Who do you suppose would get the better of it if the mayor of your city made a bet with Goldman Sachs on the direction of interest rates?  Would you be surprised if the mayor lost, costing the city’s taxpayers millions of dollars?  Do you think betting taxpayer dollars is legal?

In the years leading to the Crisis of 2008 many municipalities made interest-rate bets with Goldman Sachs, JPMorgan, Morgan Stanley, and British banks.  The cities lost every bet.  Right now, their taxpayers are paying out billions annually.  The bets will not be paid off for 15 to 20 years, costing the cities needed policemen, firemen, and schools.

The funny part of the story is that the cities keep paying despite the fact that they have a good legal defense: The bets are not enforceable because cities are not authorized to place bets with taxpayer money.

Traditionally, cities issue bonds with a fixed interest rate but with a “call option”—the power to redeem the bonds before maturity if interest rates drop so that new bonds can be issued at the lower rate.  Variable-interest-rate bonds, on the other hand, typically sell for a slightly lower interest rate but without a call option.  Consequently, new bonds cannot be issued if interest rates go up; taxpayers have to pay the higher rate.  The bankers approached the cities offering them what they said was the best of both worlds—the cities could issue variable-rate bonds to the public, taking advantage of the initially lower rate—say, three percent.  By a side agreement with the bank, the city agreed to pay a below-market fixed rate—say, 3.5 percent—to the bank.  The bank agreed to pay the city the variable rate—whatever it turned out to be—and they called the agreement an “interest-rate swap.”  The city thought it was safe because it could never pay more than the fixed rate.  It had covered the upside risk—but what about the downside?

The city overlooked the fact that, if interest rates fell, it still owed the bank the fixed rate, while the bank only owed the city the newly low variable rate.  The city—pursuant to the swap—had given up the right to call the bonds.  When the government, in response to the crisis, dropped interest rates to near zero, the bankers won—and the cities lost—their enormous bets.

Reportedly, there are at least 1,100 interest-rate swaps with municipalities and transit authorities.  The New York MTA, as of August 2011, had lost $658 million on its bets, and is losing $113.9 million annually.  The Chicago Transit Authority is losing $88.2 million annually; Detroit, $54 million; and New Jersey, $83.2 million.  Altogether, transit authorities across the United States are losing $529 million annually on the swaps.

The U.S. government, throughout the crisis, was generous to the bankers.  Would the bankers show any generosity toward the cities that had made the foolish bets?  Oakland has paid Goldman Sachs $32 million so far.  Meanwhile, the city has cut its police force from 800 to 650 and watched crime rise 25 percent.  Lloyd Blankfein, Goldman Sachs CEO, was asked at the June 2012 shareholders’ meeting if he would let Oakland out of its disastrous deal.  He replied, “I don’t think we’re in a position to do that.”  It would not be fair to his shareholders.

Congress immunized derivatives (interest-rate swaps) from state and local antigaming laws when it passed the Commodity Futures Modernization Act of 2000.  Before the act, derivatives violated these laws.  Gambling debts have been unenforceable at common law since the days of medieval England.  The 2000 law states that it “supersede[s] and preempt[s] the application of any state or local law that prohibits or regulates gaming or the operation of bucket shops (other than anti-fraud provisions of general applicability) . . . ”

The 2000 law authorized the banks to make bets, but it did not authorize our cities to enter into them.

American municipal law follows the English rule that local governments are not sovereign but creatures of statute and have powers given to them only by the state.  The House of Lords ruled in 1990 that interest-rate swaps were ultra vires of local governments—i.e., beyond their powers.  The banks argued the swaps were “akin to insurance” to cover possible risks, but the lords found they were “more akin to gambling.”  The lords’ decision effectively banned swaps in England.  The British regulator, in 2012, announced that the big British banks were guilty of “mis-selling” 28,000 interest-rate swaps to small and medium enterprises.  The banks agreed to “provide appropriate redress” to the firms.  The British have wrapped up the fiasco very neatly.

Goldman and the other banks have attached a giant siphon to drain off the tax revenues of America’s communities.  Unsophisticated public officials, of course, had no business making bets with Goldman Sachs.  But foolish public officials are nothing new in this country, and state constitutions and laws are designed to protect taxpayers from fools squandering the community’s resources.

The cities should stop paying Goldman and sue to recover what they have already paid.