Gretchen Morgenstern, the Times’ excellent business reporter,exposes another as yet unexploded credit default swap bomb, this time close to home. Seems that many municipalities have issued credit default swaps in connection with municipal bonds. In theory, the swaps allowed the municipalities to pay a slightly lower rate of interest, but that happy outcome, as elsewhere, depended on “nothing” being the answer to that perennial question: “What could go wrong?”. In fact, a lot can go wrong, and apparently a lot is about to go wrong for our municipalities:
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.
Nothing wrong with that, right?
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).
But these arrangements were riddled with risks, as issuers are finding out. The swaps were structured to generate a stream of income to the issuer — like your hometown — that was tethered to a variable interest rate. Variable rates can rise or fall wildly if economic circumstances change. Banks that executed the swaps received fixed payments from the issuers.
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.
For municipalities, that meant they were stuck with contracts that forced them to pay out a much higher interest rate than they were receiving in return. Sure, the rate plunge was unforeseen, but it was not an impossibility. And the impact of such a possible decline was rarely highlighted in sales presentations, municipal experts say.
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.
Imagine a homeowner who has a mortgage allowing her to refinance without a penalty if interest rates drop, as many do. Then she inexplicably agrees to give up that opportunity and not be compensated for doing so. Well, some towns did exactly that when they signed derivatives contracts that locked them in for 30 years.
Then there are the counterparty risks associated with municipal swaps. If the banks in the midst of these deals falter, the municipality is at peril, because getting out of a contract with a failed bank is also costly. For example, closing out swaps in which Lehman Brothers was the counterparty cost various New York State debt issuers $12 million, according to state filings.
Termination fees also kick in when a municipal issuer wants out of its swap agreement. They can be significant.
So, as it turns out, (no real surprise here) a lot can go wrong (not for the banks, of course) and most of it has, or is about to.
Credit Default Swaps appear to be the ultimate weapon of mass economic destruction. In the case of Greece and other European countries, they were used to mask government debt. In the case of the banks and AIG, they were used to mask the extent of the financial risks the banks were taking, and in the case of municipalities, they were simply a way for banks to scam municipalities that lacked the sophistication to understand the risks they were taking.
Recently Paul Volcker challenged a group of bankers to come up with a single example of a positive effect of derivatives:
“I would like one of you to give me the example of one single so-called innovative financial product that has produced benefits for economic development. I am sorry, but the answers you offered seem to me inadequate.”
Presumably those answers did not include the only one that really matters to those bankers: the positive effect derivatives have on their own paychecks.
Of course, Volcker is being viewed as sort of a cranky old man. It is really rather amazing that, given the destruction these things have wreaked, there is nary a voice in Congress demanding their abolition. Instead, there is talk about transparency, with the actual proposals riddled with built in loopholes. Not having learned from history, we are indeed doomed to repeat it.
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