Snake Oil Derivatives Salesmen Bankrupting Schools → Washingtons Blog
Snake Oil Derivatives Salesmen Bankrupting Schools - Washingtons Blog

Friday, October 17, 2008

Snake Oil Derivatives Salesmen Bankrupting Schools

Do you think derivatives are some abstract thing which don't effect real people? Or that derivatives salesmen are just good folks who innocently sold bad products?

Well, as an article in Bloomberg points out, neither assumption is true:

"The U.S. Securities and Exchange Commission is investigating a Pennsylvania school district's derivative trades with JPMorgan Chase & Co. and Morgan Stanley that paid at least $8 million in fees to the banks and advisers.


The SEC inquiry follows a Feb. 1 article by Bloomberg News showing that ... school districts across Pennsylvania were charged excessive fees by banks and financial advisers that sold them interest-rate swaps. The schools were routinely unaware of the fees they paid for the contracts, some of which have backfired amid the credit crisis.


The derivatives sold to school districts are known as interest-rate swaps, in which two parties agree to exchange periodic payments whose amounts are based on an underlying bond issue. The contracts are usually paired with municipal bonds whose interest rates are reset sometimes daily. The derivatives are designed to protect customers against the risk of higher interest rates, though they also can be used to speculate on movements in global lending rates.


The fees banks earn on the derivative transactions are rarely, if ever, disclosed, even by advisers school districts hire to render an opinion on whether the amounts are fair, the story found.

The contracts are typically awarded without competitive bidding and have left school districts exposed to soaring interest rates as the financial crisis causes banks and investors to hoard cash. Jefferson County, Alabama, has been pushed close to bankruptcy by its swap and bond deals, while elsewhere local governments have been slammed by high interest costs or fees to break derivative deals.

The Butler, Pennsylvania, school district, about 40 miles north of Pittsburgh, in August paid JPMorgan $5.2 million to escape from a derivative transaction that would have forced it to sell the type of debt being shunned by investors. Last month, the district sued JPMorgan and financial adviser Investment Management Advisory Group Inc. for allegedly conspiring to hide the fees the bank earned on that transaction and requested that the SEC investigate. The Erie, Pennsylvania, school district filed a similar suit.


At least five former JPMorgan municipal derivatives-unit employees are targets of that investigation, which centers on whether banks and advisers conspired to overcharge local governments, public records show. Some two dozen securities firms and advisers have also been subpoenaed in that investigation. No charges have been filed.


In the last week of September, the rate on $55 million of floating-rate bonds issued by [one Pennsylvania] school district in 2007 jumped to 8.5 percent compared with 1.9 percent at the beginning of the month. Two swaps with JPMorgan on the bonds added another 6.51 percent, making the district's total rate on the debt 15 percent. The overall rate has since declined to 9 percent.


"The people who sold these came to us, not to assist us, but because they saw a way, with our money, to make money for themselves and we fell for it,'' said Stephen Antalics, 79. "Who's going to pick up the expense? It's going to come out of taxpayers' pockets. The people who created this will walk away Scot free.''


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