The Scranton, Pa., School District last month was close to cementing plans to enter into a fixed-to-floating-rate swaption on two outstanding debt issues in the hopes of securing a $2 million payment to help close a shortfall in its $90 million budget.
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But some on the district's board were uneasy about such a complex transaction, and the decision ultimately was made to mothball the idea. The choice to scrap it became easier when officials learned they would qualify for unanticipated block grants from the state.
"They didn't rule it out forever and ever," superintendent John R. Williams said of the swaption. However, "a lot of them, I have to say, were a little uncomfortable with it."
In a swaption, an issuer sells the buyer an option to convert a bond issue to either a fixed or floating rate at a later date and earns a payment up front.
Apprehension among issuer officials about entering into such complex transactions was anticipated when Gov. Ed Rendell last September signed into law a bill amending Pennsylvania's Local Government Unit Debt Act to allow local municipalities, counties, and school districts to use derivatives. State authorities already had the ability to enter such transactions.
When the law took effect, some feared that small towns and school districts accustomed to issuing strictly fixed-rate debt could get in over their heads in complex swap deals despite the law's requirement to employ a swap adviser on each transaction. Others predicted a flood of swap advisers descending upon the state in search of business.
It is still too early to tell whether the use of swaps will become widespread in Pennsylvania, but financiers are looking for swap business there, and potential issuers are investigating their options. Some have already turned to swaps as a way to raise cash to help offset budget pressures.
"From what we're seeing, the swaps are being used to cure possible fiscal shortfalls," said Denis Carlson, director of public finance at Janney Montgomery Scott Inc. in Philadelphia.
Carlson pointed to the Philadelphia School District's entrance into a forward starting swap of $592 million for five outstanding series of bonds in March. At the time, the state's largest school district expected to receive $50.5 million for the transaction.
"I'm surprised at how quickly the use of swaps has grown in Pennsylvania since the legislation passed," said Martin Stallone, a managing director at Investment Management Advisory Group in Pottstown. Stallone said IMAGE has assisted four new issuers on about 10 swaps since the debt act was amended.
Training seminars have sprouted to help less savvy local issuers learn about swaps. The state's Department of Community and Economic Development has sponsored nine sessions statewide led by Eckert Seamans Cherin & Mellott -- a Pittsburgh-based law firm -- Public Resources Advisory Group, and Capital Financing Solutions.
Some local governments are more confident about using swaps with the help of a swap adviser.
Luzerne County in northeastern Pennsylvania is moving ahead with plans to use a swap on an undetermined portion of its outstanding debt. Sam Diaz, chief of budget and finance for the county, said swaps are attractive because they can help Luzerne diversify its debt portfolio, and because a swap brings cash in but "delays cash out the door."
After getting only three responses to a request for qualifications posted in local newspapers, Luzerne selected Public Financial Management as its swap adviser.
"We feel very comfortable with the adviser that we have," Diaz said.
In the recent low interest rate environment, issuers often have used floating-to-fixed-rate swaps. They sell variable-rate debt and swap into fixed-rate exposure in a long-term contract with an investment bank. Issuers may, however, be more attracted to fixed-to-floating-rate swaps if interest rates continue to move higher.
Risks to municipal issuers entering these transactions can include failing to understand the down sides of a swap and not being aware that a bilateral credit agreement may change over time. Events such as a significant rating downgrade could lead to termination of a contract.
As interest rates have shot higher in recent weeks, at least one adviser says issuers remain keen to hedge against interest rate changes.
"We've been involved in several transactions in the past several weeks," said Jeff Pearsall, a managing director at PFM in Philadelphia.
About a month ago, the Easton Area School District entered into a forward starting swap agreement on two $40 million new-money bond issues, locking in rates of 3.34% and 3.75% with counterparty RBC Dain Rauscher Inc. When it receives payment in 2005 and 2006, the funds will be used to build a new middle school.
Farther west, Pittsburgh School District leaders were "tickled pink" that they could use derivatives under the amended legislation, but decided against doing so when the district refinanced $39.9 million in debt in January, said director of finance Christopher Berdnik.
"A plain-vanilla tool at the time was better than its synthetic fixed brethren," he said. But Berdnik added that the school board would review using a swap this fall, when the district plans to issue an estimated $54 million in new-money debt. Of the district's $422.1 million in outstanding debt, just $19.4 million was sold at a variable rate.
Although the city of Pittsburgh is experiencing severe economic strain, the local school district has had strong financials, despite an overcapacity issue that has led officials to mull closing 16 schools.
Unaudited figures showed that the district had an undesignated, unreserved general fund balance of $57 million at the close of fiscal 2003, which ended Dec. 31. This year, though, has been rockier as health care costs have soared. The district bolstered this year's $525.6 million budget with $45 million from last year's fund balance, leaving the fund at $57 million.
For the Pittsburgh district, using a derivative to alleviate a budget crunch is not a part of its philosophy.
"We're not going to take a long-term risk to solve a short-term problem," Berdnik said.
