Saturday, July 03, 2010

Bond Swaps Cost Indianapolis $93 Million So Far

Indianapolis taxpayers have paid dearly for those risky bond swap agreements well-compensated financial advisers convinced our local bond bank to enter into. The IBJ's Cory Schouten has an excellent story in this week's edition that goes further in explaining what these deals were all about and what it has meant for taxpayers than anything we've seen to date in the local news media. Schouten's story tells us the City has incurred penalties of $93 million to date to unwind soured swap agreements and still has negative exposure to the tune of $65 million. The Indianapolis water company alone lost about $53 million, including a $46 million penalty to unwind the bond swap agreements it took out on about a half billion dollars in debt and another $7 million in professional fees. In all, the City had 17% of its bond debt tied up in swap agreements at one time. Schouten writes:

Wall Street bankers for decades sold municipalities like Indianapolis on debt instruments called swaps as a safe way to reduce borrowing costs and hedge against rising interest rates.

In reality, the swap arrangements were complicated bets that relied on a few seemingly reasonable assumptions: Interest rates would either stagnate or rise, and financial partners on the deals would remain strong. Both proved wrong, and taxpayers paid a big price.

Municipal units of the city of Indianapolis in 2009 paid more than $93 million in penalties to unwind spoiled swap arrangements. And city agencies including the Indianapolis Local Public Improvement Bond Bank and the Indianapolis Airport Authority still are saddled with swaps that sport a negative value of more than $65 million, an IBJ review of dozens of bond records found.
According to Schouten, the City relied on CDR Financial Products for most of its bond swap agreements, a company that is now facing federal fraud and corruption charges. "CDR, which earned at least $378,000 advising the Indianapolis Bond Bank on swap deals in 2005 and 2006, is accused of rigging bids on so-called guaranteed investment contracts, or GICs." Government agencies deposit proceeds from bond sales into the interest-earning vehicles until they need to spend the money," Schouten says. He was unable to learn whether the charges involve any of the deals CDR helped arrange for the City. At their peak use in 2005, the City had nearly a $1 billion in debt tied up in swap agreements, which included debt issued through the local bond bank and by the Indianapolis Airport Authority. Schouten explains how the deals were pitched to local decision-makers:

A city issues variable-rate bonds. Then it enters into a side deal with an investment bank that allows the city to pay a below-market fixed rate to the bank and collect variable-rate payments from the bank based on a common index.

Theoretically, the variable rate payments from the bank offset the variable rate payments the city pays to the bondholders, which are based on another short-term index specifically for municipal bonds. And, voila, the city gets to borrow at a lower, “synthetic” interest rate to build streets, stadiums, libraries and airports.
The turmoil in the financial debt market that began in 2008 turned the attractiveness of these deals upside down as Schouten explains. The large insurers of these transaction like MBIA and Depfa Bank, which insured the City's bond swap agreements, were downgraded by ratings agencies. “No buyers wanted bonds with their backing, so we had no choice but to unwind the contracts at a loss,” Daron Kintner of the local bond bank told Schouten. Kintner took over the bond bank when Kevin Taylor left to join City Securities, which also employs John Dillon, a former head of the bond bank and deputy mayor to former Mayor Bart Peterson. City Securities offered advice to the City on some of these deals. Another former bond bank head and city controller, Robert Clifford, now works for Umbaugh & Associates, which also advised the City on some of these transactions. This raises the question of whether we can trust the people our bond bank employs. Are they just biding time until one of the high-paid advisers offers them a job?

Schouten looked at board minutes of the bond bank during the 2005-06 period when several of these large deals got brokered. He said the board minutes were mum on the risk of bond swap agreements. A local expert tells Schouten he doubts that members of the bond bank understood what they were doing when they signed off on the swap agreements.

Public institutions like the bond bank should use certain tools to keep borrowing rates as low as possible, but making exotic bets on the direction of interest rates is not one of them, said Ken Skarbeck, managing partner of Indianapolis-based money management firm Aldebaran Capital . . .

Bond bank board members (all appointed by the mayor) who signed off on the instruments may have thought they were buying insurance to protect against rising rates, Skarbeck said, “but that turned out not to be the case as the swaps generated substantial losses when interest rates instead declined.”

“What strikes me is the complexity in these deals,” Skarbeck said. “I don’t understand them, I’m certain the bond bank people didn’t understand them, and the world now knows that the investment bankers who concocted and sold these things did not understand them.”

Disappointingly, Kintner tells Schouten that it is unlikely the City will take any action against any of its advisers for failing to appropriately advise it of the risk in entering into bond swap agreements. "
[Diana] Hamilton said she’s concerned by revelations about CDR Financial and wonders whether the company fleeced the city, Schouten writes. "But in general, she defends advisers who supported the swap arrangements," he continues. "Advisers on the waterworks deal included the local firms H.J. Umbaugh & Associates, City Securities Corp., Ice Miller and Baker & Daniels, as well as New York’s Bear Stearns & Co." Hamilton was singing a much different tune a couple of years back when these deals first soured. "The Democratic gubernatorial administrations of Frank O’Bannon and Joe Kernan also did not tap that market, said Diana Hamilton, who ran the predecessor to the Indiana Finance Authority for both men," wrote the IBJ's Anthony Schoettle then. “Not because I’m so much smarter than everybody else. It was really just a pricing thing,” she said. “These things change in the market a lot, and typically with auction-rate debt, you need to purchase bond insurance. And also the ... fees paid to the investment banker were higher.”  Hamilton, incidentally, owns Sycamore Advisors, LLC, a local WBE contractor. She is currently working as a subcontractor on the utilities transfer deal between the City and Citizens Energy. Her husband is John Hammond, a partner with Ice Miller, which also served as counsel on many of these bond transactions.

Schouten's story discusses how the local bond bank's staff of seven relies heavily on its advisers and often lack the experience and knowledge necessary to make informed judgments. A 2008 audit by Katz Sapper & Miller slammed the bond bank's staff. “During our audit, we found an overall lack of review and reconciliation in many areas of the accounting and finance functions,” the firm wrote. “We noted numerous instances where input was incomplete and journal entries and transfers between accounts were incorrect.”

Schouten notes that the bond bank did not even have a formal policy on entering into bond swap agreements until 2009, after it was too late to avoid the penalties that cost the City dearly from exposing it to so much risk. He notes the bond bank is now using Pat Early's Somerset Partners to do its audit work instead of KSM. Pat Early is that accounting genius that helped lead the CIB into its financial mess. I'm not too comforted learning about that. Not surprisingly, his firm gave glowing reviews to the bond bank staff in its latest audit report.


Marycatherine Barton said...

Cory Schouten in the IBJ and Gary Welsh here in this report, have stepped on some powerful toes to give us some ugly truths about the financiers and politicians who are knowingly ripping us off, here in Circle City and environs. Bravo.

I see why people are calling for a Power Party to be formed, so that we can take back the money as much as embezzled from us tax payers, by the bankers and their henchmen.

Had Enough Indy? said...

It sures seems like the IBJ is this town's best investigative report newspaper. Schouten has been doing one difficult investigation after another and doing a fantastic job in making it clear to the rest of us.

Thanks for posting this Gary. As an aside, do you know if Diane Hamilton quoted here is the same lady that serves on the MDC?

Gary R. Welsh said...

Yes, Pat, Diana serves on the MDC.