What's the connection? During the dog days of the financial crisis in 2008, the investment bank advised clients to bet that Wisconsin and 10 other U.S. states would go broke by purchasing credit default swaps against their debt. For Goldman and other Wall Street firms that used this ploy, the beauty part was that they had also previously earned millions in fees by helping most of those states sell municipal bonds.
In other words, these banks made money by finding investors to buy state debt, then made more money by selling derivatives to other investors who wanted to short that debt. As Bloomberg reported at the time:
As part of a September presentation to institutional investors on "Best Long and Short Risk Strategies," Goldman recommended buying credit-default swaps on "a basket of liquid State General Obligation credits with current and worsening fiscal outlooks," including California, Florida, Nevada, Ohio, Wisconsin and Michigan.2008: A very bad year for Wisconsin
The firm also recommended the derivatives on states with "significant unfunded pension" and other retiree obligations, including Illinois, Connecticut, Hawaii, New Jersey, Massachusetts and Nevada.
For states, growing concerns about their credit raised their borrowing costs. Estimates suggest that a one percent interest rate hike on a $1 billion bond issue would cost taxpayers roughly $10 million a year. In 2008, rates in Wisconsin more than tripled, reaching 15 percent.
Wisconsin, other states, and scores of town and cities around the country also lost big after going to Wall Street to buy variable-rate auction securities and other types of structured financial products. The market for auction-rate securities collapsed in early 2008, leaving states and municipalities holding the bag. Goldman and other Wall Street banks agreed that year to pay a total of $160 million in fines over and repurchase $15 billion worth these securities to settle several state probes into the transactions.
In another case of speculation gone awry, some Wisconsin school districts lost millions after purchasing so-called synthetic collateralized debt obligations. Wall Street banks sold CDOs to bet on the value of housing in the years leading up the financial crisis.
How the housing bubble killed pensions
Ancient history, you say? Not at all. Because whatever Wisconsin Governor Scott Walker says about the state's pension problems -- which, incidentally, are far less severe than he claims -- they're not the result of employees contributing too little to their retirement. Rather, Wisconsin's shortfall stems largely from the state getting killed in the stock market during the financial crisis.
As the housing bubble was inflating in 2003, for instance, Wisconsin issued $950 million in auction-rate bonds to fund its pension plan. The bonds did well until mid-2007, when souring subprime loans began rippling into the auction-rate and other bond markets. That turned into a full-blown crisis early the following year, when Goldman, Citigroup (C) and other large Wall Street firms stopped supporting auctions.
The bottom fell out. As the state's auditor told lawmakers last fall in explaining the long-term impact of Wisconsin pension funds losing nearly $24 billion in 2008:
[T]he value of Wisconsin Retirement System assets has fluctuated significantly over the past ten years as financial markets have experienced their worst decline since the 1930s. For example, losses in 2008 totaled $23.6 billion. While these losses were partially offset by gains of $13.5 billion in 2009, the combined value of the two retirement funds on December 31, 2009, was 17.1 percent below its peak in 2007. The losses of 2008 will significantly affect Retirement System participants and employers for the next several years.What if states had played it safe?
That's the broader lesson here for Wisconsin and other states. Numerous state pension funds are hurting not because employee benefits are excessive, as Walker contends (As an aside, see here for a remarkable recording of the governor discussing his plans to, among other things, lay off state workers with someone he thinks is chemicals mogul and Tea Party activist David Koch.) It's because the financial crisis -- caused in part by Wall Street pushing risky products and worsened by banks betting against their own clients -- crushed the stock market, which lowered the value of pension fund assets.
Economist Dean Baker of the Center for Economic and Policy Research calculates that if after 2007 states had instead invested their retirement funds primarily in 30-year Treasury bonds, then state and local pension plans would be $850 billion richer (click on chart below to expand).
As for Blankfein, he should be able to spare a little change for Wisconsinites. His base salary recently tripled, to $2 million, even after he warned the Financial Crisis Inquiry Commission last year that raising base pay on Wall Street causes bankers to take risks. No argument there.
Image from Flickr user DonkeyHotey
- Relax, States Aren't About to Go Belly Up
- A Banking Parable: Goldman Stumbles, CEO Gets a Raise, Risk Grows Higher
- Goldman Sachs: Why the Bank's Vow to Clean Up Its Act Means Nothing
- Here's Why We Still Need to Finger Culprits in the Financial Crisis
- Better Than Bernie: How Wall Street Used CDOs to Perpetrate a Massive Ponzi Scheme