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Aug. 28 (Bloomberg) -- Pennsylvania municipalities are turning once again to the kinds of derivative deals that backfired during the credit crunch as the lure of upfront cash and the potential to cut costs prove too hard to resist.
Dauphin County in July cleared the way to enter into an interest-rate swap on a deal that helped settle the debt of the formerly insolvent state capital Harrisburg. Berks County, which in 2009 spent about the equivalent of its parks and library budgets to end swaps, agreed to a new contract in March. Lancaster County in November and the Oley Valley School District in 2012 exited deals in exchange for immediate cash and new accords.
The governments are tapping swaps even as municipal borrowers from Philadelphia’s school district to California’s water resources department have paid to end money-losing derivatives that banks pitched as tools to lower borrowing expenses. In 2009, Pennsylvania had the most local governments using swaps on variable-rate debt, according to Moody’s Investors Service.
“You’ve got to think long and hard before you take a risk that you have no control over,” said Steven Goldfield, who helped develop Harrisburg’s recovery plan as senior counselor at New York-based Public Resources Advisory Group. “As a governmental official with public funds, you want to preserve the funds.”
Even after federal regulators pushed through rules sparked by the swaps fallout, public money remains at risk, according to Pennsylvania state senators backing stronger restrictions. Their bills, up for a vote as soon as next month, would have barred the latest deals.
“We still have a lot of risky transactions that are not working out well for the taxpayers,” said state Senator John Eichelberger, a Republican sponsor of the measures. “We need more protection built into the law.”
The swaps are contracts, typically between a bank and a borrower, to exchange interest payments. The agreements were intended to shield issuers from the risk of rising interest rates.
Yet the market convulsions during the financial crisis spurred expenses in excess of payments for many municipalities. Localities nationwide have paid more than $4 billion to Wall Street to terminate the derivatives, data compiled by Bloomberg show.
In the last eight years, about 1,000 audits of Pennsylvania school districts, including those who’ve engaged in swaps, have shown that “whatever benefit they got upfront wasn’t worth it on the back end,” state Auditor General Eugene DePasquale said by phone.
Swaps figured in the fiscal woes of Harrisburg, which was forced into the state’s first receivership in 2011 after skipping debt payments on an incinerator project. An audit in 2012 said derivatives tied to the deal boosted fees and risk.
In response, state senators pushed bills that would limit the use of swaps through steps such as banning upfront payments and mandating that municipalities be able to exit deals at no cost when the contracts are longer than 10 years.
Dauphin County backed the incinerator debt and made payments that the city skipped. As part of the settlement that allowed Harrisburg to exit receivership in March, the county contributes a portion of the interest rate on $24 million in fixed-rate bonds that financed the December sale of the waste facility, said Jay Wenger, managing director at Susquehanna Group Advisors Inc., the county’s financial adviser.
Last month, commissioners approved an ordinance authorizing a deal called a swaption involving an upfront payment to the county that Wenger says would go toward debt service. The counterparty, Royal Bank of Canada, would have the right at a future date to compel the county to pay a floating rate in exchange for fixed payments until 2033.
Transactions involving immediate cash have “been the cause of 99 percent of the abuse in the market,” said Lucien Calhoun, the Flourtown, Pennsylvania-based president of Calhoun Baker Inc. The company administers the Delaware Valley Regional Finance Authority, which provides municipal loans. Calhoun said the agency uses swaps for Pennsylvania localities to reduce borrowing costs.
Dauphin hasn’t entered into the contract. In 2011, it agreed to two swaps with RBC, effective in 2015 and 2016, that would cost about about $626,000 combined to terminate, according to Susquehanna.
Wenger said commissioners would do the third swap to manage their interest-rate risk, the same reason for the 2011 deals.
“They’ve been very judicious with their evaluation and decision-making,” Wenger said by telephone. “If you’re using the right tool for the right job, you’re probably going to have a lot of success with that tool.”
Commissioner Chairman Jeff Haste didn’t respond to requests for comment.
“All proposals are advanced in full compliance with Pennsylvania law,” which requires municipalities to use an independent adviser, Lauren Hopkinson, a spokeswoman for Toronto-based RBC, said in an e-mail. “In each instance, the financial risks and benefits are fully vetted” by the adviser, she said.
In Lancaster County, home to about 530,000 residents and an agricultural region known as Pennsylvania’s Dutch Country, the potential to reduce risk led to a new swap. Under a contract in November, the government received $1.9 million from RBC, which it used to exit three deals from 2004 -- including one with RBC, swap documents show. The bank had also proposed the new arrangement.
With the new swaption, RBC can trigger an exchange on Oct. 28, 2016. If it’s exercised, the bank would pay the county a fixed rate and the county would pay a variable rate from 2017 until 2033.
County Commissioner Chairman Dennis Stuckey said he supported the deal because under the 2004 contracts, counterparties JPMorgan Chase & Co. and RBC would have had recurring opportunities to exercise their agreements.
“I’ve never been a fan of swaptions, but the best I can do is to narrow the risk to the county,” he said.
Oley Valley, a district of 1,700 students northwest of Philadelphia, also entered a new contract to get out of another. San Francisco-based Wells Fargo & Co. informed school officials that it would exercise its right in 2012 under a 2004 agreement, which would leave the district paying more than it would have received, documents show.
The district decided to terminate the swap, triggering a $6.5 million fee to Wells Fargo. Officials sold $26.6 million of bonds and entered into a new agreement with Pittsburgh-based PNC Bank to pay the fee. The new contract ends in 2027.
The district’s financial adviser, Michael Vind, managing director of Financial S&Lutions LLC in Reading, Pennsylvania, said by e-mail that the bond sale and the new swap kept the debt costs the same as before the transactions.
“They made a proposal that again sounded like there was little downside risk,” said school board President Stephen Burns, who voted against the deal.
Superintendent Tracy Shank referred questions on the derivative to Vind. Marcey Zwiebel, a spokeswoman for PNC, declined to comment on its Pennsylvania transactions.
Eichelberger, the state senator, said Oley Valley shows how some governments try to fix their finances with more contracts that generate fees for advisers and lawyers.
“Often, they get into an almost never-ending transaction,” Eichelberger said.
Even though federal law requires independent advisers for municipalities entering into swaps, the compensation the advisers earn through the deal “compromises their independence,” said state Senator Rob Teplitz, a Democrat representing Harrisburg.
Most municipal officials don’t have the expertise to assess derivatives, Teplitz said.
In Berks County, finance director Robert Patrizio said it was his idea to enter a transaction in March.
Berks, with about 414,000 residents northwest of Philadelphia, has returned to the swaps market after the government lost money on earlier deals, he said. In 2009, the county paid termination fees totaling $13.8 million, about its budget for libraries and parks that year, financial filings show.
The March structure, as with one from 2011, is a basis swap in which the county receives a variable rate based on tax-exempt municipal bonds and pays PNC an amount based on a taxable variable rate, documents show.
The March swap would save at least $2.6 million over its 23-year term, and reserves would cover exit payments if needed, Patrizio said.
“Under any scenario, we’re going to make money on the deal,” he said. “We’re just killing it.”
--With assistance from William Selway in Washington.