Wall Street bankers for decades sold municipalities like Indianapolis on debt instruments called swaps as a safe way to reduce
borrowing costs and hedge against rising interest rates.
In reality, the swap arrangements were complicated bets that relied on a few seemingly reasonable assumptions: Interest rates
would either stagnate or rise, and financial partners on the deals would remain strong. Both proved wrong, and taxpayers paid
a big price.
Municipal units of the city of Indianapolis in 2009 paid more than $93 million in penalties to unwind spoiled swap arrangements.
And city agencies including the Indianapolis Local Public Improvement Bond Bank and the Indianapolis Airport Authority still
are saddled with swaps that sport a negative value of more than $65 million, an IBJ review of dozens of bond records
Meantime, Los Angeles-based CDR Financial Products Inc.—the city’s adviser on most of the swap deals—is
facing federal fraud and corruption charges stemming from its dealings with cities, school districts and not-for-profits coast
CDR, which earned at least $378,000 advising the Indianapolis Bond Bank on swap deals in 2005 and 2006, is accused of rigging
bids on so-called guaranteed investment contracts, or GICs. Government agencies deposit proceeds from bond sales into the
interest-earning vehicles until they need to spend the money. It’s not clear whether any of the allegations involve
The bond bank has been moving away from using swaps and guaranteed investment contracts since 2008, said Deron Kintner, who
took over as executive director in March.
Financial documents show the bond bank held more than $387 million in guaranteed investment contracts at the end of 2007,
but had moved all but $17 million to money-market funds and U.S. government securities by the end of 2009.
The painful process of unwinding swaps also has begun in earnest. At the peak, in 2005, the bond bank and Indianapolis Airport
Authority held almost $1 billion in swap contracts.
“Obviously, there was a mess,” Kintner said. “We knew the variable rate debt was in trouble and we were
looking for an exit strategy as soon as we could. Unfortunately, we couldn’t get out of the market as soon as we hoped.”
Nuts and bolts
The pitch for entering into swaps went something like this: A city issues variable-rate bonds. Then it enters into
a side deal with an investment bank that allows the city to pay a below-market fixed rate to the bank and collect variable-rate
payments from the bank based on a common index.
Theoretically, the variable rate payments from the bank offset the variable rate payments the city pays to the bondholders,
which are based on another short-term index specifically for municipal bonds. And, voila, the city gets to borrow at a lower,
“synthetic” interest rate to build streets, stadiums, libraries and airports.
But in 2008, turmoil in the debt markets conspired to turn the swaps into a giant liability. As governments around the world
reduced interest rates to aid struggling banks, the fixed rate cities were paying on swaps far exceeded the rate they were
Meantime, the variable interest payments the cities were collecting from the swaps were not moving in the same direction
as the variable payments they owed to bondholders, as they had for decades.
The variable rates cities had to pay shot up after Lehman Brothers, a top market-maker in variable-rate debt, failed in September
2008, triggering collateral calls. And ratings agencies downgraded the bond insurers and banks backstopping municipal swaps
(in the bond bank’s case, New York-based MBIA Inc. and Ireland-based Depfa Bank), blaming the move on exposure to subprime
“No buyers wanted bonds with their backing, so we had no choice but to unwind the contracts at a loss,” Kintner
The bond bank had to take out new bonds with a higher principal balance to pay the huge fees to Wall Street and its consultants,
meaning it will take much longer for taxpayers and utility ratepayers to pay off the debt for today’s projects.
Nationwide, municipalities and not-for-profits have spent $5 billion to escape swap transactions, Managing Director Peter
Shapiro of New Jersey-based Swap Financial Group told Bloomberg.
Consultants and advisers including the bond bank’s former swap adviser, CDR Vice President Evan Zarefsky, were mum
on the risks of swaps in 2005 and 2006, at least according to the minutes of bond bank board meetings.
Investment banks were so confident the deals would be profitable for cities that in
many cases they paid cash upfront for theoretical gains not yet earned. In the swap arrangement with the Capital Improvement
Board, Key Bank paid the operator of Lucas Oil Stadium $6 million to enter the deal.
No one answered the phone at CDR’s headquarters, and e-mails sent to the company bounced back.
The U.S. Justice Department has accused Zarefsky and other CDR officials of accepting kickbacks from banks competing for
business from municipalities. CDR bid out only one guaranteed investment contract with the Indianapolis Bond Bank, an issue
holding $13 million for waterworks, Kintner said.
The accusations against CDR do not extend to its advice on swaps. The company has denied wrongdoing.
