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Sultans of Swap: ACT III - The Getaway!

Stock-Markets / Derivatives Mar 26, 2010 - 09:21 AM GMT

By: Gordon_T_Long


Diamond Rated - Best Financial Markets Analysis ArticleThere are 7 stages to executing a successful sting operation. Whether this is the modus operandi behind the Sultans of Swap operating in the $605 Trillion OTC Derivatives market or just simple coincidence, I will leave it to you shrewd reader to determine. The seven stages do however offer us an instructive theater guide to better understand these murky instruments called Interest Rate Swaps.

Act I can be found at: SULTANS OF SWAP: Smoking Guns!

Act II can be found at: SULTANS OF SWAP: The Sting!

In Act II of our fictional play before we broke for Intermission, we saw the mechanics of how our Sting might be perpetrated. We saw how our PATSIES were "Fearing the Gearing" and being forced to rewrite their existing SWAP contracts with horrendous fees and collateral requirements. This is money that the public purse didn't budget for and has no hope of raising. What will our PATSIES do now? They have little choice -either pay the shylock's usury fees or sue!

Once again our audience was witness to some strange happening when the lights came up during the intermission.

Like a wave, the news of angry PATSIES taking their grievances to the courts surged all along the global shorelines. Let's take a quick world tour to see the carnage showing up in the court rooms.




ONE of the great advantages of financial innovation, it was often said, was that risk would end up going to those best qualified to hold it. In fact, much of it seems to have ended up in the hands of those least able to understand it. How some of it got there may soon be revealed in an Italian court.

On March 17th four big banks, 11 bankers and two former city officials were charged with fraud in connection with the sale of interest-rate derivatives to the city of Milan. The trial is due to start in May. The prosecution relates to a huge bet on interest rates that the four banks -- UBS, JPMorgan Chase, Deutsche Bank and Hypo Real Estate's DEPFA unit -- helped the city authorities to take in 2005. The banks helped arrange the sale of €1.7 billion ($2.3 billion) of bonds for the city and then also helped it swap the fixed interest rate it was paying on the bonds for a lower, floating rate. Part of the contract is thought to have involved a "collar", a way of limiting the range of outcomes on a bet, which protected Milan from rising rates but which also meant it would have to pay out if they fell.

The city claims that it was originally promised interest savings of about €60m on the deal but has now made big losses because interest rates have fallen, triggering payments to the banks. Bankers with knowledge of the transaction claim that, in fact, the city has benefited from offsetting gains as the interest rate it pays on the underlying debt has fallen too. The prosecution also claims that the banks charged more than €100m in fees that were built into the price of the swaps and were not properly disclosed to city officials. The banks all deny any wrongdoing.

The outcome of the case will be closely watched elsewhere. In Italy alone, local municipalities had derivatives exposures with a face value of €25 billion last year, according to the Bank of Italy. Some academics reckon that losses on these may go as high as €8 billion. In many of these cases local authorities swapped fixed rates for floating ones, only for collars incorporated into the deals to leave them with losses as interest rates fell. In other cases, losses may only start to show when rates move the other way. Had their bets paid off, however, it seems unlikely that any cities would be crying foul. (1)


In Germany scores of public authorities signed contracts that they seem not to have understood. In Leipzig the courts have been asked to rule in a dispute between the city and UBS. That case relates to a complex sale-and-leaseback agreement that the city signed for its local waterworks. Part of the deal reportedly entailed the city agreeing to insure a portfolio of loans against default through a collateralised-debt obligation (CDO). Making good on those loans may bankrupt the city.

In all, about 100 German local authorities are thought to have entered into sale-and-leaseback agreements with American investors over the past decade in a bid to take advantage of loopholes in tax laws. In many of these deals local municipalities unwittingly agreed to take on credit risks for various counterparties, exposing them to demands for collateral as the ratings of institutions such as AIG, an American insurer, fell. (1)


We started in Act I with Interest Rate Swaps in Greece. In Act II we broadened our discussion to the EU and touched briefly on the US. Now we see the following in the US.


"Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts. .. Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs. The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper.

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%. Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases." (7)


"The Service Employees International Union said Chicago, Denver, Kansas City, Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said. Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs."(7)

Study by the Service Employees International Union - Detailed Spreadsheet List,

The "Stop the Swaps" Campaign by the Service Employees International Union (SEIU) (15)

Exposed: Investigate the banks' Swap Schemes

Watch VIDEO: WSJ Takes On Interest Rate Swaps


In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment. State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal." (7)

While the investigation focused on the Bethlehem Area School District, Wagner called his report a "case study" of the use of swaps by all local governments in Pennsylvania. The Department of Community and Economic Development's records indicate that 626 swap filings were made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt. The precise number of different swaps and the precise amount of debt cannot be determined because the DCED data may include some double-counting. During this time period, 107 of Pennsylvania's 500 school districts, or 21.4 percent, and 86 other local governments reported to DCED that they entered into swap agreements. At least 13 investment firms, including Citibank, Goldman Sachs, J.P. Morgan, and Morgan Stanley, have entered into swap agreements with Pennsylvania school districts and other local governments. (8)


Municipalities in America are also grappling with derivative contracts they barely understand. The city of Los Angeles is pressing Bank of New York Mellon to soften the terms of an interest-rate swap on $443m of bonds that is costing the city money because rates fell. (1)

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.(7)


Jefferson County in Alabama is teetering on the edge of bankruptcy after it entered into swaps that were worth more than $5.4 billion at their peak. (1)

"Jefferson County in Alabama is on the brink of bankruptcy after sinking 100 percent of its $5 million sewer system financing into swaps. JP Morgan and CDR were also involved there."(3)


They were touted as a state-of-the-art financing tool that would help New Mexico stretch its highway improvement dollars. Nearly five years later, state officials are trying to keep the $420 million in fancy financing from turning sour. In the last six months, one of the banks involved in the so-called interest rate swaps has gone bankrupt and the state has had to post about $16 million in collateral because the value of the investments dropped. That's in addition to major political fallout. The swaps and how a California company was selected to handle them are at the center of a federal grand jury investigation that derailed Gov. Bill Richardson's nomination as commerce secretary. (2)(3)


Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year. That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment. (7)


Last August, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claims it is owed $156.6 million under the agreements. The toll authority, which is fighting the claim, said it made the payment, and Ambac sued for the other part of what it says it is owed. An Ambac lawyer couldn't be reached for comment.(7)


Richmond, Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost the struggling city an estimated $3.5 million a year, based on current interest rates. Under the revised deal, Richmond would make smaller, more regular payments to the bank over time. In November, RBC and city officials rejiggered a separate transaction that would have cost Richmond about $2.5 million. An RBC spokesman said bank officials are working with the city to "restructure the underlying bonds in a way that best serves the city's interests and those of its residents." The "goal of the original transaction was to lower borrowing costs for the city," the bank spokesman said, adding that the bonds didn't perform s anticipated because of downgrades at bond insurers that backed them. Richmond's vice mayor, Jeff Ritterman, said he still is reviewing next month's proposed restructuring. Financial woes have forced Richmond to cut its budget and lay off employees. (7)


New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps -- more than a quarter of which resulted from the Lehman bankruptcy in September 2008. (2)(5)


DPS (Denver Public Schools) entered into negotiations with JP Morgan and CitiGroup, agreeing to issue fixed-rate bonds secured by DPS school buildings and other properties. DPS then began discussion to enter into an interest-rate swap agreement with JP Morgan, Bank of America and the Royal Bank of Canada. We believe that following ensued: DPS entered into a swap transaction, believing that interest rates would stay high. As recent financial news tells us, interest rates fell. We are concerned that this may have translated to a loss of taxpayer dollars. (2)


Eight California municipalities, including Los Angeles, Fresno and San Diego County, filed civil class-action, or group lawsuits. The suits, most of which were consolidated with others in U.S. District Court in New York City, allege that banks colluded by deliberately losing bids in exchange for winning one in the future, providing so-called courtesy bids, secretly compensating losing bidders and allowing banks to see other bids.

