The problem with municipalities buying swaps

By Felix Salmon
March 9, 2010
this is how to write a good article about municipalities dabbling in derivatives.

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Gretchen Morgenson, take note: this is how to write a good article about municipalities dabbling in derivatives.

I didn’t write about the main thrust of Morgenson’s article when I attacked her comprehension of credit default swaps, mainly because it was incredibly unclear to me what she was trying to describe. But if you want to see someone do a good job of trying, I’d highly recommend checking out Bond Girl, who has a second installment today attacking the hypocrisy of municipalities who are happy to lock in fixed interest rates through interest-rate swaps, only to complain loudly when rates fall and they realize they would have been better off doing nothing.

But the fact is that municipalities around the world have been ripped off by fast-talking derivatives salesmen for years, and the whole business really is very sleazy. In their excellent FT article, Rachel Sanderson, Guy Dinmore and Gillian Tett show how Italian municipalities are losing money even on fixed-to-floating interest-rate swaps, which you’d think would be pretty hard in today’s low-interest-rate environment. They’re also losing money on sinking funds — pools of money which were meant to shore up municipal finances, but which inevitably attracted an entire aquarium’s worth of vampire squids, sticking their blood funnels into anything they could invest in high-yield instruments.

The FT talks to Antonietta Dominici, the treasurer of a tiny village called Baschi, deep in rural Umbria:

Ms Dominici does not know what assets are in the sinking fund or why the swap is still carrying losses – currently about €90,000 – in a low-interest rate environment. She says attempts to get information from BNL on this have proved unsuccessful. BNL would not comment.

And they do a great job of explaining how bankers exploited greedy Italian politicians:

In 2006, for example, Baschi was persuaded to undertake a more complicated restructuring of its debt. The swap’s value rose to €2.5m; the maturity extended to 2034; and a sinking fund was established. The bank structured the deal so that the village received an “upfront” payment of €25,000 – in effect an advance on its loan. In return for the upfront, rates would be tougher in the longer term…

It was the upfront that caused many local authorities to get high on derivatives, say experts. In the revolving-door world of Italian local politics, each new administration wanted its own upfront, so asked their bankers to restructure the deal to release more cash in advance. The terms of the swap tended to become more restrictive each time.

Some banks covered the cost of the upfront fee by pricing the interest rate swap more aggressively, so that only in unusual circumstances would the entity receive more each period than it paid out, say people familiar with the deals. In other cases, upper and lower limits on the movement of interest rates ensured the upside for the local authorities was reduced and downside risks were magnified.

I can guarantee you that every time a swap was sold, the person selling it got a nice fat up-front commission, and the unsophisticated small municipality buying it wound up getting a very unattractive deal. And the more complex the swap, and the higher the up-front payment to the town, the more the municipality was likely to be ripped off.

The underlying problem here is that interest-rate swaps tend to be sold rather than bought. If municipal treasurers came up with these plans on their own, and then asked a few banks for bids on the exact swap that they wanted, many of the rip-offs would never have happened. But instead, like subprime borrowers encouraged to monetize their home equity, they got talked into bad deals by sleazy financial professionals working on commission.

I wonder whether the Consumer Financial Protection Agency will have the ability to police swaps sold to municipalities. It should.

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