April 19 (Bloomberg) -- Wall Street banks would be held responsible for steering local governments into the kind of derivative deals that backfired amid the financial crisis, under a bill introduced in the U.S. Senate.
The legislation by Senator Blanche Lincoln, an Arkansas Democrat who chairs the agriculture committee, would impose a fiduciary duty on banks entering into interest-rate swaps with cities, towns and other municipal issuers. Lincoln said the provision is intended to ensure that banks don’t take advantage of local governments.
U.S. municipalities were hit with billions of dollars in unexpected interest bills and fees when derivatives meant to protect them from rising borrowing costs began unraveling. Such deals pushed Jefferson County, Alabama, close to bankruptcy and drew unsuccessful legal challenges alleging that JPMorgan Chase & Co. used Pennsylvania school districts to reap excessive fees.
“The dealer has adversarial interests,” said Peter Shapiro, managing director at Swap Financial Group LLC in South Orange, New Jersey, which advises localities on derivatives. “The worst mistakes and some of the greatest abuses that have gone on have been where the issuer is led to believe that the swap dealer was also its adviser.”
Derivatives are contracts based on the value of another security or benchmarks such as stock options. They have been blamed for aggravating the financial crisis that led to the longest recession since the Great Depression.
The municipal derivatives business boomed as banks sold the obligations to localities as a way to drive down interest costs or get upfront cash. While no national statistics are kept, the Municipal Securities Rulemaking Board, the market’s self-regulator, last year said participants estimated annual trading to be as much as $300 billion.
The derivatives were typically sold to municipalities to guard against the risk they took by borrowing with bonds whose interest rates fluctuated along with the market. Under such contracts, municipalities received a variable payment, meant to cover those on the bonds, and paid a fixed sum in return. That method was sold as a way to provide lower borrowing costs than available through the sale of fixed-rate bonds.
The contracts backfired in the credit crisis that erupted in 2008. Municipalities were confronted with soaring interest bills on auction-rate securities and other floating-rate bonds, while the payments they received plunged as central banks worldwide slashed interest rates. Municipalities paid banks hundreds of millions of dollars in penalties to escape from the contracts.
The interest-rate swap agreements routinely contained a clause stating that municipalities didn’t rely on the advice of bankers who sold them the derivatives and acted as the counterparties as well.
Shapiro, whose firm is hired to provide independent advice to governments entering into such trades with banks, said Lincoln’s bill could do more harm than good by giving municipalities the impression that the banks have their customers’ interests in mind.
“Issuers would be given a false sense of protection,” Shapiro said. “You don’t want your counterparty giving you advice as to the suitability of a transaction, its pricing and its risks. This is really upside down.”
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