Goldman Sachs Group Inc. (GS:US) touted the auction-rate securities that Reno, Nevada, sold starting in 2005 as a tool to generate “considerable interest savings,” according to an arbitration complaint the city filed last year.
Then, in 2008, during the global financial crisis, the market blew up for Reno and hundreds of other issuers, including Detroit and California. The municipalities had sold about $200 billion of such debt, which matures in decades yet has yields that reset monthly or weekly based on bids from investors. The collapse cost issuers $9.6 billion, according to Saber Partners LLC, an advisory firm in New York.
Wall Street dealers handling the auctions, wary of putting their capital at risk, stopped bidding for bonds that investors didn’t want, causing yields to soar. Reno learned how costly the securities could be when interest rates more than tripled to 15 percent in the course of one week, according to the complaint.
“It’s absolutely incredible how much money has come out of local governments because of this debacle,” said Peter Mougey, an attorney for Reno. The soured deals contributed to fiscal strains brought on by the 18-month recession that ended in 2009, said Mougey, who’s based in Pensacola, Florida.
Banks that recommended auction-rates to issuers wound up profiting at the expense of taxpayers stuck with the tab. Wall Street firms reaped $6.5 billion of extra revenue from borrowers from higher interest rates, remarketing and restructuring fees, and payments to end derivatives tied to the deals, according to a report prepared by Joseph Fichera, Saber’s chief executive officer, for a course he taught at the Woodrow Wilson School of Public & International Affairs at Princeton University.
The remainder of the study’s cost estimate came from areas such as additional interest paid to investors and other fees related to restructuring.
The market freeze and spike in yield penalties came as borrowers in the $3.7 trillion municipal market were facing the worst drop in revenue in 50 years, according to an April 2009 report on state tax collections from the Nelson A. Rockefeller Institute of Government in Albany, New York.
“Municipalities were exploited by Wall Street dealers that gave them bad financial advice,” said Marcus Stanley, policy director of Americans for Financial Reform, a Washington group that pushes for stronger bank regulation. “It seems to be very common for state and local governments to get very bad terms when dealing with Wall Street.”
The Securities Industry and Financial Markets Association, which represents banks and dealers in securities markets, declined to comment, Andrew DeSouza, a spokesman in Washington, said in an e-mail. Michael DuVally, a spokesman for New York- based Goldman Sachs, also declined to comment.
Banks weren’t required to bid in the auctions they handled. When auctions fail, yields can be reset according to the terms of the debt, sometimes at multiples of indexes such as the London Interbank Offered Rate. That was what caused rates for borrowers such as Reno, Nevada’s third-largest city, to spike.
Issuers had anticipated saving by obtaining short-term interest rates for longer-maturity debt. They also chose the securities to avoid paying for buyback agreements with banks, which are required when issuing variable-rate debt.
Yet that unraveled amid the financial crisis that took root in 2007. Disruptions in auction-rates began the following year as dealers facing pressure from losses on mortgage-backed securities started to pull back from bidding on the debt.
The bonds that are part of Reno’s arbitration complaint with the Financial Industry Regulatory Authority show how abruptly yields rose.
In more than 90 weekly auctions from May 2006 through Feb. 6, 2008, Reno’s yields averaged 3.6 percent, data compiled by Bloomberg show. On Feb. 13, the interest rate soared to 15 percent for a 34-year maturity.
Michele Anderson, a spokeswoman for Reno, didn’t immediately respond to a request for comment.
As issuers bought back the securities or converted them to variable-rate or regular long-term obligations, the market for auction-rate debt has shrunk to $35.6 billion since 2008, data compiled by Bloomberg show.
Dealers paid about $620 million in settlements with regulators, most of which went to investors, according to the report.
About $5 billion of the extra cost of the market’s demise was related to ending swaps, according to Saber. Auction-rate transactions often included interest-rate swap agreements, also designed to cut costs, that went awry when yields defied expectations and fell.
In June, the water utility of cash-strapped Detroit borrowed $659.8 million to pay more than $300 million to banks, including JPMorgan Chase & Co., to end interest-rate swaps. The utility has paid more than $500 million to unwind swaps tied to auction-rate securities.
Anthony Neely, a spokesman for Detroit Mayor David Bing, didn’t immediately respond to a request for comment.
Auction-rates aren’t the only financial instrument to cost municipalities. Localities are poised to lose about $6 billion through Libor bid-rigging, according to an estimate from Peter Shapiro, managing director of Swap Financial Group in South Orange, New Jersey.
Banks that set Libor have been accused of manipulating the market by setting rates too low. In June Barclays Plc, Britain’s second-biggest lender by assets, paid a record 290 million pound ($467 million) fine for manipulating the rate.
Some interest-rate swap payments were tied to Libor, the basis for $300 trillion of securities and loans worldwide. Setting Libor too low raised what issuers paid to swap counter- parties.
Fichera, in an interview, called the auction-rate freeze “the first system-wide collapse of the credit crisis” in securities markets. “The numbers speak for themselves.”
Louisiana, one of the poorest U.S. states, may have to pay a $95 million penalty to unwind a swap as part of a plan to refinance $294 million of auction-rate securities. The bond sale for repairs of the Mercedes-Benz Superdome after Hurricane Katrina came with extra costs of $42 million tied to the market collapse, according to data compiled by Bloomberg.
Whit Kling, director of the state’s bond commission, declined to comment.
Next year, 15 cases Mougey filed for municipal borrowers with Finra, which regulates securities dealers, will come to final arbitration, said the lawyer, with Levin, Papantonio, Thomas, Mitchell, Rafferty & Proctor P.A.
The cases allege that the banks handling the auctions knew the market depended on their bids for unwanted securities, and that the banks never disclosed that to issuers, he said.
In trading yesterday, municipal yields climbed as issuers sold the most debt in six months.
Yields on benchmark munis due in 10 years rose 0.12 percentage point to 1.58 percent, the highest in about five weeks, data compiled by Bloomberg show.
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