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A Descriptive Analysis of State Government Debt-Related Derivatives Policies
Abstract
The increasing use of debt-related derivatives over the last 10 years, combined with the recent global financial crisis' impact on these instruments, greatly affected the finances of many state and local governments in the United States. Some observers believe the negative effects could have been minimized had governments established prudent financial risk management policies governing these products. This research describes and analyzes debt-related derivatives policies at the state level. It finds that while 30 states used debt-related derivatives between 2005 and 2010, only 20 states have policies guiding financial derivative practices, with the policies being of varying breadth and depth.
... VRS were embraced by issuers because they appeared to reduce interest costs while maintaining a steady, predictable series of payments. Detailed descriptions of the use of VRS can be found in Stewart and Cox (2008), Stewart and Smith (2012), Singla and Luby (2014) and Luby and Kravchuk (2013). These bonds were appealing to investors because they reduced interest rate risk for the investors. ...
... The volume of all derivatives activity is estimated by the Bank of International Settlements using survey data, but derivatives related to municipal securities are not tracked separately (Wooldridge, 2016). While several studies have been published on the use of derivatives by municipal borrowers, the use of municipal securities to create derivatives has received little research attention (Luby, 2012;Luby and Kravchuk, 2013;Singla and Luby, 2014). ...
Purpose
The purpose of this paper is to measure how frequently innovative financial products appeared or became widely adopted in the municipal securities markets over the last two decades; and also investigate what types of issuers adopted the innovations, the relationship between yields and innovation and the patterns of diffusion within states.
Design/methodology/approach
Using comprehensive data on municipal securities issued from 1992 to 2015, the author searches for financial innovations as defined in the literature. The author uses issuer fixed effects models to characterize the relationship between yields and use of innovative products. Other models provide estimates of the conditional correlations between issuer characteristics and innovation usage. Finally, the author fits trend models to identify significant differences in the pace of adoption between different types of issuers.
Findings
In total, 35 security features fit one or more definitions of innovation. Extensive analysis is presented for four innovations that represent significant transfers of risk: variable rates, put options, corporate backers and derivatives. Small issuers used these innovative products, but the largest issuers adopted them to a greater extent. Usage appears to diffuse within states. Issuance of innovative securities fell during the financial crisis and has not recovered. Novel securities since the financial crisis have been created by legislation rather than by market participants.
Research limitations/implications
The data appear to cover all or nearly all municipal securities, but they do not cover loans or other types of municipal borrowing.
Practical implications
This analysis reveals that financial innovations in municipal securities markets usually take the form of a rare practice becoming widespread rather than a never-before-seen feature appearing in the market. Changes in response to legislation are an exception.
Social implications
Regulators concerned about financial stability can monitor the expansion of formerly rare securities features. This will be informative about new risks or transfers of risk in the market. They can also anticipate that expanded use of an innovation by states and high-volume issuers will be followed by adoption of the innovations by smaller, less sophisticated issuers in subsequent years.
Originality/value
This paper is the first attempt to empirically analyze the extent of financial innovation in municipal securities. Existing public finance literature has proposed definitions of financial innovation, qualitatively documented some specific innovations and empirically analyzed others. However, no previous study has empirically analyzed the entire municipal securities market for all possible innovations.
... Apparently, 1 This is not only true for municipalities but also for other levels like regional or national entities. There is an advanced strand of research literature on national and regional debt policies and derivative usages highlighting structural changes and innovations in this realm (see for example Livine & Yonay 2015, Luby 2012, Singla & Luby 2014, Trampusch 2015. However, municipal governments are arguably an even more unlikely candidate for financialization which makes them a fascinating research object (see chapter 3). 2 See for example Busch 2007, Grunwald 2007, Rehm 2012 in many of the cases individual misbehavior (e.g. ...
