Wednesday, November 26, 2008

Note to Obama: Make this Illegal

This is how it begins (from Bloomberg):
The three-member county commission [of Dauphin County, Pennsylvania] voted in August to approve two “range accrual swaps” with Deutsche Bank AG, according to minutes of the meeting. The interest-rate swaps, which involve $42 million of fixed-rate debt, guarantees Dauphin County $816,000 the first year and then wagers taxpayers’ money that short-term interest rates beginning in September 2009 won’t exceed 7 percent. Those rates are 2.2 percent now.

“It’s a way for us to raise revenue for the county,” said Chad Saylor, chief of staff to the county commission. “The only source of revenue we have, much like the school districts here, is the property tax.”

And this is how it ends (today from the WSJ):

Looming large among the reasons the [Massachusetts Turnpike] authority needs the cash are three "interest rate swap" contracts related to the Big Dig that were sealed with UBS AG, Lehman Brothers Holdings Inc. and J.P. Morgan Chase & Co. The deals have gone wrong for the state, adding to its interest burden and confronting it with up to $467 million in potential fees if the firms opt to pull the plug on the
"Did anyone know what they were doing?" asks Alan LeBovidge, who walked into the mess a year ago when he became the Turnpike Authority's executive director. Maybe, he says, his predecessors "should have been nice and conservative. It's like going to Las Vegas."

Note to any public official: do not do interest rate "swaps" which have options or knock-ins or knock-outs embedded in them.  If you think you're "raising revenue", think again.  At best you will lose money.  And on average you will lose a lot of money.    You don't know how to evaluate the value of the embedding, and, even if you did know how, you don't have access to the parameters you need in order to be able to do it.  Investment banks have access because they spend time and resources to follow the market and know what volatilities and correlations are actually worth.   And they know what looks good to you, like a fish eying a worm, and how much commission they can hide in their structure.  (Hint:  it's more than you can imagine.)    

Since no public official is likely to heed such advice, here's some more, to some other public officials:  if you are able to legislate or prevent state or town or county officers from entering into such contracts, then do so.  Public officials should be limited to borrowing money with fixed interest rates.  Bonds or loans.  It's not sexy, but it will prevent government agencies from losing the taxpayer's money at the dog races where the betting is run by the mob.

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