Scott Metzler

Interest Rate Swaps as a Hedging Technique

Hedging techniques using interest rate swaps became a very popular way of hedging short term versus long term debt and interest rate changes. For example the Wall Street Journal reported on Wednesday, November 26, 2008 Page A3 a story about the Boston area’s “Big Dig” projects’ two swap contracts intended to hedge against interest rate fluctuations. One contract was an interest rate swap with UBS where the turnpike authority was required to pay UBS $2.2 million a month in interest rate charges because of the volatility of the fixed rate interest rates to variable interest rates. If the turnpike authority does not receive a toll charge increase then a downgrade in their credit rating will cause the swap contract to spike and even be terminated resulting in a huge termination fee of $370 million. The other contract is with the bankrupt Lehman Brothers was designed to hedge the opposite direction for the floating versus fixed interest rates. The UBS contract required the turnpike authority to pay a fixed rate with an underlying floating rate bond turning their floating rate interest risk in to a fixed payment. The Lehman Brothers contract was the opposite by turning long term fixed debt payments into short term floating rate payments. The problem is the volatility of the interest rates and the potential termination of both contracts has caused the turnpike authority to be exposed to a total of $467 million in termination fees on both contracts and the risk that the hedge was designed protect the turnpike authority from has actually grown higher than if they had not performed the hedge at all. They will be further in debt and have a lower credit rating as a result. The question is though what could they have possibly done to protect themselves from this sort of risk.

Their big mistake was ignoring their credit rating risk. They were overly optimistic about the potential risk a downgrade of their credit rating would cause them. This risk would essentially cause them to have both swap contracts terminated at the same time with this astronomical termination fee. This is what they needed to buy some sort of insurance against happening. It would be like a person not having fire or flood insurance on their home and putting in a new addition and remodeling all at the same time. Hoping that they wouldn’t be hit by any flood damage or fire damage. They needed some insurance against their credit rating dropping. One good way would have been to purchase an insurance policy on the off chance of the two swap contracts terminating at the same time because of a problem.

To conclude a proper hedge must consider the major forms of risks that exist, or at least accept that those risks may appear. A good risk manager identifies the risks that are truly involved and then does 1 of the following 3 things: Mitigate the risk by hedging against it or buying some sort of insurance, Avoid the risk by not taking the actions that would cause the risk, or Accept the risk by making it very clear to all that the cost of hedging the risk is more than the chance that the risk will cost in the first place. The managers of the “Big Dig” project at the turnpike authority accepted a risk of their credit worthiness sinking that could cost them more than they can pay, and cost them all their jobs in the end. The swap spread for the interest rate for LIBOR plus whatever increased basis points that is based on their credit rating would have increased dramatically in this case. Managers needed to understand this risk and what potential problems it could have caused.