HARRISBURG, Pa. – In Pennsylvania’s capital, itself a poster child for municipal financing gone haywire, state lawmakers have rekindled an effort to ban cities, towns and school districts from engaging in interest-rate swap transactions.
Four bills before Pennsylvania’s legislature would prohibit local issuers and agencies from participating in swaps. Swaps are derivative transactions between a bond issuer and an investment bank exchanging interest obligations, commonly a contractual trade of variable interest rates for fixed rates.
Former Gov. Ed Rendell in 2003 signed amendments to the Local Government Unit Debt Act that enabled communities to engage in swap deals.
But sponsors of the new legislation say too many municipalities are in over their heads and cite the role swaps played in helping saddle 49,000-population Harrisburg with $363 million of debt from financing overruns to an incinerator retrofit project.
The latest round of swap bills stems from two hearings the Senate local government committee held last October on what went wrong with Harrisburg. The Senate, in turn, based its hearings on a January 2012 forensic audit report by the Harrisburg Authority public works agency.
Steven Goldfield, an attorney with financial firm Public Resources Advisory Group and the financial advisor to Harrisburg receiver William Lynch, worked on the Harrisburg Authority report.
“There were eight swaps on a single series of bonds. They were a disaster,” said Goldfield. “Swaps have too much downside for smaller communities in Pennsylvania.”
Last fall, Goldfield outlined in detailed testimony before the Senate local government committee how Harrisburg’s incinerator debt ballooned from an original bond issue of about $27 million.
The deals are often opaque. Harrisburg Mayor Linda Thompson, an eight-year councilwoman until her election in 2009, combed through the city’s balances when looking to seal a $9 million structural deficit and didn’t like what she saw. “No one knew all those hidden nuances,” she said in a City Hall interview.
Harrisburg City Councilman Brad Koplinski, among others, has called for a criminal investigation into the incinerator bond deals.
“It’s staggering how much was made by people who didn’t give a damn about Harrisburg,” said Koplinski, a candidate for lieutenant governor and a former attorney for the Internal Revenue Service. “Sometimes swaps work great, but the vast majority of the time they don’t.”
Pennsylvania Attorney General Kathleen Kane’s office has begun a criminal investigation into the transactions.
But not so fast on a statewide swap ban, warned one capital markets advisor.
“This would be unprecedented,” said Peter Shapiro, president of Swap Financial LLC of South Orange, N.J., whose municipal clients include Philadelphia. “Philadelphia is the fifth-largest city in the United States. No other city of this size would be prevented the flexibility to manage the city’s finances. In cities as big as Philadelphia, New York and Chicago, generally there is home rule.”
Shapiro said Pennsylvania and other states should wait for the federal Dodd-Frank Act to take full effect. Dodd-Frank, which passed in 2010, is intended to restrict abusive practices, notably regarding swaps, which had been lightly regulated.
“The Dodd-Frank Act has changed the nature of the swaps market since Pennsylvania started looking at this,” Shapiro said. “Every state should give reform a chance to work before they put in a whole new regulatory regime.”
The Senate local government panel hearing at the capitol last week included extensive testimony by former state auditor general Jack Wagner, who favors banning cities outright from swaps, and Philadelphia treasurer Nancy Winkler, who said such a move would unnecessarily handcuff her city.
Wagner, who left office in 2012 after eight years, repeated his call to take swaps away from localities and make all related bond issues fixed-rate. He said many localities have lost money through interest rates and termination fees.
“Swaps are nothing more than a form of gambling with public funds. These are very, very risky transactions,” Wagner said. “Swaps may be perfectly acceptable in the private sector, but they should have no role in government, where taxpayer money is at stake and nobody understands the transactions.”
The argument that not all swap deals are bad and some have saved a lot of money “brings no comfort to the many public entities that have been badly served by swap deals that have backfired,” said Wagner, who lost in the Pittsburgh mayoral Democratic primary in May.
“Just look at Harrisburg; look at Stockton, California; Jefferson County, Alabama; and many other entities in Pennsylvania,” he said.
Winkler, however, called on lawmakers to set aside the legislation.
“It would harm Philadelphia’s ability to manage effectively its own financial affairs,” said Winkler, the city’s treasurer since 2011 and a former managing director at Public Financial Management Inc.
Since Mayor Michael Nutter took office in 2008, Philadelphia has reduced but not eliminated its swap exposure, Winkler said.
“While we have not entered into new swaps, we must retain our ability to do so,” Winkler said. The city’s swap portfolio is just under 12% of its total outstanding debt, she said.
“Contrary to stories that have circulated, swaps have not [harmed] the city’s credit rating,” she said, citing a rating increase in June from Standard & Poor’s to A-minus, its highest S&P rating since 1979. Fitch Ratings also rates Philadelphia A-minus, while Moody’s Investors Service assigns an A2 rating.
According to a study Winkler’s office conducted examining swaps against a fixed-rate bond issue through June 30, 2012, Philadelphia ranged between a $35.1 million gain and a $28.9 million loss.
But Wagner, pointing to several examples, opposes giving larger issuers free rein.
The Delaware River Port Authority, which operates four bridges and a commuter rail line between New Jersey and Pennsylvania, had a net loss of $56 million through termination fees and additional interest related to seven swap deals in 2000 and 2001, according to data the agency provided Wagner when he was auditor general. The remaining active swaps, said Wagner, had a negative fair value of roughly $248 million, nearly the equivalent of a year of toll revenues on all four of the agency’s bridges.
Southeastern Pennsylvania Transportation Authority, which operates Philadelphia’s transit system, and the Pennsylvania Turnpike Authority also lost millions, he said.
School districts have been notably vulnerable to swap-related losses. Philadelphia’s teetering district, for which the city had to borrow $50 million last month to allow schools to open in time, had more than $1 billion of debt tied to swaps, Wagner said. An audit that Wagner’s office released late in 2009 found that Bethlehem ‘s district fell prey to “deceptive marketing tactics” and lost $10.2 million on two swaps.
Shapiro called Wagner’s statements off-mark, though both he and Winkler suggested reforms.
“The ‘losses’ that Wagner and some others have reported are simply inaccurate,” said Shapiro. “We feel that Wagner’s statements are miscalculated and if anything, inflammatory. They are based on a misconception of how a swap is structured. The hedge of floating rate to floating rate, not floating to fixed. The last five years, floating rates have been low.”
According to Shapiro, the original legislation in 2003 opened the window for smaller issuers, notably school systems, to engage in complex transactions way over their heads.
“That wasn’t the intention, but it had that side effect,” he said.
Possible solutions, he said, could include requiring Pennsylvania’s Department of Community and Economic Development to oversee deals by smaller issuers and prohibiting “off-market” swaps that involve upfront payouts – to cover budget gaps, for instance.
Philadelphia bans the latter.
“They’re effectively taxable loans and that just raises the fixed rate you would be paying,” Winkler told lawmakers.
Winkler and Shapiro recommend embedding par-call provisions, probably 10 years, which enable an issuer to call bonds in at no cost. Winkler said it’s part of the city’s swap policy.
“I feel it’s tremendously important,” said Winkler. “That gives the issuer the opportunity to refinance the bond if interest rates are lowered. If you put a par call provision in your swap, you don’t have to pay the termination payment or you materially reduce [the payment amount], which gives the swap the same type of optionality that a traditional fixed-rate bond would have.”
Disclosure is essential, Shapiro said. “You want improved disclosure,” he said. “It’s important to see all the profit and all the elements, and you haven’t seen that in Pennsylvania.”