Pennsylvania Lawmakers Could Put Stop to Swaps

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Municipalities should not conduct interest-rate swap transactions, some Pennsylvania lawmakers argue, because the complex derivative deals are way over their heads and as a result taxpayers lose too much money.

“I anticipate some pushback from the banking industry,” said Sen. Mike Folmer, R-Lebanon, who proposes a legislative package that includes an outright prohibition on municipal swaps.

Supporters of a move to ban swaps cite the Harrisburg incinerator debt fiasco, along with swap-related losses by the Pennsylvania Turnpike Commission, the city of Philadelphia and its school district, among other instances.

Such a ban would reverse enabling legislation former Gov. Ed Rendell signed in 2003. Other financial observers call instead for tighter state oversight over municipal debt transactions, while some say instances of abuse are rare.

Pennsylvania’s House and Senate, which met ceremonially on Jan. 1, will reconvene Monday and on Jan. 22, respectively.

On Tuesday, auditor general Jack Wagner, in his final week before term limits send him out of office, said an audit of the Pennsylvania Turnpike Commission found that interest-rate swaps cost state taxpayers and turnpike motorists at least $109 million over 13 years, $59 million of which related to deal cancellation fees.

Wagner said the losses worsen the finances of a commission that by state law must fork over $450 million annually, or nearly $24 billion over 50 years, to the Pennsylvania Department of Transportation for road, bridge and transit funding.

“Given its precarious financial position relative to Act 44 payments, the turnpike should not use these complicated and risky deals,” said Wagner, who also called for a municipal swap ban in 2009.

Lawmakers debated such a ban but didn’t enact it.

The turnpike commission, in a written response, accused Wagner’s staff of faulty calculations.

Bond issuers such as city governments, school districts or agencies take out interest-rate swaps — sometimes called swaptions — to convert variable rates to fixed rates to protect against interest-rate hikes. After interest rates plummeted during the recession, issuers found themselves locked into deals in which counterparties received larger payments.

Issuers often had to pay millions to exit agreements not to their liking.

Folmer, who is soliciting co-sponsors for his package, served on the Senate’s local government committee, which held two hearings last fall on the incinerator bond-financing overruns, and the roles of swaps in them, that left capital city Harrisburg more than $340 million in debt and on the brink of bankruptcy.

“We have to do something after seeing what happened in Harrisburg and elsewhere. This cannot happen again,” Folmer said in an interview.

“I’m not saying they can’t use swaps in the private industry if they want to,” he said. “You’re talking to a libertarian Republican here. I’m not a nanny type of guy. But when you’re dealing with taxpayers’ money, it goes against what we should be doing.”

David Unkovic agreed.

“I think it’s been a failed experiment,” the former state-appointed Harrisburg receiver said of the 2003 law.

Unkovic, a 30-year bond lawyer, testified before the Senate about the fees municipalities and school districts had to pay to get out of agreements. “It’s very difficult if you have to terminate a swap,” he said.

He recalled how one financially strong county, which he wouldn’t identify, had a swap option with a five-year window to exit.

“Five years ago they could have gotten out of this swaption for $4 million. And they had the money. But politically they simply couldn’t. The county council couldn’t get themselves to vote to send $4 million off to some bank in New York to get out of a swap that they probably shouldn’t have gotten into in the first place.”

The county did nothing. “They sort of waited to see if the rates went up or down. And then you’re into gambling, which isn’t good,” said Unkovic.

Rates stayed down. The county finally terminated the swap at end of its window, but instead paid an exit fee of $24 million, not $4 million.

“You just get into worse and worse situations if the market continues to go against you,” said Unkovic. “It’s pretty much like a game of Russian roulette, where every once in a while the bullet’s going to go off and there’s a bad situation.

“It’s not that there haven’t been good swaps, and maybe even most swaps are good,” he said, “but the repercussions when a swap goes bad are multimillion-dollar problems.”

Swap-related losses by the city and school district in Philadelphia combined, estimated at up to $500 million in a Pennsylvania Budget and Policy Center report early in 2012, prompted the Philadelphia City Council’s rules committee to hold a public hearing on Oct. 23.

City Treasurer Nancy Winkler, who Mayor Michael Nutter appointed in January 2011, told the council that the city entered into 20 swap transactions from 1990 to 2007 for a combined $3.3 billion, with all but $148 million issued between 2001 and 2007. The last swap contract expires in 2031.

“No swap transactions have been undertaken during Mayor Nutter’s administration,” she said. “We found it very difficult to find the documentation I would have liked to have seen about why the city chose to do the swaps they did.”

