Jan. 4 (Bloomberg) -- Between debating the location of a proposed dog park and discussing taxi permit fees one night last month, the city council in Oakland, California, turned to severing ties with Goldman Sachs Group Inc.
The vote for the city administrator to begin the process of firing the fifth-biggest U.S. bank by assets came during an eight-hour meeting Dec. 18. It culminated months of efforts by the city to exit a 1998 interest-rate swap without paying a $14.8 million termination fee. Goldman, which underwrote $83 million of Oakland debt last year, has denied the request.
The cash-strapped city addressed about $318 million of budget gaps in the last six years. It is moving toward the rare step of cutting off business with the bank that sold it a bet on interest rates that wound up backfiring. Issuers including California’s water resources department and Reading, Pennsylvania, have paid at least $4 billion to banks to end such contracts after the deals failed to protect them from changes in interest rates.
“I’m sure Goldman Sachs does not relish the possibility of losing the ability to do investment banking business with the city of Oakland,” said Robert Fuller, principal at Capital Markets Management LLC, a Hopewell, New Jersey-based swaps adviser to municipalities.
Tiffany Galvin, a Goldman Sachs spokeswoman in New York, declined to comment.
For Goldman Sachs, yielding to Oakland’s request might have produced similar demands from other issuers, said Peter Shapiro, managing director at Swap Financial Group LLC, which represents localities in swaps. The bank has been a key player in the U.S. municipal swaps market, which Shapiro estimates may total as much as $300 billion in contracts and involve about 1,000 local governments and agencies.
Some municipalities that entered into swaps have faced financial strains as falling interest rates inflated their payments as well as the price of exiting the contracts. The agreements were sold to localities as a way to hold down borrowing costs on bonds for public projects such as roads and schools.
The agency that owns the Mercedes-Benz Superdome in New Orleans will sell bonds this year to refinance debt and pay a fee of about $95 million to unwind swaps through a unit of Bank of America Merrill Lynch, which sold the initial agreement.
In June, after staving off insolvency, Detroit borrowed $659.8 million to pay more than $300 million to banks, including JPMorgan Chase & Co., to end swap agreements for a water and sewer unit.
“Banks are not in the business of giving back money that they have a contractual right to,” said Darrell Duffie, a finance professor at Stanford University’s business school in Stanford, California. Had the bank agreed, “there would be a deluge of requests from every swap counter-party that Goldman had.”
Wall Street’s most profitable securities firm before converting to a bank in 2008, Goldman was also the target of Occupy Wall Street protests at the Port of Oakland in 2011. The Oakland Coalition to Stop Goldman Sachs held a demonstration against the swap in July outside the firm’s San Francisco office.
The city paid Goldman a net $3.8 million in 2012 and $16.6 million total from 2008 through 2011, according to Scott Johnson, Oakland’s assistant city administrator. It will owe a projected $3.3 million this year and $10.7 million total from 2014 through 2021. The funds come from annuity revenue out of a closed police and fire retirement system.
“Given the contractual nature of the swap, Goldman Sachs is not agreeable to terminate the swap at $0, a decision the city has been assured was made by Goldman Sachs upper management,” according to a Nov. 14 report by Katano Kasaine, Oakland’s treasurer.
With interest rates falling, it’s to the advantage of borrowers to tear up contracts, Goldman Sachs Chief Executive Officer Lloyd Blankfein said in response to a question about Oakland’s swap at a May 24 shareholders’ meeting in Jersey City, New Jersey.
“That’s not how the financial system could work and were we to do that, we would be frankly paring the interests of our shareholders and the operations of the company,” he said. “I don’t think it’s a fair thing to ask.”
City staff and Goldman Sachs last year discussed a plan to end the swap in 2014 instead of 2021, according to the treasurer’s report. The bank said it wasn’t ready to commit to the plan and needed more time, the report said.
“Goldman Sachs has indicated it is willing to continue to explore options that would be more economical to the city,” the report said.
California’s eighth-largest city, with 396,000 residents, is still dealing with financial strains left from the recession that ended in 2009. Its $51,144 median household income is 17 percent below the state average. It has reduced 720 full-time positions, including a fourth of its police force.
Oakland entered into a so-called synthetic fixed-rate swap with the bank in 1998. It issued bonds to help finance pension obligations and used variable-rate instead of fixed-rate securities, according to reports filed with the city council.
The city was lured by the prospect of upfront cash, said Zennie Abraham, economic adviser to then-Mayor Elihu Harris. California voters had just approved Proposition 218, which limited cities’ ability to raise taxes, said Abraham.
“A lot of the city staff got enamored with the city getting a huge check,” Abraham said. “That was dangled in our face.”
The city realized a $15 million windfall from entering the contract. Oakland agreed to pay a fixed 5.6775 percent until 2021, while the bank was on the hook for a variable rate equal to the Bond Markets Association Index -- 3.09 percent at the time the bonds were issued in 1998.
“It basically put a cap on the rate of interest that the city would be paying,” Johnson said in an interview. He joined the city in 2011 from San Jose, where he was finance director. “It was a risk assessment that the city did.”
In March 2003, the city agreed to change the deal, paying a 5.7 percent interest rate, while the bank paid 65 percent of the one-month London interbank offered rate. That lowered the bank’s rate to 0.9 percent from 1.08 percent. The bank also gave the city $6 million for the reduced payments.
Oakland wound up refinancing the variable-rate debt underlying the swap in 2008, while keeping the swap contract in place. The city has realized a net benefit of about $37.5 million in present-value savings from the swap, even with various refinancings, according to an April report from the treasurer.
Still, such deals began working against Oakland and other municipalities after the Federal Reserve started lowering its benchmark overnight rate in 2007 to bolster the economy. The interest rate has been near zero for four years.
“When someone has a swap where they’re exchanging a fixed rate for a variable rate and the variable rate is being held artificially low, then obviously we’re at a disadvantage,” Johnson said. “We’re asking that Goldman Sachs recognize that and come to the table with some solutions.”
Goldman has limited business interests with the city, according to Johnson. The bank bought the $83 million in notes the city sold in June, offering a 0.21 percent yield in a competitively bid deal.
Goldman has won the right to senior manage two other competitive note deals since 1998 and hasn’t been hired as top underwriter on any negotiated deals for the city, data compiled by Bloomberg show.
When communities try to terminate swaps agreements, they typically ask for a concession rather than nullifying the deal, Shapiro said. In the end, swaps are financial contracts that both parties agree to, said Fuller.
“‘There are times when it was better for us and works for us, there were times it was better for you and worked for you’” Fuller said. “It’s regrettable that it turned out this way for them.”
In municipal trading yesterday, most maturities rallied, leaving yields on 10-year benchmark debt at 1.82 percent, data compiled by Bloomberg show.
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