Tuesday, March 23, 2010

City Governments Losing Millions In Risky Derivative Bets

City governments who participated in risky derivative trades are now scrambling to get out of bad deals, costing tax payers millions. While some are pointing fingers at the financial firms which sold the investments, the responsibility for the losses belongs to officials who made the bets. See the following post from Expected Returns for more on this.

In line with the trend of government idiocy and irresponsibility, the Wall Street Journal reports that states and cities are losing money on derivative bets gone bad. The derivative of choice? Interest rate swaps. The effect of government stupidity? Higher taxes. From the WSJ:
Buyer's remorse has hit some cities and states that did deals with Wall Street in different times.

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts.

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & amp; Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment.

State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal."
Did municipalities seriously expect to make money by purchasing esoteric derivative contracts they didn't understand at the casino known as Wall Street?

Interest rate swaps are OTC (over the counter) instruments, which means there is no official exchange where these products are traded. Counterparties agree to exchange streams of cash flow to "hedge" against interest rate movements. Basically, they're gambling against each other. This arrangement gives Wall Street firms free rein to rob unsuspecting municipalities out of millions of dollars.

Derivatives are interesting instruments- they always find a way to provide steady and "risk-free" streams of income before absolutely imploding and leaving contract holders shellshocked. Don't think for a second that we have seen the last of government bailouts. There are still hundreds of trillions of dollars of OTC derivatives floating around. As counterparties begin to renege on their obligations, we should see some real damage to the real economy. Warren Buffet called derivatives "weapons of financial mass destruction" for a reason.

Taxpayer Bailout

Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases.

Some securities-industry officials say they are open to renegotiating with municipalities so long as doing do doesn't cause a tidal wave of demands.

"If they can't come to an agreement on how to modify, the contract should stand," said Michael Decker, a managing director at the Securities Industry and Financial Markets Association, a trade group.

Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year.

That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment.
It's ironic that municipalities are scrambling to get out of swap arrangements at the exact time their bets on higher interest rates will likely net them a profit. But I suppose I shouldn't be surprised that municipalities that have so thoroughly mismanaged their finances will sell investments at the absolute bottom and buy at the absolute top.

Government officials are pointing their fingers at Wall Street for taking them for a ride, but honestly, the blame rests squarely on the shoulders of governments that bought derivatives they didn't understand. Instead of trying to bolster returns by taking on tremendous risk, municipalities should have focused on cutting spending and bureaucratic waste.

The bottom line is derivative bets gone bad will further constrain budgets and force tax rates higher. Municipalities are going to face tough choices for years to come, and layoffs in the public sector are far from over.

This post has been republished from Moses Kim's blog, Expected Returns.

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