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Study: States were cautious about investing in financial derivatives

November 11, 2013
Bloomington, Indiana --

A handful of horror stories may have created the impression that managers of public debt in the U.S. have invested recklessly in financial derivatives. But a study co-authored by an Indiana University professor finds that states have been cautious in their approach.

The study examines the 50 states' use of derivatives between 2003 and 2009. It finds that no more than about 10 percent of state debt was tied to derivatives in any year. The states stuck mostly to cautious investments in derivatives, aiming to stabilize interest costs rather than make money.

Bob KravchukRobert Kravchuk, professor in the IU Bloomington School of Public and Environmental Affairs, is co-author of the article, published in the Journal of Public Budgeting, Accounting & Financial Management. The lead author is Martin Luby, assistant professor in the DePaul University School of Public Service, who earned his doctorate at IU Bloomington.

"Many states have had no derivatives at all," Kravchuk said. "In some states, the investments were prohibited by law, and other states had a self-imposed policy that they wouldn't get involved. And it turns out that the most sophisticated states, the ones that were the most active in the debt market, were also the most careful about how they used derivatives."

Financial derivatives are financial contracts that derive their value from an underlying asset. A typical example is an interest-rate swap, an agreement in which the parties agree to exchange interest charges, sometimes trading a variable rate for a fixed rate or for a variable rate tied to a different index. The products can benefit both parties, but they can be opaque and, in some cases, risky. The market ballooned in the 1990s and 2000s, and highly leveraged investment in products tied to housing values and credit defaults was widely blamed for the collapse that produced the Great Recession.

A few local governments, including Orange County, Calif., and Jefferson County, Ala., faced financial crises related to derivatives, raising questions about public investment in derivatives more generally.

Luby and Kravchuk examined comprehensive annual financial reports for all 50 states over the seven-year period, calculating exposure to derivatives. About one-third of the states (including Indiana, Kentucky and Michigan) had no derivatives in most or all of the years included in the study. Others generally increased their derivatives in the years leading to the recession and held onto the products in 2008 and 2009, possibly because the cost of ending the contracts would have been too great.

States with the most money in derivatives included California, Connecticut, Massachusetts, New York and Texas, large states that are among the most active in debt markets. However, even those states typically didn't have much more than 10 percent of their overall debt in derivatives.

The overwhelming majority of state investment in derivatives was in "floating-to-fixed" rate swaps, in which a variable interest rate for state bonds was swapped for a fixed rate that produced predictable interest payments. States largely stayed away from more exotic types of derivatives that posed greater risk; and they also eschewed contracts that offered up-front payments in exchange for less certainty.

For a copy of the paper or to speak with Kravchuk, contact Jim Hanchett at SPEA, 812-856-5490 or jimhanch@indiana.edu, or Steve Hinnefeld at IU Communications, 812-856-3488 or slhinnef@iu.edu.