This paper explores the financialization of municipal finances through the rise of " active debt management " policies and in particular the use of interest rate derivatives. All over Europe, prior to the recent financial crisis, cities have purchased such financial products in order to manage their increasing debt portfolios and, in particular, to reduce their heavy interest payments. This practice resembles financial activities of private corporations and, thus, is in line with the political project of enterprising government often advocated under the label of New Public Management. However, local governments usually lack financial market expertise and previously had hardly any direct interrelations with global finance. Therefore, the expansion of sometimes highly complex and often risky financial products to the realm of municipal finance is surprising and in need of an explanation. Preliminary findings suggest that the combination of municipal over-indebtedness and pressures arising from austerity politics on the one hand and financial innovation as well as changing business models of financial service firms on the other hand have provided a favorable environment for the rise of municipal derivative deals prior to the crisis. Moreover, the use of established social relations between city governments and their principal banks and a wide range of highly active and often transnationally connected service provider seem to have facilitated this trend. Therefore, the case of municipal derivative deals also sheds light on regional intermediation between global financial markets and locally embedded financial systems. Bremen, 31 August 2016 When finance knocks at city hall´s door (Sebastian Möller) 2
... Moreover, the practices of actively managing the municipal debt portfolio and the related use of derivatives are highly contested both among academics 1 This is not only true for municipalities but also for other levels like regional or national entities. There is an advanced strand of research literature on national and regional debt policies and derivative usages highlighting structural changes and innovations in this realm (see for example Livine & Yonay 2015, Luby 2012, Singla & Luby 2014, Trampusch 2015). However, municipal governments are arguably an even more unlikely candidate for financilization which makes them a fascinating research object (see chapter 3). ...
In recent years, many municipalities all over Europe, often consulted by financial service firms and mostly driven by over-indebtedness, have set up so-called active debt management policies including the purchasing of interest rate derivatives like swaps, swaptions, collars and forward agreements. Thereby, city budgets and local politics in general have become much more connected with rules, performances, and rationalities of global financial markets. This extends and transforms traditional debt relations of subnational public entities and contributes to the seemingly boundless expansion of finance. In this paper, this spread of municipal derivatives in Western Europe between the late 1990s and the mid-2000s is illustrated. I argue that in order to understand the evolution, consolidation, and spreading of this entanglement of local politics and global finance, we need to combine a microscopic focus on local administrative practices and particular public-private networks on the one hand, with a macroscopic political economy perspective concerning processes of financialization, diffusion, and the transformation of business models on the other hand. The paper builds on preliminary empirical findings of the respective dissertation project and briefly discusses in the distinctiveness of local governments within global debt trails, the applicability of different theoretical lenses, and the potential additional insights of a broader research agenda transcending a narrow western focus.
... Moreover, the practices of actively managing the municipal debt portfolio and the related use of derivatives are highly contested both among academics 1 This is not only true for municipalities but also for other levels like regional or national entities. There is an advanced strand of research literature on national and regional debt policies and derivative usages highlighting structural changes and innovations in this realm (see for example Livine & Yonay 2015, Luby 2012, Singla & Luby 2014, Trampusch 2015. However, municipal governments are arguably an even more unlikely candidate for financilization which makes them a fascinating research object (see chapter 3). ...
In recent years, many municipalities all over Europe, often consulted by financial service firms and mostly driven by over-indebtedness, have set up so-called active debt management policies including the purchasing of interest rate derivatives like swaps, swaptions, collars and forward agreements. Thereby, city budgets and local politics in general have become much more connected with rules, performances, and rationalities of global financial markets. This extends and transforms traditional debt relations of subnational public entities and contributes to the seemingly boundless expansion of finance. In this paper, this spread of municipal derivatives in Western Europe between the late 1990s and the mid-2000s is illustrated. I argue that in order to understand the evolution, consolidation, and spreading of this entanglement of local politics and global finance, we need to combine a microscopic focus on local administrative practices and particular public-private networks on the one hand, with a macroscopic political economy perspective concerning processes of financialization, diffusion, and the transformation of business models on the other hand. The paper builds on preliminary empirical findings of the respective dissertation project and briefly discusses in the distinctiveness of local governments within global debt trails, the applicability of different theoretical lenses, and the potential additional insights of a broader research agenda transcending a narrow western focus.
