Wall Street vs. America

This week BusinessWeek reports on deals done between investment banks and local municipalities which, like so many other things in this economy, have gone bad, leaving the little guy in the lurch. The photo in the article is of an abandoned public school, indicative of the destruction these deals have wrought.

What happened? Cities, states and local municipalities have an ongoing need to raise capital to finance special projects and ongoing operations. To raise capital, they have historically issued municipal bonds, which are underwritten and sold by an investment bank. Investors like to buy these bonds because they are usually free of federal tax, are considered safe, and rated by a reputable agency. That system worked well in the past, and that’s how funds have materialized to build bridges, new roads, buildings and other large projects we need on a regular basis.

Like so many other things in the recent economy, this formerly working system changed in the past few years. Over time, investment banks have become more sophisticated about how to add fees, raise funds, and ensure something is still left for them if a deal should fall apart. The folks working in municipal governments haven’t experienced the same learning curve. During the boom, many municipalities signed on to deals which would protect the investment banks should things fall apart. The municipalities, not as sophisticated, thought good times would continue and did not think to build contingencies into their plans. BW reported on what has happened as a result of the economy going south.

Detroit as we know, is a city with more than just a few problems. Detroit last had a heyday in the sixties, and has never recovered. Recently, things have gotten even worse. Unemployment is 28%, home prices are down 39% since 2007, and they have a $300 million budget deficit, according to BW’s reporters. Not only that, they did some deals with investment banks during the boom which have returned to haunt them. When debt is issued, it is often customary for the issuer to include contingencies which require extra payments if the borrower(in this case, the city of Detroit) should have a fall in credit rating. Not surprisingly, Detroit’s credit rating dropped, and now they owe millions of dollars in extra payments to these financial firms.

Cities like Detroit are squeezed already – who isn’t? – so coming up with the extra funds would be difficult in good times, and next to impossible in bad times like this. Detroit has become a mere shadow of its former self, and basic services such as bus routes, education and even garbage pickup have been severely impacted.  Detroit has to make a $4.2 million payment to the investment banks each month, which it is paying for out of casino revenue. Consider what would happen if this shell-shocked city had those funds to spend on basic services!

How did this come to happen?

As I explained above, historically cities such as Detroit have issued municipal bonds to finance their budgets and investment banks have underwritten and sold the securities. Nothing wrong with that – it was a system that worked. However, things became more complicated in recent years  and derivatives were thrown into the mix. These were no longer plain-vanilla products, and the municipalities did not account for a future that would be less rosy.  As BW says, “many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts”.

But investment banks know how to collect their fees. So when the deals went bad, Wall Street made sure  the cities and local governments paid up, and the governments had even less room in their budgets to make the payments. BW reports that the New Jersey Transportation Trust Fund Authority has a $1 million payment to Goldman Sachs each month until December 2011. No wonder Lloyd Blankfein is often seen smiling these days. The Chicago Transportation Authority (CTA) had a sale-and-leaseback deal which could result in $30 million of termination fees.

Wall Street has had record success recently, and they must know there is a potential PR disaster brewing. No one likes to see the fat cats get fatter while the little guy suffers. But that seems to be what is happening. Politicians like to be seen standing up for the little guy, so there is new legislation in the works. One potential bill is to introduce a 100% tax on termination payments. Another bill will prohibit smaller governments from using derivatives.

In the meantime, it’s hard to see how Detroit will get back on its feet. But, the investment banks claim no wrongdoing. I agree that it is likely the municipalities entered into these legal agreements in a rational way, but given how successful the financial firms are, and in what bad shape the municipalities are in, something doesn’t seem quite right. One can argue that the financial firms have a duty to maximize return on investment for their shareholders and the municipalities participated on their own volition. Hmmm... A deal is a deal, but some deals seem less equal than others.

Unfortunately, the ongoing saga of Detroit may be just a beginning. There were many sale and leaseback deals struck in recent years, and they may be coming back to haunt the initiators of the deal. BW reports that 25 big municipal transportation authorities raised cash by sale-and-leaseback deals. There was an accident which killed nine people in the Washington metro area caused by old subway cars. The transportation authority ignored a recommendation by the NTSB to replace or retrofit older cars, most likely because they were trying to save money.

The Texas Teacher Retirement System has suffered an additional blow due to getting involved with investments it should never have considered, such as private equity and hedge funds. However, private equity firms and hedge funds are wonderful places to work at, because they keep collecting fees even in bad times. But, the retired teachers in Texas have not had a cost-of-living-increase since 2001, and probably do not appreciate these fancy investments.

I’ve listened to a lot of BusinessWeek podcasts, and I’m always impressed by the low-key, even-tempered manner of managing editor John Byrne. However, at the end of this one, he shocked me by saying “it’s a story that makes me angry”. His writer added, “there’s a high outrage factor”. Well said.