Early in 2011, the city chose Swap Financial Advisory Group LLC of South Orange, N.J., as its swap advisor, a firm she praised as “not tainted,” unlike its predecessors.

“As you may know, the city did have a swap advisor before, and that firm — the principals of that firm have been convicted, and most of them are either in prison or awaiting sentencing,” Winkler told the council.

Speaking later to the Philadelphia Inquirer, she identified the firm as CDR Financial Products Inc., subject of a prosecution sweep in the U.S. Department of Justice’s municipal bond bid-rigging scandal. Federal prosecutors, who accused bankers of using back-end swap payments to disguise kickbacks, have mostly wrapped up criminal cases nationwide against 19 of 20 individuals and five firms.

A message seeking comment for this story was left with Winkler. School officials did not have a representative at the council hearing. A message was left with school officials seeking comment.

“The school district didn’t come at all, I believe because they didn’t want to antagonize the banking industry,” said at-large council member James Kenney, who organized the hearing.

“Well, I don’t mind antagonizing people. The banks’ indiscretion and selfishness put communities on the wrong side of swaps,” Kenney said in an interview.

Kenney likened swaps to medical malpractice. “If a doctor cuts off the wrong leg, you’re going to sue,” he said.

The lack of indignation displayed by officials at the public hearings stunned him. “I kept saying over and over, ‘Aren’t you angry?’ ”

The Pennsylvania Bankers Association would not comment for this story. “We are going to decline at this time,” said Jill Helsel, its assistant vice president and communications director.

Despite the negative headlines, Peter Shapiro, a Swap Financial managing director, advised against a total ban on swaps.

“There have been real mistakes made, especially by some of the smaller Pennsylvania issuers, and in some cases there looks like real abuse, but the answer isn’t to throw the baby out with the bath water,” Shapiro said.

For every apparent abuse, he said, there are several examples of good transactions. “The abuses make headlines, while the good transactions go ahead quietly.”

He suggested that Pennsylvania could differentiate communities by their levels of administrative and financial staffing before crafting the appropriate safeguards.

“What’s good for the city of Philadelphia, whose financial staff is highly sophisticated and well-run, is very different from what’s good for smaller school districts,” Shapiro added.

“There is a terrible irony in Pennsylvania history regarding swaps,” he said. “The unintended consequence of that law intended to regulate swaps is it that invited many smaller, unsophisticated entities into the swap market that had no business being there. The intent of the legislation was good but consequences were different.

“It allowed good marketers from the big banks to say, ‘You should go ahead and do it. Here’s the road map and it’s the law.’ ”

The same thing happened in Tennessee, according to Shapiro.

“Different law, similar pattern. When you look at Tennessee and Pennsylvania, you see a sudden, heavy usage by smaller entities. In Pennsylvania you see school district after school district that had never handled anything more sophisticated than fixed-rate now doing these complicated transactions.”

Tennessee, beginning last year, required all issuers to adopt debt-management policies. “I don’t view this as to be revolutionary. I think this is just common-sense policy,” state Comptroller Justin Wilson told The Bond Buyer in December 2010. Wilson examined the use of variable-rate debt and swaps after the market meltdown, and said some practices troubled him.

John Filan, vice president of Chicago turnaround firm Development Specialists Inc., thinks Pennsylvania could benefit from a debt oversight panel such as the Illinois Finance Authority or the Connecticut Bond Commission.

“Pennsylvania, like Illinois, has a lot of communities. Illinois has about 7,000, Pennsylvania about 5,000,” said Filan. “What’s good for Philadelphia or Pittsburgh may in fact be good for that school district, but the school district may not have the expertise to determine that. Some local governments have a staff of one. What you’d like to see is safeguards built in, but still make the instrument available, with some execution guidance.”

Pennsylvania Treasurer Rob McCord also advised against swinging the pendulum too far in the other direction.

“If you then turn around and overregulate, you might end up regretting it,” said McCord who compared swaps to consumer adjustable mortgages.

Bryn Mawr, Pa., attorney Mark Schwartz, a former bond banker and investment banker who represented the Harrisburg City Council in 2011 and 2012, called the swap enabling law disastrous.

“Things like derivatives and swaps were banned for the longest times, and for the right reasons, until that was changed by the ‘great reformer,’ Ed Rendell, who not so coincidentally is now working on Wall Street. This kind of legislation is why Pennsylvania is always at the forefront of municipal bond debacles,” Schwartz said.

“The Harrisburg swaps were a joke. There was no economic justification for them. It was just a fee grab, all done by cozy bankers and issuers who don’t know better and could have cared less.”

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