Municipal swaps have recently hit the headlines as they are associated with recent municipal bankruptcies such as Detroit’s and Jefferson County’s. This has caused some concern for municipal bond investors, who understandably wonder what role swaps might play in municipal bankruptcies.
First, consider the role that swaps and insurance play in the financial markets in general. Homeowners who buy fire insurance, for example, aren’t disappointed when their homes don’t burn down and they can’t collect the payout. When used to fix a variable loan rate, an interest-rate swap should be viewed in the same manner. The cash flows from the two contracts—the variable-rate loan and the interest-rate swap—essentially create a fixed-rate loan, or an insurance policy against rising rates. Even if interest rates don’t rise, the policy has value to the holder in the same way that fire insurance has value in the absence of an actual fire.
Swaps are a financial instrument that must be shown at market value, or marked to market. The market value in a lower interest-rate environment is usually not worse than the equivalent prepayment penalty on a fixed-rate loan. In an increasing interest-rate environment, the market of the swap transaction could even be positive or have value to the municipality. To clarify how a swap arrangement might work for a municipality, municipal borrowers (similar to Detroit) might swap floating-rate debt to fixed-rate debt for several reasons, including (but not limited to):
- To protect against rising interest rates that would increase the cost of their floating-rate debt and interest expense
- To know, plan, and budget for actual debt expenses in the future as opposed to the unknown of a variable rate
- To get further lending: In many instances, banks won’t lend to municipalities unless they have a predicted (fixed rate) debt payment
In the case of Detroit, although they have a swap with a negative market value, the swap was not the reason for the bankruptcy. Rarely are swaps the cause, although they may be a symptom, if there is a negative market value associated with it. Jefferson County used swaps to make an expensive sewer project more affordable. The derivative is just another aspect that should be evaluated, a part of the full credit analysis of the municipality that an investor should perform prior to investing in a bond. Derivatives are not always bad—particularly for large, sophisticated issuers. Smaller issues may have less need for swaps, but the appropriate application may still exist.
Given that swap markets are not publicly traded (yet anyway), it is difficult to quantify how much of the $3.7 trillion municipal bond market has exposure to swap agreements; however, it doesn’t appear that there is a ticking time bomb of swaps about to damage the municipal market. A swap is one tool in a municipality’s financial toolbox that may make sense in certain market environments but might not be wise in others. As these bankruptcies arise, it becomes more obvious that some of these swap transactions were either timed poorly, were poor management decisions, or were the result of aggressive sales pitches by investment banks (which you may occasionally read about as part of litigation). It is rare, however, that these mistakes are the cause of the fiscal crisis or bankruptcy; rather, problems with swaps usually arise when a bankruptcy or fiscal crisis arises. The incidence of such problems has been limited over the past several years of low rates, which suggests that it is not a huge problem for the full market.
The Detroit scenario highlights the need for investors to make in-depth, continuous, independent research of all their portfolio holdings (both current and potential) with an intensive credit-focused review process that could uncover these issues. A swap is an insurance policy—one that may actually create value for the municipality counterparty and be a well-crafted financial strategy.