Eileen Norcross is a Senior Research Fellow at the Mercatus Center at George Mason University. She blogs on state and local economic policy at Neighborhood Effects.
Several high-profile municipal bankruptcies have drawn attention to the rising tab for public worker benefits, due to undervalued and underfunded pension plans. But some of the biggest recent fiscal emergencies, which have swallowed up the financial resources of Jefferson County, Ala. and now threaten Baltimore and scores of other local and state governments, have another cause: the use of the "too-good-to-be-true" debt instrument—otherwise known as the interest rate swap.
The interest rate swap is a financial contract between the bank and the government, in which a floating rate of interest is swapped for a fixed rate on the issuance of bonds. The purpose of the deal is to allow the issuing government to hedge against interest rates rising and thus save some money. But whether the government—and the taxpayer—comes out ahead or loses the gamble depends on if variable rates rise or fall relative to the fixed rate.
The practice became common in the 1990s, when big banks began to offer municipal and state governments new products to finance long-term projects (roads, sewers, parking garages), and for investment. Depending on how the deals are structured, some municipalities might still come out ahead. But the dangers should not be ignored.
As an example, consider the interest rate swap's biggest municipal casualty to date: Jefferson County, Ala. In 2002, the county issued $3.2 billion in bonds to build a new sewer. When the project was completed, Jefferson County entered into a contract with J.P. Morgan to purchase interest rate swaps—that is, to exchange its fixed rate debt for variable rates. Since the county at first estimated the project would only cost $1 billion, officials aimed to bring down its ultimate price tag.
After the 2007 market crashed, the county found itself on the other side of the deal—owing more in interest payments than it was receiving, pushing the town into bankruptcy. Local corruption played a role as well—officials pumped up the sewer system's price and accepted payoffs—but the structure of the rate swap has undoubtedly done great harm.
Jefferson County's experience with interest rate swaps is now shaking the confidence of issuers from school districts to hospitals to cities throughout the country. The revelation that the banks had colluded to manipulate the LIBOR borrowing rate (the London Interbank Offered Rate, or the rate banks charge to one another) to profit investors in derivatives markets and protect the banks' credit has led several state and local governments to file lawsuits.
A recent study by Sharon Ward of the Pennsylvania Budget and Policy Center estimates that between 2002 and 2009, 626 local governments entered into swaps in the commonwealth. Philadelphia's municipal, school, and special-purpose governments have all dabbled in derivatives. In 2004, for example, the City of Philadelphia School District took out 10 fixed-to-variable interest rate swaps with Wachovia Bank on school bonds. The district agreed to pay a fixed-rate of interest between 3.24 and 3.81 percent on the bonds. The bank agreed to pay a variable rate in return, calculated as a percentage of LIBOR.
At the time, this would have seemed like a good bet for many governments. Variable interest rates were higher than they are today and the district was hedging against the likelihood that a sudden rise would expose it to risk. So, much like refinancing a loan, swapping the variable rates for a fixed rate seemed prudent.
Then in 2008, interest rates plunged. As Ward writes, when the school bonds were issued the LIBOR was 1.493 percent. In December 2010, it was 0.26 percent. Wachovia's payments to the City of Philadelphia School District plummeted, while the district continued to make its payments based on the fixed 3.4-3.8 percent rate. In addition to being bailed out by taxpayers, Ward calculates that it transferred $71 million to the banks.
There are many interrelated factors that can bring a government to bankruptcy, and the extent to which interest rate swaps are involved is still unknown. As some have noted, swaps can be a way for governments to navigate through tough budgetary times. One principle might emerge from the wreckage, though: When using taxpayer dollars, governments should be aware of the risks of debt instruments.
- Read James Rickards: LIBOR Fraud May Be the Mother of All Bank Scandals
- Check out Economic Intelligence on Twitter at @EconomicIntel.
- Check out U.S. News Weekly: an insider's guide to politics and policy.