Jackson Jambalaya

Highlights
*Birmingham and other cities face bankruptcy or financial ruin due to interest rate swaps
*Interest rate swaps were sold to local governments by Wall Street as a way to save money
*In reality these swaps were the equivalent of financing a house note with an adjustable rate
*This week Jackson voted to use such swaps to finance $130 million for the 2002 and 2004 bond issues

Will Jackson meet Birmingham's current fate: a city slowly dragged into bankruptcy after it bet its municipal bonds on complex derivatives? The Jackson City Council approved (4-2 vote) a motion to enter into an interest rate swap for its 2002 and 2004 bonds with Duestche Bank and Rice Bank. Unfortunately for the rest of us, the gang of four who voted for this deal along with City Administrator Rick Hill (who promoted it) probably had no real idea of what they were doing, as many officials in other cities have discovered to their dismay.


Birmingham Blues
Birmingham suffered from a double dilemma: a mandate to upgrade its obsolete sewer system and an inability to pay for such an upgrade without exorbitant fee increases. It entered into an interest rate swap agreement for the bonds it issued to finance the upgrades with JP Morgan and Bear Stearns.

In its simplest terms, an interest rate swap gives a bond issuer (such as a city or county) the ability to take advantage of lower interest rates. While fixed-rate bonds are available to such entities, many choose to issue bonds whose rates (which are paid by the government to the bondholder) adjust on terms ranging from every 30 to 180 days. Issuing such bonds saves the issuer millions of dollars as they tend to have interest rates up to 100 basis points (a basis point is .01%) lower than more conservative fixed-rate bonds. However, the interest rate swap in theory gives the government entity issuing the bonds the security of a fixed-rate payment while allowing them to enjoy the benefits of a lower variable rate.

In an interest rate swap, the municipality enters into an agreement with a counterparty such as Citi or JP Morgan. The city will pay the counterparty an interest rate that is fixed (the length of which is defined in the contract) while the counterparty pays the city a separate payment based on a variable interest rate (This is a swap, which is a two-way cash flow). Remember how adjustable rate mortgages have wrecked the housing industry? Well, a little more complex wheeling and dealing based on adjustable interest rates have managed to blow up city budgets across the country as those variable interest rates devastated cities such as Birmingham when they adjusted in the wrong direction.

Bloomberg reported how Jefferson County, Alabama thought it could use these swaps to its advantage as it fell for some sweet talk from Wall Street:
"The county relied on advice from a bank, JPMorgan Chase & Co., to arrange its funding, rather than use competitive bidding. Like homeowners who took out mortgages they couldn't afford and didn't understand, Jefferson County officials rejected fixed- rate debt and borrowed instead at rates that varied with the market.
The county paid banks $120 million in fees -- six times the prevailing rate -- for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt..." Bloomberg I
"Officials there (in Birmingham) relied on the advice of JP Morgan in 2002 and 2003 while refinancing almost all the $3.2 billion of fixed-rate debt that built sewers into variable-rate bonds coupled with interest-rate swaps.
Costs Spiral: When the insurers guaranteeing the bonds lost their top credit ratings and the auction-rate market seized up in February, the yield on the bonds jumped as high as 10 per cent, from about 3 per cent in January. At the same time, the swaps tied to the debt, instead of protecting against higher rates, backfired. That pushed the sewer system's annual debt costs to $460 million, more than twice the $190 million it collects in revenue..." The trap closes on Jefferson County

When Birmingham tried to escape the death spiral it faced, the bankers from New York turned into Bruno and Vito from Jersey:
"Jefferson County failed to post $184 million in collateral in early March and has been in technical default since then. JP Morgan and other investment banks are on the other side of the swaps.The investment banks want Jefferson county to raise taxes to cover its obligations. Jefferson County wants the Wall Street brokers to renegotiate the swaps and insists it will not raise taxes.
"We are dealing with a virtual immovable force on Wall Street" the Birmingham News quoted Jefferson County Commission President Bettye Fine Collins as saying" Bruno and Vito

It should be noted that several commissioners are currently pushing for the city to declare bankruptcy. The Mayor faces criminal prosecution for allegedly receiving bribes and favors in exchange for the no-bid contracts with the Wall Street Banks. If Birmingham files bankruptcy, it will be the largest municipal bankruptcy in American history.

The Interest Rate Swap blight upon the land
Birmingham is not the only city suffering from the interest rate swap time bomb. The New York Times reported yesterday a plague of variable rates on these swaps afflicts many small towns in Tennessee:
"Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad. Municipalities that bought the derivatives were like homeowners with fixed-rate mortgages who refinanced by taking out lower-interest, variable-rate mortgages. But some local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did...."
Lewisburg, a town of only 11,000, saw its " annual interest payments on the bond had quadrupled to $1 million" this year."

Some municipalities tried to withdraw from these bond market traps:
"In Claiborne County, north of Knoxville, officials said they were recently told by Morgan Keegan bankers that extracting themselves from a municipal bond derivative would cost $3 million, a sum the poor county cannot afford...."
In Mount Juliet, a suburb east of Nashville, city leaders were surprised to discover that the payments on its bonds had increased by 500 percent to $478,000..." New York Times Story

While there are a variety of reasons why the debts skyrocketed, the cities suffering from these increases all had one thing in common: the use of interest-rates swaps that left them exposed to variable interest rates.

