Oh those unfair interest rate swaps

Berlingske, which is a Danish newspaper, has a gotcha-story [read: not really] about how Danish municipalities have engaged in speculation and thrown tax-payer monies away on derivatives for nothing.

The story is in Danish only, so here’s a quick summary (feel free to google translate):

  • Because of the financial crisis munis are in deficit
  • They’ve tried to plug that deficit by buying interest rate swaps
  • They lost billions of kroner
  • Everyone is mad
  • Margrethe Vestager (Minister of Economy and Interior), Nils Bernstein (central bank Gov.) and a couple of professors from Copenhagen Business School (whom I normally like) are outraged because… they lost money

So I have some questions, without which I find it hard to understand this story: 1) When were these derivatives contracts entered into, and 2) what kind were they?

The articles mentions exotic interest rate swaps and then explains a plain vanilla floating-for-fixed swaps.

From what I can deduct, this is a story that is very much like the City of Oakland, which Matt Levine wrote about in August.

The story is basically that the municipalities borrowed money at a floating rate and swapped those into fixed payments. There are compelling reasons to do this and not just borrow at a fixed rate, as this can be more expensive.

I went looking at Furesø County, the only county mentioned in the story, to see if I could find something. Unfortunately, they only had stuff from early-2011. What they did have, however, was quite interesting. Here’s their outstanding debt and swaps (I translated it):

Furesø County debt Oh those unfair interest rate swaps

Apart from being very opaque, one can certainly see why they lost money on their swaps as interest rates fell. The county’s 2010 budget also has reference to a swaption on the knock-out swap (with Danske Bank deciding). It’s also mysterious to me what that Yen CCY swap is precisely used for.

So what we have here is a county, which has borrowed money at floating rates (Cibor, Euribor, etc.), and then bought swaps to limit their interest rate risk. If we only look at the plain-vanilla kinda swaps, then that’s not really bad risk management. In fact, it’s quite prudent unless you were 100 % sure that rates would fall.

However, we do have mark-to-market losses on the swaps, and that’s great for news stories!

The county is thus paying a low rate on the loan and losing money on the swap, instead of just paying a higher interest rate (as they would have if they just borrowed at a fixed rate). If the swaps are fair, then I have a hard time seeing how that’s so horrible.

I think Matt Levine puts it rather well:

Anyway. I’m not sure what the moral here is. Probably: don’t enter into fixed-rate debt if rates will go down. Another possibility is: if you have the choice between doing something very plain-vanilla and at observable market rates, or doing something more customized that pays you $15mm up front, the one that pays you $15mm up front is always a worse idea.

But then again, if we could see all those swaps, we might be able to actually analyze whether they actually did anything wrong by speculating, or whether they are just paying for rates going down. It’d be nice of Berlingske, the minister, the governor, and those professors to explain what exactly it is that we are supposed to be outraged about* instead of just using vague words.

 

*Now, if some municipalities actually engaged in speculation, or used exotic derivatives which they didn’t understand, that is wrong — but then they should say so! And the article should say so too!

  • M.K.

    Det er opfølgning på denne historie fra Mandag Morgen. Der er lidt flere detaljer i den (men ikke mange). https://www.mm.dk/kommuner-p%C3%A5-casino

    Manglen på detaljer er nok en afvejning af, at derivater er noget nær umulige at forklare i en kort tekst på en måde så alle læsere kan følge med.

  • Simon

    Hej M.K., tak for linket – ret interessant og lidt ekstra information. Berlinske kunne fx have linket til den artikel… selvom jeg stadig ikke er helt overbevist (dog skal kommuner selvfølgelig ikke handle dual CMS spread to blabla swaps).

  • M.K.

    Det er ikke normalt, at medier linker til andre medier, når de laver artikler, der bygger på andre artikler (hvilket er stort set dem alle, hvilket emne er trods alt uberørt?). Men det er Casper Schrøder, der skrev artiklen for Mandag Morgen og nu er skiftet til Berlingske og tager historien op igen.

  • Simon

    Ah, havde ikke set, at MM historien var fra 2010. Men stadig – jeg får absolut INTET ud af at læse Berlinske-historien. Hvis jeg kun læser B.dk historien, så ville min konklusion være – ok, fair nok.

    Og jeg er stadig ikke overbevist (da det ser ud til, at de fleste er plain vanilla, og pengene er tabt fordi renterne er gået ned).