Gambling, Losing, and Complaining About It

There has been a recent uproar from citizens and politicians, in Los Angeles and a number of other cities and counties in the U.S., over municipal interest rate swaps that are now costing local governments millions of dollars a year. An interest rate swap is essentially a legal bet between two entities, one of which is trying to hedge its interest rate exposure. In Los Angeles’ case, the swap was made with Bank of New York (BNY) Mellon, who in 2006 exchanged $443 million worth of fixed-rate debt for an equivalent amount of variable-rate debt issued by the city.

Los Angeles made the deal to protect itself against the possibility of rising interest rates, which would have increased the interest owed on its variable-rate municipal bonds. However, in agreeing to this exchange, the city exposed itself to the risk that interest rates would fall, which they of course did—dramatically. The payoff in a swap is determined each quarter by the spread (difference) between the variable and fixed rate. Thus, the fixed-rate buyer stands to gain if interest rates rise, or lose if they fall.

Four years and one economic crisis later, the City of Los Angeles finds itself on the hook for $19 million a year (at today’s interest rates). But rather than accept the consequences of its gamble, or opt to refinance the floating rate debt with fixed-rate bonds, the city is demanding a renegotiation of the deal and threatening to never do business with BNY again if it does not comply. The most vocal cry baby of this effort is city councilman Richard Alarcon, who according to the LA Times described the deals as “tantamount to gouging” and likened the bank to merchants who sold water for $20 per gallon after the 1994 Northridge earthquake.

Conveniently, Mr. Alarcon doesn’t bother to mention that the City of LA, arguably a sophisticated investor, agreed to the deal, in which BNY also assumed risk. This is very different from the price-gouging merchants, who were taking advantage of increased demand owing to a natural disaster. “The bank is taking an unconscionable profit,” said Alarcon according to the Wall Street Journal. “We want to bring it down to a simple customer-to-vendor relationship. When a customer is not satisfied, they go to a different vendor.”

Yes, Mr. Alarcon, LA is welcome to use a different swap vendor in the future, but the city still owes the money on the legal contract signed by consenting adults. We feel that there is even less substance to these claims than to those of a gambler who asks for his losses back from the casino.

Taxpayers in LA and other municipalities where interest-rate swaps have gone awry (such as Jefferson County, AL which owes $3.2 billion on sewer bonds) are probably all wondering the same thing: Why gamble? Swaps are typically used as a hedging instrument. For example, if you have exposed yourself to the risk of rising interest rates from issuing floating-rate bonds, you can mitigate that risk (and any reward if interest rates drop) with a swap. So the city either made a cold bet on the future of interest rates, or it has succeeded in hedging another risk and still wants to recoup its losses on these swaps. What we are seeing here is nothing more than a case of buyer’s remorse at the municipal level.

Currencies and Purchasing Power

This week we are looking at the fluctuation of currency exchange rates, as well as the effects of exchange rates on investors and consumers. The exchange rate between two currencies indicates the relative worth of one currency against the other. As I write this article, the Euro-to-US dollar (EUR/USD) exchange rate is 1.36 – one Euro has the equivalent value to $1.36 USD. The American dollar-to-British Pound (USD/GBP) exchange rate is 0.66, so an American dollar in England can purchase £0.66 worth of goods. In efficient markets, equivalent items should cost the same in all countries; this is known as “the law of one price.” But since prices cannot adjust to rapidly fluctuating exchange rates, the purchasing power of one currency against another is constantly changing.

Purchasing power parity (PPP), based on the law of one price, attempts to find the appropriate exchange rate so that an identical good in two different countries has the same price in terms of purchasing power. In theory, PPP should determine exchange rates; in the real world, currencies fluctuate for all sorts of other reasons, while the prices of goods and services remain constant over short periods of time. (A notable exception is The Trader Bar in Melbourne, Australia, where the price of each drink fluctuates based on the current demand. A lighthearted, though effective, illustration of PPP is The Economist’s Big Mac Index, which compares the price of a McDonald’s Big Mac in different countries against the country’s exchange rate to show how relatively expensive or cheap each currency is.

The market exchange rate determines the purchasing power of one currency relative to another, but what determines market exchange rates? Let’s look at the recent situation in Europe and how it has affected the purchasing power of the Euro. Currencies fluctuate similarly to bonds in that a rise in interest rates results in a decrease in the currency value, which happened recently as a Greece, Spain and other European nations issued a large amount of debt. Uncertainty over these governments’ ability to repay loans to their investors forced them to issue debt at a higher interest rate than previously; as expected, the Euro declined sharply. For example, relative to the US dollar, Australian dollar and Yen, the Euro has fallen -4.90%, -5.63% and -7.66% respectively since January 1, 2010. These are drastic declines over such a short period.

Investing in the foreign exchange market is unique in that it operates 24/7 and produces small profit margins in comparison to other markets. As a rule, I do not attempt to use currencies as long-term investments. I do, however, occasionally hedge against large fluctuations in exchange rates that may affect my foreign investments by using various techniques. Currency fluctuations don’t usually affect investment returns that much over the long term, but exchange rates can be highly volatile over short periods of time.

In the long run, purchasing power parity should determine the relative value of currencies. But in the short term, currencies can be substantially over or undervalued, such as the Yuan which the Big Mac Index estimated to be almost 50% cheaper than the US dollar. So if you are looking for the best price on Big Mac’s, look no further than Beijing!