Photo Credit: Getty Images/Bill Pugliano
The Journal of Public Budgeting, Accounting & Financial Management — stay with me — published in 2012 a paper entitled ”The Use of Financial Derivatives in [U.S.] State and Local Government Bond Refinancings” by Martin J. Luby of the John Glenn School of Public Affairs at Ohio State University. The paper’s subtitle has proved prescient: “Playing with Fire or Prudent Debt Management?”
Detroit got burned big time by derivatives. A recent piece in the Financial Times rakes through the embers. Drawing on the city’s bankruptcy filing, the FT describes how a 2005 decision to borrow $1.4 billion to top up two underfunded pension funds for city employees spun into a vortex of derivatives deals that will end up costing the city dearly — regardless of the outcome of its bankruptcy proceedings. Remember that the 2005 Bankruptcy Act — handily for the big banks that dominate the U.S. derivatives market — gave derivatives safe harbor, putting their holders at the front of the creditors’ line.
The city isn’t blameless. A shortfall in pension funding in the first place suggests long-term mismanagement. Detroit lets its finances get to the point where its credit rating was downgraded, triggering penalties on the derivatives deal. The FT‘s money shot:
As of the end of June, the negative value of [Detroit's] derivatives was almost $300m, according to material from Ernst & Young submitted as part of the bankruptcy court filings. By the time the city ultimately pays off the $1.4 billion in borrowing, the total bill just from 2013 onwards will be over $2.7 billion, or almost double the original debt, of which $770 million will be the cost of the derivatives – far more than the $502 million in interest payments, these filings add.
Payments tied to these borrowings when combined with retiree obligations will eat up 65% of all city revenues by 2017 (from 38% in fiscal 2012) if not stemmed, Kevyn Orr, the city’s emergency manager, said.
State and local governments have increasingly turned to derivatives, the arcane and often opaque financial instruments that Wall Street has been manufacturing in ever-increasing numbers with all the product safety of melamine-tainted Chinese infant formula. And there are reasons for public debt managers to make this risky turn. They can use derivatives to hedge against risk and lower borrowing costs. Derivatives deals are also attractive to cash-strapped local governments because they can conceal the true size of their debts and deficits, or at least shift them off-balance-sheet and away from the prying eyes of any interested voters. They dangle, as well, the always-alluring prospect of turning a profit through speculation.
Yet they can also, as Luby’s paper shows, impart substantial long-term financial costs on state and local governments. The risks and terms, including usually hefty fees and penalties, are often buried deep in legal documents not often (or easily) read by elected officials and taxpayers. A study of derivatives by independent researcher Andrew Kalotay cited by the think tank Demos found that U.S. state and local governments had been overcharged $20 billion by banks between 2005 and 2010 alone.
In 2008, the Governmental Accounting Standards Board started requiring state and local governments to report their derivative positions. This has led to some 20 states revealing they are sitting on derivatives liabilities amounting to several trillions of dollars; none, as of the 2012 reporting, are showing derivatives gains. The 2010 Dodd-Frank financial-reform law tried to price derivatives more clearly, but banks have since lobbied for and won many exemptions to be included in the rules and regulations implementing the law that water it down.
While the Denver Public Schools system and Jefferson County, Alabama are two infamous examples of municipalities brought low by derivatives long before Detroit, this is far from an exclusively an American concern. U.S. local authorities traditionally use bond financing rather than the bank lending more common in other parts of the world, but local authorities in the U.K., across continental Europe and as fas as Australia have all been scorched by derivatives deals gone bad.
Gustavo Piga, an Italian economist at the University of Rome who wrote a report more than a decade ago revealing how European authorities were misusing derivatives and called for local governments in the E.U. to be banned from using them. That happened in the U.K. after the local council in Hammersmith in west London ended up on the wrong end of a £500 million interest rate swap in the 1990s. Piga believed local governments could be too easily rolled over by the big banks, or as he more politely put it, “even the largest and most sophisticated local authorities suffer from an expertise deficit when compared with international banks.”
There are countries where local governments make derivatives work. Sweden is one, but it has put time and resources in building up an infrastructure of professional expertise, risk management, and compliance controls into city halls. In the U.S. the Government Finance Officers Association, a trade body, advises its members “to exercise extreme caution [its bolding] in the use of derivatives” and to put in the sort of sophisticated procedures and internal controls that exist in Sweden.
We suspect that level of sophistication never existed among the Detroit city council. We also suspect it is not alone in its naïveté. Wall Street is the richer for it, far richer, while taxpayers have lost billions of dollars because of complex financial transactions local officials simply didn’t grasp.
