Hi Sam -
"Did they do the equivalent of an ARM?"
No, but you've got the sense of it. They got caught by three things:
[1] - an ARM-like feature of the bonds
"South County got into the swap when it agreed to pay an annual fixed rate of 3.52 percent to Merrill Lynch for 30 years after it sold $52 million in auction-rate securities, or debt with interest that resets at periodic bidding every 7, 28 or 35 days."
"...The $330 billion auction-rate market imploded a year ago when underwriters stopped stepping in as buyers of last resort as demand for the securities fell. Thousands of auctions failed, including those for South County, which resulted in rates on its bonds costing as much as 12 percent.
[2] - Decline in value of the contract:
"The swaps are failing because borrowers didn’t anticipate that the value of the contracts, which often mature in 30 years, would tumble as central banks cut rates. The Federal Reserve reduced its target rate for overnight lending between banks to near zero percent in December, from 5.25 percent in 2007. Swaps are agreements to exchange interest payments, usually a fixed payment for one that varies based on an index."
[3] - demand for collateral
"So-called collateral postings are a standard feature in contracts in the $400 trillion interest-rate swap market, Rosenberg said. Swaps are derivatives, or contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
The amount of collateral depends on the value of the swap. When long-term market indexes fall, so does the value of fixed- rate swaps, which can trigger requirements to put up more cash"
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The hospital gets 2/3 percent of one-month Libor from the bank to cover the cost of the auction-rate bonds, which reset weekly. Libor was 5.2% in June '08, now it's ~1.3% - so the hospital's getting much less money back, paying out collateral because the value of the contact has declined, and paying out higher interest on the auction-rate bonds the swap was tied to.
Not a pretty picture.
Jim |
