Illinois is in the throes of a major budget crisis. Even though residents have had to bear draconian cuts as critical services have been defunded, Wall Street has gotten a free pass in the state’s budget stalemate. More than halfway through the current fiscal year (as of January 2016), the Illinois General Assembly has still been unable to pass a budget because Governor Bruce Rauner has refused to make a budget deal until he gets his anti-union “Turnaround Agenda”. As a result, Illinois has delayed, reduced, or ceased funding for critical services, like low-income child care programs, domestic violence services, immigrant family services, need-based college grants, youth programs, and homeless services, to name a few. At the same time that the state has been unwilling to meet its obligations to social service providers, Illinois has nevertheless been paying banks for a whole host of financial services, like interest rate swaps.
Illinois’s Swaps Could Cost Taxpayers $1.45 Billion. Illinois has 19 hedging interest rate swap deals, which back ired in light of the 2008 financial crash. This was a result of the emergency action taken by the Federal Reserve to slash interest rates to near zero to get the economy back on track. Even though interest rate swaps were marketed and sold as instruments that would save taxpayers money by protecting cities and states from rising interest rates on their variable-rate bonds, these deals became toxic drains on public coffers because Wall Street crashed the economy.
- Through the end of fiscal year 2015, Illinois had paid financial firms like Bank of America, Loop Financial, Goldman Sachs, JPMorgan Chase, Citigroup, Bank of New York Mellon, Deutsche Bank, Morgan Stanley, Wells Fargo, and AIG $618 million in net swap payments.
- The state continues to pay the banks another $68 million a year on these deals and is expected to pay $832 million over the remaining life of these deals, from fiscal year 2016 through 2033.
- To get out of these deals early, Illinois would have to immediately pay the banks $286 million in termination penalties.
The Governor’s Swaps Failed Taxpayers in Multiple Ways. In this report, we provide an in-depth case study of the five swaps held by the Governor’s Of ice of Management and Budget (GOMB), which were linked to the state’s 2003B General Obligation bonds. We call these the Governor’s swaps. We found that the Governor’s swaps failed to provide the promised bene its to the state in a number of ways:
- The swaps misfired: As a result of the 2008 financial crash, the state’s net payments on the Governor’s swaps shot up. As a result, Illinois paid banks $192 million on these five swaps from October 2003 through June 2015.
- The state will never break even on the swaps: Given how much money Illinois has already paid its bank counterparties on these swaps, it is virtually impossible for interest rates to rise high enough for long enough for the state to break even on these deals, contrary to bankers’ assertions that swaps are designed so that both parties’ payments will even out over the long run.
- The “synthetic fixed-rate” structure broke down: Even though interest rate swaps are supposed to allow cities and states to effectively convert variable interest rates into synthetic fixed rates by protecting them from interest rate volatility, that did not happen with the Governor’s swaps. Instead, these swaps actually added an additional layer of risk on top of the variable-rate bonds and served to magnify the state’s losses.
- The swaps cost more: Entering into a variable-rate financing structure with interest rate swaps also required Illinois to use add-on products and services. Once the costs of those add-ons are factored in, the variable-rate structure for the 2003B bonds actually cost taxpayers more than if the state had just issued traditional fixed-rate bonds and avoided swaps altogether.
- The swaps can still get a lot worse: If the state’s credit rating continues to tumble and it is unable to renew its credit enhancements on the 2003B bonds in November 2016, that could trigger termination clauses on the Governor’s swaps and force the state to pay $124 million in penalties to the banks. JPMorgan Chase is both a credit enhancement provider for the 2003B bonds and a counterparty to one of the related swaps. This would potentially put the bank in a position to be able to collect termination penalties on the swap by refusing to renew the credit enhancement—a tactic the bank has used elsewhere in the past.
Illinois Could Have to Help Foot the Bill for Chicago’s Swaps. Chicago Mayor Rahm Emanuel is seeking $800 million in assistance from the State of Illinois for the City of Chicago, Chicago Public Schools (CPS), and Chicago Transit Authority budgets. Meanwhile he has refused to act to recover money from the city and school district’s interest rate swaps. Chicago and CPS also entered into a number of hedging swaps that have gone haywire. When the city and CPS both had their credit ratings downgraded in the spring of 2015, that triggered termination clauses on many of Chicago’s and all of CPS’s hedging swaps, leaving the city and CPS on the hook for approximately $419 million in termination penalties. Mayor Rahm Emanuel also decided to voluntarily terminate most of the city’s remaining swaps. That decision could drive Chicago and CPS’s total termination penalties up to $636 million. As of January 2016, the city and CPS have already paid at least $455 million of these penalties.
What We Can Do About It. The banks that sold interest rate swaps to cities and states typically misrepresented the risks inherent in the deals. This likely violated the federal fair dealing rule and the Illinois state law for fraudulent concealment or misrepresentation. The State of Illinois can take legal action to allow it to stop paying banks $68 million a year, potentially recover up to $618 million in past swap payments, and eliminate the threat that it could have to pay up to $286 million in termination penalties in the future. The state has two options at its disposal, and it could pursue both strategies simultaneously:
- Illinois’s elected leaders can petition the federal Securities and Exchange Commission (SEC) to bring an enforcement action against the banks for disgorgement of their ill-gotten gains from Illinois taxpayers. Although the Emanuel Administration has signed waivers releasing some of the banks of liabilities arising from the swaps they sold to Chicago, state officials may also petition the SEC to bring enforcement actions on behalf of their constituents living in the city as well. Mayor Emanuel’s waiver does not preclude SEC action.
- Illinois can also sue the banks under state law for fraudulent concealment or misrepresentation. In so doing, the state could also request an injunction from the judge to stop making payments during the legal proceedings, which could provide immediate budgetary relief.
Turning Illinois Around. Governor Rauner has made a choice to give Wall Street banks a free pass during the budget crisis and to force Illinois’s most vulnerable communities to sacrifice until he gets his antiunion Turnaround Agenda. However, to truly turn Illinois around, the governor should enact policies that put the interests of communities first by fully funding public services. Taking legal action against the state’s toxic swaps would be a great first step.