The Use of Financial Derivatives in State and Local Government Bond Refinancings: Playing with Fire or Prudent Debt Management?

By Luby, Martin J. | Journal of Public Budgeting, Accounting & Financial Management, Spring 2012 | Go to article overview

The Use of Financial Derivatives in State and Local Government Bond Refinancings: Playing with Fire or Prudent Debt Management?


Luby, Martin J., Journal of Public Budgeting, Accounting & Financial Management


ABSTRACT. The esoteric area of financial derivatives has become quite salient in light of the financial crisis of the last few years. In the public sector, state and local governments have increasingly employed derivatives in their bond financings. This paper analyzes state and local governments' use of a specific type of municipal derivative instrument (a floating-to-fixed interest rate swap) in a specific type of transaction (bond refinancing). The paper provides a case study of an executed bond refinancing transaction that employed a floating-to-fixed interest rate swap quantifying the substantial long-term costs financial derivatives can impart on state and local governments. The paper concludes with some specific lessons learned about debt-related derivative usage for public financial managers and offers some suggestions for further empirical and theoretical research in this area of public financial management.

INTRODUCTION

The esoteric area of financial derivatives has become quite salient in light of the financial crisis of the last few years. While much of the recent discussion in this area has been in relation to corporations', especially banks', use of these financial instruments and their contribution to the global financial collapse, state and local governments have also increasingly employed derivatives in their debt financings. Some estimate that the supply of municipal derivatives increased to over $500 billion in the years leading up to the financial crisis (Lucchetti, 2010). In general, debt-related derivatives are attractive to state and local governments because of the potential reduction in borrowing costs associated with the use of such financial products (Stewart & Cox 2008). For example, the execution of a financial derivative instrument in connection with a project financing or debt refinancing offers the possibility of significantly lower interest costs (especially in the short-term) vis-à-vis a financing that did not utilize such a financial instrument. In fiscally constrained times, such debt service savings can provide substantial operating budget relief for cash-strapped state and local governments. Thus, sub-national governments have justified debtrelated derivative use as a means of more efficiently managing their bond portfolio interest costs.

However, derivatives carry significant financial risks that have unfortunately manifested themselves to state and local governments since the onset of the recent financial crisis. As such, elected officials, the media and taxpayers are now just beginning to focus on the derivative practices of sub-national governments and their impact on government finances. For example, a March 22, 2010, Wall Street Journal front page story detailed how hundreds of state and local governments were losing money on interest rate swaps, a type of financial derivative, executed in recent years (Lucchetti, 2010) and that such losses were greatly exacerbating the operating budget deficits of these governments. Rolling Stone magazine, not a publication known for reporting on state and local government finances, detailed Jefferson County's use of interest rate swaps and the pay-for-play activities of several finance consultants and its impact on the county's much publicized troubled finances (Taibbi, 2010). As more information comes to light on state and local governments' use of these derivative instruments and their financial impacts, lawmakers have begun to propose restrictions on such risky financial instruments. For example, the Los Angeles city council recently instructed the city finance department to renegotiate or terminate an interest rate swap agreement that helped fund its water system while the State of Tennessee is attempting to restrict all of its local governments from using derivatives (Ackerman, 2009; Luchetti, 2010). Unfortunately, for many state and local governments, modifying or "getting out from under" these financial instruments is not easy and often can be quite expensive as evidenced by Jefferson County's scheduled $647 million termination payment on its swaps and the Bethlehem Pennsylvania school district's recent $12. …

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