Municipal Bombs

• Author: Randall Dodd
• Position: a former Senior Financial Expert in the IMF's Monetary and Capital Markets Department.

ASIDE from some shared names—and the movie Paris, Texas, which celebrates one of them—there seem to be few connections between European and U.S. cities. But modern finance has changed that some. Similar but complex derivatives transactions on both sides of the Atlantic have resulted in crippling financial losses for local governments.

The deals went sour in part because of the global economic crisis, which showed that many supposedly sound transactions were riskier than the municipalities believed. These deals usually involved unsophisticated local governments making deals using derivatives (see box) traded over the counter between two parties, rather than on an organized exchange or through a central clearing counterparty.

France has a reported €11 billion in outstanding notional amounts of derivatives involving 1,000 cities (a notional amount is akin to the face value of a bond). In Italy there are 467 cities with a reported €2.5 billion outstanding. Comprehensive data for Germany are not available, but at least 50 cities have derivatives transactions with Deutsche Bank alone. In the United States, where 40 states have passed laws authorizing municipal authorities to trade derivatives, such transactions have a total estimated notional amount of $250–$500 billion. As in Europe, financial disasters related to trading in those instruments have come to light in court actions. In the United States, large losses have been reported in cities and counties in Alabama, California, Ohio, and Pennsylvania, and like those in Europe, many U.S. municipalities have not publicized their bad trades, presumably to avoid embarrassment and political consequences. As a result, although there are sizable losses on both continents, comprehensive numbers are not available.

Some municipalities got into trouble simply trying to lower the cost of issuing debt for such common local government responsibilities as improvements to schools or water treatment facilities. Other governments were trying to use derivatives to cloak their debt or budget deficits. Once they got into trouble, they became susceptible to greater dangers as they traded more complex or exotic—and riskier—derivatives to recoup their losses.

Textbook arbitrage

Governments most frequently entered into a common type of derivative transaction called a swap contract to lower expected borrowing costs. A common swap involves an exchange of a fixed stream of income for a floating stream. Municipalities got into trouble when they instead issued bonds with a variable, or floating, rate, and then entered into an interest rate swap transaction (with a dealer, usually a commercial or investment bank) to convert the variable rate into a fixed rate—a process called synthetic fixed rate debt. That fixed rate was supposed to...