Any Given Sunday….

Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?


4 thoughts on “Any Given Sunday….

  1. The source article speaks about issuers with floating rate notes so the bank is paying the issuer float and the issuer is paying the bank fixed. I think you should check things out a bit better before you act.

  2. The Denver Business Journal is reporting an astonishing story about the Denver Public Schools paying 6.17 percent interest on $396 million of floating rate bonds that were part of a larger bond offering in 2011. The bonds were issued to fund a required contribution to the school system’s pension fund.

    The bonds, due in 2037, are rated Aa3 by Moody’s and were issued to refinance an earlier variable-rate bond deal from 2008. The earlier bond offering was backstopped by Dexia, the Belgian-French firm that encountered substantial credit problems. The question for Denver taxpayers: Why is the school district paying such a high interest rate? And why doesn’t it refinance?

    Current interest rates for comparable bonds at the same rating level and maturity would be 3.99 percent, according to Thomson Reuters Municipal Market Data. The cost difference between 6.17 percent and 3.99 percent for the $396 million in debt would $8.6 million per year, or about $215 million over the term of the bonds. That extra $8 million per year could hire a lot of teachers.

    But Denver can’t refinance. In a repeat of an earlier debacle, the city cannot pay off its high-priced bonds without triggering a termination event for the $396 million in interest-rate swaps that were issued with the bonds. As the Official Statement says: a “Termination Event [occurs when]… (iii) all of the 2011A Certificates are discharged, defeased, refunded or are otherwise no longer outstanding.” In plain English: You refund those bonds, and we want an upfront cash payment for these interest-rate swaps. The banks on the other side of the swaps are Bank of America, Royal Bank and Wells Fargo, and they have Denver schools over a barrel.

    **** Managing interest-rate swaps is a complex process and generally way beyond the capabilities of school district officials. **** The Denver Board of Education adopted a policy governing the use of derivatives in October 2011, but that was rather late in the game, given that the board had already entered into two series of interest-rate-swap derivatives. Denver is not alone in being locked into high-cost borrowing that cannot be refinanced. As fiscal resources contract, more bad deals will surface. Taxpayers need to know why these deals were done and to whose advantage. It’s not likely to be the public’s advantage.

  3. Pingback: ISDA take down on the New York Times « The OTC Space

  4. Pingback: FT Alphaville » How NOT to argue that derivatives are the devil’s spawn

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