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.
"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...