Big U.S. banks have paid billions of dollars to settle claims by state and federal prosecutors that they trapped unsophisticated borrowers in disastrous subprime mortgages at the height of the housing boom. Now, some Los Angeles City Council members argue that their unsophisticated little burg was similarly victimized by two predatory lenders that sold the city complex risk-hedging investments called interest rate swaps. In response, the council passed a motion Wednesday that threatens to cut off business with the banks if they don't rescind the swaps contracts at no cost.
But the city is no rube, and the predation is just conjecture at this point. While it's a good idea to try to negotiate better terms, the City Council should save its threats for those who are actually responsible for the harms it suffers.
Municipalities finance big projects by selling bonds that are paid back over 20 to 30 years, often at interest rates that rise or fall with the market. In the 1990s and 2000s, a growing number of cities, Los Angeles included, decided to hedge their risk through interest rate swaps, which were designed to replace the cities' variable payments to bondholders with fixed payments to banks.
But the swaps weren't risk-free. After Wall Street collapsed spectacularly, cities received far less from banks than they had to pay bondholders. And they couldn't terminate the long-term swaps without paying huge fees to the banks. In Los Angeles' case, the swaps it struck with Bank of New York Mellon and Dexia in 2006 are costing almost $5 million per year.
Cities across the country are demanding relief from the banks, and a union-backed coalition has urged the City Council to do the same. The coalition and its council allies, led by Paul Koretz, argue that the risks of the swaps weren't fully disclosed. But while the deals turned out much worse than anyone anticipated, it's hard to blame Mellon and Dexia (the latter of which, by the way, went bankrupt). The swaps were proposed by the city's independent financial advisors, and Mellon and Dexia bid on them in response to the city's request for proposals. And because the swaps were tied to bonds that refinanced older, higher-cost bonds, the city is still spending less than it would have had it not refinanced.
Koretz's motion calls for city officials to keep pressing Mellon and Dexia to renegotiate, and for the city attorney to consider "potential legal remedies" against the banks. That's all well and good, but the council should begin the scrutiny by taking a close look at why the city's own advisors called for the swaps in the first place, and finding out whether Mellon and Dexia delivered no more or less than what the council asked for.