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How Wall Street ‘Innovations’ Cost Taxpayers Millions

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By /THE FISCAL TIMES

Marc Joffe, Director of Policy Research for the California Policy Center, has written for the Mercatus Center at George Mason University, the Reason Foundation and the Haas Institute at UC Berkeley.

 

What do the City of Chicago and Jefferson County, Alabama, have in common with Riverside, California, and a school district north of San Diego? These local governments have lost millions of dollars by using creative municipal finance. And if citizens around the country aren’t vigilant and outspoken, their city, county or school district may become the next victim of an unnecessarily complex bond deal.

Perhaps the worst victim of municipal financial “innovation” was Jefferson County, Alabama, which filed for bankruptcy after its financing arrangements known as interest rate swaps blew up. With an interest rate swap, a borrower can issue variable rate bonds while still paying a fixed rate of interest — a transformation achieved through an arrangement with a bank. After suffering a series of rating downgrades, the City of Chicago paid $270 million to close out swaps and convert its variable rate debt to fixed.

Why bother with such complicated deals in the first place? Bankers who promoted interest rate swaps argued that municipal issuers would have lower interest costs overall by borrowing at variable rates. But fees banks collected for arranging the swaps offset these savings. Also, because bankers are more knowledgeable about swaps than politicians and government finance staffers, the terms and conditions of these deals often protected banks at the expense of borrowers.

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LV Commentator Editor’s Note:

Pennsylvania’s Auditor General, Jack Wagner, on December 17, 2009, sent a letter to every school district in PA, urging them to refrain from using interest-rate swaps and to terminate any swaps agreements they may have.  He followed-up with a letter to the General Assembly, recommending they repeal Act 23 of 2003, which permitted school districts and local governments to enter into interest-rate swaps.  To date, this has not been repealed, at a cost to taxpayers of over two-billion dollars a year.

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