Professional Documents
Culture Documents
Turned Around Jan2016
Turned Around Jan2016
Report by
Saqib Bhatti & Carrie Sloan
January 2016
About the Authors
Saqib Bhatti is the Director of the ReFund America Project and a fellow
at the Roosevelt Institute. He works on campaigns to rebalance the
relationship between Wall Street and local communities by advancing
solutions to #ix inef#iciencies in municipal #inance that cost taxpayers
billions each year. He was previously a fellow at the Nathan Cummings
Foundation. Prior to that, he worked on Wall Street accountability at the
Service Employees International Union, where he developed strategic
campaigns to hold banks accountable for their role in creating and
pro#iteering off the economic crisis. He graduated from Yale University in
2004.
• Through the end of iscal year 2015, Illinois had paid inancial irms
like Bank of America, Loop Financial, Goldman Sachs, JPMorgan
Chase, Citigroup, Bank of New York Mellon, Deutsche Bank, Morgan
Stanley, Wells Fargo, and AIG $618 million in net swap payments.
• The state continues to pay the banks another $68 million a year
on these deals and is expected to pay $832 million over the
remaining life of these deals, from iscal year 2016 through 2033.
• The state will never break even on the swaps: Given how much
money Illinois has already paid its bank counterparties on these
swaps, it is virtually impossible for interest rates to rise high
enough for long enough for the state to break even on these deals,
contrary to bankers’ assertions that swaps are designed so that
both parties’ payments will even out over the long run.
• The swaps can still get a lot worse: If the state’s credit rating
continues to tumble and it is unable to renew its credit
enhancements on the 2003B bonds in November 2016, that could
trigger termination clauses on the Governor’s swaps and force the
state to pay $124 million in penalties to the banks. JPMorgan Chase
is both a credit enhancement provider for the 2003B bonds and a
counterparty to one of the related swaps. This would potentially
put the bank in a position to be able to collect termination penalties
on the swap by refusing to renew the credit enhancement—a tactic
the bank has used elsewhere in the past.
Illinois Could Have to Help Foot the Bill for Chicago’s Swaps.
Chicago Mayor Rahm Emanuel is seeking $800 million in assistance
from the State of Illinois for the City of Chicago, Chicago Public Schools
(CPS), and Chicago Transit Authority budgets. Meanwhile he has
refused to act to recover money from the city and school district’s
interest rate swaps. Chicago and CPS also entered into a number of
hedging swaps that have gone haywire. When the city and CPS both had
their credit ratings downgraded in the spring of 2015, that triggered
What We Can Do About It. The banks that sold interest rate swaps to
cities and states typically misrepresented the risks inherent in the
deals. This likely violated the federal fair dealing rule and the Illinois
state law for fraudulent concealment or misrepresentation. The State of To truly turn
Illinois can take legal action to allow it to stop paying banks $68 million Illinois around, the
a year, potentially recover up to $618 million in past swap payments, governor should
and eliminate the threat that it could have to pay up to $286 million in enact policies that
termination penalties in the future. The state has two options at its
disposal, and it could pursue both strategies simultaneously: put the interests of
communities irst.
• Illinois’s elected leaders can petition the federal Securities and
Exchange Commission (SEC) to bring an enforcement action against
the banks for disgorgement of their ill-gotten gains from Illinois
taxpayers. Although the Emanuel Administration has signed
waivers releasing some of the banks of liabilities arising from the
swaps they sold to Chicago, state of icials may also petition the SEC
to bring enforcement actions on behalf of their constituents living
in the city as well. Mayor Emanuel’s waiver does not preclude SEC
action.
• Illinois can also sue the banks under state law for fraudulent
concealment or misrepresentation. In so doing, the state could also
request an injunction from the judge to stop making payments
during the legal proceedings, which could provide immediate
budgetary relief.
The budget crisis has had disastrous consequences for the state’s most
Even though the vulnerable residents. Without a budget, the state has stopped or
state has failed to delayed payments to many providers of critical human services. As a
make payments to result, more than 36,000 low-income children have been dropped from
social services the state’s Child Care Assistance Program.3 The state did not provide
any funding for domestic violence services in the irst half of the iscal
providers, Illinois year, putting 75,000 survivors at risk.4 Ninety percent of homeless
has still been service providers in Illinois have been forced to reduce or eliminate
making payments programs because of a lack of state funding.5 The state violated a
to inancial federal consent decree requiring it to make payments to human service
providers even in the absence of a state budget.6 Advocates were forced
services providers to take the Rauner Administration to federal court to compel it to make
on Wall Street. federally-mandated Medicaid payments to safety net healthcare
providers.7 The state has slashed funding for immigrant family services,
senior support services, youth programs, funeral and burial assistance
for low-income residents, state universities, and need-based college
grants.8 State aid to cities, towns, villages, and state universities has
also been put on hold. The state’s social safety net has been shredded,
with devastating results for communities across Illinois.
