Swaptions: The Pike Red Herring

So much chatter on this video that the 'insider' deals swirl around the swaptions, and the implication that these mysterious transactions lie somewhere at the root of the Pike financial problem when really, the derivative transaction known as a Swap or Swaption was just another ineffective means to deal with a State Authority that failed, and continues to fail to deal with  i) costs that are too high, or ii) revenues too low.

History.  The Turnpike swaption was the cobbled together temporary solution to the snowball of a problem that was big, even in 2001: revenue wasn't meeting operating expenses.

In 2002, the Turnpike owed about $2.2 billion in bonds with various maturities, but some notably maturing in 2009.  Why notably?  Just listen closely and you'll hear the crash of credit markets in the near distance.

And faced with an ongoing need for cash, the Turnpike "sold" to Lehman and USB certain rights exerciseable during the 10 year period beginning January 1, 2007, or January 1, 2009 depending upon the particular Turnpike bond.

Lehman paid to the Turnpike the sum of $35.2 million annually from 2002 to 2007. USB paid annual amounts of $22 million.   In exchange, Lehman and UBS took back rights - the swaptions - whereby Lehman would have the opportunity to undertake the debt payoff schedule on $791 million of bonds at a fixed rate leaving the Turnpike with the original variable rate, now presumably higher variable rate.  i.e. higher than fixed, because otherwise, Lehman wouldn't exercise its option.

To mitigate the risk of Lehman exercising its option in a period of rising rates, also in 2002, the right sold by the Turnpike and purchased by UBS was the right for UBS to undertake a variable rate payment on the SAME $791 million of bonds and and leave the Turnpike with a fixed rate.  That is, just the opposite of the Lehman transaction--an offsetting swap.

The inherent gamble in the offsetting swaption transaction was that likely, the "offsetting" swaps would NOT be optioned at the same time, and in the event that one leg of the swap was optioned, a prudent strategy would be to quickly refinance the bonds and eliminate the exposure, in effect, of having written a naked put. i.e. the contract allows UBS or Lehman to "put" the higher rate to the Turnpike.  This is of course, what happened, or will happen in the near future.   The profitable rights were exercised, leaving the Pike with the unprofitable leg and no borrowing ability to refinance the problem away.

All this derivative action was to counter a i) 2001 recession, ii) a delayed toll increase, iii) a Fast Lane toll discount and iv) the Central Artery operating expense.  All these inevitabilities were forseeable but ignored.  The ratings agencies didn't ignore the approaching storm, saw the risks of these costs and immediately downgraded the Turnpike debt from A/A- to BBB+/BBB soon after the swaps.

Regardless, this costly transaction is only the tip of costs-gone-arwy iceberg, and therefore a Red Herring.

Fast forward to 2008.  

Facing i) no significant cost control efforts ii) a highly leveraged balance sheet and iii) horrible debt markets, iv) a few million bucks down the drain per month in a swaption trap, in short, the perfect storm, the Turnpike can't refinance.  The Swaps didn't cause the problem, but rather only succeeded in deferring the inevitable.