Banks Kept CPS in Shaky Bond Market
November 10, 2014
By Heather Gillers and Jason Grotto
As investors across the country grew disenchanted with the risky auction-rate bond market in summer 2007, Bank of America officials became concerned that more trouble might lie ahead.
Auction-rate securities had been richly rewarding for BofA and other investment banks. But the market was shaky, and by that summer the banks were spending billions to keep it afloat. Records show that during an internal discussion in August, a senior BofA official warned of a potential market “meltdown.”
Chicago’s public school system was about to find out what such a meltdown would mean.
That same summer, BofA was preparing to underwrite a massive auction-rate bond issue for the school district. But district officials say the bank told them nothing about looming problems in the market – despite a federal law that requires banks to deal fairly with government borrowers.
The $263 million deal went forward as planned in September 2007, nearly three weeks after the BofA official’s internal warning.
Within six months of the closing, banks stopped supporting the auction-rate market and it collapsed, sending the school district’s interest payments soaring.
Chicago Public Schools had ventured into the market in the hope that it would save money over traditional fixed-rate debt. Instead, a Tribune analysis found that the 2007 auction-rate deal is likely to cost CPS an estimated $50 million more than the district would have paid on an equivalent fixed-rate bond.
In its unprecedented examination of the district’s $1 billion in auction-rate debt, the Tribune found that CPS stands to pay a high price for gambling on a risky and exotic borrowing strategy.
Banks catering to officials’ thirst for cheap money had sold CPS on auction-rate debt and derivative products beginning in 2003. Today, as students endure school closings and other cuts, the district continues to make steep payments on the deals, the Tribune found.
The 2007 deal was the last of CPS’ four auction-rate bond issues – and, according to the Tribune’s analysis, by far the most costly.
The transaction worked out well, however, for Banc of America Securities – then the investment banking arm of Bank of America – and for the No. 2 underwriter, the Royal Bank of Canada’s RBC Capital Markets. Thanks to the terms of the contract they negotiated, both banks pocketed fat interest payments on CPS bonds they were holding as the market collapsed.
Bank of America declined to respond to a question about why it went forward with the transaction.
CPS officials disputed the Tribune’s findings and provided an analysis that concluded the district has saved money on the deal to date. Unlike the Tribune, the district didn’t attempt to estimate future costs. The CPS analysis took credit for a massive upfront payment the district received as part of the deal while leaving out the higher interest payments it faces over the long term.
District Treasurer Jennie Huang Bennett said in an interview that it was inappropriate to estimate how much CPS will pay over the life of the deal. “I don’t know what’s going to happen with those bonds,” she said. “Things could change.”
Adela Cepeda of A.C. Advisory, the school district’s lead adviser on the deal, also disputed the Tribune’s analysis. “CPS did very well,” she said.
The origins of the deal date to 2005 and 2006, when the district began experimenting with a derivative product with a gimmicky-sounding name: swaptions.
The district signed swaption contracts with BofA and RBC that brought CPS $43 million in upfront cash but committed it to swap interest-rate payments with the banks in the future. Such swaps must be paired with floating-rate bonds, and the district saw auction-rate securities as a cheap way to meet that obligation.
Instead, the Tribune found, the implosion of the auction-rate market – just six months into the 30-year bond deal – turned the multipart transaction into a serious financial drain on the district.
Exactly how the district decided to enter the swaption deals is unclear. CPS officials could not explain who raised the idea of swaptions with the public school system.
The former treasurer who oversaw the transactions, David Bryant, says he doesn’t recall the details of the swaptions. The chief financial officer whose signature appears on the contracts, John Maiorca, did not return calls.
School Board President David Vitale, who oversaw the finance department as chief administration officer from 2003 to 2006 and served as chief operating officer from 2006 through 2008, declined to answer questions about the swaptions. But the deals incorporated the kinds of new-market solutions that Vitale, a former banker, had championed.
In an interview, Vitale said that in general he had tried to save money over traditional borrowing methods by taking advantage of floating-rate debt options and derivative products.
But there was a lot that could go wrong. The newer products carried a variety of potentially expensive risks that CPS could have avoided by sticking to traditional fixed-rate debt.
