Municipal Finance Data Point of the Day, Latvia Edition

Duncan Wood has a great story about sleazy municipal finance today, with big investment banks helping a major city hide hundreds of millions of dollars in debt. The city is Riga, Latvia; the bank is Deutsche (DB):

Riga itself is blunt about how it chose Deutsche Bank’s financing approach. “The city was looking at raising finance directly from banks, as well as covering a significant part of the costs from EU infrastructure funds,” says a spokesman for Riga’s city council “Regrettably, for different reasons, the central government did not approve Riga borrowing an adequate amount from banks and we could not access EU funds. In 2004, the city announced a tender to find a financing solution for the project.”

Deutsche’s solution was to lend the money to the construction company, rather than to the city – and for the construction company to pay Deutsche back, starting in 2010, using money from Riga. At a glance, it might have appeared that the construction company was arranging the financing for the bridge and Riga was simply paying for the completed bridge in instalments – and that’s what Deutsche Bank apparently argued.

But Riga had also sold Deutsche credit protection on the construction company, ensuring that if the company defaulted for any reason, the city will be on the hook for the full sum. It was this credit default swap which later made clear to Eurostat – the European Union’s statistics watchdog – and to Latvia’s state auditor, that Deutsche’s credit exposure was ultimately to Riga rather than the construction company.

When the CDS arrangement was uncovered and the scheme unravelled in September 2007, Latvia had to put out a big deficit and debt restatement, which helped precipitate its current fiscal woes; it’s now the subject of a criminal investigation, complete with 27 million lati ($14 million) in unexplained expenses. None of this will come as any surprise to people who have read Matt Taibbi’s account of the shenanigans in Jefferson County, or the FT investigation into similar behavior in Italy.

Municipalities have incredibly high wealth-to-sophistication ratios, which makes them prime targets for banks such as Deutsche, which contrived to collect a whopping 46% of the total expense of the bridge in Riga as interest payments. All too often, as in for instance the rules about who is and isn’t allowed to invest in hedge funds, or count as a Qualified Institutional Buyer of fixed-income instruments, the main criterion is not sophistication but wealth. And while banks love rich clients, they love unsophisticated clients even more, and when they get both in one package, they are willing to do things like pay Goldman Sachs (GS) $3 million to stop competing for a certain client’s business.

Rick Bookstaber is quite right that we could yet see a devastating wave of municipal defaults, not just in the US but even around the world. I was worried about this last year, and I’m just as worried now, for reasons that Warren Buffett explicated very well in last year’s letter to shareholders: it’s all about the moral hazard of muni bond insurance, and the way in which municipal grandees are ultimately going to be happier to let the insurers take the hit rather than suffer serious fiscal pain themselves. Think of it as the municipal equivalent of walking away: it can flip very quickly from something which nobody does to something which a lot of people do, the minute that the cost of default turns negative.

Is there a broad CDS index for municipal bonds, or some other way of hedging muni exposure generally? If so, it’s definitely something to keep an eye on. And if it starts creeping up, that’s a good time to start worrying about the big sell-side banks with lots of municipal clients, especially JP Morgan (JPM), which inherited the large Bear Stearns muni business. Matt Taibbi won’t be the last person to blame JP Morgan for individual municipalities’ fiscal woes.