Wednesday, March 21, 2012

Wall Street Confidence Trick: The Interest-Rate Swaps That Are Bankrupting Local Governments

Wall Street Confidence Trick: The Interest-Rate Swaps That Are Bankrupting Local Governments

Wednesday, 21 March 2012 00:00 By Ellen Brown, Truthout | New Analysis 

Far from reducing risk, derivatives increase risk, often with catastrophic results. -Derivatives expert Satyajit Das, Extreme Money (2011).
The "toxic culture of greed" on Wall Street was highlighted again last week, when Greg Smith went public with his resignation from Goldman Sachs in a scathing op-ed published in The New York Times. In other recent eyebrow-raisers, LIBOR rates - the benchmark interest rates involved in interest-rate swaps - were shown to be manipulated by the banks that would have to pay up; and the objectivity of the ISDA (International Swaps and Derivatives Association) was called into question, when a 50 percent haircut for creditors was not declared a "default" requiring counterparties to pay on credit-default swaps on Greek sovereign debt.

Interest-rate swaps are less often in the news than credit-default swaps, but they are far more important in terms of revenue, composing fully 82 percent of the derivatives trade.

"How the swaps were supposed to work was explained by Michael McDonald in a November 2010 Bloomberg article titled "Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire":

"In an interest rate swap, two parties exchange payments on an agreed-upon amount of principal. Most of the swaps Wall Street sold in the municipal market required borrowers to issue long-term securities with interest rates that changed every week or month. The borrowers would then exchange payments, leaving them paying a fixed-rate to a bank or insurance company and receiving a variable rate in return. Sometimes borrowers got lump sums for entering agreements."
Banks and borrowers were supposed to be paying equal rates: the fat years would balance out the lean. But the Fed artificially manipulated the rates to the save the banks. After the credit crisis broke out, borrowers had to continue selling adjustable-rate securities at auction under the deals. Auction interest rates soared when bond insurers' ratings were downgraded because of sub-prime mortgage losses; but the periodic payments that banks made to borrowers as part of the swaps plunged, because they were linked to benchmarks such as Federal Reserve lending rates, which were slashed to almost zero.

In a February 2010 article titled "How Big Banks' Interest-Rate Schemes Bankrupt States," Mike Elk compared the swaps to payday loans. They were bad deals, but municipal council members had no other way of getting the money. "

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