The recent LIBOR scandal has revealed yet another way the bank gamed the system, this time by manipulating interest rates. Here is a video by the SEIU, Service Employees International Union, which explains how interest rate swaps have hurt local governments.
Update 7/17/12:
The SEIU video only explained how a proper interest rate swap should work, not what the banks actually did. As in Norm's commented below, it seems like the cities made a fair bet with the banks and lost, and they should not be crying because they got what they wanted, a fixed interest rate. The only loss was the opportunity of a lower interest rate.
I added a comment which referenced an article which explains what really happen. But the article is hard to understand, so I am going to try to explain what was missing in the SEIU video that was clarified in the article.
The video implied that the banks and cities simply swapped interest payments. But what actually happened was that the cities bought a kickback which should have offset their variable interest payments. There are actually three payments involved.
a) The variable payments made by the cities to the investors who bought their municipal bonds.
b) The fixed payments from the cities to the banks to entitle them to a variable kickback
c) The kickback from the banks to the cities which should have cancelled the variable interest payments of (a).
But in reality (c) did not cancel (a) because (a) was based on SIFMA, the benchmark rate for municipal bonds, while (c) was based on LIBOR. LIBOR rates went down but SIFMA rates stayed high. So the cities had to pay both (a) and (b) but was not compensated by (b). By manipulating LIBOR the banks was able to squeeze more money from the cities.
The article says that interest swaps were horrible for the cities in other ways:
1) The cities could prepay the bond holders, as they would normally would do when interest rate fall dramatically. But they still had to keep paying the banks for the worthless kickbacks.
2) Had the banks gone bankrupt, the cities would still have to pay the banks even though they would not be getting any kickbacks.
What this shows is that the cities were totally conned by the banks. Had they understood how the interest rate swaps really worked, they would never have taken the deal. This was not a fair bet; it was rigged in favor of the banks.
I must have missed something. How did the banks manipulate the interest rates?
ReplyDeleteForexample:
The banks offered a fixed rate in place of a variable rate that could increase or decrease.
The unions/municipalities have seen rates going up and want protection from the increasing variable rate and make a deal(swap) with banks for a fixed rate.
BUT the variable rate goes down.
Now the unions/municipalities are paying more money in interest (the fixed rate is now higher than the variable rate}.
The unions/municipalities were happy with the upside of this gamble but don't like the downside.
If the banks either manipulated the variable rate so it dropped or somehow coerced the unions/municipalities into buying the swap then I agree the contracts should be nullified.
Other than that the deal seems legal and the unions/municipalities should get better money managers, live up to their side of the bargain, and stop complaining.
Norm F
The video just explains how an interest rate swap can act as a hedge. So it seems that the cities just made a bad bet. But in reality there were a lot of hidden conditions that allowed that banks to take the cities to the cleaners even if the interest rates went up. Here is an article which explains it:
ReplyDeletehttp://www.realfreemarket.org/blog/2012/07/10/banksters-rob-cities-via-interest-rate-swaps-and-libor-rate-manipulation/
The bottom line was that the city managers were completely duped by the bankers.
Thanks for the additional info but I'd risk a stroke trying to comprehend all the ins and outs. While many contracts can be win-win, others are win-lose. The city managers made a good, if shortsighted, bet and the swap worked in their favor while the interest rates were rising. But the bankers were smarter and had more information which they aren't required to share with the cities.
DeleteAll in all I have no sympathy for and fault the city managers for their lack of foresight, due diligence,and/or corruption. I don't expect banks to act with integrity and thus far they are exceeding my expectations.
NormF