Warren Buffet famously referred to derivatives as “financial WMDs.” In the wake of the 2008 global financial crisis, these words might appear prescient to some. Many have argued that the pervasive use of derivatives, instruments such as credit default swaps, made a linear finance problem geometric. When the housing market collapsed, the cumulative exposure of many banks and large financial institutions to each other via derivatives threatened to collapse the global economy. Within the realm of government finance, the role of derivatives in Jefferson County’s bankruptcy – wherein the extensive use of interest rate swaps on outstanding sewer debt led to massive termination payments – further underlines the risk inherent in these instruments. Nevertheless, many finance experts would suggest that derivatives are an integral part of an overall debt-management strategy that can generate real cost-savings for governments. Despite the clear tension between these ideas, little is known about local government use of derivatives over the past 10 years, preventing any sort of comprehensive analysis on the effectiveness of debt-related derivatives as financial management tools. This research aims to remedy this situation by providing a complete description of the debt-related derivatives transactions of the 50 largest cities from 2003 to 2012. It then builds on this list of transactions to analyze via logistic regression the factors motivating governments to use these tools.

This research will answer three important questions: 1) What are the characteristics of local government most associated with use of debt-related derivatives? 2) Does fiscal stress or declining fiscal condition have an effect on the use of debt-related derivatives? 3) Going forward, what are the implications of the use of debt-related derivatives for local government financial management?