Too Late for Regrets

When I first thought about writing Financial Armageddon, I was primarily focused on the risks posed by derivatives -- instruments whose value depends on or is derived from something else, such as a stock, bond, a loan, a commodity, the weather, or an event. In fact, my early research inspired me to publish a November 2005 article entitled "The Coming Disaster in the Derivatives Market."

Eventually, though, the project grew to encompass myriad other threats, including the untenable build-up of public and private debt in the U.S. (and elsewhere), as well as a range of other disasters-in-the-making.

Nonetheless, it is interesting (to me, at least) how each new phase of the Great Unraveling reveals ties to the financial house of cards that attracted my attentions in the first place. In “Municipal Market Regulator Regrets Enabling Losses,” Bloomberg details one of those examples.

The former chief regulator for the $2.69 trillion municipal bond market for the first time acknowledged that the governing board failed to save taxpayers in Detroit, Jefferson County, Alabama, and local California governments from suffering more than $1 billion of losses because of opaque financial instruments that backfired.

Christopher “Kit” Taylor, the executive director of the Municipal Securities Rulemaking Board from 1978 to 2007, said his board wouldn’t allow the group to set rules on swaps and derivatives. Many of these deals went awry last year as credit markets seized up, saddling taxpayers with unexpected bills just as the slowing economy reduced tax revenue.

“The big firms didn’t want us touching derivatives,” said Taylor, 62 and now a consultant on financial markets and regulatory policy, in a telephone interview from his home in Alexandria, Virginia. “They said, ‘Don’t talk about it, Kit.’”

Congress set up the MSRB in 1975 to make rules for firms that underwrite, trade and sell municipal debt. The board is funded by fees paid by member firms, which generated revenue of $22.2 million in fiscal 2008.

As a self-regulatory organization, members of the industry are granted the authority to supervise their own practices. A 15-member board oversees the organization and 10 of the directors are from Wall Street firms. Enforcement is handled by the U.S. Securities and Exchange Commission.

Near Bankruptcy

Derivatives led to the near bankruptcy of Jefferson County last year and JPMorgan Chase & Co. canceled swap contracts with the municipality on March 2 at a cost to the county of $657 million. Pittsburgh councilman Patrick Dowd said this month he wants an independent audit of a $419 million water and sewer bond and derivative deal that he says put taxpayer money at risk and cost the city $19 million of fees.

Financial instruments similar to the ones that contributed to the collapse of Lehman Brothers Holdings Inc. in September were bought by municipalities in attempts to reduce interest costs.

Use of swaps “appears to have grown substantially,” the National Federation of Municipal Analysts said in a February 2004 report, though it noted the difficulty in trying to assemble a precise estimate because the arrangements weren’t routinely reported.

Interest-Rate Swaps

Swaps are agreements to exchange interest payments, usually a fixed rate for one that varies based on an index. They are a type of derivative, contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

California is investigating if banks and financial advisers conspired to overcharge local governments for derivatives. Detroit is trying to reduce a $400 million payment required to end a swap after its credit rating was cut to below investment grade. The amount equals almost one-third of the city’s $1.5 billion annual budget.

The U.S. Justice Department is looking into allegations that banks and advisers rigged bids or fixed prices on financial contracts, according to regulatory filings by banks including New York-based JPMorgan and UBS AG of Zurich.

Banks discussed the risks to municipalities as they marketed derivatives to states, towns, schools and municipal utilities, said Thomas Doe, an MSRB director from 2003 to 2005.

“One topic at nearly every board meeting was that there was a clear recognition that swaps posed a risk to the municipal market,” said Doe, the head of Concord, Massachusetts-based research firm Municipal Market Advisors.

Overseeing Derivatives

Doe said board members and staff told him Congress didn’t give the MSRB power to oversee derivatives.

“Every time I talked to the board about swaps, I made it clear that the MSRB had no authority to take action,” said Taylor, in an e-mail. “My ‘regret’ is that MSRB would not speak out loudly that swaps were going to cost taxpayers a bundle if issuers did not clearly understand what they were doing.”

Taylor said interest-rate swaps increased in the final years of his tenure, coinciding with a decline in fees for underwriting bonds. Fees fell to $5.27 per $1,000 of municipal bonds in 2007 from $7.07 in 1998, according to Thomson Reuters.

Municipalities bought swaps to limit their risk to interest-rate movements, usually by locking in a fixed borrowing cost on variable-rate debt or in other cases getting cash payments upfront. Now some issuers are finding they must pay fees to unwind swaps when credit ratings are cut or interest rates move against them.

