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By Bloomberg

All signs pointed to a Mississippi county’s bet with Wall Street going south.

Officials in Hinds County, where one in four residents live in poverty, didn’t know what they were getting into, according to an independent audit. They couldn’t explain the mechanics of the interest-rate swaps they negotiated with Rice Financial Products Co., a New York derivatives dealer. They couldn’t say how semi-annual payments on the leveraged bets were determined.

Yet, in the decade since the contracts were first signed, Hinds County netted $6.7 million on the deal due to collapsing short-term rates in the municipal bond market. That bucks the trend of cities, states and localities exiting interest-rate swaps on much less favorable terms.

“It’s like walking out of the casino with $6 million,” said Robert Brooks, a finance professor at the University of Alabama’s Culverhouse College of Commerce in Tuscaloosa. “It could’ve gone the other way.”

It’s gone the other way for so many others. Since the 2008 financial crisis, municipalities have paid at least $9 billion to cancel the swaps, according to data compiled by Bloomberg. The contracts were supposed to reduce borrowing costs and protect them against rising payments on floating-rate bonds.

Perhaps the best-known of the interest-rate disasters was Jefferson County, Alabama, about 250 miles northeast of Hinds County. The swaps it bought in 2003, tied to a $3 billion sewer- debt refinancing with JPMorgan Chase & Co., helped push it eight years later into the largest municipal bankruptcy in history. Only Detroit’s, a year later, is bigger.

Three Deals

Hinds County includes Jackson, the state capital. It has 245,000 residents over 870 square miles and its median household income is $37,626, about $14,000 less than the U.S. median, according to the Census Bureau.

At least three municipalities profited from swaps with Rice. Durham County, North Carolina, home to the state capital Raleigh, has netted $18 million since it executed a swap with Rice in 2004. Miami-Dade County, Florida, has received $160 million.

Donald Rice, founder and chief executive officer of Rice Financial, didn’t return calls seeking comment.

Porter Bingham of Malachi Financial Products Inc. takes issue with the notion that county officials didn’t understand the terms of the swaps and their risks. Malachi was paid about $400,000 to advise on the swaps between 2006 and 2012, according to county records.

“They understood perfectly what they were getting into,” Bingham said. The swaps “were assessed and studied.”

Complicated Wager

County officials couldn’t tell an auditor how the swaps worked. It’s little wonder. The terms were a bit complicated.

In floating-rate to floating-rate “basis” swaps, local governments typically pay a bank a short-term tax-exempt rate. In return, they receive 65 percent of the taxable one-month London Interbank Offered Rate, or Libor, plus a set percentage. As long as the federal government doesn’t cut tax rates or eliminate the exemption of tax-exempt bonds, the swaps make money for municipalities.

If, however, the government curtails or eliminates the tax exemption, the yield on short-term tax-exempt rates rises and municipalities lose money.

The terms of the deal included this: “If the difference obtained by subtracting USD-LIBOR-BBA from the product of 86 percent multiplied by USD-ISDA-Swap Rate is greater than .005 percent, then sum of USD-LIBOR-BBA, .005 percent, and Constant 1 all multiplied by Factor 1.”

Got That?

That was enough to baffle Richard Ryffel, a senior lecturer in finance at Washington University’s Olin Business School in St. Louis and a former public-finance banker at Bank of America Corp.

“It seems needlessly complex,” Ryffel said.

The basis swaps that Rice sold to Hinds County, as well as Durham County and Miami-Dade County, did better than typical basis swaps because the terms of the deal were multiplied, juicing returns. Usually swaps are based on a corresponding amount of bonds. But one of the Hinds-Rice deals was leveraged 19 times, with the county basing a $29.8 million swap on $1.6 million of bonds.

Hinds County officials “could not explain how the swap was supposed to benefit the county nor did management demonstrate an understanding of the extent, multitude and nature of the various risks inherent in a swap,” according to the independent audit.

Nevertheless, for most of the swaps’ life, rates moved in the county’s favor. Hinds netted $6.7 million, using the money to pay for projects such as road resurfacing and renovating the county jail.

In March, Hinds County officials decided to quit while they were ahead and terminated the swaps.

“We’ve enjoyed those payments, but the pendulum, we thought, was about to swing the other way,” said Tony Greer, a member of Hinds County’s board of supervisors, elected in 2013. “It was just too risky for us to be in.”