Jan Olaf Gaudestad

Norwegian Towns Investing in Tender Option Bonds: Why Tender Option Bonds Rarely Become a Good Investment Jan Olaf Gaudestad

In July 2007, eight Norwegian municipalities invested in complex financial instruments sold by Citigroup through Terra Securities. All eight municipalities were hydro electric power producers and a considerable amount of their tax income was based on concession fees from electricity. To stabilize the volatile income from the energy market, the municipalities sold the future electricity production and invested the present value in the international financial markets. Narvik Kommune, one of the eight municipalities, invested in a Tender Option Bond (TOB) using a Collateralized Debt Obligation (CDO) as collateral. Only four months after the initial investment, Citigroup liquidated the investment creating a realized loss of 90%. The analysis of the TOB and the CDO structure shows that the reason for the sudden drop in the investment value was related to the loss of correlation between taxable and tax-free interest rates causing the hedges to break. In addition, the mark-to-market valuation guidelines created by the Financial Accounting Standards Board (FASB) did not offer clear guidance for how to valuate illiquid securities such as the TOB and the CDO.