But even though the state has failed to make payments to social
services providers in cities like Peoria and Decatur as a result of the
budget crisis, Illinois has still been making payments to inancial
services providers on Wall Street. Although there is a countless number
For example, in the spring of 2015, both the City of Chicago and Chicago
Public Schools had their credit ratings slashed to junk. As a result, the
city and the schools owed banks approximately $419 million in
termination penalties on their swaps.9 Now the State of Illinois faces a
similar scenario. In October 2015, Fitch Ratings downgraded the credit
rating for the state to just one notch above junk status.10 If the state’s
In this section, we will walk through the example of the ive swaps
directly overseen by the GOMB, which we call the Governor’s swaps, as
a case study. We are focusing on the Governor’s swaps because they are
connected to the state’s general obligation bonds, which means they
directly impact the state’s budget, rather than that of any particular
agency. There is also a greater level of publicly available information
about the Governor’s swaps, which makes an in-depth analysis
possible.
Illinois also had to incur some additional expenses because of its choice
to take out variable-rate debt with the 2003B series. Because variable-
rate bonds have to be remarketed, the state had to hire a remarketing
agent. Illinois also had to enter into a standby purchase agreement with
Depfa Bank for the 2003B bonds.12 A standby purchase agreement is a
form of credit enhancement—something that makes debt more
marketable to potential investors. Bondholders typically want
assurances that they will be able to sell their investments whenever
they want. Because variable-rate debt is riskier than traditional ixed-
rate bonds, bondholders often require the borrower to ind a buyer of
last resort who will agree to buy the bond if the bondholder is unable to
sell it. States do this by entering into a standby purchase agreement
with a bank. The bank that provides the agreement is the buyer of last
resort.
• The swaps mis ired: The swaps did not work the way they were
supposed to. When the Federal Reserve slashed interest rates in
response to the inancial crisis in 2008, the deals became extremely
costly for the state, which was locked into a signi icantly higher Swap payments,
interest rate. As a result, the state paid banks $192 million in net credit
swap payments through iscal year 2015 for the Governor’s swaps
enhancement fees,
alone.
and remarketing
• The state will never break even on the swaps: Given how much the fees are no more
state has already paid the banks for the Governor’s swaps, it is important than the
highly unlikely that variable rates will rise enough for the swaps to
become pro itable for the state. The one-month US Dollar London
payments that
InterBank Offering Rate (USD LIBOR), one of the variable-rate social services
indices that these swaps are based on, would have to immediately providers or
jump to 10.72% and stay there until the swap deals expire in municipalities are
October 2033 in order for the state to recover the $192 million it
has already paid the banks. One-month USD LIBOR has never gone due from the state.
that high in the 30-year history of the rate.
• The swaps cost more: The add-ons that Illinois had to purchase
when it decided to take out variable-rate debt as part of its 2003
bond issuance added to the total debt service cost to the state. Once
the costs of the swaps, credit enhancements, and remarketing fees
are factored in, the state actually paid $29 million more than if it
had used a traditional ixed-rate structure for the 2003B bonds
instead of a variable-rate structure. The added costs accrued to
banks like Loop Financial, JPMorgan Chase, Wells Fargo, and Bank
of America, among others.
*Interest rate swap payments are not necessarily made on a monthly schedule. Instead, the payment dates for each
party are speci ied in the swap agreement. We chose to represent the payments on a monthly basis to allow for an easy
comparison. This provides an approximate representation of the costs of the deals.
*The rate the banks pay the state is calculated based on a formula that is written into
the swap agreements. When one-month USD LIBOR is below 2.50%, the banks pay
Illinois a rate that is equal to the SIFMA Index. When one-month USD LIBOR is higher
than 2.50%, then the banks pay the state 67% of one-month USD LIBOR.
Figure 4: Total Payments on the 2003B Bonds & Interest Rate Swaps through June 2015
Figure 5 shows how the state’s payments on the bonds have compared
with the banks’ payments on the swaps over time. In order for the
swaps to give the state a synthetic ixed-rate on the inancing scheme,
the green and red lines would have to track each other. That stopped
happening when the green and red lines diverged in the fall of 2008.
Even though the two lines came back together in November 2013, once
the added cost of the 2.35% letters of credit fees are factored in, it
becomes clear that the swaps have failed because the banks’ payments
are nowhere near suf icient to cover the state’s total costs.
*Interest rate swap payments are not necessarily made on a monthly schedule. Instead, the payment dates for each
party are speci ied in the swap agreement. We chose to represent the payments on a monthly basis to allow for an easy
comparison. This provides an approximate representation of the costs of the deals.
If, instead, the state had issued these bonds at a ixed interest rate
under the same deals as the 2003A bonds, the total debt service costs
would have been just $364 million in interest.21 In other words, not
only has the variable-rate inancing scheme been riskier for the state, it
has also been more costly.
* The total does not add up in this column because of rounding error.
In iscal year 2015 alone, the state paid approximately $15 million
more as a result of the variable-rate structure on the 2003B bonds than
it would have if the bonds had instead been issued at the same ixed
interest rate as the 2003A bonds (see Figure 7).
