All of these entities could have damage claims for fraud, breach of contract and rescission; and that is true whether or not they negotiated directly with one of the LIBOR-rigging banks.
To understand why, it is necessary to understand how swaps work. As explained in my last article here, interest-rate swaps are sold to parties who have taken out loans at variable interest rates, as insurance against rising rates. The most common swap is one where counterparty A (a university, municipal government, etc.) pays a fixed rate to counterparty B (the bank), while receiving from B a floating rate indexed to a reference rate such as LIBOR. If interest rates go up, the municipality gets paid more on the swap contract, offsetting its rising borrowing costs. If interest rates go down, the municipality owes money to the bank on the swap, but that extra charge is offset by the falling interest rate on its variable rate loan. The result is to fix borrowing costs at the lower variable rate.
At least, that is how they are supposed to work. The catch is that the swap is a separate financial agreement -- essentially an ongoing bet on interest rates. The borrower owes both the interest on its variable rate loan and what it must pay on its separate swap deal. And the benchmarks for the two rates don't necessarily track each other. The rate owed on the debt is based on something called the SIFMA municipal bond index. The rate owed by the bank is based on the privately-fixed LIBOR rate.
As noted by Stephen Gandel on CNNMoney, when the rate-setting banks started manipulating LIBOR, the two rates decoupled, sometimes radically. Public entities wound up paying substantially more than the fixed rate they had bargained for -- a failure of consideration constituting breach of contract. Breach of contract is grounds for rescission and damages.
Pain and Suffering in California
The SEIU report noted that no one has yet completely categorized all the outstanding swap deals entered into by local and state governments. But in a sampling of swaps within California, involving ten cities and counties (San Francisco, Corcoran, Los Angeles, Menlo Park, Oakland, Oxnard, Pittsburgh, Richmond, Riverside, and Sacramento), one community college district, one utility district, one transportation authority, and the state itself, the collective tab was $365 million in swap payments annually, with total termination fees exceeding $1 billion.
Omitted from the sample was the University of California system, which alone is reported to have lost tens of millions of dollars on interest-rate swaps. According to an article in the Orange County Register on February 24, 2014, the swaps now cost the university system an estimated $6 million a year. University accountants estimate that the 10-campus system will lose as much as $136 million over the next 34 years if it remains locked into the deals, losses that would be reduced only if interest rates started to rise. According to the article:
Already officials have been forced to unwind a contract at UC Davis, requiring the university to pay $9 million in termination fees and other costs to several banks. That sum would have covered the tuition and fees of 682 undergraduates for a year.The university is facing the losses at a time when it is under tremendous financial stress. Administrators have tripled the cost of tuition and fees in the past 10 years, but still can't cover escalating expenses. Class sizes have increased. Families have been angered by the rising price of attending the university, which has left students in deeper debt.
Peter Taylor, the university's Chief Financial Officer, defended the swaps, saying he was confident that interest rates would rise in coming years, reversing what the deals have lost. But for that to be true, rates would have to rise by multiples that would drive interest on the soaring federal debt to prohibitive levels, something the Federal Reserve is not likely to allow.
The Revolving Door
The UC's dilemma is explored in a report titled "Swapping Our Future: How Students and Taxpayers Are Funding Risky UC Borrowing and Wall Street Profits." The authors, a group called Public Sociologists of Berkeley, say that two factors were responsible for the precipitous decline in interest rates that drove up UC's relative borrowing costs. One was the move by the Federal Reserve to push interest rates to record lows in order to stabilize the largest banks. The other was the illegal effort by major banks to manipulate LIBOR, which indexes interest rates on most bonds issued by UC.
Why, asked the authors, has UC's management not tried to renegotiate the deals? They pointed to the revolving door between management and Wall Street. Unlike in earlier years, current and former business and finance executives now play a prominent role on the UC Board of Regents.
They include Chief Financial Officer Taylor, who walked through the revolving door from Lehman Brothers, where he was a top banker in Lehman's municipal finance business in 2007. That was when the bank sold the university a swap related to debt at UCLA that has now become the source of its biggest swap losses. The university hired Taylor for his $400,000-a-year position in 2009, and he has continued to sign contracts for swaps on its behalf since.
Investigative reporter Peter Byrne notes that the UC regent's investment committee controls $53 billion in Wall Street investments, and that historically it has been plagued by self-dealing. Byrne writes:
Several very wealthy, politically powerful men are fixtures on the regent's investment committee, including Richard C. Blum (Wall Streeter, war contractor, and husband of U.S. Senator Dianne Feinstein), and Paul Wachter (Gov. Arnold Schwarzenegger's long-time business partner and financial advisor). The probability of conflicts of interest inside this committee--as it moves billions of dollars between public and private companies and investment banks--is enormous.
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