Cheap money can be surprisingly expensive.
Unless interest rates go back up as fast as they’ve been going down, a group of school districts and other local-government borrowers in Pennsylvania will have to pay millions of dollars to Wall Street bankers next summer.
Worried about rising interest rates last year, at least three school districts — the Upper Merion and Colonial districts in Montgomery County, and Avon Grove in Chester County — took the advice of advisers at Philadelphia-based Public Financial Management Inc. (PFM) to buy so-called interest-rate swaps. Those financial tools were touted as insurance against rising finance costs for the next few years, when their boards plan to borrow tens of millions of dollars to build new schools.
PFM matched the districts, which bet rates would rise, against an investment bank, RBC Capital Markets (owned by Royal Bank of Canada), which bet that rates would fall.
The school districts promised the banks a percentage of the money they hoped to borrow in exchange for payments that rise (or fall) with interest rates. Whoever owes more starting in June 2020 will pay the other the difference.
If rates rose, as the schools expected, they would collect a net profit, lowering their borrowing costs. It didn’t quite work out that way.
“Interest rates didn’t go the way it was projected. They actually came down,” David Szablowski, business manager for Colonial, which approved a swap deal as part of an up to $84 million school construction package last summer, told me. The bank “won the swap.”
Based on how much rates have fallen since last year — and unless rates go back up — Colonial will owe RBC $3 million next August, according to district financial projections. Upper Merion faces a payout of more than $5 million and Avon Grove will owe $1.8 million.
That’s money the districts wouldn’t owe if they hadn’t tried to hedge the market.
Those costs will double if rates fall as fast in the next year as they have in the past year. They will also double if lower rates persist into 2021, according to financial documents filed with the state. (Two area counties and at least five townships also registered swaps in the past two years, mostly for smaller bond issues. Check state list of swaps transactions here, though as noted below some swaps might not be listed.)
“The purpose of the swaps was to protect the issuers from rising interest rates on their future debt issuance," said Ed Jones, spokesperson for RBC, in an email. "As interest rates have fallen, the issuers will save money on their debt but pay to terminate their interest rate hedge. Essentially the issuers gave up the benefit of falling rates in return for protection against rising rates. We stand by the work that we do and the financing solutions we offer to all of our clients.”
PFM didn’t return calls seeking comment.
Are suburban school employees a match for Wall Street pros? After all, even Jamie Dimon, CEO of the nation’s largest bank, JPMorgan Chase & Co., was wrong about interest rates last year.
In 2003, then-Gov. Ed Rendell, whose campaign contributors included bankers, legalized swaps for local governments. Soon, county, town, and school district board meetings, often attended by very few local taxpayers, were hosting squads of bankers urging them to spread their risk. (There were three bankers and just four members of the public at the September meeting when the Colonial board agreed to support the swaps deal.)
But after the late 2000s credit crisis, Philadelphia and several upstate cities faced multimillion-dollar swap payments when interest rates fell instead of rising as expected. That prompted former Pennsylvania Auditor General Jack Wagner and legislators led by then-Sen. Mike Folmer, R-Lebanon, to try to ban such swaps.
“It is not the mission of the School District, nor most government entities, to make speculative interest rate bets. You don’t gamble with public money,” said Uri Monson, chief financial officer of the Philadelphia School District, the state’s largest.
Yet last year’s money markets made some school financiers nervous. Last fall, Colonial’s Szablowski said, Fed watchers were predicting “two, three, four interest rate hikes in 2019 into 2020. We thought, ‘That’s not going to help our taxpayers.’” He said his earlier employer, the Boyertown Area School District, had collected nearly $1 million in net swap payments in 2005 to 2015.
Szablowski said school board members were told that rates might not go up, and that they could end up owing millions. But they agreed that higher interest rates would be worse: those would have forced the district to pay more for its new middle school. The swap ensured costs would at least be no higher than projected: “It protected me from waking up with cold sweats in the middle of the night.”
It was a similar calculation for Upper Merion, where new apartment and home construction has boosted school enrollment and persuaded board members to replace one elementary school and build another. The high school will need work, too, said business administrator Michael P. Keeley. The swaps at least limited the fear that financing costs would rise further over the next couple of years.
Besides the cost of the swaps, the schools paid PFM and RBC fees totaling around $1 million, he said. As at Colonial, swaps let Upper Merion effectively put a ceiling on its bond interest rates, so it wouldn’t have to cancel or economize the elementary school plan, though it did leave savings from today’s actual lower rates on the table.
“You would expect the number of swaps had gone down, after the way [former Auditor General] Wagner talked about them," said Eric Kazatsky, municipal credit analyst at Bloomberg LP. “But even after so many towns lost money, they are still doing the same things again.”
The state Department of Community and Economic Development (DCED) collects data on swaps. Its records show the number of county, state, and local government swap contracts rose from 25 in 2003 to a peak of 168 in 2006, collapsed to 21 in the recession year 2008, then averaged 63 a year. Since 2015, the total has averaged around 20 a year. But there are signs of a small resurgence: The department recorded 13 so far this year, up from seven in the first nine months of 2017.
Kazatsky theorizes that towns are looking for novel ways to limit their borrowing costs, after President Trump’s tax reforms reduced the level of state and local taxes (SALT) that taxpayers can deduct for federal income taxes.
DCED doesn’t analyze how much these swaps help save, or how much they cost. “DCED’s sole function under the statute is to be a repository of the [swap transaction] documents and does not conduct any formal analysis of the impact,” said spokesperson Casey Smith. (Is its data complete? DCED failed to list the Upper Merion deal but added it after the Inquirer asked why it wasn’t listed.)
What about the state’s current auditor general, Eugene DePasquale?
“I’m stunned that these are starting to creep back in,” he told me. He said state auditors on his watch have warned Allentown and other communities about relying too heavily on swaps and other derivatives. “It’s like trying to win the lottery. The taxpayers are on the hook.”