Reply #39: Sewers, Swaps and Bachus By JOE NOCERA

[Demeter]

http://www.nytimes.com/2011/04/23/opinion/23nocera.html?ref=opinion

Let me tell you a story about Jefferson County, Alabama...Once upon a time — back when too many people viewed derivatives as glittering innovations with magical powers to hedge against risk — Jefferson County was ordered by the Environmental Protection Agency to upgrade its sewer system. To finance the new sewers, it issued bonds totaling nearly $3.2 billion.

After the sewer system was completed, the county moved all that debt from fixed rates to variable rates. It did so because some investment bankers at JPMorgan persuaded the county to purchase derivative contracts, in the form of interest rate swaps, that would supposedly allow it to avoid paying higher interest if rates went up. Magic indeed.

At first, this arrangement worked well enough. Though the cost of the sewers was bloated beyond belief — they were originally supposed to cost $1 billion — the county made its bond payments. The bank reaped handsome fees from its swaps contracts.

But the financial crisis caused those clever hedges to go blooey. Indeed, the swaps not only failed to protect the county from losses — they actually exacerbated the losses. In addition, two of its bond insurers had their credit rating lowered because they had also insured lots of toxic subprime derivatives. The downgrade triggered huge hikes in interest and principal for Jefferson County.*