Sunday, January 08, 2012

Today's winners of 'The Business Article Written By Someone Who Doesn't Understand The Subject' goes to Elisa Martinuzzi and Vernon Silver of their Washington Post for their badly written article about how the big bad banks are screwing small towns...

The subject is interest rate swaps a number of municipalities bought to (in these cases) change their fixed rate debt to a variable debt. And now that interest rates have supposedly skyrocketed, these towns are paying huge amounts of extra interest, so much so that it is wreaking havoc with the budgets of these fine towns.

In response, while the reporters fail to make clear, interest rate swaps are gambling and anyone who has had a basic finance course know that. Since all but the teeniest municipalities have professional managers, presumably someone in the town management would not only have known that swaps are gambling but also the consequences of making a bad bet on the direction the markets would take. And yet the writers put all the blame on the banks and none on the towns who freely made these bets.

Now, one might ask, why did they make these bets? For the same reason someone with a fixed rate loan might switch to a variable rate. You pay less (at least upfront) with a variable rate loan than with a fixed. Making such a decision isn't inherently stupid. Lots of people do it, and for any number of reasons.

In the town featured in the story, the town trade the security of a fixed rate interest payment for the potential upside of a variable rate. As interest rates were lower at the time, that allowed the town to pay less in interest payments. The town administrators likely saw this as a way of boosting the town's bottom line without having to raise taxes or cut services.

The downside is that if you bet wrong, you start paying more than you otherwise would have paid. The amount depends on when the interest rates move and the extent to which they move.

Per the numbers in the article, the town was paying 4.7 percent on its fixed rate debts.... and what are rates now? Less than 4.7% percent. These towns are paying less money in interest now than they would have had they stood pat. So how does that cause these towns to have such problems? The answer: it doesn't.

Even in the short period in which rates were higher than 4.7%, they only moved to 5.7%. A whopping 1 extra percent. On 22 million euros in debt, that 1 extra percent would have cost the town another 220,000 euros a year.... far from the huge amount the writers imply is responsible for all of the troubles that town is having.

Since the extra interest doesn't seem to be high enough to cause such problem, my guess (and I have to guess because these crack reporters don't tell us) is that these towns were operating too close to the margin and had nothing to cushion a fall off in tax revenue when the recession hit. If true, that's the bank's fault?

A minor aspect, but one the writers choose to emphasize is the bonuses paid to the salesmen. But while that (as would any incentive compensation system) might encourage them to be a big pushy, the amount of the bonus would have been a miniscule part of the overall payment these towns were making. Of course, if you're set on writing a piece to demonize the banks, go ahead and include these nuggets.

And finally, the writers don't write about the towns who have used interest rate swaps to their advantage (such as locking in a fixed rate to guard against rate swings). But where's the fun in that, as it doesn't push the narrative, does it? You can't.