Sewers, Swaps and Bachus

By JOE NOCERA
NYT

Let me tell you a story about Jefferson County, Alabama, whose county seat is Birmingham, and whose congressman is Spencer Bachus, the Republican who chairs the House Financial Services Committee.

Once upon a time — back when too many people viewed derivatives as glittering innovations with magical powers to hedge against risk — Jefferson County was ordered by the Environmental Protection Agency to upgrade its sewer system. To finance the new sewers, it issued bonds totaling nearly $3.2 billion.

After the sewer system was completed, the county moved all that debt from fixed rates to variable rates. It did so because some investment bankers at JPMorgan persuaded the county to purchase derivative contracts, in the form of interest rate swaps, that would supposedly allow it to avoid paying higher interest if rates went up. Magic indeed.

At first, this arrangement worked well enough. Though the cost of the sewers was bloated beyond belief — they were originally supposed to cost $1 billion — the county made its bond payments. The bank reaped handsome fees from its swaps contracts.

(More here.)