Yesterday’s print edition of the New York Times contained a must read piece which talked about how global bond investments by the MTA & others have backfired. The piece focuses on bonds known as “Collateralized Debt Obligations” or “C.D.O.’s”. These bonds are considered an asset backed security/structured credit product. They come in the form of adjustable rates which changed from day to day. Charles Duhog & Carter Dougherty have more:
On a snowy day two years ago, the school board in Whitefish Bay, Wis., gathered to discuss a looming problem: how to plug a gaping hole in the teachers’ retirement plan.
It turned to David W. Noack, a trusted local investment banker, who proposed that the district borrow from overseas and use the money for a complex investment that offered big profits.
“Every three months you’re going to get a payment,” he promised, according to a tape of the meeting. But would it be risky? “There would need to be 15 Enrons” for the district to lose money, he said.
The board and four other nearby districts ultimately invested $200 million in the deal, most of it borrowed from an Irish bank. Without realizing it, the schools were imitating hedge funds.
Half a continent away, New York subway officials were also being wooed by bankers. Officials were told that just as home buyers had embraced adjustable-rate loans, New York could save money by borrowing at lower interest rates that changed every day.
During the go-go investing years, school districts, transit agencies and other government entities were quick to jump into the global economy, hoping for fast gains to cover growing pension costs and budgets without raising taxes. Deals were arranged by armies of persuasive financiers who received big paydays.
But now, hundreds of cities and government agencies are facing economic turmoil. Far from being isolated examples, the Wisconsin schools and New York’s transportation system are among the many players in a financial fiasco that has ricocheted globally.
For years, municipal agencies like the M.T.A. had raised money by issuing plain-vanilla bonds with fixed interest rates. But then bankers began telling officials that there was a way to get cheaper financing.
By 2006 Depfa was the largest buyer of last resort in the world, standing behind $2.9 billion of bonds issued that year alone. It backed a $200 million bond issued by the M.T.A.
But as Depfa grew, it became more reliant on enormous short-term loans to finance its operations. Those loans cost less, and thus helped the bank achieve higher profits, but only when times were good. Indeed, some employees were worried about that debt.
Then, in mid-September, the American investment bank Lehman Brothers went bankrupt. Short-term lending markets froze up. Ratings agencies, including Standard & Poor’s, downgraded Depfa, citing the company’s difficulties borrowing at affordable rates.
That set off a crisis in Germany, where officials worried that Depfa’s sudden need for cash would drag down its parent company and set off a chain reaction at other banks. The German government and private banks extended $64 billion in credit to Hypo to stop it from imploding.
“We will not allow the distress of one financial institution to endanger the entire system,” Angela Merkel, the German chancellor, said at the time.
That crisis spread almost immediately to the M.T.A.
The transportation authority, guided by Gary Dellaverson, a rumpled, cigarillo-smoking chief financial officer, had $3.75 billion of variable-rate debt outstanding.
About $200 million of that debt was backed by Depfa. When the bank was downgraded, investors dumped those transportation bonds, because of worries they would get stuck with them if Depfa’s problems worsened. Depfa was forced to buy $150 million of them, and bonds worth billions of dollars issued by other municipalities.
Then came the twist: Depfa’s contracts said that if it bought back bonds, the municipalities had to pay a higher-than-average interest rate. The New York transportation authority’s repayment obligation could eventually balloon by about $12 million a year on the Depfa loans alone.
On its own, that cost could be absorbed by the agency. But, as the economy declined, the M.T.A. had lost hundreds of millions because tax receipts — which finance part of its budget — were falling. And its ability to renew its variable-rate bonds at low interest rates was hurt by the trouble at Depfa and other banks. The transportation authority now faces a $900 million shortfall, according to officials. It is “fairly breathtaking,” Mr. Dellaverson told the M.T.A.’s finance committee. “This is not a tolerable long-term position for us to be in.”
In a recent interview, Mr. Dellaverson defended New York’s use of variable bonds.
“Variable-rate debt has helped M.T.A. save millions of dollars, and we’ve been conservative in issuing it,” he said. “But there are risks, which we work hard to mitigate. Usually it works. But what’s happening today is a total lack of marketplace rationality.”
Click here for the complete report.
This sounds like a case of the MTA being stupid & greedy at the same time. I would assume they studied all the risks & executed potential projected return scenarios out so what made them go through with such a risky proposition? I invest so I fully understand that risks are involved. I love to take risks but only if they are legitimately worth my time. If the returns from a standard & safer strategy produce similar results with a more riskier one, common sense tells me to stick with what works. Was the minimal difference in additional money really worth putting yourself in such a hole?
I understand that the MTA & others could not have seen such a huge market crash leading to the closure of companies such as Lehman Brothers but still. these “investments” should have set off an alarm & led to a smaller investment in them or none at all. Who would sign a contract agreeing to get raped on interest if the bonds defaulted? When I see an agreement that protects the side I might do business with that much, the red flags immediately go up for me. The same should have applied to the MTA.
Maybe it is time for the MTA to clean house & bring in new financial “experts” who can make more sound judgments that not only affect the agency but the riding public as well.
xoxo Transit Blogger