Category Archives: Finance
Jeb Hensarling is not a person I am particularly fond of. He consistently votes against hate crime legislation, LGBTQ rights, pro-choice and women’s rights, and other morally correct things to do. He is socially conservative, and promulgates all of the negative social rhetoric that characterizes social conservativism. The world would be a better place if he were not a Member of Congress. Nevertheless, I actually agree with many of his positions on economics. How could I be so diametrically opposed to conservatism and yet agree with some of his policy?
I think the answer to this question lies in the distinction between social and economic policy, or more so, social conservatism and economic conservativism. I would characterize my political position as economically conservative, and much farther to the left socially. As a society we have coopted all of conservatism into Republicanism, and all of liberalism into being a Democratic, but truly that is not the case. The political spectrum is at least two-dimensional, and I certainly do not identity myself on the one-dimensional left-right spectrum.
Jeb Hensarling is the Chairman of the House Financial Services, which makes his opinions on financial matters of outsized importance. And recently, he has come out against a number of policies that I too do not hold favorably:
- Export-Import Bank
- Flood Insurance
- Terrorism Insurance
Before diving into the policies and the foundations for our opposition, it is helpful to expound a bit on my personal economic philosophy. Market intervention is warranted by the government when there is the presence of a market failure. Furthermore, regulation is justified when government policy creates perverse incentives that ought to be contained. For instance, heavy industry generates pollution, which is a cost that people who do not necessarily consume the products of industry have to incur. This is known as a negative externality and is an example of a market failure. Therefore I believe that the government has a role in helping to resolve this failure.
Similarly, many countries in the world have deposit insurance for banks. Because of this assurance banks may take more risky gambles. This is known as moral hazard. Therefore I believe that the government is justified in regulating banking, insofar as the regulations are crafted to control the moral hazard that its policies create. However, beyond these types of corrective interventions in the market, I believe that the government should not intervene and let market forces prevail, which is to the benefit of all actors in the economy. I believe that those statements express a philosophy of economic conservativism. And certainly, in terms of economics, I may not be as far right as certain conservative politicians – the Rands come to mind – but I am certainly to the right of most self-identified liberals.
Recently, since this section of the article was drafted, Congress outgunned our man Jeb and pushed the reauthorization of the bank through
The Ex-Im Bank is a government sponsored enterprise, first established during the FDR Administration. It borrows money at the government borrowing rate (Treasury rate), and then uses that money to support American industrial exports abroad. It has four main financial programs:
- Direct loans to foreign purchasers
- Guaranteeing loans made by banks to foreign purchasers
- Insuring loans made by US exporters and banks to foreign purchasers
- Loan guarantees for working capital lines of credit made by banks to American industrial firms
The purpose of these financial activities is to promote exports; in particular, to finance exports that the private sector deems too risky. Loan guarantees make up the bulk of Ex-Im financing. Direct loans are second up. Smaller firms typically take advantage of the working capital guarantees, particularly since their banks get nervous when receivables are in a foreign currency.
Due to the Ex-Im Bank’s ability to borrow at the Treasury rate it is a very profitably institution. So profitable in fact, it kicks money back to the Treasury – about $1 billion a year. The bank is not appropriated any budget funds, and has a very low default rate. However, the mission of the bank is not to generate income for the federal government. The purpose is to promote exports, support the American industrial and manufacturing economic base, and create jobs. Jobs jobs jobs!
Hensarling & Co. dislike the Ex-Im Bank because they consider it “corporate welfare,” a clever piece of rhetoric meant to mean, ‘giving money to rich companies that don’t need taxpayer help making any more of it.’ They claim that for all the money it dishes out it is fundamentally excluding other businesses. Other worthy businesses. And this is not right, so they oppose the bank, which primarily support America’s largest companies, such as Boeing, GE, and Caterpillar.
This simply is not the case. To construct the Ex-Im Bank as a deliberate attempt by the US government to support fat cats at the expense of other businesses is a distortion of reality. The government does not spend any money on the bank. Given the government’s ability to borrow at low rates, the government could set up any number of financial institutions with a similar financing model and support any industry it sees fit. It just happens to be that for 80 years the government has chosen to specifically support industrial exports (and many other industries, which the Tea Party is choosing not to mention). The opponents of Ex-Im are simply using the bank for political theatre. Like most of their arguments, their rhetoric is misleading.
