Wall Street Cheats Cities and States: Widows and Orphans Next?
There is apparently no way to avoid being cheated by Wall Street. Even the people you hire to protect you from the wolves are wolves. Look at what happened to the German bank, IKB. It didn’t trust Goldman Sachs, and insisted that an independent third party select the reference securities for the ABACUS deal it bought. Goldman agreed, and then put the wolf, Paulson, into the selection process.
Here is another example: David Rubin, Zevi Wolmark and Evan Zarefsky, and Rubin’s company, CDR Holdings, Inc. (and its subsidiary, Rubin/Chambers), Dunhill Insurance Services, Inc., which is called CDR in the indictment. Yes, this group of charmers got caught and indicted last October. The indictment names co-conspirators only by letters, but Bloomberg now has a list, which includes “Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Lehman Brothers Holdings Inc., Wachovia Corp. and 11 other banks.”
The indictment explains the background. When your City Council decides to build a new school, it sells tax-free municipal bonds to raise the money. Interest on the bonds is not subject to federal or state income taxes, so interest payments are lower than on taxable debt. The bonds are sold, but since the city doesn’t need the money immediately, it wants to earn interest for a short term. It uses a financing vehicle called a Guaranteed Investment Contract, with the charming acronym GIC. The city has to pay federal income tax on the interest income from GICs, unless it jumps through complex hoops.
One of the hoops is to require competitive bidding for GICs. States and municipalities need help with that, so they hire a broker. That was CDR’s business. It owes a fiduciary duty to its customers, to act solely in their interest. It manages the whole process, suggesting the form of the GIC, preparing the specifications for bidding, finding bidders and conducting the auction. The winner pays it a fee, which is included in the calculations for the amount of the bid.
States and municipalities also hire CDR to conduct competitive bidding for other contracts involving municipal funds, such as taxable municipal bonds, interest rate swaps and other derivatives.
The indictment asserts that the banks and CDR engaged in bid rigging over these contracts. The banks picked a winner among themselves. They decided which of them would bid and how much. They paid kickbacks to CDR to ensure the outcome they wanted, hiding them under the term “hedge fees,” allegedly fees for setting up swaps between two of the bidders. CDR told the IRS that it was conducting competitive bidding, so no tax was due. The alleged crimes include anti-trust violations (bid rigging), wire fraud and conspiracy.
The Interest Rate Swap Connection
A large number of states and municipalities bought interest rate swaps. Bloomberg reports that CDR was involved in these transactions too. Someone (Bloomberg isn’t clear) steered the borrowers away from fixed-rate bonds and into selling variable-rate bonds, using swaps to fix their interest payments. How this works: The swap sets an interest rate. If rates rise, the bank pays the borrower the difference, which the borrower uses to pay the increase in interest on the floating-rate bonds. If rates drop, the borrower pays the bank the difference.
In the usual case, if rates drop, the borrower refinances. The swap effectively prevents that, because the borrower would have to keep paying the interest differential to the bank. This forces the borrower to pay a termination fee to the bank. Bloomberg reports that one borrower, the San Francisco Bay Bridge agency, paid $105 million to terminate a swap.
According to Bloomberg,
CDR signed off on interest-rate swaps to municipalities, as banks took hidden fees sometimes 10 times as much as they charged on fixed-rate bond deals, according to data compiled by Bloomberg.
The Moral of the Story
1. You cannot protect yourself from the wolves on Wall Street without powerful regulation and criminal enforcement. Some of our European friends have learned this lesson. Anders Borg, Sweden’s Finance Minister, uses the wolf image: “We now see herd behavior in the markets that are really pack behavior, wolfpack behavior.” Angela Merkel says that speculators are the enemy. Among other things, the German government banned certain short sales, including naked credit default swaps. If only the US Senate would impose similar, potent regulation.
2. It is false that Wall Streeters do business only with sophisticated investors. In fact, unsophisticated investors turn to Wall Street for help. The goal of securities regulation is to protect them. If that regulation is too great, and annoys some sophisticated investors, they can try Germany.