In the past 15 years, the MBTA has paid Wall Street firms an estimated $236 million in interest after gambling on synthetic swaps. Such financial derivatives are rife with risk and were among the most significant contributors to the global financial crisis of 2008. The T’s reform-minded leadership would do well to trim these exposures, with an eye to eliminating them as soon as practically possible. Doing the right thing won’t be easy.
As Pioneer revealed in its February 2016 paper entitled “The Reckless Cost of MBTA Financial Derivatives,” the T built up and then doubled down on an irresponsible derivatives portfolio in the 2000s. Tempted by small upfront premiums offered by investment banks, MBTA managers made bets that interest rates would rise. At one time, these bets were on a notional principal of over $1.6 billion. This is certainly not the only example of the T seeding long-term disaster by taking what in the short-term appeared the easy way out, but it is a critical issue that must be addressed now.
The T’s risky “strategy” backfired as the Federal Reserve flooded the markets with liquidity and interest rates hit rock bottom. For years, the T has been paying tens of millions of dollars in annual swap interest. Unless the swaps are terminated, this is likely to continue for the foreseeable future, as interest rates are not headed much higher. At current rates, the swaps can easily cost the T some $200 million over the next 10 years.
In theory, these derivatives are supposed to offset the risk of wild fluctuations in interest payments on variable-rate bonds. The T pays the bank a fixed interest rate on the notional principal of the swap and gets back a variable rate similar to that on the variable-rate bonds. This convoluted structure is an imperfect equivalent of a fixed-rate bond. Then, why set it up? Well, so that investment banks can profit from incompetence at the T.
Massive counterparty risk is also among the hidden pitfalls of interest-rate swaps. While a fixed-rate bond provides certainty about how much interest will be due, a swap structure does not. Precisely when the swap insurance is likely to be needed, the counterparties tend to go under. The 2008 crash ended Bear Stearns, Lehman Brothers and Merrill Lynch as independent financial powerhouses. Since then, global financial debt has increased 22 percent, to $45 trillion, adding to the fragility of the system. The too-big-to-fail may have become too big to bail out – counterparties even less reliable than before.
Last year, a credit-rating downgrade of Deutsche Bank triggered a termination clause on its four swaps with the MBTA. An outside consultancy recommended shifting the swaps to Barclays, which had been downgraded alongside Deutsche Bank but remained within the “acceptable” range of credit risk. The T’s new leadership was wise to fire the swap consultant and retain another firm to help devise a considered debt-management strategy and borrowing policy for the authority.
Because of the prevailing low interest rates (and the fact that low rates make the swaps more expensive), it will be costly to buy out whatever swaps can be terminated right now. But removing them would end this unwelcome distraction and remove significant risk from the MBTA’s balance sheet. These are tough choices because they require paying more now to save later, short-term pain for long-term gain. However, they would also be a turning point in reshaping the T’s culture – away from its venerable tradition of financial mismanagement. Such an approach would send a clear message that it is not acceptable to take shortcuts when the T’s future and taxpayers’ money are at stake.
The good news is that the T faces these tough choices in the most favorable borrowing environment in recorded history. The MBTA’s borrowing rates are under half a percent. The roughly $500 million of floating-rate debt can be partially hedged by budgeting a large cash cushion. Cash is a better hedge than any insurance with any counterparty and proves handy for other emergencies as well. Thus, the T can realize savings on the terminated swaps with minimal interest-rate risk and no more than 5-10% variable-rate exposure in its portfolio, consistent with other state agencies. This exposure can be wound down gradually, as some of the variable-rate debt has already started to mature.
The time is ripe to take a harder look at the MBTA’s fixed-rate debt as well. While not as complicated as the swap termination, such an effort would be a massive undertaking. The MBTA’s $5 billion of fixed-rate obligations include a variety of debt instruments. The unique low-interest-rate environment means many of these bond issues can be retired by issuing cheaper fixed-rate debt, locking in the lower borrowing costs. Restructuring the T’s debt portfolio in this way can save tens of millions of dollars in annual interest for decades to come.
The right path forward is not easy, but holds real promise for the future. The Control Board can seize the moment and spark a profound transformation of the T’s financial management.