Monday, March 22, 2010

Losing Bets on a "Sure Thing"

As I have been writing here repeatedly, I believe that the biggest risk to bond investors is lower, not higher, interest rates.

When you see survey after survey tell you the one "sure bet" in the investment world today is that interest rates are headed higher, you have to question how much of this sentiment is already reflected in market prices.

Today's article in the Wall Street Journal is a good illustration of what can happen when you invest in accordance with prevailing sentiment:

Interest-Rate Deals Sting Cities, States

By AARON LUCCHETTI

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.

Muni2
Associated Press

Jack Wagner of Pennsylvania: 'It's gambling with the public's money.'

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 & 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."

Examples of Interest-Rate Swaps

This study by the Service Employees International Union, which represents municipal employees, is based on government filings and payment estimates using current interest rates. It compares the interest-rate swap payments of cities with their budget outlooks. The payments don't reflect corresponding moves in municipal bonds. Included with some examples are securities firms that entered into the transactions with the municipalities.

The Service Employees International Union said Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.

Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs.

Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs.

The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper.

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.


http://online.wsj.com/article/SB10001424052748703775504575135930211329798.html?mod=dist_smartbrief