OK folks, time to earn your stripes. Here are the documents setting up the swaptions now wreaking havoc at the Pike. If you’re up for it, read them and tell us what you find.
Please share widely!
Assignment for the BMG hive mind: figure out swaptions documents
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What do you want to know? It looks like the Pike is the fixed-rate holder on each of these things, which explains why things are going so poorly for them. With interest rates in the toilet, the cash-flow from the floating-rate side (being held by UBS, JP Morgan, Lehman, et al) is extremely low.
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p>None of the posts I’ve seen here on BMG have gone into much detail about what a swaption is, so pardon me while I wax rhapsodic for a moment. If I missed somebody else’s prior explanation, do forgive me.
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p>A swaption is an option on a swap. Options are simple enough to understand – I think most people know about stock options, for example. An option is the right – but not the obligation – to buy an underlying asset. A stock, for example, or a swap.
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p>A swap is a little trickier. They generally involve cash flows – that is, repeated payments from a source such as a bond. One side of the swap is typically a fixed rate cash flow, such as the interest from a US Treasury bond. The other side is typically a floating-rate cash flow.
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p>Now, it is important to note that the only things being “swapped” are the interest payments, not the principal – which, in the lingo of swaps, is called the notional amount. So if the Pike is trading off a 4.75% fixed rate against a floating rate, they are really agreeing to pay 4.75% times the notional amount (and receive the floating rate times the notional amount).
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p>In these documents, you see LIBOR cited a lot as the basis for the floating rate. LIBOR is the London Inter-Bank Offered Rate. It is the rate at which banks borrow money from one another, or the open market, for short periods (like three months, one month, or overnight). It moves around – an ideal floating rate that gets used as the basis for a lot of swaps.
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p>So when the Pike entered into the swaption, they gave UBS et al the right (but not obligation) to, at a later point, enter into a swap. If the swaption is exercised (and interest rates are so favorable to UBS that it’s hard to imagine the swaptions not being exercised), the Pike has to pay UBS a fixed amount per quarter, and UBS pays the Pike an amount that bounces around according to LIBOR.
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p>The thing is, LIBOR and other floating rates are in the toilet. But the Pike still has to hold up their fixed-rate payments of between 4.75% and 5% on notional amounts totalling $800M. In short, the Pike ends up having to pay UBS alone $38M/year.
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p>I haven’t gone through to see what the amounts due to the other companies are. That’s just UBS.
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p>What I can’t understand is why the Pike was issuing swaptions to begin with. It’s a derivative of a derivative, highly complex and very much akin to gambling. Isn’t the usual route to issue actual bonds? Why were they dealing with swaptions?
Excellent description of swaptions.
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p>I think the Pike entered into the agreement because UBS paid them money up front to do so, and they cared more about that than any future liability.
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p>It is also of course possible — although such a remote possibility it scarcely bears mention — that the opinions of some of the consultants on the project might have had an influence.
… is likely totally not. Funding is usually worked out through other channels. If there were consultants consulted, they were most certainly financial consultants and not engineering consultants. Usually, the only time an engineering firm is called in on any funding question is to help the agency (client) apply for federal money – such application often require an engineering review to demonstrate that it can qualify for the funds.
No one’s talking about engineering consultants.
The managers of the Big Dig were engineering consultants. If there were financial consultants involved advising the agency, they were not ‘on the project’.
Ok clearly separate the Engineering form the money Although it maybe more closely related when you consider BPB was the contractor and the fact that many of the principles are closely related to the investments and banks involved, Sort of like a family whose tree is in the shape of a wreath. Now look at the cost of the Big Dig which is the basis of these bonds in the first place back in 97-99. Also look back to the State’s cash flow position at that time. What has happened here was they were hedging. Basically for a cash payment from the bankers which was a cash return on the bonds they were forced to flot they offer ed bet that interest rates would climb over time over what they were going to pay on these bonds the banks JP Morgan, UBS, and Lehman. There is where the option comes in. Now they were paid the cost of agreeing to this bet up front and those payments ended last year. now since interest rates and the Libor are at record lows they fall below the rates on the bonds the House loses. It also appears there are riders tied to the Bond rating which effects the original notes interest rate but until I actual see the bond prospectus issued in 97 -99 I can not say with certainty. Now if interest rates went up the way some in the late 90’s were predicting they were going to have to do in order to not over heat the economy and as the fed tried to do starting 4 years ago the holders of the bet the before mention banks would be sending the house more money.
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p>Ultimately this was a play to keep cash flow in an over extended authority and avoid raising tolls or other revenue under Republican administration (cough) Paul Cellucci,
Thus we gambled and the house lost thus we lost. The play was motivated by the attempt to defer the cost of the big dig principle out 30-40 years (depending on the notes) to a point where state GDP and the average tax growth would dwarf principle paid in the 1990’s for the big dig and reduce the cost to the state budget at that time. By the way that 2.4 Billion is still out their set as balloon payments at the tag end of the notes. For you and I today this looks like a sucker’s bet and certainly not something we would do with our own homes but in the 90’s it was all to common and certainly the way things got done under deregulation. All the more reason to learn from this and put safeguards in place that prevent entering into projects we can’t pay for in the normal principle and interest 30-40 year note process. I must wonder how many of these exist in the state and in authorities like the MWRA, the MBTA and even MassPort
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p>So when you look at Mayor Menino’s beautiful city just remember it was built on a bet and we lost.
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p>As Usual just my Opinion
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