The other day I was perusing the swap notes in the financial statements of a big city I won’t name. In it I found a statement in the section on swaps:
“(6) Tax Risk. The swap exposes the City to tax risk or a permanent mismatch (shortfall) between the floating rate received on the swap and the variable rate paid on the underlying variable-rate bonds due to tax law changes such that the federal or state tax exemption of municipal debt is eliminated or its value reduced.”
I couldn’t disagree more and I’m not just being disagreeable – this is flat out wrong and it’s screwing up the issuer’s financials and potentially exposing them to legal liability. The City’s LIBOR swaps absolutely do NOT expose the City to any new tax risk. The tax risk sits in the VRDBs irrespective of whether the interest rate risk is hedged with a LIBOR swap or not. Here’s an easy example that proves it…
Say there’s a tax-exempt variable rate demand bond (VRDB)
trading at 3% with zero support costs. Let’s further assume LIBOR is at 5% which means this VRDB is trading at 60% of LIBOR. If we look at an environment where the US moves to a value added tax and the preference for tax-exempt income goes to zero, ceteris paribus (my Latin teacher would be so proud), those VRDBs will start trading at 100% of LIBOR or 5%. This is a 2% increase in cost.
Now, let’s say these same VRDBs had a 60% LIBOR swap in place with the issuer paying 4% fixed. Before the value added tax change, the issuer was paying a net 4% (3% VRDB rate minus 3% floating leg of swap plus 4% fixed rate). After the event, the issuer pays 6% (5% VRDB rate minus 3% floating leg of swap plus 4% fixed rate), a 2% increase in cost.
Notice that each situation both with and without the swap show a 2% increase in cost! So can someone please explain how the “swap exposes the City” to something called “tax risk”? Of course it doesn’t. The VRDBs have the risk; the swap is utterly irrelevant.
If there’s going to be a note on tax risk, the revised and corrected version should be:
“(6) Tax Risk. The interest paid on variable-rate bonds issued by the City is impacted, in part, by investor preference for income that is exempt from federal or state tax. Therefore a change in tax law that eliminates or reduces the value of this exemption may increase the interest expense paid by the City on these bonds.”
Frankly what these financials
succeed in accomplishing is exposing the City to legal liability due to poor and inadequate disclosure. As we can see, the reality is that all
VRDBs contain “tax risk.” So the fact that this disclosure is limited to only swapped VRDBs is flat out wrong and actually understates the possible impact of a tax law change because it ignores the City’s other bonds. With the SEC making noise about municipal disclosure
quality, auditors better start understanding what they’re doing and issuer’s must beware of this type of inaccuracy.
Here’s a quick quiz. If over the last 10 years 1M LIBOR reset weekly averaged 2.814%, and the average of SIFMA / 1M LIBOR was 82.0%, what was the SIFMA average over the same time period (all rates unadjusted for day counts, holidays etc.)?
A. 2.05% B. 2.31% (2.814% * 82.0%) C. 2.62%, or D. None of the above but it seems like a trick’s in here somewhere
The correct answer is in fact A, which is a testament to how strongly the Fed has been stepping on the money accelerator over the last decade. Monetary policy aside, if you answered B (simply multiplying the LIBOR average by the SIFMA/LIBOR ratio average) you would’ve made a very common mistake which falls into the category of the Flaw of Averages. Overreliance on simple averages, partly induced by overreliance on simple spreadsheets, can very easily lead to errors of calculation and ultimately judgment. In this case, the seemingly more intuitive answer B is over 25 basis points wrong!
How does this work? When rates are low, SIFMA/LIBOR has been high and vice versa i.e. the two rates have been negatively correlated. If you don’t capture this fact in your analysis, you’re missing a critical component of how the tax-exempt markets have worked. This ultimately leads to over-hedging, misunderstanding of balance sheet hedges, and other unintended consequences.
Luckily, there are readily accessible public finance analytics that capture these very easily.
