Girard College’s Finances Handcuffed by Rate Swaps: Muni CreditRomy Varghese
Girard College, which for 166 years has schooled and housed low-income students in Philadelphia in a walled campus by decree of its namesake founder, is paying a premium in the bond market after Wall Street deals backfired.
The school entered into sophisticated financial contracts more than a decade ago to protect against rising interest rates. Now, those swaps are locking Girard into above-market financing costs on about $59 million of debt just as the school seeks to cut expenses after its endowment shrank 25 percent in almost seven years.
Girard plans to eliminate its residential program for children from first grade through high school, a key part of the mission set out by Stephen Girard, a financier whose loans helped save the U.S. economy during the War of 1812. Its predicament echoes those of municipal borrowers nationwide that entered into swaps, which banks pitched as money-saving hedges. Some of the contracts turned against localities after the Federal Reserve cut its benchmark borrowing rate to near zero in 2008.
“Nobody understood this stuff,” said Michael Greenberger, a former trading and markets director at the Commodity Futures Trading Commission who teaches derivatives at the University of Maryland. “Schools and public entities, the cities and counties, were sold a bill of goods.”
The 30-year swaps, designed to reduce expenses on variable-rate securities by converting them to fixed payments, require the school to pay rates of about 5 percent, according to financial filings. That’s more than a percentage point above the average yield on benchmark 30-year local-government debt for the past five years, data compiled by Bloomberg show.
Ending the contracts now would cost more than what the Girard estate pays to operate the school, according to data from the board that runs the facility.
Issuers nationwide, including Detroit’s utilities and Denver’s public-school system, have paid at least $4 billion to banks to end the agreements. In 2010, Philadelphia’s school district sold debt to help pay swaps termination fees totaling $63 million. Jefferson County, Alabama, had more than $657 million in swaps claims forgiven by JPMorgan Chase & Co. as part of the resolution of its municipal bankruptcy, the U.S.’s biggest when filed in 2011.
Established in 1869 to oversee wills left for Philadelphia, the Board of Directors of City Trusts administers Girard’s estate and school. Run by unpaid judicial appointees and representatives for the mayor and city council president, the panel had no swap adviser or financial adviser for the transactions, according to documents and Kevin Feeley, a spokesman. Bloomberg News reported in 2008 that former employees of the underwriter, RRZ Public Markets, were among bankers that charged excessive, undisclosed fees on interest-rate swaps sold to Pennsylvania school districts.
Jessica Francisco, a spokeswoman in New York for JPMorgan, which was Girard’s swaps counterparty and bought RRZ in 2003, declined to comment on the transactions.
Joseph Martz, executive director of the board of directors, said the estate has no plans to retire the underlying debt and incur the termination fees, and that the swaps don’t affect its financial flexibility.
“A 5 percent rate is a fine rate now,” he said in a telephone interview.
Girard’s holdings of stocks and bonds were valued at $250 million in December, down from an all-time peak of $334 million in 2007, according to board figures. The estate needs to cut spending on the school to replenish the investment fund, Martz said. The goal is to reduce the annual school allocation to $11.8 million from about $17.5 million, he said.
The board has asked Philadelphia Orphans’ Court, which must approve changes, to permit eliminating the entire residential program, while educating students only through eighth grade starting next year. About half the 184-member staff may be fired, said Clay Armbrister, interim school president. Officials say the changes would be temporary, although they haven’t said how long the steps would last.
“The challenge is that if we continue our current spending levels, it’s just not sustainable,” Armbrister said in an interview at the school. “It’s a mathematical certainty that we’re going to run out of money. What we’re trying to do is preserve the legacy forever.”
A group of alumni and parents lost a bid on Jan. 28 to intervene in the case to prevent the moves. Current and former students say the plan would hurt children in Philadelphia, which has closed public schools and reduced programs amid deficits.
“The relationships we’ve built here are something I think would last forever,” Jailyn Beaufort, a 16-year-old 10th-grader, said by telephone. “Our bond that we’ve grown with each other, and even with the teachers, is stronger than any normal public school or day school.”
Stephen Girard, who lost sight in his right eye as a child, made his fortune in maritime trading and banking and died in 1831 at 81. He left detailed instructions in his will, down to the wall around the 43-acre campus that averages 10 feet (3 meters) in height.
He requested the construction of a “permanent college” that would be “sufficiently spacious for the residence and accommodation of at least three hundred scholars,” the document said.
