Politicians Benefited From Using Toxic Loans

A new study by Boris Vallée and Christophe Pérignon offers evidence that local politicians in France (and probably elsewhere) used high-risk loans for political gain in the years leading up to the recent financial crisis. The strategy worked: Toxic loans helped mayors get reelected.
by Carmen Nobel

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?

“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?”

"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.

More than 72% of the 300 largest local governments in France used structured loans, according to the researchers. About 43% used toxic loans

More than 72 percent of the 300 largest local governments in France used structured loans, according to the researchers. And of those loans, 40 percent can be classified as toxic. "To make it simple, the toxic ones are the ones where you can pay high coupons—typically, two-digit interest rates—for up to 30 years," Vallée explains.

The researchers set out to find out why so many local politicians took out toxic loans in the first place—and whether they understood the stakes.

Political Incentives

To test whether the election cycle affected loan activity, the researchers looked at municipalities that held elections in the first quarter of 2008. They found that structured loan transactions occurred much more frequently shortly before rather than after political elections.

Toxic loan transactions were especially frequent for incumbent politicians running in "swing" areas. Incumbent politicians running in politically contested areas (where the local government had been ruled by the same party for fewer than 10 years) were more inclined to use structured loans than those in political strongholds (where the ruling party had been in power for more than 20 years).

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.

The Role Of Financial Sophistication

That said, the researchers did assess the role of financial sophistication on the use of structured loans. They considered the size of each municipality, understanding that larger governments were more likely to employ specialized financial advisors. And they obtained the mayors' current or former occupations, educational backgrounds, and age at the time of election.

The data suggested that mayors with the most-educated backgrounds were actually more likely to take out structured loans than those with less education. Those who took out the most structured (or toxic) loans had worked previously as corporate executives or senior-level civil servants. Former blue-collar workers, farmers, and artists, on the other hand, largely stayed away from these products.

The likelihood to use structured and toxic loans increased with local government size, indicating that bad loan decisions couldn't be blamed on a lack of staff expertise. Meanwhile, the use of structured loans decreased with the mayors' ages. "This was not a senility effect," Vallée says.

Pondering the prevalence of bad loans among French municipalities, the researchers also found evidence that politicians were more likely to enter into toxic loans if their neighbors had recently done the same. "First, there's the issue of salience—if their neighbors do it, then they know it's an option," Vallée explains. "Second, there's the reassurance factor. If your friend is taking a risk, then you're more comfortable being in the same boat."

And while the paper focuses on France, Vallée notes that municipal toxic loans were hardly an exclusive French phenomenon.

"I think it was interesting to look at France because the level of creativity and risk-taking was especially high," he says. "But this was widespread across Europe, and has been observed in India, China, and the United States to some extent. Politicians are kind of the same all over the world. If you give them an opportunity, I think they will seize it. They seized the opportunity offered by innovative financial products to lower taxes."

About the Author

Carmen Nobel is the senior editor of Harvard Business School Working Knowledge.

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    • Ken Workman
    • Director, Financial Economics, Financial Economica
    This is an interesting French twist on an American sore spot. Interesting in that it adds a political element to a widespread pattern of municipal transactions that turned out badly, with no gains to be applied to infrastructure or tax return. Essentially the losses came from the wholly unpredicted drop in interest rates' effect on swapping a variable rate security for a fixed rate. The transaction is straight forward, nothing inherently toxic about it. The toxicity may be the way the deals were structured with fees approaching 30% of transaction costs, to include high exit costs from the terms of the contracts. If interest rates had risen as dramatically as they fell, the benefits would mirror the depth of current losses, now labeled toxic. It was a bet on the yield curve with Wall Street powerhouses, wrapped in oleaginous, usurious terms that were aggressively marketed to widespread municipalities. I believe for the most part, in this co
    untry the motive was cost savings rather than political, but we've never looked that deeply into it.
    • Boris Vallee
    • Author, HBS
    You are making a valid point. Hedging interest risks through variable to fixed interests does not constitute a toxic transaction, as its aim is to cover against the risk of rising interest rates. The situation is different when the local government implicitly sells an option, because in that case the local government acts as an insurer. It is hard to justify why these institutions should be the ones insuring the financial markets against certain risks... In the US, there has been examples of institutions selling swaptions: there were getting the premium of the option initially (which would help their budget), with the hope that the swaption will not be triggered (as obviously the buyer, typically a bank, will only trigger it in negative scenarios). The French transactions follow the same rationale, except they were selling foreign exchange options. The level of fees embedded in swap transactions with local government is also an important d
    imension of the market, as anecdotal evidence indeed points towards it being very high.
    • kapil Kumar Sopory
    • Company Secretary, SMEC(India) Private Limited
    This is an interesting valid study.Such loans are availed for political gains without understading high cost and other disturbing features.
    People using such measures seem to be gaining but it is only in the short run. Ultimately negative effects emerge.