Why don’t I particularly care for the Ex-Im Bank? It is because there is no evidence to point to a market failure in the export financing sector. Furthermore, the bank creates export subsidies, which distort international markets away from their natural equilibrium. It’s the same reason that I am in favor of free trade agreements. However, over 60 countries have export credit agencies like the Ex-Im Bank, so there is more or less an even playing field. But there would be just as much of an even playing field if every country scrapped their subsidies and let the market take care of international trade on its own.
Furthermore, the Ex-Im Bank is a government sponsored enterprise (GSE). It borrows at government rates and uses that money to guarantee loans aligned with the government’s long-term goals. This is exactly like Fannie Mae and Freddie Mac, the two most notorious GSE’s (which, not to my surprise, Hensarling also opposes and has sought to wind down). Now I am not saying that the Ex-Im Bank is headed towards a default a-bomb (nor am I saying that it is not), but in general, I am opposed to GSE’s. When the government supports a particular market and not others it picks winners and losers. Not particular companies as winners and losers (like Hen-chmen claims), but particular industries, as the recipients of capital or not. People see winners and shift their capital to those fields. Capital pools in one industry, whereas a more even distribution among industries may be more optimal. In addition, it actually creates moral hazard, wherein financers take on more risk than they normally would have because of the government guarantee.
With Fannie Mae and Freddie Mac, this all contributed to a huge housing bubble. The country did not need so many new single family homes. We needed affordable housing, infrastructure, investments in education, and a host of other capital intensive construction, but because of the government supporting home ownership, everyone went full speed ahead into housing until it was too late.
I don’t believe that we are in a manufacturing and industrial export bubble; however, the market may be distorted by the cheap capital flowing to the sector from the government. The market may naturally be demanding renewable energy, infrastructure, affordable housing, technology, and software, but instead a disproportionate flow of capital is going to heavy industry. In my opinion, it would just be better to not directly financially support particular industries with capital, and instead just create policies that allow industries to flourish naturally (tax policy, employment policy, intellectual capital and patents, etc.).
During an industry’s infancy direct capital support may even be the correct policy, but as an industry matures, which heavy industry in the United States certainly has, so too does the policy need to, and the capital support needs to taper and eventually disappear. This has not happened, and we continue to see massive American firms such as GE, Boeing, and Caterpillar, getting the largest sums of our export credit support.
I nearly wrote an article about government flood insurance a few years ago after Hurricane Sandy, but everything that needed to be said at the time was published by other people, so I abstained from writing my own opinion. But I think that now is an appropriate time to return to the topic.
Private homeowner’s insurance does not cover flooding. It used to, until the 1950’s and 60’s, when losses were mounting to insurance companies, premiums were rising, poorer people in flood zones were left – ahem – without a paddle, and insurance companies began dropping flood coverage altogether. Federal flood insurance covers this gap. Homeowners pay premiums and the government covers losses. Originally, the program was implemented to reduce the government’s exposure to flood losses. FEMA was paying out large sums after natural disasters to uninsured homeowners, so the insurance program was extended to communities in flood zones that were willing to adopt flood mitigation and management plans. In addition, the federal government hoped that by pooling funds into a national program, localized events could be covered and absorbed by premiums paid into the system nationwide.
However, in practice, the supposedly self-sustaining program has become costly and far from self-sustaining. Rates remain below market levels and risk has been poorly quantified and distributed. The system (which is administered by FEMA – they’re doin’ a heckofa job!) has borrowed from Treasury on multiple occasions, and is currently $24 billion – ahem – underwater.
One of the problems is the flood maps. Anyone living in a flood zone as indicated on these maps is legally required to have flood insurance. But the maps are outdated and not accurate. They underestimate the risk of floods. As a result, people who are in fact in flood zones, even though they do not have insurance because the maps do not require them to, are getting flooded out and requesting emergency relief funds. Plus, people who do have coverage are under-insured because the maps are not adequately estimating the risk that they are under.
The problem with risk identification does not point to a philosophical objection to the policy, but instead a problem with how it is carried out. These problems could be resolved by simply updating the flood maps and having premiums reflect actual risk. However, I have a more fundamental objection to the national flood insurance program: people who do not live in flood zones are subsidizing people who do live in flood zones.
I am from the Hudson Valley, which is historically a relatively safe place to live and not flood-prone. It is one of the reasons why I love my home region. And as a taxpayer, I do not want my tax money to be subsidizing people who have multiple homes or choose to live in riskier areas, such as beachside. Government policy should be incentivizing development in less-risk regions, and people who elect to live in riskier zones should foot the entire bill themselves (in this case through a private flood insurance market).
