Click here, to see Roosevelt and RAP's full report on Interest Rate Swaps.
What Is an Interest Rate Swap and How Does it Work?
Although interest rate swaps can serve many functions, we focus here on hedging interest rate swaps, a derivative instrument banks pitched to colleges and universities—and to cities, states, and other municipal borrowers—as a way to protect against spikes in interest on variable-rate debt and save money on borrowing. However, these deals were loaded with risks. These risks materialized when the banks crashed the economy in 2008, and many of these borrowers found themselves trapped in deals that began to function as big moneymakers for the banks that were party to the deals.
When borrowers such as governments, nonprofit organizations, and schools issued variable-rate bonds, banks offered them a deal. The banks said that if these borrowers would pay the banks a steady, fixed interest rate, then the banks—known as bank “counterparties”—would pay back a variable rate that could be used to pay the interest on the bonds. Banks sold interest rate swaps as insurance policies for investors, giving bond issuers a synthetic fixed rate that would let the borrowers lock in lower interest rates without having to worry about those rates shooting up in the future. Many schools signed swap deals for 30 or 40 years, contracts that would have been regarded as drastically off-market in the corporate world, where swap contracts rarely surpass seven years.
But these deals came fully loaded with a set of huge risks. Perhaps the biggest risk was posed by the egregious termination clauses embedded in the swap agreements, making them sometimes prohibitively expensive for schools to extricate themselves from. Banks pitched these deals as a sort of insurance policy for bond issuers, but they were actually more of a gamble—a bet that interest rates would rise. One of the big risks from the beginning was what would happen if variable rates were to instead dip very low. The banks would pay the issuer low payments based on these low rates, while the issuer would be stuck paying much higher payments to the bank. That is exactly what happened when the banks crashed the economy in 2008 and the Federal Reserve slashed interest rates in response. Not only did issuers’ net payments on the swaps rise when the Fed stepped in to bail out the banks, but many schools were unable to take advantage of the low interest rate environment to refinance because they could not get out of their 30- or 40-year interest rate swaps without paying harsh penalties.
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Swaps have cost just 19 schools $2.7 billion. We provide detailed case studies of 19 colleges and college systems that analyze the costs of interest rate swaps and other toxic deals. The costs associated with swaps have siphoned billions of dollars out of these schools’ budgets, at a time when schools are increasingly passing on their increased costs to students, including borrowing costs and, for public schools, costs related to decreases in state and federal funding.
In our research on Swaps, we've already found the following:
This guide assumes you’ve already thought through what a Swap is, and why it might be important to find and calculate. If you encounter unfamiliar terms, check the Predatory Municipal Finance Glossary. For multiple examples of the completed version of swaps research at a school, please see Roosevelt’s The Financialization of Higher Education report.
The guide is broken up into 4 parts:
There are two ways to fight against interest rate swaps at your school:
1. Conduct a Case study on interest rate swaps at your school. Start by using the guide to finding interest rate swaps attached in the files and reaching out to Roosevelt's national team at firstname.lastname@example.org
2. Organize at your school: Banks that sold interest rate swaps to colleges and universities typically misrepresented the risks inherent in the deals. This likely violated the federal fair dealing rule and state laws for fraudulent concealment or misrepresentation. Students concerned about their schools’ involvement in budget-draining bad deals also have options. Students can:
- Colleges and Universities weren't the only ones to be drawn in to such deals. The Refund America Project (RAP) has investigated swap losses at a host of municipal governments across the nation. For an example, see the RAP report on Illinois attached in the files above or check directly on their website.
- Our guide to Finding interest rate swaps at your school should be your primary resource.
- If you are interested in analyzing financialization at your school, contact the Roosevelt team immediately at email@example.com
- For a full set of examples for 19 schools across the nation, check out Roosevelt's Financialization of higher education report to be released in September 2017.
- To get a clear sense of how interest rate swaps worked at any one school, check out the case study of the University of Michigan attached as part of the files above.