The best manipulations often involve obscure practices, small changes and large volumes. One of the best places to find all three of these elements are municipalities across the US. And those that have learned to manipulate them have made billions from their skill…

Municipalities are the towns and cities that make up the entire country. They run municipal services like garbage removal, road construction, police and fire service, zoning, and most of the local rules that actually affect people on an everyday level. Municipalities need money for all this, money they can raise through taxes (that’s what your property taxes go to) and bonds. Municipal bonds are very popular for investors, because they are a good mixture of risk/reward: municipalities can raise taxes and so very rarely go bankrupt (although it does happen), and the rates that they offer investors are interesting. Plus, many of them are tax-free!

Because of all those advantages, and the number of municipalities in the US, the municipal bond market is huge: it’s currently over $3.7 Trillion dollars (Trillions, not billions!).

If the best manipulations require large volumes, the municipal bond market certainly qualifies. But there are other reasons that manipulators have fallen in love with that market…

For one thing, municipal government is not usually run by world experts in finance. So when they are faced with the full might of Wall Street manipulation, the winner tends to be who you would expect.

Hint: it’s not the municipalities.

Wall Street banks manipulate numbers for a living, obviously, and so when they deal with municipalities, they are often eager to offer solutions to their problems… for a price.

This, for example, is the Marlins ballpark:

It’s a nice stadium, and it cost the municipality $400M in bonds to build it in 2009. Interestingly, one set of bonds for $90M were helpfully structured by Wall Street to help the municipality with one of their main problems: the municipality really wanted to build the stadium and thus needed to borrow money, but they didn’t really have the budget to handle repayments. So Wall Street offered a simple solution: take the $90M now, and no payments for 15 years – long after every municipal politician in action would be retired and forgotten.

Miami-Dade municipality was ecstatic, and agreed to the deal. Why would you turn down a no-payment plan for 15 years, after all?

Well, there was a catch, but it was a subtle one. The bonds were not really no-interest bonds. There were interests, calculated every year, but the banks helpfully simply added the interest to the $90M principal every month, without requiring Miami to pay anything. And the month after, they charged interest again, both on the $90M and the previous month’s interest, and then added that to the growing principal. And they will do this, again and again, all the way until 2045.

In 2025, Miami-Dade will make its first payment, a measly $260,000. The next one will grow larger, though, and the ones after that will accelerate. Faster and faster. In total, to reimburse their $90M loan, Miami-Dade will pay back $1.9B. For every dollar that Miami-Dade will borrow, it will essentially repay $21.

Like one of these, but made of debt.

Why would Miami-Dade ever agree to something like this? To some extent, the bond is a highly complex one. Interest calculations are never made explicit (rather, it’s the repayment schedule that is defined in the bond). For another, the bond was structured to allow the municipal politicians to build a stadium, claim the credit, and never have to worry about the massive, budget-crushing fallout.

But at least the city sort of knew what it was getting into – it was in black and white on the bond documents. As it turns out, most municipalities aren’t that lucky…

Most cities and towns, when they raise money, want to invest it, since building a bridge typically takes a few years, and there is no reason to have the unused money sitting around if they can invest it and earn some interest on it. So they typically hire a broker, who then asks at least 3 banks to bid on what interest rate they can offer the town; the highest bidder gets the money, and the broker moves on to the next batch of municipal money. This seems like a good idea all around.

Last year, though, a court case, USA vs Carollo, showed how Wall Street banks found an interesting way around the system. Basically, the big banks decided to carve out the municipalities amongst them. They agreed with each other on what the winning bid would be, and allocated the winner between themselves. UBS would win one municpality, then Bank of America, then Chase or Wells Fargo. But how did the banks get around the broker, the indepedent agent that was supposed to ensure the municipalities got a good deal?

The quick answer is that they bribed them. The brokers would look at the bids, then essentially show one of the banks the minimum amount they would need to bid to win. Essentially, if the highest bid was Chase at 4%, the broker would advise UBS to bid 4.05%, not 5% as they had initially wanted to do. UBS would get the contract, save 0.95%, and would reward the broker with ‘fees’ for the information (which became known as “last look” by the industry).

How much was the banks’ take on this manipulation? It’s impossible to tell – no one knows how much the scheme cost the municipalities, especially since the practice became widespread in 2009. Four of the big banks agreed to pay nearly $700M in restitution, which would lead one to believe that the profits from the scheme would have easily numbered in the billions.

Hence the smile.

These types of manipulation have more of an impact than just lining the manipulators’ pockets, though. While it’s rare, municipalities do go bankrupt, occasionally. At that point, forensic accountants go in to review all the contracts, the bonds, the partners and understand what went wrong. And you can learn some interesting things from that work…

For example, in Nov 2011, Jefferson County in Alabama went bankrupt, the largest bankruptcy of a municipality to date in the US. When the accountants went in, they uncovered a hornet’s nest of manipulation gone wrong.

Essentially, when Jefferson County decided to build a new sewer system, the cost of the sewers started at $250M, and then started to grow as corrupt municipal officials and almost every manufacturer in Alabama took a bite of the project. But since the sewer system had to be paid eventually, the municipality didn’t want to raise the sewer rates (which would have spoilt the party). So, to reduce the debt payments, the municipality turned to Wall Street. JP Morgan got very creative, and structured a complex instrument known as a synthetic swap that would allow the municipality to pay a low interest rate – in exchange for lots of fees and a ton of risk. That instrument alone could fill a blog entry, but that’s not the key manipulation here.

This is the swap in question.

To entice the municipality to sign off on the swap, JP Morgan paid hundreds of thousands of dollars as a bribe to friends of the commissioners in charge of the decision. And that worked, for a while. The municipality worked with JP Morgan and signed off on swap after swap, until Goldman Sachs, another bank, started to convince members of the municipal council to hire them as the bankers for the county. JP Morgan, seeing this, decided on a novel approach: instead of competing, they simply paid Goldman off with a $3M bribe. In exchange for the money, Goldman would move on, leaving Jefferson County snug in bed with JP Morgan. In essence, JP Morgan ‘bought’ Jefferson County from Goldman for $3M. Plus the bribes they were paying the officials, of course.

“Wait. So we made $3M for NOT bribing someone? Everyone followed that?”

Now free, JP Morgan signed the county up for $2B of swaps. And no one would have been the wiser, if the swaps didn’t end up being too successful. Over time, the swaps started to cost the county more and more, as JP Morgan knew it would. But as interest rates plummeted, the swaps started to cost the county so much that it effectively forced the county in bankruptcy. When the county went bankrupt, JP Morgan cancelled the contract, and charged Jefferson County a $647M termination fee. All in all, the county paid JP Morgan $1.2B on interest alone, on a system worth $250M. When the accountants (and eventually the FBI) examined what happened, the JP Morgan bribes and manipulations were exposed. But it was such a complex web that no one from the banks were ever indicted or punished.

That is the beauty of manipulating the municipalities: if you know what you are doing, the sheer dollar amounts that municipalities must raise and spend are staggering, and gaining a few percent points on a staggering amount equal phenomenal profits. Of course, the line between phenomenal profits and outright theft is thin, but successful manipulators know how to ride that line very expertly…