In the News: Recent Developments

May 10, 2013

Denver Pays Wall Street $216 Million as Swaps Fail: Muni Credit

By Darrell Preston

Wall Street banks collected $215.6 million that Denver’s public schools paid to unwind swaps and sell bonds since the district began borrowing to cut pension costs in 2008. That sum is about two-thirds of annual teaching expenses.

The district paid $146.6 million last month to banks, including RBC Capital Markets LLC, Wells Fargo Securities LLC and Bank of America Corp., to end interest-rate swaps as part of a second attempt to restructure a 2008 borrowing, bond documents show. The April 17 deal sold as the district’s property-tax rate has risen 26 percent in two years to fund education.

“It’s very sickening,” Andrew Kalotay, president of Andrew Kalotay Associates Inc., a debt-management adviser in New York, said in a phone interview. “It’s costing people money.”

Municipal borrowers from Detroit’s utilities to Harvard University in Cambridge, Massachusetts, have paid billions of dollars to banks to end privately negotiated interest-rate bets sold as hedges. The Federal Reserve’s policy of holding its benchmark borrowing rate near zero since 2008 has turned many of the swaps into wrong-way bets.

‘Policy Decision’

Denver’s schools might have avoided borrowing if elected officials had adequately funded pensions, according to a draft study for Princeton University’s Woodrow Wilson School of Public and International Affairs by Joseph Fichera, chief executive officer of Saber Partners LLC in New York. To fill the gap, officials chose complex financings sold by Wall Street instead of raising taxes or renegotiating benefits, he said.

“The point is the amount of risk they take on to meet their obligations,” Fichera said in an e-mail. “It’s a policy decision that needs to be made after careful and fully informed analysis.”

The pension plan was underfunded by $397.8 million when the district started borrowing in 2008, according to annual financial filings. The borrowing that year closed the gap, which wound up re-emerging and growing to $638 million in 2011.

Last month, the district issued $536.9 million of certificates of participation, a type of debt structured as a lease involving school buildings. The offer carries an Aa3 grade from Moody’s Investors Service, three steps below the top.

Extra Yield

Yields on the offer, whose payments are subject to annual appropriation, exceeded those on top-rated debt. The December 2037 maturity sold with a yield of 4.24 percent, about 1.37 percentage points more than benchmark debt.

It was the latest effort to unwind a borrowing in April 2008, when the district sold $750 million of taxable, variable-rate debt.

The goal of that issue was to refinance earlier pension borrowings and fully fund pensions as part of a plan to merge the obligations into a state fund. The sale, with rates that reset periodically, came two months after the auction-rate securities market froze, leaving investors unable to redeem bonds and issuers stuck with increasing borrowing rates. Soon after Denver schools sold its debt, it faced such penalty rates, Superintendent Tom Boasberg said.

The district, which educates about 84,400 students, spent about $327 million on instruction in the 2011-2012 school year, according to official statements for last month’s sale.

Savings Erosion

Denver schools wound up doing a bond deal in 2011, along with last month’s, to convert the 2008 bonds to fixed-rate and exit swaps. The $215.6 million paid to unwind swaps as well as fees for new bond sales has eroded money the district set out to save for its pension plan. Besides the swap termination payments, the cost includes fees to underwriters and other professionals.

Interest-rate swaps are derivatives in which two parties agree to trade interest payments on a set amount of debt, letting one side create a fixed payment on variable-rate debt, as the Denver district did.

“We’ve lost hundreds of millions of dollars on deals we never should have been in,” said Jeannie Kaplan, a district board member who said she voted for the 2008 borrowing and then began pushing to end it in 2010. “Public institutions with elected boards shouldn’t be in these kinds of transactions. Our responsibility is to use the public’s money in a judicious way.”

Goal Accomplished

Boasberg disagrees. He said the transactions have accomplished the goal of moving retiree money to a state-run plan and lowering costs relative to what benefits would have cost without the deals. Even with payments to banks for transaction costs, the deals saved about $78 million, he said.

“The benefits of the transaction have been very strong,” Boasberg said in an interview. “It’s saved taxpayers a lot of money.”

For RBC Capital, which was to receive $36.75 million from last month’s sale to terminate a swap, according to bond documents, the payment “is pursuant to the original agreement governing its early termination,” Elisa Barsotti, a spokeswoman in New York, said by e-mail. “Any monies paid represent the cost of that early termination, which relates directly to current market conditions.”

San Francisco-based Wells Fargo declined to comment through Dana Obrist, a spokeswoman; as did Bank of America, according to Bill Halldin, a spokesman for the Charlotte, North Carolina-based bank. Wells Fargo was to receive $36.1 million, with $73.8 million going to Bank of America.

Bond Comprehension

Kalotay, Kaplan and John MacPherson, a former principal in the jurisdiction and an employee of the pension fund when it was under the district, said the extra fees and expenses to unwind swaps are making the costs higher than if the district had just sold fixed-rate debt in the first place. The $215.6 million is 29 percent of the $750 million of variable-rate debt sold in 2008 with a swap designed to limit borrowing costs.

“There was not one person on that board who understands bonds,” said Kalotay, who has studied costs of the earlier deals, including fees paid to enter the swaps, and testified about them before the U.S. Securities and Exchange Commission.

Superintendent Boasberg said taxes haven’t been raised to cover costs of repaying the debt. Still, the district has asked voters for overrides on its mill levy to cover more costs not covered by its general fund, according to bond documents and Kaplan.

The payment “will affect the classroom,” Kaplan said.

MacPherson said the borrowings will add $1 billion to pension costs over the life of the loans compared with a scenario where the district had just merged its pension plan into the state system.

“This deal hasn’t done much for anyone — except the bankers, who are dancing in the streets,” said MacPherson.

Market Movement

In the $3.7 trillion local-debt market, yields on tax-free bonds are the highest in a month.

At 1.8 percent, yields on benchmark 10-year munis compare with 1.81 percent for similar-maturity Treasuries. The ratio of the two yields is about 99 percent, meaning local debt is relatively expensive compared with federal securities.

Tax-free local bonds have yielded less than Treasuries in only five of the past 41 trading sessions, data compiled by Bloomberg show. The ratio has averaged 92 percent since 2001.

© 2015, Bloomberg News, May 10, 2013

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