My beef with the NYTimes and Morgenson on Municipal Swaps, pt1

Posted by Peter Orr on May 08, 2010

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.  

Dear Sir/Madam:

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:

"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.

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."
Don Hecker
Manager/Staff Editor 
But what instrument made this basis blow out???  Read it in pt 2