Of course, there are always questions of poverty and mobility. There are many impoverished communities around the United States in flood prone areas. I am amenable to a program that assists these communities, but this would be a vastly scaled down national flood insurance program, not the $24 billion indebted behemoth that we see today. Over time the country would be better off if flood-prone regions became less populated. Scaling back flood insurance would achieve that. Some of the saved money could even be used for relocation assistance, or any number of other assistance programs.
The Terrorism Risk Insurance Act (TRIA) was enacted after September 11, 2001 so that large development projects could continue as insurance companies, banks, and developers, readjusted their models for terrorism risk. It has been continually renewed since them. It is supported by Congresspersons and Senators from major metropolitan areas, developers, and of course insurance companies who can transfer their risk to the federal government. Organizations such as the NFL and NASCAR also support TRIA, since it helps to insure large events such as the Super Bowl.
Treading into appropriate risk and terrorism is an ideological minefield. Dare I ‘let the terrorists win’? Pushing aside those considerations (which, yes, I believe are asinine), if there is risk in development, then I believe that the federal government and by extension, the taxpaying public, should not have to bear the risk. This is a running theme in this article and a general belief of mine. Investors should bear risk, not anyone else. If large-scale development is too risky because of the potential for terrorist attacks, then do not engage in large-scale development, or at least modify plans to disperse risk and make them less desirable or less likely targets.
A market failure common in insurance is adverse selection. Adverse selection is when the people most likely to have to make a claim buy the most insurance. This overwhelms the mutual risk sharing pool of premiums (since not many people who are not making claims are paying in) and the insurance scheme fails. It is very common in health insurance. Sicker people bought more insurance, and as a result policies were always going up and up and up, forcing out healthier people (and putting them at risk for sudden and expensive health emergencies). The individual mandate in the affordable Care Act was meant to address this very issue of adverse selection. But I do not see any adverse selection taking place in the terrorism insurance market. The case can certainly be made that New York and a handful of other states bear more risk, but insurance is administered at the state level anyway, so this risk concentration is not contributing to any adverse selection at a national level.
Another theme in this article is that I do not categorically oppose all of these programs and want their subsidies rescinded, immediately. However, moderation and more specific selection of beneficiaries are imperative. With the example of terrorism insurance, perhaps developers in Washington DC do bear outsized risk due to the presence of the federal government. The government could then rightfully offer terrorism insurance for developments in the District of Columbia. And as I mentioned in the case of the Export-Import Bank, direct government support of infant industries may be warranted and appropriate. However, I do not agree with these largescale subsidy programs.
TRIA is likely a program that had its merits in 2001 and 2002 when America was one big patriotic brothel and everyone wanted to do anything that they could to fight the terrorists and help the country get out of a recession quickly. However, since then, there have not been any terrorist attacks and there has never been a terrorist insurance claim filed (the Secretary of the Treasury has to declare an act of terrorism for the government to backstop the insurers, and he declined to do so after the Boston Marathon Bombing). Since 2001 terrorism insurance has just become a profit getting boondoggle for the insurance companies. New developments are required to have terrorism protection by the banks, so the insurance companies are guaranteed revenue, while the federal government backstops the majority of the risk. The risk is also extremely difficult to quantify and model, because terrorism attacks have been extremely rare, are subjectively defined, and the loss distribution of the attacks has been extremely wide. This directly calls into question the insurance industry’s pleas for government support.
Luckily, there have not been any terrorist attacks in the United States since September 11. As a result, terrorism insurance has only cost tax payers $1 million a year in administrative fees. However, were there to be an attack, in addition to the loss of life, injuries, and property damage, a huge hole may get blown in the national budget. Taxpayers, whether or not they are shareholders of development companies, would have to fill this hole.
Essential Air Services
I am not aware of Representative Hensarling’s position on Essential Air Services (EAS), but it is a government program in the vein of the others that I have discussed here in this article. I am not a fan of the program.
Prior to 1978 the government heavily regulated air travel. Fares and routes were mandated by the government. This system provided flights to smaller and more remote cities around the country. After deregulation, communities feared that airlines would eliminate flights to smaller cities, since these flights are less profitable. In response, the government enacted EAS, subsidizing flights to 160 rural communities around the country (43 of these communities are in Alaska). Excluding Alaska, which has separate operating parameters, the program cost $241 million in 2014. Apply the Eric Test: Is there evidence of a market failure in the rural aviation industry? I don’t believe so.
