Auckland Council loses $1.4 billion in interest rate bet

Auckland Council has booked $1.4 billion in balance sheet losses on interest rate derivatives in the past two years after its strategy of fixing interest costs long-term backfired when interest rates cratered.

The pain, or rather the lack of immediate relief from the cost of borrowing, comes as local government finances come under considerable strain as the pandemic bites. This week the council forecast by 2024 there would be a $1b Covid-19-shaped hole in its budgets, and signalled years of emergency belt-tightening.

But at the end of last month when the council’s annual report was released, notes to the accounts also flagged a $665m loss in the value of its interest rate derivatives during the year, on top of a similar $719m loss the year prior.

An audit note provided by the Auditor-General said of the $1.4b in losses: “This is primarily the result of the Auckland Council and Group using derivates to fix the interest rates paid on borrowings at rates higher than current marker interest rates.”

These interest rate hedges – effectively a tool for council to fix the rate it pays on debt – saw the average interest rate paid by Auckland Council last year on its $10b of total debt reach 4.35 per cent, after hitting 5.35 the years before.

These rates are above those paid by even consumer borrowers for residential mortgages today, and are far higher than the sub-1 per cent yield the council’s bonds are attracting on the NZX secondary market.

Mayor Phil Goff declined repeated requests from the Herald this week to discuss or justify the hedging losses and whether ratepayers were locked into now-overpriced loans, with a statement from his office saying he had “nothing further to add” to statements by his council’s treasurer John Bishop.

Bishop described the hedging strategy as designed to ensure certainty in council expenses, and said the policy had been in place since the Super City council was established in 2010.

He said they insulated the council and ratepayers from the shock of any rate rise. “If interest rates went up by 1 per cent, that would add $100m to interest rates every year and we’d have to put up rates by 6 per cent.”

Bishop conceded the inverse – with the hedging positions meaning ratepayers were unable to benefit from a 6 per cent reduction in rates from a 1 per cent drop in interest rates – was also true, but backed the approach as “locking in certainty, so we can plan with confidence”.

He told the Herald some of its hedging positions, covering $2.9b of the council’s debt, were for 10 years, and the highest rate amongst such swaps was 5.3 per cent.

Economist Rodney Jones, of Wigram Capital, said the scale of the council’s position – which covered almost all its long-term debt, and with a large chunk locked in for a decade – could be described as “extremely aggressive”.

“I can understand you have some hedging in place on a three-year view – but I don’t see how it’s prudent to go beyond three years. And for all of your debt as well?” he said.

“This disaster – and this a disaster – is symptomatic of a systemic problem in local government.”

University of Auckland senior lecturer in accounting Lily Chen said the $1.4b in paper losses from hedging at Auckland Council “certainly appears to be poor practice of risk management, but hindsight is always 20/20”.

Jones said extensive hedging which locked in higher costs of borrowing if interest rates fell, affected a “fair number” of local councils in New Zealand, and left local government vulnerable when economic shocks such as Covid occurred.

While economic crashes typically pushed interest rates downwards, hedged positions meant they were unable to take advantage of lower borrowing costs just as the need for cheap debt became most acute, Jones said.

Harbour Asset Management senior credit analyst Simon Pannett said the council’s hedging strategy was not atypical of large corporates.

“When you look at it in hindsight, you could be saying ‘they would be paying less interest now’, but what they were doing was risk mitigation by locking in rates,” he said.

Pannett conceded the $1.4b of hedging losses “does look ugly from an accounting perspective”, but the effect on cashflow was nil and they would reverse if interest rates were to rise.

Hedging decisions at Auckland Council are made by a cluster of finance officials and private sector experts, with governance oversight provided by the finance and performance committee.

Committee chairwoman councillor Desley Simpson said Bishop, and other members of the treasury team, were scheduled to appear before the committee on Thursday where the hedging strategy – and criticism from Jones and Chen – would be canvassed.

“I’m not saying the policy is wrong, but there’s nothing wrong with questioning to see if it’s right. We will question officials as to whether the policy is still fit for purpose, or if there need to be any changes to reflect our current financial challenges,” she said.

Local government minister Nanaia Mahuta declined to comment specifically on Auckland Council’s hedging position or losses, but expressed confidence in local government debt management practices generally.

Mahuta noted in her statement: “It is prudent for local authorities to take moderate positions that do not expose ratepayers to extremes.”

Requests for comment from the opposition National Party, in flux post-election reallocating portfolios amongst a greatly diminished caucus, went unanswered this week.

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