Press (and Fed): Market-based expectations wrong for issuers and investors

Posted by Peter Orr on Sat, Apr 25, 2015 @ 07:00 AM

We’ve written a number of articles talking about financial forecasting being a necessary evil, implied forward yields being miserable predictors of realized yields, and recently the inappropriate use of option pricing models (requiring market-based inputs) when doing refunding analysis. We even wrote a paper on it as we see a lot of misunderstanding by pubfin practitioners on this point.


But what I didn’t expect was for the press to actually make news out of it. Last  week a financial advisor friend and (u)ncalculated risk contributor pointed out a short but important BondBuyer article written by Gary Siegel, who picked up on an economic letter published by the San Francisco Fed that re-iterates this theme. Now I’ve been known to critique the press from time to time, but have to give props to Mr. Siegel on this one. 

In customarily gentle tones the Fed researches, Michael D. Bauer and Glenn D. Rudebusch of the SanFan Fed, say “policymakers should be cautious in relying on the expectations information in market prices…market-based expectations do not correspond exactly to real-world expectations because asset prices also reflect the compensation that investors require for making risky and somewhat illiquid investments.” For munis, “somewhat illiquid” definitely constitutes a glass-is-half-full descriptor. Plus munis are even more complicated because of their uncertain tax treatment, a significant risk to the investor.

Mr. Siegel in his Bondbuyer article goes on,

“The authors suggest distinguishing between ‘real-world’ and ‘market-based’ expectations. Real world expectations are defined as those "based on the standard 'true' probabilities of everyday interpretation," while market-based are strictly figured through prices in financial markets. Statistical models are used to calculate real-world expectations.”  
This is precisely why we at Intuitive Analytics have implemented the best real-world, yield-curve and market model we can find, so investors and issuers can test policy for just about anything that has market sensitivity within a consistent, coherent framework. And this model happens to perfectly capture the real-world behavior of all relevant markets using whatever history the modeler determines is relevant. And on that note, I love the way Messrs Bauer and Rudebusch describe the policymaking process,

“…choosing an optimal policy under uncertainty involves two steps: (1) assigning probabilities to uncertain future outcomes depending on the choice of the current setting of policy, and (2) ranking the relative desirability of different policy choices by evaluating their expected benefits and losses. …a policymaker would use real-world probabilities to calculate the expected net benefits of a variety of possible policy actions, and then choose the policy action that maximizes that net benefit.”

So easy! And eminently sensible. And it happens to be exactly what we did in analyzing refunding policies in our paper identifying the best refunding policy yet known. And as we recently described, evaluating muni callables by both issuers and investors involves assigning real-world probabilities to refunding outcomes driven by the complicated and simultaneous dynamics of multiple yield curves, no small task. 

Congrats to Mr. Siegel and the BondBuyer for picking up on an important piece of the forecasting and policy-making puzzle. Note we are not paid by the Bondbuyer in any way. Quite the contrary; think our 2015 renewal statement’s on my desk (we’d certainly take a subscription discount though…hint hint).  But I don’t want anyone to get the mistaken impression that all we do is press bash here. 

If you’re reading this the chance that you’re a central banker is relatively slim. However, you may well be in a position where you have to forecast financial variables (bond yields, perhaps?) in order to evaluate fixed vs floating, a 4% vs 5% coupon, expected muni hedge performance, a 7 year call feature, a refunding candidate, or even a broader financial policy. In any event, it’s the real-world expectations that matter.

Tags: financial forecasting, press

The NYTimes and the 0.14% that Swallowed Your Town, pt3 (final)

Posted by Peter Orr on Mon, May 31, 2010 @ 11:07 AM

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...

Tags: municipal swaps, press, swaps that swallow town

NYT and Press: Get Your Facts Straight About Municipal Swaps

Posted by Peter Orr on Wed, Mar 10, 2010 @ 01:33 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...  

Tags: Wall Street, SIFMA, public finance, swaps, municipal swaps, press