Mostly Economics

HBSWK discusses a paper on the topic.

It is based on French politicians who have used fancy finance to make political inroads:

Talk of the recent financial crisis often falls into a simplistic narrative of villainous banks, marketing toxic financial products to innocent customers who did not understand their risks. Among the storied victims are municipal governments that took out loans with initially low interest rates, only to see the rates skyrocket when the crisis hit. Many mayors cried foul, insisting that they had been hoodwinked.

But were the local politicians really unwitting fools? “There is no doubt the transactions were very risky, as interest rates on these loans frequently exceeded 20 percent,” says Boris Vallée, an assistant professor in the Finance unit at Harvard Business School. “The question is, Did local politicians get fooled into engaging in risky transactions, or did they take the risks knowingly, opting for the short-term benefits in spite of the risks?”

Vallée recently tackled that question in the paper The Political Economy of Financial Innovation: Evidence from Local Governments, cowritten with Christophe Pérignon, a finance professor at HEC Paris. The study offers empirical evidence that politicians routinely used high-risk loans on purpose, for political gain, in spite of the risks. Furthermore, the strategy worked: Toxic loans helped incumbent mayors get reelected.

The researchers focused their study on France, having gained access to two valuable data sets: The first contained the entire debt portfolio for most of the 300 largest French local governments as of December 31, 2007; and the second contained the loan-level data for all the outstanding structured transactions of Dexia, the leading bank in the market as of December 31, 2009. (Shortly thereafter, Dexia fell apart in the European debt crisis.) The data showed that so-called structured loans accounted for 20.1 percent of the 52 billion euros in total debt for the municipal sample.

Similar to subprime mortgages, structured loans usually carry a few years of guaranteed low interest, which allows local governments to reduce the cost of their debt quickly and obviously. But after the honeymoon period, these loans end up carrying highly variable interest rates resulting from exotic exposures. For example, the City of Saint-Etienne saw the interest rates on one of its major loans rise from 4 percent to 24 percent in 2010, due to the depreciation of the pound sterling. In total, losses on toxic loans doubled the city’s debt levels.

The politicians reaped rewards till gains were made. Post-crisis they blamed it on banks for misselling:

Vallée and Pérignon analyzed how the politicians used the loans—whether they had invested the money in equipment or services for the city, or used the cash to lower taxes for their constituents, or both. It turned out that for the most part, they had used the short-term savings from the loans to lower taxes. “This action is consistent with politicians seeking reelection by catering to taxpayers’ preference for low taxes, which represents a likely channel for the previous result on the effects on reelection,” the researchers write.

The strategy apparently worked. Controlling for potential selection effects, the researchers found that using structured loans led to an increase in the likelihood that a politician was reelected.

“These financial innovative products appear, therefore, to have aligned banks’ incentives, as the transactions were highly profitable, with local politicians [who] had an interest in getting reelected,” Vallée says. “However, this happened at a large cost to the taxpayer, as the positive effects of the loans were short-lived, and interest on toxic loans ballooned when the crisis hit.”

In the wake of the financial crisis, many local politicians filed suits against their banks, claiming that they had not comprehended the risky nature of the loans they undertook.

“Local politicians have been vocal ex post both in the media and in [the] French Congress,” the researchers write. “For instance, in his testimony before the French Congress’s committee on toxic loans, the deputy mayor of the City of Saint-Etienne, who originally decided to take on some toxic loans, stated that ‘[he] was not able to read the information [he] received because [he was] not a financial expert.’ “

Vallée, who holds a doctorate in finance from HEC Paris, is currently working on a study of byzantine banking behavior toward individual investors. But in the case of structured loans, he argues that a borrower need not be a financial expert to realize the stakes. “They are not that complex, and after spending 10 minutes on it, someone with a college education will be able to understand the risks,” he says.

As this blog keeps saying..one should be weary of anything in high and sophisticated finance. Whes it bites back, it bites hard..