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May 27, 2013 | By | Posted in Features

In Pennsylvania, swaps are a $17.2 billion problem

By Melissa Daniels | PA Independent

HARRISBURG — From the edge of the Delaware River to the picturesque countryside of Lehigh Valley, and up and across the Alleghenies, local governments and school districts in the Keystone state have a $17.2 billion problem.

BURNING MONEY: Clockwise from left: Sen. John Blake, Sen. John Eichelberger, Sen. Mike Folmer and Sen. Rob Teplitz speak at the Harrisburg incinerator to announce municipal borrowing legislation, after examining the cause behind debt in the incinerator project.

It’s not crumbling infrastructure. It’s not underfunded public pensions. It’s interest-rate swaps, a high-end finance maneuver that’s costing local governments millions each year – money they don’t have to lose.

It all started in 2003 when the state passed a law legalizing interest-rate swap transactions for local governments. Marketed as a way to help local governments manage borrowing costs, swaps are deals made between investment banks and local governments. The parties agree to “swap” interest rate payments – with the local government, for example, paying market-based variable rates instead of a fixed rate. Think of it as sort of an adjustable-rate mortgage.

But it can backfire.

“It’s like going to Hollywood Casino and the house always wins,” said Sen. Mike Folmer, R-Lebanon. “Wall Street wins every time.”

It backfired on Bethlehem Area School District. Getting out of two of 13 swap agreements cost $10.2 million in 2007.

It backfired on the city of Harrisburg, where at least eight swap transactions contributed in part to $350 million in debt associated with the city’s trash incinerator project.

It backfired at the Port Authority in Pittsburgh, which had to pay $39.2 million in 2011 to get out of a swap deal it entered in 2004.

When the local government loses, who wins? The investment bankers who are the other party to the swap. Oftentimes, major banks such as JP Morgan Chase, the Royal Bank of Canada, Deutche Bank and Wells Fargo are behind public-sector swap deals. And they can make out with millions at the expense of the publicly funded municipality. Swaps can devastate a local budget if it has to be terminated, or ended, because the city or school district is losing money.

Though there are numerous instances of the transactions backfiring, some see interest-rate swaps as creative financing, and a way to protect themselves from risk. It may have looked that way to Pennsylvania legislators when they passed the law, Folmer said.

FOLMER: State Sen. Mike Folmer, R-Lebanon, says swaps are too risky for public money.

“They may have (seen) it as an opportunity, as a creative way for local governments to raise revenues without having to raise taxes,” Folmer said. “As it turned out, it wasn’t a very good idea. We found out about them, now we need to ban them.”

Through September 2012, 108 school districts, or 22 percent of all districts statewide, and 105 local governments carried $17.25 billion in public debt tied to swaps through about 800 transactions, according to the Department of Community and Economic Development.

Folmer has introduced legislation that would ban interest-rate swaps for all local governments, school districts and taxing authorities in Pennsylvania as part of a municipal finance reform bill package, announced last week, suitably at the site of the incinerator.

A second bill from Sen. Rob Teplitz, D-Dauphin, would ban interest-rate swaps specifically for the Philadelphia city, Philadelphia County and its school district. State law governing their borrowing would have to be amended separately.

It’s unclear if any other state has enacted an interest-rate ban, partially because not all states allow local governments to engage in swaps in the first place, Teplitz said.

The senators supporting the ban say they expect a full lobbying effort from the financial industry, which may claim eliminating swaps tie the hands of local officials to manage debt. But Teplitz said evidence of the past decade shows it’s time to put a stop to the transactions.

“Clearly there is enough evidence to support a ban rather than just some minor tweaking or greater oversight or greater training,” Teplitz said. “I’ve heard all those arguments, I’ve seen the evidence, and there’s nothing short of a ban that’s going to protect the taxpayers.”

TEPLITZ: The first-term Dauphin County state senator is pushing for a ban on interest rate swaps, citing debt to local governments.

TEPLITZ: The first-term Dauphin County state senator is pushing for a ban on interest rate swaps, citing debt to local governments.

Though swaps  - formally called qualified interest rate management agreements – are less popular since the financial crisis of 2008, active transactions still exist. In Philadelphia, swaps are responsible for $186 million in debt, according to Bloomberg reports.

In a recent state audit, the Parkland School District was called out for having a swap transaction on $47 million in bonds. But the transaction has been working to the district’s benefit, according to Parkland’s response, and the district does not have any plans for new swap deals in the near future. Still, auditors advised terminating the swap “as soon as it is fiscally responsible to do so,” as the tables could turn and cause the district to lose money.

In Tennessee, state government had its own tango with swaps regulations. In April 2009, Comptroller Justin Wilson introduced rules that added transparency and oversight to swap legislation after some local governments lost millions on swap deals.

“Basically, we had local governments who did the swaps and didn’t understand what they’re doing,” Wilson said. “That’s simply what the problem was. Swaps can be a very useful tool, but you need to know what you’re doing.”

Tennessee’s new rules took effect at the end of 2011. In short, they require municipalities to “know what they’re doing,” Wilson said. They also must disclose any conflicts of interest, inform taxpayers of the transaction and disclose all costs, fees and risks involved. That includes disclosing the fees swap dealers are making off the transactions.

Since those steps were put in place, the number of transactions has dropped dramatically, Wilson said.

Federal laws regarding local government swaps also have changed since Harrisburg and many other Pennsylvania entities entered the agreements. The Dodd-Frank Act of 2010 addressed previously unregulated swap dealers with disclosure rules.

Now, dealers must be more up front with local governments about the risks involved, and give more updates on how the deal is working. The swap dealer also must be clear that they are there as a counter party, with their own interests, and not looking out for the good of the local government. Instead, the local government must have a third-party adviser.

Alongside the swaps ban are additional proposals from Senate Local Government Committee Chairman John Eichelberger, R-Blair, and Sen. John Blake, D-Lackawanna, who helped spearhead hearings on the Harrisburg incinerator finances last fall.

They include proposals to create more oversight at the state level for municipal borrowing, and prevent local governments for guaranteeing the debt taken on by an independent authority.

Another would also enable the State Ethics Commission to investigate alleged ethical violations by people involved in financial transactions by municipal authorities.

Eileen Norcross, a senior research fellow for the free-market research Mercatus Center at George Mason University, said it’s a positive sign that Pennsylvania is looking into better rules concerning how municipalities are borrowing.

Norcross cited ongoing cases of municipal debt involving swaps and other borrowing practices – like public debt liabilities of the city of Scranton – that indicate borrowing is becoming a more severe problem. Norcross said while she supports local control for municipalities, when it comes to issues of accounting, they are creations of the state.

“If they end up in trouble, it becomes a state problem,” Norcross said.

Nationwide, swaps in particular are getting more scrutiny as “opaque instruments,” she said. Though it may seem like a good idea at the time, exposing a local government to potential debt through an interest-rate swap can leave taxpayers on the hook for a decision their public officials may not have been prepared to make, Norcross explained.

“They’re making a bet that they’re going to have some savings if they enter into one of those contracts,” she said. “If they don’t, the taxpayers will end up bailing them out.”

Contact Melissa Daniels at melissa@paindependent.com

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Melissa Daniels is a reporter for PA Independent. She can be reached at 717-350-0962 or Melissa@PAIndependent.com

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