By Martin Z. Braun
Nov. 26 (Bloomberg) -- As Wall Street’s biggest banks run away from derivatives, Dauphin County, Pennsylvania, home of the state capital, Harrisburg, is embracing them.
The three-member county commission voted in August to approve two “range accrual swaps” with Deutsche Bank AG, according to minutes of the meeting. The interest-rate swaps, which involve $42 million of fixed-rate debt, guarantees Dauphin County $816,000 the first year and then wagers taxpayers’ money that short-term interest rates beginning in September 2009 won’t exceed 7 percent. Those rates are 2.2 percent now.
“It’s a way for us to raise revenue for the county,” said Chad Saylor, chief of staff to the county commission. “The only source of revenue we have, much like the school districts here, is the property tax.”
The commission’s decision shows the appeal of derivatives, even as states, cities and counties reel from misplaced bets on them. It also illustrates the lure of easy money at a time when municipal finances are deteriorating and the market for interest-rate swaps is under a federal criminal investigation into whether Wall Street banks conspired to overcharge local governments on the contracts.
Florida’s Miami-Dade County paid about $75 million in July to terminate a swap on its water and sewer bonds after the credit rating of an insurer guaranteeing the debt was cut. It plans to pay an additional $40 million to $50 million, following a refinancing this month. New York paid $44.6 million as of Sept. 30 to unwind swaps after they failed to protect the state when the interest on auction-rate securities surged.
‘Seen Enough’
“Haven’t we seen enough?” said Steve Goldfield, a senior managing director at Public Resources Advisory Group in Media, Pennsylvania, a financial adviser to state and local governments. “If everything works perfectly, it might be an OK idea. But usually, everything doesn’t work perfectly.”
Dauphin Commission Chairman Jeff Haste didn’t return requests for comment. Losses on debt payments the county would incur if short-term rates rise above 7 percent, which have happened 20 percent of the time the past quarter century, would be counteracted by higher yields on the county’s cash investments, which total $110 million, said Jay Wenger of Harrisburg-based Susquehanna Group Advisors Inc., the county’s swap adviser.
‘Saw the Benefits’
“We really view them as kind of offsetting in that kind of high-rate environment where the swap value starts to deteriorate, but your cash portfolio would improve in terms of interest income,” Wenger said at the Aug. 20 meeting, minutes show.
County commissioners “weighed the risks and saw the benefits,” Saylor said.
Swaps are private agreements, meaning no comprehensive data exists on how many municipalities are involved in the almost $400 trillion interest-rate derivatives market or the total paid to exit the contracts. A review of Pennsylvania Department of Community and Economic Development records shows that at least 185 school districts, towns and counties in the state have entered into derivatives deals with Wall Street since 2003, when state law was changed to explicitly allow the trades.
Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates or the weather. In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index.
Upfront Cash
Public agencies may benefit by using interest-rate swaps to lower borrowing costs or lock in rates for future bond sales.
Governments may use swaps as a way to generate upfront cash, an attractive feature at a time when the recession is eating into municipal finances. At least 31 states and District of Columbia face a combined budget shortfall of $24 billion this fiscal year, the Center on Budget and Policy Priorities in Washington said Nov. 12. The estimate on Oct. 10 was $8.9 billion.
Pennsylvania’s Adams County, home of Gettysburg, sold Charlotte, North Carolina-based Wachovia Corp. an option on a swap in June, according to the state’s economic development department. The “swaption,” which works in favor of the municipality if interest rates rise, allowed Adams County to pocket $1.1 million.
Mountain States Health Alliance did a $25.3 million “total return swap” this year with Merrill Lynch & Co. The derivatives increased liabilities at the 1,700-bed hospital system in eastern Tennessee, bordering the Appalachian Mountains, by $79.6 million as of the end of June, according to its audited financial statements. The swap boosted the hospital’s assets by $96,000, the documents said.
Betting on Bonds
The agreement calls for Mountain States to pay Merrill interest based on a short-term municipal bond index through 2012 on the $25.3 million, which is the amount of bonds the hospital has outstanding from debt issued in 2001. In return, the hospital receives interest of 6.25 percent. If the value of the bonds fall, the hospital will have to pay Merrill the difference between the price of the securities at the time the swap was agreed upon and when it is terminated. Should the bonds rise, Merrill pays.