The costs are coming at a bad time for state and local governments. The economy will likely shrink 2.5 percent this year, according to the median estimate of 55 analysts surveyed by Bloomberg. The U.S. unemployment rate rose to 8.1 percent in February, the highest rate since 1983. State governments are working to reduce deficits estimated at about $160 billion this year and next, according to the National Conference of State Legislatures in Denver.

Providing Information

 “I saw more bankers looking out for their self interest in my last years at the MSRB,” Taylor said. “The attitude had changed from, ‘What can we do for the good of the market,’ to, ‘What can we do to ensure the future of my business.’ The profit wasn’t in the underwriting, it was in the swap.”

There has been no increase in oversight of derivatives by the MSRB since Taylor left. Doe said board members and staff told him Congress didn’t give the MSRB power to oversee the contracts.

Lynnette Hotchkiss, the MSRB’s executive director, declined to comment on events before she replaced Taylor in 2007 and said underwriters and dealers haven’t undermined effort to provide information to the public. She cited the development of the Emma disclosure system to provide price data and other financial information about borrowers to investors via the Internet.

“To hear that the bankers are slowing things down just doesn’t resonate with me,” Hotchkiss said. “The members have been willing to spend a lot of their own money for transparency that benefits the market.”

Pricing Information

Taylor says bankers consistently stood in the way of efforts to increase transparency in the municipal bond market.

The first system for disclosing trades was established in 1994. It took until 2005 to provide real-time prices, where details of a trade are released within 15 minutes instead of the next day or several days later.

Before the MSRB forced the issue, there was no public information on trades, so investors depended on brokers for pricing data. Stock and Treasury prices were widely available, and the corporate bond market started developing a disclosure system in 1998 and had it operating in 2002.

“Right up until the day we went to real-time disclosure, I was getting calls from bankers wanting to delay it,” Taylor said. “The only ones who benefited from delaying transparency were those who profited from the trades.”

Politicians & Lobbyists

Taylor also said he got calls from bankers attempting to delay the board’s initiative in 2005 to ban underwriting firms from hiring former politicians and lobbyists as consultants to help win municipal bond sales.

“Those who opposed the ban on consultants kept calling for more studies,” Taylor said, declining to name bankers who thwarted his efforts.

There’s no cumulative data available on the amount of potential losses because swap are unregulated. If there is an effort by Congress to bring regulation to the swap market, the MSRB would want to play a role, Hotchkiss said.

The MSRB proposed in a letter to Congress on Feb. 6 that it be given greater authority to oversee interest-rate swap advisers and other parties that aren’t monitored in the municipal bond market, according to an MSRB release.

‘Appropriate’ Body

“We believe that the MSRB is the appropriate regulatory body to regulate these unregulated municipal market participants,” the board said in a letter to Senate and House committee officials who oversee banking.

The Securities Industry and Financial Markets Association, representing securities dealers and underwriters, supports granting the MSRB broader regulatory authority, said Tim Ryan, its chief executive officer, in testimony to the Senate Banking Committee March 10.

Doe said he’s in favor of centralized regulation with the provision that the industry needs a role and input involving rulemaking. Letting the industry oversee itself when proposals threaten potential income streams doesn’t work, he said.

“Not wanting to put that revenue stream at risk can be very intimidating,” Doe said. “It makes it very challenging to advocate for change.”

Comments

[Darkcloud]

Michael,

Thanks for your great efforts to keep us in the light. Check out what follows:

[excerpt] Representatives of the Federal Reserve, AIG's lead U.S. overseer, are talking with French regulators and AIG officials to deal with the consequences of a complicated legal scenario in which the departures of the managers in Banque AIG, a subsidiary of AIG's Financial Products unit, could trigger defaults in $234 billion of derivative transactions, according to people familiar with the situation and a document AIG provided to the U.S. Treasury...
The executives at Paris-based Banque AIG, Mauro Gabriele and James Shephard, have resigned in recent days but have agreed to stay on for a transition, according to people familiar with the matter. In the wake of their resignations, AIG must replace them to the satisfaction of French banking regulators. If they don't, French regulators may appoint their own designee to manage the bank -- an outcome that could trigger defaults under the bank's derivative contracts. The private contracts say that a regulator's appointment of a manager constitutes a change in control, according to a person familiar with the matter; the provision is often included in derivative contracts where parties want to preserve a way out if something about their counterparties changes.

here's the link: http://online.wsj.com/article/SB123802506167942421.html

Remember "Where's the beef?" We need judges who will say" Where's the risk? Fuzzy risk here, so no taxpayer bailout payments for fuzzy risk bailout clauses."

Best regards,

Steve (Darkcloud)