There are 7 stages to executing a successful sting operation. Whether this
is the modus operandi behind the Sultans of Swap operating in the $605 Trillion
OTC Derivatives market or just simple coincidence, I will leave it to you shrewd
reader to determine. The seven stages do however offer us an instructive theater
guide to better understand these murky instruments called Interest Rate Swaps.
In Act II of our fictional play before we broke for Intermission, we saw the
mechanics of how our Sting might be perpetrated. We saw how our PATSIES were "Fearing
the Gearing" and being forced to rewrite their existing SWAP contracts
with horrendous fees and collateral requirements. This is money that the public
purse didn't budget for and has no hope of raising. What will our PATSIES do
now? They have little choice -either pay the shylock's usury fees or sue!
Once again our audience was witness to some strange happening when the lights
came up during the intermission.
Like a wave, the news of angry PATSIES taking their grievances to the courts
surged all along the global shorelines. Let's take a quick world tour to see
the carnage showing up in the court rooms.
SMOKING GUNS & FOILED GETAWAYS
CITY OF MILAN, ITALY
ONE of the great advantages of financial innovation, it was often said,
was that risk would end up going to those best qualified to hold it. In fact,
much of it seems to have ended up in the hands of those least able to understand
it. How some of it got there may soon be revealed in an Italian court.
On March 17th four big banks, 11 bankers and two former city officials were
charged with fraud in connection with the sale of interest-rate derivatives
to the city of Milan. The trial is due to start in May. The prosecution relates
to a huge bet on interest rates that the four banks -- UBS, JPMorgan Chase,
Deutsche Bank and Hypo Real Estate's DEPFA unit -- helped the city authorities
to take in 2005. The banks helped arrange the sale of €1.7 billion ($2.3
billion) of bonds for the city and then also helped it swap the fixed interest
rate it was paying on the bonds for a lower, floating rate. Part of the contract
is thought to have involved a "collar", a way of limiting the range of outcomes
on a bet, which protected Milan from rising rates but which also meant it
would have to pay out if they fell.
The city claims that it was originally promised interest savings of about €60m
on the deal but has now made big losses because interest rates have fallen,
triggering payments to the banks. Bankers with knowledge of the transaction
claim that, in fact, the city has benefited from offsetting gains as the
interest rate it pays on the underlying debt has fallen too. The prosecution
also claims that the banks charged more than €100m in fees that were
built into the price of the swaps and were not properly disclosed to city
officials. The banks all deny any wrongdoing.
The outcome of the case will be closely watched elsewhere. In Italy alone,
local municipalities had derivatives exposures with a face value of €25
billion last year, according to the Bank of Italy. Some academics reckon
that losses on these may go as high as €8 billion. In many of these
cases local authorities swapped fixed rates for floating ones, only for collars
incorporated into the deals to leave them with losses as interest rates fell.
In other cases, losses may only start to show when rates move the other way.
Had their bets paid off, however, it seems unlikely that any cities would
be crying foul. (1)
CITY OF LEIPZIG, GERMANY
In Germany scores of public authorities signed contracts that they seem
not to have understood. In Leipzig the courts have been asked to rule in
a dispute between the city and UBS. That case relates to a complex sale-and-leaseback
agreement that the city signed for its local waterworks. Part of the deal
reportedly entailed the city agreeing to insure a portfolio of loans against
default through a collateralised-debt obligation (CDO). Making good on those
loans may bankrupt the city.
In all, about 100 German local authorities are thought to have entered
into sale-and-leaseback agreements with American investors over the
past decade in a bid to take advantage of loopholes in tax laws. In many
of these deals local municipalities unwittingly agreed to take on credit
risks for various counterparties, exposing them to demands for collateral
as the ratings of institutions such as AIG, an American insurer, fell.
We started in Act I with Interest Rate Swaps in Greece. In Act II we broadened
our discussion to the EU and touched briefly on the US. Now we see the following
in the US.
HUNDREDS OF US MUNICIPALITIES
"Hundreds of U.S. municipalities are losing money on interest-rate bets
they made during the bull market in hopes of protecting themselves from higher
rates. The deals backfired when rates fell, shriveling the sums paid to municipalities.
Now some are criticizing Wall Street and trying to exit the contracts. ..
Government agencies that saw the transactions as a cushion against fiscal
surprises now are being squeezed by the arrangements. The supply of municipal
derivatives swelled to more than $500 billion before falling in the past
two years, estimates Matt Fabian, managing director at research firm Municipal
Market Advisors. Moody's Investors Service says the surge was fueled by Wall
Street marketing efforts, demand from state and local governments and "relatively
permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both
of which are taking steps to tighten rules.
