Explaining Southern California's economy

Why Oakland vs. Goldman Sachs is an interest-rate mess

Earns Goldman Sachs

Richard Drew/AP

The price of Goldman Sachs stock is shown at a trading post on the floor of the New York Stock Exchange. The Wall Street bank is fighting with Oakland about a deal that goes back to the late 1990s.

If you want to engage in a nice, deep dive into the murky depths of municipal finance, investment banking, and the post-financial crisis world of rock-bottom interest rates, then you're going to want to spend some time getting to know a dispute that's been brewing between Oakland and the Wall Street investment bank that everyone loves to hate, Goldman Sachs. 

The Financial Times has been covering the fracas. But I'll break it down to a few bullet points:

•15 years ago, Oakland did a deal with Goldman to buy interest rate swaps, a type of financial derivative, as insurance against interest-rate volatility on bonds Oakland had issued.

•The bonds in question were commonly used before the Great Recession, but since then cities have gotten rid of them, refinancing the variable-rate debt into fixed-rate debt. But Oakland's swap deal with Goldman runs through 2021.

•The original 1997 swaps deals entailed...well, swapping the variable rate for a fixed rate. Goldman took responsibility for the variable rate, and all the risk it entailed, while Oakland got a fixed rate: 5.6 percent on $187 million.

•Sooo...the underlying bond debt has been refinanced out of what the swap was originally designed to "hedge," or protect Oakland again. But the swap deal remains in place — and it's costing Oakland $4 million a year, and would cost the city $16 million to get out of. It's already cost the city $32 million. And Goldman doesn't exactly want the deal to end.

What's kind of surreal about this is that the original variable-rate bonds whose interest formed the basis for the derivative are basically gone. All that remains is the long-term derivative contract with Goldman, which in an era of rock-bottom interest rates is yielding a decent return for the bank (although Goldman's CEO, Lloyd Blankfein, made four times as much last year alone in total compensation).

And the fixed rate on that contract is now higher than the variable rate Goldman is paying out — a rate that's fallen as interests rates have dropped to near-zero levels since the financial crisis.

It gets worse. As Fortune's Stephen Gandel notes, the rate the cities were paying on the variable side wasn't based on the interest rate benchmark they prefer to use — it was based on the rate that Goldman and other banks wanted to use. That rate was based on Libor. And we all now know what was going on with Libor before the financial crisis: it was being gamed by the very banks that were using it to create these swaps (although probably not Goldman). 

And then it gets still worse. Even thought Goldman might be inclined to let Oakland off the hook, it can't necessarily do that easily because when it did the swap with Oakland, it did yet another swap to protect itself. So for example if its variable rate rose well above Oakland's fixed rate, and it found itself in the position that Oakland is now in, it could swap its variable-rate exposure for fixed and push the problem off onto somebody else who was willing to roll the risk dice.

Ah, the joys of pre-financial crisis financial engineering! It was a hall or mirrors!

"What a mess!" you say.

Yes, what a mess.

You might say the right thing to do is for Goldman to let Oakland out of the contract, minus a penalty, primarily because the underlying variable-rate debt is no more. But that would entail a loss for Goldman. It could also entail a loss for Oakland, because the whole justification for these swaps in the first place was to reduce the cost of municipal borrowing, in the form of a lower interest rate. Resetting the clock to the late '90s would simply recreate an old problem for munis, at a time when cash-strapped cities need lower borrowing costs more than ever.

But then again you could also ask why Oakland would get involved with a fixed rate higher than 5 percent on a 25-year basis when, in 1997, it could see that municipal bonds yields had been falling for a decade.

There's no easy resolution to this conflict. As the FT points out, other cities, including Los Angeles, have paid up to escape their swaps problem. Oakland may ultimately wind up doing that, as well. And to its credit, Goldman has responded to the not-very-intimidating Oakland City Council threat to quit doing business with the bank by offering to reduce the amount Oakland would have to pay to exit the deal.

Of course, these swaps — and their Libor benchmarking — were products that the banks invented and sold to cities in the first place. Caveat emptor? 

It doesn't seem like anyone — not Oakland, not Goldman — is really going to win here. But it may end up being the courts that make the final call.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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