I generally have something of a bipolar reaction to reading Gretchen Morgenson’s column. On the one hand, if she catches me in the right mood, I’ll find her writing somewhat entertaining – I mean, let’s face it, through her storytelling she’s unwittingly producing the financial equivalent of the Darwin Awards. On the other hand, if one actually takes her seriously, she could potentially be one of the most intellectually dishonest representatives of the mainstream media (and that’s saying a lot).
Her latest installment, Exotic Deals Put Denver Schools Deeper in Debt, is pretty outrageous.
She begins:
In the spring of 2008, the Denver public school system needed to plug a $400 million hole in its pension fund. Bankers at JP Morgan Chase offered what seemed to be a perfect solution.
The bankers said that the school system could raise $750 million in an exotic transaction that would eliminate the pension gap and save tens of millions of dollars annually in debt costs – money that could be plowed back into Denver’s classrooms, starved in recent years for funds.
Ah, yes. Step #1 to writing a New York Times human interest story: Begin with a not-so-subtle suggestion that the school system’s woes are derived from a plan hatched by greedy bankers, not the fact that the board of education decided for years not to fund their pension obligations. By the end, said bankers will have stolen money from children. Yes, children. (Bankers tend to eat their young, in case you were wondering.)
Here’s the background Morgenson provides:
Rather than issue a plain-vanilla bond with a fixed interest rate, Denver followed its bankers’ suggestions and issued so-called pension certificates with a derivative attached; the debt carried a lower rate but it could also fluctuate if economic conditions changed …
The Denver school board unanimously approved the JP Morgan deal and it closed in April 2008, just weeks after a major investment bank, Bear Stearns, failed. In short order, the transaction went awry because of stress in the credit markets, problems with the bond insurer, and plummeting interest rates.
Since it struck the deal, the school system has paid $115 million in interest and other fees, at least $25 million more than it originally anticipated.
To avoid mounting expenses, the Denver schools are looking to renegotiate the deal. But to unwind it all, the schools would have to pay the banks $81 million in termination fees, or about 19 percent of its $420 million payroll.
That’s a nice touch – comparing the amount to the system’s payroll. So the school board decided to issue (taxable) variable-rate debt to fund its pension shortfall, and enter into an interest rate swap agreement to convert the variable-rate debt to a fixed rate. That’s not especially exotic, but OK.
Why would the school board undertake such a transaction? Well, duh, that’s the structure the Evil Wall Street Bankers sold them on. She continues:
The school system solicited advice from several banks on how to handle this problem and ultimately decided to issue bonds that allowed it to refinance its existing debt of $300 million, which had a fixed interest rate. It also raised another $450 million, most of which went into the pension to fill the gap on that plan. Together, $750 million was raised using the riskier pension certificates.
The Denver certificates contained debt issues that had variable rates and were to be resold to investors in weekly auctions; the arrangement carried an annual interest rate of around 5 percent, not counting fees and costs associated with that type of debt [that would be fees like remarketing fees, a liquidity facility, rating agency surveillance fees, etc.]. Fixed-rate debt would have cost 7.2 percent.
Denver schools had issued pension certificates before, but this time the banks added a little extra spice to the recipe: an interest-rate swap that made the variable debt mimic a fixed-rate instrument. If prevailing rates fell, the school system would have to make up the difference to the banks. But if interest rates rose, the swap would protect the school system from having to pay higher debt costs.
Morgenson then goes on to explain how the bankers sold this structure to the school board, conveniently neglecting to discuss the unique risks attendant to synthetic fixed-rate transactions and skipping over the collapse of the auction rate securities market that was almost simultaneously underway. (People who make decisions about $750 million bond deals do not read newspapers, obviously.) I’m sorry, given the level of outright panic in the muni market at that time, I find this absolutely impossible to believe. She writes:
According to several members of the board of education, the bankers’ presentations for the 2008 debt deal outlined its risks in broad terms, discussing, for example, what would happen if interest rates shifted or the economy weakened a bit. The banks provided no full-blown worst-case scenarios to the board, focusing instead on the transaction’s upside: lower debt costs and a potential saving of $129 million in pension costs over the next 30 years.
Morgenson indicates that the board members were thus completely caught off guard when they discovered down the road that they might have to make a considerable termination payment to unwind the swaps and change the nature of the transaction.
