If you've ever signed up for anything finance-related, you're used to getting all sorts of unsolicited information about potential investments and advice. If you haven't seen them already, it's just a matter of time before you start getting letters in the mail promising you the name of a stock that will give you a 100% return every three days or a list of penny stocks that will help you strike it rich. Generally, you can take pride in dumping these mailings straight into the garbage, knowing that you weren't one of P.T. Barnum's suckers born every minute.
Not everyone, however, has the knowledge to avoid deals that are too good to be true. According to a recent report from Bloomberg, a school board in Reading, Pa., entered into a transaction with Deutsche Bank (NYSE:DB) that involved a type of derivative transaction called an interest-rate swap. Apparently, financial advisors to the Reading school board claimed that the transaction could earn the district $16 million over the next 30 years. Faced with cuts in state funding and in need of money for education costs, the school board jumped at the prospect of this supposedly free money. Now, however, things haven't worked out the way the board's advisors suggested they would, and so instead of getting an initial installment on that $16 million, the school board currently owes Deutsche Bank about $230,000.
Betting on rates
The reason the Reading school board finds itself owing money on this ill-advised transaction is that interest rates haven't behaved the way the board and its advisors had hoped. With this particular type of interest-rate swap, known as a yield-curve swap, two parties agree to pay each other a certain amount based on the behavior of interest rates on fixed-income securities with specific maturities. In the Reading transaction, the school board agreed to pay an amount based on a short-term interest rate, while Deutsche Bank agreed to pay an amount based on a rate calculated using securities that mature in five years. Depending on which rate happens to be higher, one party will have to pay the difference between the two payment amounts to the other party.
The theory behind the yield-curve swap was probably intriguing to the school board. When short-term interest rates are lower than longer-term rates, the payment the school board would have to make would be less than Deutsche Bank's payment, and so Deutsche Bank would have to pay the difference to the school board. However, because of the current inversion in the yield curve, short-term rates now exceed the longer-term rates used in the transaction, thus resulting in the school board's payment to Deutsche Bank.
Some alarming notes
Of even greater concern than the school board's liability under the transaction are some related facts. First, the promise of free money came at a substantial price to the school board. Deutsche Bank received an initial fee of $575,000 for agreeing to the transaction, and the school board's advisors and attorney took an additional $400,000 for their role in setting up the swap. It says something about the quality of the sales pitch that the school board was willing to put up nearly a million dollars just to do this risky transaction.
On the other hand, it appears that the school board didn't really understand the level of risk involved in the derivative transaction. In this case, a difference of less than 0.2% in the two interest rates led to nearly a quarter million dollars of liability. According to the article, many municipalities and local government agencies are having similar deals marketed to them, and the officials with responsibility over public funds often don't take the time to learn about the particulars of the contracts they sign. Companies such as JPMorgan Chase (NYSE:JPM) and Merrill Lynch (NYSE:MER) are among those entering into similar swaps.
Last but perhaps most disturbing, the school board's response to its liability under the contract was to enter into another swap transaction to raise the funds to pay the $230,000 it owes. Rather than being circumspect about relying on an agreement that already burned the school once, the school board appears to be doubling down on its bet in the hopes that rates will finally move in the right direction.
Money is never free
The lesson you can learn from this is that no matter how attractive an offer may be, there's always some type of risk involved in any moneymaking enterprise. As persuasive as the Nobel Prize-winning quantitative models from Long-Term Capital Management in the late 1990s may have been to investors who agreed to give them a try, it soon became evident that those models had a fatal flaw. Moreover, many of those who participated in LTCM were institutional investors, who presumably have more knowledge about esoteric financial-management methods than a typical local-government official would.
The first mistake that many investors make is to look for unrealistically high returns over short periods of time. While you may get lucky and succeed in finding such investments from time to time, investments that offer such high potential returns usually involve an equally high level of risk. If you make those bets enough times, you'll likely find yourself on the losing end of the financial equivalent of a game of Russian roulette.
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Fool contributor Dan Caplinger is fascinated by all of the zeroes in a typical derivative contract, but he doesn't own any derivatives or shares of the companies mentioned in this article. The Fool's disclosure policy is there to educate you.