Students were away on summer break in 2005 when the district’s financial team first used swaptions to bring in some quick cash.
In exchange for $18 million, CPS sold Bank of America the option of requiring the district to enter an interest-rate swap two years down the road. The upfront money was so alluring that CPS did it again a year later, selling a second swaption to the Royal Bank of Canada for about $25 million.
If the banks chose to set the swap contracts in motion, the district had a plan. It would issue new, floating-rate bonds and use that money to pay off fixed-rate bonds from 1997. When the swaps started, the district would owe interest payments to the banks at a fixed rate identical to what it had been paying on those older bonds.
In return, the banks would pay CPS based on a floating rate pegged to the London Interbank Offered Rate, or Libor. The hope was that those payments would match what the district owed on the new bonds.
If that worked out, CPS would have gotten $43 million in upfront cash while still making debt payments based on the same fixed rate as before.
Fluctuations in interest rates could wreck that equation, however. If the floating interest rate on the bonds exceeded the Libor-based floating rate, the district’s payments could balloon.
Records show the Chicago Board of Education voted unanimously to give school finance officials the authority to enter into the swaptions, approving resolutions that didn’t list the terms or the specific amounts involved.
Bryant, the former CPS treasurer, said the district relied on outside financial advisers to evaluate such complex deals. A.C. Advisory, which has been assisting CPS with bond issues since 1996, served as the lead adviser on the swaptions, records show.
The firm prepared presentations evaluating the BofA and RBC proposals. But the worst-case scenarios shown in the documents were not as bad as what would actually happen.
For example, the firm predicted that, once the exchange of payments began, the most the district would have to pay to end the contracts early would be $69 million. The cost now stands at $90 million, according to the district’s comprehensive annual financial reports.
The maximum CPS could lose if swap payments did not match bond payments, according to the presentations, was less than $400,000 per year.
In just the first six months of the swaptions, that mismatch ended up costing CPS $2.4 million, a Tribune analysis found. Today the mismatch amounts to more than $1 million per year.
The firm also didn’t address what could happen if the district chose to issue auction-rate bonds – which it went on to do – rather than another kind of floating-rate debt.
Instead, to evaluate whether the Libor-based swap payments CPS received would match the bond rates it would have to pay, A.C. Advisory looked at the historical differences between Libor and a composite variable-rate municipal bond index published by the Securities Industry and Financial Markets Association, a trade group.
The SIFMA rate was a questionable proxy, however, for the auction rates on the bonds the district would eventually choose. A week before A.C. Advisory’s presentation, the auction rate on a portion of the district’s debt had exceeded SIFMA by 20 percent.
“Auction rates are different from SIFMA rates because the bond structures are completely different,” said Joseph S. Fichera, CEO of the New York-based financial advisory firm Saber Partners, who has served as an expert adviser on auction-rate securities for the U.S. Securities and Exchange Commission.
Replicating past Libor rates also offers less insight into future trends than more sophisticated financial analyses, experts said.
A.C. Advisory’s presentations attempted to calculate worst-case interest-rate costs by looking at historical averages for Libor and SIFMA, taking the scenario in which the gap between the two rates would be most expensive, and then repeating it year after year to see how much the district could end up paying.
That method is “not unreasonable,” said Andrew Kalotay, founder of Andrew Kalotay Associates, a New York debt management advisory firm that advised the city of Chicago on a recent bond deal. But both he and Fichera called it simplistic.
“These are what they call ‘ballpark numbers,'” Fichera said. “They don’t take into account the complexity and risk associated with the school district’s specific situation.”
Another technique A.C. Advisory used assumed that future interest rates would match past rates – that rates one year in the future would match what they were one year in the past, rates two years in the future would equal rates two years in the past, and so on. The firm called this “mirroring.”
Experts criticized that technique, again calling it overly simplistic. “That’s nonsense,” Kalotay said.
Matt Fabian, a managing partner at Concord, Mass.-based Municipal Market Advisors, who has testified before Congress about government finance, called the technique inappropriate.
Cepeda told the Tribune her firm provided objective analysis of the risks and costs of the deals on which she advised the district. She said she consulted closely with CPS officials.