One of the (few) benefits of leaving a perfectly functional Street job is that I'm now free to have a free dialogue with the free press using my now free(er) speech. To that end, I decided to engage the NYT a few weeks back regarding Gretchen Morgenson'sThe Swaps That Swallowed Your Town article. This is the first of 3 posts recounting the transcript as surprisingly, they did engage.
Most of the press on municipal swaps, as already critiqued here, is now as much concerned with drawing an emotional response from the reader usually with the mild sacrifice of fact or perspective. On this particular article, Peter Shapiro has already done the yeoman's duty of correcting the numerous inaccuracies on the LinkedIn Municipal Bond Forum; the exchange there is worth a read. I had a more narrow objective with the NYT; get a correction published of this sentence, "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." My first salvo of my triple attempt at a correction, and the senior editor's response is below.
The article "The Swaps That Swallowed Your Town," through a healthy dose of misinformation coupled with basic misunderstanding, does a great disservice to the very talented municipal and state finance officials that manage complex capital programs. No different than the homeowner who must decide to use either a fixed or adjustable rate mortgage, these officials must make tough decisions about interest rates. Most of the time they employ traditional fixed rate bonds. However, history has indicated that over substantial periods variable rates often offer lower cost than fixed rate. As a result, states and municipalities frequently allocate a certain percentage of their borrowing to variable rate bonds in order to save the taxpayer on expected interest costs. One way to manage some of the risks inherent in these variable rate bonds is through the use of interest rate swaps.
The article is not inconsistent with the above (though I believe frankly sensationalizes at the expense of clarity). The writer runs amok, and unfortunately this is the thrust of most of the article, when she states, "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." This is factually INACCURATE...Interest rate swaps hedging variable rate bonds are designed to work and have worked in any and all interest rate environments. To report otherwise is simply false. If the Times cares about correctly reporting information it will retract this statement immediately and visibly.
Further, what happened during the meltdown that really affected municipalities had two primary components:
1) an overreliance on risk-laden bond insurers to raise money in a very thin auction rate securities market and
2) banks retreating from providing support for variable rate bond programs.
But both of these problems had nothing to do with interest rate swaps. The Lehman collapse, if anything, showed municipalities that the swaps market functions incredibly well even with the implosion of a major player. Billions of notional were assigned in an orderly fashion to other dealers in a way that actually wound up making most affected states/municipalities better off.
Thank you for your time and I hope to see the correction quickly and visibly noted. As someone who has worked in the industry for 15+ years, this type of misinformation is both unnecessary and damaging. I hope the Times can admit when it has exaggerated a story to the point of inaccuracy. I understand it's the exaggeration that may sell more papers, but I expect the Times to hold itself to higher standards.
Peter C. Orr
The reply surprisingly went into basis differential between swap and bond rates and even LIBOR index issues. Of course, this was not directly mentioned anywhere in the article.
Dear Mr. Orr,
We considered your request for a correction and have decided that the article does not contain any correctable errors. The writer, Gretchen Morgenson, noted:
That is the 'narrow range' we referred to in the column. It is not narrow anymore and that is what is causing problems for issuers."
"The only way the swaps would work as they were supposed to was if the interest rate the municipality paid out to its bondholders was close to the interest rate it received from the bank that entered into the swap (which was a percentage of 30-day LIBOR). This has not been the case and that is why these swaps are causing trouble for municipalities--they are paying out more than they are receiving.
But what instrument made this basis blow out??? Read it in pt 2
"It is better to understand a little, than to misunderstand a lot."
