How Derivatives Got Cities and Counties in Hot Water

There were two articles at NYT yesterday on the municipal financial situation. You can read them here and here. The first one is about how Moody’s Investors Service assigned a negative outlook to the creditworthiness of all local governments in the United States, the first time it had ever issued such a blanket report on municipalities. This kind of message will likely lead to many downgrades of municipal bonds in the near future.

The second article is more interesting. In Tennessee, a single investment bank, Morgan Keegan, sold $2 billion worth of municipal bond derivatives to 38 cities and counties since 2001, dominating and monopolizing this market there. What is even more interesting is that Morgan Keegan wears several hats at the same time and engages in all phases of selling the derivatives.

They are first the “educator”, giving seminars to local officials to pitch the derivative products, then the financial advisor to the cities and counties to recommend, of course, the derivatives they created, then the underwriter/banker to sell their derivative products to the locals. Needless to say, making lucrative fees and profits every step along the way.

Those derivatives are complex interest rate swaps -- basically they depend on the sustainability of a good economic situation. However, once the bond is downgraded, suddenly the acceleration clause in the contracts will shorten the bond life substantially, e.g. from 20 years to 7 years. As a result, the local government sees its interest payment skyrocket multifold.

The derivatives sold by Morgan Keegan become a vicious circle and downward spiral right now. When the first downgrade by a rating agency causes the interest payment to go up 4-5 times, thanks to those swaps, it makes the cities financially worse off at the worst possible time. Then this forces them to assume more debt and do more financing in order to just pay these skyrocketed interest payments, which would cause a rating agency to downgrade their debts even further.

What is interesting is that the seminar material produced by Morgan Keegan and reviewed by NYT doesn’t seem to talk much about risks (only rewards), with no mentioning of the risk and consequences of potential rating downgrade. The best part is that when the city officials said they didn’t understand those products, Morgan Keegan told them “‘Don’t worry if you don’t understand it.”

“He told us it would be a good thing and there wasn’t much downside,” said Mayor Duncan of Claiborne County. He then laughed, adding, “When everything went belly up, of course, they told us it wasn’t their fault.”

It's a little similar to AIG (AIG), in that even AIG has many decent money making business units, but the derivatives in one small unit have bankrupted all of them. The sad thing here is even if some cities/counties are still financially viable with local tax revenue inflows, at the end, these derivatives will bankrupt most of them, swapping more taxpayer’s money to the bankers.

Comments

[Karen Consumer:]

Can you repossess a city or a state?

I ask that question facetiously, but I don't understand the muni bond derivatives. Would someone please put it in laymans terms?

Apr 08 05:20 PM

[Ferdinand E...:]

What was it that Mohammed Ali once said: don't run through fire in 'drawers' (= underwear) soaked in gasoline. This is the same as saying that if you don't understand derivatives, stay away from them.

And understanding derivatives is virtually child's play. Hardly takes any effort at all if you are interested in the subject. I taught elementary courses in futures and options in 3 or 4 countries, and cannot remember a student who couldn't understand them, although perhaps there were a few. The problem evidently is that because you can understand and avoid having trouble with elementary derivatives, investors think that they can trust the sellers of complicated derivatives. Generally they can, but apparently often they cannot.

Apr 09 09:19 AM

[mktcycler:]

Can someone please explain how these poor cities' interest payments could have quadrupled due to some sort of ratings outlook downgrade and resultant shortening of the bond maturity? Quadrupled?!? The muni yield curve is not steep enough and the yield spreads between various muni rating catefories is not wide enough to explain anywhere near that level of change.

Apr 09 01:02 PM

[Edward Ulys...:]

It was just another way to lie, in order to steal. If you bother to look up the Top 10 Major Holders of MCO (Moodys), you'll see the same names as GS (Goldman Sachs) , AIG and RF (Regions Financial, which owns Morgan-Keegan). Barclays (London) and AXA) Paris are significant major holders within the major holders. That's the foreign control in our financial mess, as has been almost since the beginning of our country.

That's why these derivatives were sold as protection against interest rates going up, because the sellers knew they would be able to manipulate the rates down. Remember that the FED has always said that they were owned by their member banks. So you just have to look at who controls the largest member banks. Very interesting pattern.

Apr 09 01:08 PM

[jagaer:]

The problem is not with the derivative but with the underlying variable rate debt. These particular debt instruments are quite complicated in and of themselves. Long term debt is financed by a short term debt instrument. Every 7 days the holders of this long term debt can "put" their bonds to a remarketing agent. The remarketing agent attempts to sell those bonds to a new buyer. The holders of this form of debt is actually a short term investor. If the bonds cannot be sold to a new buyer, a liquidity provider will purchase the bonds. Once this occurs the bonds are referred to as bank bonds. At a certain point the liquidity is paid a taxable rate of interest typically the prime rate and principal payment is accelerated to a 7 year repayment schedule. This is how the muniplaity's payment increase dramatically because they have to repay principal on a different schedule.

The interest swap works in this manner. Without going into detail, the swap works like this: a fixed rate paid to a counterparty is determined and the counterpary pays a variable rate for example 60% of three month US $ LIBOR to the issuer. This is netted. The issuer pays the fixed rate -the variable rate to the counterparty. This is a cash flow agreement seperate from the actual debt payments. These payments are based on a notional amount. The notional amount is simply the principal payment scchedule used to determine the counterparty payment.

Swap Fixed Rate- 60% 3 M US$ LIBOR= Payment to Counter party
In a perfect world 60% 3 M US$ LIBOR = Variable Rate payment to Debt Holder

The final payment by the issuer would then be Swap Fixed Rate + Variable Rate Debt Fees (Remarketing Agent, Liquidity Provider, etc)

IF the variable rate debt fails this formula ceases to work. Note principal payment is accelerated so notional schedule no longer = principal payment schedule. Additional payment to bond holder is now a a taxable rate. The formula no linger works.

The issuer now pays accelerated principal payment + a higher interest rate. The accelerated principal payment is what hurts.

This is because due to the failures of bond insurers and liquidity provider that made VRDOs unmarketable leading investors to put their bonds in mass forcing the liquidity providers to buy them.

On Apr 09 01:02 PM mktcycler wrote:

> Can someone please explain how these poor cities' interest payments
> could have quadrupled due to some sort of ratings outlook downgrade
> and resultant shortening of the bond maturity? Quadrupled?!? The
> muni yield curve is not steep enough and the yield spreads between
> various muni rating catefories is not wide enough to explain anywhere
> near that level of change.

Apr 10 03:34 PM