Americans Clueless Paying Wall Street $20 Billion for SwapsDarrell Preston and Aaron Kuriloff
Seven months after Hurricane Katrina ripped holes in the Superdome’s roof in 2005, Louisiana State Bond Commission members made what they were told would be “the best of a bad situation” in financing the stadium’s renovation.
Acting against the recommendation of their staff, the commissioners voted for a Merrill Lynch & Co. plan to use debt and interest-rate swaps to pay for the job. While the deal helped keep the National Football League’s New Orleans Saints from leaving town -- and the arena got new scoreboards while 12,000 seats were converted to luxury class -- taxpayers became the losers for supporting a winning team.
The cost of financing the work has reached $42 million, almost a quarter of the $187 million spent on Katrina-related repairs and enhancements and three times as much as expected. The deal became so expensive that the state repurchased the debt sold by the New York investment bank to stop the bleeding.
“It was a flawed idea out of the gate,” said Robert Brooks, who teaches financial management at the University of Alabama in Tuscaloosa.
Scores of public officials, including Michael Bennet, now a U.S. senator from Colorado, and Jon Corzine, the former governor of New Jersey, bought the same Wall Street pitch: So-called auction-rate bonds would lower financing costs by allowing them to pay short-term rates, and interest-rate swaps would protect them if markets moved in the wrong direction.
Corzine didn’t respond to a request for comment. A spokesman for Bennet, Adam Bozzi, defended the move made when the senator was superintendent of the Denver public schools, saying that the financing put the district “in much better financial shape.”
Brooks said that it was “no surprise that the leaders went for something with that level of complexity. An auction-rate security with a swap is much more exciting for the officials, but it’s terribly expensive for taxpayers.”
Government overseers often didn’t understand that the market was controlled by the banks that sold the derivatives they claimed would minimize risk, and that could impose penalties when deals unraveled.
From Portland to Puerto Rico, officials gambled with sewer, road, school, pension and stadium financing. Municipal securities made up about half of the $330 billion auction-rate market when it collapsed in February 2008, data compiled by Bloomberg show. Taxpayers have forked over $20 billion in fees for swap agreements in the past five years, according to Andrew Kalotay, chief executive officer of the debt-management firm Andrew Kalotay Associates Inc. in New York.
Public officials, Kalotay said, “think they know what they’re doing, and they screw up.” Few have acknowledged their mistakes. “No one wants to say out loud they’re unsophisticated,” said Marcus Stanley, policy director of the Washington-based nonprofit Americans For Financial Reform, a coalition of unions and civil rights and consumer advocates.
“In most cases, the elected political leadership are part-time amateurs,” said Roger Noll, professor emeritus of economics at Stanford University near Palo Alto, California. “They get a noisy political grassroots movement that wants to subsidize a team, and then they get sold a bill of goods.”
In Louisiana, Treasurer John Neely Kennedy, who serves as bond commission chairman, warned before the Merrill Lynch plan passed in March 2006 that the swaps could backfire. There was so much pressure to overhaul the 37-year-old stadium for the Saints that he said he felt as if he had “a gun to my head.”
The NFL franchise did stay put in the arena, known since October as the Mercedes-Benz Superdome. Not only that, the Saints acquired quarterback Drew Brees, won the Super Bowl in 2010 and will play the San Francisco 49ers in the second round of this year’s playoffs on Jan. 14.
Still, the costs to the state are “outrageously high,” Brooks said. That the auction-rate deal was done in part to satisfy team owner Tom Benson made it all the more imprudent, said Robert Baade, a professor at Lake Forest College near Chicago and co-author of a 2006 study that found subsidizing the Saints after Katrina wouldn’t make economic sense.
The Bayou State’s costs spiraled out of control after banks, reeling from the credit crisis, stopped acting as buyers of last resort at auctions of floating-rate securities.
Rates on the debt surged, going as high as 20 percent. The swaps didn’t cover the difference. Investors shunned the market. “If the banks were cardiologists, they would have been sued and thrown in jail years ago for what they have done,” Brooks said.
‘Ignorance No Excuse’
The Louisiana Stadium and Exposition District did sue, claiming bond-insurer Financial Guaranty Insurance Co., a unit of New York-based FGIC Corp., sold the agency protection that became worthless and that Merrill Lynch fraudulently failed to tell officials everything they needed to know.
Charles “Buddy” Roemer, Louisiana governor from 1988 to 1992, said he doesn’t buy the contention that Tim Coulon, who was the head of the stadium agency at the time of the deal and urged the bond commission to approve it, and the commissioners didn’t have enough information. “I don’t think ignorance is a good excuse here,” Roemer said. “I don’t think unsophistication is a good excuse. All these entities pay large sums for legal and financial advice.”
In May 2010, U.S. District Judge Loretta Preska dismissed the claims against FGIC. The state has appealed. Officials with FGIC didn’t respond to telephone calls seeking comment.
Preska tossed out seven counts against Merrill Lynch, now a subsidiary of Charlotte, North Carolina-based Bank of America Corp., letting stand accusations of breach of fiduciary duty, intentional and negligent misrepresentation and fraud. The bank denied the claims in its response. “LSED and its sophisticated advisers fully understood the risks of the bonds and knowingly accepted those risks in exchange for a lower interest rate,” said William Halldin, a spokesman for the bank, in an e-mail.
Coulon, who left the agency in 2009, declined to be interviewed, saying in an e-mail that he was “proud of the work and creativity” that went into the Superdome project.
Jason Redmond, a spokesman for the treasurer’s office, said Kennedy declined to be interviewed. Greg Bensel, a team spokesman, didn’t respond to a request for an interview with Benson, who bought the Saints in 1985 for $70 million.
