Originally created 06/04/06

You don't just get something for nothing in a municipal bond swap



The bond swap that the Augusta Commission has narrowly approved may appear as if the city can get something for nothing, but this is far from the case.

Despite the $80,000 that the commission has wasted on consultants to explain the swap, it is really a quite simple transaction. In this swap, Augusta pays Deutsche Bank one interest rate, and Deutsche Bank pays Augusta another rate. Each rate changes on a weekly basis, but so long as the interest rate Deutsche Bank pays Augusta is higher than the one Augusta pays them, the city makes a profit.

There are three serious problems involved with this swap, however.

First and foremost, there is no guarantee that the relationship between interest rates will remain in the city's favor. Augusta will be paying a short-term interest rate, in this case the seven-day Bond Market Association municipal bond index rate, and will be receiving a long-term rate from Deutsche Bank, in this case the five-year Libor interbank rate.

Historically, short-term rates are usually below long-term rates. But when inflation fears intensify and the Federal Reserve is raising short-term interest rates, those short-term rates can and usually do rise above long-term rates. Over the past several months, the gap between five-year rates and the seven-day rate has narrowed considerably as the Federal Reserve has raised rates and as inflation fears have picked up.

FURTHER FEARS of inflation because of high gasoline and other energy costs could potentially force the Fed to raise short-term rates further, in which case the rate the city of Augusta pays in the swap could be higher than the five-year rate it receives. In this scenario, the taxpayers of Augusta would owe money, potentially a considerable amount of money if inflation fears escalate.

In the early 1980s, short-term interest rates were as much as 6 percent above five-year rates; in such a worst-case scenario, the city of Augusta could owe millions of dollars on the swap, on top of whatever other deficit it might already face.

The second problem with the swap is that Augusta is forgetting why Deutsche Bank would ever enter into such an agreement in the first place - the bank is not simply giving money away out of charity. Where Deutsche Bank, or any other bank that enters such a transaction, makes money is through the fact that they pay the city a relatively stable interest rate whereas Augusta pays them a relatively volatile rate.

HISTORICALLY, VOLATILITY in the seven-day BMA rate has been much higher than in the five-year Libor rate. Augusta then has to worry that the volatile interest rate that it pays may jump much more than the generally more stable rate that Deutsche Bank has to pay. In the financial markets, we would have effectively given away an option on interest rate volatility. When interest rate volatility is high, Deutsche Bank wins and we the taxpayers lose.

The third problem with this particular swap arrangement is the lack of transparency in the way the swap agreement has been made. Instead of the city of Augusta requesting bids from various investment banks to enter into this basis swap, we have simply accepted the terms arranged by Gardnyr Michael Capital Inc., which is acting as the middleman between the city and Deutsche Bank. According to press reports, Gardnyr Michael or its employees have been contributors to former Commissioner Richard Colclough's campaign and to nonprofit organizations linked to Colclough and former Commissioner Bobby Hankinson.

A competitive bid process, in which brokers other than Gardnyr Michael would be invited to submit proposals, might result in better terms for the swap, and those better terms could mitigate the risk that Augusta would be taking. But solidarity among the friends of Colclough on the commission appears to have trumped better business practices, and we the taxpayers have given Gardnyr Michael a sweet deal in exchange for its campaign finance donations.

(Editor's note: The writer is an Augusta financial analyst who conducts research on interest rate markets.)