Wrong-Way Financial Bets Have Hit Hard (Wall Street Journal Page C1 - July 8, 2010)
The Wall Street Journal ("WSJ") ran an article on the front page of the Money and Investing section titled "Wrong-Way Financial Bets Have Hit Hard" (see the post script for the link to the online article), which is riddled with fallacies. I am under no delusions and realize that anything I say, no matter how true, will be a mere whisper in the nose-bleed section of a Metallica concert compared to the WSJ's reach. Nevertheless, I just can't bear to read such a biased article without standing up and speaking the truth to all who will listen.
A reader with no background knowledge was likely left with mental images of a nefarious investment banker in a black pin-striped suit grasping a bleeding IV in one hand, that was just ripped out of the arm of an elderly patient in the ICU, and a stack of "contracts" in the other. Another image that may come to mind is a huddle of these banksters over a roulette wheel taking "bets" from their clients, while grinning at the thought of making their vig. Those mental images conjured by Mrs. Dugan are just the kind that sell newspapers.
The article describes interest rate swaps executed by various hospitals (and health systems) across the country. While the article fails to name the exact product (likely due to the author's ignorance of the subject), it is clear by the description that it is a floating-to-fixed rate swap. The article is unambiguous in its characterization of these transactions as speculative through the use of such terms as "wager," "bet," and "betting" in seven places throughout the text. This is a blatant, willful mischaracterization. I challenge Ianthe Dugan to produce a single hospital throughout the country that "[bet] incorrectly that interest rates would rise" through the use of an interest rate swap. The transactions were all reviewed and approved by the Boards serving these hospitals that are made up of local community leaders. Does anyone really believe that these individuals, that are highly respected community members, would make a multi-million dollar "bet" that interest rates would rise?
What is a floating-to-fixed rate swap?
A floating-to-fixed rate swap is a transaction in which one counterparty (the hospital) pays a fixed interest rate and the other counterparty (the bank) pays a floating rate. The glaring oversight that Mrs. Dugan fails to explain is that these transactions are not executed in a vacuum. Virtually all, if not every single one, of these transactions were executed in conjunction with the issuance of floating rate debt. When you look at the swap and floating rate debt together, the hospital is left with a "synthetic" fixed rate. The cashflows look like this (from the hospital's perspective): pay fixed rate on swap, receive floating rate on swap, and pay floating rate on bonds. The floating rate on the swap is structured in such a way that it is expected to equal the floating rate paid on bonds. On a net basis, the hospital is left paying the fixed rate on the swap, which is called a "synthetic" fixed rate.
Why would anyone enter into a floating-to-fixed rate swap?
Hospitals executed these transactions because it offered a lower cost of debt. For example, let's say that a hospital could sell a plain vanilla, 20-year fixed rate bond at 5.50%. The hospital would be able to sell synthetic fixed rate debt at some lower cost (let's say 5.00%). In this case, the synthetic fixed rate structure would offer 0.50% in savings versus a traditional fixed rate transaction. So long as the floating rate received on the swap equals the floating rate paid on the bonds, the hospital is left with the synthetic fixed rate of 5.00%. Mrs. Dugan made the argument that the transactions backfired when the Fed cut short-term rates, but that is simply untrue. The cuts in short-term rates did cause hospitals to make net payments under the floating-to-fixed rate swaps, but this was offset by lower floating rates on the underlying bonds.
Many hospitals across the country executed these transactions and enjoyed the benefit of lower net rates. There are, literally, hundreds of hospitals across the country that used this structure to fund projects at lower rates, which allowed them to build larger projects that provided much needed hospital beds in their communities, and spurred job creation.
What are the risks of swaps?
As is the case with any financial product, there are risks associated with them. The majority of the problems that arose were associated with the underlying floating rate bonds, not the interest rate swaps. Hospitals that used Auction Rate Securities ("ARS") as the underlying variable rate product suffered as a result of the ARS market failure. In addition to the risks associated with the underlying variable rate products, there are risks associated with the "mark-to-market" of the swap. The value of a swap changes as a result of movements in interest rates and to the extent that long-term interest rates fall, the value of the swap will be negative to the hospital. In other words, if the hospital wanted to terminate the transaction early, they would need to make a payment to do so. This risk was realized when hospitals with underlying variable rate products that failed had to terminate the swap before maturity. There are many other risks associated with swaps that are beyond the scope of this article. If anyone is interested in those, please let me know in the comments section and I will be happy to provide an article dedicated solely to the risks of swaps.
Despite these risks, there are many other hospitals with underlying floating rate debt that is still performing and they are enjoying the benefit of lower rates afforded by the synthetic fixed rate structure. Those hospitals that did not make the WSJ article are accumulating those savings, and will ultimately invest those funds in new facilities, renovations, and other projects aimed at improving patient care.
In conclusion, these transactions were not something dreamed up by a mad scientist to dupe the hospitals across our country. More importantly, they absolutely were not "wagers" or "bets". They are financial products that come with risks, as well as rewards. Articles like the one that Mrs. Duganwrote may do a good job of selling newspapers, but they paint a picture of Wall St. that is just not true. The vast majority of Wall St. investment bankers are honest people that care deeply about their clients. It is appalling that the WSJ would print something that is this far off the mark with an utter disregard for the reality of the situation. Perhaps it was my own naivete to trust any source of news, but I now find myself reading everything in the WSJ with a heap of salt. I hope more people that work on Wall St. will start standing up for themselves, and speaking out against the "Wrong-Way" journalism being perpetrated by the likes of Mrs. Dugan.
Sincerely,
Muniwiseguy
Post Script
The online WSJ article is titled "Hospitals Sue Wall Street Over Trades". This is different than the title of the hard copy, which was "Wrong-Way Financial Bets Have Hit Hard". Note that the count of seven references to "wagers", "bets", and "betting" was based on the hard copy version that included "bets" in the title. The link to the online article is: "http://online.wsj.com/article/SB10001424052748704545004575353190698790172.html".