“Whatever they agreed that they wanted to show, that they wanted to have, they had every single one of those scenarios,” she said.
Cepeda also said nobody could have predicted that a global economic crisis would wreak havoc on the markets. “Anyone can be a brilliant ‘financier’ with 10 years of hindsight,” she wrote in a letter to the Tribune’s editor.
Kalotay said the risks of the swaptions should have been apparent at the time. With such a complicated deal, he said, “you find a very high probability that something is going to go wrong over 25 years.”
Once BofA and RBC opted to set the interest-rate swaps in motion in July 2007, CPS prepared to refinance the 1997 fixed-rate debt with floating-rate bonds that could be paired with the swap contracts.
CPS chose auction-rate securities for the refinancing. Other types of floating-rate bonds didn’t carry the same risks, but auction-rate debt was a quick and cheap option in the short run, sparing CPS the time and expense of setting up liquidity agreements with third-party banks.
The deal would be the district’s fourth and last auction-rate bond issue, following previous deals in 2003 and 2004.
To bring the $263 million bond deal to market, the school system turned to BofA and RBC – the same banks that bought the swaptions. The two banks agreed to underwrite the majority of the deal while several other banks underwrote smaller portions.
But even as BofA and RBC prepared to close on the new bonds, they were watching pressure build in the auction-rate market.
There weren’t enough customers for the bonds being put up for auction. In the summer of 2007, the two banks were using more and more of their available cash to buy up the surplus bonds.
The Royal Bank of Canada’s inventory of auction-rate securities, for example, had ballooned from $250 million in January 2007 to $2 billion by the end of July, according to filings in a 2009 case that the SEC brought on behalf of investors after the market collapsed.
Yet in June 2007, RBC representative James Pass wrote to CPS’ treasurer that auction-rate bonds were a “concise and cost-effective” strategy “ensuring CPS obtains the lowest cost of capital.” Pass did not respond to a request for comment.
As the summer wore on, propping up auctions became an increasing burden for banks. Officials inside BofA grew concerned about just how precarious the market was, SEC case filings show.
On Aug. 17, a senior BofA official said in an internal discussion that a shortage of cash from banks and investors “could trigger a ‘meltdown'” in the market, according to the SEC complaint against BofA.
Later that month, in another internal discussion, senior BofA officials “expressed concern about the fragile nature of the (auction-rate securities) market,” the complaint said.
Cepeda, whose firm was the lead adviser on the bond issue, said no bank officials warned her how unstable the market had become. The deal closed Sept. 5, municipal bond data show.
In the weeks leading up to the deal with CPS, records show, Bank of America provided documents that laid out what the district might expect to pay over the next 23 years. The predictions, which assumed interest rates would remain stable and favorable, were simplistic at best, according to two experts on municipal securities who reviewed them at the Tribune’s request.
“If this was not accompanied by anything else, it would be deceptive,” said Dave Sanchez, an attorney with the SEC’s Office of Municipal Securities from 2010 to 2013.
Fichera said BofA should have calculated a range of possible outcomes, including a best-case scenario, a worst-case scenario and the middle ground, to show what the school district might pay depending on how rates moved and other risk factors.
“To make informed decisions, a government finance official should have a lot more disclosure than this,” he said.
Sanchez said the incomplete cost predictions, as well as BofA’s failure to warn CPS about the potential for a meltdown, raise questions about whether the bank violated a federal law that requires banks to “deal fairly” with government borrowers and not to engage in dishonest or deceptive behavior.
“If any part of the bank has concerns that there may be a ‘meltdown’ and that’s not disclosed to the issuer, that would certainly raise questions of fair dealing,” Sanchez said.
The SEC, which enforces the fair-dealing rule, declined to comment.
Vitale, who oversaw the district’s auction-rate borrowing strategy, said he had been under the impression that the banks would support auctions for CPS debt “because they presented a case of why they would, (including) what they’d done previously.”
But banks never put that commitment in writing.
As one BofA risk manager put it in a December 2007 memo quoted in the SEC complaint: “We don’t have a legal obligation to support these deals, but we have a moral one.”
