The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.
The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?
Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.
Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.
Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.
As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.