Pennsylvania officials yesterday weighed in on an initiative to prohibit local governments from using derivatives, with most participants in the public hearing urging greater state regulation and guidelines for such instruments rather than ending swaps at the local level.

The Senate Finance Committee held the meeting to hear from market participants and stakeholders regarding two initiatives.

S. 1277 would end the use of swap agreements for cities, towns, school districts, and local authorities and repeal Act 23, which lawmakers signed into law in 2003 and opened the door for derivative use at the local level. Another bill, S. 1278 would require municipalities to hire outside financial advisers through a competitive bidding process.

The bills are in response to millions of dollars that Pennsylvania school districts have lost in swap agreements. In one swap contract, the Bethlehem Area School District in Lehigh County was forced to absorb a net cost of $8.84 million.

The district in May 2009 paid counterparty JPMorgan Chase & Co. a termination fee of $12.3 million when the district refinanced a 2003 floating-rate note deal to 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 for entering into the derivative.

Sen. Lisa Boscola, who represents parts of Lehigh County, is the primary sponsor for both measures.

She stressed that taxpayers should not have to take on potentially higher property taxes to offset losses from derivative agreements that went sour for local issuers.

“We must put an end to all this,” Boscola said during the committee hearing. “The goal of my legislative package is solely to protect taxpayer dollars. Taxpayer dollars should never, ever be compromised again with financial swaps in my school district, or in any municipality, or by any other municipal authority.”

Robert Teplitz, chief counsel and director of policy and planning at the Department of the Auditor General, agreed that municipalities and local governments should not be able to use swaps and derivatives.

Along with losses that schools districts took on from such instruments, he pointed out several other government entities that would be forced to pay counterparties millions of dollars if they had to terminate their swaps today or have already paid banks in negative derivative deals.

The Pennsylvania Turnpike Commission in December made eight payments totaling $52.6 million to counterparties to end swap contracts. That amount totals more than one month of toll collections.

Some of the issuers involved — the Delaware River Port Authority, the Southeastern Pennsylvania Transportation Authority, and the PTC — are transportation entities that cannot afford to lose money in financial transactions as the state faces a nearly $500 million funding gap for infrastructure in fiscal 2011, he said.

“Public money that could be funding transportation has been lost through swaps, and additional public funds are at risk,” Teplitz told the committee. “Instead of sending our money to Wall Street, we should be investing it in our critical transportation needs here in Pennsylvania.”

While many speakers recommended greater state oversight, education, and restrictions on derivatives, Teplitz said the state should ban swap contracts at the local level.

However, several market participants — including the Pennsylvania School Board Association — said derivatives can be a necessary financing tool that can enable issuers to obtain lower interest rates.

Supporters of derivatives said additional state guidance, restrictions on the number of swaps and the total amount of swaps a municipality could hold, and mandatory fee disclosures, including the actual dollar amounts as opposed to formula quotes, are some examples of how further regulation would enhance the use of derivatives.

“The reality is everybody uses whatever finance tool they can to manage their assets and their liabilities,” said Jay Wenger, managing director at Susquehanna Group Advisors Inc. “We believe this is a very valuable finance tool. We think it’s one that can and should be sharpened, not taken out of the tool box and thrown away.”

While derivatives can bring basis risk and counterparty risk, and leave issuers reliant on liquidity providers, when used prudently, swaps can offer local governments debt-service savings, said Patrick Cusatis, assistant professor of finance at Penn State Harrisburg.

“If the proper guidelines are in place, the savings relative to the risk are greater,” Cusatis said.

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