Warren Buffet famously referred to derivatives as “financial weapons of mass destruction”. Turns out the MBTA — already saddled with enormous debt — has been stashing them, and losing:
State Auditor Joseph DeNucci faulted the MBTA yesterday for a series of complex financial maneuvers designed to save the cash-strapped agency money, maneuvers he said drove up borrowing costs by $55 million.
… “It appears the MBTA was willing to accept short-term cash for long-term debt,” DeNucci said in a written statement, “and then paid millions of dollars in termination fees when the interest rates changed and became unfavorable to the authority.”
From Adam, here's the actual report, and the quote:
In an effort to manage their annual debt service costs on its $4.6 billion of outstanding debt, the MBTA decided to utilize interest rate derivatives to try to reduce their exposure to rising interest rates and lower their annual bond interest expense. During this period the MBTA entered into 12 such agreements totaling approximately $1.632 billion. However, we determined that contrary to their expected savings, the MBTA incurred additional interest costs of more than $55 million during the period July 1, 2000 to December 31, 2005 by utilizing interest rate derivative agreements. As a result, the MBTA actually increased their total indebtedness by using derivatives to manage their debt.
Oy. The T was acting like a fantasy-addled homebuyer, taking out an ARM at cheap interest rates, and paying through the nose when — to no one's surprise — they went up. Just like all those clever people in the big banks taking on lousy risks in tricked-out investment vehicles, they mistook hidden risk for non-existent risk.
How about some actual accountability — or accounting, even — for the MBTA? Or is this just business as usual?
The death spiral continues.
Was the problem that too much of their annual budget goes to pay the interest on loans the Lege took out on their behalf and then gave back to them with forward funding?
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p>Was the problem structural inefficiencies, in bureaucracy, equipment, or the track?
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p>Was the problem contracts — wages, health, pension, etc?
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p>What were they doing with the short term cash? What were their other options?
When the hole’s dug 6 feet, the pressure is too intense to dig oneself out of it.
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p>I’m sick of people thinking and acting as though the MBTA needs to break even. The city – and state – would crumble if we didn’t have it. That simply means those who depend on it – imho businesses – need to start paying for it. Shut down the MBTA and suddenly Boston’s ability to be a financial leader in the world is over in one breath.
I don’t understand why the article reports this as gambling. The way a rate swap works is you agree to pay a fixed interest rate to someone in exchange for them paying you a variable rate. If you have a large amount of variable rate debt, this allows you to lock in the current interest rate (you will pay a fixed rate and somebody else will pay the actual interest on your debt). This is equivalent to someone who has an ARM loan on their house signing a contract with a third party who agrees to apy all the interest on their mortgage in exchange for the homeowner paying a fixed interest rate to the third party. If interest rates rise, you benefit. If interest rates fall, you lose. But either way, it means that you have predictable interest expenses, which can provide some benefits.
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p>If interest rates had risen since 2000, the T would have saved a lot of money by doing this. Given that interest rates were at (or close to) 30 year lows in 2000, it was not unreasonable to think they would be going up. The T would have been unable to afford higher interest rates, so they effectively refinanced at fixed rates, but did so in a less expensive way than actually reissuing all their bonds. Staying with variable rate bonds when interest rates are at historic lows would be the choice that most resembles gambling.
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p>If the T is paying money for insurance and the events being insured against don’t happen, will people be complaining about all the money spent on insurance premiums? Buying insurance is a way to lose a guaranteed amount of money. Your only other option is to hope that events work out in your favor. Interest rate insurance is no different.
I don’t know where you’re getting the term ‘insurance’ from. The MBTA, near as I can figure out here, isn’t purchasing insurance. Althoug I haven’t read the Herald piece, I have read the Auditors report. The T is attempting to mitigate the cost of the debt it already has… Basically, in ’99 the lege pulled the rug out from under the MBTA, which previously relied on the Commonwealth to back it’s debt. While the Commonwealth ponies up some funds, and others are garnished from the towns local to the T, all for prior debt and ongoing operations, new debt is now the sole responsibility of the MBTA.
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p>The Authority entered into some swap agreements (long term) which it later terminated when they went south. The bulk of the 55 mil is either in ‘termination fees,’ or fees for ‘fixing the rate’ (amending the agreement) They are even brazen enough to say that the 55mil represents ‘savings’ from the likely higher cost of staying with the swap agreement(s). The auditors call bullshit on this and point out their attempts to douse the fire with gasoline: The authority went and issued some variable rate bonds to pay for fixing the variable rate swap, duh. (The auditor, somewhat audaciously, tweaks the Authority by pointing this out [page 17] and flatly stating that if they’d simply issued these same bonds upfront and suck up the incidentals they’d have plus 27 mil on interest costs…)
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p>The audit raises some questions about how these swaps were negotiated, which bears looking into, as well.
Instead of insurance against casualty, it is insurance against rising interest rates. Because it is not purchased as an insurance policy, it might be better described as a hedge, but this is a distinction without much of a difference.
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p>jkw did an excellent job explaining how it works.
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p>Terrible job by a reporter who had no idea what he/she was writing about.
Interest rate swaps are derivate instruments, and as such carry inherent risks, as well as benefits, to the issuer From the auditors Report
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p>I can see how you think this is insurance but I can’t square that with what actually happened:
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p>A) The Authority entered into some agreements in order to ‘reduce it’s debt service cost’ knowing full well that the interest games they were playing might turn against them.
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p>2) They then backed down, because they forecast the deal(s) costing much much more over the long term than expected and either terminated some agreements and/or modified others, with the net effect being that they incurred greater costs. This makes it clear that they were not interested in insuring for themselves a fixed rate. Else, why did they walk away from it?
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p>That’s not insurance, that is a clear example of ‘taking a chance’ and then attempting to mitigate the cost of taking that chance. The point of contention here, it seems to me, is not that they weren’t taking a risk, but whether or no they were doing so responsibly and/or judged the risk adequately. There is a large question mark surrounding how, when and why these swaps were negotiated so the question about reasonableness cannot, at present, be answered. On the face of it, maybe any reasonable accountant, or money manager, or what have you would certainly have considered it an option and maybe pulled the trigger on such a deal given the interest rates at the time… I just can’t see how anybody considers that ‘insurance’.
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p>I no longer even read much reportage. With the internet, you can often go straight to the source and find out for your self.
Even if it was an insurance move to turn variable interest into fixed and therefore predictable interest, the more prudent move would have been to issue fixed debt in the first place, rather than gamble on interest rates after the fact. Save the transaction costs.
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p>Poor MBTA. Hindsight’s a bitch.
On the shoulders of the state. With debt mounting, this stuff for getting short-term cash is inevitable. Wrongheaded, yes, but inevitable. The state should absolutely take over the debt and substantially increase funding.
take over some of the old debt, and agree to fund future projects. The MBTA is suffering short term… making it hard for them to worry about long term efficiencies. Take off some pressure, and give them projects that boost revenue [like making all green line platforms 3 cars in length, so they can pack lots more people in during rush hour with very little additional operating costs].