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Blagojevich’s expensive swaps are about to cost Illinois even more money

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Illinois

* Press release…

Sen. Daniel Biss (D-Evanston) today called on Gov. Bruce Rauner to seek to renegotiate lucrative interest-rate swap deals that send $6 million in taxpayer money to big banks every month at the expense of Illinois’ poorest residents and struggling college students.

An alarming new report indicates the state of Illinois is engaging in the same kinds of interest-rate swap deals that crippled the finances of the City of Chicago and Chicago Public Schools. So-called “swap” arrangements perversely penalize the state for low interest rates caused by the global financial crisis.

Illinois has spent $618 million on such swaps already, and the total cost to taxpayers could climb to $1.45 billion by 2033, when the deals are set to end. In addition, according to the report, taxpayers could be on the hook for $124 million in termination penalties as soon as November, depending on how long budget negotiations are delayed.

Biss noted that a great deal of harm is being done to the state’s most vulnerable residents – the poor, the elderly, the disabled and struggling college students – as a result of the current budget impasse.

“In this environment we have an obligation to pursue every possible avenue to relieve fiscal pressure, and if seniors, children and the disabled are being forced to sacrifice, then there’s no reason for Wall Street to remain untouched,” Biss said. “We in the legislature have a responsibility to the people of Illinois to explore these questions and do our best to recover any legally available funds.”

* The International Business Times has a very good article on this…

An interest rate swap is type of financial derivative that allows a bond issuer — like the State of Illinois — to limit or manage exposure to fluctuations in interest rates. The issuer pays a fixed interest rate on a floating-rate bond. The bank on the other side of the swap pays the variable rate and pockets the difference between the fixed and floating rates.

When Illinois first entered into the now-costly swap deals in the early 2000s, the intention was to hedge risks and save money on the billions of dollars in variable-interest bonds that state agencies had issued. These bonds, issued under former governor Rod Blagojevich, are pegged to fluctuations in the broader interest rate environment.

But in order to lock in what state financiers saw as bargain interest rates, the governor’s office entered into swap agreements with ten major Wall Street banks. Under the deals — which are commonplace in the corporate world — the state would pay the banks a fixed interest rate, while the banks paid bondholders the variable rate. In theory, the maneuver would protect the state from sharp interest rate moves.

When the stock market crashed and the Fed lowered interest rates virtually to zero, the state couldn’t refinance at the lower rate. “The swaps kept the state locked into rates nearly 4 percent higher than what its bank partners were paying bondholders,” the article states.

* Back to the article…

The state has paid $618 million in swap fees since 2003, according to the ReFund America report, with another $832 million yet to come. While Ciccarone noted that those totals include the interest Illinois would have otherwise paid on the variable-interest bonds, they also include tens of millions of dollars in additional costs related to the complex requirements that swaps entail.

Those fees might not be all. Today, with interest rates still scraping historic lows, termination fees totaling $286 million prevent the state from exiting its swap agreements.

* And the study says that more problems are likely heading our way…

The swaps can still get a lot worse: If the state’s credit rating continues to tumble and it is unable to renew its credit enhancements on the 2003B bonds in November 2016, that could trigger termination clauses on the Governor’s swaps and force the state to pay $124 million in penalties to the banks.

JPMorgan Chase is both a credit enhancement provider for the 2003B bonds and a counterparty to one of the related swaps. This would potentially put the bank in a position to be able to collect termination penalties on the swap by refusing to renew the credit enhancement—a tactic the bank has used elsewhere in the past.

$124 million is not chump change. Go read the whole thing.

posted by Rich Miller
Tuesday, Jan 19, 16 @ 3:37 pm

Comments

tink..tink..tink….tink,tink,tink…chipping away at the dam.

Comment by Honeybear Tuesday, Jan 19, 16 @ 3:46 pm
Whoops, there goes some of that $510 million of RaunerRevenue.

Comment by 360 Degree TurnAround Tuesday, Jan 19, 16 @ 3:53 pm
This is another Democratic boondoggle. A contract is a contract though. If politicians mismanage the state’s finances, credit ratings get lowered and a financial cost will be extracted.

