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.