By subsidizing flights to smaller rural cities the government is making the cities marginally more attractive places to live. However, the economy works most efficiently when labor moves to where it is in demand. During the early and mid-20th century smaller rural cities were certainly labor centers. Agriculture was more labor intensive and employed more Americans, mining was more prominent, and industry and manufacturing was more dispersed. However, in the current economy demand is concentrated in larger cities that have hi-tech firms, universities, established industries, cargo infrastructure, and large health care systems. Smaller rural cities ought to shrink in size until they reach equilibrium – residents who desire to remain in the city and receive satisfaction from doing so can live there, and they can pay workers in the service industry sufficient wages so that everyone in the city can maintain happy and healthy lifestyles. EAS disturbs this equilibrium, and we are all paying for it! I don’t like it.
I do not propose that these communities be immediately cut off. People and communities need time to adjust. However, over time, service needs to be transferred away from these communities, and I suspect that population will decrease as well. Many of these communities were once thriving, due to the presence of industry, such as mining, which is no longer present. These people would now be better off, and so would the rest of the country, if they moved to other population centers where their labor is in demand and they have easier access to public and private services, such as quality health care, education, shopping, entertainment, banking, government services, and social networks. Kill EAS, Jeb!
Government subsidies and related economic support programs are often pet projects of politicians from around the country. That is why so often politicians from across the aisle get in bed together on these issues. If the policy benefits their district or state they will support it, political and economic philosophies aside. To see through this political theatre and their rhetoric apply the Eric Test: Is there evidence to indicate the presence of a market failure? If not, oppose the policy or regulation.
This is part three of a four-part series of posts on the Economics of Oil. Previous posts:
First off, at this point you are probably wondering what similarities Bitcoins have to oil. I suppose that the main hypothesis of this post is that Bitcoins are nothing more than a plain old commodity, just like oil, and they are subject to the same market forces. In fact, at this moment “Bitcoin miners” are struggling with the same issues that shale oil producers in North Dakota and oil sands extractors in Alberta, Canada are struggling with.
Bitcoins are a digital currency. They do not exist in any physical form, and there is no central monetary authority, like the United States Federal Reserve or the European Central Bank, that can issue new Bitcoins. The currency was established in 2009 on a system of computers. The computers maintain a running log of every Bitcoin transaction (basically a big long list of debits and credits) known as the “Blockchain.” The computers interact with each other to clear transactions and verify that their registries on the Blockchain are legitimate. Every time a user successfully verifies a block of transactions (which is a complicated computing algorithm that needs to be “solved”) the transactions are processed and that user receives a pre-determined number of newly minted Bitcoins for her efforts.
The designers of Bitcoin programmed the software so that the algorithms that need to be solved to verify the Blockchain and win yourself new Bitcoins get solved about every ten minutes. As more computers are added to the system, the algorithms are programmed to get more difficult. And with more and more user-systems vying for the new Bitcoins, more and more powerful computer systems are needed to be the first system to successfully verify the Blockchain and win the digi-cash. Basically, mining Bitcoins is deliberately designed to get progressively more difficult over time. Cloud computing companies are literally selling use of their systems to Bitcoin miners. Massive amounts of capital are being put into configuring powerful computer systems. And this comes with its own costs and externalities. A lot of electricity is needed to cool super-computing systems, and if the electricity is generated through non-renewable means then there is the additional cost of the pollution that is generated.
The similarity between Bitcoins and oil, I contend, is not because Bitcoins are “mined” in this digital sense. Rather, it is because we allocate capital to Bitcoin mining in much the same way we allocate capital to oil extraction. Bitcoins have absolutely no intrinsic value. They only have value as expressed in terms of other currencies (such as US Dollars or Euros). So, ostensibly, Bitcoins have exchange rates and have an ever changing value to them. Yes, certain companies do accept Bitcoins in lieu of traditions currencies, but prices are still expressed in the traditional currency and then converted into Bitcoins based on the prevailing exchange rate. This is what drives Bitcoin miners to devote their computing power to Bitcoin mining. They can then sell their Bitcoins for other currencies and use that money in the traditional sense.
So when the exchange rate, or rather the value of Bitcoins goes down, there is less incentive for Bitcoin miners to devote their computing power to Bitcoin mining because they could be using their super computers for more lucrative endeavors. And mining Bitcoins is an expense endeavor. It requires ever more sophisticated computer equipment as well as vast amounts of electricity to cool the computers. And this is just like oil. It costs money to get oil out of the ground and into barrels, just like it costs money to mine Bitcoins. And if the price of oil falls below what it costs a company to extract oil, that company will shutter rigs until the price of oil climbs back up. All the same, if the value of Bitcoins drops below what it costs to mine them, the digital mining company will flip the switch to ‘off.’
