Unsophisticated state and local government officials have been sold billions of dollars of flawed financial products by Wall Street banks, leaving taxpayers on the hook for even more. The banks advised the governments to issue auction rate bonds to lower their financing costs and purchase interest rate swaps to protect the governments if the market moved in the wrong direction. The officials did not understand that the market was controlled by the banks and that the banks could impose penalties when the products unraveled, which they did.
Auction rate securities comprised a $330 billion market just before its collapse in February 2008. About half of that was issued by municipalities. Banks sold the municipalities approximately $20 billion of faulty interest rate swaps, a cost ultimately borne by the taxpayers (“Americans Pay Wall St. $20B for Bad Swaps,” Bloomberg).
The article makes one thing clear: Wall Street pros treat government amateurs the way Las Vegas treats most card-counters ? they eat their lunch (unlike Vegas, however, Wall Street owes the duties of a professional to their clients). “In most cases, the elected political leadership are part-time amateurs,” Roger Noll, professor emeritus of economics at Stanford University, was quoted as saying, adding: “They get a noisy political grassroots movement that wants to subsidize a team, and then they get sold a bill of goods.”
That’s what happened in Louisiana. Under enormous pressure to keep the Saints from moving after the Hurricane Katrina devastation, Louisiana undertook to repair and renovate its 37-year-old stadium in New Orleans. Merrill Lynch persuaded the Louisiana State Bond Commission to use a combination of auction rate securities and interest rate swaps to pay for the renovation. The commissioners spent $187 million on repairs and renovations, and $42 million on financing costs ? almost 25 percent of the amount borrowed!
When the auction rate securities market collapsed, ultimately because Wall Street stopped propping it up, the state’s interest rate obligation on the debt soared as high as 20 percent, and the swaps did not cover the difference. It got so expensive that the state repurchased the debt to stop the bleeding, but it could not afford the cost of issuing new debt to pay off the existing debt, nor the $45 million cost to unwind the interest rate swaps, according to the article.
Louisiana sued Merrill Lynch and bond insurer FGIC Corp. The suit claimed in part that Merrill Lynch fraudulently failed to disclose all the material facts and risks of the strategy it recommended, and breached its fiduciary duty in so doing. The court reportedly dismissed the claims against FGIC but let stand the fraud and breach of fiduciary duty claims against Merrill Lynch, which apparently are pending.
Page Perry is an Atlanta-based law firm with over 170 years collective experience protecting investor rights and fighting Wall Street greed.