In too deep
By the end of 2005, the city of Indianapolis had entered into swap agreements on more than $928 million in municipal
debt for deals including the $1.1 billion Indianapolis International Airport terminal and a $530 million acquisition of the
About 17 percent of the roughly $4 billion in bonds issued by the bond bank were in swap contracts. With the waterworks deal,
the risk was more concentrated: City leaders put 60 percent of the debt in variable bonds with swaps so they could save money
on interest and fulfill a promise not to raise rates.
Kintner said the bond bank and other city entities had no choice but to unwind swap deals and actually got a better deal
than many less fortunate entities by waiting for the market to stabilize.
Harvard University, for one, paid almost $1 billion in late 2008 to escape out-of-the-money swaps. Had the university opted
to wait a few months, the penalty fees would have fallen by more than half.
The city’s swap contracts (excluding $300 million in airport bonds) at the end of 2008 had a negative book value of
$177 million. And the potential tab was looking worse: If interest rates remained static and the Bond Bank opted to keep the
swaps open, taxpayers would have been on the hook for an extra $354 million—more than twice the price of building Conseco
The bank managed to retire the waterworks swap in 2009 for a penalty of roughly $46 million (plus $7 million in consulting
fees and accrued interest) paid to J.P. Morgan and Loop Capital, down from what would have been $110 million at the market’s
nadir. The original swap also included Bear Stearns Co., which was acquired by J.P. Morgan with government assistance.
Taxpayers the same year shelled out $27 million to J.P. Morgan to unwind a swap on Circle Centre mall bonds, and $20 million
to KeyBank to unwind a swap on debt issued by CIB.
The losses to Indianapolis taxpayers could grow even steeper, as several out-of-the-money swaps remain active.
One example is the $14.6 million owed on bonds that funded an incentive package for Simon Property Group Inc. to build a
new headquarters downtown in 2004. A swap deal on the bonds had a negative fair value of more than $900,000 at the end of
2009, records show.
The Indianapolis Airport Authority also has swaps on more than $350 million in variable-rate debt tied to construction of
the new airport. A swap on the bonds had a book value of negative $60 million in June.
The negative book value has not led to any out-of-pocket costs for the authority, Jeremiah Wise, its treasurer, said in an
The authority has been paying about 4 percent on the synthetic fixed-rate (swapped) debt, compared with the 5 percent it
pays on its actual fixed-rate debt. Despite the fact the swaps are currently under water on paper, they have allowed the authority
to pay less interest on the associated bonds.
“The swaps themselves are functioning better than budget and better than initially forecast,” Wise said.
Public institutions like the bond bank should use certain tools to keep borrowing rates as low as possible, but
making exotic bets on the direction of interest rates is not one of them, said Ken Skarbeck, managing partner of Indianapolis-based
money management firm Aldebaran Capital.
Skarbeck said Wall Street and firms like CDR Financial deserve the “majority of the blame” for aggressively marketing
such products to public officials including those who run the Indianapolis Bond Bank.
The bank, created in 1985, issues and holds bonds to raise money for municipal agencies including CIB, the Marion County
Health and Hospital Corp., Indianapolis Airport Authority and the Indianapolis-Marion County Public Library. The bank holds
loans and cash valued at $4.5 billion.
Bond bank board members (all appointed by the mayor) who signed off on the instruments may have thought they were buying
insurance to protect against rising rates, Skarbeck said, “but that turned out not to be the case as the swaps generated
substantial losses when interest rates instead declined.”
“What strikes me is the complexity in these deals,” Skarbeck said. “I don’t understand them, I’m
certain the bond bank people didn’t understand them, and the world now knows that the investment bankers who concocted
and sold these things did not understand them.”
A key question is whether the investment banks and advisers selling municipalities on the swaps made the public officials
aware of all the risks, said Craig T. Jones, a partner in the Atlanta-based law firm Page Perry LLC, which specializes in
investment fraud cases against brokers and financial advisers.
Jones figures few public officials would enter into derivative obligations to save a few bucks were they aware of the multimillion-dollar
risks of doing business with bond insurers and banks with so much exposure to risky subprime debt.
He said the same officials should now pursue legal action against the bankers who profited from the pricey payments to unwind
“Whether there’s a misrepresentation or not, there’s certainly a misunderstanding,” Jones said. “If
you’re a broker or dealer or who’s dealing with some clown elected to a four-year term with millions to spend,
I think it’s too easy to take advantage of that situation. The broker still has an obligation to only recommend suitable
Kintner said legal action is unlikely, but he’s not ruling it out if actual proof of wrongdoing is discovered.
It’s easy in hindsight to criticize swaps as imprudent, but not all the deals turned sour. Many have saved
taxpayer dollars and some resulted in cash payments to the city.
