Thursday, April 20, 2006

 

Municipalities 'Plunge' Into Derivatives

The New York Times has this report on derivatives. "Once used almost exclusively by corporate risk managers, derivatives have recently become a popular tool for local governments seeking to reduce their cost of borrowing. Instead of simply issuing bonds, as they did in the past, governments now often issue bonds and simultaneously enter into derivatives contracts, usually of a type known as interest rate swaps."

"After watching hundreds of towns, school districts, power utilities, port authorities and other government bodies plunge headlong into the derivatives markets over the last few years, accounting rule makers have decided those governments should reveal the extent of their involvement with the exotic instruments, and spell out what risks they may pose for taxpayers and bondholders."

"Some of the renewed enthusiasm was apparently kindled by swap contracts that included big upfront payments to the governments, a powerful temptation for officials struggling to balance their budgets. When swaps perform as advertised, they do indeed make it cheaper for governments to borrow. But when something goes wrong, they can wreak havoc."

"'The public needs to better understand the nature of these transactions,' said Robert H. Attmore, chairman of the Governmental Accounting Standards Board, an independent group that writes accounting rules for state and local governments. The seven-member board voted Tuesday to proceed with a project to make governments provide much more information about their use of derivatives."

"One example of what can go wrong is now playing out at the Delaware River Port Authority, which handles bridges, railroads and other transportation services near Philadelphia for Pennsylvania and New Jersey. In 2001, the port authority was planning to sell $358 million of bonds. Officials wanted to economize by using a floating interest rate."

"But the port authority also wanted to protect itself from future interest rate increases. So it struck a side agreement with UBS Securities, involving a type of derivative called an interest rate swap option, or swaption. The terms meant that UBS would get the larger payment if interest rates fell below a certain point, and the port authority would get larger payments if rates rose above it. The swap was thus meant to serve as a hedge for the port authority."

"Before the bonds could be issued, the governors of Pennsylvania and New Jersey had a falling-out over plans to dredge a long stretch of the Delaware River. That caused a split on the port authority's board, making it impossible to issue the bonds. Meanwhile, interest rates have remained low, prompting UBS to exercise its swap option and start collecting its money. Now the authority must make payments to UBS every month, even though the bonds were never sold."

"The port authority's recent financial statements do not show that the problems were looming. In 2003, the port authority did disclose, in its footnotes, that it had entered into several interest rate swap options in exchange for upfront payments totaling $40 million from three financial services firms. The footnotes explained that the port authority would be exchanging a stream of payments with UBS for many years if UBS exercised its option. But they did not show how big the payments might be, or explain the risks."

"Peter L. Block, a director in Standard & Poor's government ratings division, said analysts like him were eager to see what would show up once the new accounting procedures come into force. Mr. Block said he was guessing that most swaps would pass the coming accounting test. 'If 98 percent are stable,' he said, 'you want to know about the 2 percent that aren't, because you might have big exposure to them.'"

Comments:
This is shocking. When I took governmental accounting, it was some of the hardest to understand. To bury a derivatives contract in the footnotes is downright dangerous. Keep in mind many of these municipalities issue tax exempt bonds; the kind that widows and orphans are steered into. If GASB doesn't clean this up, we will see another Orange County blowup. In the meantime, I for one will stay away from muni's.
 
Read some of Joe Mysak's columns over on Bloomberg.com about the muni market. Derivatives are one of many problems. Once again we the taxpayers get to pay the damages.
 
Anybody know of a blog devoted to educating small investors and the curious about derivatives
 
Chicken-
Mish covers the subject frequently and has a post up right now about them: http://globaleconomicanalysis.blogspot.com/
 
Thanks LV
 
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