This month Pennsylvania became the first state to propose (as far as we can determine) an outright ban on the use of derivatives for taxpayer entities. After a state law in 2003 that allowed government entities to use derivatives, more than 700 swaps have been done on over $15 billion of debt for school districts, boroughs, townships and cities in the Keystone state. (Note: Chatham historically has not advised in the municipal space therefore we did not advise on any of these hedges) Many of these hedges have not fared well and some are outright disasters for school districts and municipalities, threatening their solvency. So it is easy to understand the fury that led State Senator Mike Folmer to introduce a bill to bar publicly funded entities to engage in derivatives.
How did we get here?
Assume you are the finance manager of a poor rural school district in northwestern Pennsylvania facing budget cuts and crumbling infrastructure. A big money center bank shows up in your town and offers a $750,000 payment for you to enter into a pay-fixed swap for 5 years and gives the bank the right to extend that rate for another 10 years. Of course, the bank correctly caveats this offer by telling you that they are not advisors and you should consult with one but how can you turn down fifteen years of protection PLUS a check for $750,000!
Where do you sign! The bank tells you this is done via something that everyone uses called swaps and invites you to a conference in NYC where you are wined and dined with the movers and shakers of finance. You may not understand how it all works but in NYC you meet sophisticated financial people who assure you all the cutting edge finance directors are doing this—come on and join the 21st century. And your district does badly need the $750,000.
Let’s break down this two part transaction consisting of a 5 year pay-fixed swap PLUS the district is selling a swaptions to the bank for cash. While falling rates certainly made the 5 year pay-fixed swap part look bad over the past years, it is no different than if the district would have borrowed fixed rate bonds. While the negative mark-to-market may be emotionally tough, the 5 year swap portion could have been a prudent decision. The brewing disaster was the swaption. First, even for highly rated liquid companies a 5 year forward hedge is a stretch but for a poor school district it is just a really bad idea. Secondly, the true value of the option was $1.75 million and the bank took a $1 million profit and only paid the district $750,000 (numbers from an actual case). The district bought the wrong product AND they got screwed on the price. In this case, the district eventually needed to pay $2.9mm to buy out of the swaption, leaving an already poor district financially crippled.
On a side note, about four or five years ago I had a conversation with our local school district’s finance manager who told me that this structure was pitched to him quite persistently with the enticing offer of upfront cash. Thankfully for our district he told me that he won’t do deals he doesn’t understand and he couldn’t get his head around this structure. He is a hometown hero!
If it is this bad, shouldn’t they be banned?
Just because something is abused doesn’t necessarily mean it should be banned. If it did, we would ban fire, prescription drugs, premier cable sport packages, smart phones for teenagers and fast food. Fire can burn down houses but it also keeps us warm in the winter and cooks our food so despite the tragic headlines of fire disasters, no one is calling on a ban on fire. We don’t ban these things when the good outweighs the controllable bad. There are two questions to that statement: 1) does the good outweighs the bad? and 2) how controllable is the bad?
Does the good of muni derivatives outweigh the bad? Prior to the introduction of FAS133 (ASC 815), corporate America suffered periodic derivative blow-ups, almost always from exotic derivatives (which companies usually had no business entering into). The response was not to ban derivatives rather to creatively control them through hedge accounting rules. Today blowups are rare in America publicly held firms while companies in other countries, especially Latin America have suffered serious blow-ups over the past few years. Essentially the accounting standard forced companies to use derivatives to hedge rather than speculate.
There is no doubt that municipal derivatives have been abused. But rather than banning a powerfully helpful product, why not simply allow derivatives that qualify for hedge accounting, while requiring strict rules and a heavy reporting/analysis/approval burden for anything that doesn’t qualify? This would essentially kill the use of exotic products for municipals which is the source of almost all of the problems and leave the useful products perfectly legal and accessible.
We care about this issue, not only as Pennsylvania taxpayers but because many of these disaster stories should violate peoples’ sense of fairness and justice. But rushing to ban things rather than figuring out how to creatively control a powerful yet dangerous tool is not the answer. Ensuring that derivatives are only used as hedges for publicly financed entities is a better way to go.