Sounds plausible, eh? Well, I decided to do something Morgenson clearly did not do, which is take 20 seconds and search the Municipal Securities Rulemaking Board’s EMMA website for the offering documents on this bond deal, which I might add is a service that is freely available to the public because the MSRB is awesome like that. Here is a link to the official statement. (And yes, I realize 324 pages is a lot, but it is mostly the school system’s financials.)
You might be surprised to learn that one of the board members Morgenson quotes for the article (and treasurer at the time of the deal), Bruce Hoyt, is himself an investment banker by trade (page 67). So is Morgenson suggesting that the folks from JP Morgan and RBC were keeping another investment banker in the dark about the collapse of the ARS market? Is she suggesting that an investment banker would not understand the risks associated with swaps?
Morgenson mentioned that the board of education had used pension certificates in the past, which is true. In fact, the board issued variable-rate pension certificates in two series in 2005, which were included in the approximately $300 million of outstanding debt refunded with the 2008 transaction being discussed (page 3). If you read further, included in the costs of issuance on the 2008 bonds is a $12,129,000 swap termination payment related to the 2005 deal (page 21). It would seem that going into the exotic and spicy 2008 deal, the board had prior experience with both synthetic fixed rate bond deals and being well out-of-the-money on interest rate derivatives contracts. (That is one of the worst things about Morgenson’s pieces involving swaps – she talks about termination fees as if they are just another fee, as if the contract has no real value, and as if the counterparty is not also taking some risk in entering into the agreement. I wonder if she also thinks distressed borrowers should just be able to renegotiate their outstanding bonds when their debt burden begins to seem unaffordable.)
In case the board members failed to peruse the bond disclosure documents they signed off on, their accountant provided them with an explanation of their outstanding 2005 swap and swaption contracts (with JP Morgan as the counterparty) in the notes to their financial statements (page 49 of Appendix II), which no doubt was formally presented to them each year. There is also an accessible and quantitative discussion of the terms, fair value, counterparty credit risk, basis risk, and termination risk associated with those contracts. Judging by the value of the contracts at the end of the fiscal year and the termination payment that was ultimately made, it seems the board also had experience with going underwater fast on a swap before the 2008 deal.
Now, if Morgenson had done this research going into her interviews, don’t you think she would have asked the board members why they chose to enter into this kind of transaction given their immediate past experience with derivatives? I’m actually kind of curious what the response to that question would be. The best explanation she provides is that the board was advised to conduct this transaction, and the adviser (Royal Bank of Canada) had a conflict of interest (of which the board was aware, because it signed a waiver acknowledging as much) because the same firm was serving both as the board’s financial adviser and the remarketing agent on the bonds, thus making money on the deal. (And why would the board, if it cared at all, find this arrangement acceptable?)
In fact, Morgenson does little to explain the board’s motivation for entering into the transaction, which I think is why she invests so much effort in trying to draw an analogy between this bond issue and the nefarious adjustable-rate mortgages that some home buyers used. I suppose someone could call synthetic fixed rate pension debt an affordability product, but that’s about the only similarity between the two. It’s actually a ludicrous comparison. At any rate, she wants you to take it for granted that the board was simply duped.
I think there are two things that could have motivated this transaction that were not explored in the article. The first is that the system had outstanding debt that needed to be addressed. I was somewhat curious as to why they would have needed to make such a large payment on the 2005 PCOP swaps, given the valuation included in the financials just a few months before that. Incidentally, it appears that deal was insured by Ambac, which had lost its AAA rating from Fitch just months before the 2008 deal closed. The board probably would have been highly motivated to get out of that contract at the time. The second is that the board was likely OK at the time with taking considerable risk to reduce its cost of capital because it was painfully cognizant that funding a pension with debt is an arbitrage game (hence the tax status on the bonds). A game that it ultimately lost anyway when the market crashed.
It’s not so much that I am trying to defend the banks here, but I’ve really kind of grown to despise reporters that as a matter of principle treat every idiot like a victim, to the extent that they do not even bother to question the accuracy of what they are reporting. In this story, the board of education either (a) was looking for a financial shortcut to cancel out years of poor financial decisions that will have no inexpensive remedy, or (b) opted to rubber stamp an irresponsible transaction at taxpayers’ expense, just like they did the transaction before it.
If anyone reads this situation differently, please feel free to let me have it.
