Hundreds of state and local governments are losing big money as a result of interest-rate swaps they made with Wall Street Banks, according to a recent Wall Street Journal article by Aaron Lucchetti.
An interest rate swap is a derivative in which the parties exchange streams of interest payments. Like all derivatives, they can be used as either used a hedging strategy (conservative) or for speculation (risky). Securities firms receive higher fees for selling the swaps than they receive for selling traditional fixed-rate debt.
In most cases, municipalities borrowed money at lower variable interest rates. To hedge against a rise in interest rates, municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving floating rate payments from banks that would increase if interest rates rise. Interest rates have not risen, however, and the interest that banks have to pay municipalities has often fallen below 0.5%, resulting in net transfers of public funds to the Wall Street firms.
Interest rate swaps are exacerbating the financial problems faced by state and local governments throughout the U.S., which are already facing shrinking tax revenue and high pensions and other costs.
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