Local Government Finances

[Shalodge]

I don't have a great financial knowledge and struggle to make sense of the way my Council (and others) hedge the interest rates on their large debts. It occurred to me that many on this forum seem to know a bit more than me so might have some valuable input on the question of swaps and derivatives.

A good place to start would be with this article on the Tauranga CC debt and an argument over the impact of the use of derivatives.

http://www.sunlive.co.nz/news/43313-council-debt-claim-challenge.html

In my case we use the new Local Government Funding Agency as well as commercial bank lines of credit at floating interest rates. We then use 'swaptions' (Interest rate swap options) to manage interest rate risk according to our financial policy. i.e 50% is effectively fixed for 5 years and other lesser percentages with a small % actually floating. The total external borrowings are in the range of $30M.

The effective Interest rate via the swaps is currently around 5.7% overall. (This includes all debt related costs)

Our adviser is Asia Pacific but what gets me is the appalling mark to market ratio that we end up with. This is the difference between what we would have paid if the borrowings had floated and what we paid via the swaps.

We are never on the winning side when it comes to our swaps and are always paying and never collecting. The M to M ratio is normally $1 - $2M unfavourable.. When questions are asked we are always told it is the cost of a conservative hedging policy!

Other councils are in similar positions and someone is making a killing? Is there a better way?

Russell ORR

[absoluteproperty]

The only better way would be for either more locally owned competitiors (Kiwibank has proven that local competition does not always work, as Kiwis have not really warmed to it as much as some including myself had hoped) or through legislation.
The government, being right wing, are less likely to legislate against financial institutions and the functioning of financial mechanisms.
One way from this would be to begin sourcing funding directly from overseas such as the Auckland Supercity council recently has, but this I assume would be in large scale purchases, understanding that even foreign entities would be looking to get as higher profit margins as possible.

Because of the lack of local competition, and the small size of local institutions (including councils) in respect to overseas entities in the larger markets, it is likely that we would always have a relatively higher profit to risk ratio stuck against us in comparison to other markets. Part of the reason for this is the lack of diversity in our export sector, and our heavy reliance on imported goods due to the lack of local industry vs. somewhere such as the US, Japan, Australia, Germany.

[Perry]

What happened to the LG Assn plan
for their own 'finance company?'

[Davo36]

What happened to the LG Assn plan
for their own 'finance company?'

Perry, it's in place, and Russell says they use it.

[Davo36]

I don't know anything much about this sort of thing, but I do know that local councils/counties etc. got screwed royally leading up to the GFC. Some Aussie councils successfully sued their banking advisers. In the states, some local counties have been lumbered with debts so huge they will take decades to pay off, if ever, thanks to Goldman Sachs et al.

Now, reading that article, it looks like Tauranga are screwed. The graph at the bottom shows it all. When even accountants can't understand what the debt is, how much chance does the man in the street have? And this is the situation up and down the country as far as I can tell.

And this paragraph is priceless:

Mayor Stuart Crosby told Ian local authorities have different financial requirements they have to work under, imposed by central government. He suggested Ian meet with council staff and arrange a workshop.

Typical council response i.e. they don't answer the question at this time and suggest that the person asking it needs to learn a bit more and some council drone will help them at some later date. And so the question is skirted around and never actually answered.

Now, interest rate swaps: I understand them to simply be a contract undertaken to limit the amount the council would suffer should interest rates rise greatly. And these 'swaps' contracts are offered by various banking institutions. It's similar to insurance. The thing is though, the insurance companies always win in the long run and so will the banking guys. They will have better actuaries. And of course we all need to have insurance. We know it's kind of a gip, but we all buy it every year. And the council guys will do it for the same reasons. If interest rates shifted from 5 to 10% they'd rightly be asked why on earth they didn't do something to protect the council.

And so they do. They purchase these options every year, because a) It's not their money they're spending to get the insurance, so who cares? and b) They are covering their arses and c) It's probably actually prudent to do so.

The above is just my very layman's understanding of it all and I am happy to be proven incorrect.

[Shalodge]

Yes we are using the LGFA but they lend at floating rates like everyone else and their margins are not any better than retail bank margins. It is not possible to find money at fixed long term rates even if you were prepared to pay ridiculous interest.

It seems that the only way to insure against interest rate rises is to use derivatives, or if you are big enough, a bond issue.

[speights boy]

Has anyone asked if say 3 smaller councils could jointly issue a $100m 5 year bond?

[Maccachic]

Here is Tauranga's Graph - might have to move back to Dunedin.

[Shalodge]

There is quite a cost in issuing bonds .. and borrowing overseas is currently a lot cheaper .. its just that the risk is higher. Changes in the FOREX rate not only affect debt servicing costs but can increase the principle as well.

Debt figures don't tell the entire story .. Take the Tauranga CC case as above.. Looks horrendous but the what TCC have done is push costs forward (intergenerational equity) because they believe that is the fairest thing given that most of the money went to assets with a very long life. Its not the debt so much as what it is spent on.

Tauranga CC have the lowest rates in NZ for a CC. If they were to increase their rates by 30% they would only be on a par with Auckland and would repay their debt in 10 years.. As long as that pink line is going up not down and it is not just rate rise increases (ie more ratepayers - growth) , then it is sustainable?

For district that are not growing and actually declining , debt is a real problem...

Russell

[speights boy]

There is quite a cost in issuing bonds .. and borrowing overseas is currently a lot cheaper .. its just that the risk is higher. Changes in the FOREX rate not only affect debt servicing costs but can increase the principle as well.

But isn't your original post implying it is not in fact cheaper?
Why will no one in NZ lend to councils at a fixed rate?

[Shalodge]

Yes it is .. but I understand the one off setup costs to be able to do that are high for a 'small' council? Even if 3 councils got together I understand that they individually would need to comply with the financial requirements to issue prospectus etc. I think the LGFA is structured to avoid that but it is interesting that they haven't used bonds only off shore borrowing?

Again I am not certain of any of this and I am open to comment?

Russell