The aim of this paper is to analyze the effects of structural asymmetries related to the use of interest rate swaps within the European Union (EU) on the sustainability of public debt. The fiscal consolidation required to comply with the European budgetary rules increased for some countries the incentives to use debt related instruments (i.e., financialization of debt). Indeed, in the period 2006–2020, 17 EU countries used interest rate swaps to hedge their public debt. Dynamic panel data analysis results show that a 1 percent increase in the ratio of interest rate swaps to debt, ceteris paribus, leads to an improvement of the primary surplus over GDP by 0.49, thus ameliorating the sustainability of public debt. However, financial contracts imply additional risks that can ultimately impact in the medium term on public debt, which are not currently assessed by the standard Debt Sustainability Analysis (DSA). The aim of the paper is to fill this gap and discuss the main policy implications of the use of swap. In the post pandemic era, the political economy of debt reduction should properly consider the financial risks related to swaps.
Purpose
This study contributes to the literature on local administrations' debt and attempts to answer the following research questions: (1) What effects do swaps produce on regions' debt? (2) Have swaps been used to finance discretionary debt?
Design/methodology/approach
The paper investigates the debt burden as influenced by economic, financial and political variables and forces with panel data techniques, and tests whether swaps have been used to financing debt due to unfunded expenditures.
Findings
Panel data results of 15 Italian regions over the 2007–2014 period shows that regions with higher debt exhibited a higher interest rate exposure and have employed derivatives hoping to counterbalance the reduced resources received from the central state, in line with other European countries' experience (i.e. France and Greece).
Research limitations/implications
The scarcity of official data and information on swaps has limited the empirical investigations in the literature but did not reduce the losses of local administrations.
Originality/value
This study creates the first database on swaps purchased by Italian regions to investigate their impact on their debt. Results show that highly indebted regions with reduced funds from the central state and diminished local resources are more likely to use swaps to fund their debt. Italian regions heavily depended on long-term debt to finance their non-healthcare services, rather than current revenues; swaps have been used to finance discretionary (non-healthcare) debt.
At the turn of the millennium, US states started to employ debt-related derivatives. Surprisingly, the prevalence of these instruments among states peaked soon after the first corporate scandals involving such complex financial tools. Why did states embrace swaps? I build on political and sociological arguments and posit that both the industry’s and the state’s interests must be considered. The swaps industry started marketing swaps to treasurers as part of their fee-based business model and in response to declining profits, while governments welcomed swaps as they fit the treasurers’ professional agenda. I test this argument with original data on the initial swaps adoption by US states between 1989 and 2014. The event history analysis lends support for the theory. The findings complement explanations for the rise of risky instruments among states and contribute to the literature on financialization.
The restructuring process of sovereign debt is not yet managed under common global rules; public debt stabilisation is an explicit policy goal in the EU, but cannot be achieved if local public authorities do not control their liabilities and connected risks. EU local administrations’ debt soared due to the economic downturn, reduced resources transferred from the central state and increasing expenses. After 2000, French and Italian local authorities extensively underwrote complex financial instruments, such as over the counter (OTC) interest rate and exchange rate derivatives and structured loans (i.e. loans with embedded derivatives) to manage their growing liabilities; the proliferation of derivatives among European public administrations has been favoured by the absence of proper disclosure and of monitoring procedures. Losses due to structured loans accumulated and in 2017 French local authorities asked for state rescue; similarly, some Italian regions and municipalities reported relevant losses. The reduction of financial risks can be achieved by improving information and transparency, by reducing moral hazard, and limiting ‘revolving doors’. Monitoring is a complex task and should explicitly keep up with financial innovation; the introduction of any list of investible products by public administrations would lead to a circumvention; incentives work better than limits in financial markets.
Despite significant coverage in the financial press in recent years, financial engineering by city governments via the use of financial derivatives such as interest rate swaps remain an understudied area of urban financial policy. Indeed, press accounts and other case or conceptual urban studies research emphasizing the downside of these transactions are some of the only sources of information on these instruments. These stories and studies often allude to or speculate on a more basic question: Why would a government choose to enter into a complex financial instrument like a debt-related derivative? This research posits three exploratory hypotheses—financial health, financial experience and/or financial sector influence, and governance structure—culled from media accounts and the urban studies literature on the use of debt-related derivatives by city governments in the United States. It empirically explores these hypotheses by examining the various fiscal, financial, and issuer characteristics of the largest 50 U.S. cities and their choice of whether to use debt-related derivatives. The research finds that the characteristics of government most associated with debt-related derivative use are declining financial condition, increased financial experience and/or financial sector influence, and prior use of interest rate swaps.