Comment by Muscular Tuesday, Jan 19, 16 @ 4:02 pm
Who knew Rod was smart enough to understand this stuff?

Comment by 47th Ward Tuesday, Jan 19, 16 @ 4:03 pm
If the government can renegotiate the rates, that’s great. If they can’t, then maybe they need to pay the $286 million in termination fees. But here’s the thing: If interest rates had shot upward, no one would be complaining.

Comment by Fusion Tuesday, Jan 19, 16 @ 4:06 pm
“A contract is a contract though.”

And Muscular’s endorsement of public sector pensions has been noted.

– MrJM

Comment by @MisterJayEm Tuesday, Jan 19, 16 @ 4:07 pm
Literally, we are still paying for Blago.

Comment by Abe the Babe Tuesday, Jan 19, 16 @ 4:07 pm
The perfect storm of a former Governor who tried to run the State on a credit card and a current Governor who won’t make the payments. Both convinced of their greatness.

Comment by Sir Reel Tuesday, Jan 19, 16 @ 4:08 pm
Fusion @4:06. Exactly!

I read the report… it’s ridiculous.

Is Illinois so inept it must blame the mean ol’ banks for letting it into a swap that didn’t pan out?

I’m no friend of big banks, but Illinois knew what it was doing. Interests rates then dropped, it wasn’t good for our swaps, so… yeah, let’s blame the banks.

Comment by In the Middle Tuesday, Jan 19, 16 @ 4:10 pm
Crazy for governments to be involved in SWAPs.

Who are the “experts” on the government side who even understand the concept, much less know how to gamble on interest rates — particularly when the banks were illegally fixing the LIBOR to begin with?

In the past, I’ve dealt with munis who got in a mess of trouble with SWAPS based on the sales-pitch of some clouted-up sharpie salesmen. They had no idea what the potential downside was. Yet they entered the contracts, anyway.

Comment by wordslinger Tuesday, Jan 19, 16 @ 4:10 pm
Fusion @4:06. Exactly!

Comment by In the Middle Tuesday, Jan 19, 16 @ 4:11 pm
Swaps are basically insurance. The state entered into these agreements to keep from being subject to wild market fluctuations and they have. Unfortunately the markets moved in what would have been wildly in the state’s favor if they hadn’t entered into these agreements and now the state can’t benefit. However if the markets had moved the other way the state would be the beneficiary of these agreements.

So few people understand these swaps that we keep seeing various pols grandstanding demanding their money back from the banks. The City of Chicago just last week postponed a vote that would have allowed the City to pay a penalty to end their unfavorable swap deals just so a few folks could grandstand against the banks some more. No one demands their homeowners insurance money back if their house doesn’t burn down, but never get in the way of a good political grandstanding I guess.

It sucks but no one would be crying foul if the markets had went the other way. The state locked in their rate using swaps to prevent against the rate skyrocketing. Instead it tanked and the state can’t benefit, but that’s the agreement they made.

Comment by The Captain Tuesday, Jan 19, 16 @ 4:27 pm
Man, all these swaps going underwater. All these bankers making big money on the deals. It’s almost as if they had some kind of inkling that interest rates would fall through the floor a few years in. And now they’re all raking in early termination fees, just as interest rates are starting to trickle back up.

It’s a great scam.

Whenever a banker tells you that he’s got a great way to help save you some money, run away.

Comment by jerry 101 Tuesday, Jan 19, 16 @ 4:37 pm
I sympathize with the notion that Illinois finds itself in this unfortunate position, but that’s how derivative swaps work. If market interest rates were at 10% right now, Illinois would be in a great position of savings. Illinois might be paying more than the current market interest rates, but that can still change. Illinois, like many other governments interested in financing things, bought the derivatives as sense of security against high interest rates. Now some lawmakers in Illinois are trying to renege on the deal. I know that no one feels pity for bond traders, but can you imagine if Goldman came to the statehouse and said “interest rates are too high and we’re losing money on your derivatives now, please let us refinance!”

Comment by NixonHead Tuesday, Jan 19, 16 @ 4:39 pm
Captain, the thing is, it’s not like its hard for governments to just issue 30 year bonds with a fixed interest rate.

