NYT and the 0.14% that Swallowed Your Town, pt 2

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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.  

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

Refunding Efficiency: Not the Holy Grail of Decision Criteria

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Lots has been studied and even reported on the decision criteria involved in pulling the trigger on a public finance refunding. When is the right time? What bonds do I choose? What savings target do I use? The old rule of thumb that present value (pv) savings should be at least 3% of refunded par is taking some criticism which I won't repeat here. Suffice it to say it's a threshold originally conceived by bankers and as such, the bar for a "Go" decision is not very high. I personally think it's age discrimination; this calculation does have a good three decades under the belt...

One proposed alternative is to look at something called "refunding efficiency." This involves taking the pv refunding savings on a transaction and dividing by the theoretical value of the refunding option. The closer refunding efficiency is to 100% the better. Without going into free boundary problems and other option exercise minutiae, suffice it to say that coming up with a reasonable hypothetical value of the optional redemption feature in a bond issue is no simple task. It's not as easy as just valuing the bond option using Hull-White, BDT or other fixed income model. The issuer's refunding option can involve interrelationships between taxable escrow security prices and tax-exempt bond market volatility at different points on the yield curve that, along with tax-exempt bond vol itself, inevitably lead to unobservable (read "anyone's guess") inputs.

And here's where the logic flaw often resides. Just because refunding efficiency on a deal is calculated, based upon the aforementioned heroic assumptions, to be 80% refunding efficient does not mean the issuer has somehow left the other 20% of value on the table somewhere. There is no practical way to capture that 20%. It is a purely hypothetical number. Even stripping the option and selling it doesn't replicate the economics the issuer faces (plus can have real pain-in-the-neck tax consequences).

I'm not saying this refunding efficiency metric is useless. I am saying that it should be interpreted very carefully: refunding efficiency is a comparative way to see the likelihood that refunding savings might be higher at a later time. It is a measure of possible opportunity cost. Looked at this way, it is debatable even whether market implied parameters are the right ones to use in pricing the refunding option. Applying forward rates and implied volatilities willy nilly to every financial model that needs an input is a mistake all too often made by analysts buying too much into their own quantitative hype, and usually trying to sell something. I'll leave this to explore more fully in another post, but suffice it to say that it is absolutely incorrect to estimate real world (as opposed to "risk-neutral") probability densities or forecasts using market-implied parameters.

So if refunding efficiency is not the holy grail of refunding decision analysis, and it's just a way to get a sense for the opportunity loss involved in pulling the refunding trigger, then the issuer is still left with a fundamental and not easy risk management decision. A bird (pv savings) in the hand is worth how many in the proverbial bush? This is a classic utility preference problem whose answer will differ depending upon the views, needs, and circumstances of the issuer. No absolute rule of thumb (95%, 85%) will ever be applicable to every issuer or every situation.

Often the credibility of a certain mode of analysis is directly correlated to the perceived sophistication involved. In fact, often the exact opposite approach should apply - the fancier the model, the more skepticism it should face about the assumptions embedded in it.

I think we all should be very careful of holy grail quantitative metrics, particularly if they have the danger of becoming a new "industry best practice." Regulators, under the guise of wanting to adopt "industry best practice," incorporated various Value at Risk (VaR) concepts in their rules. Over the last 18 months, I hope we learned that applying a one-size-fits-all number to complicated risk management problems without fully understanding the assumptions and limits can be very, uh... risky.

NYT and Press: Get Your Facts Straight About Municipal Swaps

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"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...  

The Big BAD Mistake about BABs

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"Prediction is very difficult, especially if it's about the future." 

- Niels Bohr (long before Yogi Berra) 

Lots of people seem to be making a big mistake analyzing Build America Bonds (BABs).  The popular and straightforward analysis is to compare yields on traditional fixed rate bonds (or "BOBs" as I call them - Boring Old Bonds) to the after-subsidy yield on BABs.  Here's an example:

The (overly) simple analysis says that BOBs are the cheaper cost of capital through about year 12 and then BABs are the way to go thereafter.

The heroic simplifying assumption of course that works so nicely in spreadsheets and standard software packages is that this line-item Federal subsidy duck will stay staticand not shot down over the entire life of the bonds.  Is this a good assumption?   Let's look at some facts:

-     The BABs legislation explicitly states that the subsidy is not permanent and can be changed at any time

-     The BABs subsidy is qualitatively very different than the one inherent in BOBs.  As anyone dealing with a government budget knows, there's a fundamental practical and political difference between revenue lost in the opportunity sense (BOBs) vs the Treasury needing to cut a check for a subsidy as with BABs  

-     The US debt and fiscal imbalance are ugly. Some argue worse than they've been excluding WWII

With these facts, is it prudent to be overly optimistic about this US subsidy staying static over 20-30 years, through changing administrations, congressional seats and political winds?  I don't think so.  In fact, the analysis of this risk is not unlike the oft-discussed "tax risk" that people cogitated about when evaluating synthetic fixed-rate borrowing strategies using LIBOR swaps.

Putting a finer point on it, when an issuer sells BOBs the following risks are shifted to the investor:

1)   Interest rate - rates go through the moon, the investor suffers the MTM loss. The nominal cost of capital for the issuer is locked in.

2)   Credit - should the issuer's credit deteriorate, again the investor suffers

3)   Tax law - should the US become less reliant on income taxes and more on consumption taxes or VAT or shifts to a flat tax, the preference for tax-exempt income would fall and investors would suffer losses.     

For BABs, the third item no longer applies.  The investor gets a taxable coupon.  Has the third risk gone away entirely?  I think it's been transformed.  That third "tax law" risk is now replaced with US Fiscal Policy Risk (FP Risk^TM) which I would argue is significantly non-zero and different qualitatively then we've seen before in the tax-exempt markets.