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Banks Take Advantage of States in Fiscal Crisis

The same large banks whose unregulated actions were primary contributors to the economic downturn have also been manipulating state and local governments to profit from budget deficits for years.

Essentially, banks are alluring states with the promise of a means to cut borrowing costs and increase returns through the use of an interest rate swap.  The mechanism is a derivative that allows cash-strapped municipalities and states to exchange interest payments on a variable bond deal for an allocation of funds from a bank.  So, the bank would establish a fixed rate on the bond and swap for the variable "interest rate of the bond that was set by larger macroeconomic forces, such as the Federal Reserve."  Unfortunately, the results have been disastrous.

These type of deals are losing propositions for states and municipalities.  Under unfavorable marketing conditions, interest payments and fees associated with these deals can jump dramatically.  Since the federal government decreased interest rates to shore up financial institutions, the banks were able to profit tremendously while budget gaps at the local and state level continue to grow.  As Mike Elk from the Campaign for America's Future explains:

"While banks are still collecting fixed rates of from 4 percent to 6 percent, they are now regularly paying state and local governments as a little as a tenth of one percent on the outstanding bonds...Banks and states were supposed to be paying equal rates. However, with the Fed lowering interest rates, which was anticipated, now states and local governments are paying about 50 times what the banks are paying...To make matters worse, these state and local governments have no way of getting out these deals. Banks are demanding that state and local governments pay tens or hundreds of millions of dollars in fees to exit these deals."

The deals have cost state governments and taxpayers almost $28 billion in interest and fees at a time when states are already collectively facing billion dollar deficits and considering huge cuts to essential public services.

Some of the areas in the country that are being hit the hardest have amassed massive debt as a result of similar deals.  For instance, Detroit, with an unemployment rate of almost 15 percent, entered a derivatives deal with UBS and other banks that supposedly permitted $2 million in annual interest savings on $800 million worth of bonds.  In order to protect against losses, the deal carried a stipulation that if Detroit's credit rating dropped, the banks could negate on its obligations and charge a breakup fee.  As the city's credit rating plummeted during the recession, it found itself in a position of owing over $400 million.  Now, the city is using casino revenue to pay $4.2 million in monthly payments to the banks.  The city must pay the banks before considering funding other services.

Similar to U.S. Representative Elijah Cummings' (D-MD) comments on the use of bailout funds, the banks are basically "slapping these American taxpayers in the face by continuing the...business-as-usual attitude."  Fortunately, states are taking proactive steps to confront these issues.

  • Pennsylvania State Auditor General Jack Wagner called on the legislature to prohibit municipalities and school districts from entering interest rate swap contracts.  He stated, "[q]uite simply, the use of swaps amounts to gambling with public money.  The fundamental guiding principle in handling public funds is that they should never be exposed to the risk of financial loss.  Swaps have no place in public financing and should be banned immediately.”
  • Tennessee Comptroller of the Treasury Justin P. Wilson recommended the state place limitations on variable rate debt for financing projects.

Some states are even considering the creation of state-owned banks to protect against the abuses of private banks, foster public accountability and fiscal integrity, increase local economic development investments, promote competition, and expand lending to small businesses. North Dakota, with a 4.4 percent unemployment rate and a $700 million budget surplus last year, is home to the country's only state-owned bank.

  • Legislative and gubernatorial candidates in Florida, Oregon, Idaho Illinois, and California have floated the idea of creating a state bank.
  • Massachusetts Sen. President Therese Murray and Virginia Del. Bob Marshall each advanced initiatives in their respective states to study the creation of a state bank.
  • Washington Rep. Bob Hasegawa introduced HB 3162 this year, a bill that would create a state-owned bank.

Resources:
Bankster USA
Business Week - Wall Street Plays Hardball
Campaign for America's Future - How Big Banks' Interest Rate Schemes Bankrupt States
YES! Magazine - Whose Bank? Public Investments, Not Private Debt