| Impact of Interest Rate Swaps | | | Janis Vera Todd | BUS 250 International BusinessProfessor Masudur Chowdhury | 3/12/2010 |

|

The first article that we will look at deals with interest rate swaps is “New Jersey Swap for Unsold Bonds Cost $22,000 a Day (update2)”. This article is about mismanagement and misunderstanding of financial obligations on behalf of New Jersey and the officials of 2004. This administration used financial backing by the Bank of Montreal in an interest-rate swap that was linked to unsold bonds. They were basically gambling with the unknown future of the market that the funds are tied to with a floating interest rate to help cover the budget of building new schools in the future. The problem soon became apparent when the changes of fixed rates were moved to floating interest rates which started to rise. The swap rates were bench marks for debt and as the gap began to widen the bank rates started to change to allow the bank to make money and forcing New Jersey to go further into debt. They are now trying to reorganize what financial debts are left to get lower interest rates and to be able to sell off the remaining swaps in 2012. This way they can refinance without incurring the fifty million dollar penalty for canceling the contract with the approval of the Treasury department.
Because James Florio and James McGreevey, the governors at the time, went through with these financial decisions without thought out and understanding of the swap more clearly they would have known that changing from a fixed interest rate to a variable interest rate was not the best thing to do. At least with a fixed interest rate you know what the payments are going to be every time but with a variable rate it can go up or down each payment since you are now at the will of the market even though the principal is locked. New Jersey isn’t alone in this scenario; borrowers from Massachusetts to California are also dealing with this type of financial crunch (McNichol, 2009).
Along with being uneducated with the workings of the interest rate swaps it seems some of the decisions were made more on the level of personal dealings. There are pending investigations to see if “Wall Street banks conspired with brokers to rig bids on contracts” or not (McNichol, 2009). Former mayor Larry Langford has already been convicted of accepting bribes from a banker friend in turn giving that friend underwritten contract. With all these factors taken into consideration it is no wonder that there are such high monthly payments due in these instances.
Since New Jersey was in the situation of not borrowing fast enough to meet its contractual obligations they are revamping that agreement. Under the new terms they are able to suspend the floating-rate payments and lower the fixed rate cost until 2012 (McNichol, 2009). The new agreement also allows New Jersey to avoid the approximate fifty million dollar termination fee by reinstating the original construction bonds. This financial mismanagement in as little as three years would have covered the price of not only typical elementary schools but also the salaries of one hundred and thirteen teachers for three years each. Of course the people responsible for this unfortunate situation are either refusing to answer calls or even hanging up on them and even pretending they have no knowledge of the situation they put the state in.
In the mean time New Jersey is planning on selling some of its variable rate bonds to make up for some of the swap to still allow construction to continue. While this should help to alleviate some of the financial burden aggressive management, education on how the money should be invested and accountability will be the only way for New Jersey and other states to get out of this loop hole.
The second article dealing with interest rate swaps is more about the cause and effect of the swap interest rates. Because the swap interest rates are benchmarks for debt when debts rises so does the interest rate. Other factors to base the rates are the crash of the mortgage and automobile industries along with the LIBOR (The London Inter-Bank Offered Rate). The LIBOR plays a major role in the payment amount since this is the “benchmark for floating short-term interest rates and is set daily” (Bond Basics: What Are Interest Rate Swaps And How Do They Work, 2008 ). This as well as the weakening dollar allowed the gap to widen between the floating and the fixed interest rates increasing the risk measures. When the dollar becomes stronger the swap interest rates will begin to lower opening up this credit product to highly qualified credited banks with double-A ratings and higher (Bond Basics: What Are Interest Rate Swaps And How Do They Work, 2008 ). The Libor also helps to determine the potential risk for investors with this type of credit.
All of this is causing the foreseeable future of interest rates controlled by the Federal Reserve to be near zero. The yield points have also fallen allowing the Treasury yield to decrease along with it. Based on the LIBOR floating payments on the swap rates are usually higher than the Treasury yields. All of which is important since the swap rates help dictate the rates for investors for other forms of debt from mortgage-backed securities to auto-loan (Capo McCormick, 2009). Since this is the case swaptions are being used to speculate the future calling for normalization and a decline on the long-term swaption. Interest swap rates are seen as a volatile option but if they normalized then this signals expectations for the rates over the next year. All the traders have to do to calculate this rate would be by adjusting the implied volatility by the rate struck at the swaption (Capo McCormick, 2009).
An interest rate swap is when one party exchanges a set of interest payments for another’s cash flow to help manage their fixed or floating assets and liabilities (Interest rate swap, 2010). These are ways to establish short term financing for companies and allows the banks to get out from under association with risk or interest-rate exposure. The most common swap is the exchange from fixed-rate payments to floating but when flipped this is a way to match their assets or liabilities. With New Jersey they received the short end of the straw when it came to rates. If the rates would have fallen then New Jersey would have lower payments to make to the bank but as the rates continued to rise they were losing money hand over fist even though the principal remains consistent. The key to stay even when dealing with interest rate swaps is to keep the sum of expected profits and losses to equal zero (Bond Basics: What Are Interest Rate Swaps And How Do They Work, 2008 ). The option that New Jersey is doing to counter out the swaps at hand and correct the financial mess they are in is to create countervailing swaps. These are basically the same kind of swaps just with a different counterparty to whitewash the original swap.
The key is to keep in mind that the future is never known and you are taking a gamble when dealing with floating interest rates. You are at the will of the market and past performance is not a guarantee for future results. The previous information can help one get an idea of how it things will move in the future but there are too many unknown variables that can factor in. Who is to say factors such as timely repayments, obligations meet, and economies staying strong will continue in the future. The best you can do is educating yourself on the rates and have aggressive management in place to minimize any potential losses or issues that may arise.

References:

Bond Basics: What Are Interest Rate Swaps And How Do They Work. (2008 , January). Retrieved March 9, 2010, from pimco.com: hrrp://www.pimco.com/LeftNav/Bond+Basics/2008/Interest+Rate+Swaps+Basics+1-08.htm
Capo McCormick, L. (2009, November 19). Interest-Rate Swap Spreads Widen as Investo Risk Appetite Ebbs. Retrieved February 1, 2010, from bloomberg.com: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajiZ372zl.Wk
Interest rate swap. (2010, March 9). Retrieved March 9, 2010, from en. wikipedia.org: http://en.wikipedia.org/wiki/Interest_rate_swap
McNichol, D. (2009, December 4). New Jersy Swap for Unsold Bonds Costs $22,000 a Day (update 2). Retrieved February 1, 2010, from bloomberg.com: http://www.bloomberg.com/apps/news?pid=20601109&sid=asLzODkeRFKI&pos=11