City Of Oakland Taps Occupy Wall Street To Take On Goldman Sachs ~ MAKE MONEY BLOG$

MAKE MONEY BLOG$~As the world’s most powerful investment bank Goldman Sachs is no stranger to fighting all sorts of battles, but the city of Oakland, Cailf. is challenging the firm like no one ever has before.

The Oakland City Council voted unanimously (one member was absent) last week to end its relationship with investment banking giant, Goldman Sachs, if it did not terminate a costly financial agreement.

At the heart of the matter is a so-called interest rate swap deal that the city entered with Goldman back in 1997. In its most basic form an interest rate swap involves two counterparties; one party is concerned that the interest rate will go up and the other is worried it will go down. “To protect themselves the parties engage in a contract where, in effect, they cover each others’ risk,” explains Tony Cherin finance professor at SDSU.

In this case, Oakland wanted to protect against higher interest rates so it locked in a fixed rate of 5.6% that it would pay to Goldman. In exchange, Goldman would pay the city a variable rate tied to Libor.

Back when Oakland first entered the deal at 5.6% on $187 million in bonds it was deemed a safe bet because it shielded the city from a potential hike in future rates. It worked out well for the city until the financial crisis hit and interest rates hit rock bottom.

The deal backfired as interest rates have dropped to record levels near 0% in the aftermath of the financial crisis when the Fed pushed rates down. Meanwhile the city of Oakland is still stuck paying the 5.6% rate until 2021 when the contract expires while Goldman is in paying the city the now very low variable rate near zero.

The city says the deal, which was pitched as a way to save it money, is costing it $4 million annually. According to one group in favor of terminating the contract with Goldman Oakland will end up paying $20 million by 2021.

Last week Oakland’s city council voted 7-0 in favor of passing a resolution that authorizes the City Administrator to negotiate the termination of a swap agreement with Goldman. But it gets even more interesting because the City Council says if Goldman refuses to terminate the deal (and waive all the termination fees) then the city of Oakland will never do business with the bank again in any capacity. It goes as far as to say that a refusal by Goldman to terminate will force it to use all good faith efforts “including options proposed by the Stop Goldman Sachs Coalition”–a group with members affiliated with the Occupy Wall Street movement.

Requests to the City Council for comment have yet to be replied to.

It’s unlikely Goldman will give in to those kinds of demands because for one thing no bank is willing to tear up a contract that has the potential to give it millions in payments. (And this is the vampire squid we’re talking about, after all.)

The matter was addressed by CEO Lloyd Blankfeinduring the bank’s annual meeting with shareholders on May 24 when an Oakland resident brought it up. The Oakland resident told Blankfein Oakland is already facing dire economic conditions with libraries closing and police officers being laid off adding that since Goldman received taxpayer bailout money in 2008 it should consider terminating the swap agreement in order to protect residents in Oakland. He also called it “an issue of morality.”

Blankfein did not agree with that particular sentiment. “No. I think it’s an interest of shareholder assets. The fact of the matter is we’re a bank,” he replied. He later said he would acknowledge the request.

Goldman’s refusal to agree to such terms (cancel the agreement and waive all fees) makes sense. It doesn’t appear that Oakland was lured into a deal with false promises of say, a guarantee that it would save money, for example. It appears to be an unfortunate case of buyer’s remorse on the part of not just Oaklandbut many municipalities that entered interest rate swap deals before the crisis and that are now paying up on bad bets on the movement of interest rates.

According to a report in April from the Refund Transit Coalition, a coalition of public transit groups there are dozens of municipalities that have entered what the group calls “toxic swap deals.” It says in Baton Rouge, Boston,Charlotte, Chicago, Detroit, Los Angeles, New Jersey, New York, Philadelphia, the San Francisco Bay Area, San Jose, and Washington, DC alone banks are overcharging taxpayers and riders $529 million a year. The banks in those deals are all over the map and include Bank of America, JPMorgan Chase, Citi, Wells Fargo, Goldman, Morgan Stanley, Bank of New York Mellon and Deutsche Bank, according to the report.

Making matters worse, and perhaps more interesting, is the recent Libor-rigging scandal. Regulators are investigating banks (Barclays already paid $450 million) for manipulating the rate. Libor, the rate at which banks borrow from one another, is one of the most important rates of the last decade and is the basis for roughly $800 trillion worth of loans and financial instruments–including derivatives contracts like, you guessed it, interest rate swaps.

Critics say if banks are manipulating Libor rates lower then they themselves are borrowing money for less while their counterparties in interest rate swap contracts are stuck paying them much higher rates. Marti G. Subrahmanyam, a finance professor at NYU’s Stern School of Business, says it’s easy these days to tear apart banks for wronging clients but adds that if a bank hasn’t engaged in wrong-doing then its best to let such contracts stand as is. “In 1997, no one knew which way interest rates would go. If I was offered a rate of 5% I took it and saved money over the next few years. But I can’t start saying the rate isn’t fair in 2012 just because it’s not working in my favor,” he adds.

As for the Libor-rigging that may have helped banks with their interest rate swap positions: That’s a bigger issue, Subrahmanyam argues.

“It’s one thing to lie about your borrowing rate to make you look better. That’s like saying you’re 5 feet 9 inches when you’re really 5 feet 7 inches. But if banks were colluding to push the rates in one direction or another then that’s a much more serious problem,” Subrahmanyam says.

source: forbes/com

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