When I was deputy governor of the Reserve Bank of New Zealand, the Reserve Bank’s investment committee proposed an arbitrage deal.
I decided to discuss it with the governor, Don Brash, who had a merchant banking background. Don’s response has stayed in my mind ever since. He said if an arbitrage deal looks too good to be true, that’s usually because it isn’t true. You need to look at the whole deal, not just one part of it.
Peter Nicholl
Waipā District Council in their recent press release said that the arbitrage deal they had entered into was ‘low risk’ because the ‘interest rates were locked in on both sides of the transaction’.
The News sent some follow-up questions, and the answers confirmed the rates were locked in – but not in for the same length of time. Their deposits with ANZ and BNZ mature on April 14, 2025, so the interest rates on the deal are locked in for eight months. The loan they have borrowed from the Local Government Funding Agency is fixed for the term of the loan. The loan matures on April 20, 2029. The interest rate on that side of the deal has been locked in for almost five years.
A profit will be made on the arbitrage deal between now and April 2025, but whether or not the whole transaction will be financially advantageous won’t be known until the loan side of the transaction has reached its end.
Waipā told us they had made a $400,000 profit from this arbitrage deal. This is like the All Blacks putting out a press statement saying they had won a game when they were ahead after 20 minutes. This game is far from over.
Most mortgage holders in New Zealand have faced a similar question regarding borrowing to the one Waipā has just faced: do I borrow long-term at a lower interest rate now or borrow short-term at a higher rate in the expectation/hope long-term interest rates will be lower in a year or two? Most mortgage holders I know have decided to borrow short now in the expectation that long-term interest rates will come down significantly and it will be cheaper and less risky to lock in a long-term interest rate next year or the year after.
Waipā has adopted the opposite strategy. They have borrowed at a fixed rate for five years now. If Waipā has made a miscalculation on borrowing rates, it won’t show out in their financial accounts over the next four years. They will suffer what economists call an ‘opportunity cost’. That is, if they had waited, they could have borrowed the $50 million at a lower cost – and that would have been good for ratepayers.
I think Don Brash’s words will turn out to be right again. The arbitrage deal Waipa has entered into looked too good to be true because once you look at the full deal, which includes locking in a borrowing cost for five years, it may turn out not to be true.
See: Council defends ‘low risk’ investment
See: Letters to Editor
See: Letters to Editor
