In the 2nd post on the topic, Dan Cooreman of the Sunday Business section indicated that the problems Gretchen Morgenson spoke to in her article,The Swaps That Swallowed Your Town, were in fact related to the variable rate instruments. He seemed to agree with exactly my point but ultimately, my final words (below) to the Times editors on the topic have gone unanswered.
Thank you for the response, Mr. Cooreman, and the quote from the NYS Division of Budget. You have hit on, and seemingly agreed with, exactly my point - if what Mrs. Morgenson was talking about was how "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" why wasn't the headline, "Auction Rate Securities and Bad Variable Rate Bonds Gobble a Gotham Near You"? Did someone bury the lead? If it's the auctions and variable rate securities that are swallowing your nearest town, where is the "ensnared in the derivatives mess" coming from in the article? Why is it all about how interest rate swaps have caused a problem??? The fact is, in the vast majority of cases, they didn't.
The critical background Ms. Morgenson seems to misunderstand is that interest rateswaps are only really useful for hedging interest rate risk. They are not designed to hedge the fragility of the auction rate market, the melting down of MBIA, Dexia's balance sheet exposure, or "credit concerns for a number of liquidity providers." Blaming the swaps for these problems (the headline is about swaps after all) is akin to having a fearsome headache after a late night and blaming the hat you're wearing in the morning for the pain. Here's the equivalent headline, "Knit Cap Causes Enormous Hangover." The cap is there to keep your head warm, not fix your headache, and it certainly didn't create your hangover in the first place.
The reporter has conflated every possible economic and financial event that could impact an issuer's specific auction or variable bond rate, and then blamed interest rate swaps for not hedging them all. This is again, dead wrong. These interest rate swaps were never designed to remove all the risks inherent in an auction or variable rate borrowing program, and to imply otherwise is again, fundamentally incorrect. And anyone in public finance who's worked on these structures knows it.
The story in its entirety is misleading at best but this sentence in particular, "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." is patently untrue, and there's no way to avoid it. New York Times readers deserve a clarification. And the talented public finance officials who structured these transactions on behalf of taxpayers, prudently and with the best information available at the time, are owed even more. If the New York Times is going to Monday morning quarterback the credit crisis, at least get the facts right.
On this Memorial Day, my dad the Navy officer and Korean War vet may not have fully approved of my sneaking in some work-related activity. That said I'm pretty sure my dad the writer and English Lit
major wouldn't get too bent. Thinking of you...
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.
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:
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.
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
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