Another interesting attribute about Bitcoins is that every four years, since the currency’s establishment in 2009, the number of Bitcoins that can be mined by a new block verification halves. So from 2009 through the end of 2012 the number was 50, now it is 25, and in 2017 it will be 12.5. By 2030 the number of Bitcoins will be limited to around 21 million. To me, this raises an interesting question. If Bitcoin only works because the people mining the coins for a profit are also verifying the Blockchain, once there are no more Bitcoin to mine, won’t everyone spending massive amounts of money on super-computing capabilities just stop bothering, making it impossible to verify transactions and trade Bitcoins, essentially destroying the currency? There needs to be an expectation that the value of a Bitcoin will be perpetually increasing, otherwise the entire system will cease to function.
And that is precisely what is happening right now in the United States oil extraction business (well, not a total destruction of value, but the drop in the price of oil is certainly concussing the current system). The number of oil rigs in the United States, as reported by Baker Hughes, peaked in October at 1,609 rigs. It has since fallen to 1,421 rigs. This basically indicates that exploration for new oil, which accounts for an enormous initial investment, is dropping off; however, United States domestic production is still surging. US crude production added 60,000 barrels a day last week, according to the Energy Information Administration (EIA). That puts the United States at 9.19 million barrels a day. However, as the price continues to fall and companies alter their exploration and investment plans, we very well may see domestic production peak.
An abundance of oil was discovered in North Dakota that was relatively cheap to extract, given the price of oil. So producers flocked to western North Dakota (a place where even geese wouldn’t flock to) and started to drill baby, drill. Over the same time period, emerging economies, such as China, and developed economies, such as those of Europe and Japan, slowed down. The demand for oil decreased, but the supply was steadily increasing. This has precipitated a large drop in the price of oil. Normally, we would expect Saudi Arabia to cuts its own production of the black gold to stabilize the price, but as I previous wrote, I believe they are not doing that this time around for political reasons. But it doesn’t hurt that this “price war” could help drive the Bakken Shalers out of business. Whereas Saudi Arabia only spends between $5 and $6 to get a barrel out of the ground, in North Dakota it costs maybe $42 on average to extract it out of the ground and get a 10% return on capital. The lower oil goes, the more it hurts American and Canadian producers, whereas Saudi Arabia has $900 billion of cash reserves on hand to ride out any prolonged dip in the price of oil.
As a result of the flooded market and Saudi Arabia’s decision, the price of oil has dropped below the point at which it is profitable to continue to pump it out of the ground in the Bakken Shale fields of North Dakota. North Dakota, which has undoubtedly had the best performing economy in the country, even throughout the Recession (home prices in North Dakota actually went up through the Recession, whereas in most of the rest of the country they were plummeting), may finally see its wings melt. Texas, Oklahoma, Colorado, Louisiana, Alaska, and parts of Canada, may also see employment losses. The Federal Reserve Bank of Texas has estimated that there may be 140,000 job losses in Texas alone in 2015 as a result of the drop in the price of oil. Policy makers and regulators are also bracing for some troubles ahead for certain banks, housing markets, and even state budgets that rely on oil revenues.
However, over all, the drop in the price of oil will be good for the American economy. By saving at the pump Americans will be able to pad their savings accounts as well as go out and buy other things that will spur the economy. The Keystone Pipeline, which has been in the headlines for years now, might wind up being a moot point after all. The Pipeline was intended to bring crude oil from the oil sands of northern Alberta, Canada, to the US Gulf Coast. But oil sands extraction is costly and may drop in the future now that the price of oil is so much lower. If the pipeline ever gets built nothing may ever run through it.
As for Bitcoins, the only possible positive outcome of the boom (or is it a bubble?) that I see is that computing power might become exchange traded. First, companies became exchange traded on stock markets. And since then commodities and even more obscure assets like shipping contracts (Baltic Dry index) have become traded on exchanges. I don’t see any reason why computing power couldn’t become exchange traded in the future. Cloud computing companies are already offering their services over the internet to global markets; if there is enough volume in the market all that is needed is for the contracts to be standardized so that they could be traded freely between suppliers, consumers, and even speculators.
In the case of Bitcoin, I fear that by creating this digital currency and beginning to accept payments denominated by it, we are simply letting people with immense computing power at their disposal generate wealth for themselves. In addition, they are diverting their computing power from other uses that might be better for society, such as genomic coding, and in the process driving up the price for computer processing for the rest of us.
