News & Politics » Deanna Isaacs on Culture

The big swap

Illinois is withholding funds for education and social services, but still paying Wall Street banks for some bad bets.


  • Illustration: Paul John Higgins (Tim Boyle/Getty Images)

If you've seen my new favorite movie, The Big Short, you've heard that banking used to be a boring, old-boys' enterprise that mostly consisted of lighting up a cigar, making a fixed-interest loan to the neighborhood hardware dealer, and taking a nap.

Then derivatives came along, and the stodgy old banking business turned into Las Vegas on wheels. The Big Short is a hugely entertaining (and appalling) take on the variable-rate mortgage repackaging that brought on the 2008 subprime crisis and nearly shut down the economy.

But mortgages weren't the only financial instruments generating derivatives. In the early years of the 21st century, state and local government bonds—those staid and sleepy behemoths—were being issued with their own set of variable rates and a magic little add-on feature that was supposed to make them safe—a derivative known as an interest-rate swap.

And Illinois was in. According to the ReFund America Project, which earlier this month issued an admirably readable report, "Turned Around: How the Swaps that Were Supposed to Save Illinois Millions Became Toxic," Illinois taxpayers have already paid the big banks that sold the state these swaps $618 million.

Over the life of the deals, the last of which will expire in 2033, Illinois will pay about $832 million more.

The bill this year alone will be $68 million.

That's a total of about $1.45 billion for the banks, for deals that were sold as insurance and were supposed to be a zero-sum game.

How'd it happen? If this were The Big Short onscreen, we'd now get Margot Robbie in a bubble bath to explain the kind of financial details that usually cause our eyes to glaze over. For this story, Rod Blagojevich in a bubble bath, or in full Elvis mode, would do. It was during Blago's reign in Springfield that Illinois bought most of the 19 swaps ReFund America says the state still holds.

So, while I try to lay this out, maybe you could imagine Rod, with forelock and guitar. The refrain would go something like this: "You ain't nothing but a sucker . . . "

(I tried to reach Blagojevich's chief financial officer, John Filan, for this cameo. He didn't respond, but he's apparently still around. In the fall of 2014, he was consulting for the Chicago Public Schools, which is struggling with its own swap payments, and last week the Sun-Times reported that his wife, Sally Csontos, was recently hired to be CPS's executive director of change management at a salary of $160,000 a year.)

Back in 2003 the appeal of adjustable rates was the same for the state as it was for the millions of home owners who were biting on easy-to-acquire floating-rate mortgages: they were cheap at the moment. The obvious catch was that, sometime in the future—that hard to picture, oh-so-distant future—they might, you know, go up.

Not to worry: the banks had a way to protect the state against that—and this is where (drum roll) the magic interest-rate swap comes in. Buy it, and—presto!—you've changed that sexy but unstable variable rate into something just like a good old reliable fixed rate. They called it a "synthetic fixed rate."

A swap, of course, involves two entities trading items, usually of equal value. In this case, the swap would be a side deal to the bond sale: the state and the bank would agree to pay each other interest on the bonds, with one important difference. The state would pay a fixed rate of interest to the bank, while the bank would pay a variable rate to the state.

Got that? OK. At the same time, the state would be paying a variable rate to its bondholders. So, if interest rates rose significantly, the bank's payments to the state would go up enough to cover the increased amount the state would be paying the folks who bought the bonds.

The theory was that, in the end, the swap would be a wash. The state would get upside interest-rate protection, and the only real money the bank would make would be the fee it charged for entering into the deal.

It apparently didn't occur to the guardians of Illinois taxpayers' money that interest rates might go the other way. Which they soon did, with a vengeance.

And that's when it became suddenly and painfully clear that the swap "insurance" the state had purchased had actually been a bet that interest rates would go up, while the banks that sold the swaps had bet on rates going down.

In 2008, when the housing market crashed, the Federal Reserve cut interest rates to near zero, where they've stayed ever since. As the ReFund America report demonstrates, the impact on the Illinois swaps was drastic: between December 2007 and December 2008, the state's monthly net payments on just five of them, for example, jumped from $264,000 to $1.5 million.

ReFund America says the swaps never worked well, but the last seven-plus years have been especially ugly, with the state locked into paying the banks high, precrash fixed rates while the banks pay the state postcrash, "easy-money" rates of next to nothing.

Now, stalled out over a multibillion dollar budget gap, Illinois is cutting or withholding funding for education and social services, but is still making those swap payments to big banks like Wells Fargo and JP Morgan Chase.

ReFund America's Saqib Bhatti, who coauthored the report with Carrie Sloan, says the state should take legal action to stop further payments and to potentially claw back the $618 million that's been paid to the banks so far.

According to the ReFund report, it was "standard practice" for the banks to downplay risks or fail to mention them at all when pitching the swaps, which would have been a violation of federal fair-dealing rules. Illinois could ask the Securities and Exchange Commission to investigate and bring a "disgorgement action," and could also file suit itself under state law, Bhatti says.

The other option, paying onerous termination fees to the banks—they'd amount to as much as $286 million—is what Illinois shouldn't do, Bhatti says, akin to paying a ransom. (The city of Chicago, which entered into its own swap deals during the Daley years, has already paid or authorized payment of nearly $300 million in early termination penalties under Mayor Emanuel, and would have authorized another $106 million if the City Council's Progressive Caucus hadn't put a hold on it earlier this month.)

The swaps didn't show up in Governor Rauner's State of the State address Wednesday, but then, neither did the fact that the state doesn't have a budget. But they're on his radar: a Rauner spokesperson advised by e-mail that "the Governor's Office of Management and Budget is doing an in-depth analysis of these swaps in order to reduce the State's payments and minimize its financial exposure."

So there's a chance our pro-business, venture-capitalist governor will take on those big banks and make them do the right thing any day now.

But don't bet on it. v

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