In the San Francisco Bay area, public transit riders are paying $104 million in higher rider fees to cover the cost of exotic financial insurance known as an interest rate swap. In Detroit, the inability of the city to make interest rate swap payments signaled eventual bankruptcy. So the recent news that the city of Los Angeles wants out of its 2008 interest rate swap insurance contract on a sewer revenue bond is causing concern on Wall Street and beyond.

On Aug. 12, the Los Angeles City Council threatened to stop all business with the Bank of New York Mellon (BNY) and Dexia Bank unless they paid back payments on insurance the city bought. What the city bought was insurance against risk of loss on $281 million municipal wastewater system revenue bonds.

But the city didn’t buy conventional insurance coverage. Instead, officials bought an interest rate swap that provides insurance against loss — as well as the prospect of reaping a big financial gain if interest rates rose significantly. Since the city might have defaulted on the sewer revenue bond if it filed for bankruptcy in the future, the financial insurance would guarantee payment to bondholders and possibly could reap the city a big windfall if interest rates rose.

This swap was more of a calculated gamble by L.A. officials than a predatory banking practice. It is similar to a participating whole life insurance policy where the policyholder shares in any excess profits called dividends. When the sewer bond was issued in 2008, the mortgage meltdown drove up interest rates on municipal bonds. By using a swap, L.A. significantly lowered borrowing costs — by $21.7 million according to the city administrator.

Balks turn down L.A.’s demand

Unsurprisingly, the banks rebuffed the L.A. City Council’s demand. Neither bank was willing to refund past insurance payments because it would mean the other party involved in the swap would have to take a loss. They understood that the city’s request was akin to an individual asking his insurance company to refund his medical, auto or homeowner’s liability insurance payments because he had filed no claims since 2008.

Yet this perspective didn’t occur to any of the 14 L.A. council members who voted unanimously to request that BNY Mellon and Dexia return $65 million in so-called “unfair profits and fees” paid since 2008 on a $151 million interest rate swap on a sewer revenue bond.

Nor did they anticipate the reaction in financial circles. Some analysts believed that by asking for a refund, the city  is signaling it can no longer afford to make the interest payments on the swap that included the sewer bond. The Wall Street Journal and many others saw this as a forewarning of municipal bankruptcy.

But the maneuver played well with those eager for a chance to beat up on big banks. Los Angeles public labor unions accused BNY Mellon and Dexia of “gouging L.A. taxpayers” with “predatory” high-risk deals and supported withholding future business if the banks didn’t refund the sewer bond interest rate swap payments.

How a swap works — and how L.A. hoped to profit

To understand this controversy, it’s important to understand what an interest rate swap is. Let’s assume two people want to swap apples for oranges. If apples cost $1 each and oranges 50 cents each, then a fair trade is to trade one apple for two oranges and vice versa. This is the simple basis of a swap.

But if tomorrow the price of oranges goes up to 60 cents, the person receiving the oranges would get $1.20 in value and can reap a 20 cent windfall. In financial terminology, this is called arbitrage, where one can make more from a trade or from house flipping (“buy low, sell high”).

But instead of a deal where one person wins 20 cents and the other loses out, if both persons agree to negotiate for a share of the 20 cents in higher value, then it becomes a win-win deal, because they also can both lower any costs of borrowing for the transaction.

Such hedging against loss by both parties in a trade when prices go up or down is what drives interest rate swaps. So  it is strange that Los Angeles officials would accuse Wall Street banks of greed when greed is part of the city’s motive for doing an interest rate swap.

Like an underwater mortgage

The sewer bond swap had a negative fair value of $24.7 million as of June 2013, according to city documents. A negative value interest rate swap contract is like an “underwater mortgage” where there is more mortgage owed on a property than what it could be sold for. This is a result of the Federal Reserve’s  Zero Interest Rate Policy, which has made borrowing money more attractive at almost no interest than in 2008 during the financial crisis.

