Failed auctions compounded by swaps for local governments (Bloomberg) (28-02-2008)

Feb. 28 (Bloomberg) -- States, cities and hospitals across the country who issued auction-rate bonds in combination with interest-rate swaps on the advice of their bankers are now getting squeezed by both, as they had expected yields on the debt to decline along with benchmark rates when they bought swaps to protect against rising interest costs; In reality the bonds' rates are up an average 3.1 percentage points since September, while the one-month Libor has dropped 2.7 points.

As these financial instruments failed borrowers end up losing more as they are obliged to pay record-high interest on auction-rate debt billed as a cheap alternative to traditional bonds. Investors became worried last year, retreating from auctions that determine new rates every seven to 35 days. Now UBS AG, Goldman Sachs Group Inc., and other brokers are refusing to be bidders of last resort, and the $330 billion market is frozen.

Municipalities and their taxpayers are paying for swap agreements that haven't worked for months.

New York State’s borrowing costs over the five years through March 2007 would have been $176.9 million higher if it had sold conventional fixed-rate bonds instead of going to the auction-rate market and entering into swaps, according to a state report.

Now New York State has $3.5 billion of swaps associated with its $4 billion of auction debt, and all of the bonds cost more than the variable rate that banks including Goldman, Merrill Lynch & Co. and Lehman Brothers Holdings Inc. are paying on its swaps.

Among 57 auctions held on New York's bonds between Feb. 13 and Feb. 21, 53 failed. Rates ranged from 3.30 percent to 7.19 percent, and the variable rate is 65 percent of one-month Libor, or about 2.03 percent today.

 Source: Bloomberg