One example is a 2005 swap related to incentives for a planned United Airlines maintenance facility. The city terminated
the swap—which was tied to about $50 million in bonds—after about six months, at a profit of $750,000, said Diana
H. Hamilton, president of locally based Sycamore Advisors LLC and an adviser on the deal.
“If you were doing variable rate debt, you could either do hedged or un-hedged,” she said. “It was standard
to do hedged. Throughout the municipal world, people thought it was an acceptable practice.”
Hamilton said she’s concerned by revelations about CDR Financial and wonders whether the company fleeced the city.
But in general, she defends advisers who supported the swap arrangements. Advisers on the waterworks deal included the local
firms H.J. Umbaugh & Associates, City Securities Corp., Ice Miller and Baker & Daniels, as well as New York’s
Bear Stearns & Co.
“It’s not that they were doing something malevolent,” Hamilton said. “They were doing something they
thought at the end of the day they could save their issuers money.”
The problem is, swaps require not only a high level of monitoring but also good timing, which is tantamount to gambling with
taxpayer money, said Gary R. Welsh, a local attorney who has written extensively on the fallout from the waterworks swaps
on his Advance Indiana blog.
When it comes to public debt, governments should keep the variables to a minimum. Swaps do the opposite.
“I don’t think they should be allowed to do them—they shouldn’t be allowed to play these games,”
Welsh said. “Nobody seemed to be taking any action to protect the taxpayers.”
The Indianapolis bond bank may have been vulnerable to a push to chase lower interest rates in part because its
staff of just seven to eight people relied so much on outside advisers. Indeed, it is rare for a city of Indianapolis’
size to have its own bond bank.
An annual audit in 2008 by the accounting firm Katz Sapper & Miller slammed the bond bank for a “lack of well-defined
accounting policies and procedures” and a “lack of training and expertise in the accounting department.”
The firm implored the bank to hire people with an “appropriate level” of accounting experience and review its
accounts more than just once a year.
“During our audit, we found an overall lack of review and reconciliation in many areas of the accounting and finance
functions,” the firm wrote. “We noted numerous instances where input was incomplete and journal entries and transfers
between accounts were incorrect.”
Responding to the audit, the bond bank hired a trust accountant. The following year’s audit, also by Katz, was less
harsh but again suggested management “ensure accounting work is being performed in a timely manner and adequate segregation
of duties is maintained.”
One illustration of the problem: The bank adopted a policy governing its use of swaps and derivatives in August 2009—after
the organization had already entered into more than half a billion dollars’ worth of swap agreements.
The new policy limits the amount of exposure to individual institutions and requires the appointment of an independent adviser
and monitor of swap agreements.
The bank hired a new auditor to examine its 2009 numbers, Somerset CPAs, and in June the firm delivered a report showing
progress on a number of the earlier concerns.
Cities and school districts should consider swap arrangements in the future on a limited basis, but only if they have a level
of sophistication and access to the right information, said Hamilton, the former public finance director under Gov. Frank
“It’s like anything, like too much ice cream,” she said. “That doesn’t mean there’s not
an appropriate level for these kinds of things. If there are substantial savings, in some parts of your portfolio it makes
sense to do them.”
City Securities and other advisers recommend municipalities maintain no more than 15 percent of their debt in variable-rate
arrangements. Part of the reason is hedging such deals means factors other than the creditworthiness of the bond issuer can
affect the bond value, said Kevin D. Taylor, an executive vice president who runs the company’s public finance department.
“In general, swaps are useful tools, but you have to go into these with open eyes and knowing you’re taking on
another set of risks,” including the possibility the market will snub bonds backed by certain banks or bond insurers,
said Taylor, who served as executive director of the Indianapolis Bond Bank from 2008 to early this year.
He said fixed-rate debt is the way to go these days, thanks to very low rates.
Local issuers, including the Indiana Stadium and Convention Building Authority and the Indianapolis Bond Bank, are moving
to take advantage.
“I’d say we’re extremely averse to [swaps] now, and if we ever did them again, we’d keep it to a
minimum,” Kintner said. “Simpler is better and safer.”
But Kintner isn’t the first bond bank head to espouse the value of simplicity. His predecessors, including Barbara
Lawrence, who did not return phone calls, described swap deals as “very simple” and “straightforward”
at board meetings in 2005 and 2006.
The minutes of those bond bank meetings don’t suggest a high degree of skepticism over swaps.
“Who would have ever thought that we would have entered into such a tumultuous period in the credit markets?”
Taylor said. “The variable rate market had performed just as it was expected to for decades.
“Nationwide, maybe we just lost sight of the risks that were being taken on—a costly lesson.”•