How Wall Street Fraudsters Plunder Public Finances, And How to Fight Back

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June 19, 2013

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Editor’s note: This article is part of an ongoing AlterNet series, “The Age of Fraud,edited by Lynn Stuart Parramore.

Say your town needs a new bridge. It might turn to Wall Street to come up with strategies to finance the project. This is supposed to be a win-win arrangement, but in the lucrative municipal finance business, one side has turned out to be the big loser. Guess which?

Nearly five years after Wall Street’s shady activities triggered massive funding crises for cities, states, and municipalities, the $3.7 trillion municipal finance cesspool has yet to be dredged. Banks continue to profit from their bad – or even fraudulent – advice that cost billions of dollars of taxpayer money. Meanwhile, the rest of us must tighten our belts, or pay higher taxes, or see services slide.

Let’s take a look at how bankers cooked up scams to drain the public coffers and why they continue to get away with it.

How your community became Wall Street prey

Many municipalities invested in flawed “structured finance” deals on the advice of bankers who said these complex transactions would give them a better deal than simpler, traditional products. So trusting public finance officials lined up to follow their advice – only to be told later that advice was not to be relied upon.

Tellingly, few (if any) corporations used similar structures to meet their funding needs. Nor did the banks themselves. Unfortunately, these products didn’t work as advertised, and public funding costs exploded as a result.

The financial structures bankers inflicted on the public are not easy to understand, but please try and stick with us: Banks rely on this complexity to obscure just how badly cities and states that followed their advice were hosed.

One common structure combined three key pieces: variable rate demand bonds (VRDBs), letters of credit and interest rate swaps. Municipal treasurers were looking to achieve the equivalent of a fixed rate financing– think of a 30-year mortgage–at lower than the market rate. And they signed on the dotted line in record numbers for these deals, with issuances of these complex bonds peaking in 2008.

Bankers realized that many professional investors – such as money market fund managers – cannot hold long-term debt, and instead prefer investments that can be dumped quickly when market conditions change. So bankers created VRDBs, which were “putable”– allowing buyers to get their money back, in most cases, every week, if they chose. Bankers thought these bonds, which in effect came with a money-back guarantee, would appeal to money market fund investors. At first, they did.

Alas, there’s no such thing as a free lunch. A bond that can be returned, with no penalty charges, every week doesn’t sound at all like the long-term infrastructure financing the city or state wanted. So banks promised municipal clients that if investors wanted to return bonds, the bank would find another buyer. Sounds like it might work out okay, right? 

But what would happen if no one wanted to buy these returned bonds? To avoid leaving its municipal client and investors in a lurch, the bank created a guarantee, a letter of credit, that would provide alternative financing. Think of this letter of credit as insurance that would allow the city or state to continue to pay its bills if the market for its bonds dried up, while providing assurance to bond investors that the bond could be redeemed on demand.

The final piece of the structured contraption was a complex derivative, an interest rate swap. It was supposed to convert the weekly variable interest rate on the bonds to a fixed interest rate. This was another form of insurance that was meant to protect the public authority if interest rates went up.

This article originally appeared on: AlterNet