airport of about $22 million, even though its terms were much better than those Oakland agreed to.

Greg Smith wrote that at Goldman Sachs, the gullible bureaucrats on the other side of these deals were called “muppets.”  But even sophisticated players could have found themselves on the wrong side of this sort of manipulated bet.  Satyajit Das gives the example of Harvard University’s bad swap deals under the presidency of Larry Summers, who had fought against derivatives regulation as Treasury Secretary in 1999.  There could hardly be more sophisticated players than Summers and Harvard University.  But then who could have anticipated, when the Fed funds rate was at 5%, that the Fed would push it nearly to zero?  When the game is rigged, even the most experienced gamblers can lose their shirts. 

Courts have dismissed complaints from aggrieved borrowers alleging securities fraud, ruling that interest-rate swaps are privately negotiated contracts, not securities; and “a deal is a deal.”  So says contract law, strictly construed; but municipal governments and the taxpayers supporting them clearly have a claim in equity.  The banks have made outrageous profits by capitalizing on their own misdeeds.  They have already been paid several times over: first with taxpayer bailout money; then with nearly free loans from the Fed; then with fees, penalties and exaggerated losses imposed on municipalities and other counterparties under the interest rate swaps themselves.

Bond-Graham writes:

The windfall of revenue accruing to JP Morgan, Goldman Sachs, and their peers from interest rate swap derivatives is due to nothing other than political decisions that have been made at the federal level to allow these deals to run their course, even while benchmark interest rates, influenced by the Federal Reserve’s rate setting, and determined by many of these same banks (the London Interbank Offered Rate, LIBOR) linger close to zero. These political decisions have determined that virtually all interest rate swaps between local and state governments and the largest banks have turned into perverse contracts whereby cities, counties, school districts, water agencies, airports, transit authorities, and hospitals pay millions yearly to the few elite banks that run the global financial system, for nothing meaningful in return.

Why are these swaps so popular, if they can be such a bad deal for borrowers?  Bond-Graham maintains that capitalism as it functions today is completely dependent upon derivatives.  We live in a global sea of variable interest rates, exchange rates, and default rates.  There is no stable ground on which to anchor the economic ship, so financial products for “hedging against risk” have been sold to governments and corporations as essentials of business and trade.  But this “financial engineering” is sold, not by disinterested third parties, but by the very sharks who stand to profit from their counterparties’ loss.  Fairness is thrown out in favor of gaming the system.  Deals tend to be rigged and contracts to be misleading.

How could local governments reduce their borrowing costs and insure against interest rate volatility without putting themselves at the mercy of this Wall Street culture of greed?  One possibility is for them to own some banks.  State and municipal governments could put their revenues in their own publicly-owned banks; leverage this money into credit as all banks are entitled to do; and use that credit either to fund their own projects or to buy municipal bonds at the market rate, hedging the interest rates on their own bonds.

Read the whole article here