Unintended Consequences

Most of the press about the current crisis points to Credit Default Swaps (CDS), but there is another type of “swap” that may end up blindsiding us – the Interest Rate Swap contract.  What is an interest rate swap and how would it affect you?

Let’s say your local water district needs to raise about $100 million to build a new sewage treatment plant.  The district doesn’t have that kind of money, but does have a revenue stream to pay off borrowed money.  Typically in the past, how this would have been handled is an underwriter would create a bond offering, sell them as fixed rate municipal bonds via competitive bidding and then the revenue would pay the bonds off over 20 or 30 years.

Enter the “hot shot” investment banker… [these are hypothetical numbers to explain what an interest rate swap is and to explain the concept].  The banker from New York says to the unsophisticated local politician…. I have a deal for you – it’s not that old fashioned bond thingy that nobody uses any more.  You need to borrow $100 million.  If you do this as a fixed rate offering, you’ll need to pay 7% interest.  Rather than do that, I can get you the money at 5% (LIBOR + 3%), and save you $2 million a year in interest.  (assuming LIBOR = 2%)

If the borrower has a clue, they will say “Hold on a second – LIBOR is a variable interest rate.  If interest rates go back up, we’ll have to pay more interest.  If LIBOR goes above 4% we’ll end up paying more for a variable rate loan than if we had sold fixed rate bonds.  (assuming that 7% was even a real number)

Enter the Interest Rate Swap – the hot shot banker says “Have I got an answer for that.  I can arrange with an insurance company (think a company like AIG) that will guarantee this won’t happen.    Here is the deal – you pay them 5% up front ($5 million) and they will guarantee to pay you Libor +3% and you agree to pay them 5% if LIBOR goes back above 3%.   We’ll just add the 5% to the loan and in a couple years the savings will pay that premium – it’s a win-win deal.

So how could that possibly go wrong?  “Counterparty Risk“… the Interest rate swap agreement is only worth something if the seller stays in business.  If the swap seller is unable to honor the agreement (let’s say AIG declares bankruptcy), then the buyer is now left with a variable rate loan for $105 million at LIBOR+3% without the “hedge” in place to protect it from rising interest rates.   It’s pretty likely that over 20 or 30 years that LIBOR will float back up and the revenue won’t cover the interest and water rates will have to go up, or if the interest payments aren’t met, then the bank can force new higher rates onto the agency due to the default.

The seller books an upfront fee as complete profit and looks very profitable, and the contingent liability of what they might have to pay in the future might be zero, or it might be essentially infinite (how high could LIBOR go in 30 years?).  

The really bad part of this is that once local governments became aware of interest rate swaps, some of them were talked into acquiring interest rate swaps in the secondary market as the guarantor.   Say the company in the example finds another city that will take the swap off their hands by giving them $1 million  (to fill a budget hole) and they get themselves completely off the risk and book a $4 million pure profit.  When the deal falls apart, that $1 million in “free” money could quickly turn into $500 milion in real liability.

That’s how this could bite you – if someone in your local community is playing around in the interest rate swap market way over their head, thinking they found a source of “free” money to fund their own pension plan.

*** Update March 25th 2009 ***

Bloomberg Story

Guy in charge of setting the rules for Municipal Bonds underwriting realizes it was a mistake to not prohibit local government agencies from playing in the interest swap market.   Jefferson County is expected to file for bankruptcy.  You want goverment running your health care?