Thursday, April 12, 2012

Reno v. Goldman Sachs

We know Reno is still enduring some tough times. Gaming has been struggling (although the February gaming numbers suggest a turnaround may finally be underway), and employment recovery seems to be lagging behind Southern Nevada. And even the city itself has had to struggle with its finances. However, the City of Reno is now claiming that its financial problems were caused by something deeper than just the business cycle.

Yesterday, Reno announced its plans to sue Wall Street powerhouse Goldman Sachs over $210 million in supposedly "safe" bonds that Goldman persuaded Reno to issue... $210 million in "auction rate securities" that ended up essentially junked once the 2008 Global Financial Crisis triggered "The Great Recession".

Joe Peiffer, an attorney with the New Orleans-based law firm Fishman Haygood Phelps that was hired in December to represent Reno, said Wednesday those damages could total into the “multiple millions” of dollars.

He said Goldman Sachs withheld key information when it told Reno to issue bonds on the $330 billion “auction rate securities” market that ultimately fizzled in 2008 amid the global financial crisis.

“The problem was they weren’t told everything (they) needed to know to understand the risk,” Peiffer said. “It was something the banks knew and didn’t tell the cities.”

As a result of the market crash, Reno’s interest rates spiked, forcing the city to scramble to refinance through Goldman Sachs, which also served as Reno’s underwriter and broker-dealer for the bonds.

That resulted in millions in extra fees and interest payments.

This included the city draining a $5 million reserve fund to cover interest payments on the event center debt after the interest rate jumped to 15 percent and an $8 million termination fee it paid Goldman to fix the downtown trench debt.

So what exactly happened? Let me... No, I'll let RGJ's Brian Duggan explain.

So what exactly is an “auction rate security”?

It’s a relatively complex financial instrument that has been around since the 1980s (and first introduced to the municipal market in 1988 by Goldman Sachs, according to the New York Times). It allowed municipalities to issue long term debt at short-term interest rates by resetting the rate every seven to 35 days in a formalized bidding process.

Cities figured that would result in lower interest rates over time and investors thought they could get a liquid investment at higher interest rates compared to other liquid investment options like money market funds.

What cities and investors didn’t know, according to state and federal court filings against banks involved in the auction rate securities market, was the extent the market relied on the financial institutions to keep it running.

In other words, the banks were keeping the market alive by bidding on the bonds, too — and didn’t tell anyone. So when the banks stopped making those bids in February 2008 as the credit crunch began to squeeze the financial system, Reno’s interest rates spiked on the downtown events center bond and forced the city to drain a $5 million reserve fund to cover interest payments that jumped to 15 percent overnight. The city was also forced to pay millions of dollars in fees to the bank to refinance the debt.

Reno’s filing with FINRA says had the city known the market was so dependent on banks like Goldman Sachs — the Biggest Little City’s big bank of choice throughout much of aughts — it would have thought twice about issuing the debt on the auction rate securities market.

So long story short, this was just another one of Wall Street's "Get rich quick!" schemes that had municipal governments thinking they were getting a great deal on bond revenue when they were really just getting hosed. And believe it or not, a former Goldman Sachs executive has at least suggested that his former employer hosed Reno. In fact, Greg Smith, the former Goldman Sachs executive director who ran the firm's US equity derivatives business in Europe, the Middle East, and Africa took to The New York Times' Op-ed page last month to blow the whistle.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?” It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave. Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about “muppets,” “ripping eyeballs out” and “getting paid” doesn’t exactly turn into a model citizen.

Shortly after Smith left Goldman Sachs, Jacki Zehner, the youngest trader and first female trader to make partner in the firm, stepped forward to confirm Greg Smith's account of what happened at Goldman Sachs. And Zehner actually expressed regret over Goldman Sachs' creation and sale of "so much junk" in the form of "mortgage backed securities", credit default swaps, and auction rate securities that duped so many clients and investors and led to the 2008 financial collapse.

So much junk was created that should never have been with disastrous consequences and that will be a black mark on the whole industry for a long time, as it should be. That in and of itself is testimony to the industry in general having lost its way. When you create toxic waste and market it as if it is was not, you are indeed harming your moral fiber. I know many people who were in ‘that business’ who quit because they could not in good faith sell the crap they were being asked to create and market.

Last year, the Occupy/99% movement sprouted as a protest against Wall Street greed run amok. Back in October, Occupy Las Vegas famously made a mark on the CNN/Western Republican Leadership Conference Presidential Debate.

And of course, this was the same week that Mitt Romney infamously declared that no one should try to stop home foreclosures. Romney and his affiliated PACs have received over $1 million from Goldman Sachs so far this cycle, and he's responded with calls to repeal the kind of financial regulations that curb the kind of "so much junk" that Goldman Sachs has profited from.

Until last month, Goldman Sachs was becoming controversial because of its role in the mortgage meltdown and real estate collapse. But now, we're seeing another way that Goldman made money while putting people at risk. Now, we're seeing an entire city in crisis.

I'm sure we'll be hearing about Reno's "reckless fiscal policy" in the coming days. And yes, the City of Reno may not entirely be blameless in green-lighting this scheme to score "easy money" and avoid making tough decisions on revenue. However, I also have a hard time seeing how Reno could have done this on its own without Goldman Sachs "whispering sweet nothings" in city leaders' ears. It's increasingly looking like Wall Street's top financial powerhouse had a key role in Reno's present crisis at City Hall. We'll have to see how liable Goldman is ultimately held for this, but for now we're reminded again of what happens when we carelessly brush off regulation and oversight to let the financial industry make up its own rules.

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