Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:
“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”
At which point we need to stop to point out that the example is actually wrong. We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:
“These swaps were supposed to save the public some money. And, for a while, they did.”
Oh, maybe this won’t turn out so badly? But then:
“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”
To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.
Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:
“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni. The price, in the form of a termination fee, can be enormous.”
Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.
But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)
The article then goes on to say:
“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”
It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.
So now we get to the crux of the column:
“…the banks are taking advantage of our generosity by gouging us on these toxic deals.”
What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?