Big financial problems come to Tennessee and Lewisburg; NYT uncovers costly deals through the same instrument that brought housing mess: derivatives

The New York Times tonight reports on how communities such as Lewisburg, TN., and others across the country have been put in precarious financial conditions by a financial firm using that infamous instrument called a "derivative".

Derivatives helped destroy the housing industry and our economy. Now they have cropped up with municipalities purportedly taken down the wrong fiscal road with the promise of savings.

Pity the good people of Lewisburg. The cost of interest paid on their sewer bonds has quadrupled to a shocking $1 million.

Here is an excerpt of this emerging story for Tennessee and communities in other states:

LEWISBURG, Tenn. — Five years ago, this small factory town was struggling to pay the interest on a bond for new sewers. Bob Phillips, Lewisburg’s part-time mayor and full-time pharmacist, was urged by the town’s financial adviser, an investment bank named Morgan Keegan & Company, to engage in a complex financial transaction to lower interest rates.

When a Lewisburg official attended a state-sponsored seminar designed to lay out the transaction’s benefits and risks, he was taught by investment bankers from Morgan Keegan.

And when Lewisburg decided to go ahead with the transaction, who was there to make the deal? Morgan Keegan.

In January, local officials were shocked to discover that annual interest payments on the bond had quadrupled to $1 million. Morgan Keegan, they said, did not serve them well in any of its roles.

“We’re little,” Mr. Phillips said, “and we depend on people wiser than us in financial ways to keep us informed, tell us what things mean, and I really didn’t think we got that.”

Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad. Municipalities that bought the derivatives were like homeowners with fixed-rate mortgages who refinanced by taking out lower-interest, variable-rate mortgages. But some local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did.

The municipal bond marketplace was so lightly regulated that in Tennessee Morgan Keegan was able to dominate almost every phase of the business. The firm, which is based in Memphis, sold $2 billion worth of municipal bond derivatives to 38 cities and counties since 2001, according to data compiled by the state comptroller’s office.

After The New York Times made inquiries, the Tennessee comptroller, Justin P. Wilson, ordered a statewide freeze on bond derivatives and a review of the seminar taught by Morgan Keegan and others.

Representatives of Morgan Keegan pointed out that they saved cities and counties money for years by delivering lower interest rates, and that the economic decline that created the turmoil in the bond market was beyond their control. Moody’s credit rating agency on Tuesday issued a negative outlook for the fiscal health of municipal governments.