Sunday, November 5, 2017

Frank Newman: Council derivatives

Derivatives are the sort of things you generally only come across in movies about wheelers and dealers in far-away places like New York and London - but they have a relevance much closer to home.  You may be surprised to learn that the Whangarei District Council (WDC) has $244.5 million worth of interest rate derivatives. A council staff member has confirmed ratepayers are exposed to valuation movements on the full amount. That's a lot of money at risk, and raises many questions - but more on that later.

Derivatives are complex, but here's a simple run down on the basics, as I understand they relate to the WDC. A derivative is a generic term applied to a financial arrangement that derives its value from another market. These arrangements take many forms (futures, options, swaps), and very smart individuals sitting in high rise office towers around the globe keep coming up with new variations so they can enrich themselves by creating a new market and clipping the ticket on the deals that are done.

The WDC derivatives relate to interest rate swaps. An interest rate swap is where two parties "swap" interest streams that have different payment terms attached to them.  In the case of the Council they use derivatives to avoid the risk of interest rate changes on their debt servicing costs - they are hedging their risk. To do that, they enter into an arrangement whereby they would receive the variable (spot) interest rate on an agreement amount of debt from the other party to the transaction (which offsets the variable interest they are paying on their debt), but they agree to pay a fixed rate to that party. In effect they have  swapped their variable rate debt to a fixed rate.

As a result, the Council is shielded from rises in interest rates (at least for the agreed term of their swap agreement). Conversely, if interest rates were to decline they would miss out on the benefit of those lower rates.

Essentially there are two types of participants in derivative markets - hedgers, like the WDC, who want to eliminate risk, and speculators. Speculators have no involvement with the underlying commodity or financial instrument itself, but want to make money by correctly anticipating the direction of a market (interest rates in the case of an interest rate swap). The speculator wants to benefit from the very uncertainty that the hedger is trying to avoid.

What is a little surprising is that the WDC has $244.5 million worth of interest rate derivative contracts, which is a lot higher than its external debt of $162 million in the form of debentures (loans secured against the council's assets). In effect the WDC is fully hedging on its $162 million debt, but speculating on the $82.5 million of additional derivative cover.   
The WDC may have a good reason for doing so, but it needs to explain that in the annual report. The Annual Report does have some reporting on risk in the sensitivity analysis section, which in essence says that a half a percent fall in interest rates would cost ratepayers about net $3 million.

The problem with Interest rate swaps is their complexity. Even renowned hedge fund manager George Soros is quoted as saying, "the risks involved…are not always fully understood, even by sophisticated investors, and I am one of them.”

Therein lays the danger. If George Soros struggles to assess the risks, how are councillors going to do so? Do they understand enough to question staff? Do staff understand enough to question the people managing the swaps for them? Do the media understand enough to ask the right questions? I suggest the answer is all cases is likely to be ‘no’.

The most notable case of a municipality getting into strife over interest rate derivatives is Orange County, California, in 1994.  Fortunately the WDC is not in that league, but given how little is understood about WDC's derivatives it needs to do a far better job reporting the costs and benefits of having the contracts. Have ratepayers benefited from these contracts? What has been the financial cost or gain over the last year, and over the last five years?

One would hope that this is a matter addressed by Audit New Zealand, but they make no mention of derivatives in their statement contained in the Council's 2017 Annual Report. A comment to the effect that they have reviewed the derivative contracts and are satisfied they do not pose an undue risk would be useful, but it is not unreasonable to expect the Council to provide a thorough report to ratepayers on the benefits and risks of Council's use of derivatives.  It is after all, ratepayers who would pick up the bill if the derivatives turn bad.  

Frank Newman writes a weekly article for Property Plus.

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