Many of the deals generated higher fees for securities firms than traditional
fixed-rate debt. Government officials, for their part, entered the deals
in hopes of reducing borrowing costs. The swaps were introduced in many cases
along with floating-rate debt that municipalities issued because it was cheaper
than traditional fixed-rate debt. Lower interest rates have served them well
on this; their borrowing got cheaper.
But municipalities also added swaps to the mix, promising to pay a fixed
rate to banks, often 3% or more, while receiving payments from banks that
vary with interest rates. On the swaps, the municipalities generally have
been losers, as the interest that banks have to pay them have often fallen
below 0.5%. Government budgets are stretched thin, prompting officials to
look for dollars wherever they can. The clashes over the swaps come amid
growing scrutiny of the municipal-bond market, where the U.S. government
is investigating whether there was bid rigging in certain cases." (7)
CHICAGO, DENVER, KANSAS CITY, PHILADELPHIA, MASSACHUSETTS, NEW JERSEY, NEW
YORK & OREGON
"The Service Employees International Union said Chicago, Denver, Kansas
City, Philadelphia, Massachusetts, New Jersey, New York and Oregon all are
in the hole on swaps agreements they made with financial firms. The required
payments range from a few million dollars to more than $100 million a year,
the union said. Such deals are deepening the misery faced by state and local
governments throughout the U.S., already facing their worst financial squeeze
in decades because of shrinking tax revenue and stubbornly high pensions
and other costs."(7)
In Pennsylvania, 107 school districts entered into interest-rate swap agreements
from October 2003 to last June. At least three have terminated them. Under
one deal, the Bethlehem, Pa., school district had to pay $12.3 million to
terminate a swap with J.P Morgan Chase & Co., according to state auditor
general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have
proposed restrictions on municipalities' ability to use swaps. "It's gambling
with the public's money," Mr. Wagner said. "Elected officials are simply
no match for the investment banker that's selling the deal." (7)
While the investigation focused on the Bethlehem Area School District, Wagner
called his report a "case study" of the use of swaps by all local governments
in Pennsylvania. The Department of Community and Economic Development's records
indicate that 626 swap filings were made in Pennsylvania between October
2003 and June 2009, which related to $14.9 billion in debt. The precise
number of different swaps and the precise amount of debt cannot be determined
because the DCED data may include some double-counting. During this time
period, 107 of Pennsylvania's 500 school districts, or 21.4 percent, and
86 other local governments reported to DCED that they entered into swap agreements.
At least 13 investment firms, including Citibank, Goldman Sachs, J.P. Morgan,
and Morgan Stanley, have entered into swap agreements with Pennsylvania school
districts and other local governments. (8)
CITY OF LOS ANGELES
Municipalities in America are also grappling with derivative contracts they
barely understand. The city of Los Angeles is pressing Bank of New York Mellon
to soften the terms of an interest-rate swap on $443m of bonds that is costing
the city money because rates fell. (1)
The Los Angeles city council approved a measure this month instructing city
officials to try to renegotiate an interest-rate deal with Bank
of New York Mellon Corp. and Belgian-French bank Dexia SA.
The pact, reached in 2006 to help fund the city's wastewater system, currently
is costing the city about $20 million a year. The banks declined to say how
they would respond to a request to renegotiate.(7)
JEFFERSON COUNTY, ALABAMA
Jefferson County in Alabama is teetering on the edge of bankruptcy after
it entered into swaps that were worth more than $5.4 billion at their peak.
