Banks Have Won Big and State and Local Agencies Are The Big Losers In Bets On Interest Rates

State and local governments and agencies have paid around $28 billion to Wall Street banks that sold them protection from swings in interest rates. They were able to finance projects at lower rates by using variable interest rate instruments instead of fixed interest rate instruments.  In order to protect themselves from an increase in interest rates, they purchased interest rate swaps as insurance.  The direction of interest rates is largely determined by central banks, and the large banks determine the LIBOR which is the interest rate that banks pay when they borrow from each other.  The market for interest rate derivatives is the largest market in the world.  It is a form of insurance that differs from most kinds of insurance that offer protection against accidents or natural disasters.  The direction of interest rates is determined by central bankers and by very large banks.

The financial crisis was caused by bad bets than many banks made packaging and selling derivatives that were based upon mortgages.  Central bankers responded by dramatically lowering interest rates.  That was poison for the state and local agencies that had purchased protection against higher interest rates.  They were forced to make payments to their counterparties ( Wall Street Banks) or to pay huge penalties to terminate their interest rate swap contracts.  This has created hardships for state and local governments.  They have been forced to divert taxes, that are used to provide government services, to make payments to the banks.

One of the problems that we face in financial markets is that governments that borrow from banks, and pension funds that purchase derivatives from banks are much less sophisticated than the bankers who sell the derivatives. The banks are also better protected from the bad bets that they make. They have been rescued by central bankers who have found ways to offload the risks that they took with toxic mortgage securities.  The pension funds and government agencies that purchase risky derivatives are on their own.