Interest Rate Derivatives: A Ticking Time BombHoracio RochaIrving ChanVibhore Kumar

OutlineMotivation & quick factsReal Case StudiesWorse case scenarios

Interest rate derivativesA ticking time bomb that is:Big & out of proportionWidespread in impactShortsighted

Big & out of proportionDerivatives market$600 TrillionGross notional value of derivatives market$437 TrillionIn OTC interest rate contractsCompare to$82 TrillionSize of worldwide bonds market$58 TrillionSize 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 impactWhile 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

ShortsightedIn response to very low short-term interest rates

many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt

This has led to a substantial increase in default risks if there is an increase in short-term rates

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

Municipalities are crying foulMany swaps were cash positive to the to municipalities in the early years, but with low interest rates these have become a burdenThe problem is compounded due to declining tax revenues

Trying to RenegotiateThe 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 CourtAmbac sued the Bay Area Toll AuthorityThough 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 swapsOther 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 DealsThis 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 ScenarioJefferson County, Alabama, was pushed to the brink of bankruptcy last year when interest on floating-rate 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 costsThe 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!