L.A. becomes a test case in battle to undo interest rate swap deals

Market Beat

“I can pay. I just don’t want to.” That’s the unapologetic position of the “walkaways” -- homeowners who have no equity in their houses and who no longer see the point of paying their mortgages, even though they’re financially fully capable of doing so.

Now comes the Service Employees International Union with a variation on that walkaway idea, but for states and municipalities.

The union wants government officials to demand that banks tear up a type of insurance policy many municipalities bought from the banks a few years ago.

The SEIU says these long-term deals may be legal, but it asserts that they’re now costly and unfair when local governments face such dire budget straits and are slashing jobs, union and non-union.


Bankers obviously make easy targets nowadays. They face the collective wrath of the nation. The SEIU is goading municipalities to step up and take their shot.

The union is focused on so-called swap agreements that have been commonly used by local governments to protect against swings in market interest rates on their borrowings. The SEIU has made the city of Los Angeles a test case in the battle to undo these swaps.

L.A. in 2006 sold investors $317 million in floating-rate bonds to raise money for sewer projects. The city then turned around and made a deal with Bank of New York Mellon and the Belgian bank Dexia to cover the risk of a jump in rates on the securities.

That’s the “swap”: The city agreed to pay the banks a fixed annual interest rate -- 3.34% -- on the debt amount and, in turn, received back from the banks payments based on a floating rate tied to a key benchmark of short-term rates.

The arrangement actually worked very well for L.A. in the first few years of the deal, earning it millions of dollars above its bond interest costs. Then the credit crisis hit, the economy crumbled and the Federal Reserve slashed short-term interest rates to near zero.

Now, Los Angeles still is paying the banks the 3.34% fixed rate, but is getting back close to zero, down from the 5% it had earned initially. In hard dollars, the city is paying $19 million a year to the banks, while getting a relative pittance from them. And the swap agreements don’t expire until 2028.

L.A. could get out of the contracts early, but only by paying termination fees of at least $26 million.

Have these swaps been a bad deal for the city? Not according to Natalie Brill, L.A.'s chief of debt management. She says the city has saved a net $14.5 million by using floating rate debt, and the swaps, since 2006, compared with issuing plain-vanilla fixed-rate bonds.

The whole idea, she notes, was to have insurance against rising interest rates. And if the economic recovery is sustained, interest rates are likely to rise again at some point.

“We still see this as the lowest cost of borrowing,” Brill said of the bond deal and the swaps that cover it.

The city of Riverside has swaps similar to Los Angeles’ covering $128 million of bonds, Chief Financial Officer Paul Sundeen said. Echoing Brill, he thinks it makes sense to keep that insurance against a possible upturn in market rates.

As for trying to unilaterally rewrite a swap agreement, Sundeen said: “We entered into a contract. We all knew what we were doing.”

That has not impressed L.A. City Councilman Richard Alarcon. With the SEIU’s backing, he sponsored a measure that the council passed unanimously a week ago to develop tests by which to gauge banks’ “cooperation” with the city on issues such as home foreclosure abatement. The redo-the-swaps demand is included in the measure.

Anna Burger, the SEIU’s secretary-treasurer in Washington, condemns the banks’ swap profits as “outrageous” at a time of deep budget cuts by state and local governments.

When I noted that the swap deals still could pay off in the long run for municipalities like L.A. if interest rates should rebound, Burger said that was beside the point. “They should renegotiate now to get a lower interest rate,” she said.

As for honoring the sanctity of a contract -- well, too bad, Burger said. The SEIU, she said, has been willing to alter its own contracts with government employers to cut costs.

L.A. city workers, including 10,000 SEIU members, last summer agreed to temporary furloughs and to defer two years of raises.

“The banks have been able to borrow at near-zero interest rates from the government,” Burger said. “What are they doing to help solve the problems in the economy?”

Bank of New York Mellon declined to comment on its swap deal with L.A. Dexia officials weren’t available.

The City Council’s measure orders Brill to go back to the banks and try to renegotiate the swaps. But she noted that even if some savings were realized they wouldn’t help close the city’s $485-million budget gap, because the sewer-bond account is a separate entity.

Still, the SEIU knows it’s pushing a hot button here. Swaps are derivative instruments, and “derivative” is a four-letter word with many Americans. Didn’t those things help to crash the financial system and the markets?

What’s more, this would be an ideal time for government officials to maintain that, unlike Riverside’s Sundeen, they didn’t understand what the banks sold them. It may even be true in some cases.

“You have to ask, were these swaps the most suitable vehicle for what they [governments] wanted to do?” said Dennis Santiago, head of bank-ratings firm Institutional Risk Analytics.

But if the banks begin modifying a few swaps just to be magnanimous, they’ll open the floodgates. If, on the other hand, they refuse to budge, they risk being cut off from doing other business with angry governments and their pension funds. That is what the L.A. City Council’s measure threatens.

Privately, bankers say they’re being extorted. They also know they’ll get no sympathy from the public.

The argument for cutting municipalities a break on swap deals “has a thin veneer of seeming reasonable,” said Jonathan Macey, a securities law professor at Yale Law School.

But the more the country gets in the habit of thinking that signed agreements are meaningless, Macey said, “there’s no contract immune from being tinkered with. Where does it end?”