Quantitative easing has resulted in collateral damage. Municipalities, public-owned entities and small companies have been damaged as a result of derivatives contracts that locked them into paying high interest rates before the full effect of QE became apparent. Investment banks that sold such contracts have been accused of mis-selling them, lawsuits are winding their way through the legal system, and regulators are being pressured to crack down on the use of derivatives.

Consider the City and County of Denver, whose public school system alone paid $216 million since 2008 to unwind swaps intended to lock in borrowing costs on floating-rate bonds. In Denver’s 2011 annual report, the city discloses holding many more such swap agreements which it says it entered into “in order to protect against rising interest rates.”

When rates fell, municipalities that wanted to refinance such debt had to pay bank counterparties termination costs based on mark-to-market valuations of the swaps. U.S. localities from California to Massachusetts have paid at least $4 billion to banks to end such contracts since 2008.

In Portugal publicly-owned companies such as the city of Lisbon public transit system owned swaps with a total notional value of 12 billion euros at the end of 2012, according to a report by the Portuguese finance ministry. These contracts, whose purpose was to “minimize exposure to interest rate risk”, had a negative mark-to-market value of 2.8 billion euros at the end of 2012, as a result of interest rate declines.

To make things worse, some swaps were structured with exotic features that delivered upfront benefits that exacerbated the impact on the downside. Such “toxic” contract features are behind the threat by Portugal’s government to prosecute JPMorgan Chase & Co. and Banco Santander SA.

In the U.K., where municipalities are restricted by law on their ability to issue bonds and use derivatives, banks instead focused on small business customers, such as the owners of hotels, retirement homes and even fish-and-chip shops that took out floating rate loans. In one case heard in a U.K. court, Scottish real estate company Grant Estates Limited said that Royal Bank of Scotland Group Plc persuaded it to pay a fixed rate on a 775,000 pound swap in 2007 on the basis that it provided “fixed rate protection.” When interest rates subsequently plunged, the company went bankrupt.

When interest rate swaps were invented in the 1980s, they did provide some “¨users—such as savings banks with mismatched assets and liabilities—with protection against spikes in rates at that time. They provided major corporate borrowers, such as IBM, with a way of tweaking their debt mix in order to take advantage of low floating rates without having to refinance existing debt.

These early users of swaps were financially sophisticated enough to understand the trade-offs of the contracts they entered into. They could afford to hire the big law firms such as Allen & Overy that helped craft the International Swaps & Derivatives Association master agreements that governed the contracts.

However, trading of over-the-counter derivatives with large corporations had largely matured by the late-1990s, and other than persuading hedge funds to bet on the contracts, dealers seeking new business found governments, municipalities and small businesses ripe territory for selling derivatives.

To see how that business expanded, look at the derivatives statistics compiled by the Bank for International Settlements. In 1998, banks globally reported a notional $3.7 trillion interest rate swaps with non-financial counterparties, with a gross market value of $160 billion. By mid-2008, that notional amount had grown to $36.4 trillion with a market value of $655 billion.

To win that volume of business, swap dealers needed the new customers to sign up to the ISDA regime under which they could be treated as arms-length counterparties without the dealer having any advisory or fiduciary responsibility for them. Such a status was essential in order for banks to book profits on the trades by hedging them in the market.

Consider what happens if dealer does a swap with a Colorado or Portuguese municipality and hedges it with another firm. If there is any possibility that the municipality might not be legally obliged to pay out on the swap (other than by going bankrupt) then the dealer’s offsetting position with the other firm is no longer a hedge, and a bank regulator might demand that the dealer holds additional capital against the swap. Such a capital charge might remove the business justification for doing the swap in the first place.

So banks pitched the advantages of derivatives in terms of “protection”, “risk management”, or lower borrowing costs, while ensuring customers signed agreements pledging that they were sophisticated.

In the disputes that have come to court, banks have pointed to lengthy disclaimers where the new users of derivatives agreed that they understood the risks that swaps could go against them. They signed waivers declaring that the banks had no fiduciary responsibility for their client. The English legal system, which is often specified in swap contracts as the venue for disputes, tends to uphold these contractual agreements, throwing out cases brought by the likes of Grant Estates.

And yet, in the face of evidence that municipal or small-business users of swaps didn’t understand what they were buying, the strategy has crumbled. In the U.K., lawmakers have forced regulators to get tough on banks over interest-rate swap mis-selling, and some early cases are heading for the appeal court. In the U.S. and Europe, lawmakers are imposing bans or restrictions on municipal or state-owned companies from using derivatives.

One can’t blame derivatives dealers for not knowing in advance that the swaps they sold to municipalities and small businesses would perform so badly. Then again, the banks had no reason to care—they were hedged against whatever outcome occurred. For their customers who entered into the contracts without understanding the risks, that revelation isn’t a consolation. For the banks that’s one reason why the boom in local government and small business derivatives is over.

(Published by Bloomberg, 17 May 2013)