The architect, Thomas Ustick Walter, also designed the U.S. Capitol dome. In 1848, its first year, the school hosted 195 students. Graduates include Myer Feldman, an adviser to President John F. Kennedy; the geneticist John D. Gearhart; and actor Russell Johnson, who played the professor on the 1960s television show “Gilligan’s Island.” Johnson died last month.
Girard’s definition of eligible students -- poor, orphaned white boys -- has expanded to broadly include children with a single parent or guardian whose income qualifies them for free or reduced-price lunches. Applicants take tests and are interviewed, and dozens are turned away yearly. This year, 328 students, mostly from Philadelphia, live on the grounds five days a week.
Campus life is key to the experience. After classes, students return to their dorms, divided by grade and gender. Residential advisers escort them to dinner, organize activities and read to the younger children. Two-thirds of the teachers have been at the school for more than a decade, union representatives said.
Girard’s bequeath of $6.48 million has financed his vision. Forbes named him in 2007 as the fifth-richest American ever, with a net worth estimated at $95.6 billion in 2006 dollars.
He left stocks, bonds, real estate and coal operations. Income from coal started to drop after the 1950s, Martz said.
Financial-market turmoil fueled the estate’s predicament, according to Martz. The fund that Girard started was valued at $250 million as of December, down from $334 million in September 2007, according to Martz and board presentations. The holdings include stocks, bonds, mutual funds and private equity, a financial filing shows. The estate sold some of the assets to support the school, a board document said. The recession also hurt the estate’s commercial property leases, Martz said.
To finance real-estate investment, the estate sold variable-rate bonds in 1999, 2001 and 2002 totaling $102.7 million. RRZ Public Markets was the underwriter. Concurrent with the offers, the estate entered into swaps so that for 30 years, it’s locked into paying fixed rates while receiving a variable one from the counterparty, JPMorgan.
The board entered those agreements without outside advice.
“To the best of Joe’s knowledge, the underwriter served that function on those deals,” said Feeley, the spokesman for Martz, who began his job in 2007.
Regulators have since moved to protect municipal borrowers from entering into such deals without understanding the full consequences. Under rules created after the passage of the Dodd-Frank law, banks are required to ensure that borrowers have advisers capable of evaluating the transactions.
JPMorgan in 2003 bought RRZ, whose chairman and other employees went to work for the New York-based bank.
Jeff Pearsall, managing director of Philadelphia-based Public Financial Management, hired in 2008 as the estate’s first financial adviser, said the board probably entered into the contracts to save money and lock in borrowing costs. PFM hasn’t evaluated whether the transactions have saved money compared with issuing fixed-rate debt, he said.
“Presumably, they thought rates were at a very low and attractive level,” Pearsall said by telephone. “No one has been a perfect prognosticator of interest rates.”
The derivatives are performing as expected, and the estate can benefit as interest rates rise, Martz said.
Interest rates on 30-year Treasuries will climb about 0.7 percentage point to 4.24 percent by year-end, according to the median forecast of 52 analysts in a Bloomberg survey.
Municipal issuers nationwide that engaged in similar bets found themselves losing as the Fed has kept its benchmark overnight rate near zero since 2008 to bolster the economy. As a result, the costs to exit the transactions rose.
Girard ended the contracts for the 1999 deal in 2012. It redeemed the bonds and paid JPMorgan $7.51 million to cover the termination fee and accrued interest, according to PFM.
That move “made complete sense” because redeeming the bonds, which required the estate to make principal and interest payments, freed up cash, Martz said.
For the remaining two bond deals that involve swaps, the estate would pay the principal only at maturity in 2031 and 2032. Until then, the estate makes monthly interest payments of 4.975 percent and 5.305 percent, and receives 0.1 percentage point less than a benchmark swap index, documents show. On Jan. 8, the index fell to 0.03 percent, the lowest in more than 20 years.
Ending these contracts would cost $18.5 million, according to PFM. The estate spends $17.5 million annually to operate the school, according to Martz.
“They’ve lost the flexibility to refinance at low rates,” said Andrew Kalotay, president of New York-based Andrew Kalotay Associates Inc., an adviser to municipal and corporate borrowers. “If they had issued plain-vanilla bonds, they could have refinanced” without paying termination fees.
The estate should have avoided swaps and other actions that jeopardize the school’s purpose, said Jared Freedman, a representative for the American Federation of Teachers Pennsylvania, which represents Girard teachers.
“Stephen Girard did not leave this money so people can just invest,” he said by telephone. “It was specific to the school and the children.”
Martz said he didn’t see anything the school should have done differently with its finances.
“It looks to me that people made good decisions with the information that was available,” he said. “All you can do is to deal with the reality of what’s existed and try to move forward to help this institution in the future.”