Mountain States Health Alliance Chief Financial Officer Marvin Eichorn and Adams County Chairman George Weikert didn’t return calls seeking comment.
“We’ve got to get municipalities out of managing their interest-rate risk based on their view of the world,” said Robert Brooks, the Wallace D. Malone Jr. endowed chair of financial management at the University of Alabama, Tuscaloosa. “If they can’t explain clearly to their constituencies what they’re doing, perhaps the transaction fails the explainability test and shouldn’t be done.”
Alabama Bankruptcy
In Alabama’s Jefferson County, home of Birmingham, rising interest costs on more than $3 billion in adjustable-rate sewer bonds combined with wrong-way bets on swaps is threatening to produce the biggest municipal bankruptcy since Orange County’s default in 1994. Governor Bob Riley is negotiating with JPMorgan Chase & Co. and the county’s bond insurers to restructure the debt and swaps.
Attending the Dauphin County meeting where the swap arrangement was approved were Deutsche Bank municipal derivatives salesmen Doug Goldberg and Sam Gruer, the minutes show.
The Justice Department informed Gruer in November 2007 that he is a target in a federal criminal investigation of the municipal derivatives market, according to Financial Industry Regulatory Authority records. Gruer, who stopped working for Deutsche Bank in September, denies wrongdoing, the records show.
Two-Year Probe
About 30 banks, brokers and insurance companies have been subpoenaed in the two-year probe, and at least nine individuals have disclosed they’re targets of the investigation. On Sept. 3, JPMorgan, a former Gruer employer, shut down the unit selling debt derivatives to municipalities.
Dauphin County commissioners were aware that Gruer was under investigation, Wenger said in an interview. “We don’t have any evidence of any wrongdoing by anyone at Deutsche Bank,” he said.
Frankfurt-based Deutsche Bank received about $260,400 for the two swaps, according to the county. Michele Allison, a Deutsche Bank spokeswoman, declined to comment.
The terms of Dauphin County’s swaps -- one $30.7 million, the other $11.1 million -- guarantee a profit for the municipality in the first year. Firms such as Deutsche Bank are willing to provide such terms because they can profit by hedging the risk of the contracts with other parties. They also get fees for arranging the transactions.
$816,000 Payment
From September 2008 through September 2009, the county pays Deutsche Bank the three-month London interbank offered rate. In exchange, Deutsche Bank will give the county three-month Libor plus a fixed percentage, guaranteeing the county about $816,000.
Beginning September 2009 and lasting until the swaps mature in 2018 and 2023, the county makes money if short-term floating rates stay below 7 percent; loses if they exceed 7 percent. Three-month Libor is forecast to be 1.72 percent in the third quarter of 2009, according to the weighted average estimate of 24 economists surveyed by Bloomberg. It was 2.18 percent today.
On the $30.7 million swap, the county will pay Deutsche Bank three-month Libor through 2018. Deutsche Bank will pay the county three-month Libor plus 1.71 percentage points times a ratio. The ratio is determined by the number of days three-month Libor is less than or equal to 7 percent in a specified period divided by the number of calendar days in the period.
On the $11 million swap, beginning Sept. 1, 2009, and ending in 2023, the county pays three-month Libor and receives the same formula from Deutsche Bank, except the fixed spread is 2.62 percent instead of 1.71 percent.
‘Speculative Trade’
“It’s a purely speculative trade. It’s not a real hedge,” said Andrew Kalotay, chief executive officer of New York-based Andrew Kalotay Associates Inc., which advises corporations, federal agencies and municipalities on debt management. “You know how volatile it is. Why do you need to make that bet?”
Since its inception in 1984, three-month Libor has exceeded 7 percent about 20 percent of the time, including all of 1985, 1989 and 1990, according to data compiled by Bloomberg. This year, three-month Libor ranged from a low of 2.13 percent Nov. 12 to a high of 4.82 percent on Oct. 10.
To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net.
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