Martha Haines says she was powerless at the Securities and Exchange Commission to prevent banks from selling derivatives to state and local governments that cost taxpayers billions of dollars -- mostly in penalty fees to Wall Street -- during the worst financial crisis since the 1929 Crash.
“We could see this trouble developing,” says the 59-year-old Haines, who led the SEC’s Municipal Securities office from 2001 until she retired in June. “Yet we had no authority to address it.”
A year after passage of the Dodd-Frank Act, regulators at three government agencies belatedly are preparing to impose rules on the business of selling derivatives to borrowers financing on behalf of taxpayers. While the law won’t prevent the use of derivatives, it marks the biggest change to the public finance market since tax laws were overhauled in 1986, said Lynnette Hotchkiss, executive director of the Municipal Securities Rulemaking Board.
Dodd-Frank “does provide layers of protection that didn’t previously exist,” she said in an interview.
Commodity Futures Trading Commission regulations implementing the law, the most significant financial legislation since the Glass-Steagall Act of 1933, would force derivatives dealers to disclose prevailing market rates when contracts are signed to prevent overcharging, an all-too-common flaw of derivative contracts sold to municipalities.
The CFTC draft rules require banks that pitch such deals to act in governments’ best interests, and that municipalities be aware of the risks and be capable of bearing them. The law also regulates advisers who pitch governments on such opaque financings.
The SEC and MSRB also are requiring that municipal financial advisers act in their clients’ best interests. Dodd-Frank also gave the MSRB authority to draw up rules aimed at protecting municipalities.
States, municipalities and institutions such as Harvard University paid more than $4 billion in fees to banks when the derivatives, sold as a way to minimize risk, exploded as the housing market’s collapse cascaded through financial markets. Jefferson County, Alabama, was pushed toward bankruptcy as it and other governments were saddled with soaring costs tied to interest-rate swaps just as the longest recession since World War II tipped their budgets into the red.
“There are wounded and dead public institutions around the country that are in distress -- jobs have been lost, unions have been undercut -- because they have not understood one of the trickiest transactions in the investment handbook,” said Michael Greenberger, a former trading and markets director at the CFTC who teaches law at the University of Maryland. “They need regulatory protection.”
A derivative is a financial contract whose value is derived from stocks, bonds, currencies or commodities, or linked to events such as changes in interest rates or the weather. Municipalities frequently bought derivatives known as interest-rate swaps to reap promised savings when they sold floating-rate securities. The strategy turned into a money-loser when credit markets collapsed in 2008.
The new rules won’t keep states and localities from entering such deals. Nor will they make the risks and terms, now buried in bond documents or annual reports, more apparent to taxpayers. Dodd-Frank actually postponed consideration of whether to impose tougher disclosure rules on municipalities.
Instead, the proposed regulations are aimed at curbing Wall Street’s worst abuses in the $601 trillion unregulated derivatives market. Bank lobbyists have pressed the CFTC to alter the proposed rules, including the disclosures aimed at their fees, saying they go beyond what was intended by Congress.
“The proposed rules would include requirements that go well beyond Dodd-Frank,” Kenneth Bentsen, a vice president of the Securities Industry and Financial Markets Association, and Robert Pickel, executive vice chairman of the International Swaps and Derivatives Association, said in a Feb. 17 letter to regulators.
Pennsylvania Auditor Jack Wagner says they don’t go far enough. He was among state lawmakers who voted unanimously in 2003 to authorize municipal derivatives. By 2009, as financial losses mounted, he called for the Legislature to ban them.
‘Impossible to Measure’
“The rules certainly are a start, but they are far from addressing the issues and problems we have seen with interest-rate swaps,” Wagner said in an interview. “It’s impossible to measure the risk.”
As much as $300 billion a year of interest-rate swaps were sold during the market’s peak, the MSRB estimated based on figures from investment banks.
The swaps were mostly bought by governments that sold variable-rate securities. Banks gave them adjustable-rate payments in return for fixed payments, helping borrowers guard against rising interest costs and providing lower expenses than fixed-rate bonds.
The deals unraveled when banks began hoarding cash after credit dried up in 2008 and bond insurers that backed variable-rate bonds lost their top ratings. The interest rates municipalities had to pay banks soared to as much as 20 percent because of penalties built into the contracts. As central banks reduced lending rates, payments municipalities received plunged, adding financial burdens instead of eliminating them.
Shift in Confidence
Wall Street’s risk-taking appetite fueled the market for municipal derivatives, which has since shrunk to about a 10th the size, said Peter Shapiro, managing director of Swap Financial Group LLC in South Orange, New Jersey, which advises on such deals.
“Nobody believed risks would ever be realized, and everybody was overconfident,” he said. “It’s gone from super-confident to totally under-confident.”
During the height of activity, lack of disclosure requirements meant Wall Street could charge municipalities fees that have since proved predatory. Banks led by JPMorgan Chase & Co. charged Jefferson County $120 million for swaps tied to $3.2 billion of bonds. That was as much as $100 million more than was justified, according to Porter, White & Co., an adviser brought in to analyze the deals.
Jefferson County Swaps
JPMorgan bankers also used the Jefferson County swaps to funnel payments to friends of local commissioners to land the deals, according to the SEC. The transactions left Alabama Governor Robert Bentley working to head off the biggest-ever municipal bankruptcy.
In 2003, JPMorgan Chase convinced the Butler, Pennsylvania, school district to enter into an option on an interest-rate swap in return for a $730,000 payment. That was half what the district later found it to be worth, according to a lawsuit filed against the bank.
When JPMorgan moved to exercise the option in 2008, Butler paid $5.2 million to back out. Its lawsuit foundered when a judge ruled such trades were exempt from securities-fraud laws.
Butler’s school superintendent didn’t respond to a request for comment. Justin Perras, a spokesman for JPMorgan, which shut its municipal derivatives unit in 2008, declined to comment.
Harvard University in Cambridge, Massachusetts, paid $497.6 million in 2008 to end $1.1 billion of interest-rate swaps with JPMorgan and Goldman Sachs Group Inc., and separately agreed to close another $764 million of the agreements at a cost of $425 million. JPMorgan was the lead banker when the school sold bonds whose proceeds were used to make the termination payments.
Concern Over Duplication
Among concerns expressed by financial-industry lobbyists, banks, public officials and trade groups over the new rules is what they say are duplicating regulations that may limit their ability to trade.
“Everybody’s really confused, frankly, by all this and what it’s going to mean,” said William Daly, a lobbyist for the Bond Dealers of America, a Washington-based trade group for municipal debt underwriters. “I can’t predict what the business will look like when the regulations are all done.”
Under proposed CFTC rules, banks that pitch derivatives could be considered advisers. That would put them in a fiduciary role that banks and public officials say could prevent financial companies from executing swap trades with customers.
“Most or all dealers now active in executing over-the-counter swaps with state and local governments would need to stop providing these products,” Susan Gaffney, the Washington lobbyist for the Government Finance Officers Association, said in a Feb. 22 letter to the CFTC.
That may not be a bad thing, said Greenberger, the former CFTC director of trading.
“Billions of dollars have been lost,” he said. “Municipalities are better off not dealing in swaps because they have been catastrophic.”