States And Cities Pay Wall Street $4 Billion To Exit Bad Deals

Cities and states have had to pay Wall Street firms $4 billion since 2008 to get out of complicated interest rate deals that went sour, Bloomberg reports.

After more than a decade of selling deals that were supposed to help local governments fund public projects, banks and insurance companies are now raking in payments as already-strapped cities and states try to exit the agreements. According to Bloomberg's investigation, the payments, to exit a total of more than $500 billion worth of deals, have soared to over $4 billion. They come at a time when states face budget shortfalls of about $72 billion, according to the National Conference of State Legislatures.

The deals, called interest rate swaps, are designed to allow a borrower (in this case, the local government) to pay a low and consistent rate of interest on their debt. What once seemed attractive, though, is now corrosive: In the wake of the financial crisis, Wall Street firms failed to uphold their end of the bargain and weren't able to cover the governments' interest payments, Bloomberg reports. The governments want out, and it's costing them dearly. In New York, for instance, the state initially saved about $203 million from the swaps, but it has now paid about $247 million to exit, Bloomberg says.

The termination payments come on top of fees that banks have already collected for selling the deals. Government officials, not surprisingly, are incensed.

The interest rate swap mess compounds an already growing risk: municipal debt default. As the Wall Street Journal reports Wednesday, some cities and towns are choosing to stop paying certain debts.

The next major financial crisis, analyst Meredith Whitney argued in September, could come from local government defaults. Spending has outpaced revenue in cities and towns over the past decade, and this unsustainable situation was worsened by the financial crisis, Whitney said in an interview after the release of an extensive report. She noted that municipal debt has doubled since 2000. Ballooning pension obligations make the problem even worse than it appears.

And now, the WSJ reports, some municipalities are behaving like homeowners who walk away from their mortgages. While investors sue, the cities and towns say they don't have to pay.

Menasha, Wis., for example, still hasn't paid $23 million for debt that helped finance a failed steam plant, even though the payment was due in September 2009, the WSJ says. The city spends an average of $80,000 every month to battle investor lawsuits, according to the WSJ.

Vallejo, Calif., has been mired in bankruptcy proceedings for more than two years. Harrisburg, Penn., has been considering filing for bankruptcy, as a failed incinerator project has clobbered its budget.