Too Big to Trust? Banks, Schools and the Ongoing Problem of Interest Rate Swaps

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Executive Summary

Philadelphia, like many cities, has faced serious financial difficulties in recent years.  These difficulties have forced the city government to make ends meet by cutting agency budgets, cutting services and raising taxes.  The city trimmed almost $100 million off its budget during 2008 and 2009, and the school district faced a $629 million budget hole just this year, which was closed by laying off teachers and cutting programs for students. 

Philadelphia is not alone.  Two years after the official end of the Great Recession, Too Big to Trust ReportPennsylvania and the nation have yet to recover fully.  Pennsylvania’s unemployment rate was 7.9% in November 2011, and the state would have to add 239,600 jobs to regain its pre-recession employment rate.[1]  Sluggish job growth and weak consumer confidence have dampened tax revenue, causing devastating cuts to public schools and colleges, and leaving local governments with fewer resources to cope with the effects of the economic downturn.  While these financial difficulties may have various causes, large financial institutions are significant culprits.

Large financial institutions played a role in causing the Great Recession.  As the Financial Crisis Inquiry Commission concluded, “Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding.”  The economic fallout of this recession has cost the city, and the nation, greatly. 

The risky and speculative financial instruments that brought down banks and brokerage houses have also cost Pennsylvania taxpayers millions of dollars.  At the instigation of the financial services industry, beginning in 2003, Pennsylvania school districts and municipalities began to use qualified interest rate management agreements (interest rate swaps and swaptions[2]), risky financial instruments that put them on the wrong side of declining interest rates and led them to pay out millions of dollars to investment banks.

The impact has been significant: according to Pennsylvania Auditor General Jack Wagner, 107 school districts and 86 local governments entered into swap agreements related to $14.9 billion in debt between October 2003 and June 2009[3].

Interest payments and cancellation fees associated with these interest rate swaps and swaptions have cost the city hundreds of millions of dollars.  City agencies and the school district entered these financial transactions with financial institutions, many of which received billions of dollars in bailouts following the economic crash.  Many of these financial losses have already been realized, but currently active deals mean the city stands to lose millions more in the years to come.  Overall:

  • The city and school district have lost $331 million in net interest payments and cancellation fees relating to swaps negotiated with bailed out financial institutions such as Wells Fargo, Morgan Stanley and Goldman Sachs, as well as other banks; and
  • The city could potentially lose more than $240 million in additional net interest payments from still-active swaps between the city agencies and the same financial institutions if interest rates continue to remain low.

These financial institutions have profited, while Philadelphians have paid the price through lost city services, lost jobs, and lost school programs.  The financial institutions, on the other hand, have returned to profitability with subsidies from taxpayers—including Philadelphia taxpayers—and with multimillion-dollar contracts with the city.  Moving forward the banks should respond as good corporate citizens of Philadelphia, by refunding a portion of the lucrative cancellation fees they received for terminating bad deals and renegotiate those deals which are currently active.

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Endnotes

[1] Keystone Research Center, http://keystoneresearch.org/issues-guides/pa-economy-track/

[2] A swaption is an option giving the buyer the right to enter into a swap agreement by a specified date.

[3] Office of the Pennsylvania Auditor General. A Special Investigation of the Bethlehem Area School District, Lehigh/Northampton Counties: A Case Study of the Use of Qualified Interest Rate management Agreements (Swaps) by Local Government Units in Pennsylvania, November 2009. http://www.auditorgen.state.pa.us/Reports/Investigations/invBASD111809.pdf