Who do you suppose would get the better of it if the mayor of your city made a bet with Goldman Sachs on the direction of interest rates? Would you be surprised if the mayor lost, costing the city’s taxpayers millions of dollars? Do you think betting taxpayer dollars is legal?
In the years leading to the Crisis of 2008 many municipalities made interest-rate bets with Goldman Sachs, JPMorgan, Morgan Stanley, and British banks. The cities lost every bet. Right now, their taxpayers are paying out billions annually. The bets will not be paid off for 15 to 20 years, costing the cities needed policemen, firemen, and schools.
The funny part of the story is that the cities keep paying despite the fact that they have a good legal defense: The bets are not enforceable because cities are not authorized to place bets with taxpayer money.
Traditionally, cities issue bonds with a fixed interest rate but with a “call option”—the power to redeem the bonds before maturity if interest rates drop so that new bonds can be issued at the lower rate. Variable-interest-rate bonds, on the other hand, typically sell for a slightly lower interest rate but without a call option. Consequently, new bonds cannot be issued if interest rates go up; taxpayers have to pay the higher rate. The bankers approached the cities offering them what...