Interest rate swaps are a perfect example of of free market espoused by neoliberals. Swaps are practically free of regulation, they are purely private deals between consenting corporate adults, and they are a massive part of the financial straight-jacket worn by states and municipalities. They are a transmission belt of money from taxpayers to gigantic banks and their rich owners.
According to the Office of the Comptroller of the Currency, at 9/30/13, the most recent available date, the notional amount of interest rate swaps for all banks is $146.6 trillion. (Table 8.) The top three banks hold $128.3 trillion. It’s been highly profitable for most giant banks. JPMorgan took in $19.9 billion in revenues between 2009 and June 2013. Bank of America made $7.3 billion, and Wells Fargo sucked in $15.3 billion. Only Citibank lost money, to the tune of $5.4 billion. These are estimates; banks don’t report interest rate swaps as a separate line item.
Interest rate swaps are supposed to enable borrowers to obtain the benefit of fixed interest rates when lenders refuse to give them fixed rate loans and insist on making floating rate loans. The way it works is that the parties enter a contract, one written by the bank. They agree to a target rate, say 5%, and an interest index, say, LIBOR. They agree to a nominal amount, usually in multiples of $10 million. Say LIBOR is 3%. Under the contract, the borrower pays the lender an amount equal to 5% – 3% = 2% of $10 million, $200,000. If interest rates go to 6%, the bank pays the borrower 6%-5% = 1% of $10 million, $100,000. In effect, the borrower pays a 5% fixed rate, regardless of LIBOR, and pays a bunch of fees and expenses to the bank.
How did that work out for Detroit? The New York Times Dealbook Blog explains:
Detroit entered into the swap contracts in 2005, when it tapped the municipal bond market for $1.4 billion to put into its workers’ pension funds. Much of the deal was structured with variable-rate debt, and the swaps were intended to work as a hedge, to protect Detroit if interest rates rose. But rates fell, and under those circumstances, the terms of the swaps called for Detroit to make regular payments to UBS and Bank of America. The swaps cost Detroit about $36 million a year.
The point of the transaction was to give Detroit’s pension plan money to invest in the stock market, where it expected to receive a higher rate of return that the 5.8% interest it was paying on the municipal bonds. The wisdom of that choice was questioned by plenty of Detroit politicians not aligned with the mayor, Kwame Kilpatrick, as well as outsiders. (Page 65.) As it happens, investment results were terrible in the first three years. The plan was damaged in the Great Crash, and never recovered. Withdrawals and payments have been substantial. Since the bonds were issued, LIBOR has never exceeded 5.8%, so this was a dead-weight loss to Detroit and a highly profitable transaction for the issuers of the swaps, UBS and Merrill Lynch, now part of Bank of America.
The municipal bonds were downgraded to junk in 2009, which was a default under the swap contracts. So the parties rewrote the swaps and Detroit pledged the proceeds of its casino taxes as collateral.
So now Detroit is in bankruptcy, and it needs to borrow money to fund itself while it tries to reorganize. But to do that, it has to get out of the swap transactions. At the time the bankruptcy was filed, UBS and Bank of America demanded $345 million to terminate the swaps, on top of the money the bankers have collected over the years. As the case moved forward, the banks negotiated over the termination fee, and agreed to accept $165 million. The Bankruptcy Judge refused to accept that settlement, saying that the collateral arrangement was likely illegal because the pledge was not one of the allowed uses of casino taxes under Michigan law.
It’s a good thing Detroit has this legal argument, because US Courts treat swaps contracts as bargains between equals, and strictly enforce them. You might think that if there is a known government effort to keep interest rates low, a swaps contract failed in its intended purpose and should be cancelled, or at least modified to produce some kind of equitable outcome. But that is utterly beyond the comprehension of Judges.
Banks were able to use the free market in politicians to secure themselves in bankruptcy. The legislators who passed the amendments to the Bankruptcy Code, including a number of prominent Democrats, handed banks a huge benefit: derivatives, including interest rate swaps, cannot be modified in bankruptcy. The debtor is on the hook for all of the losses. The amounts used to pay banks are taken directly from all unsecured creditors. In Detroit’s case, that includes the workers whose pensions will be cut, and municipal bond investors.
The Fed has kept interest rates at historically low levels. That insures a steady flow of money to banks. As Bloomberg explains, when interest rates rise, it will have a big impact on bank earnings.
I haven’t discussed the well-known corruption in setting of LIBOR rates, which may or may not have affected Detroit, recent disclosures of front-running in interest rate swaps, or corruption in the arrangement of deals as happened in Jefferson County Alabama. I haven’t tried to explain why states and municipalities are poor candidates for swaps, and I haven’t looked at the impact of swaps on cities and states around the country; read this by Mike Elk for an overview.
Banks have made huge profits from taxpayers because the Fed kept interest rates low. Skipping past all the fraud, that’s your Free Market, Mr. Tea Party Conservative. Enjoy.