Brokers participated in the collusion by facilitating communication among banks and sharing in illegal profits, the civil class-action suits allege. (2)(4)

... And on and on. Get the message?

After a long Intermission, let us get back to the conclusion of our play.


The third act is the unraveling of the plot. The characters involved in the heist will be turned against one another or one of the characters will have made arrangements with some outside party, who will interfere. Normally, most of or all the characters involved in the heist will end up dead, captured by the law, or without any of the loot; however, it is becoming increasingly common for the conspirators to be successful, particularly if the target is portrayed as being of low moral standing, such as casinos, corrupt organisations or individuals, or fellow criminals.

Act III begins with all our actors on stage. The PATSIES are scared. They finally understand their Interest Rate Swap and realize what they or the political predecessor had agreed to. Do they take the Greek option and come clean by blaming it all on the previous government? To most this is not an option. Needing help, they have assembled all the actors to give them advice.

What the endless list of legal proceedings above tells us is:

1- Swaps have permeated into every facet of local, municipal, city and state governments. 2- Swaps are a major financial instrument being used broadly in debtor nations and governments. 3- When the PATSIES find themselves in the gears they more often than not sue. They plead ignorance, not too dissimilar to US homeowners who expected to make a killing on their overleveraged McMansion. All are turning out to be very messy Getaways.

What should be readily apparent to the shrewd observer is that the biggest debtor in the world, with the least means of paying and an international reputation for devious behavior, is missing. Where is Uncle Sam in all this?

Prima Facie says Uncle Sam must have participated in some minor fashion.

We are going to try something different in our play. For those who have seen Avatar in the cinema, you will recall you were given special glasses so you could view the show in 3D and therefore get the full impact of the presentation. We are going to do the same thing but with a modern day "internet" twist so you see the reality of all this.

I invite you to click the following link - read the complaint - (at least the yellow highlighted section) - then hit the back button on your browser before we continue. Ready? CLICK



If this doesn't sit you up straight then you need to check for a pulse!

I Want You To Pay Taxes

I am sorry dear reader, the getaway has already happened! The masked getaway happened New Year's Eve while we were all preparing to party. I believe ladies and gentlemen you have just witnessed a near perfect getaway! To me, the most probable justification for such an unprecedented action would be a collateral call on US government obligations of historic proportions. There are of course other possibilities.

Just in case some of our readers don't yet realize the significance of what happened, I can assure you that you will. Everyone will eventually pay through our servitude with higher taxes, reduced entitlement programs and a much lower standard of living for years to come, if the facts in this complaint are valid.


I am not a conspiracy buff. I believe in Occam's Razor. The simplest answer is likely the answer and not to assign suspicions to more complicated possibilities or sinister people. In my opinion, what is going on here is not conspiracy but rather just plain stupidity sprinkled heavily with greed, unintended consequences, moral hazard, hubris and the remnants of the Greenspan PUT.

Sure there are plots and strategies, but they will be noise when the $605T in derivatives start to unwind. Yes, $605T has a $3.7T net credit exposure but there are $36T CDS (Credit Default Swaps) that must be paid and not one person has accrued a cent for that payout. Everyone expects to be 'out of town' by that time! Everyone has their eye on the exit without trying to draw too much attention. It is still former Citigroup CEO Chuck Princes' lament: "as long as the music is playing, you've got to get up and dance!".

