Thursday, March 18, 2010

Interest Rate Swaps

Italian and international investment banks structured a variety of derivatives for local authorities, particularly during the period from 2001-2008, writes Rachel Sanderson.

The most common was the interest rate swap, which in the case of the larger entities was often coupled with a bond issue. The local authority would pay, on a monthly or quarterly basis, an amount of interest on either a fixed or floating rate basis. In return they received floating or fixed rate amounts (which could be used to pay interest on the bond issue, if any). By doing this local authorities hoped to get lower interest rates and cut their borrowing costs. Whether they did so mostly depended on movements in eurozone interest rates.

According to Italian Treasury sources and those advising the authorities, the majority of these deals were on fair commercial terms. However, advisers say that in some cases the pricing of the swaps was modelled in such a way that the authority would lose money in almost any economic environment and would have to pay significant amounts to unwind the transaction.

Upper and lower limits on interest rate movements – “caps” and “floors” – were set so as to minimise the risk for the bank. For example, even if interest rates fell below the percentage identified as the “floor”, the entity would still be required to pay interest calculated at the “floor” percentage. Upfront payments, effectively a cash advance, could be incorporated into a transaction to benefit the town or city at the start of a deal, but in return they would usually have to pay higher rates in the longer term, which could cause losses to add up. Banks could also restructure swaps to extend their maturity. Like a personal loan this would have the effect of reducing outgoing payments in the short term but those payments would run for much longer and the final sum would often be higher.

Local authorities could also lose out through a structure involving the management of the entity’s sinking fund by an arranging investment bank. According to Treasury sources and advisers, money set aside to cover future payments was in some cases re-invested in risky assets by the investment bank acting as a fund manager. The bank could also charge a management fee and where assets in the fund delivered in excess of a set yield, could take the excess as further revenue.

No comments: