The city of Los Angeles has sued more than 30 Wall Street investment banks and municipal bond insurers, accusing them of reaping hundreds of millions of taxpayer dollars in illegal profits, while other California cities are preparing similar lawsuits.
"These cities are taking on Wall Street for the abuse they've suffered over the last couple of decades," said Joseph Cotchett, one of the private lawyers pressing Los Angeles' lawsuit, said on Thursday.
"Los Angeles was one of the victims ... there are more coming," said Cotchett, a Burlingame, California attorney who won a jury verdict for more than $3 billion in a class-action suit against Charles Keating, Jr. and associates arising from the savings and loan crisis of the 1980s and 1990s. In an interview with Reuters, Cotchett said the suits argue bond insurance that municipalities must often buy is a "scam," adding the cases have the potential for major financial consequences for the municipal debt market.
"This wave of cases is going to make the subprime problem look minuscule," he said. One of two complaints filed by Los Angeles in local court on Wednesday claims a conspiracy to prop up the market for bond insurance, a galling expense for municipalities given their low default rate, even when they lack sterling credit ratings.
The lawsuit, filed against bond insurers including Ambac Financial, MBIA Inc's MBIA Insurance Corp, and Financial Guaranty Insurance Co, claimed Los Angeles was forced to purchase insurance from a triple-A-rated guarantor to benefit from that top rating.
Standard & Poor's, Moody's Investors Service and Fitch Ratings were not listed as defendants in the complaint because they are shielded by a federal law, according to Cotchett, but the complaint noted the rating agencies have "interlocking business relationships" with bond insurers that help underpin the bond insurance market.
"This situation is not economically rational and serves as a detriment to public entities and has led to unnecessarily high borrowing costs for public entities and unlawful profits for the insurer defendants," the complaint said.
Municipalities have proven "far less likely to default than the insurance companies that they paid to guarantee their debt," the complaint added. "In short, plaintiff paid insurance premiums for nothing."
Ambac, MBIA and FGIC declined to comment on the complaint. Los Angeles, which like other cities, US states and agencies issues municipal bonds to fund various public projects, has an investment-grade "Aa2" general obligation rating with Moody's and an "AA" rating with Fitch. Typically, top-rated bond insurance will result in lower borrowing costs.
But most bond insurers lost their "AAA" ratings as a result of exposure to risky subprime mortgage-related securities, leaving Los Angeles and other cities facing higher insurance premiums, interest rates and refinancing costs, the city said.
As bond insurer ratings were downgraded, wreaking havoc particularly in the auction-rate securities market earlier this year, some officials, including California Treasurer Bill Lockyer, called on rating agencies to rate municipal debt with the scale used for corporate bonds. That would likely result in mass upgrades for muni debt because of its low default risk.
Spokesman Tom Dresslar said Lockyer had not seen Los Angeles' lawsuit, but noted that under the current bond insurance system, "taxpayers get screwed." "The dual rating system for years has ripped off taxpayers. They have had to pay hundreds of millions of dollars that they shouldn't have had to shell out for bond insurance premiums and higher rates," Dresslar said.
Los Angeles' complaint said the bond insurers were motivated to make sure bond issuers' credit ratings stayed artificially low, while the guarantors maintained their own high credit ratings to be able to charge high premiums for bond insurance. "The first goal was achieved by conspiring to misuse their dominant control of the bond insurance market to perpetuate and maintain the dual bond rating system," the complaint said.
"The second goal was achieved by failing to disclose their true risk profile by recklessly endangering their 'AAA' status by insuring subprime loans and investing in exotic subprime financing instruments," the complaint added.
In a second complaint filed against banks and others involved in investing Los Angeles' bond proceeds, the city accused the companies of colluding to rig the bidding process supposed to produce the most competitive rates for the investments, which included guaranteed investment contracts and swaps.
Los Angeles City Attorney Rocky Delgadillo said that as a result, the city did not obtain competitive rates, losing tens of millions of dollars it should have earned. A group of states, cities and other muni issuers sued a slew of investment banks in March, alleging a conspiracy of price-fixing and bid-rigging. Oakland, California, filed its own suit in April after a probe by the US Justice Department, the Internal Revenue Service and the Securities and Exchange Commission initially focused on GICs for municipal bonds.