Pennsylvania’s worthy debate over swaps

September 10, 2013

It was a mixed picture as Pennsylvania Senate Local Government Committee took testimony today about how local PA governments issue debt and enter into interest rate swaps. Has every local government in Pennsylvania made as big a mess issuing debt as Harrisburg? Was every school district bamboozled into multiple layers of expensive and unnecessary interest rate swaps like the Bethlehem School District?

Philadelphia Treasurer Nancy Winkler assured Committee Chairman John Eichelberger that the city had reined in its swaps portfolio and was mostly assuring members of the committee that Philadelphia would not suffer substantial losses from swaps. She was fighting off legislation that would have banned Philadelphia from entering swap agreement. The Philadelphia City Council passed a resolution asking the General Assembly to ban the city from the practice.

Meanwhile the former Auditor General of Pennsylvania Jack Wagner, in standout testimony, used former government official Larry Summers as an example of how risky interest rate swaps are:

In reality, swaps are nothing more than a form of gambling with public funds. The party that guesses right wins and gets paid; the party that guesses wrong loses and must pay the other party. How much is won or lost is determined by the size of the underlying debt, how much interest rates fluctuate, and other factors.

How risky are swaps? Just ask Larry Summers, a former U.S. Treasury Secretary and top White House economic adviser, who is reportedly under consideration to be the next chairman of the Federal Reserve Bank. This is a man who should understand complex financial instruments. Yet as President of Harvard University from 2001 to 2006, Mr. Summers approved swaps so toxic that the school paid banks a total of almost $1 billion to terminate them.

Boom! Swaps are definitely risky but how should the state regulate their use by local governments? Pennsylvania passed a law in 2003 that allowed local governments to use swaps and here is what happened according to Wagner:

Unfortunately, when it comes to gambling taxpayer money in swaps, Pennsylvania school districts and municipalities are No. 1 in the nation, according to Moody’s Investors Service. On a statewide basis, according to the Department of Community and Economic Development (DCED), 108 of 500 school districts – a shocking 21 percent – and 105 local governments in the Commonwealth had $17.25 billion in public debt tied to swaps between October 2003 and September 2012.

Wagner’s primary criticism of muniland swaps is compelling (emphasis mine):

  • Do the local elected officials who vote to enter into these transactions really understand them?
  • None of the other parties involved – the financial adviser, bond counsel, swaps counsel, local government solicitor, or the investment bank – appear to get paid unless the deal goes through. Do you believe that local governments are ultimately protected against conflicts of interest in these transactions?

Bethlehem School District is the new poster child for abused municipality. In 2008 the district had $280 million in debt and $420 million in swaps. It has been slowly wiggling its way out from the swaps:

A lot of the testimony at the hearing was members of the status quo asserting that local governments could manage swaps but most of these people earn their living from the established system. In their telling some swaps blow up and some make money and safeguards should be established. I hope the Senate Committee weighed the personal interest of these people alongside their testimony. Some swaps working and some losing is usually how gambling works.

Meanwhile the state Department of Community and Economic Development endorsed the legislation that would require their department to review local government debt offerings before they were brought to market rather than after issuance:

Senate Bill 901 would replace the single review with a two-step process, and require a local government unit to submit a preliminary application to us before the debt is incurred. As part of our preliminary review, the Department would be authorized to examine and verify the local government unit’s compliance with audit and disclosure requirements, determine that adequate security will be in place to insure completion of the project to be funded, and review the facts that would justify treating the debt as “self-liquidating”.

I’m fully in favor of this Pennsylvania legislation. The review of local bond offerings at the state level will add time to the offering process but will likely shield local governments from making big, costly errors. Kudos to Committee Chairman John Eichelberger. I hope he is able to get the legislation through the General Assembly without being completely watered down.

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I would challenge supporters of the bill to take a closer look at how effective DCED is at performing its current functions let alone adding these stifling measures

Posted by EdTroxell | Report as abusive