Local issuers in Pennsylvania have entered into about $6 billion in interest rate swaps since the state passed a law in 2003 allowing school districts and other municipalities to tap the swap market, according to data from the state Department of Community and Economic Development.
Despite the heavy volume of swaps, market participants say they can’t generalize about the success of these transactions since circumstances vary widely from issuer to issuer. However, after the rush to market over the last two years it is clear that not all municipalities are pleased with their swaps.
Lancaster County is one such example. The county, a tourist destination northwest of Philadelphia known for its Amish communities, is considering ending two variable-to-fixed-rate swaps negotiated in 2001 and 2002. The county’s story illustrates the risks and rewards of these complex transactions.
“These trades are traps for the unwary,” said Steven Goldfield, of counsel to Cozen O’Connor and counselor to Public Resources Advisory Group, who worked on the state’s swap legislation and conducted swap workshops for municipalities.
Goldfield said swaps could prove useful for hedging interest rates as long as issuers carefully evaluate and understand the various risks involved, including basis risk, tax risk, and termination risk.
Pennsylvania’s swap bill went into effect in September of 2003, permitting local entities such as school districts and quasi-independent authorities to enter into swap agreements. State authorities and counties already had the authority to do such deals, although the volume of these transactions wasn’t monitored before the new law set requirements for issuers to register their swap activity with the state.
Tom Vernau, president of the Pennsylvania Government Finance Officers Association, said he sensed a general nervousness among localities toward swaps.
“People aren’t having the positive experiences with them that they had hoped,” Vernau said.
Lancaster is weighing a $46 million bond sale that would enable the county to refinance two underlying bond issues on the two swaps and to pay a termination fee of $7.5 million to end the swap agreements. The county’s deliberations were first reported in a local newspaper.
The first transaction involved a swap on $24.9 million of bonds originally issued in 2000, for which the county received an up-front payment of $3 million. The second was a swap on $13.9 million of bonds sold in 2003, for which the county received $630,000. Bear, Stearns, & Co. is the counterparty for both transactions.
The former Penn Capital Advisors, which was acquired last year by Public Financial Management, was financial adviser on both deals, and Investment Management Advisory Group Inc. was swap adviser on both. Concord Public Financial Advisors Inc. worked as financial adviser on the 2003 swap.
Access Financial Markets became Lancaster County’s financial adviser in early 2004, and officials amended the terms of both swaps later that year. For the swap negotiated in 2001, the county pays a fixed rate of 5.195% and originally received 67% of the London Interbank Offered Rate. That rate was amended to 60% of Libor plus 0.303%. For the 2003 swap, the county pays a fixed rate that ranges from 4.6089% to 4.7295% and originally received 67% of Libor plus 0.31%. The county now receives 60% of Libor plus 0.5575%.
These so-called compound formulas work well with low interest rates and became popular throughout the country between 2002 and 2004, said Peter Shapiro, managing director of Swap Financial Group in South Orange, N.J. Under this structure, as rates rise the municipality in effect receives a lower percentage of Libor.
Some Lancaster officials fret that the county has paid more than it has received from the counterparty for the duration of the two swaps. Discounting the up-front payments, the first swap has lost money since November of 2004, and the second has lost money since May of this year, officials said.
As of September, the county had paid $400,000 above the variable rate on the swap negotiated in 2001 and entered in January of 2002.
Libor would have to climb to 8.154% on one swap and 6.953% on the other for the county to break even on the deals. Three-month Libor late last week was 4.39%.
“My position is municipalities should not be in these agreements,” said county Controller Dennis Stuckey. “Our best course of action is to cut our losses.”
While the county controller does not have a vote on bond sales or swaps, Stuckey’s office administers debt payments and tracks the swaps. Assistant deputy controller Darlene Davis said she understood the up-front payments to be a large incentive for the county, which must balance its budget each year, to enter into the swaps. Davis said she did participate in the swap negotiations.
The decision to use swaps rested with the three county commissioners. The two who voted for the swap agreements, Ron Ford and Paul Thibault, are no longer in office and could not be reached for comment. The third county commissioner, Pete Shaub, voted against the measure. Shaub said proponents of the swap used the term “budget magic” to describe the transactions.
“I didn’t think they were appropriate for the financial structure of the county,” said Shaub, who is still in office.
However, some market participants say the only way to truly analyze a swap’s success is to compare its cost of issuance with what the issuer would have paid doing a traditional bond sale.
Any issuer who did a floating-to-fixed rate swap over the past five years is probably paying more to the counterparty than it receives, according to Martin J. Stallone, managing director at IMAG. But the fixed rate on the swap must be compared with the fixed rate the issuer would have gotten with an alternate financing to gauge whether the issuer will lose money over the life of the deal, he said.
Stallone was the swap adviser for Lancaster when it entered into the two swaps it has considered unwinding, but declined to comment on the county’s situation since he hasn’t evaluated it in two years, he said. Stallone said he had never heard the term “budget magic” used in reference to swaps.
One banker who heads a derivative desk said swaps must not be viewed in isolation from the underlying bonds, even though the swap doesn’t affect the principal owed. A swap that’s “underwater” today is no different from bonds that were sold before at a higher rate and are now trading at a premium because rates are lower, he said.
Gordon Walker — the Penn Capital financial adviser who Lancaster officials said worked on the swaps and who is now with PFM — did not return calls for comment. Lancaster’s current financial adviser, Matt Kirk of Access Financial Markets, also did not return calls for comment.
Shaub said Lancaster County commissioners will likely decide in December whether to unwind their two swaps. The county has six other swaps and three swaptions outstanding.