Democrat Kathleen Blanco, Louisiana’s governor in 2006, said that even in retrospect the auction-rate bond deal was worth it. “Losing the Saints was not an option, as far as I was concerned,” she said by e-mail. “With no crystal ball it was impossible to predict the colossal failure of the financial system and its attending costs.”
In the end, the money spent to get the Superdome ready for the 2006 football season came mostly from other sources, including the Federal Emergency Management Agency, the NFL and the state general fund. The auction-rate bonds covered only about $40 million, according to financial reports from the stadium district.
Most of the rest of the $294 million the bonds brought in went to refinance earlier borrowing. The price tag -- which was originally expected to be $14 million -- will be at least $42 million, including fees for the securities and swaps, the cost of the auctions and expenses incurred when the bonds were repurchased, according to data compiled by Bloomberg.
The costs have been steep for other auction-rate borrowers. New Jersey, which got into the debt under Corzine, and the Denver schools, which issued the securities under Bennet, later borrowed money to end related interest-rate swap agreements. New Jersey paid $122.6 million in one case, and the school district spent about $62 million.
Denver Schools Respond
Michael Vaughn, a spokesman for the district, said the 2008 deal cut the cost of unfunded liabilities for retirees, facilitated the merger of its pension plan with a state fund and hire more teachers. It allowed the school system “to avoid severe budget cuts,” he said.
Louisiana didn’t need the burden, said state Representative Jim Fannin, a Democrat from Jonesboro. The state this fiscal year cut spending on health care and prisons, canceled workers’ pay raises and eliminated 4,000 positions.
“There are so many other needs,” said Fannin, chairman of the Appropriations Committee of the House of Representatives.
The bonds were another chapter in the financial relationship between the state and the 45-year-old Saints, a team so popular fans filled the stadium during the 20 years it took to notch a winning season, though in the 1980s some started wearing paper bags on their heads during the games.
“We love our Saints,” said Tricia Miller, a lawyer in New Orleans. “The Saints are what keeps our city together, before, during and after Katrina.”
Before the hurricane, Benson had sought a new home for the team. The Superdome lacked the revenue-boosting amenities of stadiums in larger, wealthier markets. In 2001, after he complained it failed to meet league standards, Louisiana agreed to pay the Saints $180.5 million over 10 years, a subsidy meant to put it in the middle of NFL franchises in terms of revenue.
The state had to borrow, from Merrill Lynch and others, to make some of those payments. When the stadium agency in early 2005 started planning to restructure its debt, one goal was to free up money to help fund the subsidies, Whit Kling, director of the bond commission, said at the meeting where the Merrill Lynch auction-rate deal was approved. The bank had been hired after the agency issued a request for proposals through the bond commission in April 2005, according to court documents.
Katrina changed the equation. Louisiana was, as Kennedy, the state treasurer and commission chairman, put it at the meeting, “between a rock and a hard place.”
Revenue from the hotel tax dedicated to paying off Superdome debt had plummeted to about $24 million in 2006 from about $41 million before the hurricane, which killed an estimated 1,400 in New Orleans. The stadium, where more than 25,000 people had taken shelter after much of the city was flooded, needed repairs as well as enhancements.
The Saints were playing “home” games elsewhere, including San Antonio, where Benson owns car dealerships. Not only was he noncommittal about the team’s future, the mayor of San Antonio said they were talking about a relocation to Texas.
Before they voted, Kennedy told commissioners: “I’m not enamored with this proposal.” According to a transcript, he said he thought paying FGIC $13 million for insurance was “unconscionable” and that he was uncomfortable with the swap.
“I just want everybody to understand what we are doing,” Kennedy said. “This is a derivative. It can work in our favor. It can also work not in our favor.”
For his part, Coulon called the deal “the best of a bad situation,” according to the transcript. The Superdome had been an economic force in the city, attracting conventions, concerts and events such as the Essence Music Festival. “It’s not all about the sports franchises,” Coulon said. “It’s about the economic viability of the city, the symbolism of the Dome.”
The plan was approved on a voice vote. And most everything about the deal that could go wrong did.
Credit markets began to melt down as the contagion from the sub-prime-mortgage market spread in 2007. FGIC lost its AAA rating in January 2008, and buyers became less interested in the securities because the lower grade meant there was more risk that they wouldn’t get paid in the event of a default. The auction-rate market fell apart the next month.
The state decided it couldn’t afford the $45 million fee to unwind the swaps associated with the bonds, nor the cost of issuing a new set to pay off the existing securities. It bought the debt back after the Legislature in March 2008 approved the move. Kling said the plan is to hold it until it matures.
While federal law doesn’t allow such purchases, the Internal Revenue Service made exceptions after the auction-rate debacle. The state will have to pay a fee of about $8 million for the privilege, according to Kling.
The bonds earn 1.25 percent now, data compiled by Bloomberg show. “We’re paying ourselves,” Kling said.
In April 2009, the state committed to spending more than $400 million to secure Benson’s promise the team would stay in New Orleans through 2025.
The stadium agency made several improvements to the Superdome, including adding 15 boxes and 3,400 seats close to the team benches, at a cost of $85 million. A company Benson owns, Zelia LLC, bought a mostly empty 26-story building next to the stadium and Benson pledged to renovate it, and the state signed a $153 million, 20-year lease for 320,000 square feet of office space for more than 30 agencies. Benson and the stadium agency signed a contract to redevelop the nearby New Orleans Centre mall. The state promised the Saints as much as $6 million a year if stadium revenue doesn’t meet undisclosed targets.
In October, Superdome naming rights were sold to Daimler AG’s Mercedes-Benz unit for about $60 million. Republican Governor Bobby Jindal said that may produce enough to “significantly reduce or eliminate taxpayer funding currently spent to support the Saints.”
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