Imagine this: The scene is a meeting of the Whanganui Council Finance Committee. It is election year.
The Mayor: "Finally, I come to the question of hedging. As you know we have income of hundreds of millions of dollars a year and our projected outgoings are slightly less. Sofar so good.
"The trouble is that half our expenses are interest so that bit goes up and down with interest rates. If interest rates go up we will have less money in the bank. If they go down, on the other hand, we will have a nice profit to spend on our town.
"Should we enter into a hedge with a bank under which they will agree to meet the interest payments provided that we pay them a fixed amount each year? That would transfer any risk to them if interest rates go up but leave them with the profit if interest rates go down."
Councillor: "What? Do you mean some scumbag sitting at a bank desk in Auckland would make a profit at the expense of our ratepayers? How would we explain that even though interest rates had fallen we had no extra money for schools and hospitals?"
Mayor: "Mmm, yes, that is a difficult one with elections coming up."
Councillor: "Perhaps if we got the very best consultants they could tell us whether interest rates were more likely to go up or down so that we could make the right decision. I suppose that in some years they might guess wrong but, if they were good enough, the strategy would pay off in the long term."
Mayor: "That seems a sensible approach. The basic principle of financial planning is Eastwood's law. When you are deciding whether to do something which might make a profit or a loss you should ask yourself one question 'Do I feel lucky?' Well, do you … ladies and gentlemen?"
Not having attended a council meeting I cannot say whether this is exactly how decisions are made but one thing is clear. Since, as Steve Baron explained in his excellent article on Valentines Day, councils are obliged to have a Liability Management Policy, it is unlikely that all the council's debt will be at a floating rate although some of it might be.
That, of course, makes sense. Councils, like individuals, accept an element of risk.
Did you buy that washing machine without paying for the extra five-year warranty? You take the risk that the machine goes wrong but, then again, the warranty was expensive and you could afford a new machine if it really came to it.
That was probably a sensible commercial decision. The trouble starts when you begin to take risks which you cannot afford to have gone wrong.
Leave your house uninsured: if it burns down you will be homeless. If a council accepts big risks like an increase in interest rates and rates do go up the homelessness will be for the poor and deprived.
That is why I was surprised when, in the middle of his excellent article on St Valentine's day, Baron said that rather than hedging their liabilities perhaps councils 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".
Whether that is sensible must depend upon the nature of the firm and whether the risk can be absorbed. For investment banks the answer may be "yes" but as to whether the professors' theory should lead councils to take risks they cannot afford in order to prevent windfall profits falling into the hands of the banks?
