Several high-profile municipal bankruptcies have drawn attention to the rising tab for public worker benefits, due to undervalued and underfunded pension plans. But some of the biggest recent fiscal emergencies, which have swallowed up the financial resources of Jefferson County, Ala. and now threaten Baltimore and scores of other local and state governments, have another cause: the use of the "too-good-to-be-true" debt instrument—otherwise known as the interest rate swap.
The interest rate swap is a financial contract between the bank and the government, in which a floating rate of interest is swapped for a fixed rate on the issuance of bonds. The purpose of the deal is to allow the issuing government to hedge against interest rates rising and thus save some money. But whether the government—and the taxpayer—comes out ahead or loses the gamble depends on if variable rates rise or fall relative to the fixed rate.
The practice became common in the 1990s, when big banks began to offer municipal and state governments new products to finance long-term projects (roads, sewers, parking garages), and for investment. Depending on how the deals are structured, some municipalities might still come out ahead. But the dangers should not be ignored.
As an example, consider the interest rate swap's biggest municipal casualty to date: Jefferson County, Ala. In 2002, the county issued $3.2 billion in bonds to build a new sewer. When the project was completed, Jefferson County entered into a contract with J.P. Morgan to purchase interest rate swaps—that is, to exchange its fixed rate debt for variable rates. Since the county at first estimated the project would only cost $1 billion, officials aimed to bring down its ultimate price tag.