Our worsening economy has led to countless stories about sub-prime mortgages and a sinking financial and banking sector. But the present crisis is affecting municipalities, state governments and authorities as well. Too many government entities have used either variable rate bonds or entered into swaptions (interest rate swaps), resulting in large increases in debt service costs.
There are those who would claim that the risk associated with variable rate debt and interest rate swaps is worth taking because quite often they result in lower debt service costs. And, while that is true, it does not diminish the argument that governments have a stronger fiduciary duty to taxpayers than a corporation has to its shareholders. This unique relationship dictates that conservative management be exercised.
In other words, governments ought to only use fixed rate debt instruments. This provides much needed predictability in public budgeting. Beyond that, fixed rate debt can be refinanced to take advantage of lower rates, when available. Sure, there would be some costs associated with any refinancing. But not only are refinance costs not particularly high, but they are a small price to pay compared to the fiscal distress governments are now facing as variable rates go up, up, up.
On another front, the difficulties that have plagued Ambac and MBIA ought to make issuers of public debt a bit more cautious when using a bond insurer. Ambac and MBIA, like many other financial institutions exposed themselves to incredible risk with CDOs (collateralized debt obligations). It is hard to know what the solution to this problem is as there are only a limited number of bond insurers, and going to market without insurance would make for enormous debt service costs, or possibly prevent issues, for some smaller governments. Hopefully the monolines will get out of the CDO field, especially those related to real estate, as soon as possible.