At face value, this Bloomberg News story is ridiculous: The state of New Jersey is paying Goldman Sachs almost $1 million a month to protect against interest rate risk on bonds that no longer even exist.
But, hey, a contract is a contract, right?
In 2003, New Jersey's Transportation Trust Fund Authority raised $345 million by issuing variable rate interest "auction-rate bonds." So-called because their interest rates changed periodically according to regular auctions, the bonds became all the rage in the late '90s and 2000s for municipalities looking for the cheapest way to raise money. Because of the periodic resets, the yield that the Trust Fund Authority would have to pay investors never got too far from current short-term interest rates. And in fact, reports Bloomberg, New Jersey saved about $9.9 million between 2003 and 2008 by going with auction-rate instead of fixed-rate bonds.
The big risk, for New Jersey, would be that interest rates would rise over the course of a bond's maturity, and the periodic resets would result in New Jersey being forced to keep forking over higher yields to investors. But New Jersey decided to be clever, and hedged against the risk of that happening by agreeing to an "interest rate swap" with a partnership run by Goldman Sachs.
New Jersey agreed to pay a fixed sum of money per month to Goldman Sachs, in return for Goldman Sachs taking on the variable rate risk associated with the auction-rate bonds. That meant, if rates did go higher, Goldman Sachs would take the hit.
But then came the financial crisis, and the entire auction-rate bond market collapsed, because suddenly no one wanted to take on any new risk at all -- nobody came to the auctions. Interest rates collapsed. New Jersey ended up being forced to redeem the bonds, but according to the terms of its contract with Goldman Sachs, still must make fixed payments until 2019.
"This vividly shows the risk of entering into interest-rate swap agreements," said Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board in Alexandria, Virginia. "The world's got to see what stupidity even the sophisticated investors like the transportation fund can get into."
A big mess for New Jersey, though not necessarily a sign of Goldman Sachs evil. Until you consider the comment made by a Goldman Sachs representative, Michael DuVally, to Bloomberg.
"The economics and risks involved in this transaction were fully understood when the authority decided to enter into this swap six years ago."
How to say this politely? DuVally's assertion cannot possibly be true. If we've learned anything from the financial crisis, it is that almost no one, from Alan Greenspan on down, understood the risks associated with mixing auction-rate bonds and interest-rate swaps. Not Goldman-Sachs, which would be bankrupt right now if it weren't for multiple government bailouts, and not New Jersey, which certainly would have been more circumspect if it had any clue as to how vulnerable the entire financial system was to a major crisis.
The truth is in fact the exact opposite. The profitability of complex financial instruments is predicated on the requirement that the risks inherent in them are not fully understood.