NYT on Wall Street Versus Small-Town America

The New York Times fronts a story that illustrates well the asymmetry of information between the financial industry and those it hawks its wares to.

In this case, it’s Morgan Keegan selling muni-bond derivatives to Lewisburg, Tennessee, pop. 10,413, and other small towns in the state. The firm pitched the derivatives as can’t-hardly-lose money savers, but they’ve since blown up in the town’s face in a way it couldn’t have imagined.

Five years ago, this small factory town was struggling to pay the interest on a bond for new sewers. Bob Phillips, Lewisburg’s part-time mayor and full-time pharmacist, was urged by the town’s financial adviser, an investment bank named Morgan Keegan & Company, to engage in a complex financial transaction to lower interest rates.

When a Lewisburg official attended a state-sponsored seminar intended to lay out the transaction’s benefits and risks, he was taught by investment bankers from Morgan Keegan.

And when Lewisburg decided to go ahead with the transaction, who was there to make the deal? Morgan Keegan.

In January, local officials were shocked to discover that annual interest payments on the bond had quadrupled to $1 million. Morgan Keegan, they said, did not serve them well in any of its roles.

This is the problem with the blame-the-homeowners movement writ large: It supposes that these things are fair negotiation, with neither side having a major advantage over the other. It supposes that financial advisers like mortgage brokers don’t have a fiduciary responsibility to those they sell to (where they don’t in a legal sense—they always do in an ethical and moral sense— they should). It supposes corporations and agents should have immunity from selling products that blow up in their customers’ faces.

Like for instance:

“We’re little,” Mr. Phillips said, “and we depend on people wiser than us in financial ways to keep us informed, tell us what things mean, and I really didn’t think we got that.”

Times reporter Don Van Natta Jr. has found a really good vehicle to tell this story. Not only did little Lewisburg get hammered, others in Tennessee did, too.

The municipal bond marketplace was so lightly regulated that in Tennessee Morgan Keegan was able to dominate almost every phase of the business. The firm, which is based in Memphis, sold $2 billion worth of municipal bond derivatives to 38 cities and counties since 2001, according to data compiled by the state comptroller’s office.

And that’s just a small part of the bigger national picture:

Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad. Municipalities that bought the derivatives were like homeowners with fixed-rate mortgages who refinanced by taking out lower-interest, variable-rate mortgages. But some local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did.

It’s interesting to note that firms do themselves a favor by talking in these stories. Morgan Keegan does here even though it probably knew it was coming under the hammer. After all, it had a pretty conspicuous conflicts of interest here: It advised the municipalities on the swaps.

But it’s the same old song: They can advise you, but it’s all up to you, and they can’t take any responsibility for their advice:

“People are upset; we’re upset, too,” said Joseph K. Ayres, the firm’s managing director. “We’ve been very successful helping a lot of communities try to weather this storm. Obviously, there are going to be a few disappointments. People are going to look to find a scapegoat. We’re big boys and girls. We understand that.”

I think the Times does a pretty good job explaining how the arcane financial product works for readers without making them want to run away—no easy feat. That said, I don’t understand this part:

But as the nationwide credit market collapsed, most of the bond insurers’ credit ratings were downgraded, including the Ambac Financial Group, the primary insurer of Tennessee bonds. That allowed the investors to accelerate the retirement of the debt, usually from 20 years to 7, leading to a steep increase in the interest rate.

Did the change in the time needed to pay back the debt result in higher interest rates? Seems like that would send the principal payments soaring, but interest rate increases would be triggered by something else.

The Times also is good showing how Morgan Keenan played down the risks of its scheme—if it acknowledged them at all (with bonus Greenspan tweak):

In a 177-page book used in 2003 and reviewed by several bond experts for The Times, there was far more about rewards than risks. On a page titled “Interest Rate Swap Risks” for example, there is no mention of the consequences of a downgrade in the bond insurer’s rating. Ms. Evans said the daylong seminars, held in Memphis, Nashville and Knoxville, amounted to “nothing more than an infomercial.”

The first page of a manual used at a 2007 seminar quotes the former Fed chairman Alan Greenspan extolling the virtues of derivatives in 1999.

Need more convincing?

Peter Shapiro, the managing director of Swap Financial Group of South Orange, N.J., said the material “certainly doesn’t have what we would consider the requisite amount of detail going through the risks, how they materialize and how you might attempt to mitigate them.”

Sounds like these folks have themselves a lawsuit.

The piece has more on information asymmetry:

Sheila Luckett, the city recorder in Mount Juliet, attended the swap school twice. “It was way over my head,” she said. “I’m not a bonds person. People with Morgan Keegan told me, ‘Don’t worry if you don’t understand it.’ ”

And more nails for the coffin:

In many corners of Tennessee, the first anyone heard of interest-rate swaps was from C. L. Overman, a vice president of Morgan Keegan who assured officials that the deals carried little risk, city and county officials said.
“He told us it would be a good thing and there wasn’t much downside,” said Mayor Duncan of Claiborne County. He then laughed, adding, “When everything went belly up, of course, they told us it wasn’t their fault.”

The paper makes clear that regulators are to blame, as well, largely because they just didn’t regulate.

Good job by the Times.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.