Port Authority Losing Millions on Swaps

bayonne Port Authority Losing Millions on SwapsThe Port Authority of New York and New Jersey is shelling out more than $2 million per month on three interest rate swaps tied to bonds that either never were issued or have long since been refunded.

In all, the agency has paid Wall Street banks more than $37 million since 2007 to cover the three swaps, which currently have a market value of approximately negative $145 million.  When combined with other swaps the agency has paid to terminate over the past two years, the total swaps payout crests $70 million since 2007.

The swaps are basically an exchange of a fixed payment by the PA for a variable one from a counterparty tied to a short term interest rate.  The derivatives, which are essentially a bet with another company on which way interest rates will move, are meant to protect the PA in the event that interest rates soar.  When used as a hedge, a swap is designed to lock in a low fixed rate payment to offset the long term risk of a variable rate bond.  The variable rate payment paid by the counter party is designed to track the rate paid by the PA on the bonds, offsetting each other and mitigating the risk of soaring rates.

When no underlying bond is issued, the swaps become a pure bet on rates. When interest rates are high as they were in 2006 when the deal was cut, the PA stands to break even or make money on the swaps.  But, when rates go in the tank, the fixed payments the PA is forced to make far outweigh the variable payment it receives.

In June 2006, when all three swaps were made, the short-term rate on which the swaps are based – known as the London Interbank Offered Rate or LIBOR – stood at over 5.5 percent.  Today that rate is .29 percent.

The swaps, which have a face value of $647 million, were entered into by the PA at a time when interest rates were on the rise and public finance professionals across the nation were looking for ways to lock in lower rates on future bond issues.

In the case of the PA, two swaps were entered into in anticipation of the issuance two years later of variable rate bonds and a third to hedge a variable rate bond issued that year.

When tied to a variable rate bond offering, the swap is meant to protected the issuer against a spike in interest rates, in effect, creating a low fixed rate payment instead of a fluctuating one.

But officials miscalculated the financial picture as the effective date of the swaps coincided directly with the latest recession, which has forced interest rates down to levels never seen before.  As a result, the underlying bonds were never issued on two of the swaps and the PA has been forced to pay out millions to the counterparty banks. The third bond issue was retired in 2008, but the swap, which had plummeted in value, remained on the books.

In addition to the losses, the PA was forced to pay interset on its variable rate bonds that was higher than it would have had it not hedged the offering with the swap.

At current interest rates, the PA will pay out $27.7 million more per year than it takes in on the swaps.  But canceling the contracts would cost far more – upwards of $140 million at current market value – leaving the PA little choice but to ride the wave and hope interest rates begin to climb.

Losing from the start

Port Authority financial statements show within months of their inception, the market value of the swaps had dropped to negative $23.4 million.  The following year the market value fell to negative $42 million as interest rates continued to plummet.

In 2008, the year the PA was supposed to issue the underlying bonds on two of the swaps, interest rates were at half their 2006 levels and the value of the swaps had dropped to negative $197 million.  That year’s financial statement reflects the PA’s concern over the unhedged swaps.

One thought on “Port Authority Losing Millions on Swaps

  1. What the hell ever happened to issuing fixed rate bonds?  Instead, you get variable rates, relieving the lender of the risk, and then you pay Wall Street a second time to hedge the risk you now have.  Who sold that idea?

    Moreover, if interest rates had soared, the counterparty probably would have gone bust anyway and not paid the Port Authority.  Unless it received a federal bailout.

    Fixed rates have been lower in this past decade than just about ever before.  Why the hell was all this stuff required?  The government agencies didn’t need it, and didn’t benefit.

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