Another creative way to hide government debt

10 Nov 2010 by Jim Fickett.

A trick to hide debt, used by many municipal, regional, and sovereign governments in recent years, was to disguise loans by incorporating them within interest rate hedges. This was one of the key ways Greece hid its true deficit for so long. Now evidence has come out that the same tricks were used by cities and states in the US. Although quite ugly, this is not, however, one of the big problems facing state and local governments, at least in aggregate.

The basic idea of an interest rate swap is very simple. Suppose that I have an adjustable rate mortgage, and am worried that rates will go up in the future. And suppose that some bank is sure that rates will stay low. We might agree to swap a stream of interest payments, so that I would pay them a fixed 6% rate, and they would pay me the variable rate on my mortgage. I would have peace of mind, at what would currently be thought an above-market rate. They would have hopes of long-term profit, via assumption of the risk that I did not want to hold.

Naturally, it gets more complicated.

Several months ago there was a flood of news about European governments at all levels having gotten into considerable trouble with swaps. There were really two issues. One was that elected officials, often with no numerical aptitude and no financial training, were taking on risks they did not understand. The second was that some swaps were set up as a way to disguise what was really borrowing. In particular, this method was used to hide part of the Greek government deficit. Satyajit Das, the author of a well known book on derivatives, explained how the system worked in an 18 Feb 2010 Financial Times article:

[Swaps] entail exchanges of one stream of payments for another. At the commencement of the transaction, if the contract is priced at current market rates, then the current (present) value of the two sets of cash flows should be equal (ignoring any profit). The contract has “zero” value - in effect, no payment is required between the parties.

Using artificial “off-market” interest or currency rates, it is possible to create differences in value between payments and receipts. If the value of future payments is higher than future receipts, then one party receives an upfront payment reflecting the now positive value of the contract. …

In December 1996, Italy used a currency swap against an existing Y200bn bond ($1.6bn) to lock in profits from the depreciation of the yen. Italy set the exchange rate for the swap at off-market rates - at the May 1995 level rather than the current rate.

… The swap was really a loan where Italy had accepted an unfavourable exchange rate and received cash in return. The payments were used to reduce Italy's deficit helping it meet the budget deficit targets of less than 3 per cent of GDP.

The Greek transactions are believed to be similar cross-currency swaps linked to the country's foreign currency debt, structured with off-market rates.

In my adjustable rate mortgage example above, I might agree to a 7% fixed rate, instead of 6%, and receive some cash up front as part of the deal. Thus the contract becomes a combination of an interest rate swap and a loan.

For months now there have been hints that state and local governments in the US were involved in similar deals, but none of the articles I read provided any concrete evidence. Yesterday Bloomberg had a piece which provided the evidence. The information was not easy for Bloomberg to track down:

[the article is based on] a review of hundreds of bond documents and credit-rating reports by Bloomberg News.

In contrast to the subprime crisis, few taxpayers know anything about the cost of untangling municipal swaps. The only disclosure of payments to Wall Street often is buried in documents borrowers have to give investors when they sell bonds.

Here is the hidden borrowing:

Sometimes borrowers got lump sums for entering agreements. …

The business was so lucrative that banks and insurers were able to write teaser checks to lure borrowers into swaps. The arrangements were akin to Goldman Sachs giving Greece $1 billion in off-balance-sheet funding in 2002 through a currency swap, helping the nation mask budget gaps to meet a European Union debt target.

“Tinkering with debt was something that you could hide behind,” said Jeffrey Waltman, a city councilor in Reading. The city got upfront payments totaling $7.6 million from Wachovia Corp. in 2005 and 2006 for contracts it later terminated.

“Maybe it didn’t mean so much of a tax increase, or maybe it didn’t mean laying off people,” said Waltman. “It was what appeared at the moment to be a painless effort.”

The banks had an ideal customer in state governments. Not only were they gullible holders of large amounts of money, but they were in a position to rewrite the rules:

New York was among about 40 states that passed laws, often at Wall Street’s urging, permitting municipal derivatives before the credit crisis, according to [a report by the Financial Crisis Inquiry Commission, published by the International Monetary Fund in June]. Tennessee passed rules in 2001 that required borrowers to attend a swap school.

Memphis-based Morgan Keegan Inc., a division of Birmingham, Alabama-based Regions Financial Corp., was selected to teach the classes. The firm sold many of the $12.7 billion of the deals subsequently done by more than 40 counties, municipalities, districts and authorities, according to Justin Wilson, the state comptroller.

The whole thing, yet another replay of the usurious moneylender preying on foolish borrowers, is revolting. But, at the same time, it seems from the Bloomberg piece as if the total costs involved are small relative to unfunded retirement obligations. Bloomberg's headline is “Wall Street Collects $4 Billion From Taxpayers as Swaps Backfire”. And the swaps in view in the article were on principal totaling a few hundred billion, so if cities overpaid a few percent in interest for a few years, that cost might also come to a few billion, or at most a few tens of billions. All quite small compared to the trillions in unfunded obligations.