The deal isn’t a complete disaster for the city. As noted above, it lowered borrowing costs by $21.7 million. And the sewer bond insurance swap contract has until 2028 before it expires. If the Federal Reserve significantly raises interest rates during that period, the city’s gamble could yet pay off.

Yet instead of explaining that the city’s sewer bond insurance swap amounted to speculating with public funds, Los Angeles officials are counting on financial illiteracy among the public and the media to sell a dishonest narrative about predatory banks.

If interest rates go up sharply — as some fear because of huge pending government deficits — it’s doubtful that the city of Los Angeles would refund any of its windfall to banks because it doesn’t want to look “greedy.”

By Chriss Street

Last week in my article here, “Misery Index about to soar in CA, US,” I warned that a rise in a combination of inflation and unemployment, known as the Misery Index, could “distort financial markets.” And it could result in “significant capital losses” on their huge bond investments of the U.S. Federal Reserve. These distortions and losses would slam the economy, especially in California.

This week, Morgan Stanley heightened those concerns by stating that, if the economy contracted and inflation continued to rise, the U.S. government could suffer a loss of $547 billion on the Fed’s massive portfolio.

Given California’s heavy dependence on federal spending, the state’s treasury would be hit hard. According to a study by the California Budget Project, “In federal fiscal year (FFY) 2010, which ended September 30, 2010, $333.8 billion in federal funds came to California. Most of those dollars went directly to Californians without passing through the state budget.” Most of that money went to Social Security, Medicare, military pensions and other direct payments to persons.

Also, the study found that, for the state government, federal spending was “$91.5 billion in the 2010-11 budget — approximately 40 percent of total state expenditures.”

If the Fed’s portfolio loss leads to reduced federal-budget expenditures, California would lose the most of any state.

Bernanke testimony

In his semi-annual testimony to Congress on monetary policy and the economy this week, Federal Reserve Chairman Ben Bernanke was forced to try to reassure financial markets that there was only a very low possibility of an imminent financial crisis.  He calmly said, “Where the problem still remains unaddressed is in the longer term. And so it doesn’t quite match to be doing tough policies today when the real problem is a somewhat longer-term problem.”

Bernanke went to great lengths to make the case that central bank money printing and bond speculation were prudent stimuli to reinvigorate the American economy. He specifically pointed out that Fed’s easy-money policies have held down interest rates and helped a revival in the housing market and car sales.  The chairman also pointed out how a weak job market was more responsible than the Fed for keeping inflation low.

But as I had pointed out, the low inflation rate reported in of the Consumer Price Index has been dramatically understated because 41 percent of the index is real estate returns, which have been down over the last four years. And according to the McKinsey Global Institute Commodity Price Index; the prices for food, raw material, metals and energy prices rose over the last four years to historic highs.

During the same period, the price of a gallon of gas rose by 132 percent. And recently the costs of food rose by 8.1 percent. Now that the Fed money-pumping is providing below-market interest-rate financing, real estate inflation is jumping and the CPI will soon spike higher.

Sequestration

President Obama has been desperate over the last two weeks to try to avoid the 2 percent federal spending cuts that are part of the financial sequester.  But even after this modest reduction is implemented, the Congressional Budget Office projects that, over eight years, his administration will have engaged in $7.5 trillion in deficit-spending  and the national debt will almost have doubled.

Bernanke tried to help the president’s cause by uttering the usual concerns that suffering by millions of long-term unemployed was good reason to not make cuts until the economy recovered.

Bernanke was given good marks for his congressional performance.  The stock market rebounded and Diane Swonk, chief economist at Mesirow Financial in Chicago, said of Bernanke’s testimony, “Those worried that the Fed may end large-scale asset purchases prematurely should be reassured.”  But as I remember, those nice folks from Chicago were also very positive in November 2008 with the election of Barack Obama.

Wasn’t that right before the last financial crisis, where the stock market lost 50 percent of value and unemployment skyrocketed to more than 13 percent in California?

