Friday, August 6, 2010

Exotic Municipal Finance

The New York Times has an article on the problems of the Denver school system. Needing to plug a $400 million hole in their pension system they turned to JP Morgan.
The bankers said that the school system could raise $750 million in an exotic transaction that would eliminate the pension gap and save tens of millions of dollars annually in debt costs — money that could be plowed back into Denver’s classrooms, starved in recent years for funds...
Rather than issue a plain-vanilla bond with a fixed interest rate, Denver followed its bankers’ suggestions and issued so-called pension certificates with a derivative attached; the debt carried a lower rate but it could also fluctuate if economic conditions changed.
The contract was signed just as the financial crisis was getting underway. So interest rates fell. Now, of course, the contract has turned against them and it is paying much more interest than planned, and to terminate the contract it will cost an additional $81 million.

It will be argued that the problem is derivatives. But the real issue is simpler. Should municipal agencies use exotic finance to cover their expenses. It comes down to two simple questions:
  1. Is the agency well-suited to speculating on the course of interest rates? Is it better able to forecast interest rates than those selling the derivatives?
  2. Is the agency well-suited to coping with the risks associated with such speculation?
It is hard to believe a school board could answer yes to either of these questions.

This is another example of where the lack of belief in market efficiency let somebody down. One could argue, in fact, that there is a normative reason to believe in market efficiency. Forget the positive evidence. Just believe markets are efficient, then you won't believe JP Morgan bankers can save you money without increasing your risk. If you do so, you are not going to be suckered into bad bets.

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