It is becoming more and more apparent that today’s breed of politicians is good at only one thing, getting elected.

As folks that have never run a business, never had to tell an employee to clean off his desk or risk any of their own money, our lawmakers should quit pretending like they know what they are doing and let the hard stuff up to the professionals.

Let ‘em outsource the legislation, I say.

Don’t get me wrong, I love my home state of Pennsylvania, but it is run by a gang of numbskulls. By mid-November they have run out of important things to do and are now searching for ways to keep busy.

The state’s auditor general, Jack Wagner, has decided he no longer wants school districts or local municipalities to have the right to hedge their books.

He calls the notion of entering swaps, “…gambling with public money.”

The so-called financial expert backs up his statement with the fact that a local school district had to spend $12 million in “excessive fees and other charges” to unravel swap contracts it had with Morgan Stanley and JP Morgan.

Wagner failed to mention the many, many times the same contracts saved school districts millions of dollars.

If you’re not familiar with the world of swaps, it is a pretty simple concept that allows you to trade something like variable interest rates for fixed rates. Or, in the case of my graduate finance tests, orange juice futures for pork belly futures.

Ask any finance professional worth his salt and he will tell you he’ll take a fixed interest rate over a variable rate any day. A fixed rate is predictable and can be planned for. A variable rate, on the other hand, can do just about anything.

But when school districts or local municipalities offer bonds, they often have to issue them with variable rates, especially when rates are low.

To protect themselves in case interest rates make a drastic turn in the wrong direction, they call in swap dealers like Morgan Stanley or JP Morgan. With a few strokes of a pen, they can lock in a fixed rate.

Unfortunately, as has been the case across the world, swap contracts that made sense in an environment with climbing interest rates no longer make sense now that investors have access to darn-near-free money.

The schools and towns that were acting responsibly by entering basic swaps are now forced to make larger payouts because their hedges went the wrong way.

And what’s a better way for a wannabe politician to get some votes? Make it look like he’s saving poor, old taxpayers from evil Wall Street financiers.

Idiots.

It is this kind of action that forces CFOs to enter the world of creative accounting. Outside of the commodities industry, I dare you to dig through any company’s 10-K and find the word hedge, swap or derivative.

You’ll be hard-pressed to find it, yet any big firm is most certainly using swaps for protection.

But don’t tell their shareholders. If just one contract goes against them, shareholders tend to revolt, telling executives to stop “gambling” with their money.

Knowing that swaps, futures and option contracts are fantastic way to create predictability and price limits, CFOs continue to enter agreements. They simply call them something else.

Ever seen that line on the balance sheet that says “other”?

That’s your swap.

If a politician, elected or appointed, thinks forcing schools and municipalities out of swap contracts will save taxpayers any money, they are either ignorant fools or lying to you.

*** Speaking of ignorant, Alaska’s Department of Revenue is ready to make a blunder of its own. The organization has an unfunded pension balance of $7.5 billion, a common problem these days.

What’s the 49th state’s solution? It wants to issue a $2 billion bond and invest the proceeds in the equities market. If things go its way and the state earns the market average of 8% annual gains on its equities, it could rake in an extra $40 million annually.

But talk about a gamble.

Right now, the state’s bonds are selling with rates just above 6%. But the department says it won’t consider a bond issue unless the rates are below 5.5%. I sure hope not.

Imagine if you or I walked into a bank these days and said give me ten grand. I’ll pay you back with my stock-market gains.

Unless you got out of a $100,000 car and live in a $2 million mansion, you’d be laughed out of the joint.

Now, it’s easy to argue Alaska has more than enough collateral to back up the bonds. I mean it’s not going bankrupt anytime soon. But the chances of a loss on this “intrastate carry trade” are far too high.

Trying to time this top-heavy market is nearly impossible, especially when it will take nearly two months to get the bond sale lined up.

How’s this for the ultimate proof this is a horrific idea? If the state had made the move lawmakers first approved it just months before last fall’s market collapse, it would have lost hundreds of millions of dollars and would have remained on the hook for a couple of billion bucks.

With investing logic like this, it’s no wonder tax rates are soaring across the country. When it comes to investing, our leaders are clueless.

I’d rather let Madoff invest my money. At least he’d have fun with it.

For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a “swap” for a specific commodity like corn and then hedge their position in the futures markets. There is no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that is traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.

The key word in the announcement yesterday was the word “classification.” Right now the banks are classified as hedgers and as such have no limits. But they are not really hedging the actual physical commodity as a farmer or General Mills might do, but the hedge is their financial position.

If the CFTC decides to look through them to the funds, and they did use the word transparency in their announcement, they could decide to change the classification of the banks from hedgers to speculators. While I do no think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme, and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.

For what its worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they are getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it is but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The hand writing is on he wall.

Does this mean I am not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It is just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it is a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.

Source: Swapping out Commodities