I should start by saying that this post is not really about economics so much as finance, but it should certainly interest anyone interested in public finance, the Detroit bankruptcy, the lunancy that sometimes encapsulates our financial system, and the Great Recession that the world is still recovering from.
Today and through the coming weekend it looks like lawyers from Detroit, Bank of America, UBS, and Syncora Guarantee will be negotiating a possible settlement which stands as a major hurdle to the city emerging from bankruptcy. I read the details of the dispute today in the New York Times DealBook, and it seems like classic pre-2008 bonanza economics backfiring on us once again. It just seems so clear to me that this would not make sense. Please let me know if you think I am missing something, but here is my take on things:
In 2005 Detroit had to make a $1.4 billion payment to its pension plan. There wasn’t any money to be found, so they floated bonds. Bank of America and UBS underwrote the offering, and Syncora Guarantee, as well as the Financial Guaranty Insurance Company (FGIC), insured the bonds, ostensibly protecting investors against losses. Ya know, just in case Detroit couldn’t pay.
Detroit did not want to have to reach too deep to keep the labor peace, so the bonds were floating rate. Just in case rates went up, they bought interest rate swaps from their friends at Bank of America and UBS. If interest rates went up the banks would cover the additional payments to the investors, and in the event rates went down Detroit would have to pay the banks.
And in the great legal morass that is Wall Street, the banks decided to spin one more web. They insured the interest rate swaps they entered into with Detroit. Ya know, just in case Detroit couldn’t pay. And the insurance companies were the same two that had already insured the bond payments to the investors.
In 2005 this mutually entangling deal was heralded as so innovative that it was awarded the Deal of the Year Award by The Bond Buyer trade publication. But this deal, along with all the other toxic waste from the pre-Recession bonanza, just shifted risk around. It never eliminated it, or mitigated it.
Interest rate swaps were all the rage in the aughts. I can see the bankers’ pitch book from my desk:
“Eliminate your interest rate risk with our interest rate swaps.”
“In this interest rate environment, you can’t leave your floating rate obligations out in the cold. Protect them with interest rate swaps from Goliath National Bank.”
Municipalities around the country piled into the deals, and they are now suffering the consequences. By their nature, swaps are contrarian bets. One side thinks rates will go up, one side things rates will go down (if rates stay the same it is essentially a push). Both sides enter into the deal thinking they’ve got the sweet end of the bargain. For the cities like Detroit, they figured interest rates were going to stay the same or go up. With this thinking, it was the perfect deal. They could essentially synthetically lock in a low rate by issuing the floating rate bonds and entering into the interest rate swaps. But on the other hand, banks would only enter into so many of these deals if the deal was sweet for them, AKA they figured interest rates were going to stay the same or go down.
Municipalities throughout the United States must have all been drinking the same Kool-Aid that the banks were dishing out, because the banks did well in the deals and the counties and cities are all suffering. And I don’t find this hard to believe. Banks have sophisticated interest rate projection models. Plus they have already been found to have been manipulating interest rates (granted, for trading advantage, not to profit from clients, but it still points to their less than honest intentions). Because of this, municipalities around the US (Jefferson County, Alabama comes to mind) have been fighting the banks in courts on the grounds that the swaps were improperly peddled to them.
Interest rate swaps were the first failure of basic human reason brought on by FBDS – Financial Bonanza Disillusionment Syndrome. The second was for the same two companies, Sycora and FGIC to take on all of the risk in the deal. Not only did the bond insurers guarantee the bonds, they also guaranteed the swap payments for the banks. And that seems beyond the limit of reasonable risk to me. It stands to reason that if Detroit was having trouble making bond payments it would also be having trouble making any required interest rate swap payments. Maybe the bond insurers were hoodwinked by the same bankers who sold the interest rate swaps to the city.
The rest is history. Rates went down, so Detroit had to pay up to the banks. The just in case Detroit couldn’t pay turned into the largest Chapter 9 in US history. In the end, Detroit is dealing with a great big tangled mess, not the grand feat of social-financial engineering that was lauded in 2005. The investors, the bond insurers, the city, and the pension fund are now all fighting it out to get the biggest piece of the pie. I wonder if anyone sitting in that room right now is saying, “What were we thinking back then?” My hope by publishing this post is that the next time someone has an idea like this they will use common sense, economic principles, and sound risk management to steer clear of another fiasco like the one Detroit is facing right now.