That moral obligation would soon be trumped by the bottom line. BofA and other banks pulled their support for many auctions in February 2008, causing rates to skyrocket.
The complaints filed by the SEC the following year detailed BofA’s internal concerns as well as the growing inventory of auction-rate bonds at RBC. To settle claims that they failed to disclose the risks of auction-rate securities to investors, both banks later paid hundreds of millions of dollars to bondholders who were unable to cash out when the market collapsed.
But the SEC, which has historically advocated for the interests of investors, took little action on behalf of government borrowers like CPS.
While bankers gave CPS no warning about trouble in the auction-rate market, according to school officials, records show the banks did take action to protect themselves.
On CPS’ earlier auction-rate bonds, the contracts set a cap on interest payments that was pegged to prevailing short-term rates; for example, 250 percent of Libor.
The cap helped insulate CPS from out-of-control interest costs because the payments CPS was receiving on its interest-rate swaps also were tied to Libor. That meant the mismatch between the two rates – the difference the district had to pay – would be limited.
But when BofA and RBC closed the 2007 deal with CPS, the contracts set the cap at the highest rate allowed under state law. The new cap would not fluctuate with Libor or other prevailing rates, leaving the district vulnerable to a larger mismatch than before.
In early 2008, as the auction-rate market sputtered, the Libor-linked swap payments from BofA and RBC didn’t come close to covering what the district owed investors on the bonds. The mismatch grew to as much as 4 or 5 percentage points.
That expense, on top of the fixed 5.25 percent payment CPS owed the banks on the swap, became a powerful drain on the school system – amounting to a combined interest total that at times exceeded 10 percent.
The banks, meanwhile, stood to get that handsome return on any auction-rate bonds they had scooped up. On the CPS debt that they owned, the banks could pocket the payments they were due as bondholders in addition to the payments they were collecting from the district on the swaps.
Fichera said the new type of rate cap shifted risk from the banks supporting the market to the government borrower.
“The fixed maximum rate protected the banks with no apparent economic benefit to the issuers,” he said. “It’s going to benefit the banks whenever there’s a market disruption.”
For CPS, auction-rate bonds were hardly turning out to be “cost-effective,” as RBC had predicted. By mid-February, an A.C. Advisory presentation estimated the monthly cost of the 2007 bond to be $1 million more than CPS had expected to pay.
BofA and RBC declined to answer questions from the Tribune. An RBC spokeswoman noted that four other banks also underwrote portions of the deal.
Cepeda disputed the Tribune’s finding that sticking with fixed-rate debt would likely have cost the district far less than auction-rate debt. She objected to any effort to compare the cost of the 2007 deal with a hypothetical fixed-rate alternative – even though CPS itself did so in response to the Tribune’s questions.
The district, Cepeda said, had “believed it could not” refinance its original 1997 debt at fixed rates – instead of floating rates – under terms of a 1997 intergovernmental agreement that allowed CPS to use some city property tax dollars to make debt payments.
The Tribune pointed out that the agreement contains no such prohibition. Cepeda then said in an email that CPS “may have been technically able” to choose fixed-rate debt.
Within a year of inking the 2007 auction-rate deal, CPS was looking to refinance to escape the rising costs. But the district couldn’t replace the bonds with safer, fixed-rate debt because of the swap agreements, which needed to be attached to floating-rate bonds.
The cost of terminating the two swap contracts had risen to more than $64 million, according to an A.C. Advisory presentation from 2008. The district was already scrambling for cash to terminate some of its other swaps and did not have that kind of money to spare.
So the district refinanced the auction-rate securities with new floating-rate bonds and transferred over the related swap contracts.
Today it would cost $90 million to terminate both swaps. Under the contracts, the district will continue to make payments until 2030.
By the time the refinanced 2007 bond deal is paid off, according to the Tribune’s analysis, the district likely will have spent about $50 million more than it would have on fixed-rate debt – even after accounting for the $43 million CPS received upfront for the swaptions.
Today that $43 million is long gone. CPS spent the money within two years of inking the deals – using it to pay off debt.
© 2014, The Chicago Tribune, November 10, 2014