New Jersey Swap Unwind

August 21st, 2015 9:07 am | by John Jansen |

Via Matt Levine at Bloomberg (this is an excerpt from a longer article):

Toxic swaps.

New Jersey, like many states, has issued floating-rate bonds, and then swapped them back to fixed rates using derivatives with banks. (See, e.g., page I-47 in this 2014 bond offering document, or pages I-39 and I-40 ofthis one.) Like many states, New Jersey was a bit nervous about this: There is some history of municipal swaps not working out quite as intended, due to divergence between the floating rate paid by the issuer (based on the Sifma muni rate) and the floating rate paid by the banks (based on Libor). And New Jersey is flirting with ratings-agency downgrades that might give its swap counterparties the right to terminate their swaps or demand collateral. So Reuters reports:

New Jersey has terminated all of its interest rate swap agreements under Governor Chris Christie, paying banks $720 million to unravel $4.2 billion of swaps and wiping from its books a potentially big, unpredictable liquidity risk.

Sure, unpredictable liquidity risk: Those swaps had a very negative mark-to-market, because New Jersey pays fixed rates and gets back floating rates, and interest rates have been low over the past few years, lower than they were in “the early to mid 2000’s,” when most of these swaps were done. And if those downgrades happened, New Jersey might have had to terminate the swaps and pay the negative mark-to-market to the banks, which would cost it … um … about $720 million. Get it out of the way though. Here’s New Jersey Treasury spokesman Christopher Santarelli:

Swaps “have been considered to be toxic by market participants and the administration. The state saw an opportunity to clean up its balance sheet and did so,” Santarelli said in an e-mail.

Toxic, right. There is a history of swaps causing heartache for municipal issuers, so it is entirely understandable that New Jersey would want to get out of its swaps. On the other hand, interest rates are low, and one of the big economic questions of recent months is “When Will the Fed Raise Rates?” The answer is probably soon, or soon-ish. When the Fed raises rates, the floating rate that New Jersey pays on its bonds will probably go up, costing it more money — a cost that is no longer hedged. And when rates go up, the mark-to-market on those vanished swaps would have become less negative, making it cheaper to terminate them. As one anonymous Twitter wag put it, “Unwinding all your swaps right before the Fed starts to raise rates” is the “most State Treasurer trade ever.”

Elsewhere in municipal finance, Hillview, Kentucky, is “the first city to file for bankruptcy since Detroit did two years ago.” The problem seems to be not swaps but “a contract dispute with a local company, Truck America Training, over a land sale,” and it seems a little rough for a business to put the city where it’s located into bankruptcy.

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