Pennsylvania lawmakers are moving forward with bipartisan legislation that would prohibit cities, towns and school districts throughout the state from entering into swap agreements.

The initiative to prohibit derivatives at the local level is in response to a state auditor general report released in mid-November. That report identified millions of dollars that the Bethlehem Area School District lost due to swap agreements, including a $12.3 million termination fee it made to JPMorgan in May 2009. Auditor general Jack Wagner has called for a ban on derivatives for all local governments.

“Regardless of whether the General Assembly acts upon our recommendations, no local government unit or municipal authority in this commonwealth should enter into or utilize such instruments from this day forward,” the report reads.

Democratic state Sen. Lisa Boscola, who represents parts of Lehigh County — where the Bethlehem School District is located — plans within the next two weeks to file a bill that would prohibit the use of swaps and derivatives at the local level, including for major cities and large school districts.

Boscola believes derivatives are too risky an instrument for municipalities and schools.

“This is taxpayer money and it’s compromised,” shea said. “You’re playing roulette or you’re gambling with this money and it might work out for some areas, but for a heck of a lot of others it did not.”

The auditor general’s report showed that Bethlehem’s borrowing costs on a 2003 note deal would have been $15.5 million less if it had sold variable-rate debt without a hedge and that it would have saved $10.2 million if it had issued the bonds in fixed-rate mode with no swap.

In addition, the district paid counterparty JPMorgan $12.3 million last year when the district refinanced the floating-rate notes to a fixed rate after Dexia SA did not renew a liquidity enhancement on the variable-rate notes. The district had received a $3.46 million up-front payment on the swap.

In total, Bethlehem entered into 13 ­different swaps, the most of any school district in the state, for a total notional amount of $272.9 million, according to Wagner’s report.

While swaps can generate interest-rate savings, issuers take on various risks such as basis risk between different variable-rate indexes, counterparty risk, and the risk of losing credit enhancement on variable-rate bonds and notes.

Sen. Pat Browne, a Republican who represents Lehigh and Monroe counties, will co-sponsor the Boscola bill. Browne chairs the Senate Finance Committee, which will weigh in on the swap measure.

Meanwhile, in the lower chamber, Rep. Mario Scavello, R-Monroe County, said he plans to amend his bill, HB 1905, so that all local governments would no longer have the authority to enter into hedge transactions. The bill currently would prohibit only school districts from using swaps and would not apply to cities, towns, or local authorities.

“We’re going to probably amend the bill to eliminate for all,” Scavello said. “When this bill was put together I did it because of the school district in my area, but then the auditor general came back with his report and that really cemented it for me and many in the legislature.”

Boscola said she anticipates larger municipalities like Philadelphia and Pittsburgh may push to amend her forthcoming legislation in order for major cities to retain the financial flexibility of being able to enter into derivatives when appropriate.

“I would like to see it across the board, but if [larger municipalities] can show a reason why they should be exempt then that can be addressed in the amendment process,” Boscola said.

Local governments throughout Pennsylvania have used derivatives to hedge variable-rate debt. In an October report, Moody’s Investors Service stated that the state’s municipalities hold the largest share, 22%, of hedged variable-rate debt out of approximately 500 local governments that it rates. Following the Keystone State are California and Texas, each with 17%, and Tennessee with 13%.

“For California and Texas, these percentages primarily reflect the large number of issuers in these states, but for Pennsylvania and Tennessee, they reflect the relatively permissive state statutes concerning these structures and the promotion of these instruments by various market participants,” according to the Moody’s report.

Tennessee last year implemented rules that require local government issuers to follow specific risk-assessment procedures prior to entering into a derivative, maintain professional staff to monitor obligations over the life of the agreement, and follow state reporting requirements. Congress and federal regulators also are reviewing the use of derivatives by municipalities.

According to the auditor general’s report, of Pennsylvania’s 500 school districts, 107 have entered into at least one swap agreement and 86 other local government units have used at least one derivative between October 2003 and June 2009. The state’s Department of Community and Economic Development records derivatives used within the state as municipalities must report their swap agreements to the DCED. From October 2003 to June 2009, the department received 626 derivative filings, accounting for $14.9 billion of debt, according to the auditor general.

Pennsylvania lawmakers expanded the use of derivatives at the local level in 2003 when both chambers unanimously passed Act 23, which for the first time allowed school districts to enter into swap agreements. Gov. Edward Rendell signed Act 23 into law on Sept. 24, 2003. He has yet to speak out on the issue of banning all local governments from swap transactions, but will consider new legislation in light of lost taxpayer money from derivatives that have proved costly for local issuers, according to Rendell spokesman Gary Tuma.

“The Rendell administration believes that swaps are risky business propositions and it has urged school districts to be very cautious,” Tuma said in an e-mail. “Given the current market, however, it is doubtful that there is a district out there considering a swap. Legislation to set appropriate parameters to protect school districts from risky investments may make sense, but we would need to see the details of a bill before confirming that we support a particular approach or piece of legislation.”

Rating analysts said they look towards a city or town’s financial management to assess whether an issuer has the capability to manage a swap agreement.

“Sometimes using derivative products can provide an issuer with some up-front flexibility, but from Fitch Ratings’ perspective, we tend to view the use of swaps and swaptions, and things of that nature, with a little bit of concern as they tend to expose issuers to the possibility of unexpected and sometimes unaffordable financial demands in the future,” said analyst Chris Hessenthaler. “So we really look for management to have a very clear and sophisticated understanding of the benefits and the risks associated with using derivative products.”

Lawmakers will now discuss the merits of derivatives and the financial flexibility they can provide as well as the risks that issuers — particularly smaller ones with limited in-house financial staff — take on when hedging variable-rate debt.

“I could see much tighter restrictions, making it so there would have to be greater safeguards,” said Peter Shapiro, managing director at Swap Financial Group LLC. “If you wanted to put a prohibition in, I could see how that could be applicable to smaller entities that clearly, by virtue of their size, could not handle the complexities. To make it so that you disadvantaged the larger urban school districts [and municipalities] who could use these savings, and have the sophistication to understand them, it just doesn’t make any sense.”

Philadelphia, the state’s largest city, is one example of a municipality that may prefer to keep its ability to use derivatives in order to obtain the lowest cost of borrowing.

“I think that we do want the flexibility to be able to make that decision ourselves so that we make the most cost-effective decisions for the city,” said city Treasurer Rebecca Rhynhart.

Since Philadelphia Mayor Michael ­Nutter took office in January 2008, the city has not entered into any new swap agreements and his administration is currently managing its derivative portfolio.

Prohibiting municipalities from using swaps would follow similar limitations that apply to the state itself. By law, Pennsylvania cannot enter into hedging transactions, although state authorities and agencies can use such instruments.

Along with Wagner’s push to stop all municipalities from using swaps and legislation to restrict or ban derivatives, other entities are reviewing the pros and cons of swap agreements.

On Dec. 28, the Delaware River Port Authority, a bi-state agency that manages four bridges and a light-rail line that connects southern Pennsylvania to southern New Jersey, voted to end its ability to use derivatives in the future. The decision follows swap termination payments the agency has made, including a nearly $40 million payment it made in December to UBS Securities LLC to end a swaption that was set to begin Jan 1.

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