Big banks and corporations don’t just trade money, they trade interest rates. Does that sound odd? How can you trade in something so intangible as an interest rate? This practice is called an interest-rate swap, or rate swap. Assume two people each take out a $50 loan. One of them has a variable interest rate and the other a fixed rate. Both of them want to try to put themselves in a better position. The person with the variable rate thinks the interest rate is going to go up, so he would prefer a fixed rate, even if that rate is higher than the currently applied variable rate.
Assuming the variable rate increases, a fixed rate would result in lower total interest payments. Ultimately, he would pay less to settle his debt. The one with the fixed rate thinks the interest rate is going to decrease, meaning his fixed rate is set too high, resulting in more interest charged to his debt than if he had the variable. They would like to trade, but since the principal amounts on their loans are the same, there is no reason to exchange the $50. They agree between themselves to pay the interest on the other’s loan.
That, in its simplest terms, is an interest-rate swap. It takes place on much larger scales and usually only involves sophisticated borrowers and investors, but is essentially the same thing. The parties to a rate swap both hedge their money on an expected increase or decrease in interest rate.
Two great examples that hit close to home for lawyers at Beasley Allen et al, deal with the Baldwin County Sewer Service LLC (Baldwin Sewer) and the bankruptcy filed by Jefferson County, Ala. Baldwin Sewer serves almost 15,000 customers in southern Alabama. From 2002 to 2007, Baldwin Sewer borrowed about $42 million through variable-rate debt, working with Regions Bank’s predecessor, AmSouth Bank. It also entered into three swap agreements from 2005 to 2007. In 2006 and 2007, the swaps worked as intended, saving the utility money.
During the recession in 2008, however, the variable-rate market crumbled. Prior to that, many municipal borrowers, expecting the usual interest rate increase, entered into rate swap agreements. But after 2008, the Federal Reserve maintained the variable, benchmark overnight rate close to zero in the hopes of encouraging economic growth.
After its swaps, Baldwin Sewer, like other municipal borrowers, was stuck with a much higher fixed-rate. Baldwin Sewer ended up paying $7.4 million in swap payments instead of achieving the expected, and promised, savings. Seeking to reverse the swap agreement, Baldwin Sewer sought help through arbitration.
In March this year, an American Arbitration Association panel ruled for Baldwin Sewer against Regions Bank when it found “a continuing but hidden fraud” when the rate swap backfired. The arbitrator found “a pervasive failure of the bank to communicate the true risks” of the swap and “active misrepresentations of the financial obligations” the utility faced.
While not the only factor leading up to Jefferson County’s bankruptcy, costs incurred from rate swaps that went sour certainly did not help. According to Bloomberg, other municipal borrowers (ranging from cities to universities) have paid at least $5 billion in fees when the swaps they purchased similarly failed. Others are considering legal recourse. In Los Angeles, for example, at least one city council member is pushing to reverse the swaps that cost the city $65 million. Not every borrower will succeed in getting back his or her losses as Baldwin Sewer did. Instead of continuing to pay the high, fixed rates, many are choosing to terminate the swap agreements and are paying exit fees. Detroit, for example, is paying $85 million to end the rate swaps it entered into.
It should be noted that rate swaps are not always bad. In fact, in certain cases they can be beneficial. As the early days of Baldwin Sewer’s swaps show, municipal borrowers can save money. But, as with all investments, there are risks. Few experts anticipated the 2008 recession and the effects it would have on variable interest rates and the economy in general. Investors should at least be familiar with the concept and be fully aware of all the terms and risks before entering into a rate swap agreement. If you need more information on this subject, contact Rebecca Gilliland, a lawyer in our firm’s Consumer Fraud Section, at 800-898-2034 or by email at Rebecca.Gilliland@beasleyallen.com.
Sources: www.bloomberg.com; and www.primco.com
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