Lex | Financial Times
Do vampire squids swim in San Francisco Bay? The government of Oakland, California, suspects so. They are taking on Goldman Sachs, hoping to wriggle out of derivatives deals that are costing the city dearly.
Oakland is pushing Goldman to reduce the fee to exit interest rate swaps that are now costing the city $4m annually – and calling on other municipalities to put pressure on their own banks. Before the financial crisis, these deals were common, and must have seemed low-risk. Municipalities borrowed with floating rate debt and then added swaps to offset the risk of rising rates. The swaps allowed the cities to pay a fixed amount to a bank such as Goldman, and in return receive a payment that would rise with rates.
A plunge in interest rates to historic lows has put the municipalities way out of the money. The Refund Transit Coalition estimates that these deals are costing $2.5bn a year. Then, the tentacles: there is a penalty for terminating the swaps early, and it rises as interest rates fall. Oakland argues that the historically low rates that make the swaps so painful for local governments are an artificial result of government policies put in place, in part, to support the banks.
Oakland has a point there, and this is embarrassing for Goldman, which is trying hard to rehabilitate its image. A groundswell of such resistance should worry other banks. They typically hedged with “mirror” deals that have their own costs to unwind. Local governments largely did not have to post collateral against their swaps – as companies do – leaving the banks exposed. If Oakland inspires other municipalities to similar action, the banks could get stung.
Should old contracts be broken, though, there could be an equally painful increase in what cities pay to borrow in the future. Squids or no, both Oakland and Goldman are in dangerous waters.