The end of muniland interest-rate swaps for Pennsylvania?

Pennsylvania may have suffered more damage from municipalities using interest rate swaps than any other state in America. Many cities and school districts were sold these “hedging” instruments after former governor Ed Rendell pushed legislation allowing their use in 2003. The fallout for the state has been devastating.

October 6: Muniland snaps

Small communities, large cities and school districts have suffered substantial losses from their use. Bloomberg reported in March 2008 how a school district suffered deep losses:

James Barker saw no way out. In September 2003, the superintendent of the Erie City School District in Pennsylvania watched helplessly as his buildings began to crumble. The 81-year-old Roosevelt Middle School was on the verge of being condemned. The district was running out of money to buy new textbooks. And the school board had determined that the 100,000-resident community 125 miles north of Pittsburgh couldn’t afford a tax increase. Then JPMorgan Chase & Co., the third-largest bank in the U.S., made Barker an offer that seemed too good to be true.

David DiCarlo, an Erie-based JPMorgan Chase banker, told Barker and the school board on Sept. 4, 2003, that all they had to do was sign papers he said would benefit them if interest rates increased in the future, and the bank would give the district $750,000, a transcript of the board meeting shows. “You have severe building needs; you have serious academic needs,” Barker, 58, says. “It’s very hard to ignore the fact that the bank says it will give you cash.” So Barker and the board members agreed to the deal.

What New York-based JPMorgan Chase didn’t tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn’t understand.

Who knows what kind of promises and selling enticements bankers are using now with public officials. In fact we don’t know how many interest rate swaps are outstanding among public entities, their terms or even if banks have forced their full upfront payment through termination triggers. It’s a muniland minefield.

Swaps – complicated and sophisticated products – are not appropriate for public entities. Philadelphia is projected to lose $186 million on interest rate swaps gone bad. The current treasurer has said all the paperwork for the deals could not be found. The Philadelphia Inquirer’s Joe DiStefano reports:

“We found it very difficult to find the documentation I would like to have seen, about why the city entered into swaps,” said Winkler, a Mayor Nutter appointee who previously worked for Philadelphia-based Public Financial Management (PFM), financial adviser to Philadelphia under Nutter and to other communities across the U.S.

Where are the people who recommended that Philadelphia buy swaps? “The city’s prior swaps advisers, the principals, were convicted and are mostly either in prison or awaiting sentence,” Winkler said.

And Harrisburg, Pennsylvania’s near-bankrupt capital, seems to have been improperly loaded with interest-rate swaps, according to the state’s prior fiscal manager, David Unkovic.

So is Pennsylvania doing anything to stop this scourge that is blanketing the state? In fact, a Republican state senator, Mike Folmer, is organizing legislation to ban the use of interest-rate swaps. Folmer is already aware that bank lobbies will be working hard to kill his legislation. Lauren Lyster of Yahoo! Finance interviewed Folmer (video here):

“My argument is these are really risky investments,” Folmer says. “If you want to invest your money, God love you, invest any way you see fit, just buyer beware. But when you’re investing other people’s money, tax dollars, you need to be held to a whole different standard.”

These swap deals were designed to allow municipalities to hedge against the risk of rising interest rates. But if rates go the wrong way, they can backfire. Lawmakers like Folmer have experienced the fallout of swaps deals firsthand. Harrisburg, Pennsylvania filed for bankruptcy in October 2011 (the case was later dismissed by a judge) and as of last November was still facing more than $340 million in debt. Interest rate swaps were a key component in the debacle.

This is not the first effort of the Pennsylvania General Assembly to ban swaps. The Bond Buyer reported in 2010:

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.

Pennsylvania is already late on banning interest-rate swaps for public entities. As local budgets shrink, it’s a pity to see so much money go to pay off gambling bets to Wall Street.