Something of Interest

During spring term, for the past ten weeks in my international finance class I was studying issues on political policies involving the foreign exchange market dealing with the different options contracts. Dealing with swaps can be difficult because of the risk involved such as credit risk, regulations on contracts, and transaction cost. There are many types of capital transactions that take place in the market especially in states and cities.

In a Wall Street Journal article I read over, Interest Rate Deals Sting Cities, States, the author discussed the swap contracts that cities and states make with big banks and financial firms which can end up being unprofitable investment in the long run. Bullish bets made on the interest rate market have caused many of U.S. municipalities to lose money. These bets were placed to lower borrowing cost and to protect the cities from higher interest rates. The contracts had a floating-rate because it was cheaper for municipalities to use in order to borrow more rather than have the traditional-rate debt. Some contract deals didn’t go as planned; causing rates to decline and a drop in the amount of money municipalities were expecting to receive. Many tax payers were affected by the transaction because they had to pay for it out of their pockets. Some city councils, such as Las Angeles, are renegotiating interest rate deals with big bank corporations to help with the funding of different local projects for the city. From October 2003 thru June of 2009, 107 municipal school districts in Pennsylvania signed interest-rate swaps contracts, 3 of those contracts had been cancelled. Some districts had to compensate to get out of their contracts such as Bethlehem school district that paid J.P Morgan $12.3 million in order to cancel their contract. Author Aaron Lucchetti stated in the article that State lawmakers are in the process of setting restrictions on municipalities’ ability to use these forms of swaps because the public is uniformed about the where about of their money and they do not fully understand how the system of these contracts work. Some States are paying any where from $1 million to over $100 million to financial firms for their interest rate swap contracts. Financial firms like Bank of New York Mellon Corporation, Goldman Sachs Group, and Belgian-French Bank have high fees for security firms than traditional fixed-rate debt. Swaps were eventually added into the package by many cities and states, stating to pay fixed rates of 3% to Banks. All the while Banks interest rate payments were at a floating rate from as low as 0.5%. The municipalities were not gaining anything from the swap agreements. Although the deal was made to help municipalities save money and borrow more, government officials are investigating if there was any foul play involved. A civil dispute for alleged payments owed for various swap agreements over a unit of bond insurer’s from Ambac Financial Group sued Bay Area Toll Authority. Bay Area Toll Authority paid Ambac Financial after credit rating of insurer’s downgraded and after bonds were retired of $104.6 million to cancel the swap contract. Which Ambac claims that Bay Area Toll Authority owed $156.6 million for the various contracts.

Overall, some industry officials believe that the swap contracts are in good standing and that no modifications are needed. On the other hand, others officials are open for renegotiation as long as there is no extensive list of demands and can be settled out of court. Many State and government officials are reviewing proposed contracts and restructuring agreement deals with financial institutions in their cities best interest to help better the borrowing process based on the fluctuation of interest rates.
The main goal for banks is to hedge risk for their customers. Financial institutions are also the main traders who enter into agreements to buy and sell swaps. They will usually place asking and biding prices on different contracts to be traded throughout the market to minimize risk in fluctuations and prices in commodity to a profit.
This article raises a lot of concerns about the financial firms being reliable and trustworthy. All firms have to build solid reputations so that customers can invest in them with good faith. These firms then write up contracts due to modifications in interest rates, expectations changes because of adjustments of price levels, inflation rates, and supply and demand and sell them off to the highest bidders in the market at predetermined prices. I agree with the municipalities renegotiating the contracts with the big firms. It will allow them to borrow more and provide funding for more community projects. But, as the cities borrow more and more, they should make sure they lock in a variable rate and look into their agreements for all the details as to what obligation and rights they have.

Ericka B.