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Thursday
Jun232011

Derivative Financial Instruments

There is one line item in the Council accounts described as 'Loss on Revaluation of Derivative Financial Instruments - $1.158m (deficit)'. This is otherwise described as interest hedging, and the figure goes up and down every six months depending amount of the nominal debt being hedged, and the movement resulting from the revaluation of the hedges.

The lack of explanation has caused no little concern, and at the risk of further confusion, I will attempt to interpret the information that has been supplied on request. The concern is of course rooted in the Wall St. debacle surrounding 'derivatives', and 'hedges' generally.

This practice was re-instated in 2007 when Council again became a 'net-borrower'. It followed a presentation by its independent financial advisors – these are the people who continuously analyse Council’s current and future borrowing requirements against what funding is available from the various banking sources, and advise on what steps should be taken to protect Council's interests.

This service has proved extremely beneficial in the past, particularly in view of the inability of Council to meet its term borrowing target as part of its Liability Management Policy. The unavailability of long term bank funding at a reasonable cost lies behind this, and has given rise to the demand by some councils to establish a bond market to meet their needs. For a council the size of TCDC, such arrangements are probably impractical because of the extremely expensive continuous Standard & Poor type monitoring implicit in such arrangements.

Consequently, Council’s borrowing is ranged within 2 – 4 year terms. This is what councillors need to understand when they talk about Council borrowing being no different to taking a mortgage on the house - I kid you not – that is what one current Councillor was heard to say during the discussion earlier this year on extending the Council’s total borrowing beyond its current self imposed limit.

It is because of the inherent risk associated with short term borrowing of this nature that Council decided in 2007 to re-enter into the derivative market in order to provide a cushion against the effects of rapidly rising interest rates when loans need to be ‘rolled over’, or new loans entered into.

IFRS (International Financial Reporting Standards) require that these instruments (in this case, interest rate swap contracts) are valued annualy, and TCDC Liability management Policy requires them to be valued every six months as if they are ‘closed out’ at that point. What results is what is called ‘point to point fair value’. The only benefit this provides is that the figure that appears on a single line on Council’s accounts every six months represents the figure they are worth should all the contracts be ‘cashed up’ at that point.

When this single line item showed up as a $1.158m. (book) deficit in the accounts presented to Council in  February this year with no explanation, one would have thought that it would give rise to questions. But obviously Councillors were well aware of the remifications surrounding it as the accounts were passed like hot coals as usual. The Financial Controller – Steve Baker is subject to cursory questioning at best.

In answering my query on the matter, Steve is at pains to point out the instrument is an important part of applying prudent management tools in regard to risk, and specifically:

“so that a sudden increase in borrowing costs do not force an increase in general rates”.

In effect, what Council is doing is insuring its interest rates out beyond the nominal period of the loans that it has undertaken – in the case of TCDC, the weighted average is around 4 years.

The following table provided by Steve shows the progressive revaluation of the instruments, and the nominal debt being hedged at each point:- note the nominal debt as at 28 February does not appear to fit with the intentions announced in early December to throw out the existing total borrowing limit of 150% of revenue, and replace it with a limit that excludes ‘internal” borrowing – effectively an increase of $55m. in the borrowing limit, but it does reflect the deferal of capital works projects referred to elsewhere that was designed to meet the rate reduction target.

Valuation Date        Nominal Debt Hedged ($m.)      Movment in Fair Value of Hedges

30 June 2007                        15                                                  834,081

30 Dec. 2007                        15                                                 (478,778)

30 June 2008                        29                                                  151,238

31 Dec. 2008                        45                                              (2,477,532)

30 June 2009                        59                                               1,626,532     

31 Dec. 2009                         59                                                  602,201

30 June 2010                        71.5                                          (1,922,201)                  

28 Feb. 2011                         51                                              (1,158,345)

Steve explains the movement between 30 June 2010 and 28 February as having resulted from the decision taken by the former Council in June 2010 to reduce the ten year forecast annual rate increase from the earlier 7.5% to to around 3.1%.

Steve Baker goes on:

“this was a significant change in direction and as a consequence of this decision a number of the hedging instruments in place at the time to meet projected borrowing requirements needed to be restructured, and this was undertaken over the following months”.

The re-valuation at 30 June 2011 (following the Annual Plan to be adopted on 29 June) and 28 February 2012 (following the Ten Year Plan to be adopted on 28 September) will be very interesting in view of the changes that are likely to have taken place with the adoption of Council's new spending plans. Were these to incorporate the ambitious plans put forward in particular by Whitianga and Thames Councillors, a substantial negative change to the instrument valuation may be expected.  This may of course be offset by the already well telegraphed plan to cancel stormwater capital expenditure for three years from 1 July 2012 in favour of implementing all their pet projects prior to the next election. How responsible is that?

What we as rate-payers need to be aware of is that having our rates marginally protected against the effects of rapid and substantial interest rate increases comes at a hedging cost only, but increased  borrowing carries risk – substantial risk. I just hope that our current crop of neophyte councillors are aware of those risks before they succumb to the siren song of those whose mantra is “if you want it, you can have it – now!”

 

 

 

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