By Gretchen Morganson, New York Times, March 6, 2010
AS more details surface about how derivatives helped Greece and perhaps other countries mask their debt loads, let’s not forget that the wonders of these complex products aren’t on display only overseas. Across our very own country, municipalities, school districts, sewer systems and other tax-exempt debt issuers are ensnared in the derivatives mess.
Like the credit default 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. Taxpayers should be outraged, but to be angry you have to be informed — and few taxpayers may even know that the complicated arrangements exist.
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.
New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps — more than a quarter of which resulted from the Lehman bankruptcy in September 2008.
(You can find this report online at bit.ly/cS8ZFV.)
As of Nov. 30, 2009, New York had $3.74 billion worth of swaps outstanding. Even so, New York doesn’t have as much of a problem with swaps as other jurisdictions. Still, New York could have spent that $103 million on many other things that the state needs.
The prime example, of course, of a swap-imperiled issuer is Jefferson County, Ala. 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.
Critics of swaps hope that increased taxpayer awareness of these souring deals will force municipalities to think twice. “When municipalities enter into these swaps they end up paying more and receiving much less,” said Andy Kalotay, an expert in fixed income.
Why is that? One reason, Mr. Kalotay said, is the use of swap advisers.
“The basic problem is the swap adviser gets paid only if there is a transaction — an unbelievable conflict of interest,” he said. “It’s the adviser who is supposed to protect you, but the swap adviser has a vested interest in seeing something happen.”
WHAT is especially maddening to many in the municipal securities market is that issuers are now relying on the same investment banks that put them into swaps-embedded debt to restructure their obligations. According to those who travel this world, issuers are afraid to upset their relationships with their bankers and are not holding them accountable for placing them in these costly trades.
“We need transparency where Wall Street discloses not only the risks but also calculates the potential costs associated with those risks,” said Joseph Fichera, chief executive at Saber Partners, an advisory firm. “If you just ask issuers to disclose, even in a footnote, the maximum possible loss or gain from the swap they probably wouldn’t do it. And if they did that, then investors and taxpayers would know what the risks are, in plain English.”
Mr. Fichera is right. At this intersection of two huge and extremely opaque arenas — the municipal debt market and derivatives trading — sunlight is sorely needed.