Gov. Bruce Rauner, who previously promised voters he would bring his well-honed business skills to get Illinois back on track, will be tested in coming months as he tries to fix a bad financial bet made more than a decade ago between the state and Wall Street banks.
This fall, the governor will decide whether to fight the banks or concede to at least $150 million in penalties that potentially must be paid to the institutions as the result of a financial arrangement that backfired — a cost borne by taxpayers.
When officials in Gov. Rod Blagojevich’s administration prepared to sell $600 million in bonds in 2003 for general spending uses, they were concerned that rising interest rates would drive up the cost to repay the debt. To protect themselves, they entered into contracts known as swaps that are supposed to protect against interest rate spikes. Such contracts work to keep the repayment of debt at a steady rate with few surprises.
Trouble is, the contracts are designed to work in a time of rising interest rates. After the financial markets collapse of 2008, rates plunged.
Through last year, Illinois paid almost $400 million in interest and fees for the single $600 million bond issue, a figure that would have been tens of millions of dollars less had the state entered into a lending agreement with a flat interest rate of around 4.75 percent, according to one analysis. (Bonds are essentially loans to government. Banks act as middlemen to sell the debt in pieces to investors.)
“This adventure cost taxpayers dearly,” said Saqib Bhatti, a policy analyst at liberal-leaning think tank Roosevelt Institute. “Illinois would have been better off issuing fixed rate bonds and avoiding swaps altogether.”
The unexpected drop in interest rates would have been bad enough. But the state’s deteriorating financial condition — due in part to its unpaid pension obligations — made matters worse. Continued downgrades by major bond rating agencies of the state’s credit rating can force a termination of the swaps — forcing the state to pay a penalty in the range of $150 million.
The Republican governor soon will have to decide what to do because of an upcoming deadline. Letters of credit — bank guarantees of the safety of an investment — expire in November, forcing him to act.
Rauner has three choices to mitigate the issue. He can pay the full penalty to the banks in order to get out of the swaps and refinance the bonds at a lower rate. He can continue the current arrangement, although new guarantees will likely raise borrowing costs. Or he can sue the banks or use the threat of litigation as leverage to get a better deal, as even some allies advocate.
“I would like to see negotiation rather than just fork over the money,” said Rep. David Harris (R-Mount Prospect), ranking member of the Revenue and Finance Committee. “If the state felt it had a strong legal case, I couldn’t argue against it. We’re dealing with public dollars and that has to be protected.”
|Rep. David Harris|
Rauner is paying dearly for specialists to help advise him. The state has a two-year $100,000 contract with Chicago law firm Katten Muchin Rosenman (former Mayor Richard M. Daley’s employer) and a two-year $425,000 contract with New Jersey specialist Swap Financial Group.
So far, Rauner isn’t showing his hand.
“The failed swap agreements negotiated by the Blagojevich administration now pose financial risk to Illinois taxpayers, and have limited our ability to pay for education and social services,” spokeswoman Catherine Kelly said. “The Rauner administration has started to clean up the mess and reduce some of the risks associated with these toxic swaps.”
She declined to address options including the possibility of litigation. The banks are AIG Financial Products, Bank of America, Deutsche Bank, Merrill Lynch Capital Markets, JPMorgan Chase and Loop Capital Markets. All declined to comment.
Some skeptics say that Rauner, a veteran private equity dealmaker, won’t have the appetite to go after the banks he worked so closely with during his long business career.
Yet Rauner has a clear fiduciary duty — Illinois can’t afford to pay high borrowing costs at a time when the budget crisis spurred the governor to cut or reduce critical services such as university funding and grants, programs for low-income families, the homeless and victims of domestic violence.
Illinois isn’t the only public borrower bedeviled by interest rate swaps. Cities, counties, and public pension funds across the country also purchased swaps not only as a hedge against volatile interest rates but as investments.
The Chicago Public School Teachers’ Pension and Retirement Fund late last year filed a suit in federal court, charging that a group of investment banks hold an “anti-competitive stranglehold over the market for interest rate swaps, in violation of antitrust laws.” These swaps were purchased as an investment (a different purpose from the city and state governments that sought them as a hedge against higher interest rates in bond issues.) The suit, which gained class action status, seeks damages from 30 banks, including Bank of America, Barclays and Goldman Sachs. The teachers were joined in their lawsuit by the Chicago Police Pension Fund and other municipalities.
Earlier this year, city of Chicago Treasurer Kurt Summers sent letters urging Rauner, as well as city pension funds, to join the teachers or file their own lawsuits to recover money lost from investments in swaps.
Summers testified in June before the Illinois House Revenue and Finance Committee that there’s potential to recover “tens of millions of dollars in potential damages.”
In endorsing litigation to challenge interest rate swaps, Summers broke with Mayor Rahm Emanuel, who asserted there was no basis for legal action. Chicago paid penalties of $377 million in recent years to terminate city and Chicago Public School swap deals with banks including Goldman Sachs, JPMorgan Chase and Wells Fargo.
There are alternative options for legal action.
Bhatti said Illinois can pursue a claim in state or federal court, or a federal enforcement action, claiming that the banks misrepresented the risk inherent in the swaps.
Barring litigation, Rauner can decide to pay the $155 million penalty for exiting the swaps and refinance the bonds at a lower fixed rate.
Illinois, as a large borrower, may have leverage to wrest concessions from the banks.
“You don’t have to say, ‘Yes, sir,’ when the banks demand a windfall that no one anticipated,” said Tom Sgouros, a public finance consultant in Rhode Island who served as senior policy adviser to the state treasurer.
He and others note that other municipalities won concessions. San Francisco was able to negotiate a settlement with JPMorgan Chase avoiding millions in termination fees related to a museum bond issue.