Corporate & Securities Law

Interest-Rate Swaps Dig Municipalities Deeper Into Debt

By Keith Griffin

Interest-rate swaps have become synonymous with toxic investments for a growing number of states, cities and towns across America. States and local governments initially turned to the exotic financial instruments as a way to boost their budgets. Instead, many have found themselves pushed to the brink financially and forced to cut basic services like public transportation and sanitation.

An interest-rate swap is a contract between a bond issuer such as a school district or a state or city government and an investment bank. Both parties involved in an interest-rate swap transaction essentially ?bet? on the movement of interest rates. Whichever party guesses wrong ends up paying. How much is paid or lost depends on several factors, including the size of the debt and current economic conditions.

When the housing industry started to crumble in 2007, followed by the downturn in the financial markets, interest-rate swap deals quickly began to sour for many state and local governments. Case in point: the Denver school system.

Denver schools turned to interest-rate swaps in 2008 on the advice of JPMorgan Chase and the Royal Bank of Canada. The deal was supposed to eliminate a $400 million pension fund gap for the school system. Instead, it caused a financial drain on Denver?s already-strapped budget. So far, Denver schools have paid $115 million in interest and other fees - an amount that?s at least $25 million more than what was initially envisioned.

Escaping an interest-rate swap is not easy or cheap. As reported Aug. 6 by the New York Times, Denver schools must pay the banks $81 million in termination fees, or about 19% of the system?s $420 million payroll.

Wisconsin is in a similar boat. Several years ago, s group of five school districts invested in derivatives as a way to boost returns to a joint pension fund. They now face losses of nearly $200 million, with the retirement system close to bankruptcy. A lawsuit has since been filed against the financial institutions behind the deal, Stifel Nicolaus & Co. and the Royal Bank of Canada (RBC).

Perhaps the most publicized case involving interest-rate swaps is that of Jefferson County, Alabama. As in the Denver school system, JP Morgan was the bank that arranged the Jefferson County deal, which entailed refinancing the Jefferson County sewer system in 2002 and 2003 with $5 billion in interest-rate swaps. Far from the money-saving investment proposed by the bankers, the deal nearly bankrupted Jefferson County.

If you have a story to tell involving interest-rate swaps, please contact a member of the securities fraud team at Maddox, Hargett & Caruso.

Full post as published by Representing Investors on August 07, 2010 (boomark / email).