"Jefferson County in Alabama is on the brink of bankruptcy after sinking
100 percent of its $5 million sewer system financing into swaps. JP Morgan
and CDR were also involved there."(3)
They were touted as a state-of-the-art financing tool that would help New
Mexico stretch its highway improvement dollars. Nearly five years later,
state officials are trying to keep the $420 million in fancy financing from
turning sour. In the last six months, one of the banks involved in the so-called
interest rate swaps has gone bankrupt and the state has had to post about
$16 million in collateral because the value of the investments dropped. That's
in addition to major political fallout. The swaps and how a California company
was selected to handle them are at the center of a federal grand jury investigation
that derailed Gov. Bill Richardson's nomination as commerce secretary. (2)(3)
Escaping isn't cheap or easy. Under a transaction between Oakland, Calif.,
and a Goldman
Sachs Group-backed venture, Goldman paid the city $15 million in 1997
and $6 million in 2003, according to Oakland financial reports. But now,
the city stands to lose about $5 million this year. That money "is coming
out of taxpayers' pockets and could be used for other things," said Rebecca
Kaplan, a city council member. She wants the city to renegotiate. But the
city faces a $19 million termination payment. Oakland officials didn't respond
to requests for comment. (7)
SAN FRANSICO BAY AREA TOLL AUTHORITY
Last August, a unit of bond insurer Ambac
Financial Group sued the Bay Area Toll Authority for payments it said
it was owed under various swap agreements. The authority paid Ambac $104.6
million to terminate the swaps after the insurer's credit ratings were
downgraded and bonds associated with the swaps were retired. Ambac claims
it is owed $156.6 million under the agreements. The toll authority, which
is fighting the claim, said it made the payment, and Ambac sued for the
other part of what it says it is owed. An Ambac lawyer couldn't be reached
Richmond, Calif., is expected to restructure a $65 million agreement with Royal
Bank of Canada that could cost the struggling city an estimated $3.5
million a year, based on current interest rates. Under the revised deal,
Richmond would make smaller, more regular payments to the bank over time.
In November, RBC and city officials rejiggered a separate transaction that
would have cost Richmond about $2.5 million. An RBC spokesman said bank
officials are working with the city to "restructure the underlying bonds
in a way that best serves the city's interests and those of its residents." The "goal
of the original transaction was to lower borrowing costs for the city," the
bank spokesman said, adding that the bonds didn't perform s anticipated
because of downgrades at bond insurers that backed them. Richmond's vice
mayor, Jeff Ritterman, said he still is reviewing next month's proposed
restructuring. Financial woes have forced Richmond to cut its budget and
lay off employees. (7)
NEW YORK STATE
New York State provides a good example. An Oct. 30, 2009, filing describing
its swaps shows that for the most recent fiscal year, April 2008 to March
2009, the state paid $103 million to terminate roughly $2 billion worth of
swaps -- more than a quarter of which resulted from the Lehman bankruptcy
in September 2008. (2)(5)
COLORADO - DENVER TEACHERS' PENSION
DPS (Denver Public Schools) entered into negotiations with JP Morgan and
CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings
and other properties. DPS then began discussion to enter into an interest-rate
swap agreement with JP Morgan, Bank of America and the Royal Bank of Canada.
We believe that following ensued: DPS entered into a swap transaction, believing
that interest rates would stay high. As recent financial news tells us, interest
rates fell. We are concerned that this may have translated to a loss of taxpayer
EIGHT CALIFORNIA MUNICIPALITIES
Eight California municipalities, including Los Angeles, Fresno and San Diego
County, filed civil class-action, or group lawsuits. The suits, most of which
were consolidated with others in U.S. District Court in New York City, allege
that banks colluded by deliberately losing bids in exchange for winning one
in the future, providing so-called courtesy bids, secretly compensating losing
bidders and allowing banks to see other bids.
Brokers participated in the collusion by facilitating communication among
banks and sharing in illegal profits, the civil class-action suits allege.
... And on and on. Get the message?
After a long Intermission, let us get back to the conclusion of our play.
ACT III - THE GET AWAY
third act is the unraveling of the plot. The characters involved in the heist
will be turned against one another or one of the characters will have made
arrangements with some outside party, who will interfere. Normally, most
of or all the characters involved in the heist will end up dead, captured
by the law, or without any of the loot; however, it is becoming increasingly
common for the conspirators to be successful, particularly if the target
is portrayed as being of low moral standing, such as casinos, corrupt organisations
or individuals, or fellow criminals.
Act III begins with all our actors on stage. The PATSIES are scared. They
finally understand their Interest Rate Swap and realize what they or the
political predecessor had agreed to. Do they take the Greek option and come
clean by blaming it all on the previous government? To most this is not an
option. Needing help, they have assembled all the actors to give them advice.
What the endless list of legal proceedings above tells us is:
1- Swaps have permeated into every facet of local, municipal, city and state
2- Swaps are a major financial instrument being used broadly in debtor nations
3- When the PATSIES find themselves in the gears they more often than not sue.
They plead ignorance, not too dissimilar to US homeowners who expected to make
a killing on their overleveraged McMansion. All are turning out to be very
What should be readily apparent to the shrewd observer is that the biggest
debtor in the world, with the least means of paying and an international reputation
for devious behavior, is missing. Where is Uncle Sam in all this?
