Bloomberg online has an interesting article about Pennsylvania municipalities using the derivatives market to for upfront cash. Derivatives, such as interest rate swaps and options, have a sordid history in the municipal finance world.
The current fad appears to have municipalities entering into “swaptions”. A “swaption” is an option to enter into an interest rate swap at some point in the future. Very simply, the municipality is selling an option, for which it receives cash upfront and then has a potential future liability from the interest rate swap.
In the case cited in the Bloomberg article, Dauphin County would receive upfront cash from Royal Bank of Canada. In return, Royal Bank of Canada has the option to compel the County to enter into an interest rate swap, where the County would be paying a floating rate of interest. This option and the potential swap are off-balance sheet liabilities and expose the County to higher future interest rates.
