Streetwise Professor

March 22, 2010

Come si dice inglese ‘Gli Swaps non sono Opzioni gratuite ‘ ?

Filed under: Derivatives,Economics,Politics — The Professor @ 7:51 pm

Come si
Last week I wrote about how numerous Italian municipalities are regretting their decision to enter into interest rate swaps.  Today’s WSJ reports that many American cities, towns, and counties are experiencing similar regrets, and are talking about escaping their contractual obligations.

As reported in the WSJ, the facts seem pretty simple and straightforward.  On the basis of this reporting, the municipalities’ complaints are meritless.  Specifically, the WSJ states that the municipalities (a) borrowed at floating interest rates, and (b) swapped that floating rate into a fixed rate via a swap.  The terms of the swaps were such that the fixed rate in the swap were lower than the municipalities could have borrowed at fixed rates:

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.

So, what the municipalities did is lock in an interest rate via a combination of floating rate borrowing and a swap.  They locked in a lower rate than they could have by borrowing at fixed rates.

Yes, if they hadn’t done that, their interest costs would have been lower due to the dramatic fall in rates–and if they’d borrowed at floating rates, rather than fixed ones.  But, by giving up the possibility of paying a lower floating rate, the municipalities protected themselves against the possibility of higher interest rates.

That’s what’s called hedging, people.  And you don’t evaluate hedges ex post, based on what did happen.  You evaluate hedges ex ante, by determining what transactions optimize your risk-return trade-off, based on what could happen.

You don’t evaluate hedges ex post because, lacking a crystal ball, you didn’t have that information available when you made the hedging decision.  If you can see the future you have no need to hedge.  If you can’t see the future, and want to avoid risk, you might want to hedge.  And if you do, roughly speaking, about half the time you will regret it ex post.  But woulda, coulda, shoulda is a bogus way to evaluate hedges.  You have to evaluate them based on the information you had when you made the decision, not based on what actually transpired in the unknowable future.

The municipalities seemed to have wanted to make one way bets: to protect themselves against rate increases, but profit from rate decreases.  You can do that, but you have to pay for the privilege–by buying options.  But even if they had done that, the municipalities would still have experienced ex post regret, and presumably would be whining about the wasted option premium spent buying caps that proved unnecessary after the fact.  (But, again, hedging decisions have to be made before the fact–they are decisions to reduce risk made in the presence of uncertainty about the future.)

So what the municipalities are claiming is that they should get FREE options that allow them to profit when rates are high but don’t impose any loss when rates are low.  Hey, I’d love to get free options too.  But good luck finding someone willing to give them to you. (Actually, Uncle Sugar does that with some regularity, through Too Big to Fail, or implicit guarantees of Fannie and Freddie.  There the taxpayers are the ones that end up paying for the options.)

The municipalities might have something to complain about if they could show that the swaps were priced off-market, or included various option features that were systematically mispriced in favor of their counterparty bank (as has been alleged in some Italian deals).  Even then, my sympathy would be limited because they could have and should have obtained independent valuation analysis to protect themselves against this sort of opportunism.  And I should note that the WSJ article doesn’t say a word about any mispricing or off-market pricing.

Absent evidence of deliberate mispricing (and perhaps not even then), the municipalities should get no legal relief from their contractual obligations.  There are attempts worldwide to escape transactions that were entered into voluntarily, but which were regretted afterwards because of the way the market moved.  In China, for example, energy consuming firms are exploiting government pressure to escape some of their obligations under various energy derivatives trades entered when prices were very high, and which went way underwater when prices plummeted.  Now the Italian and American municipalities.  (Notice how governments seem to think that contracts don’t apply to them when it’s inconvenient to perform?)  These efforts undermine the market, and have the perverse effect of making hedging more costly as counterparties have to price in the risk of not getting paid in full; indeed, they can make hedging impossible altogether as nobody is willing to enter a heads-I-lose, tails-the-municipality wins deal for no compensation.

It seems that the municipalities are attempting to exploit–and feed–the hostility towards derivatives to escape the consequences of their own decisions.  Let’s hope that if it comes to legal action, judges take a very skeptical view of such claims, and make municipalities play by the same rules as grown up commercial parties.

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