I AM ACCUSING NO ONE OF ANY CRIMES. How can I be accusatory in what is predominately a completely unregulated, non-exchange traded, off-shore, off-balance sheet, modern day wild west? What laws other than contract and tax laws? All the Sultans of Swaps are likely acting according to the letter of the few domestic laws applicable and in the manner carefully crafted by their legions of highly paid litigators. Even if effective legislation existed, there will still be examples of wayward behavior when the amounts of money involved are in the 100's of millions and billions. Unethical and illegal behavior unfortunately should be fully expected. This is why laws must be comprehensive, unambiguous and harshly enforced. Former Fed Chairman Greenspan's 'laissez -faire' philosophy was nothing short of naïve irresponsibility that has resulted in the global financial system being placed in a criminally tenuous position!

The actors in my estimation who are most at fault in our play are the sleepy eyed DIRECTORS and specifically the House of Representatives Finance Committee - chaired by Barney Frank and the US Senate Banking Committee - chaired by Christopher Dodd. If you are looking to assign responsibility for this mess, it begins and ends there.

The Sultans of Swap have proven that capitalism works brilliantly! In the US Gilded Age of Robbers Barons, capitalism also worked magnificently. Our great grandfathers understood rampant greed first hand and knew that smart legislation and regulatory enforcement were mandatory. They also knew guards must always man the sentinels. We are coming up on two years since the financial crisis erupted. What meaningful legislative bill (if any) has been passed? If we are this slow arriving at the scene of the crime, how can we possibly believe we can out run the crooks? We will always be 'a dollar short and pound light' operating within the current legislative framework.

Wall Street on a Money Roll
I Want Yo To Spend, Spend, Spend

Whistleblower Harry Markopolos testified before the Madoff Congressional Hearings, that the US legislative process and regulatory enforcement are seriously ill-equipped to either understand the financial world we now operate in or stay abreast of the breathtaking advances in structured finance. I don't want to appear cynical, but I see it as NASA level rocket scientists being supervised by politicians who likely failed high school algebra. They don't even know what questions to ask. Unfortunately the people ALWAYS willing to help the legislators with both the questions and answers are the Washington army of paid lobbyists. Lobbyists, as we are all acutely aware, have never been accused of having the public interest as their prime motivator. So who will tell the emperor he has no clothes? Remember, it is ultimately our pockets that are being picked.


Some would argue it is no longer a government for the people.

White Collar crime has been interesting to watch over the last 10 years. I used to have a filing tag entitled 'malfeasants'. By 2005 it had become such a large file I had to start breaking it down into sub categories. It was very telling to me that something was seriously amiss morally.

I was on the conference call when Jeff Skilling stepped down, Ken Lay took over Enron and Andy Fastow explained that Enron's problem was the 'short crowd'. I heard the same 'short seller' refrain during Bear Stearns and Lehman just days before they both collapsed. I heard it again earlier this month from the Greek Minister of Finance and even Angela Merkel and Nicolas Sarkozy. It never changes. I have concluded it takes two - an incompetent PATSY and someone with a STRATEGY.

I remember Bernie Evers, the founder and CEO of the Wall Street darling stock, WorldCom, weeping as he was led away in handcuffs while hearing all the townspeople and church parishioners saying how honest he was. I recall Dennis Kozlowski the CEO of Tyco, a beaten man and imprisoned man, watching his wife desert him even after spending millions of Tyco shareholder money on an exotic island birthday party for her. I watched Joseph Nacchio's meteoric rise after leaving ATT to lift Qwest to prominence only to be sentenced to six years behind bars. The message is that none of these men thought of themselves as criminals. They perceived themselves as tough minded businessmen taking advantage of legal loopholes for competitive advantage, with a business STRATEGY that the lawyers felt they could defend in court. It was worth the business risk of being challenged and possibly receiving inconsequential fines. It took irate public and panicked politicians to force the penalties to match the impact of the crimes.

If you notice, all these examples are from the dotcom bubble. I don't recall anyone being led away in handcuffs since the largest financial crisis in modern times has occurred. The Sultans of Swap are ripe for the wrath of public anger when real interest rates rise, taxes are increased, retirement entitlement promises are slashed and shortages squeeze the life out of the public in the years to come.

