Gambling, Losing, and Complaining About It

There has been a recent uproar from citizens and politicians, in Los Angeles and a number of other cities and counties in the U.S., over municipal interest rate swaps that are now costing local governments millions of dollars a year. An interest rate swap is essentially a legal bet between two entities, one of which is trying to hedge its interest rate exposure. In Los Angeles’ case, the swap was made with Bank of New York (BNY) Mellon, who in 2006 exchanged $443 million worth of fixed-rate debt for an equivalent amount of variable-rate debt issued by the city.

Los Angeles made the deal to protect itself against the possibility of rising interest rates, which would have increased the interest owed on its variable-rate municipal bonds. However, in agreeing to this exchange, the city exposed itself to the risk that interest rates would fall, which they of course did—dramatically. The payoff in a swap is determined each quarter by the spread (difference) between the variable and fixed rate. Thus, the fixed-rate buyer stands to gain if interest rates rise, or lose if they fall.

Four years and one economic crisis later, the City of Los Angeles finds itself on the hook for $19 million a year (at today’s interest rates). But rather than accept the consequences of its gamble, or opt to refinance the floating rate debt with fixed-rate bonds, the city is demanding a renegotiation of the deal and threatening to never do business with BNY again if it does not comply. The most vocal cry baby of this effort is city councilman Richard Alarcon, who according to the LA Times described the deals as “tantamount to gouging” and likened the bank to merchants who sold water for $20 per gallon after the 1994 Northridge earthquake.

Conveniently, Mr. Alarcon doesn’t bother to mention that the City of LA, arguably a sophisticated investor, agreed to the deal, in which BNY also assumed risk. This is very different from the price-gouging merchants, who were taking advantage of increased demand owing to a natural disaster. “The bank is taking an unconscionable profit,” said Alarcon according to the Wall Street Journal. “We want to bring it down to a simple customer-to-vendor relationship. When a customer is not satisfied, they go to a different vendor.”

Yes, Mr. Alarcon, LA is welcome to use a different swap vendor in the future, but the city still owes the money on the legal contract signed by consenting adults. We feel that there is even less substance to these claims than to those of a gambler who asks for his losses back from the casino.

Taxpayers in LA and other municipalities where interest-rate swaps have gone awry (such as Jefferson County, AL which owes $3.2 billion on sewer bonds) are probably all wondering the same thing: Why gamble? Swaps are typically used as a hedging instrument. For example, if you have exposed yourself to the risk of rising interest rates from issuing floating-rate bonds, you can mitigate that risk (and any reward if interest rates drop) with a swap. So the city either made a cold bet on the future of interest rates, or it has succeeded in hedging another risk and still wants to recoup its losses on these swaps. What we are seeing here is nothing more than a case of buyer’s remorse at the municipal level.