Posted by Peter Orr on Wed, Jul 28, 2010 @ 06:59 AM
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.
Posted by Peter Orr on Tue, May 18, 2010 @ 02:01 PM
This is the second round of commentary (of three) with the NYT editors justifying their mistake in the article,
The Swaps That Swallowed Your Town. My response was simple, though I was forced to use a three number example.
__________________________________________
Dear Editor(s),
I'll try and keep this brief.
Given Ms. Morgenson's response, it is clear she is sorely confused about what has caused financial strain for states/municipalities. I'll prove this simply, although I will use a few numbers - 3 to be exact. Let's take the last year to represent our time period of market stress (though you could pick any reasonable representative period, the answer will be substantively identical). The first number is 0.20%, which is the average of 67% of 1M LIBOR over the last year. I use 67% because it is the most common rate municipalities have used in swaps to hedge variable rate bonds. The second number is 0.34%. This is the average of the SIFMA index, the index against which all tax-exempt variable rate bonds are priced. The difference between these two numbers is the spread that Ms. Morgenson shockingly claims is outside the "narrow range." It is this crushing differential that she, and worse, the NYTimes has told its entire readership is going to imminently "swallow" all the swap-exposed towns near you in a madly corrupt, swap induced, financial maelstrom. And how big is this staggering, non-narrow differential??? 0.14%. Please look carefully at where the decimal point is on that number; it is no mistake.
This would be funny if it weren't exposing such flagrant misinformation and flat out bad reporting. And if 0.14% isn't in the "narrow range," I would ask Ms. Morgenson what is, exactly? As a point of reference, the 2 year average differential is 0.32% so this wild differential has only gotten narrower over the last year. The simple undeniable fact as it relates to this "narrow range" issue is that the current period actually shows one of the narrowest spreads we've seen historically, because the actual level of interest rates is so close to zero. Again, this is simple, unalterable, basic fact that anyone can check. I urge you to run this by your "municipal experts" in the story, or anyone else who knows something about public finance - I assure you they will agree with me. Your readers deserve better and this egregious mistake should be corrected.
Again, the actual reasons states and municipalities are under stress from their debt programs are exactly those that I described in my first letter: failed auction rate securities and variable rate bond programs which have lost the support of the banks. Whether those programs were hedged with interest rate swaps is an entirely separate issue, though admittedly can cause additional stress if the state/municipality chooses to terminate the swap.
I'm sure Ms. Morgenson is a good writer; as an NYT reader I have enjoyed some of her articles in the past. Unfortunately in this case, she is in over her head, knows only enough about the subject matter to be factually wrong, and has embarrassed the New York Times. I believe an editor's job is in part to acknowledge and correct when the paper doesn't have its facts straight. The premise of this entire article is clearly mistaken (I hope in good faith and not just to sell papers), and your readers deserve to know it. There's enough falsehood in our public discourse without news organizations throwing their own rubbish onto the heap.
Happy to discuss this or the real challenges municipalities face with whomever cares about accurate reporting. At minimum I look forward to a correction of this error.
I was a bit edgy that day so the tone wasn't quite as constructive as I would've liked. Nonetheless, here was the response from Dan Cooreman of the NYT Sunday biz section:
Mr. Orr:
Thank you for the additional information in your email message of last evening. But it seems that you and Gretchen Morgenson are discussing two different things.
Here is a summary of her explanation:
The spread that was referred to in the column did not refer to the difference between 67% of LIBOR and the average of the SIFMA index. When the column said the contracts assumed that the rates in the deals would stay in a narrow range, it was referring to the problems associated with spikes in interest rates on variable rate debt. When the spread between this rate and that received by the issuer from the swap counterparty blew out, it created significant problems for tax-exempt debt issuers. A crucial reason for this, as you and the column both pointed out, was the seizing up of the auction rate securities market.
As outlined in the Annual Performance Report from the New York State Division of the Budget: "In 2008-09, the crisis in the credit markets negatively affected the performance of the swap portfolio. The global credit crisis has highlighted that the use of these financial instruments can expose municipal debt issuers to large unanticipated costs. In particular, the increased costs associated with credit risk, basis risk and early termination payment risk have had a significant impact on the performance of synthetic fixed rate swaps. During the past year, the collapse of the auction rate and bond insurance market, in conjunction with rising credit concerns for a number of liquidity providers (commercial banks) caused the interest rates on certain variable rate bonds to increase to unprecedented levels. For example, interest rates on auction rate bonds in the Tobacco bond program rose to 14.2 percent from 4 percent over a one month period. The dislocation in the credit markets negatively affected more than half of the state's variable rate portfolio ($5.2 billion)."
