Monday, March 8, 2010

Morgenson on muni derivatives

Original posted on Self Evident by the Bond Girl:

I generally approach Gretchen Morgenson’s pieces with the knowledge that her writing is going to be nonsensical and incoherent, but so much in this piece on municipal derivatives is flat-out factually incorrect that my head seriously almost exploded reading it. Before I explain why, let me say that I do actually think there is a lot of corruption in the municipal derivatives market, and if I have time in the near future, I will write something with more detail on that topic. Also, she quotes some well-known market participants at the end, like Dr. Kalotay and Fichera of Saber Partners. I think these are both brilliant people who have made significant contributions to public finance. Unfortunately, they are not smart enough to stay the heck away from Morgenson.

She starts off with this:

Like the credit default swaps [um, currency swaps?] that hid Greece’s obligations, the instruments weighing on our municipalities were brought to us by the creative minds of Wall Street. The rocket scientists crafting the products got backup from swap advisers, a group of conflicted promoters who consulted municipalities and other issuers. Both of these camps peddled swaps as a way for tax-exempt debt issuers to reduce their financing costs.

Now, however, the promised benefits of these swaps have mutated into enormous, and sometimes smothering, expenses. Making matters worse, issuers who want out of the arrangements — swap contracts typically run for 30 years — must pay up in order to escape.

That’s right. Issuers are essentially paying twice for flawed deals that bestowed great riches on the bankers and advisers who sold them.

Paying twice? I’m not even sure what she thinks this means. Does she mean in addition to the interest payments the issuers (may have) made under the swap? They did not pay to get into the swap agreement in the first place. I guarantee you that muni issuers understood that they could potentially be making a termination payment on the swap. But most issuers considered this as just another cost of issuing debt (similar to professional fees or a bond insurance premium). Also, she makes it seem like the municipalities are drowning under the cost of termination payments, when in reality, these are often paid from future borrowings (in fact, an issuer may not have an option on this due to the federal tax code), which makes a big difference when you are talking about cash flow.

The statement that these instruments are “flawed” because rates did not behave the way issuers thought they would behave betrays enormous financial naivetĂ©. If I purchase an options contract, for example, and I turn out to be wrong about the performance of the underlying asset, does that make the option contract flawed? No, it just makes me wrong.

She continues:

Here’s how municipal swaps worked (in theory): Say an issuer needed to raise money and prevailing rates for fixed-rate debt were 5 percent. A swap allowed issuers to reduce the interest rate they paid on their debt to, say, 4.5 percent, while still paying what was effectively a fixed rate.

Well, except that the issuer actually issued variable-rate debt and swapped it to fixed in the transactions she’s describing. They then booked the debt in their budgets at a lower cost and used their revenues to address other governmental funding priorities, which Morgenson neglects to mention. To make the argument that municipalities actually came out behind in this arrangement, you cannot just look at the termination cost on the transaction. You have to look at what the municipality paid or received over the life of the contract. She’s going to have to do a lot more math to make this point. It may be that the timing is troubling for municipalities, but that speaks more to how the trajectory of government spending has left governments with little margin for error.

Back to Morgenson:

Sales presentations for these instruments, no surprise, accentuated the positives in them. “Derivative products are unique in the history of financial innovation,” gushed a pitch from Citigroup in November 2007 about a deal entered into by the Florida Keys Aqueduct Authority. Another selling point: “Swaps have become widely accepted by the rating agencies as an appropriate financial tool.” And, the presentation said, they can be easily unwound (for a fee, of course).

Widely accepted by the rating agencies? Actually, I’d argue that the rating agencies at the time would have frowned upon an issuer with a sizeable debt program that did not include some measure of variable-rate debt and interest rate derivatives. This is probably too complicated for Morgenson to wrap her mind around, but an issuer with nothing but fixed-rate debt is actually not protected from interest rate risk.

Morgenson continues:

The contracts, however, assumed that economic and financial circumstances would be relatively stable and that interest rates used in the deals would stay in a narrow range. The exact opposite occurred: the financial system went into a tailspin two years ago, and rates plummeted. The auction-rate securities market, used by issuers to set their interest payments to bondholders, froze up. As a result, these rates rose.

Say what? How did we get to auction rate securities? Does she think this is the only kind of variable-rate debt issued in the municipal bond market? Beyond that, the big issuers of ARS that had difficulty refinancing were student lenders (which issued variable-rate debt to match variable-rate subsidies provided by the federal government) and hospital credits. I’m guessing she heard some anecdotes from Mr. Fichera, and completely bungled the message? ARS issuers are paying rates stipulated in bond documents, and if anything that is a problem with ARS, not swaps. Also, what does she think the benchmark rates have done since the financial crisis?

Back to Morgenson:

Another aspect to these swaps’ designs made them especially ill-suited for municipal issuers. Almost all tax-exempt debt is structured so that after 10 years, it can be called or retired by the city, school district or highway authority that floated it. But by locking in the swap for 30 years, the municipality or school district is essentially giving up the option to call its debt and issue lower-cost bonds, without penalty, if interest rates have declined.

This should be a simple cost-benefit analysis for the municipality, which is giving up the ability to call debt after ten years, at which point interest rates may or MAY NOT be lower than they were when the bonds were sold, for a lower cost of capital during the initial period. Again, she is implying that issuers of traditional fixed-rate bonds are protected from interest rate risk. Another thing she neglects to mention is that muni issuers pay for that call option in the interest rate on the bonds.

I think the funniest argument she makes in the piece is calling Jefferson County, Alabama the “prime example … of a swap-imperiled issuer,” noting that “its swaps were supposed to lower the county’s costs, but instead they wound up increasing its indebtedness. Groaning under a $3 billion debt load, the county is facing the possibility of bankruptcy.” Those deals were fraudulent. Larry Langford, former president of the Jefferson County Commission, was just sentenced to 15 years in prison. How does one get from there to swaps not being suitable for municipalities in general?

Toward the end of the article, she makes the argument that swap advisers get paid to give advice on swaps, ergo they advise municipalities to enter into swap agreements so they can get paid. She provides absolutely no evidence on this matter, beyond appealing to the authority of Dr. Kalotay and Mr. Fichera. In my professional experience, I have worked with some outstanding swap advisory firms and some that should probably not exist. But I can say the same thing about bankers, lawyers, accountants, etc. This really is not much of an argument, but if you believe the problem exists, look at the structure of compensation, not the instrument about which the professionals are providing advice.

I think the thing that gets me most about this piece is that she makes it sound like municipalities are just getting duped over and over again by banks. They aren’t. I can think of dozens of issuers whose short-term “how do I plug the budget gap this fiscal year” thinking lead them to do swaptions and other investments that they should not have gotten into. There are also plenty of outstanding lawsuits that could be discussed that suggest fraud is rampant in the municipal derivatives industry. If I have time in the future, I will write what Morgenson would have written if she cared about detail and conducted bona fide research. But these issues can be addressed through (1) stronger regulation, and (2) citizens caring about their government enough to participate and hold officials accountable for their decisions.

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