Although the state saved nearly $36 million in interest payments with
the variable rate, it paid an extra $51 million in fees to nine different
banks. The banks captured all of the state’s savings from the lower
interest rates. Figure 8 breaks down these fees for iscal year 2015 by
bank.
However, the decision to terminate may not be fully in the hands of the
state. The typical interest rate swap agreement speci ies a number of
termination triggers that give the bank the right to terminate the swap
and collect penalties. According to the of icial statement of the 2003
General Obligation bonds, Illinois’s swap counterparties may terminate
the swaps “if the State’s [credit] rating falls below ‘BBB’ from [Standard
& Poor’s], ‘Baa’ from Moody’s and ‘BBB’ from Fitch.”23 In October 2015,
Moody’s downgraded Illinois to Baa1, just three notches above the
termination trigger,24 and Fitch downgraded Illinois to BBB-, just one
notch above the termination trigger.25 Both rating agencies cited the
state’s budget stalemate as a key reason for the move. If the stalemate
drags on, it could lead to further downgrades.
Because the state has taken letters of credit on the 2003B bonds, the
Governor’s swaps are relatively insulated from these downgrades for
now. As mentioned above, letters of credit are a form of credit
enhancement, which allow borrowers to take advantage of banks’
higher credit ratings. In fact, Moody’s released a report in November
However, these letters of credit all expire on November 27, 2016. That
puts Illinois taxpayers in a precarious position. If the state’s own credit
rating continues to slide and any of the six banks that have provided
the letters of credit on the 2003B bonds—JPMorgan Chase, PNC, Wells
In November 2016, Fargo, State Street Bank, Royal Bank of Canada, or Northern Trust—
the State of Illinois refuse to renew them when they expire, then that additional layer of
could ind itself in protection would vanish and taxpayers could be on the hook for $124
million in termination penalties. Even if the banks do agree to renew
a similar position, the letters of credit, they can charge the state substantially higher rates
with JPMorgan because they will have Illinois over the barrel. The state will need those
Chase squeezing letters of credit to avoid an even larger $124 million payment.
on one end in
JPMorgan Chase is Illinois’s largest letter of credit provider on the
order to get paid 2003B bonds and also counterparty to one of the Governor’s swaps.
on the other. That means the bank has a con lict of interest. If Illinois’s credit rating
gets downgraded to junk and JPMorgan Chase refuses to renew its
letter of credit, that could trigger the termination clause in the bank’s
swap agreement with the state. That would allow JPMorgan Chase to
collect approximately $11 million in swap termination penalties from
Illinois taxpayers.
This very scenario has played out elsewhere. In 2010, JPMorgan Chase
did this exact thing with the Asian Art Museum of San Francisco, which
is a public-private partnership that is inancially backed by the City of
San Francisco. The bank provided the letter of credit to the museum for
a bond and was also the counterparty for a related swap. When the
bank refused to renew the letter of credit, it caused Moody’s to slash
the museum’s credit rating to junk, which triggered termination clauses
on the swap and an accelerated payment clause on the underlying bond
(which meant that the museum would have had to pay back the entire
outstanding bond principal that was due over 23 years on a highly
accelerated schedule).27 The city forced the bank to the bargaining
table and was eventually able to secure a favorable settlement that
avoided the termination penalties and re inanced the museum into a
ixed-rate bond.28 In November 2016, the State of Illinois could ind
itself in a similar position, with JPMorgan Chase squeezing on one end
(by refusing to renew the letter of credit) in order to get paid on the
other (by collecting termination penalties on the swap).
If it were not for the city and CPS’s swap penalties, Mayor Emanuel
would have an additional $636 million to put toward those budgets
instead of having to turn to Spring ield for assistance.
Figure 10: The Cost of Swaps to the City of Chicago & Chicago Public Schools
Figure 10 shows that interest rate swaps have proved very costly for
Chicago and CPS. Once the outstanding termination penalties are
factored in, the total price tag for these deals for the city and CPS will
top $1.4 billion.
Now the mayor is requesting assistance from the state to help the city
pay its bills. However, even though Mayor Emanuel refused to take
legal action against the banks, state of icials can still intervene on
behalf of their constituents who live in Chicago by petitioning the SEC
to bring an enforcement action against the banks that sold swaps to the
city. The mayor’s forbearance agreements do not prohibit the SEC from
taking legal action against the banks on behalf of the city.
Governor Rauner has been holding the Illinois budget hostage in order
to get his anti-union Turnaround Agenda. However, ratcheting up
attacks on working families would hardly be a turnaround for Illinois. It
would be more of the same in a state that has been prioritizing
payments to Wall Street ahead of vital community services for years. To
truly turn Illinois around, we need a budget that chooses to fully fund
the public services on which all Illinoisans depend and that makes
banks, major corporations, and the wealthy pay their fair share. We can
start by taking on the banks that sold Illinois the toxic swaps that are
projected to cost taxpayers nearly $1.5 billion if left intact. That is the
kind of turnaround that Illinois working families can get behind.