House of Sticks: Where Are The Watchdogs?

By Kent Lyndon

We’re supposed to have flying cars in five years, so let’s board an imaginary vehicle and hop around to a few large American cities and see what has been happening. First stop: Denver. Oh my. The Denver Business Journal has some restless reporters. Heather Draper treated us to this headline at 4:00 A.M. MT 4-12-13: “Denver Public Schools to spend $177.4M to end swap deals”. Multiple good reasons, of course, persuaded DPS to take on the swaps. They were supposed to fix certain unfunded pension situations and reduce risk……if interest rates went in the right direction. They didn’t, so the transaction became just another exponentially leveraged bet, with taxpayers money, that went haywire. Three of our giant banking buddies were on the sale end of that deal. Read the article. It’s not long, and it’s very enlightening and easy to follow.

Let’s fly over Chicago. That city’s financial struggles have made headlines for months.
I just happen to have a copy of the “Chicago Public Schools Policy Manual” on hand. The title of the main subject, dated 7-24-13, is: “Debt Management Policy”. Section: 404.1 Board Report: 13-0724-PQ1 Scroll down in the Policy Text to Section 2: Part B. “Use of Derivatives Instruments”. “Derivatives transactions may only be used for appropriate purposes that provide a measurable benefit to the Board….” The final statement reads, “The Board shall not enter into derivatives transactions for speculative purposes”. Isn’t it interesting that the use of derivatives actually is written into public school policy manuals?

Now, follow me through Chicago as we make a couple of rounds. Writers Grotto and Gillers penned the lengthy piece for the Chicago Tribune on 11-7-14: “Risky bonds prove costly for Chicago Public Schools”. I will offer you a couple of quotes from the article that will propel you to the nearest computer to read it in its entirety: “From 2003-2007, the district issues $1 billion worth of auction-rate securities, nearly all of it paired with complex derivatives contracts called interest-rate swaps, in a bid to lower borrowing costs.” Making several longer stories short, interest payments on adjustable rate debt became negligible when overall rates collapsed, and it costs millions extra to terminate the original agreements. Speculative? When the underlying asset represented by a leveraged derivatives contract goes against the grain of the contract and causes contract values to fall, does the arrangement go from being a hedge to being a speculation? Does the use of exponential leverage even justify the use of the term “hedge”?

Is March 30th, 2015, a recent enough date for you? Ponder an article penned by a Commonwealth of Kentucky state government official who handles the sale and structuring of bonds for schools across the state. The title of Kristi Culpepper’s article is, “How Chicago has used financial engineering to paper over its massive budget gap”. I’ll treat you to just a few quotable lines, and then you can dash off to find it for yourselves. “Chicago made headlines at the end of February after Moody’s downgraded the city’s general obligation bond rating to Baa2. Moody’s has cut Chicago’s rating five notches in less than two years. This downgrade, however, placed the city’s credit below the termination triggers on some of its outstanding interest rate swaps. The city has been working to renegotiate the terms of those contracts with its counterparties. (new paragraph) If Chicago’s general obligation rating falls below investment grade, the city’s credit deterioration will become a self-fulfilling prophecy. The city risks nearly $400 million of swap termination payments and the acceleration of its $294 million of outstand short-term debt”.

Twenty years later, after the bankruptcy of Orange County, California, highly leveraged debt instruments continue to create havoc in our school systems just like they did in Jefferson County, Al., Detroit, Mi., and Pennsylvania (previous articles). No private derivatives contract is without leverage. Ask Lehman Bros. executives about leverage. Keep in mind that hedging loses all value when leverage begins to work against the contract holder. Private derivatives are created to represent commodities, currencies, credit instruments (credit default swaps), and interest rate instruments. Sometimes, like what happened in the credit markets in 2007-08 and what has happened in the interest rate markets 2009 through 2014, extreme value fluctuations of the underlying assets and the lack of liquidity can and will clobber the best laid plans. Throw in exponential leverage, and how can we dare call any transaction a hedge and not a speculation?

Stand by. We’ll land back home for now, but not for long. I really wish I could tell you that the corpus of the last fourteen months of columns was nothing more than a series of silly April Fools pranks. Where’s the accountability to the taxpayer? Gone. It left when the FDIC began underwriting underwater derivatives contracts. Now you and I are responsible for them. Go back and read my previous columns. All of them feature well-researched articles from mainstream publications who employ articulate and efficient journalists.