Bankers = Drug Dealers, And We Are The Addicts

Villify them, call them out, protest against them, but whatever you do, don’t stop them.  Don’t interrupt the flow.  We can’t take it!

There is outright theft going on in America right now, and nobody cares.  It doesn’t matter.  The current ringleader of the thieves is Citigroup, which will be the lead underwriter of the $900 million Illinois Build America Bond issue that is slated for this week.  But it doesn’t matter the name (Citi, JPM, MS), the game is the same.  We are using an ill-conceived stimulus program (Build America Bonds) to funnel new debt to issuers that would otherwise and correctly be precluded from borrowing, and allowing these thieves to not only make money off the underwriting, but also to profit from taking some of these bonds into their own inventory and then marking them up!  Along the way, the same group we claim we hate, the same group that got rich for facilitating our own apetite for debt, is ramping up their profits once again!  Why aren’t we outraged!?

Build America Bonds

Part of the stimulus package was a program to widen the possible buyers of state issued debt.  Why?  Because states were having trouble issuing debt in ‘08 and early ‘09 at what the states considered ‘reasonable’ yields.  Now, reflect on that for a moment.  Back at the height of the financial meltdown investors were looking at states whose finances were in shambles and asking themselves, “Are these states a good risk?”  The answer was obvious, “No!”  To that end, states like CA had to pay a pretty penny (5-6%) to issue bonds back then.  Remember, this is the TAX FREE rate.  That’s a great deal, as long as CA pays.  Take that caveat for what you will.

Along comes the Build America program, where the federal govt tells states that it will subsidize their interest payments on bonds that are issued for infrastructure projects.  The twist is that the bonds are now taxable, which widens the number of participants that might buy them.  For bonds issued in ‘09 and ‘10, the subsidy is 35%, bonds issued in ‘11 the subsidy is 32% and bonds issued in ‘12 the subsidy is 30%.

So how does it work in reality?  Let’s say you are a state and would like to issue bonds.  If you are considered a quality credit, then typically your cost of issuance is 20-25% less than the corresponding treasury.  However, if you are a questionable credit, say because you don’t pay your bills, or haven’t balanced your budget, or made the required payments to your pension plan, or whatever, then your cost of issuance, or interest rate, could be higher than treasuries.  Now, this would be weird, because treasuries are taxable and state bonds are tax free.  But in the current situation, where a lot of states are out of whack financially and investors are scared, state issued bonds are seeing higher yields and treasuries are of course at low yields.

In come Build America Bonds.  A state, let’s say, Illinois, would like to do something to rebuild it’s crumbling infrastructure, which might also create a few jobs, but the state is in terrible shape because it spends like a drunken sailor and has the fiscal responsibility of a 6-year-old.  Currently the state has $5 billion of unpaid bills from LAST YEAR, and a budget gap of over $1 billion for this fiscal year.  In short, they are awful.  You would think that a state in this sort of situation would have no luck whatsoever in getting anyone to loan them money for something less than 20% interest.  But no!  Build America to the rescue!  In comes the US government (which is code for “taxapayers across the nation”) to subsidize the interest on a bond deal for Illinois.  Why?  In the name of stimulus, of course!  They must get more money!  They must spend!  If they cannot balance their budget, pay their bills, or provide for their retirees, then WE MUST GIVE IT TO THEM!

And so we do. 

Illinois is selling $900 million in Build America Bonds, the yield is expected to be about 7.50%.  Keep in mind, this is 35% subsidized by me and you.  Illinois pays 4.8% of the interest, you and I pay the rest.  The only reason Illinois would issue these bonds is if they could not borrow at 4.8% on their own, tax free, because investors think they are a bad risk.

Now comes the theft.

Illinois uses an underwriter to sell their bonds, in this case Citigroup is the lead underwriter.  They make a fee for issuing the bonds.  They also get first crack at buying the bonds.  Since Build America Bonds came out last year, the process has been for the bonds to come at an attractive yield (7.5% and 1/3 of interest backed by the US govt is pretty attractive!) but then mysteriously a chunk of the bonds are not available for the general public to buy.  Instead the bonds go to the underwriters and their friendly institutions, and miraculously the bonds are more expensive in 2-3 weeks.  What happened?  The underwriters priced the bonds with the yields a little high, then took the bonds for themselves and their best clients, knowing that there would be a built in profit on day one.

Why would we allow such theft?  Because we are addicted to debt.  It is the one answer that we hear to cure our ills.  Sure, alternative energy is out there, greater savings, higher wages, etc.  But the US govt is spending $1.4 trillion it does not have, and states are meeting their required obligations by borrowing (pension bonds), and we as consumers are being begged, absolutely begged, to spend on credit – houses, cars, appliances.  In the case of states many legislators have no clue of how they could function without borrowing.  None.  They will pay any price, jump through any hoop, as long as they get their fix  debt.

The kicker is that the bonds from Illinois are not being actively marketed to US investors, instead, the director of capital markets spent his time doing a road show in Asia.  It seems that foreign investors think a 7.50% yield on a bond that is ostensibly 1/3rd backed by the US govt is a better deal than a 4.10% treasury.

Over the last 20 years we have built our economy on the extension and management of debt.  In the process we made those who deal in debt, the bankers, rich.  We realized in ‘08 that the emperor had no clothes, and the risk of the debt was not magically whisked away by securitization, CDS’s, or any other financial “invention,” but by then we were addicted.  We stand here today hating the drug dealer, but paying him just the same.  Tomorrow, we will owe the debt, and the banker will be wealthier. 

Read the original story at H. S. Dent