Swaps in New Jersey

You may have seen the story in the news recently about how the state of New Jersey is paying Goldman Sachs $1 million a month for protection against rising interest rates affecting bonds that the state paid off last year. This story is really about credit swaps, and how they have ended up affecting each of us.

The details in the New Jersey case are still a bit murky, as they tend to be with these Wall Street rocket-scientist deals. But what happens, in a nutshell, is that the state sells bonds at an auction rate, which fluctuates with the market on either a daily or weekly basis. A banker like Goldman Sachs comes along and offers a swap, in which the state sells the bonds to Goldman at a rate that has historically tracked the auction rate. In return, the state agrees to pay off Goldman at a fixed relatively low rate of, say, 3.6 percent.

As long as the auction rate continues to track the rate of the swap, New Jersey has essentially traded the uncertainty of selling bonds at the variable auction rate with the certainty of the fixed rate. But what happens when those rates fall out of sync with each other, and the auction rate goes up? That's exactly what happened when the credit markets began freezing up last year. The state ends up paying the difference between those two rates and the 3.6 percent to Goldman.

The whole purpose of the swap was to protect the state against interest rates rising much above 3.6 percent. Now, though, interest rates are close to zero - and the state is stuck paying the higher rate to Goldman as well as the out-of-whack auction rates.

So even if the state has redeemed those now-toxic variable-rate bonds, it can still end up owing huge sums to the bankers who presented it with the swap in the first place. Even in this simplified version of the saga, you can see that what was sold as a way to guard against higher interest rates has become, in an age of sinking interest rates, a massive bill for our state's taxpayers.