Is "prudent financial management" really all that prudent when city and district councils continue to opt for fixed interest rates on their loans — rather than floating interest rates — with ratepayers missing out on saving billions?
No, that's not a trick question. The truth is council financial records show that a little known financial policy adopted by city and district councils around New Zealand has effectively cost ratepayers billions of dollars over the past 10 to 15 years.
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For example, in Whanganui, ratepayers have missed out on saving nearly $11 million over the past 13 years because they use fixed interest rate loans. Palmerston North ratepayers have missed out on saving nearly $12 million over the past 13 years. In larger local authorities like Wellington, ratepayers appear to have missed out on $206 million over the past 15 years and in Auckland, a whopping $1.25 billion (not a spelling mistake) since the
Super City was established in November 2010.
The policy I'm referring to is each council's Liability Management Policy which aims to protect councils against adverse interest rate rises on their loans and having such a policy is a requirement under the law. However, the act does not state specific amounts that councils must follow but most councils have a policy to fix between 50 per cent and 95 per cent of all loans that are greater than one year in duration.
However, councils do not just take out a fixed rate loan like you and I might do, they use a financial derivative called an interest rate swap. The outcome of these interest rate swaps must be reported in a council's financial report and that is how we can tell what effect this policy is having.
An interest rate swap is a financial contract between two parties who agree to exchange (or swap) the interest payments on loans. It's a zero sum game — if X profits from the agreement then Y loses, and vice versa. Why would corporate borrowers use an interest rate swap? Well X wants to protect itself from an adverse rise in interest rates and Y thinks interest rates are going to fall. The reason councils use these financial derivatives is because it gives them more flexibility and more options than a simple fixed loan with a financial institution. interest rate swaps are not good and they are not bad — they are simply a financial tool.
The interest rate swap market was established back in 1982 when interest rates were extremely volatile and businesses wanted some form of certainty. Then, in the blink of an eye, a billion dollar financial market for interest rate swaps was created. These days the swap market has grown to a head-spinning US$5 trillion.
Swaps have received plenty of negative publicity over the years. For example, many unsuspecting New Zealand farmers were persuaded to take out saps when mortgaging their farms. According to one report, up to 200 farmers lost nearly $1 billion using these financial derivatives that very few people, including bank staff, actually understood. And, just recently, the Court of Appeal overturned a High Court ruling and forced the ANZ Bank to compensate a Taranaki farming couple regarding interest rate swaps.
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When it comes to interest rate swaps, councils take advice from expert treasury advisers who regularly monitor interest rate markets and evaluate the outlook for interest rates.
Given that so many councils around New Zealand have done so poorly out of interest rate swaps, over an extended period of time, one has to wonder if such advice is even worth paying for? Perhaps instead, they should take advice from Professors Smith, Smithson, and Wilford who noted that "much of textbook portfolio theory suggests that not hedging might be a firm's best policy". Hedging is "hedging your bets" against interest rate
It's fair to say these losses are only "opportunity cost" losses. Councils don't have to make extra payments because interest rates have dropped (they still pay the fixed amount agreed upon) but they do miss the opportunity of saving ratepayers a lot of money when interest rates drop. The bottom-line is that if councils had simply taken the floating rates on offer, ratepayers would have been billions of dollars better off over the past 10 to 15 years.
Councils review their liability management policies every three years. So perhaps it may just be time to do some serious navel gazing and amend or repeal this policy?
Of course, if councils had initially adopted a floating interest rate policy and interest rates had risen over the past 10 to 15 years, people would probably be asking why councils had
not fixed interest rates on their loans.
Some councils would also argue swaps are like insurance and we all have to pay an insurance premium, even if our house doesn't burn down. The difference here is that this insurance is looking rather expensive and it's not an actual asset they are insuring. The outcome of this policy is no reflection on council staff who are simply doing what the policy requires them to do and often it seems like they can never win, but the fact is that this financial policy appears to have failed ratepayers around New Zealand.
&bul; Steve Baron is a Whanganui-based writer, author and Founder of Better Democracy NZ.