Rate 'swaps' have their place

By Justin P. Wilson

Pennsylvania Auditor General Jack Wagner recently made headlines with his suggestion to ban local governments from engaging in exotic financial transactions known as "swaps." These are often very complex transactions in which many local governments agreed, at least in theory, to "swap" a variable interest rate on borrowed money to a fixed rate.

I understand Wagner's concerns, but I don't agree with his proposed remedy. As in Pennsylvania, many local governments in Tennessee have engaged in swaps. In fact, according to a recent report by Moody's Investors Service, Pennsylvania and Tennessee are home to more than one-third of the local governments in the United States that have engaged in swaps and variable rate debt transactions.

And certainly, in many cases, swaps have turned out badly for our cities and counties.

Wagner called swaps "gambling" with public money. "The fundamental guiding principle in handling public funds is that they should never be exposed to the risk of financial loss," Wagner said in a news release. "Swaps have no place in public financing and should be banned immediately."

His news release erroneously reported that Tennessee made a decision to ban swaps. Actually, we took a different approach. Our Tennessee State Funding Board recently issued guidelines that permit the use of swaps as long as the communities meet tough conditions designed to demonstrate that they fully understand the risks involved and communicate them to their citizens.

We all understand that risk is present in our lives. Any time we get in a car, there is the chance of being involved in an accident. And risk is also present in financial transactions, especially when borrowing money.

People who are sensible about their finances spend some time weighing risks. For example, is a new homeowner better off making a low down payment, using variable rate financing, buying a smaller house, or even foregoing home ownership and renting instead? Will the price of housing continue to rise? Are the brokers, lending officers, Realtors, and other advisers more interested in scratching each others' backs for commissions and fees than they are in getting their clients the best possible deals?

A local government faces a lot of the same issues when it borrows money to build a school, a road, or a police station. Taken to the extreme, any government's decision to take on new debt could be considered "gambling" with the public's money. And despite their potential risks, swaps - when properly used - can reduce risk and lower interest payments.

Under the swap guidelines we adopted last month, we applied four simple principles. They are:

Local government officials must demonstrate they understand the risks taken.

Governments must explain to their citizens what they are doing in language the citizens can understand.

Governments must tell their citizens what fees they are paying.

Those who advise the government should represent the government in the transaction and nobody else.

A local government that wishes to engage in swaps must demonstrate that it has people on its staff with sufficient expertise to understand these complex transactions. And it is required to have an audit committee. And a capital improvement plan. There must be at least one public hearing about the transaction, and all the information must be available to the citizens.

Communities that can't meet all the requirements contained in the guidelines can appear before my staff to explain why they feel qualified to enter into those types of transactions anyway.

In Tennessee, we are not interested in taking away the ability of local governments to manage their own finances. We believe our local governments, within reasonable guidelines, are sovereign entities that are responsible for their own actions.

Going back to the driving example, we know that people traveling by cars can get into accidents. That's why we have speed limits and require passengers to wear seat belts. But we don't ban law-abiding drivers who can demonstrate that they know the rules of the road and can handle automobiles safely from going onto our public streets. This doesn't guarantee that there won't be accidents, but we believe our approach is better than banning automobiles altogether.

We feel the same way about swaps.