OK, remember Felix Salmon’s explanation of synthetic CDOs from my previous post? Good, because you’re going to need it.

Earlier this month, Planet Money and The New York Times collaborated on a story about how five Wisconsin school districts may have blown $200 million – $165 million of which was borrowed – on an investment that no one involved, including the investment banker selling the deal, seems to have understood. The details aren’t entirely clear from the main Times article, but by looking up a couple of other Planet Money posts, I’m pretty sure it went something like this:

1. 5 Wisconsin school boards took $35 million of their own money and borrowed another $165 million from Depfa.
2. They used the $200 million to buy a tranche of a synthetic CDO created by Royal Bank of Canada.
3. Royal Bank of Canada took that money, and presumably money from other people as well, and created that synthetic CDO by selling insurance (using credit default swaps) on $20 billion worth of corporate bonds. The synthetic CDO was like an ordinary CDO in that it had cash flows coming in – premium payments on the credit default swaps. The up-front money (including the schools’ $200 million) was needed as collateral. It’s not clear how senior the schools’ tranche was, but the Times says that most if not all of the $200 million in collateral will be lost, so it was probably pretty junior.
4. If there were no defaults, the schools would have netted $1.8 million per year – a 5.1% return.

We’ve all made bad investment decisions. I don’t want to pick on the Wisconsin schools for choosing a bad investment, but for something else: having the wrong investment goal.

There’s a corporate finance principle which says, in essence, that companies shouldn’t be making risky financial investments that their shareholders could make on their own. Making risky investments in their business can be justified, but otherwise they should return the excess cash to shareholders and let them invest it on their own. The same principle should hold with greater force for local governments. If you have a $35 million surplus and for operational reasons you want to keep it, it should be invested in something safe. If “something safe” doesn’t give you the return that you think you need, then you should raise taxes, issue bonds, or cut back on your plans.

Now, structured financial products can play a role in reducing your risk. In general, derivative trades have a “safe” side and a “risky” side. For example, if you buy a call option, you are on the safe side: you are paying a fixed amount, and you may enjoy an unlimited gain. However, if you sell a call option, you are on the risky side: you are gaining a fixed amount, but you may face an unlimited loss. Credit default swaps are similar in that one side gets a guaranteed but small stream of payments, but faces a very large but unlikely loss. So it makes sense for a local government to use derivatives to hedge some other exposure it has – but not to basically write call options or credit default swaps for other people.

This may seem unutterably obvious, so why do I bother bringing it up? Well, apparently it is still going on. Bloomberg has a story about how local governments and agencies are still using derivatives to boost their short-term cash flows. The most common technique seems to be interest rate swaps, in which the government gets paid at a fixed rate and pays at a floating rate (with more complex variants, of course). Again, these have the property that the inflows are fixed but the outflows are not, which means they are the reverse of a hedge. And like many derivatives, they are zero-sum contracts: someone on the other side of the trade thinks that he is going to make money on it, which means that your risk-adjusted expected return should be zero. Actually, they are less-than-zero-sum contracts, because the investment banks in the middle always get their fees. When is this going to stop?

(Wait a second, you may say: If governments shouldn’t be taking on open-ended positions, then what is the federal government doing? That’s different, though: in their case, they are taking on open-ended positions in order to further the public interest in a broad sense, not to get a higher return on their money. For example, the FDIC is guaranteeing bank debt in order to ensure the health of the financial sector, not because it thinks it can make a quick buck. Reasonable minds can differ about how effectively the government is serving the broad public interest, but most of us think they have to try.)

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