(Editor’s note: Terry Boyd and Curtis Morrison contributed to this post.)

In the biggest U.S. financial crisis since the Recession, municipalities across the United States are going broke on almost a weekly basis.

Last week, it was Stockton, Calif. This week, Reuters has a story about Scranton, Penn.’s mayor reducing all city workers’ pay to minimum wage last week because the city doesn’t have the cash to pay their full salaries.

A news release this morning from the mayor’s office made us wonder: “How is Louisville doing?”

Metro Mayor Greg Fischer announced the city will pursue combining the Louisville Water Co. and the Metropolitan Sewer District, an initiative announced earlier this year.

In other cities such as Birmingham, Ala., financial gambles that included kickbacks to officials became hidden time bombs, so arcane the media didn’t document them until it was too late.

Surprise … on paper, at least, MSD has issues, namely $32.2 million in losses on derivatives for 2011, according to MSD financial statements:

The Income Statement as of December 31, 2011, shows a decrease in net assets of $32,172,000 due to an “unrealized” (non-cash) value adjustment to existing SWAP agreements. The negative value adjustment is because interest rates are close to 0% right now, but when rates increase to an amount favorable to MSD, the SWAP agreements can be terminated by MSD without penalty. This option is not reciprocal for the counter-parties. The existing SWAP agreements do not mature for another 20 to 30 years, so changes in interest rates are expected in that time frame.

The key word in that paragraph is “unrealized.” Translated, that means the loss is a “notional” loss that would only occur if MSD had to unwind investments called “fixed-to-floating interest rate swaps” at today’s interest rate.

In essence, before a management shakeup last December, MSD officials made a bet that interest rates would rise, but they didn’t. Crucial rates such as the federal discount rate have stayed at just above zero. MSD has issued about $1.6 billion in debt to build infrastructure and other improvements, and at one time, MSD had 10 such interest rate swaps, which are time-limited contracts, said Steve Tedder, MSD spokesman.

Chris Tobe, a former investment committee member and trustee at Kentucky Retirement Systems, said MSD officials bought $78 million interest rate swaps from Enhanced Financial Solutions in Paoli, Pennsylvania. Enhanced Financial Solutions sold interest rate swaps issued by Bank of America, Deutsche Bank, Morgan Stanley and Wells Fargo.

The contracts/investments are derivatives, a type of potentially risky hedging tool that says issuers will protect the amount of yield MSD has to pay if interests rate shot up. Overall, MSD pays the institutional investors and individual investors who buy MSD bonds about a 4-percent yield. (A heck of a lot better than CDs.)

As of last December, MSD has only two interest swap contracts, leaving the other deals when contracts expired, Tedder said. MSD can exit those two interest rate swap positions without a loss when interest rates rise, which they surely will over 20 years.

But those contracts could still turn into major losses under a number of scenarios, including a credit downgrade, as happened in other cities such as Birmingham, Ala.

MSD officials apparently fell victim to a Wall Street sales pitch a lot of utilities and municipalities fell for. Investment banks such as Goldman Sachs would convince cities to sell variable rate bonds at lower rates and buy fixed-to-floating interest rate swaps as insurance in case interest rates went crazy.

If the variable bond rates rose above a certain amount, the swap counterparty (usually investors who bought the investments from, say, Goldman Sachs) paid off the issuing agency. If the variable bond rate went down, the debt holders lost. Ah, but the internal workings of such deals were complicated by the investments being linked to Libor, the London Interbank Offered Rate, which the world now knows was manipulated by banks such as Barclays and at least 15 other giant banks.

Here’s what happened, according to the Fiscal Times website:

The additional losses from misreported Libor rates only exacerbated what had already become an exceedingly bad deal for public agencies. Most swaps contracts included large cancellation fees. In a falling interest rate environment where long-term tax-exempt bond rates have fallen to well below 4 percent, it became prohibitively expensive for governments to refinance floating rate debt that had been fixed via the swaps contracts at 5 percent or more.

Libor manipulation has cost transit systems and other municipal services billions, according to media reports.

If this sounds worrisome to you, it also bothered city officials as they took a close look at MSD finances earlier this year after an audit by former Kentucky Auditor Crit Luallen. When Fischer brought in Water Company President Greg Heitzman to replace former MSD executive director Bud Schardein, the first move was to end all the swaps contracts possible, said Chris Poynter, Fischer’s spokesman. “(Heitzman) said, ‘We have to make sure we get these in order,'” Poynter said. City financial officials “never would have used these,” he said.

Oddly, all this made it through Luallen’s MSD audit without setting off any alarms. And Tedder noted the Yield Enhancement Plan, which included the derivatives position, had been profitable for years, and that MSD officials were able to exit the plan without penalty.

We had to go back and re-watch the video of Luallen’s press conference where she released the MSD audit in mid-December 2011. She didn’t mention $32 million.

While Luallen’s audit brought initial attention to some corruption, no criminal charges were filed over such questionable financial moves. No one was arrested.

This is what KRS board member turned SEC whistle blower and investment consultant Tobe had to say:

“As a former financial investigator for Auditor Ed Hatchett, I have been very disappointed in the superficial audits from the APA (Auditor of Public Accounts) and very disappointed with our AG’s (Attorney General’s) lack of interest in financial shenanigans in the Commonwealth.”

Now, we’ve saved the fun part of this for last.

If MSD has potentially explosive derivatives positions, what’s lurking inside the $340 million worth of debt issued by the Louisville Arena Authority for KFC Yum! Arena?

Consider this – Insider Louisville research shows that yields on most of the arena bond tranches touch 7 percent, compared to the MSD bonds’ 4 percent and corporate bonds now yielding about 3 percent.

Was there a temptation to take a hedging position that involved fixed-to-variable interest swaps?

We tried to find someone to talk to about this, but the Arena Authority apparently doesn’t have a spokesman after the management switchover to AEG from the Kentucky Fair Board.

We contacted state officials in the office of Arena Authority Chairman Larry Hayes, who is also secretary of the Kentucky Cabinet for Economic Development.

They emailed back a contact for all Arena Authority financial questions – a  vice president.

At Goldman Sachs.



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