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8 April 2009 21:09 GMT

MUNI WATCH: Swaps Backfire On Municipal Finance Officers

By Stan Rosenberg Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)–Finance officials for state and local governments in recent years have stepped up their use of a complex financing instrument in an effort to lower their overall borrowing costs.
In many instances, however, this addition to their toolbox – essentially an interest-rate bet – has backfired, sometimes big time, pushing at least one municipality to the brink of bankruptcy.

The instruments are interest-rate swaps, which allow a borrower to hedge against rising interest rates. They can save state and local governments money when they sell debt that carries a floating interest rate. But when interest rates move in the opposite direction, as they have since the outbreak of the credit crisis in 2007, the results can be painful. And the downgrades of bond insurers haven’t helped.

Estimates on the amount of interest rate swaps tied to municipal debt range from $200 billion to $500 billion as the total is difficult to gauge in this unregulated market. It’s also hard to determine how many municipalities that have used interest rate swaps are facing losses because of a paucity of data.
Still, examples abound.

The current poster child for this situation is Jefferson County, Ala., the largest county in the state and home to Birmingham, its capital city. The county’s water and sewer systems tumbled hard when its interest-rate bets went wrong and which it can’t afford to pay.

A bankruptcy there would be the largest ever for a state or municipal government, but Jefferson County isn’t alone in facing problems with swaps. Detroit is losing money on these instruments, a form of derivative that essentially enables any municipal entity to substitute a floating rate that it pays on bonds for a more stable fixed rate in a swap agreement with some counterparty.

Pittsburgh is having problems, as are universities like Harvard. In the healthcare sector, hospitals have bled money, too.

These bets are “toxic tools that have to be handled with care,” said Joseph Fichera, chief executive of Saber Partners, a New York City-based financial advisor to corporations and state and local government.

Fichera maintains that local officials commonly don’t understand the deals they’re getting into – which many of them concede – but he adds the real failure rests with the advisors they employed “who did not do thorough due diligence and effectively challenge the bankers on assumptions, calculations and risk.”

The Municipal Securities Rulemaking Board, the self-regulatory group for dealers in the $2.7 trillion state and local government bond market, recently has been pushing hard to bring all financial advisors under its regulation, including swap brokers.

In a typical swap, a municipality that sold bonds paying a variable rate – one that typically changes with some index – would agree with another party to pay it a fixed rate while it accepts a variable rate in exchange.

Payments are made periodically between the two parties over the life of the bonds, depending on the direction and the extent of interest rate moves. When the bet backfires for the municipality and it doesn’t have the funds to pay the counterparty – or the payment would stretch its budget to the limit – the municipality may want to terminate the swap.
The problem is the counterparty can demand a hefty fee to terminate the swap, especially when many local governments are trying to exit at once.

Much of the reason for municipal officials being caught off guard also can be traced to the downgrading of bond insurers who previously had provided their state and local issuers with gilt-edged credit ratings. Agreements allowed for the counterparty in such situations to accelerate repayments, which the municipality may not have been able to afford.
Still, the full magnitude of the problem isn’t known. Only time will tell how painful these derivatives ultimately will be.

(Stan Rosenberg, a veteran observer of the municipal bond industry, writes about issues and trends in the muni market for Dow Jones Newswires. He can be reached at 201.938.2143 or stan.rosenberg@dowjones.com)


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