The Swaps That Swallowed Gretchen Morgenson's Brain

NY Times Business writer Gretchen Morgenson goes to war against reality with her latest attack on the derivatives market.

Critics are pounding everywhere, but I am saving my favorite for last (Spoiler link!).

Felix Salmon points out that Ms. Morgenson scores an own-goal by leading with the notion that Greece ran into trouble with insidius credit-default swaps.  NO, it was currency swaps, as any Times B-writer ought to know.  (And where are the editors?)

The Stone Street Advisors leave no stone unthrown, noting that since the Orange County debacle a mere sixteen years ago, it has been common knowledge that municipalities engage in swaps, not always to their benefit.

But the Gretchen (like a reverse Osacr for the business community) goes to Powerline and their readers for this laugher:

Morgenson helpfully provides a link to the New York State Budget report on their interest rate swap portfolio, having claimed that the poor schmucks in the State of New York treasury operation had to "pay out " $103 million to exit certain swaps. But when you go to the report itself it tells a different story entirely! The purported $103 million is actually a staged nominal "defeasance" amount -- in effect a rolling deposit -- that has the economic effect of retiring the swaps. But net, net, net of all that.....the State of New York over a 7 year period is over $40 million ahead on its swaps portfolio compared to conventional financing!...Sure....2 years ago they were cumulatively $140 million ahead and the recent unpleasantness has cost them a bundle....in foregone gains or "profits" at Wall Street's expense...but they are STILL, after all the crisis effects, well ahead of where they otherwise would have been.

This is the author's own link, cited as a prime example of the perfidious interest rate swap market!... And it shows the OPPOSITE of what is claimed in the article!!!

Well, that factoid may have been obscured by its presentation as the very first point in the Executive Summary; no doubt Ms. Morgenson was poring through the footnotes for the real scoop.  But for the rest of us, here we go, from the NY State Budget Report:

I. Executive Summary

• Since its inception in 2002 through the end of March 31, 2009, the Division of the Budget (DOB) estimates that the swaps program has resulted in $41.4 million of reduced interest costs, when compared to traditional debt issuances. In 2008-09, the crisis in the credit markets negatively affected the performance of the swap portfolio. For existing swaps, the estimated overall savings declined by $23.0
million. In addition, the State incurred $78.9 million in costs (present value) related to swap terminations.

And lest that is not clear it is accompanied by a helpful chart:

That is quite a leap to get to the notion that swaps have been a disaster for NY State. But here is Ms. Morgenson:

Termination fees also kick in when a municipal issuer wants out of its swap agreement. They can be significant.

New York State provides a good example. An Oct. 30, 2009, filing describing its swaps shows that for the most recent fiscal year, April 2008 to March 2009, the state paid $103 million to terminate roughly $2 billion worth of swaps — more than a quarter of which resulted from the Lehman bankruptcy in September 2008.

(You can find this report online at bit.ly/cS8ZFV.)

As of Nov. 30, 2009, New York had $3.74 billion worth of swaps outstanding. Even so, New York doesn’t have as much of a problem with swaps as other jurisdictions. Still, New York could have spent that $103 million on many other things that the state needs.

No doubt.

Let's have a To be Fair moment - but the NY State officials in charge of the swaps program and the firms advising them have an incentive to portray the decision to use swaps in a favorable light, and a lot of these valuations are built on assumptions about alternative financings that are entirely hypothetical.

And that ends out fairness moment - if Ms. Morgenson thinks these valuations are phony, she should investigate that.  Otherwise, her discovery that a past decision to execute a fixed rate financing can look dumb if rates subsequently decline is hardly newsworthy.

Comments

[sylvia]

Wow. That post was way long. And I have to read multiple articles linked as well. It will take me a while to digest it so I can comment. But I like the subject.

[sylvia]

Okay, what I glean from it so far is you are defending the swaps because they resulted in interest rate savings. Which is good. But at what price to get those?

Remember people in a pyramid scheme are also overjoyed at first with their assets skyrocketing in value on paper in their statements. Until they try to cash those assets in. So yes, I think it's a good possiblity those valuations are phony.

[Pofarmer]

FWIW, Market Ticker had post up last week about AIG selling CDS to Greece.

[Thomas Collins]

I am going to hazard a guess that these contracts paled in comparison with Greece's straight debt. Blaming derivatives arrangements for Greece's woes is another way for progs to avoid facing the reality that they are running out of other people's money to spend.

By the way, the bummer on hedge contact termination payments is not that the governmental body has to pay when it wants to get out of a swap, but that these contracts are typically written so that even if the termination event is the bankruptcy of the private counterpary (such as Lehman Brothers), the governmental party still may owe a termination payment. Nonetheless, these contacts pale in comparison with others sources of governmental liability woe, such as unfunded pension liabilities.

[Thomas Collins]

The Cato Institute has a lot of interesting materials on proposals to regulate derivatives and other regulatory proposals in response to the financial bubble. See LUN for examples.