Another Faustian Swap: Indianapolis Water Authority Forced To Cough Up $100 Million-Plus

Another day, another group of American taxpayers forced to cough up tens of millions of dollars to Wall Street over a little-noticed provision in a “swap” contract gone sour. Last week we brought you the parallel tales of sudden budgetary meltdown in Tennessee, Alabama, Illinois, New Mexico and Philadelphia that in part prompted the credit rating agency Moody’s to issue a blanket negative credit outlook on all bonds issued by American cities and towns. Today it’s the Indianapolis Water Authority being screwed in a swap deal that might force the utility — and by extension, its customers — to cough up a collateral call of as much as $100 million.

The deal is a familiar one: in 2005 the city of Indianapolis refinanced $550 million in fixed-rate bonds to raise money to fund its acquisition of its old water company from the private utility company NiSource, which agreed to sell it as a condition of regulatory approval of its merger with Columbia Energy Group. The deal involved the ailing bond insurer MBIA as well as a similar German-Irish firm called Depfa Bank, which insure the utility’s ability to pay up by writing credit default swaps on municipal bonds that protect investors in the event of default. But as Barney Frank pointed out last week, the risk of municipal bonds defaulting is historically minimal — while the risk that MBIA and Depfa might default was steadily rising as they began to chase the riskier (AIG-dominated) business of writing swaps on collateralized debt obligations. And when those “insurers” started to see their credit downgraded last year, suddenly it was municipalities like Indianapolis that were swamped with calls demanding collateral — which translates to a major refinancing being funded by an emergency 17.5% rate hike this summer.

If you’re having trouble getting your head around how this works, it’s a little like this: in order to get a cheaper interest rate on your mortgage, you pay you bank extra for a “swap” insuring the investors who buy the mortgage in the case of your default. But then the bank that originated the mortgage starts making riskier loans and its credit rating agencies downgrade its debt, it turns out the owner of your mortgage can demand collateral from you. Except in the case of municipal bonds, the homeowners are cities and towns with the legal authority to tax citizens and an infintessimal record of actually defaulting — and the banks were using your interest payments to extend home loans to unemployed high school dropouts and senile 80-year-olds living on Social Security.Cities and states got suckered into these deals through a mixture of corruption and incompetence. In Tennessee, it appears to be the former; in Illinois, where former Gov. Rod Blagojevich has been charged with taking a cut of an $809,000 fee Bear Stearns paid a lobbyist for steering it the lead underwriter position in a 2003 swap deal, an elaborate conspiracy of corrupt public officials allegedly enabled such transactions.

No official corruption investigation into the Indianapolis deals has yet been announced, but a blog that has been following the deals depicts a typically cozy clique of bond lawyers, bankers and accountants surrounding the city’s Bond Bank. This paragraph in particular jumped out at us:

. And just for the fun of it, it’s worth noting that the person Mayor Ballard named as executive director of the Bond Bank is Kevin Taylor, who joined city government after leaving AIG’s Global Investment Group. Yes, that’s the same AIG of mega-government bailout fame. AIG’s entry into the business of bond default insurance contributed to its financial mess. You just can’t make up stuff this good.

And while enough newspapers are still in business to bring you the tale of a new city, state, school district or park authority getting screwed every day by the same unregulated swaps that begat the crisis, why would you bother?

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