Jackson picks up the interest-rate swap gauntlet Jackson's leaders ignored these dangers, as well as the fate of Birmingham, and plunged headfirst into the interest rate swap pool. This week the city council voted 4-2 (Crisler proposed the motion, McLemore seconded it, Bluntson and Tillman voted for it, Weill and Barrett-Simon voted against it) to approve Mr. Hill's recommendations to approve such a swap for nearly $130 million in 2002 and 2004 public works bonds.

Mr. Hill glossed over the exposure to adjustable rates in a story published last week in the Northside Sun:
"The city hopes to swap the fixed interest rate of 4.99 percent for a lower rate on two water and sewer bonds issued in 2002 and 2004.
Officials are now negotiating the terms of the agreement with Duetsche Bank and Rice Financial Products, the two banks that will actually conduct the rate swap. The city has brought on Sterne Agee and Leach Inc., a national investment firm with an office in Jackson, to serve as its financial advisor, as well as two local law firms - Baker Donelson Bearman Caldwell and Berkowitz, and Anthony Simon - to serve as legal counsel for the transaction. In the transaction, the city would hire an underwriter to issue new bonds with variable-rate interest to pay off its current debt. Duetsche and Rice would take those bonds and exchange them with an investor for bonds with a lower fixed interest rate. If a lower interest rate isn’t found, the bank would wait a year and try again. The transaction would save the city between $10 million and $13 million in interest payments over the life of the bond, money that will be paid to the city up front if the city agrees to the deal. Hill said the transactions wouldn’t occur until 2012 and 2014.
HILL said the city can do this because investors search for different types of debt to boost their portfolios. Despite the benefits of the transaction, there are a number of risks the city has to consider. “Right now, the markets are in such a shape that investors might not want to buy variable-rate debt,” he said. In that case, the city would have to re-pay the up front money...." Sun story

One must ask what kind of dope Mr. Hill thinks we are smoking if he expects us to buy this malarky. Investors will be more than happy to buy variable rate debt as long as they think they can squeeze us for every cent of it. The reporter failed to ask Mr. Hill what would happen if the rates adjust? How exposed is Jackson to these toxic variable interest rates? No serious person expects the interest rates to remain near zero as they are now. As interest rates increase (not to mention the effect Obama's deficit spending will have on the bond markets) over the next few years, any deal using these variable rates will cost Jackson much more money. Something ignored by Mr. Hill while he pimped this deal for the loan sharks.

It is also troubling that the city did not advertise for bids on the refinancing. Since the fees for these refinances will cost us up to nearly $3 million, Mr. Hill should have sought competitive bids. What was his criteria for choosing these banks? What are the fees going to be and why are we awarding contracts worth millions in fees without any bidding whatsoever? In fact, the story says the terms are being negotiated. The city council approved these swaps without even knowing the final terms of the agreement. As Mac would say, you CAN'T be serious.

While the article was short on details, the resolution passed by the city council contained some details:
1. There was an original swap agreement in 2002 with two other banks, one of which was replaced by another as its credit rating declined. Someone should ask Harvey why he decided to enter into these loans (One can hear the Melton administration jumping up and down squealing with glee "Its Harvey's fault! It's Harvey's fault!)
2. The swap obligations (payments on the swap) are junior in lien only to the bond liens themselves. Text of resolution

It is interesting to note the resolution says nothing about the city receiving ten million dollars from the banks although it is probably spelled out in the master agreement. Councilman Jeff Weill of Ward 1 voted against the bill and sent this statement to Jackson Jambalaya explaining his vote:
"I had no comfort level with the swap initially proposed last November. Since that time the mayor of Birmingham's been indicted and Attorneys General across the US have convened grand juries looking into these schemes. They are purely fee driven. Even the 'independent' financial advisers who advised the council had an interest in the transaction, not to mention the players and the bond lawyers.
Most of those proposing this deal worked hard to obscure the costs of issuance. As a lawyer and former prosecutor that was a giant red flag to me."

The media and citizens of Jackson should hold Melton, Hill, Crisler, Bluntson, McLemore, and Tillman accountable for trying to push this crap on us. There was no competitive bidding. Jackson is exposed to an adjustable rate agreement similar to those that have devastated other local governments. The fees were not even mentioned or made available to the public yet we are expected to fork over millions of dollars of our money to shysters, bankers, and money pimps, oops, I meant "advisers". While every other municipality is running away from these instruments of financial self-destruction as fast as they can, our leaders instead choose to chain us to a ticking time bomb with these variable rates. If these variable rates go south, Jackson will pay dearly for that ten million dollars of juice it got from the Krauts. We should hold the council's feet to the fire and demand a thorough hearing on this matter as well as opening this entire process to competitive bids. Thanks to these guys, Jackson is going to be just like Birmingham in more ways than one.

Note: Efforts to reach Rick Hill and Harvey Johnson were unsuccessful.
Additional articles:
JP Morgan, facing criminal probe, exits municipal swaps
Same firm advising Birmingham in trouble in New Mexico did similar work after making donations to Richardson
http://www.subprimelosses.com/blog/index.php/2009/03/24/interest-rate-swaps-create-financial-nightmare-for-hospitals-tax-exempt-groups/
Interest rate swaps nightmare for non-profits, hospitals
Jefferson County can't make $636 million debt payment