Aug. 31 (Bloomberg) -- The Massachusetts Turnpike Authority faces the possibility of higher borrowing costs because of derivative agreements it made with UBS AG and Lehman Brothers Holdings Inc. involving $800 million of debt for Boston's `Big Dig' highway project, credit-rating analysts and officials said.

UBS may exercise an option it bought from the authority to start an interest-rate swap on the bonds on Sept. 4. Should Lehman exercise a similar option it purchased, the authority may end up paying variable interest rates on more than a third of its debt, a prospect credit raters said is risky given the agency's pinched finances from cost overruns on the $14.8 billion Big Dig.

The authority is among U.S. state and local borrowers lured by the prospect of upfront cash into complex derivative agreements such as swaps, private contracts that aren't regulated by the Securities and Exchange Commission. The agency received $64.3 million for the options it sold the banks in 2001 and 2002, helping offset revenue lost when it deferred toll increases.

``It was something that the authority never should have entered into,'' said Mary Connaughton, a member of the agency's board appointed by former Governor Mitt Romney when he tried to merge the authority with the Massachusetts Highway Department. ``In the end, the toll payers end up with the risk, and that's not right.''

A derivative is a financial contract whose value is derived from tradable securities or linked to events such as weather changes. In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on the movements of benchmark indexes or rates used by banks to track borrowing rates.

Different Gambles

In the turnpike authority's case, the agency sold derivatives in a bet that interest rates wouldn't change substantially, and that it would make more money than it would cost to issue bonds later if the wager was wrong. The banks were making different rate bets, UBS that rates would fall and Lehman that they would rise.

The turnpike authority in May 2001 sold UBS an option for $29.1 million to enter into a swap on long-term bonds issued in 1997 and 1999. Under the terms, the authority would sell variable-rate debt and pay Zurich-based UBS a fixed rate of 4.75 percent to 5 percent for 35 years. The authority would in turn get payments from UBS equal to a percentage of the London interbank offered rate, or Libor, and use that money to make payments on the variable-rate debt.

Next Week

The audit committee of the authority's board was told on Aug. 21 in a presentation by Lehman bankers that they anticipated UBS would exercise an option to begin a swap on $335 million of the $800 million deal on Sept. 4. UBS can exercise the option, known as a swaption, on the remaining $465 million next year, according to the presentation.

UBS bankers met with turnpike officials this week, according to authority spokesman Mac Daniel, who declined to elaborate. Doug Morris, a spokesman for UBS, also declined to comment.

Lehman's option, purchased in November 2002 for $35.2 million, ``was designed to offset the 2001 UBS swaption,'' the authority said in financial statements. Under the terms, the agency would make a payment based on an index of variable-rate municipal bond yields and get a 5 percent fixed rate from the New York-based investment bank.

The authority in 2002 was told by bankers and its financial adviser, Robert Lamb of Wayne, New Jersey-based Lamont Financial Services Corp., that if Lehman ever exercised the option it would probably happen simultaneously with UBS and the two would cancel each other out. The authority wouldn't have to sell floating-rate bonds, and would simply alter the fixed rate it pays on the $800 million in bonds.

Rate Risk

Connaughton and credit-rating companies said they are concerned that should Lehman decide not to exercise its option at the same time as UBS, the authority would be exposed to interest- rate risk from the variable-rate bonds it would have to sell.

``The number in and of itself may not be a lot but it poses a challenge for the authority to manage given all of its other financial obligations and constraints,'' said Scott Trommer, a transportation analyst at Fitch Rating.

The authority, which operates Interstate 90 from Boston to the Massachusetts border with New York, has seen costs of managing the Big Dig highway-and-tunnel project spiral from the estimated $2.8 billion before construction began.

Indication

Lehman indicated in its Aug. 21 presentation that it might not exercise its option on Sept. 4. The authority wouldn't comment on the Lehman deal.

Paul Haley, a Lehman banker in Boston who has been involved in the transaction, didn't return calls seeking comment. Haley is a former state representative who chaired the House Ways and Means Committee.

Lamb defended the deal and said he never guaranteed that the UBS and Lehman swaps would happen simultaneously. He said they have set aside reserves, which they could use to buy an interest- rate cap on the variable-rate debt if they needed.

``The swaps are fine and the authority will do fine with them.'' said Lamb, who no longer works for the authority. ``They've got sufficient protection and sufficient reserves.''

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net

Last Updated: August 31, 2007 15:07 EDT