Jan. 17 (Bloomberg) -- 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 loss, of course, is not remotely over, because the position is not closed out and is almost certainly highly leveraged. That means that there may be many more quarters without heat in the schools until Reading passes a bond issue to pay off the bankers. It also means that in addition to being the third poorest city in Pennsylvania, Reading ranks among the tops in credulity**. Hey, we all need to excel in something.
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...
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.
A few simple questions (that are seemingly never asked) could have completely avoided the situation above:
a) What is a school board doing investing in interest rate swap derivatives in the first place?
b) Where did they think the magical $16 million was going to come from? A Nigerian prince?
Unless they could answer those two questions, the Reading School Board had absolutely no business pretending to be investors***.
But rather than just mocking the foolishness of one elected school board****, the important points here are that there are no risk-free transactions and that the bankers who issue these derivatives are more than happy to sell that risk off to the credulous to get it off their own books. There are untold trillions of dollars' worth of such risk, and as this systemic risk spreads, so do the nooks and crannies into which it must be tucked to keep the game going. The world is full of idiots who are willing to spend your money to buy a seat in this rigged casino. But don't complain, you elected them.
It's not surprising, of course, that the banksters took their cut ahead of time and made off with a million in taxpayer funds. That's what they do. What will be a big surprise is when school boards nationwide create classes in what Sir Alan Greenspan called "cascading cross defaults"***** to explain what happened when the fools who bet more than they had on whether interest rates would go up or down could not pay, leading to other fools who could not collect and therefore could not pay, leading to other fools who could not collect and therefore could not pay, leading to a lot of people who didn't understand much about economics eating dog food to survive.
And if you don't know who those people are, they may very well be you.
* "May" is the most dangerous word in finance.
** The two are almost certainly related.
*** They should stick to pretending to be educators.
**** Why beat a dead horse?
***** He said about Long Term Credit Management - a hedge fund run by two Nobel Prize (economics) winners that went tats up when a couple "sure thing" bets went bad - that "... it was the FRBNY's judgment that it was to the advantage of all parties--including the creditors and other market participants--to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults." The Fed rushed in with handfuls of free money to stop the dominoes that had begun falling. It worked in 1998, but today the problem is just a bit bigger than it was then. Hey, maybe it'll work again. I sure as hell hope so, too: my dog is not big on sharing.