Bankers scammed governments into entering into these agreements that locked in an interest rate slightly below what they would have gotten in a standard fixed interest rate borrowing, but made it extremely difficult to refund the bonds by linking them up with massive early termination penalties. The zealous way swaps were pushed back in the 2000’s was stunning. I audit a lot of governments and nonprofits. One year, none of my clients had these things. A year later, half of my clients had these things. And there was no real reason for it. So yeah, the impact is really less than what’s advertised, so where the rip off really happens is with refunding. If interest rates fall, and with normal bonds, you can do a refunding to take advantage of the fall, and pay nothing beyond the costs of issuing the new debt. With variable rate debt attached to a swap, you have to pay huge penalties, making it very, very costly to refund the bonds.

Comment by jerry 101 Tuesday, Jan 19, 16 @ 4:42 pm
==This is another Democratic boondoggle.==

This is a Blagojevich boondoggle. Of course I wouldn’t expect you to make a comment without your customary “blame the Democrats” whining. It’s all partisanship all the time for you.

Comment by Demoralized Tuesday, Jan 19, 16 @ 4:44 pm
–This is another Democratic boondoggle.–

Curious how they managed to replicate it for thousands of government bodies around the world.

– A contract is a contract though. If politicians mismanage the state’s finances, credit ratings get lowered and a financial cost will be extracted.–

If you can’t spot the chump the first time the deal goes round, you’re it.

Here’s a decent primer.

http://ritholtz.com/2012/07/the-big-losers-in-the-libor-rate-manipulation/

Comment by wordslinger Tuesday, Jan 19, 16 @ 4:56 pm
The State voluntarily selected to make the derivative deal. How would this be evil banker’s fault? The State is guaranteed the security of a non-variable interest rate set by the derivative deal. It’s the leaders of the State that are at fault for making the deal. If interest rates were really high right now, the evil bankers would be in the same position that the State is in.

The political class in Illinois has and will likely continue to fail you.

Comment by NixonHead Tuesday, Jan 19, 16 @ 4:57 pm
If these banks were providing social services we’d have no problem not paying them

Comment by LizPhairTax Tuesday, Jan 19, 16 @ 5:06 pm
Whether its a billion dollars in bank fees and swap charges, or $125m, I am sure that JPMChase and the others, will get that money back on Main Street. /s

Comment by cdog Tuesday, Jan 19, 16 @ 8:07 pm
The analysis is fundamentally flawed. The swaps fall or rise in value based on the current market fixed rate of a comparable duration (average maturity) to that of the swap. That variable rates fell did not impact the value of the swap. So, the argument is that the taxpayers of Illinois would have been better off if the state had left the bonds in a variable rate and never swapped the rate to a fixed rate? The State is very conservative with its debt and of the $15 billion plus outstanding of state debt this is the only piece that was issued as variable rate debt and swapped to fixed. My guess is at the time, this synthetic fixed rate was lower than if the bonds had been traditional fixed rate which is why GOMB did this. Similarly if the state had sold fixed rate bonds in 2003 that are non-callable and tried to buy them back today it would pay a premium because long term rates are lower today than in 2003. That is all a swap termination is - a discount or premium to current market. Too bad there is such unsophisticated analysis out there which basically says take money from the big banks because they have money. I thought Biss was supposed to be so highly educated. He should learn math.

Comment by ReasonableChicagoan Tuesday, Jan 19, 16 @ 8:21 pm
=Crazy for governments to be involved in SWAPs.

Who are the “experts” on the government side who even understand the concept, much less know how to gamble on interest rates — particularly when the banks were illegally fixing the LIBOR to begin with?

In the past, I’ve dealt with munis who got in a mess of trouble with SWAPS based on the sales-pitch of some clouted-up sharpie salesmen. They had no idea what the potential downside was. Yet they entered the contracts, anyway.=

I know when CPS did it, the chief negotiator was David Vitale who was appointed to be President of Rahm’s rubber stamp board. He had come to CPS from the world of high finance and was happy to negotiate with his contacts in that industry.

Comment by Carhartt Representative Wednesday, Jan 20, 16 @ 8:23 am