Interest-rate swap firms could get paid first as Detroit bankruptcy looms

[TexasT]

I see that there is a large misunderstanding has to how an interest-rate swap works.

While not knowing exactly how this specific CoD swap was set up, the generally go something like this:

Let’s assume the CofD has an existing debt of $1 million with an interest rate that is floating [[variable) pegged to say the 10 year Treasury Rate. At the time they issued the debt the 10Yr T was at 5.0% but could go up or could go down. Well, the CoD did not like the riskiness of a variable rate and wanted to have the known stability of a fixed rate loan. So they entered into a swap agreement. Banks arrange these things, sometimes with another, third party. Swaps are usually entered into as a protection against the risk of rising interest rates

In a swap, the CofD accepts from the third party a fixed rate at let’s say, 5.25% - they are willing to pay a modest premium over their current 5.0% variable rate in order to have the stability of a known, fixed rate.

But, this is a VERY sharp two-edged sword. If variable rates rise, then the CofD is protected from paying the higher interest rate. They would look like geniuses for buying this rate protection if rates had gone up.

However, if interest rates fall, as they have, to 2.46%, then the CofD still pays at the 5.25% interest rate. Had the CofD remained with the original variable interest rate, then they would now be paying a lower rate. Instead, the rate they are paying is more than double today’s variable rate.

It is really had to fault the CofD in a swap. They took a gamble with a third party [[using the bank as an intermediary) that variable interest rates would be going up soon. The other guy assumed variable rates would be dropping. These things are done in business each and every day.

Depending on which way variable rate move [[higher or lower) one party will be a HERO and the other party is a ZERO.

The credit swap is not the entire issue. The deal they accepted to terminate the credit swap is [[$50M/yr for total of over $800M).