This study empirically examines the impact of debt management policies on borrowing costs incurred by U.S. state governments when issuing debt in the municipal bond market. Based on positive political theory and the benefit principle of taxation, it is proposed that states that adhere to best practice debt management policies transmit signals to the credit ratings, investment community and taxpayers that the government should meet its obligations in a timely manner, resulting in lower debt costs. As a result of a multi-block multivariate regression model the implication of adhering to debt policies aimed at promoting transparency results in a borrowing cost savings in terms of true interest cost (TIC) of close to 1,000,000 of debt issued (-.769, p<.10). However a comprehensive debt policy is not a significant indicator of borrowing costs. These results suggest a product of a pull push process between the economic forces of the bond market on one hand and politics on the other, pulling the administrative function toward efficiency in the former and democratic values of responsiveness and transparency in the latter. The problem lies in policies that respond to the bond market but virtually exclude any other community interest in policy making. It is recommended that openness in government and allowing taxpayers to understand government services are essential goals in ensuring responsible citizen oversight and providing taxpayers the opportunity to be less likely to propose restrictive initiatives or force dramatic political or management changes through the electoral process or bond referenda.
Bank Balance Sheets and Income StatementsInterest-Sensitive Gap ManagementDuration Gap ManagementValue at Risk
Debt-related financial derivative usage by state and local governments became a very salient topic over the last few years in light of the Great Recession and its impacts on the efficacy of these financial instruments. However, there has been a dearth of systematic research on the types and kinds of derivatives state and local governments have actually employed in recent years. While anecdotes of financial derivative usage has grabbed the headlines (such as the case of Jefferson County, Alabama), there has been little research examining the derivative portfolios among states or local governments pre- and post-Great Recession. Using descriptive research, this paper attempts to rectify this gap in the literature for state governments as a means of better understanding how the recent financial crisis has impacted the critical debt management decision to use financial derivatives.
The esoteric area of financial derivatives has become quite salient in light of the financial crisis of the last few years. In the public sector, state and local governments have increasingly employed derivatives in their bond financings. This paper analyzes state and local governments' use of a specific type of municipal derivative instrument (a floating-to-fixed interest rate swap) in a specific type of transaction (bond refinancing). The paper provides a case study of an executed bond refinancing transaction that employed a floating-to-fixed interest rate swap quantifying the substantial long-term costs financial derivatives can impart on state and local governments. The paper concludes with some specific lessons learned about debt-related derivative usage for public financial managers and offers some suggestions for further empirical and theoretical research in this area of public financial management.
Jefferson County, Alabama undertook a series of risky financial maneuvers in 2003 that included issuing large amounts of variable rate and auction rate securities as well as engaging in numerous interest rate swaps in order to lower the burgeoning costs of repairing its sewer system to comply with federal regulations. These complex financial instruments, intended to lower debt service costs on the county's $3 billion in outstanding sewer warrants, led the county to financial bankruptcy in the wake of the financial markets collapse. This paper explores the choice of securities by analyzing the risk of adjustable rate securities and interest rate swaps, examining the Jefferson County case in detail, and providing some lessons for future financial management within the context of unexpected events such as the current recession.
Jefferson County, Alabama undertook a series of risky financial maneuvers in 2003 in order to try and lower the burgeoning costs of repairing its sewer system to comply with federal regulations. These complex financial instruments, intended to lower debt service costs on the county’s over $3 billion in outstanding sewer warrants, led the county to financial ruin in concert with the financial markets collapse. This paper explores the choice of securities by analyzing the risk of adjustable rate securities and interest rate swaps, examining the Jefferson County case in detail, and providing some lessons for future financial management within the context of unexpected events such as the current recession.
The teaching of qualitative analysis in the social sciences is rarely undertaken in a structured way. This handbook is designed to remedy that and to present students and researchers with a systematic method for interpreting qualitative data', whether derived from interviews, field notes, or documentary materials. The special emphasis of the book is on how to develop theory through qualitative analysis. The reader is provided with the tools for doing qualitative analysis, such as codes, memos, memo sequences, theoretical sampling and comparative analysis, and diagrams, all of which are abundantly illustrated by actual examples drawn from the author's own varied qualitative research and research consultations, as well as from his research seminars. Many of the procedural discussions are concluded with rules of thumb that can usefully guide the researchers' analytic operations. The difficulties that beginners encounter when doing qualitative analysis and the kinds of persistent questions they raise are also discussed, as is the problem of how to integrate analyses. In addition, there is a chapter on the teaching of qualitative analysis and the giving of useful advice during research consultations, and there is a discussion of the preparation of material for publication. The book has been written not only for sociologists but for all researchers in the social sciences and in such fields as education, public health, nursing, and administration who employ qualitative methods in their work.
