In William J. Quirk’s essay “How Goldman Sachs Is Swindling America’s Cities” (American Proscenium, July), Professor Quirk evidences profound misunderstanding of what is happening in an interest-rate swap.
An interest-rate swap for a borrower is a way to remove or reduce interest-rate risk from a transaction. This was described adequately in Professor Quirk’s article. The fact that the cities had lost their ability to call their bonds in after a period is irrelevant. If they had issued a callable bond, the market would have demanded a higher initial interest rate.
To portray these city financial managers as making stupid bets against sophisticated Wall Street types is to misunderstand Goldman Sachs’ motive in engaging in this transaction. Goldman Sachs doesn’t care whether they will be paying floating rates or fixed rates. They will be equally well off either way. After all, does your bookie care which way you bet on the Notre Dame-Michigan football game? Of course not. If his book becomes imbalanced, your bookie will simply lay the bet off. That is exactly what Goldman Sachs will do as well. Goldman will always make money on their swaps book as long as they keep their transactions balanced, so Goldman doesn’t care if our municipality wins or loses in its particular transaction.
Professor Quirk Replies:
Mr. Jones thinks I am misunderstanding Goldman Sachs’ motive for engaging in interest-rate swaps. Goldman Sachs, he writes, is just like your bookie taking a bet on the Notre Dame-Michigan game. If he gets too many bets one way or the other, “your bookie will simply lay the bet off.” Finally, he writes “To portray these city financial managers as making stupid bets against sophisticated Wall Street types” misunderstands the transaction.
Why, then, did the cities lose every bet? Why have the banks bribed local officials to get swap deals? The SEC investigated events leading to the bankruptcy of Jefferson County, Alabama—the largest local-government bankruptcy before Detroit.
The mayor of Birmingham is serving a 15-year sentence for taking bribes, and two associates are serving five-year sentences. The director of the SEC’s Division of Enforcement said, “The transactions were complex but the scheme was simple. Senior J.P. Morgan bankers made unlawful payments to win business and earn fees.” Another SEC officer said, “This self-serving strategy of paying hefty secret fees to local firms with ties to county commissioners assured J.P. Morgan Securities the largest municipal auction rate securities and swap agreement transactions in its history.” One banker, in a taped phone call, told the county commissioners, “Whatever you want—if that’s what you need, that’s what you get—just tell us how much.” J.P. Morgan even agreed with the president of the county commission to pay Goldman Sachs three million dollars, although Goldman performed no services. When was the last time a bookie bribed someone to make a bet?
The point of my article is that the big banks have swindled America’s municipalities. It was the banks, not the municipalities, that concocted these bizarre financial transactions and sold the municipalities on them. It was the banks that raked in exorbitant fees putting these deals together. It was the banks who insisted that the municipalities give up the ability to call their bonds. Mr. Jones calls this “irrelevant,” but it is anything but. A call is the traditional means for municipalities to take advantage of lower interest rates. It calls in the old high-interest bonds and issues new ones at the lower rate. Because of the swap, they are now stuck with higher rates and can’t call the bonds. It has cost the municipalities hundreds of millions, causing cuts in police and fire protection.
Mr. Jones attributes a benign motive to the banks: He thinks that, because they can theoretically hedge their side of the bet, they do not care whether interest rates go up or down. It was not a bet for them; it was arm’s length high finance at its rational best. Mr. Jones assumes that the banks hedged their side. But who knows what they did? Derivatives are veiled in secrecy. Who knows whether and how they assessed their risk? Who cares? It does not make it any less of a bet. It doesn’t lessen the cost to the municipalities of losing the bet. It does not change the fact that the banks took advantage of unsophisticated public officials. It does not explain why every bet made with the municipalities paid off for the banks. The banks made their money at the expense of the municipalities at every stage—at inception, during the term, and, if the municipalities want out, at termination.
If only the banks were bookies.