June 9 (Bloomberg) -- An arbitration ruling in favor of an Alabama sewer company that fought its bank and recouped payments on failed interest-rate hedges may have implications for municipalities facing similar fees.
Baldwin County Sewer Service LLC, which serves almost 15,000 customers in southern Alabama, sold variable-rate debt starting in 2002 and entered interest-rate swaps to lower borrowing expenses, only to have the agreements blow up and raise costs.
An American Arbitration Association panel ruled for the utility. In a March decision, it found “a continuing but hidden fraud” when the swaps didn’t work as promised after the variable-rate market crumbled in 2008 during the recession. The arbitrators told Birmingham-based Regions Bank to pay $7.4 million, the net amount of swaps payments the utility made.
“The bank was unable or unwilling to work with us after the market collapsed,” said Gerry McManus, chief financial officer of the utility, based in Summerdale, east of Mobile Bay on the Gulf Coast.
“If you buy something and it doesn’t work, you take it back,” he said. “The swap didn’t work the way they said it was supposed to, so we went to arbitration to make them take it back.”
The settlement has parallels in the $3.7 trillion municipal market, where borrowers from cities to universities have paid at least $5 billion in fees to banks that sold them swaps that failed following the financial crisis, according to data compiled by Bloomberg. In Los Angeles, a city council member is pushing to unwind swaps that have cost the metropolis $65 million.
The swaps are agreements, usually between a bank and a borrower, to exchange interest payments. The contracts were intended to protect issuers from the risk of rising interest rates. With the Federal Reserve holding its benchmark overnight rate close to zero since 2008 to help jump-start the economy, the Baldwin County utility and municipalities were left making payments that exceeded the amount they received, or owing termination fees to exit the instruments.
Swap payments contributed to the strain on Jefferson County, Alabama, the largest municipal bankruptcy on record before Detroit filed last year. As it struggles to emerge from bankruptcy, Detroit is paying $85 million to end swaps. Borrowers from Denver’s schools to the state authority in Louisiana that owns the Mercedes-Benz Superdome have paid to exit the agreements.
“This is a story that has been repeated elsewhere, including the municipal-bond market,” said Joseph Fichera, chief executive officer of Saber Partners LLC, a New York financial adviser to companies and governments. “It offers insight into how small issuers are vulnerable and can be abused by bankers. That’s why fair-dealing rules well before the credit crisis talked about protecting issuers who must rely on bankers.”
From 2002 to 2007, the Baldwin County sewer company borrowed about $42 million through variable-rate debt, working with Regions Bank’s predecessor, AmSouth Bank, according to the arbitrator’s ruling. It also entered three swap agreements from 2005 to 2007. In 2006 and 2007, the hedges worked as intended, saving money.
The utility’s understanding was that the swap had given it a fixed rate. Yet when financial markets convulsed in 2008, the bank had to buy back the debt and the utility was locked into paying a higher rate. Since then, the rate it receives under the swap agreements has fallen along with the Fed’s benchmark. With the mismatch, the utility wound up paying a net $7.4 million on the swap since 2008.
The arbitrator found “a pervasive failure of the bank to communicate the true risks” of the swap and “active misrepresentations of the financial obligations” the utility faced. The ruling quoted one bank employee as saying the bank’s relationship managers handling the utility had a “total lack of understanding of interest-rate swaps.”
The utility could have paid $8 million to get out of the swap, said Billy Bonner, its attorney.
“There was a big disconnect between what the products could do and what the people selling them said the products could do,” said Bonner, an attorney with Cunningham Bounds LLC in Mobile. “My client was in a position where they couldn’t afford to pay it off.”
Regions Bank, a unit of Regions Financial Corp., declined to comment on the arbitration, said a spokeswoman, Evelyn Mitchell.
After the financial crisis, the bank “worked with clients to mitigate the impact of these unprecedented market conditions by voluntarily restructuring such transactions whenever possible, and successfully resolved the majority of these matters out of court some time ago,” she said.
Bonner said his client’s situation is similar to that of many municipalities because the legal wording in the swaps documents “was so much in favor of the bankers that a lot of people think they can’t get out of them.”
Though local-government borrowers have been reluctant to fight back over swap payments, many have considered it, said Robert Fuller, a principal at Capital Markets Management LLC, a Hopewell, New Jersey-based swaps adviser to municipalities. They are often deterred by wording in the agreements in which they acknowledge that they understand the contracts.
“The big question is whether swap providers explained the risks fully to issuers,” said Fuller. “There are egregious cases out there where people didn’t understand what they were doing. It wasn’t a level playing field.”
Former U.S. Representative Bradley Miller said he is planning to meet in coming weeks with the Los Angeles city council, where Councilman Paul Koretz is seeking to unwind swaps with Bank of New York Mellon Corp. and Dexia SA. Miller, a North Carolina Democrat, said he has been talking with public-worker unions about how to get municipalities to recover funds on money-losing swaps.
Kevin Heine, a spokesman for New York-based BNY Mellon, declined to comment. Caroline Junius-Tchekhoff, a spokeswoman for Brussels-based Dexia, didn’t immediately respond to an e-mail sent after business hours.
The Los Angeles city administrative officer issued a report in May defending the swap, and recommended not to terminate the deal.
Miller said that he has read the Baldwin County decision and that he has been exploring filing arbitration for municipalities to recoup costs on some of the arrangements.
“Those transactions were not very good deals for municipalities from the outset,” said Miller, now an attorney with New York-based Grais & Ellsworth LLP. The Baldwin County transaction “appears essentially identical to the financing deals that were prevalent for public entities in the last decade.”
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