Interest Rate Derivatives:

A Ticking Time Bomb

Horacio Rocha
Irving Chan
Vibhore Kumar

Outline
Motivation & quick facts
Real Case Studies
Worse case scenarios

Interest rate derivatives

A ticking time bomb that is:
Big & out of proportion
Widespread in impact
Shortsighted

Big & out of proportion

Derivatives market
$600 Trillion
Gross notional value of derivatives market
$437 Trillion
In OTC interest rate contracts

Compare to
$82 Trillion
Size of worldwide bonds market
$58 Trillion
Size of world economy

Big & out of proportion (contd.)

In comparison to the almost $600 trillion in
interest rate derivatives
There were "only" $36 trillion involved in credit
default swaps as of June 2009.
Credit default swaps were largely responsible for
bringing down Bear Stearns, AIG (and see this),
WaMu and other mammoth corporations.

Widespread in impact
While credit default swaps were largely
limited to US banks, interest rate derivatives
are more international
80% of the world's top 500 companies use
interest rate derivatives to control their
cash-flows*
Many universities, municipalities and others
smaller institutions have invested in interest
rate derivatives
*April 2003

Shortsighted
In response to very low short-term interest
rates
many U.S. corporations have swapped their
long-term (fixed interest rate) debt into shortterm (floating interest rate) debt
This has led to a substantial increase in default
risks if there is an increase in short-term rates

Widespread Use
Hundreds of municipalities contracted
and are now losing money on interest
rate swap trades.

Heavily marketed high fees

Desire to lower debt burden
Unsophisticated investors
Many did not bother to get multiple bids

Widespread Use (contd.)

Across the US
Pennsylvania, Tennessee, Texas were
particularly hard hit
Pennsylvania - 107 school districts
entered into interest-rate swap
agreements from 2003 to 2009
Texas has 17% of all swap agreements,
according to Moodys.

Municipalities are crying foul

Many swaps were cash positive to the
to municipalities in the early years,
but with low interest rates these have
become a burden
The problem is compounded due to
declining tax revenues

Trying to Renegotiate
The City of Los Angeles interest-rate
deal with BNY from 2006 to help fund
the city's wastewater system,
currently is costing the city about $20
million a year.

Termination
The Bethlehem, Pa., school district
had to pay $12.3 million to terminate
a swap with J.P Morgan Chase
The City of Arlington financed part of
Cowboys Stadium using swaps, the
city had to pay $10.9 million to get
out of the contracts.

Some Deals Have Led to Court

Ambac sued the Bay Area Toll
Authority
Though the authority paid Ambac
$105 million to terminate the swaps,
Ambac claims it is owed $156.6
million under the agreements.

States are Planning to Limit Use

Tennessee may be the first in the
U.S. to limit municipalities use of
swaps
Other states are also looking into
regulation, however the issue may be
more complex due to larger
borrowers

A deal that went bad

Sampling of Interest Rate Swap

Deals
This study by the Service Employees
International Union, which represents
municipal employees, is based on government
filings and payment estimates using current
interest rates. It compares the interest-rate
swap payments of cities with their budget
outlooks. The payments don't reflect
corresponding moves in municipal bonds.
Included with some examples are securities
firms that entered into the transactions with
the municipalities.

Worst Case Scenario

Jefferson County, Alabama, was
pushed to the brink of bankruptcy
last year when interest on floatingrate bonds skyrocketed and
derivatives tied to the bonds added to
the debt. The county defaulted on
$3.2 billion of sewer bonds in
September 2009

Conclusion:
Many of the deals generated higher fees for securities
firms than traditional fixed-rate debt. Government
officials, for their part, entered the deals in hopes of
reducing borrowing costs
The deals backfired when rates fell, shriveling the sums
paid to municipalities.
To terminate a contract would cost a municipality more
money than what is owed.
Taxpayers will foot the bill for the swaps.
Many municipalities are operating on a deficit and still
have these swap contracts
What will happen next????

Times up!