This is the aspect of the deals that the column was referring to, not the difference between 67% of LIBOR and the SIFMA index.
Dan Cooreman
Sunday Business section
Ahh. So the article was referring "to the problems associated with spikes in interest rates on variable rate debt"? Wait, what was the title of her article again? Somehow I don't remember seeing anything about interest rates on variable rate debt. Read the third and
final chapter.
Posted by Peter Orr on Wed, Mar 10, 2010 @ 12:33 PM
"Knit Cap Creates Huge Hangover" is Not a Good Headline
I know the "Complicated Stuff You Don't Understand Is Secretly Destroying You" theme is an eminently reliable one that reporters have used since time immemorial. Couple it with the now wildly popular "Wall Street Fat Cats are Stealing Your Money" theme and you've got a ready-made recipe for some uber-potent journalistic catnip. Reporters from WSJ,Bloomberg News (covering this for years and still looking for that Pulitzer...), and most recently the NYTimes have gotten wild highs off of combining these two stories into some variant of, "Wall Street Robs a Town Near You with Interest Rate Swaps." The facts in these stories, if discernible beyond the often fuzzy innuendo, are usually distorted at best or flat out wrong. So let's get the story straight. Much of it ain't that sinister or complex and the talented public finance professionals who work to save tax and rate payer money deserve it.
No different than the homeowner who must decide on either a fixed or adjustable rate mortgage, public finance officials must make tough decisions about interest rates. Most of the time they employ traditional fixed rate bonds, or as I call them, Boring Old Bonds (BOBs). However, history has shown us that over substantial periods variable rate bonds have offered a lower cost of capital than BOBs. Yes, this is obviously not a rule and far from a prediction about the future. However, it was not unreasonable or uncommon for an issuer to decide to have a certain portion of its debt exposed to the short end of the yield curve. If the issuer had working capital or short duration assets on the balance sheet, this was in fact the prudent risk management decision. The rating agencies even had a rule of thumb: no more than 20-25% debt in a variable mode, unless it came with a compelling story.
Public finance borrowers used auction rate securities (ARS) and traditional variable rate demand bonds (VRDBs) with bank liquidity support as floating rate instruments. Now enter the subprime meltdown and subsequent credit/liquidity black hole from the last 18 months. In retrospect, ARS were sold in an extremely thin and fragile market which evaporated during the crisis; ARS rates went to a failure rate, which was often, though not always, very high. VRDBs performed well if the issuer was lucky enough to have a strong bank name behind them. Others suffered and had rates go to the moon. Where are the interest rate swaps in all this? NOWHERE! And that's the point.
Interest rateswaps were used to hedge the interest rate risk inherent in the ARS or VRDBs. Over the last year, the difference between 67% of LIBOR and SIFMA was 0.14%. For the record, historically that's an extremely narrow spread. These swaps were never designed to hedge MBIA falling off a cliff, the ARS market vanishing, or Dexia's credit rating. And therein lies the absurd (and I suppose predictable) conflation mistake reporters make on these stories. It's the interest rate swaps fault for not hedging all the credit events that occurred with the issuer's bonds. Blaming the interest rate swap for these problems is a bit like having a fearsome headache after a late night and blaming the pain you have on the hat you're wearing in the morning. Here's the headline, "Knit Cap Causes Enormous Hangover." The cap is there to keep your head warm, not fix your hangover. And it certainly didn't create your headache in the first place.
Don't get me wrong. I'm hardly naïve. I realize that having used interest rate swaps to hedge the interest rate risk in ARS and VRDBs has often made the situation more difficult to workout or refinance into fixed rate bonds. Collateral calls if applicable have further pinched liquidity at just the wrong time and the negative mark-to-market value of the swaps can be large with rates this low. If refinancing with BOBs, at least the MTM is partially offset by the issuer selling BOBs into a lower fixed rate market than the one in which the swap was executed. I realize that's all just financial reality and shouldn't get in the way of a good ol' beat up the Street story, particularly not these days. And that's where the real meat of this story is - whether these contracts are enforceable given the clear verdict in the court of public opinion. Are our legal institutions powerful enough to withstand our political ones? I'll save that for another post but it was actually covered recently by the press...and relatively well; you can read it here.
In the meantime, if you're a reporter and you want to do a balanced, factually accurate article about municipal swaps, I'm available. We're installing new lines to handle call volume...
Posted by Peter Orr on Sun, Oct 25, 2009 @ 04:22 PM
"It is better to understand a little, than to misunderstand a lot."
- Unknown
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.
Posted by Peter Orr on Sun, Aug 09, 2009 @ 07:54 AM
"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?
Posted by Peter Orr on Thu, Jun 25, 2009 @ 08:59 AM
"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.