Interest Rate Swap

Crucial (and complicated) concepts in public money explained.

Put very simply, an interest rate swap occurs when a person or entity with debt makes a deal with a creditor in which that creditor will pay the other party’s variable rate debt. In the case of a municipality, its government pays back the creditor for the debt at a flat interest rate. If a government is holding debt tied to the market rate, depending on interest rates in given year, the government’s debt payments could vary significantly. This makes budgeting pretty tough.

So, the government makes a deal with a bank: the bank will make the government's debt payments and, in exchange, the government will pay back the bank using a flat interest rate. The government gets predictability while the bank is playing the odds that it will come out on top. This is because the bank negotiates for a higher overall interest payment from the municipality than it thinks the market will average over the life of the loan/debt.

Rate swaps reached their height in the mid-2000s but many governments today avoid them for good reasons. What caused governments to shy away? These swap deals got really lopsided when interest rates tanked because now the fixed rate is often a lot higher than the variable rate. For a real life example, read this breakdown of changing interest rates affected a big chunk of Detroit’s debt.

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Daniel Luzer is GOVERNING's news editor.