Chicago Public Schools’ $100 Million Swaps Debacle Demonstrates High Cost of High Finance

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from Naked Capitalism:


Chicago Public Schools’ $100 Million Swaps Debacle Demonstrates High Cost of High Finance
Posted on November 28, 2014 by Yves Smith


I’ve been late to write up an important series published by the Chicago Tribune earlier this month on a costly swaps misadventure by the Chicago Public Schools. Like all too many state and local government entities, the Chicago Public Schools were persuaded to obtain $1 billion of needed ten-year financing not through the time-and-tested route of a simple ten year bond sale but the supposedly cost-saving mechanism of issuing a floating-rate bond and swapping it into a fixed rate. An impressive, expert-vetted analysis of the deal by the Chicago Tribune estimated that the school authority has in fact incurred $100 million in present-value losses on that $1 billion bond issue.

What is important about this story is that the CPS’ sorry experience has been replicated at state and local entities all over the US and abroad, yet remarkably few have been willing to sue. In some cases, it’s likely that rank corruption was involved, that the consultants hired to vet the deal were cronies and not up to the task, or worse, that key people at the issuer were overly close to the banks involved. In other cases, officials are afraid of banks, that if they sue them, they’ll be put on a financing black list and will have trouble fundraising. That’s nonsense by virtue of how competitive and fee-hungry bank are. And the more government authorities that got the nerve to sue, the less noteworthy any particular case would be.

As the series explains, entities like the Chicago Public Schools has previously been protected from their naivete by not having the authority to engage in fancy finance. But the state of Illinois passed legislation in 2003, written by a lawyer at an in-state bond firm, even though no local entity had asked for these new powers. Here is how local governments were set up to be shorn:

The bill specified that any government able to issue at least $10 million in bonds could enter an interest-rate swap, making the deals accessible to towns with populations as small as 12,000. Lawmakers did not put even that restriction on auction-rate bonds.

The law also gave municipal officials explicit permission to raise taxes in order to pay interest on swaps.

Yet despite the potential risks to taxpayers, the bill included few oversight measures or checks on towns and school districts. For example, the bill did not cap the percentage of debt that could be issued at floating rates. In CPS’ case, that amount at one point rose above 40 percent. The state of Illinois, by comparison, is restricted to 20 percent.

Few Illinois government entities took advantage of the new, um, flexibility, but the Chicago Public Schools did in a big way, issuing $1 billion of auction rate securities by 2007 and swapping them into fixed rates. That amount of auction-rate securities issuance was not only more than any other school district in Illinois issued, it was more than was sold by the state of California. Crisis followers no doubt recall that the auction-rate securities market promised investors that the instruments were almost as liquid as money-market funds, and they could get cash back in weekly auction. The reality was that there was not enough investor buying at auctions. Dealers were supporting the auctions and carrying more and more inventory. When the monoline insurers were facing downgrades, which would have left the investment banks with losses (most issues were guaranteed by monolines), dealers dumped their inventories and quit supporting the market. The deals had clauses so that if the investor was unable to get his money back at a weekly auction, the issuer, here meaning Chicago Public Schools, would have to pay a much higher interest rate.

And that’s before you get to the swap losses. .................(more)

The complete piece is at: http://www.nakedcapitalism.com/2014/11/chicago-public-schools-100-million-swaps-debacle-demonstrates-high-cost-high-finance.html