"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...