Exiting Interest Swaps Connected To Lehman Brothers Proves Costly
In the wake of the Sept. 15 bankruptcy filing of Lehman Brothers Holdings, New York and other municipalities are finding themselves stuck with unexpected costs to get out of interest-rate swap contracts gone sour. In the case of the Big Apple, it has paid Lehman and Wall Street banks at least $75.9 million since March to buy out ill-fated swap agreements.
Between 2002 and 2005, New York was among several issuers that turned to interest-rate swaps as a way to lower borrowing costs on some $7 billion in bonds, according to a Dec. 24 article by Bloomberg. What they failed to take into account, however, was the unexpected. In this case, the unexpected meant the sudden bankruptcy of a counterparty - an event that not only terminates a swap contract but could do so in less-than-desirable “mark-to-market conditions.”
When the unexpected became reality on Sept. 15 with the bankruptcy of Lehman Brothers, New York and others like it were forced to pony up funds in order to exit their interest-rate swap agreements and issue new debt to replace bonds linked to the swaps.
Making matters worse: Many states already are financially strapped and have record budget deficits looming. Spending millions, and in some cases, billions of dollars, to cover increased interest payments and penalties couldn’t come at a more fiscally problematic time.
In a swap contract, two parties agree to exchange interest-rate payments. Typically, the deal consists of exchanging a fixed payment for a variable interest rate.
Besides New York, a number of state and local governments have been burned by interest-rate swaps tied to Lehman Brothers. When officials in Sacramento County, California, terminated the county’s swap with Lehman recently, they had to pay $23 million. Then, because the terms of the new deal with Deutsche Bank were not as favorable as those with Lehman, Sacramento County officials had to pay an estimated $8 million more for protection from fluctuations in interest rates.
The Butler Area School District in Pennsylvania is another municipal agency to lose big because of interest rate swaps. In August, the district opted to pay JPMorgan Chase $5.2 million to get out of its swap contract - more than seven times what it paid to enter the agreement in the first place, according to Bloomberg.
JP Morgan also is a central figure in several lawsuits involving interest-rate swap deals for a sewer system in Jefferson County, Alabama. County commissioners there now contend the Wall Street banks - and JP Morgan in particular - that devised the financing arrangement overcharged the county by as much as $100 million. Since then, the county has been teetering on the brink of bankruptcy.
In September 2008, following federal probes into its interest-rate swap deals, JP Morgan announced that it would no longer sell derivatives to state and local governments.
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