Bloomberg just ran a story on municipalities entering into derivatives contracts to help finance budget deficits. I’ve seen this movie before about 15 years ago, and I can tell you how it ends: in tears. As someone who spent much of my career in the realm, I can and have provided examples of the prudent use of derivatives: primarily, as risk management tools for issuers. The problem is, these municipalities are neither hedging anything nor do they truly understand the ramifications of their actions.
Without getting too complicated, counties, cities and states who feel desperate sometimes sell massive amounts of optionality to investment banks, with large embedded spreads for the dealers, and hope and pray that the options they’ve sold don’t move in the money. Problem is, they almost always do. My fervent belief is: hope and prayer should not play a role in municipal finance (or in the White House, for that matter). If there are fundamental problems with balancing the budget, deal with it head on. But there is never a free lunch, and the pains of unwinding disastrous derivatives transactions can burden local governments for a generation.
Back in the ealry 1990s, when municipalities felt the same pressure they feel today, they sold massive amounts of “index amortizing swaps,” swaptions, range accrual swaps and other leveraged structures in order to take in premium income to finance near-term cash needs. This was done in a low rate environment, when the Fed pushed down short-term rates to 3% (which was considered low back then) to spur economic growth and volatility was also low. Essentially the worst time to be selling optionality based on rates staying low or within a prescribed range. In the event that rates (either short or term rates, depending on the structure) rose, either the municipality would be sitting with a large notional, low received-fixed swap rate (where they are left with the prospect of paying rising short-term rates in excess of the fixed rate received) or the need to make a large cash payment in the future. So what happened? The Fed cranked up rates by 300 bps over an 18 month period, volatility spiked, the yield curve flattened and counterparties that were short optionality, like the municipalities and corporations such as P&G, Gibson Greetings and Air Products, got crushed. There was no hedge. There was only desperation (municipalities) and greed (corporations).
After everything we’ve been through as a society, and will be going through over the ensuing years as we extricate ourselves from the current crisis, haven’t we seen enough of the misuse and abuse of financial instruments? I certainly think so. While I am generally not a believer in saving people from themselves, when fiduciaries impacting thousands and millions of people use poor judgment with long-term implications, legislators need to intercede with sensible regulation. And fast.