Defective Security Swaps

The attorneys at the law firm Shepherd, Smith, Edwards & Kantas LLP are currently investigating claims of institutional investors involving swaps or other ongoing, inappropriate investments.  Many companies, state municipalities, and other governments were talked into entering into swap transactions, either as a part of another securities transaction such as a new bond issuance, or on their own.  Typically, these swaps were sold as ways to hedge fluctuating liabilities that the customer already had, or in some other way to reduce financing expenses.

In a typical swap, the two parties are effectively exchanging a fixed rate and a variable rate.  The party that currently has a variable rate liability, oftentimes a bond, enters into the transaction to avoid the carrying costs associated with that bond’s benchmark rising.  In exchange, that party agrees to pay the other party a fixed, periodic payment.  If the swap is done correctly, it allows the party with the original variable rate to avoid the consequences of its bond, or other liability, rate increasing because, if the rate were to increase, that rate increase would actually end up being paid by the swap counterparty.  Conversely, if the rate on the bond decreased, the costs of that obligation would go down correspondingly to the increased cost of the swap, creating a wash.  The party has effectively transformed a variable obligation to a fixed one.

Unfortunately for many of those customers, many of these swaps have proven wholly ineffective in fulfilling their expressly stated purposes.  The reasons for these failures can vary significantly.  In some cases, the swaps are set up incorrectly, such as not taking into account various reasons that the underlying obligation could fluctuate, or not marking the swap to the same benchmark as the underlying obligation.  Whatever the reasons for their failure, many institutions have found themselves with hugely expensive carrying costs for these swaps and equally huge termination penalties to try to get out of them.

Last month, the state of New Jersey spent over $122 million to unwind various swaps that the state had entered into.  At one point, New Jersey had over $3 billion worth of swaps on their ledger sheets.  As interest rates fell, the state found itself owing huge amounts of money on what had been pitched as cost saving measures.  Many of the costs rose so high that state officials decided it was better to create an entirely new bond issuance to raise the $122 million necessary to buy their way out of them.  If interest rates stay as low as they are now, New Jersey may find it necessary to buy out more of the swaps.  Currently, New Jersey would be facing over $400 million more in termination fees to completely unwind the swaps still on the books.

Many other municipalities and corporate bond issuers were also sold swaps as part of those packages, and ultimately lost millions of dollars due to those swaps.  Bloomberg has estimated that bad swaps have cost governments in the U.S. roughly $4 billion to date.

If your institution was sold a swap that has drastically risen in carrying costs, or that the institution was forced to pay an early termination penalty to get out of, contact the lawyers with Shepherd, Smith, Edwards & Kantas for a free, no obligation evaluation of the swap to determine if you may have a cause of action to attempt to recover some or all of those increased expenses.