“What The Hell Are Alabama Residents Doing Trading Swaptions?” Just Ask Tennessee…

A day after the credit rating agency Moody’s issued an unprecedented blanket negative outlook report on the debt of all American cities and towns, a fascinating New York Times story today further illuminates the process by which so many small municipalities signed on to risky derivative securities contracts that exploded on them last year, in some cases quadrupling their interest payments.

The story focuses on Tennessee and the Memphis-based investment bank Morgan Keegan, which recently celebrated its rise to top underwriter status in the state and the south central U.S., managing a whopping 39% of Tennessee bond issuances last year.

Tennessee is one of few states with laws requiring public officials charged with approving derivatives deals to attend “swap school” to learn about the risks and complexities of the contracts. The state comptroller says he asked business professors to write the swap school textbooks, but when they declined the task was left to…Morgan Keegan, which had also been retained as an adviser to many of the state’s towns.

In many corners of Tennessee, the first anyone heard of interest-rate swaps was from C. L. Overman, a vice president of Morgan Keegan who assured officials that the deals carried little risk, city and county officials said.

“He told us it would be a good thing and there wasn’t much downside,” said Mayor Duncan of Claiborne County.

Then a few months ago, according to the Times, Overman called to tell county officials they had a few weeks to refinance an $18 million bond or pay a quadrupled quarterly payment of $700,000. Perhaps unsurprisingly, Morgan’s swap school curriculum understated such risks, and the Times has the textbook to prove it. The big risk factor they missed? It’s a familiar one:

A swap allowed a municipality to keep a portion of its debt at a fixed interest rate and a portion at a variable rate. The municipality was, in effect, betting that interest rates would move in its favor. Investors protected themselves by taking out insurance that guaranteed they would be paid. But as the nationwide credit market collapsed, most of the bond insurers’ credit ratings were downgraded, including the Ambac Financial Group, the primary insurer of Tennessee bonds. That allowed the investors to accelerate the retirement of the debt, usually from 20 years to 7, leading to a steep increase in the interest rate.

Although such a provision was in the swap contract, several local officials said that possibility had not been explained to them.

You may recall that municipal officials in Tennessee were hardly the only ones who didn’t pay enough heed to that line in the swap contract: the failure to factor in the possibility of a ratings downgrade is to a great extent what brought down AIG. The big difference, of course, is that AIG, which all but invented swaps contracts, should have known better. In Tennessee, legislators hired an investment bank to explain the risks to them, and the bank failed to do so. And it wouldn’t be the first time Morgan Keegan concealed derivatives risks from investors: the bank was just ordered to repay a San Francisco-based investor in one of its bond funds a $267,711 arbitration settlement, the largest such settlement in a bond fund on record, for misclassifying as bonds its investments in complex “derivative-laced” CDOs and CMOs. It’s the fifth straight case the investment bank has lost in what the arbitration lawyer suing Morgan expects to be a “tsunami” of rulings against the firm.

Meanwhile in Alabama, the state school construction authority is dealing with a derivative deal-gone-bad by simply refusing to make payments pending a decision in a federal lawsuit it filed attempting to get the contracts thrown out. In a post decrying the authority’s failure to honor contract law, even the government haters at the blog Zero Hedge have to wonder:

the real question is what the hell are Alabama residents doing trading swaptions?

See above, guys.

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