Prima Facie says Uncle Sam must have participated in some minor fashion.
We are going to try something different in our play. For those who have seen
Avatar in the cinema, you will recall you were given special glasses so you
could view the show in 3D and therefore get the full impact of the presentation.
We are going to do the same thing but with a modern day "internet" twist so
you see the reality of all this.
I invite you to click the following link - read the complaint - (at least
the yellow highlighted section) - then hit the back button on your browser
before we continue. Ready? CLICK
[NOTE: FOR LEGAL REASONS THE COMPLAINT CAN NOT BE VIEWED
ANY PLACE OTHER THAN VIA THIS LINK]
If this doesn't sit you up straight then you need
to check for a pulse!
I am sorry dear reader, the getaway has already happened! The masked getaway
happened New Year's Eve while we were all preparing to party. I believe ladies
and gentlemen you have just witnessed a near perfect getaway! To me, the most
probable justification for such an unprecedented action would be a collateral
call on US government obligations of historic proportions. There are
of course other possibilities.
Just in case some of our readers don't yet realize the significance of what
happened, I can assure you that you will. Everyone will eventually pay through
our servitude with higher taxes, reduced entitlement programs and a much lower
standard of living for years to come, if the facts in this complaint are valid.
I am not a conspiracy buff. I believe in Occam's Razor. The simplest answer
is likely the answer and not to assign suspicions to more complicated possibilities
or sinister people. In my opinion, what is going on here is not conspiracy
but rather just plain stupidity sprinkled heavily with greed, unintended
consequences, moral hazard, hubris and the remnants of the Greenspan PUT.
Sure there are plots and strategies, but they will be noise when the $605T
in derivatives start to unwind. Yes, $605T has a $3.7T net credit exposure
but there are $36T CDS (Credit Default Swaps) that must be paid and not one
person has accrued a cent for that payout. Everyone expects to be 'out of town'
by that time! Everyone has their eye on the exit without trying to draw too
much attention. It is still former Citigroup CEO Chuck Princes' lament: "as
long as the music is playing, you've got to get up and dance!".
I AM ACCUSING NO ONE OF ANY CRIMES. How can I be accusatory in what
is predominately a completely unregulated, non-exchange traded, off-shore,
off-balance sheet, modern day wild west? What laws other than contract and
tax laws? All the Sultans of Swaps are likely acting according to the letter
of the few domestic laws applicable and in the manner carefully crafted by
their legions of highly paid litigators. Even if effective legislation existed,
there will still be examples of wayward behavior when the amounts of money
involved are in the 100's of millions and billions. Unethical and illegal behavior
unfortunately should be fully expected. This is why laws must be comprehensive,
unambiguous and harshly enforced. Former Fed Chairman Greenspan's 'laissez
-faire' philosophy was nothing short of naïve irresponsibility that has
resulted in the global financial system being placed in a criminally tenuous
The actors in my estimation who are most at fault in our play are the sleepy
eyed DIRECTORS and specifically the House of Representatives Finance Committee
- chaired by Barney Frank and the US Senate Banking Committee - chaired by
Christopher Dodd. If you are looking to assign responsibility for this mess,
it begins and ends there.
The Sultans of Swap have proven that capitalism works brilliantly! In the
US Gilded Age of Robbers Barons, capitalism also worked magnificently. Our
great grandfathers understood rampant greed first hand and knew that smart
legislation and regulatory enforcement were mandatory. They also knew guards
must always man the sentinels. We are coming up on two years since the financial
crisis erupted. What meaningful legislative bill (if any) has been passed?
If we are this slow arriving at the scene of the crime, how can we possibly
believe we can out run the crooks? We will always be 'a dollar short and pound
light' operating within the current legislative framework.
Whistleblower Harry Markopolos testified before the Madoff Congressional Hearings,
that the US legislative process and regulatory enforcement are seriously ill-equipped
to either understand the financial world we now operate in or stay abreast
of the breathtaking advances in structured finance. I don't want to appear
cynical, but I see it as NASA level rocket scientists being supervised by politicians
who likely failed high school algebra. They don't even know what questions
to ask. Unfortunately the people ALWAYS willing to help the legislators with
both the questions and answers are the Washington army of paid lobbyists. Lobbyists,
as we are all acutely aware, have never been accused of having the public interest
as their prime motivator. So who will tell the emperor he has no clothes? Remember,
it is ultimately our pockets that are being picked.
GOVERNMENT IS NO LONGER SERVING THE PEOPLE!
