Wall Street Abuses Have Significantly Increased the Economic Problems Currently Faced by State and Local Governments


In “Paying a price for risky schemes,” Atlanta Journal Constitution reporter Russell Grantham presents an excellent overview of how at least a dozen metro governments and nonprofits that issued debt were whipsawed by the “shadow banking system” ? the freezing of the auction rate securities markets and complex derivative contracts called swaps. As a result, they have been forced to pay or owe as much as $394 million that they did not expect to, according to the article, which identifies the borrowers as:

“Atlanta airport, Atlanta water/sewer, Underground Atlanta, Children’s Healthcare of Atlanta, Piedmont Healthcare, Woodruff Arts Center, Georgia Tech, Georgia State University, DeKalb Medical Center, Emory University, Gwinnett Medical Center, Marietta, MARTA, Power South Energy Cooperative, and Cobb County Kennestone Hospital Authority. “

How did this happen? Grantham’s article includes a depiction of “How interest rate swaps work (and sometimes don’t). Traditionally, to fund civic projects, municipal and non-profit borrowers issued long-term bonds with fixed interest payments to be made over, say, 30 years. While a secondary market existed, in which the bond holders could sell their bonds a variable prices if they wanted to, the interest payments remained fixed until maturity.

In an adjacent box, Grantham describes how a swap deal works. The municipal borrower still issues long-term bonds that mature in, say, 30 years. Instead of a fixed rate of interest, however, the municipal borrower pays a lower variable interest rate to the lenders/investors who buy their bonds. (Investors were willing to do that because auctions were held, usually weekly, in which bond holders could sell if they wanted to (they were led by Wall Street to believe), and the bond interest rates would be reset.) At the same time, the municipal borrower entered into a swap contract with a bank (usually a Wall Street bank) in which the borrower would receive a variable payment from the bank (which was supposed to cancel out the variable interest the borrower has to pay out on its bonds) and would make a fixed payment to the bank, which was only a little higher than its outgoing variable payments, but was locked in, supposedly. The net result was supposed to be that the borrower could finance its projects with long-term obligations at a lower interest rate than would otherwise be possible.

What went wrong, according to the article, was everything. When the economic meltdown began in 2008, Lehman Brothers, which was a party to many of the swap deals, went belly up, “credit markets [i.e., auction rate securities markets] that set key short-term interest rates froze up,” and “interest rates dropped as the recession deepened, causing the swaps value to Wall Street firms to soar.”

What also happened, which the article does not spell out, is that when the auctions failed, the interest rate that the municipal borrowers had to pay rose to a penalty rate of, say, 15%, but there was no corresponding rise in the rate that the bank had to pay to the municipal borrower. The result was a net flow of money from the municipal borrower to the bank. As a result, Grantham says:

“Many municipal borrowers were forced to refinance their bonds or face dramatically higher loan payments. And the cost of terminating the deals rose, in some cases, by tens of millions of dollars. All this occurred just as Atlanta and other entities were also cutting jobs and services to deal with growing budget deficits.”

J. Boyd Page, senior partner of Page Perry in Atlanta observed that “This is an arena where Wall Street has really over-stepped its responsibilities. Simply stated, Wall Street banks have taken unfair advantage of many dedicated, hard working civil servants and, in so doing, have harmed taxpayers everywhere. Many of these products are immensely complicated and require advanced degrees in finance or mathematics to fully understand. Very few devoted civil servants have ample training to be able to understand the risks associated with these investments.”

Municipal and non-profit borrowers who were misled by Wall Street’s shadow banking system may have compelling claims to recover their losses. Many such institutions have recognized that they have a responsibility to their constituents to bring such claims.

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. Page Perry’s attorneys are actively involved in counseling institutional and individual investors involving municipal securities. For further information, please contact us.