Another Day, Another Bagholder Getting Fried?

Another day, another bagholder getting fried by a derivatives strategy that didn't quite work out as promised?

I wonder if the initial conversation went something like this: "We're from Wall Street and we're here to help."

Anyway, in "Swaps Backfire As Cost Saver On Public Debt." the Wall Street Journal details the latest (but certainly not the last) sorry episode from the land of Frankenstein Finance.

Auction-Rate Turmoil Hits Local Governments; Jefferson County's Woes

Already reeling from bond-insurance trouble and faltering credit markets, municipalities face another concern: A popular derivatives strategy has suddenly turned sour.

The trade, known as an interest-rate swap, is supposed to help local governments, schools, museums and hospitals lower borrowing costs. More recently, the turmoil in the auction-rate securities market has caused the use of certain swaps to backfire, forcing issuers to pay much higher rates.

Jefferson County, Ala., has been the hardest hit. This month, it failed to produce an additional $200 million in collateral for its swaps, triggered by recent credit downgrades. Jefferson is negotiating with the banks that sold it the swaps in an effort to prevent them from terminating the contracts and pushing the county toward bankruptcy protection.

While Jefferson County has been particularly aggressive in swaps, the practice has become increasingly widespread among tax-exempt borrowers. During the past three years, municipalities have entered into more than $500 billion of interest-rate swaps, according to the Swap Financial Group, a South Orange, N.J., advisory firm that specializes in these derivatives.

"There are more than 100 municipal entities around the country trying to deal with the same problem as Jefferson County, only on a lower magnitude," said Peter Shapiro, a managing director at Swap Financial Group.

The problem: Two interest rates that tend to move in sync with each other diverged greatly after the auction-rate securities market failed. That left many municipalities paying bondholders a significantly higher rate than they were receiving from their counterparty in the swap transaction. Usually, those two rates are much closer together.

Still, analysts say swaps can be a valuable tool for municipalities. "There's always a speculative element when you do a swap," said Peter Block, a public-finance analyst at Standard & Poor's. "But in most cases, it's a calculated risk."

Yet, others have long worried that as these derivatives grew more complex, municipalities may have failed to fully understand the risks. "Before an issuer gets involved in them, it needs a good swap policy, good advice and good monitoring," Martha Haines, chief of the Office of Municipal Securities, told The Wall Street Journal in 2005. "I'm concerned that little guys are getting in and don't know what they're doing."

Mr. Shapiro said other swap-related risks that municipalities may have once dismissed can't be ignored today. The biggest, he said, is counterparty risk, or the possibility that the financial institution providing the swap runs into trouble. With many big banks struggling to raise capital, he said, "people are taking this risk more seriously."

S&P said in a report last year that interest-rate swaps were enjoying their fifth consecutive year of strong growth. The report cited a growing number of new swap products and several states passing legislation to allow the use of swaps, including Pennsylvania, Connecticut and North Carolina.

"Governments hate to raise taxes," said Robert Fuller, principal of Capital Markets Management, financial advisers specializing in muni debt. "If they can financial engineer a way out of raising taxes through the use of swaps, most will want to do it."

The city of Houston, for one, shows how interest-rate swaps can help cut costs, but more recently have resulted in municipalities paying higher rates. Under some of its swap agreements, the city has three streams of payment: It pays a floating rate to bondholders, it received a floating rate from its swap counterparty, and it pays a fixed rate back to that counterparty.

When both the floating rates were roughly equal, the city was able to save money -- about $18 million over the three years -- rather than issue fixed-rate debt, officials say.

But when the auction-rate securities market seized up last month, the rate that Houston paid to bondholders rose as high as 7.8%. Meanwhile, the floating-rate payments Houston received from its swap counterparty were only about 2.1%. That gap meant the city's borrowing costs increased by about $3 million in recent months, versus a comparable fixed rate.

"We were in the hole about 5% on the mismatch between what we were receiving and what we were paying," said Jim Moncur, Houston's deputy controller. He said the city would quickly lose the entire $18 million in savings unless it stopped paying interest based on the auction-rate securities market. Houston is shifting out of the auction-rate market, but that will include additional costs, Mr. Moncur said.

Robert Whaley, a finance professor at the Owen Graduate School of Management at Vanderbilt University, said municipalities should generally avoid swaps and issue most debt with a simple a fixed rate. While it is possible that the fixed rate might bring in some additional costs as interest rates fall, it eliminates uncertainty about debt payments.

"That's a safe management strategy," he said. "You lock in your rates so you can focus on the business plan."

Comments

[mw]

We are constantly hearing that we are in "UNCHARTED WATERS"... Remember the mighty "TITANIC" was in "CHARTED WATERS" when it sank!

[Snappy Tom]

I just want to mention two things: first, and file this under "Systemic Crises Spreads", the intrusion of hedge funds into the commodities arena has caused pandemonium here in the hinterland. Local grain elevators and small town banks have been discombobulated by the leveraged speculative community. We are rubes out here after all. There is real fear that the elevators, having faced margin call after margin call will not have the money to buy the coming crop. That crop as I've mentioned earlier promises to be very good to excellent. The local banks have been lending heroically to cover the calls. It is routine for elevators to employ hedging in their business models. Those models did not count on the massive amounts of hot money flooding and then leaving their market. There are also reports that farmers are finding credit tough to find. It will be an evil irony if Wall Street's poison ruins one of the export oriented sectors that could have helped shore up an otherwise failing economy.

Secondly, I want to comment on how the Fed's mask is totally off now. It is obvious that the only real game in town is the profits of the Fed's shareholders. What ever it takes for as long as it takes is what will be done to preserve the profits of those immensely powerful shareholders. Its not about the dollar, or the economy or a recession or the housing market or the stock markets except as they relate to that elite group's ability to generate outsized profits at whatever cost. The United States has been reduced to a host; our financial markets have morphed from that which made us prosperous to a foul corruption on our very beings. Its there for all to see.

The inevitable end game of a fiat currency regime is just over the horizon.

[Independent Accountant]

As I have quoted before, "Banking establishments are more dangerous than standing armies", Thomas Jefferson.