The New York Times Fluffs Bond Insurance. Again
Oh, lordy, almost no posts for ages, and then two days in a row. Both about the New York Times' ability to come to quite witless conclusions based on fairly straightforward information. Today, Don Van Natta has a go at probing the municipal bond market. The results are far from good-looking,
Now I'm a bitter, angry person. You can see it in my treatment of by all accounts blameless, and occasionally impressive, Times reporters such as Andrew Ross Sorkin and Gretchen Morgenson. You can probably dismiss a lot of this as needless sour grapes, if the Times didn't pump out awful adverts talking about how "the Times employs the best journalists in the world. Period." So screw 'em, they can take it.
I must say, I thought that I would soon have to hang up my "slightly ropey monoline bond insurer expert" hat, accept that being familiar with bond insurance now ranks up there with being an expert on the workings of the VCR. Had my fun with the Times and bond insurance. Time to move on.
Mr. Van Natta is not that familiar with finance, beyond a stint covering some of Eliott Spitzer's antics. As far as I can tell, he's the nearest thing the Times has to a Clinton expert, so he deserves more than a little credit for trying to find a more stimulating beat.
But really. Guys. This is bad. But let's get through some of the useful angles first. No doubt about it, the cozy collusion between local municipal bond underwriting firms and state governments is an accident waiting to happen. It's not at all reassuring that the only major casualty of a probe into this collusion is the nomination of Bill Richardson as commerce secretary.
No doubt that the private sector's tutoring of public sector employees is not as thorough as it should be. Still, let's see how taxpayers react when they try and go on some $2000 a head external training course. Maybe the ratings agencies could run it for cheap. Heh.
First we have a couple of paragraphs telling the story of what happened to the town of Lewisburg, Tennessee. Then we get the lede:
Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad.
Crikey! They mentioned derivatives! Case closed, Orange County all over again. [Quick note at this stage - Orange County was using derivatives as investment products, not as part of its debt issuance]
I'm now going to quote the offending paragraphs in full, where the reporter tries to explain what happened:
For decades, the tax-exempt municipal bond was considered as safe a way to raise money as it was to invest money. If a city wanted to build a bridge, a hospital or a school, it raised the money by issuing a bond and repaid investors over decades. Bonds were considered conservative and dependable.
[If this was a Michael Moore documentary we'd be hearing perky 50s music and grainy scenes of nuclear families gambolling in the suburbs. This paragraph is not too objectionable, though somewhat loosely-written, possibly to make the contrast between then-prevalent and current municipal finance look greater than it really is. I mean, most municipalities are still issuing long-term debt to build bridges, schools hospitals, sewers, even power plants. Most of these bonds are still considered safe and dependable.]
Beginning in the late 1970s, big states like California began to use variable rate bonds as a way to save money. By the late 1990s, some rural counties and small towns jumped on board as a way to avoid raising taxes.
[See, this is where things might have got interesting. Why did munis switch to the floating rate market? Where did the demand come from? Why, for instance, did the market not have some helpful financing corporation like Fannie Mae propping up 30-year fixed finance?]
Not long afterward, interest rate swaps were introduced.
[At this point the Darth Vader March kicks in. Needless to say, an issuer with revenues that are not correlated to movements in interest rates might want to look at hedging this interest rate exposure.]
A swap allowed a municipality to keep a portion of its debt at a fixed interest rate and a portion at a variable rate [Or all of it]. The municipality was, in effect, betting that interest rates would move in its favor [No it wasn't. It was hoping that they wouldn't go lower than the rate at which the swap was struck, at which point letting the bonds float would have made more sense. This is called being out of the money. At this point, you're kicking yourself, but you're hardly in the poorhouse. You might even be able to reassure yourself that while you are paying a little bit more in interest you're not going to suffer if interest rates shoot up again, which they well might over the term of a 20-year plus bond]. Investors protected themselves by taking out insurance that guaranteed they would be paid [Gari's head explodes. No. No. No. No. No. The state and its underwriters set up the bond insurance. It's one reason, alongside hitting up the variable rate market, that the bonds were so cheap.] But as the nationwide credit market collapsed, most of the bond insurers’ credit ratings were downgraded, including the Ambac Financial Group, the primary insurer of Tennessee bonds. That allowed the investors to accelerate the retirement of the debt, usually from 20 years to 7, leading to a steep increase in the interest rate.
Although such a provision was in the swap contract, several local officials said that possibility had not been explained to them.
[By now, the explanation has not so much gone of the rails, but is trundling through a fifth dimension breaking all laws of physics, and the driver's natty striped uniform has morphed into something from George Clinton's band]
Please, Don, you're going to have to lay out what happened. Either you, or one of the interns, or one of your sources is going to read the bond indenture. Because this makes no frickin' sense. Was Ambac insuring the issuer's obligations under the swap contract as well as its obligations to bondholders? Could well be. But it ain't what you wrote. The bondholders have the right to accelerate the bonds in the event that the insurer is downgraded. That, my friend, is a story that has already been written, it's about the perils of relying on bond insurers, who buildt a business model built on inaccurate ratings, and it has zip to do with derivatives.
Should a municipal treasurer have said "sod the .3% saving in interest costs, I think these bond insurers might go bust'? Maybe. Should he have avoided tapping the auction rate securities market? Maybe, in fact, I'm still not 100% certain that Van Natta isn't describing an auction rate deal gone wrong (The link, by the way, is to a more lucid Times story to which Sorkin contributed reporting. Can't be hating all day long). But then I haven't seen the indenture.
[I have, by slim way of qualification, recently turned down the offer of an interest rate swap on a largish agricultural loan. This is because I think that rates will stay low for quite a while. But if they do head up, I will not complain to the papers about how evil derivatives are. I promise. But I digress]
I can lay out a couple of scenarios under which derivatives might have become part of the story. The swap counterparty - the guy taking the fixed-rate payments in exchange for making the variable rate ones, might have had the right to accelerate, or even terminate, the swap, in the event of an insurer downgrade. Happens to a bunch of people, I'm sure. This might, in turn, have allowed the bondholders to accelerate their bonds. Or the swap had nothing to do with it. I don't know, I don't have a copy of the bond indenture. I pray that Mr. Van Natta did.
The article's reporting seems to follow the underpants gnome strategy:
Step 1: Load up on risky stuff like "derivatives" and "bond insurance"
Step 2: ?
Step 3: Ruin
If the Times wants to suggest that too much diversity in municipal finance products is a bad thing, have at it. I think my inability to discern from the article exactly what happens gives you an indication that there are several ways to skin a muni. Ditto for inveighing against bond insurance, dubious statehouse-prowling bond firms, floating rate debt and genial but clueless state treasury officials.
But don't, for the love of all that is sweet and beautiful, fling out a premise like "derivatives are some scary sh1t, run for your lives", and then fail to explain what went wrong with using an interest rate hedging strategy. This is financial illiteracy of the highest order. Epic fail.
[Accrued Interest has the adult explanation here]