There might be collusion going on in Philadelphia. Before you think of “Russia,” “Vladimir Putin,” “Donald Trump,” and “2016” like a word cloud, the city of brotherly love’s collusion has to do with allegations that several major financial institutions manipulated municipal bond markets, resulting in lost millions that could have gone to schools, transit, and utilities.
Philadelphia Sues the Banks
The city of Philadelphia alleges that seven big banks conspired to inflate interest rates of a bond type commonly used by municipalities and public organizations, according to an antitrust lawsuit recently filed in U.S. District Court in Manhattan.
Meanwhile, the Department of Justice may have a part to play in this quagmire. The DOJ’s antitrust division initiated a preliminary criminal review of the named banks late last year: Bank of America, Barclays, Citigroup, Goldman Sachs, JPMorgan Chase, the Royal Bank of Canada, and Wells Fargo.
According to the City Solicitor, Philadelphia will use phone and email records to prove the banks agreed not to compete over the variable-rate demand notes (VRDNs) between February 2008 and June 2016. The lawsuit alleges that this kept rates artificially high, and the banks collected millions of dollars in fees “for doing, essentially, nothing.” “The alleged misconduct of the defendants potentially resulted in Philadelphia – and entities across this country -paying above-market interest rates for years,” Marcel Pratt, Philadelphia’s legal representative, said in a statement.
Philadelphia believes the banks colluded to manipulate the VRDNs to make millions of dollars more from the $1.6 billion bonds the city purchased. The city contends that this funding was meant for crucial services, including, hospitals, water supplies, and education. The Securities and Exchange Commission (SEC) has proceeded with its investigation and gotten in touch with four of the banks believed to be involved.
What’s a VDRN?
A variable-rate demand note, otherwise known as a variable-rate demand obligation (VRDO), is a type of long-term debt instrument backed by a direct-pay letter of credit. These municipal bonds are payable on demand and earn interest using the existing money market rate. The VRDN allows local governments to borrow funds for an extended period while covering short-term rates to investors.
VRDNs are issued in $100,000 denominations (minimum), and they are historically sold to corporations, money-market mutual funds, and wealthy individual investors.
What makes a VRDN attractive is the option to sell it at its full-face value with short notice – every investor is required to contact the “remarketing agent” at least seven days before the intent to sell the obligation. It’s an interesting financial product for outside observers because the agents need to keep borrowing costs low, but they also need to ensure interest rates are attractive enough for investors.
It isn’t just Philadelphia that has been the supposed victim of collusion.
In recent months, similar lawsuits have been filed by several states across the country, including California, Illinois, and Massachusetts. These jurisdictions are alleging that the big banks conspired to “robo-reset” state VRDN rates without considering investor demand and local conditions.
RT reports that these cases are attempting to recover more than $1 billion in fees. California is trying to get back $719 million, Illinois is looking to regain $349 million, and Massachusetts wants $100 million back.
A Municipal Bomb
America’s municipal bond industry totals nearly $4 trillion, but it seems the nation’s appetite for these investment vehicles are waning amid mutual fund outflows, surging supply levels, and falling prices. Has the air finally been deflated from this enormous bubble?
Local governments have promised more than they could afford with generous pension schemes. These lucrative vote-buying programs may have appeared to be affordable when they were first promised, but with interest rates still at historic lows and the bond market failing to deliver an income to fund these pensions, politicians are merely kicking the can down the road and burying their heads in the sand.
This is bad news for the muni bond market because this could spell disaster in the future with a tidal wave of defaults and a tsunami of losses. With insolvency not out of the question, cities may wish their only problem was collusion.