Swap Mess

October 14th, 2015 10:12 am | by John Jansen |

This story about the cost of unwinding swap agreements by the City of Chicago reminds me that the only perfect hedge is in a Japanese garden.

Via Bloomberg:

Chicagoans’ Cost to Exit Swap Agreements Approaches $300 Million
2015-10-14 14:01:48.60 GMT

By Elizabeth Campbell and Darrell Preston
(Bloomberg) — Chicago’s attempt to clean up a legacy of
wrong-way bets on interest rates is costing taxpayers at least
$270 million since Moody’s Investors Service cut its rating to
junk in May, city documents show.
The payouts to Wall Street banks, which come as the Windy
City considers a record tax increase to cover pension costs, are
more than the city spends a year to collect garbage at 613,000
homes, and could cover the cost of hiring more than 2,000 police
officers. The pain isn’t over yet as officials plan another
round of debt restructuring that could cost $110 million to
unwind derivatives on its water debt early next year.
“I don’t think the public should be gambling with its
funds,” said Richard Ciccarone, Chicago-based chief executive
officer of Merritt Research Services, who has been analyzing
municipal finance since the 1970s. “Save the speculation for
people who risk their own money, not for taxpayers.”
The city was forced to restructure obligations after
decades of failing to address its rising pensions and borrowing
to cover debt service, a legacy that began under former Mayor
Richard M. Daley and continued until this year under Mayor Rahm
Emanuel. Moody’s downgrade of Chicago’s general-obligation debt
in May forced the city to begin a debt restructuring the mayor
was already planning.
Chicago and other municipal borrowers in the past decade
made bets on the future direction of interest rates through
agreements with banks to swap interest payments. But when rates
fell under the Federal Reserve’s attempt to stimulate the
economy after the financial crisis, many issuers ended up on the
wrong side of the bets. Since then issuers have paid at least $5
billion to unwind the agreements.

Sewer Debt

The city is selling $439 million of bonds Wednesday, part
of which will cover $70.2 million to end an interest-rate swaps
tied to variable-rate debt for the city’s sewer system. That’s
on top of $185 million paid to unwind swaps on general-
obligation and sales tax debt since May. The estimated $270
million total also includes the cost to banks and other
professionals to restructure, according to data Bloomberg
compiled from city documents. Chicago owed as much as $396
million to banks in March, before the city started terminating
the swap agreements, according to market values at the time.
Chicago paid less than mark-to-market valuations, said Molly
Poppe, a city spokeswoman.
While the city’s refinancing and tax hike increase the
burden on residents at a time when the city’s finances are
already squeezed, investors and credit raters have praised the
move. One month after cutting Chicago’s rating to speculative
grade, Moody’s called the refinancing a “credit positive.” Now
there’s more certainty about how much the city may have to pay
out, Matt Butler, a Moody’s analyst in Chicago, said in a June
11 report.

Yields Decline

Chicago’s bonds has rallied since Emanuel pitched his plan
to raise property levies by $588 million over four years.
Federally tax-exempt bonds maturing in 2038 traded last week for
an average of $1.04, up from $1.01 five weeks earlier, before
the tax hike was announced. That trimmed the yield to 4.5
percent from 5 percent, according to data compiled by Bloomberg.
“It felt like the market was not comfortable with the
amount of risk that we were taking,” Carole Brown, Chicago’s
chief financial officer, said in an interview Monday. The
restructuring “demonstrates kind of a conservative and
responsible financial practice to eliminate that risk by
eliminating those swaps.”
Wednesday’s deal will take care of the wastewater swaps,
and the city will likely end the water-swap agreements in early
2016, according to Brown. Chicago will have to pay about $110
million to terminate the later, according to the city.
About $332 million of the sewer issue is federally tax-
exempt and will be re-offered as fixed-rate obligations, and an
additional $107 million of taxable debt will help cover the cost
to terminate the agreements, according to bond documents.

Borrowing Costs

The second-lien wastewater bonds, which are repaid from
sewer-system revenue, won a higher rating from Standard & Poor’s
this week, which raised its rating by one step to A, five levels
above junk, and applauded the elimination of the liquidity risk.
S&P has a stable outlook on the debt.
The wastewater credit faces “elevated volatility” because
of its ties to the city, said Robert Amodeo, head of municipals
for Western Asset Management Co., which has $452.5 billion under
management, including some Chicago debt. He said he is
considering buying the wastewater bonds given the strength of
the underlying credit.
“There are some ongoing challenges there,” Amodeo said in a
telephone interview from New York. “You can’t completely
separate it from the city.”
The city’s ratings and borrowing costs are tied to its
progress in getting the refinancing done, according to Brown.
The hope is that credit companies will respond positively to the
Emanuel administration’s steps to secure revenue for pensions,
and eliminate the liquidity risk, leading to a higher rating and
better borrowing costs, she said.
In the meantime, taxpayers in the city of 2.7 million are
on the hook for the higher tab tied to deals made decades ago.
“We’re paying these fees at the same time the city is
looking at the biggest tax increase in its history,” said Saqib
Bhatti, a Chicago-based fellow at the Roosevelt Institute, which
has been recommending that governments with swaps should push to
cut the fees rather than pay Wall Street banks. “Working
residents of the city are going to have to sacrifice to for the
city to pay these fees to the banks.”

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