New Jersey’s Economic Development Authority plans to issue as much as $2 billion of bonds early next month to refinance school-construction debt and terminate $1.7 billion of interest-rate swaps.
The agency will pay an estimated $296 million to end the swaps, which it entered into beginning in 2002. The refinancing will save the state about $278 million in debt payments, which will cover all except $18 million of the termination fees, said Andrew Pratt, a spokesman for Treasurer Andrew Sidamon-Eristoff.
The transaction also will allow the state to reduce its risk as it projects higher costs next year for letter-of-credit-backed agreements amid new financial regulations, Pratt said. It’s unclear how much the rules, which require banks to set aside money to back such borrowing, may raise the state’s costs, he said.
“There’s going to be a lot of demand and fewer suppliers,” Pratt said. “It will be a tremendous reduction in our risk.”
Derivatives known as swaps, in which two parties agree to exchange payments based on underlying assets or indexes, were sold to states and local governments as a way of saving taxpayers money. The agreements backfired after the financial crisis, leaving the buyers with soaring interest bills. The trades have since cost public agencies and nonprofits more than $4 billion in fees to back out of them, according to data compiled by Bloomberg.
“I don’t think there’s a voter in this country who thinks that is what they elected their municipal leaders to do, to guess where rates are going,” said Robert Brooks, a professor of finance at the University of Alabama in Tuscaloosa who questions governments’ use of swaps.
“It’s unfortunate,” he said in a telephone interview. “They were bad bets, and states should get out of the betting business altogether.”
Borrowers seeking to exit swap deals should appoint or contract with an independent entity to verify all pricing and ensure they are getting the best deal, Brooks said.
“This prudent transaction marks the beginning of the end of New Jersey’s foray into exotic financial engineering,” Sidamon-Eristoff said in a statement. “It will save our taxpayers more than $18 million by cleaning up our books and eliminating much of our open-ended legacy exposure to complicated and risky derivatives agreements.”
List of Swaps
Pratt said Bank of America Merrill Lynch will handle the transaction for the state and that a list of the swaps to be terminated hasn’t been completed.
Bank of America, which bought Merrill last year, is listed in a Nov. 30 state report as counterparty in one of 16 swaps linked to school-construction debt. That 2006 arrangement would cost the state $45.4 million to unwind, according to the report.
Merrill is listed as counterparty on a May 2010 swap that would cost the state $102.3 million to exit. As of Nov. 30, the state had 27 swap agreements with 11 counterparties with a combined value of $4.15 billion, according to the report.
Neither the Bank of America nor the Merrill derivative has been selected, and if they are, the state will place limits on the information the firm’s bankers can share with its swaps desk, Pratt said. Kerrie McHugh, a spokeswoman for Bank of American Merrill Lynch, didn’t immediately return a call seeking comment.
As a result of the bond issue, $1.5 billion, or 84 percent, of the Economic Development Authority’s variable-rate demand bond portfolio will convert to fixed-rate, Standard & Poor’s said in a report this week. The transaction also will terminate 57 percent of the agency’s swaps, reducing the so-called mark-to-market position of its portfolio to negative $288 million from negative $584 million, S&P said.
The sale also will eliminate the agency’s need for letters of credit in fiscal 2011 and 2012, and reduce the state’s total need for such borrowing by 41 percent, according to S&P said.
The amount of swaps to be terminated may change depending on market conditions, Pratt said.