STATE COLLEGE: Controversial deal may put pressure on district

Swap costing millions

Ed Mahon

FIRST OF TWO PARTS

When financial adviser Lou Verdelli first introduced the idea of an interest rate swap to State College Area school board members, he told them to focus on the solid arrow.

That flat line could let them pay an interest rate of less than 4 percent on $58.05 million of debt for 20 years.

“That solid line is representing something that’s not changing, so a fixed rate. ... That gives us budget certainty, that eliminates a lot of interest rate risk on a large amount of the financing that’s needed for the project,” Verdelli, then a managing director of Public Financial Management Group, told the board at a Feb. 27, 2006, meeting. “So that’s the most important part of what goes on on page four.”

Page four of the report contained information on three other moving pieces in the agreement, which have all changed to work against the district’s interests.

Board members say they were properly informed of the other risks involved in entering into an interest rate swap agreement with the Royal Bank of Canada. But a Centre Daily Times analysis shows that in today’s financial market, the district now stands to spend at least $8 million more by activating the agreement than it would by incurring similar debt through standard fixed rate bonds.

Documents obtained from the school district after a request under Pennsylvania’s Right-to-Know law, recordings of previous meetings and interviews with financial experts and those involved in the swap deal reveal that several decisions brought the district to the point where it is today. The district:

•Issued but did not incur debt before an Act 34 Hearing on the proposed high school project so as to avoid a voter referendum on a tax increase;

•Relied on advice from a committee whose meetings were not open to the public;

•Missed an opportunity to terminate the swap contract for the cost of $168,623.45 on June 29, 2007, more than a month after the board approved ending the high school construction project. Five months later, the district paid $104,000 in fees to push back the activation date of the swap from Dec. 1, 2007, to Dec. 1, 2010;

•Incurred greater risk by pushing back the activation date of the swap.

“Even if the swap is reasonably fair on entry, the municipalities ... tend to get really nailed when they modify the terms,” said Andrew Kalotay, the head of a New York City-based firm that advises corporations and municipalities on debt management, bond valuation and derivatives. “It goes from bad to worse.”

Higher fees

Here’s how the swap was supposed to work:

The district would borrow money from a bondholder at a variable interest rate, based on the Securities Industry and Financial Markets Association Municipal Swap Index .

At the same time, it would enter into an interest rate swap with the Royal Bank of Canada — the district would pay the bank a fixed interest rate on $50 million-plus and the bank would pay the district a variable interest rate based on 67 percent of the London Interbank Offered Rate (LIBOR), a primary benchmark for interest rates around the world.

The hope was the variable rates would at least cancel each other out, leaving the low fixed rate as the district’s main cost for the loan.

Even if the two variable rates do in fact cancel out — which is not a guarantee and would not be the case in current market conditions —

another problem has emerged.

Since the collapse of the financial markets in September 2008, the fees associated with entering into variable rate debt have quadrupled.

“Those deals fell firmly out of favor with the recent credit crunch. Those deals were just not getting done,” said Gary Gray, a finance professor in the Smeal College of Business at Penn State who specialized in creating municipal derivative products. “It just doesn’t make any sense any more to do them.”

Banks used to charge a rate of interest of .30 percent, but now it would be about 1.25 percent. For the district, that equals a cost swing from less than $2 million to at least $7.4 million over the life of the debt.

Verdelli said the .30 percent rate was based on historical data.

“It certainly wasn’t something that any of us anticipated,” Verdelli said of the cost increase. “We’ve seen that widespread across the state, that hundreds of issuers that had the exact same situation are faced with costs that are much higher than the market norm.”

Verdelli wasn’t involved with the school board’s decision in November 2007 to push back the activation of the date of the swap. That decision increased the fixed interest rate that the district has to pay the Royal Bank of Canada from 3.884 to 4.356 percent.

With a 4.356 percent interest rate, the district would pay $23.68 million in interest over the 18-year term of the swap agreement. In today’s market, the district would likely be able to secure a fixed interest rate at 3.73 percent, which would cost $22.14 million, according to an analysis performed this month by Public Financial Management after a question from a Centre Daily Times reporter.

Gray doesn’t consider swaps inherently good or bad. And he pointed out that Harvard University paid $500 million to exit interest-rate swap agreements, “showing that even big-time investors can get into transactions that they don’t understand.”

But he thinks the district made a mistake by entering into the agreement while the high school project was a contentious issue in the community.

“Sometimes there’s smart uses. Sometimes there’s dumb uses. The incredible thing is that someone advised them to issue into the swap before having the bonds irrevocably in place. That is one of the worst ideas I’ve heard,” said Gray.

Closed meetings

In a Feb. 3, 2006, report, Verdelli and John Frey, senior managing consultant at Public Financial Management, advised the citizens advisory committee for finance that the district enter into a swap agreement on debt of either $58.05 million or $30 million.

Risk would occur on the first option, the report says, if the high school project were canceled or significantly reduced and other projects weren’t ready. But they said that risk was offset by the fact that the district had other looming construction projects.

The committee agreed with the first option and recommended it to the school board. The CAC meetings at which those decisions were made were closed to the public until February 2008, after the five new school board members took office.

However, “the CAC’s recommendations, as well as the nature of their deliberations, were openly discussed in a public meeting,” board member David Hutchinson said in an e-mail this week. At the time, he was the board representative to the finance committee. “The board’s deliberation, and the decision were also public.”

Second opinion

By November 2006, less than seven months after he advised the district to enter into a swap agreement, Verdelli had accepted a job with the Royal Bank of Canada’s investment and corporate banking subsidiary, according to an article in Bond Buyer, a national trade newspaper that focuses on the municipal bond industry.

“There certainly wasn’t a conflict,” Verdelli said in a phone interview this week from his Lancaster office. He later added, “I have 17 years of experience, and I certainly wouldn’t jeopardize that.”

He said he’d arranged other swap agreements between school districts and Wachovia and PNC banks. And he noted that the Royal Bank of Canada was the lead swap partner for districts across the state because of its high credit rating.

In 2006, American International Group was the world leader in municipal swap deals. That bank needed an $85 billion line of credit from the federal government in September 2008 to stay afloat. Lehman Brothers, which ranked 12th, collapsed that same month.

Gray, the Penn State professor who thought Verdelli’s advice was “one of the worst ideas I’ve heard,” does not view Verdelli’s job switch as any inherent conflict of interest.

“People hire people that they work with,” said Gray.

Said school board President Rick Madore, “I can assume he was above board. ... It is something we’re looking into, whether there was any problem.”

Frey will present the district with its options for going forward on Monday night. Board members say they plan to get a second opinion. And possibly, Madore said, a third.

“That’s not to say that we don’t trust the guy who gives us our first opinion, but I think it’s good to a get a second perspective,” said Madore.

Ed Mahon can be reached at 231-4619.

COMING SATURDAY: State College Area School Board missed opportunities to get out of the swap at little cost to the district, and school board candidates answer the question of what to do now.