The prior two posts came to one simple conclusion: most tax-exempt issuers who have used LIBOR based swaps to hedge variable bonds are over-hedged (see prior posts for details why). This conclusion has two primary ramifications:
- If you hedged with, for example, 15% more swap than necessary than the issuer paid 15% more to the swap dealer than necessary. Across an estimated $1.5 billion+ in compensation to swap dealers over the last several years on these, its real dough
- In high rate environments, the overall cost of funding will be lower than expected and in low rate environments higher
Let's look at a simple example. AnyCity, USA uses a 3.50% $100 million 68% 1M LIBOR to hedge $100 million in tax-exempt variable rate demand bonds (VRDBs). This 68% number was determined using an historic average and an implicit assumption of zero correlation between 1M LIBOR and SIFMA/1M LIBOR ratios. If one had assumed correlation of -.35, which is more consistent with what we've seen and might reasonably expect, then the right hedging index would be 58% LIBOR plus 0.52%. Both of these swaps carry a fixed rate of 3.5%.
When rates are low, the floating leg of the swap at 68% of 1M LIBOR is less than the 58% of LIBOR plus 52bps. On our $100 million swap for AnyCity, the graph of LIBOR rate level versus annual benefit to having the 58%+52 basis point leg looks like this:
Now obviously as rates go higher the benefit becomes a loss, but that's the point: this is no longer a hedged position as there's an inherent interest rate view within the structure. The overall synthetic fixed-rate structure (variable rate bonds swapped to fixed) performs worse than expected in low rate environments but better than expected in high rate environments. This is due to the fact that we expect SIFMA/LIBOR ratios to be somewhat higher on average in low rate environments and vice versa (the negative correlation between rates and ratios). What does this all mean? Well, few issuers are entering into new synthetic fixed rate deals so it matters more for those that are doing restructuring. What is the optimal portfolio-wide level of LIBOR based swaps for hedging tax-exempt variable rates? Probably less than one might think. What's an issuer to do? Well, if you have more swaps than you need than you could unwind some swaps now though in this rate environment they're likely under water. You could wait for rates to rise and unwind when the swaps are closer to a zero mark or even an asset. Have to be careful though...that'd be speculating.
"Our lives improve only when we take chances - and the first and most difficult risk we can take is to be honest with ourselves."
- Walter Anderson
Although it may not look related out of the gate, this post is a continuation of the prior post on LIBOR swaps over-hedging tax-exempt variable rate bonds. I want to start by looking at how one might build a reasonable interest rate model that would facilitate calculating this % LIBOR correctly, so that we expect to minimize the volatility of our synthetic fixed rate structure. Let's say your job is to build an interest rate model that captures the uncertainty inherent in SIFMA and LIBOR. This would be an unusual task for "quants" in public finance whose primary responsibility is coming up with accurate and often elaborate variations of present value ideas. The "model" used most frequently among front-line in investment bankers/advisors in this sector and in part due to an overreliance on spreadsheets looks something like this:
Some historic average over a selected time-period is used to create a static, flat, deterministic assumption for short rates over the time horizon of the analysis. This IS a type of interest rate model no doubt though one whose strength is not in capturing uncertainty/variability.
If an analyst were trying to create a SIFMA and LIBOR market model using two risk factors, perhaps un-intuitively s/he would not want to use "SIFMA" and "LIBOR" as the risk factors themselves. A detailed reason why is beyond the scope of this post (though you can find an outstanding thorough treatment here), but to put it simply, too much of the variability in SIFMA is also present in LIBOR. Let's face it, as US$ denominated short term interest rates, both SIFMA and LIBOR will be driven largely by changes in US monetary policy.
The better choice for a 2 factor model is LIBOR and SIFMA/LIBOR ratios. SIFMA/LIBOR ratios better reflect the unique component of risk in SIFMA itself i.e. the taxable/tax-exempt relationship. But how does this relate to the correlation impact on swap structure mentioned in the first post? It turns out that historically and on average, as LIBOR falls SIFMA/LIBOR ratios tend to go up and vice versa. In the industry vernacular bankers call this "yield compression" and it has a number of reasonable economic and technical explanations.
