Compound interest slugs Miami ballpark
It shocks me sometimes, the lack of economic and financial literacy that supposedly knowledgeable persons demonstrate. The latest example caught me two weeks ago at LaGuardia Airport, when I picked up a copy of the Miami Herald left in the waiting area by a fellow traveler.
An article on the financing of the new ballpark (or stadium) for the Miami Marlins baseball team threw me for a curve. The journalist described a 91 million dollar loan, issued in 2009 for repayment in 2048, with a rather strange debt-servicing structure. I presumed financial knowledge, since the writer was contributing to the Herald’s business section.
The loan discussed requires no debt-servicing payments until 2026, when the first annual payment amounts to 260,000 US dollars. In 2029 the payment jumps to 8 million dollars per year, in 2034 to 30 million dollars per year, in 2039 to 83 million dollars per year and finally in 2042 comes what the journalist calls the “big hit” as interest due reaches 118 million dollars per year. Summing all the annual payments, the journalist expresses wonder at how a loan of USD 91 million will ultimately cost taxpayers USD 1.2 billion.
Frank Hinton, head of the Miami-Dade County bond program, was also wowed by the figures. “It’s an expensive way to borrow money,” he said. “You’ve got 1.2 billion dollars to pay back. It is a lot of money.” Hinton mitigated his remarks by alluding to the effects of inflation, but still the whole article leaves the layman reader pretty scared and even appalled that “for every dollar Miami-Dade borrowed in this transaction, it will pay back 13 dollars.”
How did the journalist strike out in presenting this unorthodox loan? He forgot two things. First, interest is compounded and hence foregoing payments for a couple of years will increase the amount one has to pay back. Second, a dollar of 2009 is not directly comparable with a dollar issued today, and certainly not with a dollar of 2048. My overall call is that the writer took advantage of readers’ lack of economic literacy to make an impression; so strike three on the journalist’s stadium pitch.
To make the case of compounding clear, imagine that instead of this rather bizarre structure, Miami-Dade County had issued a zero-coupon bond, one for which the accumulated interest is paid at maturity together with the principal. Such a bond would have run for 40 years. If for the sake of the example we assume an interest rate on this zero-coupon bond of 7%, then at maturity in 2048, Miami-Dade County would have to pay back the cumulated foregone interest as well as the principal, which for 91 million dollars borrowed would amount to 1.3 billion US dollars.
The more complex structure of the actual loan has an underlying interest rate of roughly 8.2% per year. This might seem rather high when compared with the level of US interest in 2009 (yields on 30-year US Treasuries were 4.5% in 2009) and today. If at all, it is here where one can blame bankers for giving a loan with such high interest rates.
Then again, 8.2% interest can only be considered high if one believes that the fate of the US over the next 35 years will remain that of low inflation and low interest rates, namely a Japanese-type of economy. Going back to the 1970s, 1980s and 1990s, when inflation was high, so too were 30-year interest rates, sometimes well above 8.2%. If inflation starts accelerating in the next couple of years, it could even be that by 2048, hindsight will see this loan as a rather good deal.