Californian University Sues Banks over Swaps

Los Angeles August 01.2007

Biola University in La Mirada is suing Bank of America Corp. and BNP Paribas, saying the banks conspired to overcharge the Christian school for $84.2 million of derivatives. In the suit filed in U.S. District Court in Los Angeles, Biola said the banks misled it into believing that it paid a fair price for four derivatives it bought in 2002 and 2004. The contracts were linked to tax–exempt bonds the college sold. Biola is represented by the law firm Freeman, Freeman & Smiley in Los Angeles and is seeking $25 million or more in compensatory and punitive damages.

Tax Exempt Bonds

Tax–exempt bonds are valid debt obligations of state and local governments. The interest paid to bondholders is not includable in their gross income for federal income tax purposes. This tax–exempt status remains throughout the life of the bonds provided that all applicable federal tax laws are satisfied. Various requirements apply under the Code and Income Tax Regulations (the "Treasury regulations") including, but not limited to, information filing and other requirements related to issuance, the proper and timely use of bond–financed property, and arbitrage yield restriction and rebate requirements. The benefits of tax–exempt bond financing can apply to the many different types of municipal debt financing arrangements through which government issuers obligate themselves, including notes, loans, lease purchase contracts, lines of credit, and commercial paper.

Managing Municipal Bonds Interest Rate Risks

Municipal bond issuers face uncertainties about future interest payments. Interest paid on municipals have traditionally been low but can pile up over time. In order to address this uncertainty, borrowers can enter into swaps that result in either a synthetic fixed rate or synthetic floating rate. Synthetic fixed rate swaps are called "floating–to–fixed" interest rate swaps.

In this specific case, Biola bought "synthetic fixed–rate" swaps, which issuers of variable–rate bonds use to effectively convert their interest bill into one based on a fixed rate. Biola bought three of the instruments from BNP, acting on the advice of Bank of America, which sold the fourth swap to the school, the suit says.

In the law suit, Biola estimates that the fixed rates it has subsequently been paying on the swaps were excessive. In addition, Biola alleges, Bank of America reached a separate "secret deal" with BNP to share its profit on two of the deals. The University alleges that without prior consultation, Bank of America engaged in a transaction that enabled it to share the profit earned by BNP Paribas. In an apparent copy–cat version of the original swap deal (BNP Paribas’s swap with the university), BNP Paribas allegedly agreed to pay Bank of America the fixed–rate payments it would receive from the university in exchange for the floating–rate payments it owed. BNP Paribas also received an upfront payment of $2.58 million from Bank of America.

In effect Biola estimates that BNP has profited from the original transaction at its expense because it argues, the up front fees were funded by excessive profits extracted from Biola on the swap transactions, and probably excessive underwriting fees the Bank of America charged Biola on the original bond issuances.

The original swap deal meant that BNP Paribas would absorb the risk that the university would fail to make its payments. But Biola says that payments are far higher than what would be appropriate to compensate the bank for any event of default of the payments of bond interest to investors. The suit also claims Bank of America made payments to others who had no role in the transaction, without disclosing their identities.

Synthetic municipal derivatives swaps

In general an interest rate swap (IRS) is a contract arrangement between two counter–parties who agree to exchange interest payments for a fixed period of time and on a defined principal amount. The main characteristics are as follows:
• In an IRS, the notional (or principal amount) is not exchanged. The objective of the transaction is to convert one interest rate basis to a different rate basis (e.g., from floating to fixed, or from fixed to floating).
• The payments on an IRS are a function of the notional principal amount, interest rates, time and risks involved.
• The swap counterparties agree to exchange interest payments on specific dates, according to a predetermined formula. These exchanges typically cover periods ending on the payment date and reflect differences between the fixed rate and the floating rate at the beginning of the period.
• Fixed and floating payments are netted against each other to prevent redundant transfers of cash between counterparties; a net settlement is the only transfer of cash, made by the owing party on the payment date.
• Swap counterparties may use BMA Index which is the standard, variable rate, tax–exempt index and thus the closest match to where most issuers’ bonds will trade. They may also elect to use LIBOR which is the taxable equivalent to BMA and reflects the market for taxable, high–grade paper. The difference between BMA and LIBOR rates largely reflects the tax rate differential.

In a floating–to–fixed interest rate swap, an issuer or borrower sells variable rate bonds to investors, and at the same time enters into an interest rate swap whereby the issuer pays a fixed rate to the swap counterparty (provider) and, in return, receives a floating rate. The floating rate that the issuer receives can be based on the actual variable rate on the bonds or on a market generic index such as the Bond Market Association Municipal Swap Index ("BMA").

In a fixed–to–floating rate interest rate swap, the issuer issues traditional fixed rate municipal bonds, and at the same time enters into a fixed–to–floating interest rate swap whereby the issuer receives a fixed rate that exactly matches the issuer’s fixed rate debt obligation. In return, the issuer pays a floating rate to the swap provider that is based on a generic index (generally BMA), plus or minus a spread. Since the fixed rate receipt from the swap provider exactly offsets the fixed rate debt obligation to bond holders, the issuer is left with a synthetic floating rate payment. The spread to BMA that the issuer pays to the municipal derivative provider will change based on the credit rating of the issuer, timing of execution, term of the fixed-to-floating interest rate swap and the fixed rate on the issuer’s bonds.