Thursday, January 18, 2007

Derivatives, The Monster That Ate The Future part III

I have reprinted Mish Shedlock’s article below in it's entirety. I do not pretend to know the first thing about the derivatives markets, but Mish has brought up the subject a number of times and can tell us something about it.
Vern
Ponzi Financing On Interest Rate Swaps
The third-poorest city in Pennsylvania is a lot poorer because of a 28-year bet on interest rates that already has gone awry.
The Reading, Pennsylvania, school district, which has 18,323 students, this week must pay $230,000 to Deutsche Bank AG, Germany's largest bank, because it's on the losing side of a wager that long-term interest rates will rise faster than short- term interest rates.
In April, the board rushed approval of the so-called interest rate swap in eight days after its adviser said the transaction may earn the district $16 million by 2034.
While Reading's taxpayers are liable for the loss, bankers and advisers already have pocketed $1 million in fees for arranging the swap, enough to buy 11 Mercedes-Benz S-550 sedans.
This week's payment to Deutsche Bank would have covered the school district's monthly utility bill.
"It was all done in a real hurry," said Keith Stamm, the only member of the board to vote against the deal. "The whole board is so desperate to try to find a way to raise money, they see this floated in front of them as a big-time amount of money and they want to go forward with it.
"Local governments from Augusta, Georgia, to Oakland, California, are being lured by similar opportunities to speculate with derivatives created by the world's biggest banks. Most of the $400 billion of private agreements sold to municipalities escape taxpayers' notice and are little understood by the public officials and administrators who approve them.
The school board paid Frankfurt-based Deutsche Bank $575,000 to arrange the contract, known as a constant maturity swap, and awarded $400,000 to its financial advisers, including Reading-based Concord Public Financial Advisors Inc. and lawyers for arranging the trade, school officials said.
Ted Meyer, a spokesman for Deutsche Bank in New York, declined to comment on whether the agreement, also called a yield-curve swap, was suitable for the school district.
Dennis Kelley, the school district's director of finance, said he was "surprised" to learn he owes $230,000. He said the district would pay the money using proceeds from another interest-rate swap.
"Nobody Questioned It""
It was arcane, nobody questioned it," Cinfici said. "Everything was presented to us at the last minute. I said, `Well, I'll trust in the guys' judgment.
"More than 70 Pennsylvania school districts have notified the state they planned swaps with banks including Morgan Stanley, Wachovia Corp. and JPMorgan since 2003, when state legislators permitted them. Is there any wonder now why profits at Goldman, Merrill, etc are soaring?
Top 5 Reasons for Interest Rate Swaps
5) "It was arcane, nobody questioned it"
4) "It was all done in a real hurry"
3) "Well, I'll trust in the guys' judgment"
2) "The whole board is so desperate to try to find a way to raise money"
1) "The district can pay the money owed using proceeds from another interest-rate swap"
If this is not ponzi financing at its finest, what is?Mike Shedlock / Mishhttp://globaleconomicanalysis.blogspot.com/

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