One of Andrew Clavell’s best posts is the one where he was giving advice, retrospectively, to a Pennsylvania school board which was being sold swaptions by investment bankers:
Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.
It’s not just Pennsylvania school boards, of course. It’s also Alabama sewer systems. If you want all the gory details about what went wrong with Jefferson County’s sewer debt, then Bloomberg has a 3,300-word article explaining the whole thing. But suffice to say that Jefferson County managed to get itself embroiled not only in an interest-rate swap gone, wrong, but also in bond insurance from Financial Guaranty and XL – and, to top it all off, it also managed to issue $2.2 billion in auction-rate securities.
The Bloomberg article talks a lot about the consequent fiscal hardships in Jefferson County, where the $145 million a year available to make interest payments is at least $100 million short of its annual interest bill. The article doesn’t talk about losses elsewhere, which have come as a result of S&P downgrading Jefferson County’s auction-rate securities to CCC.
But those losses can pop up in the most unlikely of places, including Israeli technology companies. Here’s the press release announcing IncrediMail’s latest quarterly results:
Financing expenses for the year and the quarter included a one-time write-down of $4.9 million taken to reflect the revaluation of a $5.0 million Auction Rate Security purchased as an investment in July 2007. Recent volatility in global credit markets has adversely affected the liquidity of this security. As a result, the security was recently downgraded from a AAA to a CCC rating by Standard & Poor’s. Although the Company continues to receive interest payments every 28 days, in light of a valuation of the security recently received from the Company’s banker, the Company has recorded an “other than temporary impairment” charge of $4.9 million on its statement of operations.
It’s certainly hard to value illiquid auction-rate securities, but writing down a still-performing $5 million ARS to just $100,000? That’s quite amazing: IncrediMail should be earning that much in interest alone in just a few months.
Now I don’t know that IncrediMail owns Jefferson County sewer bonds, although they fit the description. But I do know that all the losses here are a function of municipalities and corporations being sold financial instruments they didn’t fully understand, with large profits for investment banks along the way. And when I say large, I mean enormous:
The county paid banks $120 million in fees — six times the prevailing rate — for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.
In February, the county’s interest rate soared to as much as 10 percent, up from 3 percent just weeks earlier. The swaps have now compounded the risk that Jefferson County will file for bankruptcy as it faces its worst financial crisis since it was founded in 1819.
Did Jefferson County know that it was paying $120 million in fees? I doubt it. Even relatively ignorant municipal treasurers know that interest-rate swaps aren’t exactly rocket science, and fees on them should never be that large. But just like capitalized closing costs on a subprime mortgage, fees aren’t always disclosed in an obvious and transparent manner. Especially when the bankers on the deal, such as Charles LeCroy of Raymond James and then JP Morgan, are the kind of people who end up getting fired, convicted on federal fraud charges in Philadelphia, and sentenced to three months in jail.
But it’s not outright fraud which is the problem here, it’s more the culture of greed on Wall Street. Sometimes it can result in genuinely useful innovations; at other times, it can result in poor Alabama counties being forced to declare bankruptcy, with knock-on effects which can reverberate all the way to the other side of the planet.