Back in 2003, the New Jersey Transportation Trust Fund Authority, which funds rail and road projects in the state, sold $345 million in auction-rate bonds. That’s where the trouble began:
Bloomberg: “This vividly shows the risk of entering into interest- rate swap agreements,” said Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board in Alexandria, Virginia. “The world’s got to see what stupidity even the sophisticated investors like the transportation fund can get into.”
While New Jersey replaced the debt with fixed-rate securities in 2008 after the $330 billion auction-rate bond market froze, the swap — in which two parties typically exchange fixed payments for ones based on floating interest rates — isn’t scheduled to expire until 2019.
So thethe state was sick of paying a variable interest rate on its massive debt load. So it “swapped” interest rates with Goldman, opting for a fixed rate instead:
In New Jersey, the 3.6 per cent fixed rate the trust fund is paying on the swap has pushed the cost to taxpayers of the original $345 million borrowing to 7.8 per cent, the most the authority has paid since it was formed in 1985, according to records posted on its Web site.
The state paid $940,000 under the agreement last month and a total of $11.4 million since the auction-rate bonds were redeemed. The expenditures come as the fund reaches its borrowing limit and Governor Jon Corzine, Goldman’s former chairman who was a U.S. senator when the contract was signed, seeks $400 million in budget reductions as tax receipts fall.
This is just one of several stories of interest-rate swaps gone bad. But bear in mind a few things. Everyone seems to have been caught off guard by the decline in interest rates over the past few years. This isn’t just a matter of banks foisting bad deals on state and municipal governments — Larry Summers (no fool) got burned when serving as the President of Harvard.
On the fact that the bonds don’t exist anymore is a red herring. The state chose to replace the bonds, voluntarily, from floating to fixed. There’s no reason that should get them off the hook from a side bet.