The public in Iceland would have made Johnny Depp proud when they said 'forget about it' in a public referendum concerning Iceland's debt. This was a monumental stand that got little US media attention. We are hearing the Greek public say NO! We are seeing US Tea Parties say NO. Scott Brown's stunning election in the bluest of blue states was the public saying NO! We are now hearing the Service Employees International Union (SEIU) say NO!

What does it mean to our Sultans of Swap? Their STRATEGY is built on certain perceived TRUISMS:

  1. People pay their taxes; therefore Sovereign Debt is the Holy Grail
  2. Economic growth may slow but is continuous and will outstrip the growth of cumulative debt payments
  3. Potential penalties for possible regulatory actions will be insignificant compared to the 'Vig' or the 'Take' or the 'Sting'. It is worth the business risk.
Lon Chaney

All of these 'truisms' for the first time in my lifetime now solicit questions.

The famous actor Lon Chaney starred in the 1914 film The Embezzler. The silent era plot could have been our theater guide for this play. I felt it was unfair to the vast majority of the Sultans who are simply providing 'legally' innovative solutions to fulfill their constituents' and clients' addictions.

Embezzlement is the act of dishonestly appropriating or secreting assets, usually financial in nature, by one or more individuals to whom such assets have been entrusted.[1] Wikipedia Lon Chaney

Learn more at the SULTAN SWAP SENTINEL

(1) 03-18-10 Cities in the casino - Municipalities and derivatives  The Economist 
(2) 03-17-10 Banks Stealing From Colorado Teachers' Pension The  Huffington Post
(3) 01-25-09 State Bond Deal Losses its Luster Albuquerque Journal
(4) 01-23-10 California Probes Muni Derivatives as Deficit Mounts  Bloomberg
(5) 03-05-10 The Swaps That Swallowed Your Town  New York Times Gretchen Morgenson
(6) 03-11-10 Banks win on Swaps while DPS loses courtesy of Bennet & Boasberg?
(7) 03-22-10 Interest-Rate Deals Sting Cities, States  Aaron Lucchetti, Wall Street Journal
(8) 11-08-09 Auditor General Calls on General Assembly to Ban Risky “Swap” Contracts by Schools, Local Governments
(9) 03-12-08 High Finance Backfires on Alabama County  Wall Street Journal
(10) 11-13-09 Alabama county sues JP Morgan over sewer bond debt  Reuters
(11) 03-09-10 And Now Oakland Just Voted To Repudiate Interest-Rate Swaps With Wall Street Business Insider
(12) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps  Business Insider
(13) 03-09-10 A Preview: California's Coming War On Banks And Pre-Crisis Swaps – Slide Set  Business Insider
(14) 08-21-09 Ambac Suit a Long Shot; Lawyers, Swap Advisers Don't See a Win for Insurer  AllBusiness
(15) 03-09-10 Stop the Swaps  SEIU Blog

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Gordon T Long   Web: Tipping Points
Mr. Long is a former executive with IBM & Motorola, a principle in a high tech start-up and founder of a private Venture Capital fund. He is presently involved in Private Equity Placements Internationally in addition to proprietary trading that involves the development & application of Chaos Theory and Mandelbrot Generator algorithms.

Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

© Copyright 2010 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or recommendation you receive from him.

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28 Mar 10, 09:19
occam's razor

i enjoyed the series immensly

according to occam's razor i think people may come to the correct conclusion the majority of the time....with the biggest weakness being that ......the mindset allows conflict of interest's that work to the detriment of others (conspiracy's) to go perpetually un-noticed because they are assumed to be a fiction just like carefully and meticulously concealed financial crime ...since these are never the most obvious ...thus "likely" incidences...these perspectives are ignored by occam's razor and this get's played over and over on a case by case basis.

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