Interest rate swaps became a relatively popular means for municipal governments to save some money during the 1990s and into the 2000s. The basic idea is that an issuer (the government) enters into a contract with a bank to exchange interest rate payments on a cash flow. These can be structured to exchange a fixed payment for a variable payment in return, or vice versa.
These interest payments are calculated based on an underlying asset or instrument, such as a bond. That makes interest rate swaps a derivative, as their value is derived from an underlying financial instrument.
The issuer’s goal is to hedge against fluctuating interest rates and impart some stability to their budget.The bank’s incentive is to make a fee. It works for the issuer when they guess correctly and – by way of example -the issuer agrees to a payment based on a fixed rate of interest that is low relative to the adjustable rate of interest the bank pays to the municipality in return.
But that’s not what happened as rates began to fall after 2008. Many municipal issuers found themselves paying banks a fixed rate that was high relative to the variable rate the bank was paying in return. Jefferson County, Alabama is the most notorious example, as my recent article in US News explains. At work in this larger story is the role the LIBOR interest rate rigging scandal played in suppressing the variable rate leading some governments to sue banks for damages.
Pennsylvania governments were particularly keen on interest rates swaps, with 626 swaps having been entered into across the Commonwealth. Depending on how they were structured, some entities have come out ahead. The majority have lost on the contracts. That includes SEPTA, as Pennsylvania Watchdog explains.
Is the problem with the interest rate swap concept? I’d argue that the answer lies in how they are used. What might be a good hedging instrument for the financial sector exposes the public sector to a set of risks that aren’t fully appreciated. The risks -including the real hazard that the municipality incorrectly guessed the direction interest rates would travel- are passed on to taxpayers or service users.