Some would argue it is no longer a government for the people.
White Collar crime has been interesting to watch over the last 10 years. I
used to have a filing tag entitled 'malfeasants'. By 2005 it had become such
a large file I had to start breaking it down into sub categories. It was very
telling to me that something was seriously amiss morally.
I was on the conference call when Jeff Skilling stepped down, Ken Lay took
over Enron and Andy Fastow explained that Enron's problem was the 'short crowd'.
I heard the same 'short seller' refrain during Bear Stearns and Lehman just
days before they both collapsed. I heard it again earlier this month from the
Greek Minister of Finance and even Angela Merkel and Nicolas Sarkozy. It never
changes. I have concluded it takes two - an incompetent PATSY and someone with
I remember Bernie Evers, the founder and CEO of the Wall Street darling stock,
WorldCom, weeping as he was led away in handcuffs while hearing all the townspeople
and church parishioners saying how honest he was. I recall Dennis Kozlowski
the CEO of Tyco, a beaten man and imprisoned man, watching his wife desert
him even after spending millions of Tyco shareholder money on an exotic island
birthday party for her. I watched Joseph Nacchio's meteoric rise after leaving
ATT to lift Qwest to prominence only to be sentenced to six years behind bars.
The message is that none of these men thought of themselves as criminals. They
perceived themselves as tough minded businessmen taking advantage of legal
loopholes for competitive advantage, with a business STRATEGY that the lawyers
felt they could defend in court. It was worth the business risk of being challenged
and possibly receiving inconsequential fines. It took irate public and panicked
politicians to force the penalties to match the impact of the crimes.
If you notice, all these examples are from the dotcom bubble. I don't recall
anyone being led away in handcuffs since the largest financial crisis in modern
times has occurred. The Sultans of Swap are ripe for the wrath of public anger
when real interest rates rise, taxes are increased, retirement entitlement
promises are slashed and shortages squeeze the life out of the public in the
years to come.
The public in Iceland would have made Johnny Depp proud when they said 'forget
about it' in a public referendum concerning Iceland's debt. This was
a monumental stand that got little US media attention. We are hearing the
Greek public say NO! We are seeing US Tea Parties say NO. Scott Brown's stunning
election in the bluest of blue states was the public saying NO! We are now
hearing the Service Employees International Union (SEIU) say NO!
What does it mean to our Sultans of Swap? Their STRATEGY is built on certain
People pay their taxes; therefore Sovereign Debt is the Holy Grail
Economic growth may slow but is continuous and will outstrip the growth
of cumulative debt payments
Potential penalties for possible regulatory actions will be insignificant
compared to the 'Vig' or the 'Take' or the 'Sting'. It is worth the business
All of these 'truisms' for the first time in my lifetime now solicit questions.
The famous actor Lon Chaney starred in the 1914 film The
Embezzler. The silent era plot could have been our theater guide
for this play. I felt it was unfair to the vast majority of the Sultans
who are simply providing 'legally' innovative solutions to fulfill their
constituents' and clients' addictions.
Embezzlementis the act of dishonestly appropriating or secreting
assets, usually financial in nature, by one or more individuals to whom such
assets have been entrusted. Wikipedia
Gordon T. Long has been publically offering his financial and economic writing
since 2010, following a career internationally in technology, senior management & investment
finance. He brings a unique perspective to macroeconomic analysis because
of his broad background, which is not typically found or available to the
Mr. Long was a senior group executive with IBM and Motorola for over 20 years.
Earlier in his career he was involved in Sales, Marketing & Service of
computing and network communications solutions across an extensive array of
industries. He subsequently held senior positions, which included: VP & General
Manager, Four Phase (Canada); Vice President Operations, Motorola (MISL -
Canada); Vice President Engineering & Officer, Motorola (Codex - USA).
After a career with Fortune 500 corporations, he became a senior officer of
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CBEX), where he spearheaded global expansion as Executive VP & General
In 1995, he founded the LCM Groupe in Paris, France to specialize in the rapidly
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Gordon T. Long is a graduate Engineer, University of Waterloo (Canada) in
Thermodynamics-Fluid Mechanics (Aerodynamics). On graduation from an intensive
5 year specialized Co-operative Engineering program he pursued graduate business
studies at the prestigious Ivy Business School, University of Western Ontario
(Canada) on a Northern & Central Gas Corporation Scholarship. He was subsequently
selected to attend advanced one year training with the IBM Corporation in
New York prior to starting his career with IBM.
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