Stock Market and Investment Losses and Credit Crisis and State Government and Investing and Opinion and Investing Column and Banking & Finance and Government

Complex bond schemes haunt Indy, other cities

April 20, 2009

The city is just beginning to digest the news that came out of left field regarding Indianapolis Water Co.'s bond transaction gone wild.

The fiasco is the result of derivatives used to alter the character of the interest payments on IWC bonds issued via the Indiana Bond Bank in 2005. Back then, these derivative transactions were the Wall Street concoction du jour and were sold to municipal leaders as money-saving strategies.

These complex arrangements imploded with the credit crisis and have turned out to be financial black holes from which there is no easy escape.

Federal Reserve Chairman Benjamin Bernanke has said he is aware that some governments are stuck in interest-rate swaps that no longer work as intended. Congress recently asked the Fed to help dislodge the credit problems that are now haunting the municipal bond market.

Bernanke countered that the Fed doesn't have the ability to affect that market, although he did suggest that a federal bond-reinsurance program could assist municipalities in restructuring their debt obligations.

Miscues like that which took place at the Indiana Bond Bank are playing out across the country. Civic leaders in Birmingham, Ala., are trying to rectify a bond-derivative disaster that has the county teetering on bankruptcy. In Tennessee, numerous towns are dealing with similar default scenarios, causing the comptroller of Tennessee to freeze all derivative transactions on municipal debt.

These interest-rate swaps and auction-rate strategies were put together by Wall Street's financial mathematicians who relied on complex models to test their performance under various market environments. The products they devised and sold promised the preposterous ability to turn higher-cost longterm debt into lower-cost short-term debt.

It is clear now that even the creators of these black-box "structured products" did not understand them. Their ultimate destruction was sealed with the global liquidity crunch, caused by failing subprime loans and excessive leverage—factors that obviously were not considered in their models.

Moody's Investor Services has now issued a negative outlook on the creditworthiness of all local governments across the United States. This was the first time the firm has ever issued such a blanket report, and it affirms the stress on municipal governments as revenues fall amid the economic downturn. Moody's also suggested that conflicts lie ahead between taxpayers who are struggling with their own household budgets and elected officials who are searching to boost revenue via tax increases (or, in IWC's case, rate increases).

With financial bombs like the $100 million cost of IWC's bond debacle and the $40 million shortfall at CIB, those predicted confrontations have already arrived in Indianapolis.

One thing civic leaders, and all investors, should learn from this episode is that, when the Armani suits show up (the wolves in sheep's clothing) bearing complex investments that claim outcomes too good to be true, just remember that there is no free lunch.
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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