Municipal Bond Derivatives

The lead story in The New York Times today is titled, “Firm Acted as Tutor and Adviser When Selling Towns Risky Deals.” It is an investigative article describing how towns have invested in municipal bond derivatives with variable rates and are now facing excessive payments as a result.

The article focuses on Morgan Keegan & Company and its role in Tennessee as financial adviser, investment banker and underwriting for municipal bond derivatives, a clear conflict of interest. It describes how these financial products are very similar to the adjustable rate mortgages sold to consumers, with skyrocketing interest rates when the economy declines.

Tax-exempt municipal bonds have always been considered a safe way to both invest money for consumers and to raise money for cities. The article describes how things got worse when municipalities were allowed to execute “interest rate swaps.” These swaps were basically a bet on future interest rates and were covered by insurance to protect the investor. However, when the rating of the bond insurer declined, the interest rate rose dramatically.

I only understand the vague outline of this process, but the municipalities have clearly been deceived about the possible downside of the process. In fact, the company pushing these “municipal derivatives” was responsible for educating officials about them, and, coincidentally, the company makes more money from these adjustable rate investments than those with a fixed rate.

One more example of the power of greed and deception in unregulated financial markets.