How do we capture this in a two-factor interest rate model that doesn't take a PhD to understand? For details on that you can read this and/or get a spreadsheet example. Suffice it to say, it really isn't so bad. To ultimately answer the original question, does this inverse relationship between rates (LIBOR) and ratios (SIFMA/LIBOR) impact the *right* percentage of LIBOR to use when hedging tax-exempt variable rate bonds? Absolutely. The graph below shows the LIBOR swap % that minimizes debt service volatility at different levels of expected correlation between LIBOR and SIFMA/LIBOR ratios.
The bottom line is that using simple averages for this LIBOR swap hedge calculation does 2 things: a) ignores the fact that these structures are not equivalent to fixed rate bonds, a fact that's been sometimes painfully understood over the last 18 months and b) implicitly assumes a correlation of zero between rates and ratios which leads to a hedge ratio that is too high, and ultimately more LIBOR swap than is necessary. What are the cash flow and mark to market ramifications of this over-hedging? Stay tuned for the 3rd and final installment on this topic. In the meantime and if you're involved in the biz, how do YOU do this calculation?
"Opportunity is missed by most people because it is dressed in overalls and looks like work."
- Thomas Edison
Over the last decade, many tax-exempt issuers have executed interest rate swaps based upon a percentage of the 1M or 3M London Interbank Bank Offered Rate in order to hedge the interest rate risk inherent in tax-exempt variable rate, or (perhaps unfortunately) auction rate securities. Whether or not these "synthetic fixed-rate" structures are appropriate for all or any tax-exempt issuers is a hot topic these days in light of expected regulatory changes, and one I'm not touching here. What I am going to discuss is something more fundamental to implementation: how does one arrive at the *best* structure to minimize overall debt service volatility, have historical practices led to chronic over-hedging and if so, what are the ramifications.
The usual methodology employed to determine the "right" percentage of LIBOR for the floating leg of the swap is usually calculated based upon some historic average of the ratio of the SIFMA swap index, a weekly tax-exempt floating index, to 1month or 3 month LIBOR. Ignoring tax and accounting issues for the moment, if the goal is to minimize the expected variability of overall net debt service payments this simple averaging method is incorrect in all cases save one: the expected correlation between SIFMA and LIBOR is precisely 1. My personal assessment is that most issuer/advisor/banker participants in this particular market are not accustomed to thinking explicitly about correlation as it relates to their risk management decisions. However, they're making implicit assessments of correlation quite often, sometimes with regrettable consequences.
Let me explain. Any recently test-taking CFA candidate (congratulations by the way) will tell you that the variance minimizing hedge ratio is calculated using the following simple formula:
Volhedged item / Volhedging item * Correlationbetween the 2
This formula has intuitive appeal. If the volatility of my hedging item is far greater than the item hedged, my hedge ratio should fall, which you can see it does. As it relates to correlation and in the canonical edge case, if I have a 0 expected correlation between the item I'm hedging and the item I'm hedging with, we'd expect our hedge ratio to be zero as well; you can't hedge something with something else if you expect no co-movement between the two items.
But is it our best judgment that (changes in) SIFMA and LIBOR will be perfectly correlated going forward? What does history tell us? If we look at the levels themselves, it's clear their correlation isn't perfect. Below are 5 year rolling correlations of one month averaged SIFMA and 1M LIBOR.
What does all this mean? If we expect that SIFMA LIBOR ratios will be 68% going forward (a common and frequently used historically calculated average ratio), then the right hedge ratio would scale this by our expected correlation which likely does not equal 1. A reasonable expected correlation between 85-90% would yield an optimal hedge ratio of between 57.8 and 61.2%. Some banks have gotten to numbers like this by performing regression calculations, which of course are just alternative ways of determining correlation.
So what and who cares? Well, let's compare an issuer with a 70% LIBOR swap paying a 3.5% fixed rate versus one with a 60% LIBOR swap with a 3% fixed rate. The latter has used roughly 14% less swap to do its hedging, which means the 60% LIBOR swap's value is less sensitive to changes in interest rates. This will have important ramifications for mark to markets and collateral posting. For more detail on that and how to capture these effects within a market model, stay tuned for Part2.