CHRISS STREET & PAUL PRESTON

Present “The American Exceptionalism Radio Talk Show”
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By Chriss Street

If there was an Academy of Motion Picture Arts and Sciences award for the best acting performance by a CEO, Jamie Dimon of J.P. Morgan Bank would surely win the Oscar for his dismissal of a $2 billion off-shore derivative loss as “a complete tempest in a teapot.”  Dimon tried to use all his theatrical skills to distract the American public from discovering that the U.S. Federal Reserve’s policy of loaning money to banks at zero-interest-rates has made derivative trading wildly profitable, but made lending to American businesses less profitable.

As fallout from the J.P. Morgan fiasco exposes the bloated derivative activities of major banks, the Federal Reserve will be forced to terminate the zero interest rate policy and let rates rise to retard bank speculative actions.  Higher interest rates will stimulate banks to make more commercial and industrial loans, resulting in higher U.S. economic growth.

Achilles Macris, J.P. Morgan’s CIO in their London office, began using the bank’s access to cheap capital from the Fed to amass a huge over-the-counter derivative gamble that high yield and sovereign debt interest rates would fall, after MF Global suffered a $1.2 billion loss on similar bets and was forced to file for bankruptcy last October 30.

Morgan’s gamble became very profitable after December 21 when the European Central Bank began making $640 billion off three year loans at 1 percent interest, referred to as “Long Term Refinancing Operations” — LTROs — available to the banks of Portugal, Ireland, Italy Greece and Spain — the PIIG countries.  By the end of December, J.P. Morgan’s total derivative exposure was $70.2 trillion on just $1.8 trillion of bank assets, according to the U. S. Controller of the Currency.  Morgan is reported to have continued heavy derivative buying in January and February.  Its profits soared again when the ECB announced LTRO2 as another $714 billion in three year low-interest loans to PIIGS banks.

The stock of J.P. Morgan vaulted from $29 per share in December to $45 a share in March as rumors swirled that Achilles Macris and his London team of six had already made $2-3 billion as high yield and sovereign debt interest rates continued to fall.  A jubilant Jamie Dimon announced that J.P. Morgan would increase its dividend and buy back $15 billion of its stock.

France and Greece

Everything seemed rainbows and unicorns for J.P. Morgan until two weeks ago, when France and Greece elected hardcore leftist candidates who want to abandon austerity spending cuts and increase social welfare spending.  Interest rates on the PIIGS sovereign debt shot back up and J.P. Morgan appears to have suffered a $4-5 billion loss.  It also appears the bank has been unable to limit its losses to $2 billion by selling out of their enormous derivative positions.

Jamie Dimon tried to dismiss the losses by promising heads will roll. But congressional hearings will soon illuminate to American taxpayers that the Fed has provided the capital that has allowed America’s three largest banks to engage in $173 trillion in leveraged derivative speculation:

The derivative exposure of these three banks alone exceeds 11 times the American economy and 2.7 times the economies of all the nations on earth.  On December 30, the derivatives leverage ratio of these three banks stood at 37 times.  Menacingly, this leverage ratio exceeds the average leverage ratio of 32 times assets for Lehman Brothers, Bear Stearns and Merrill Lynch, shortly before the shock of their collapse instigated the start of the Great Recession in 2008.

Federal Reserve Policy

After five years of miserable unemployment numbers and virtually no growth, it seems clear the Federal Reserve’s $2 trillion increase in bank lending at zero interest rates has been better at expanding the international derivatives markets than expanding the American economy.  The Federal Reserve owns much of the blame for this phenomenon.  By keeping interest rates so low, banks were unable to make a rate of return above their cost of capital on traditional lending.

Kansas City Federal Reserve Bank President Thomas Hoenig in a recent interview warned that an extended period of ultra-low interest rates invites speculative behavior:

“When you have zero rates that go on indefinitely, you are inviting future problems.”

The recent J.P. Morgan derivatives fiasco has demonstrated that the Fed’s zero interest rate policy has encouraged risky financial speculation that is highly dangerous and potentially destructive.  It’s time for the Fed to let interest rates rise, so banks can get back to the business of financing America’s real-economy.

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