Philadelphia Can’t Explain Its Swaps Yet Fights Ban: Muni Credit

Philadelphia may see costs from interest-rate swap contracts climb to as much as $186 million. Yet it’s lobbying to exempt itself from a proposed Pennsylvania ban on the derivatives that would be the first in the U.S.

State Senator Mike Folmer, a Republican, in February introduced a bill that would bar publicly funded entities from engaging in the derivatives, which can be used to protect against swings in interest rates. The ban would deny Philadelphia, which had entered into $3.5 billion of swaps, access to a useful tool, said Rob Dubow, finance director of the fifth-most populous U.S. city.

“We have financial professionals; We know how to do them and know how to structure them appropriately,” Dubow said of the contracts in an interview. “There have been places where there have been real problems with swaps, and I think people have reacted to that.”

The stance of Philadelphia, which is rated three steps above junk by Standard & Poor’s, is at odds with moves by other cities. Next week, Oakland, California’s city council will hold a hearing on steps toward ending business with Goldman Sachs Group Inc. after the bank denied its request to exit a swap without paying a $14.8 million termination fee.

$4 Billion

Localities from California to Massachusetts have paid at least $4 billion to banks to end such contracts after they failed to provide the intended protection. In 2009, Jack Wagner, Pennsylvania’s former auditor general, urged lawmakers to prohibit swaps, saying they risk taxpayer money.

In swaps, two parties agree to exchange interest-rate payments over a period of time. Typically, one agrees to pay a fixed rate and the other a variable rate that changes with a benchmark index or formula defined in the contract.

While Dubow said Kinser Group, a local lobbying firm, is working on the issue for the city, Philadelphia’s position is drawing fire from some lawmakers. The city council yesterday approved a resolution urging the state legislature to pass a swaps ban.

“If you want to do imaginative kinds of investments, you should do it with your own money, not the taxpayers’,” said Councilman James Kenney, a Democrat. “What’s upsetting about it and what’s obnoxious about it is that the city taxpayer is paying a lobbyist to put them in a position to further lose money.”

Holly Kinser, president of the Kinser Group, said by telephone that she wouldn’t discuss the matter. Dubow declined to elaborate on the lobbying efforts.

Documentation Gap

In Philadelphia, where more than a quarter of the population of 1.5 million lives in poverty, there’s “insufficient documentation” to determine the reasons for entering into its $3.5 billion of swaps, Treasurer Nancy Winkler told the City Council in October.

Almost all the swaps from 2001 to 2007, which predated the current administration of Democratic Mayor Michael Nutter, were transactions in which the city received a floating rate from banks on a notional amount of debt and paid fixed, she said. Some of the contracts were tied to variable-rate debt, according to her presentation.

The deals initially performed well, and “tens of millions of dollars” in upfront payments flowed into municipal coffers - - until the credit crisis that began in 2007, she said. As some types of variable rates sank, Philadelphia’s borrowing costs exceeded the payments it received. Letters of credit also became more expensive as banks were less willing to offer them. In cases where the backstops were unavailable, officials terminated swaps and issued debt at higher interest rates, she said.

Relative Cost

As a result, Philadelphia’s borrowing cost may swell by as much as $186 million compared with what it would’ve paid to issue fixed-rate debt, she estimated. That’s more than triple the $60 million that school officials have asked the city to help fill a budget hole, after voting to close about 9 percent of their schools.

The swaps projection doesn’t account for any savings in future restructurings, and the city has yet to incur overall losses, Winkler said in an interview.

There are currently no plans to enter into new derivatives, Dubow said. In 2009, the city adopted guidelines that swaps transactions must save at least 5 percent on financings compared with conventional fixed-rate bonds. Swaps shouldn’t exceed 35 percent of total debt and must have several providers to reduce counterparty risk, the policy said.

Philadelphia Terminations

From October 2003 to June 2009, Pennsylvania local governments, authorities and schools entered into 626 swaps transactions on $14.9 billion in debt, and Bethlehem’s school district lost at least $10.2 million on such agreements, according to a report from Wagner, the former auditor general. In 2010, Philadelphia’s school district sold debt to help pay termination fees totaling $63 million.

“The financial community is a very powerful force,” said Wagner, a Democrat running for Pittsburgh mayor after his term ended last year.

Folmer introduced his bill as part of a package of measures sparked by the fiscal crisis in the capital, Harrisburg, which is under state receivership. A financial audit released last year flagged Harrisburg’s use of swaps, calling them unnecessarily complex transactions that resulted in excessive fees and higher risks.

U.S. First

A state ban on municipal swaps would be a first in the U.S., said Peter Shapiro, managing director of Swap Financial Group LLC, which advises Philadelphia and other municipal and corporate clients.

It makes sense for some borrowers to use derivatives to lock in interest rates now, he said.

Investors are speculating that yields will rise amid signs of a strengthening housing market. Ten-year Treasury yields will climb about 0.7 percentage point to 2.5 percent in a year, according to the median forecast of 68 analysts in a Bloomberg survey.

Philadelphia is “more sophisticated than many corporations” and shouldn’t be “deprived of financial tools which can help them reduce risk, save taxpayer dollars and manage their financial affairs more prudently,” he said.

Ban Backers

That view isn’t echoed by some municipal organizations in the state. The Pennsylvania State Association of Boroughs supports a ban on swaps, said Christopher Cap, executive vice president. Elam Herr, assistant executive director of Pennsylvania State Association of Township Supervisors, said it may back Folmer’s bill.

The Pennsylvania School Boards Association, however, opposes a prohibition and would like to see more oversight and disclosure instead, said Beth Winters, chief lobbyist. A ban would be inefficient and costly, and the group will lobby legislators as the bill advances, she said.

Meantime in the $3.7 trillion municipal market, tax-exempt debt is rallying to the strongest in three weeks amid the slowest non-holiday issuance period since February.

At 1.94 percent, yields on 10-year muni benchmarks are the lowest since March 12. Yet they still exceed the 1.76 percent interest rate on similar-maturity Treasuries. The ratio of the two is 110 percent, the highest since September, signaling munis have become relatively cheaper than Treasuries.

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