Who Else Is Paying For Those Fat Wall Street Profits?

There’s another big reason — besides AIG — that Wall Street trading desks have been booking such fat profits lately: fees they’re collecting closing out interest rate swaps that have been exploding in the faces of cities, states, towns and public utilities over the past year.

Put another way: they’re not just booking those billions soaking the government, they’re booking them soaking…the government. Along with hospitals, utilities, park authorities, pretty much every other realm of the public or nonprofit sector…

Including Harvard! In December the university raised $2.5 billion dollars in a bond offering partially designed to give them the capital to buy out of $570 million in underwater interest rate swaps it had invested in back in 2005. The swaps were expressly endorsed by then-president Larry Summers, now head of the National Economic Council.Harvard sold the bonds with the underwriting and advisory services of JP Morgan, Morgan Stanley and Goldman Sachs — the same group of banks, according to Bloomberg, that endorsed the “Summers swap.” Another recommendation: that Harvard offer an interest rate as much as 1.41 percentage points higher than an identically rated corporation would pay to borrow the money to sweeten the deal for investors.

(That, if you were wondering, is an example of the unequal credit system perpetuated by the rating agencies differing standards for corporate and public debt that so rankles House Financial Services Chairman — and Harvard alum — Barney Frank.)

At those terms, money came flowing in to Harvard:

“It was a riot,” said John Flahive, a senior vice president at BNY Mellon Wealth Management, of demand for the Dec. 10 bonds. His $1 million buy “was only 20 percent or 25 percent of what I wanted.”

And much of it came right back into the coffers of the banks with whom it had entered into its 19 swap contracts — including Goldman, Morgan Stanley and JP Morgan.

The value of Harvard’s swaps dropped as the fixed rates sought by banks in exchange for floating rates on new swaps fell below what the university was paying. By Oct. 30, its swaps were worth a negative $570 million, meaning that’s how much Harvard needed to pay to get out of them, S&P said.

Some proceeds from the $1.5 billion bond sale paid termination fees for the forward-rate swaps, the S&P report said. Harvard declined to say how much it spent to get out of the agreements. As much as $99.3 million of the $1 billion sale paid off swaps related to existing debt, Harvard’s official statement on those bonds said.

It’s hard to explain exactly how swaps sent so many public sector institutions into such fiscal peril so quickly, except to say that the contracts all hinged on the financial health of a few bond insurers that all went bust in tandem with AIG, and relatively liquid markets that started to collapse with Bear Stearns. But critics have long suspected the swaps were engineered primarily to ensure a steady stream of fees to the banks that arranged the deals — and last year Ben Bernanke wrote a letter to Congressman Jim Moran suggesting public sector entities might consider banning derivatives in the future.

As for Harvard, we’re pretty sure their business model is safe. Good thing they got rid of that Summers guy though, huh.

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