This study analyzes the failure of the municipal bond and municipal note futures contracts. The municipal bond contract is shown to have been the most effective hedge in the municipal market over its tenure. Changes in volume in the municipal bond contract were closely related to changes in the volume in the U.S. Treasury bond futures contract, the spot–municipal-over-bonds (MOB) ratio, and visible supply. The failure of the municipal bond contract is mainly attributed to a decrease in trading volume in the U.S. Treasury futures market. This was impacted by the onset of electronic trading, which the municipal futures market was reluctant to embrace. The municipal note contract was a less effective hedge than U.S. Treasury note futures and ten-year London Interbank Offered Rate swaps. The failure of the municipal note futures contract is attributed to the existence of well-established alternative hedges, and segmentation in the municipal market. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:656–679, 2008
We reviewed the fiscal 2003 financial statement footnote disclosures of the fifty states and the 100 largest cities in the United States (US) to ascertain the nature and extent of derivative activities among US state and municipal governments. There were 23 state governments and 23 municipal governments that have engaged in such transactions with an aggregate notional value approaching $32 billion. These governments enter into these transactions primarily to hedge the interest rate and cash flow risks associated with their long term variable rate demand obligations and auction rate debt. Our findings also indicate that the widespread implementation of GASB TB 2003 - 1 has improved the quality of state and municipal disclosures with respect to their derivative activities. In June 2008, the GASB issued its Statement 53 which mandates the accounting measurement of these derivative financial instruments at their fair value on the statement of net assets and promises to further improve their footnote disclosure.
The amount of outstanding, long-term, tax-exempt state debt has grown precipitously over the last decade, from 264 billion in 1987. But there have been few attempts to carry out broad studies of basic state debt management policies, using comparative state data. As a result, policy-makers lack guidance as they attempt to adjust policies and procedures to meet the rapidly evolving requirements associated with public borrowing. This paper reports on a national survey of state debt manage ment policies - policies devoted to the planning, preparation, sale, and repayment of debt for which states consider themselves responsible.
This article explores the importance of various debt policy factors using a national survey of government finance officers. Further, it examines whether the presence of a particular factor in a debt policy influences finance officers' perception of its importance. We find that debt policies tend to be technical in nature and that broad policy issues are most often not included in debt policies. Moreover, we find that the inclusion of debt management factors in debt policies has a powerful influence on their perceived importance by public managers.
State-level indebtedness is large and persistent and bond issuance has become increasingly complex. In light of these conditions, professional standards have been proposed by some organizations (including the Government Finance Officers Association) seeking to persuade members to codify sets of desirable practices into policies for debt issuance. We surveyed state government debt managers to assess the comprehensiveness and prevalence of debt policies. We find little evidence of the adoption of comprehensive formal debt policies. Instead, states rely more heavily upon the guidance provided by their own sets of standard practices or “rules of thumb.”
Bond Debacle Sinks Jefferson County
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Municipal Bond Basis
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Reforming Debt Management Practices: The Case of Illinois, 2004
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Interest Rate Bets Bite Cities, States
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Guidelines for the Effective Uses of Swaps in Asset-Liability Management
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Elements of a Comprehensive Local Government Debt Policy
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How Banks Could Return the Favor
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Understanding Municipal Derivatives
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The Development of a Planned Debt Policy
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Understanding and Valuing Municipal Derivative Securities
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Asset‐Liability Management: Managing Swaps
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Municipal Derivative Mythology Turns on 500 Swaps
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Competitive versus Negotiated Municipal Bond Sales: Why Issuers Choose One Method Over the Other
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Residual Interest Bonds (RIBS)
- Gray Gary
Guidelines for the Effective Uses of Swaps in Asset‐Liability Management
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Re: File No. S7-25-11/Business Conduct Standards for Dealers of Security-Based Swaps and Major Security-Based Swap Participants
- Gaffney Susan