New York is twice impacted by the collapsing world of complex finance: first for the obvious reason and second because in recent years, it has structured much of its own $54 billion in debt in a way that makes the city more acutely vulnerable to intense market disruptions. It’s also more vulnerable to double-backing effects from its own future fiscal crises, should it ever come to that.
This morning, the Times detailed some of this risk in discussing how municipalities have increased their variable-rate and derivative-dependent debt:
Governments generally prefer fixed-rate bonds because the cost is predictable — but variable-rate bonds were attractive because of their generally lower rates. Securities firms tried to merge the best of both worlds by linking derivatives contracts to municipal bonds. One structured product was a variable-rate demand note, which gave the investor the option of putting the note back to the securities firm if the investor decided the rate was too low.
When investors grew nervous about the creditworthiness of those securities firms, including Lehman Brothers, they started returning these notes back to the source.
Further, when the money markets which provide the funding for other types of variable-rate notes dried up starting two weeks ago, municipalities found that they could not access such funds for the rates to which high-quality municipal issuers like New York were accustomed. (The Times doesn’t provide figures here, but other sources have noted that issuers that a few months ago were paying 2 percent or so annually were paying 5 to 10 percent.) Of course, when a city or town has fixed-rate bonds, it dooesn’t face this risk; it doesn’t matter to that issuer what current interest rates are until it’s time to issue a new fixed-rate bond.
New York City, in particular, through its increased issuance of variable-rate debt, has made its budget vulnerable to what could be hundreds of millions of dollars in extra interest-rate costs, should the credit-markets freeze last through the end of the year. As the city comptroller notes, as of December, and as FW noted a year ago, citing an earlier comptroller report, New York had nearly 21 percent of its borrowing obligations in variable-rate debt, or nearly $12 billion, up from negligible levels a decade ago.
If the city is forced to pay sharply higher rates on just half of that debt, or forced to refinance into fixed-rate debt at higher rates, it could see interest costs increase by $200 million a year, just when it is scrambling to save every penny. (New York hedges some of this risk, but hedges have a nasty habit of not working just when you need them to.) Yes, the city has saved money over the years through this type of structured-finance, but it may turn out that it wasn’t worth it in the end.
The real risk for the city gets worse, though. New York, much like companies like AIG and Lehman, has also increased the chance that it could start bleeding cash in a real city-specific credit crisis. How? Read this excerpt from a Moody’s report, published in early September:
The city has entered into 12 interest-rate swap agreements associated with its general obligation bonds … and two swaptions …. As of June 30, 2008, the net marked-to-market value of the swaps and swaptions was -$55.7 million. Thirteen of the agreements could terminate early if the city’s rating were to fall below Baa3. One agreement could terminate early if the city’s rating were to fall below Baa1 and its marked-to-market value was less than -$75 million. In each case, the city would be required to post collateral. There are also two swaps and two forward-starting swaps related to city appropriation-backed debt issued through the Dormitory Authority of the State of New York. … The counterparties have the right to terminate the agreements if the city’s rating were to fall below Baa3. If the city’s rating were to fall below Ba2, DASNY would be required to post collateral. … Additionally, there are seven outstanding swaps associated with appropriation-backed debt issued through the New York City Industrial Development Agency …. The counterparty could terminate the agreement if the city’s general obligation bond rating were to fall below Baa3.
Of course, the city’s rating hasn’t been that low in nearly 30 years. Still, stranger things have happened, and these what-if blowups might be risks New York doesn’t need lurking in its fiscal corners.
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