The Trouble with Swaps: An Investigation of Municipal Interest Rate Swap Use in Pennsylvania

Open Access
- Author:
- Kober, Jesse Richard
- Area of Honors:
- Risk Management
- Degree:
- Bachelor of Science
- Document Type:
- Thesis
- Thesis Supervisors:
- Ron Gebhardtsbauer, Thesis Supervisor
Ron Gebhardtsbauer, Thesis Honors Advisor
Lisa Lipowski Posey, Faculty Reader - Keywords:
- actuarial science
risk management
interest rate swap - Abstract:
- In 2003, the Pennsylvania state government passed Act 23, which allowed for the explicit legalization of municipal interest rate swaps. Interest rate swaps are a form of financial derivative that involve an exchange of payments based on the movement of market interest rates. Potential benefits of swaps include expanded financing options and reduced borrowing costs. Few local government officials have the financial background necessary to understand the complexities of these swaps. Still, hundreds of school boards and local authorities across the state of Pennsylvania have accepted offers from investment banks to enter into interest rate swaps. Sometimes these swaps involve a substantial upfront payment to the government unit in exchange for agreeing to the deal (e.g., the swaption discussed in Chapter 4). Officials are attracted by the promises of immediate debt savings but ignore the significant threats of interest rate risk and credit risk. In addition, because municipal swaps are not formally regulated, they can involve hidden fees and collusion between investment banks and financial advisory firms. Municipal interest rate swaps have become a divisive political issue for Pennsylvania leaders. Some argue that the swaps are a dangerous use of public funds and that the government should enact a statewide ban. Others point to the economic benefits of swaps and claim that nothing should be done. Perhaps the more appropriate response lies somewhere between these two extremes. Increased state oversight and stricter transparency requirements are a few of the ways that might limit municipal swap use to only those governments that have the appropriate degree of financial sophistication.