How swaps work — 
and don’t

By Russell Grantham

The Atlanta Journal-Constitution

Interest rate swaps are one of several so-called “derivative” securities whose value is based on changes in value of another security or number, such as a stock price index, oil prices or interest rates.

Many investors use them to make speculative bets. But farmers, companies, banks and others have long used them to “hedge” against the risk of falling corn prices or rising interest rates.

Such derivatives have been at the heart of regulatory reform efforts in Washington, D.C., to avoid future financial crises. Recently passed bills in the House and Senate would tighten regulation of the complex securities and perhaps force banks to spin off their lucrative units that sold many of the derivative deals to municipalities.

Cities and other municipal borrowers began using interest rate swaps in a big way in the last decade to help them borrow money at relatively low interest rates.

A typical bond-swap package might work 
like this:

A city borrows $100 million for 30 years, at a variable interest rate that changes each week. The city’s varying payments go to the bondholder. The city also signs a 30-year swap contract with a “counter-party” such as Goldman Sachs, which agrees to make variable-rate payments to the city. The city, in turn, makes payments to the counter-party based on a fixed interest rate.

The two variable payments theoretically cancel out and the city is left with a bond payment at a fixed interest rate, similar to the traditional bonds municipal borrowers traditionally used.

Crisis and new risks

But as the financial crisis demonstrated, the complex deals were bedeviled with risks those traditional bonds didn’t have.

The auctions that set the weekly rates froze up, essentially locking up the variable bonds. Counter-parties such as Lehman Brothers collapsed. Bankers that guaranteed the deals forced the borrowers to drastically accelerate debt payments. Interest rates plunged, but the fixed rates cities were paying did not. To get out of the deals, cities had to pay them millions of dollars in termination fees and refinance the bonds.