Swaps Money Train Prepares for Final Run in Muniland: Joe Mysak

Commentary by Joe Mysak

Aug. 26 (Bloomberg) -- The money train is coming to a screeching halt. Maybe.

The ``money train'' is the term used by David Bronner, chief executive officer of the Retirement Systems of Alabama, to describe the bankers, lawyers, consultants and advisers who helped put together Jefferson County's sewer bond financing and associated mountain of interest-rate swaps. You know, the one that is driving the Alabama county to bankruptcy?

``It's time to stop the money train,'' Bronner told a meeting of local officials on Aug. 15, according to the Birmingham News. ``They are waiting to get paid again, and again, and again.''

Bronner, who has put forward a plan for the retirement fund to buy the sewer system from the county, hit upon something with this characterization of the bond business, or at least certain parts of it, as a ``money train.''

This year's auction-rate securities freeze illustrated the workings of the train. Securities firms were paid to underwrite the auction-rate deals, they were paid to run the regularly scheduled auctions (whether they failed or not), and then they were paid again to refinance the auction-rate debt.

The money train -- what an apt expression!

Perpetual Deals

Or at least that was the plan, until state officials, notably New York State Attorney General Andrew Cuomo and Massachusetts Secretary of State William Galvin, demanded that the securities companies who had built the market and then broke it, to fix it.

Not only will the firms buy individual investors' auction- rate securities back, some of them will also reimburse municipal issuers who refinanced that paper after they started paying higher and higher penalty rates. Well, we shall see.

The money train made its most profitable runs in the land of municipal swaps and derivative products.

Not until I looked at some of these transactions in detail did I realize the financial engineers who set them up never regarded the deals as separate and discrete.

No, they considered these deals as perpetual money machines. If one interest-rate swap wasn't working quite the way the issuer thought it should, that was fine; they could set up another one, and buy a bunch of options from the issuer, as well. So you could never really say this deal was a loser. There was always another deal, and you could simply borrow the amount you needed to terminate one and begin another.

School Districts

In Pennsylvania, some school districts are deciding to get off the swaps-and-derivatives money train, although of course they have to pay to do so.

Bloomberg reported last week on one school district that a few years ago was paid $730,000 for an option to enter into a swap, and is now paying $5.2 million to cancel the transaction.

Some others are doing the same, which just goes to show that there's really no such thing as free money in public finance, I guess. So many small municipalities regarded selling these ``swaptions'' as collecting free money.

They are today presumably wiser. What Pennsylvania should do now is study in some sort of comprehensive way just how school districts have fared since being allowed to get on the swaps-and- derivatives money train in 2003. Everyone in the state house seemed to think it was a terrific idea back then.

In 2007, a team of Bloomberg reporters looked at a batch of the swaps-and-derivatives deals and concluded that the school districts routinely paid too much for both the deals and for the advice they were required to get.

State Role

It is difficult to see how the nation's smaller and less sophisticated municipal-bond issuers -- that is, the majority of the market -- can keep engaging in swaps-and-derivatives transactions that they can neither evaluate nor understand.

Are they still doing so? No doubt they are still being pitched such things.

It doesn't look good for the money train, though, especially as more facts and details are revealed about how these things were priced and sold, and how they behaved under stress.

Maybe the states have a role here. They, after all, are the ones who resolved the auction-rate securities freeze. Maybe now they can take a good look at the public-finance money train.

(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net