Bethlehem district losing on money deal

From the Allentown Morning Call

Bethlehem district losing on money deal
Bad bet? Interest rate swaps are costly, at least temporarily.

By Steve Esack | Of The Morning Call October 5, 2008
Several years ago, Bethlehem Area school officials knew they had to borrow money to renovate and expand the district's two high schools. They didn't know that decision would lead to a chain of events that would cost the district plenty and threaten its financial stability.

At the time, the board turned to business manager Stanley. J. Majewski Jr., about how to pay for the high school projects. Majewski then sought the advice of Les Bear, the district's longtime financial consultant, who was working at the time for the investment firm Arthurs LeStrange & Co.

In 2003, Bear suggested a bond swap, which the state Legislature had made legal that year. The swap is a risky, unconventional transaction that involves a partnership with the banking industry.

The district would swap the construction bonds' fixed-rate interest, which never changes, for investment banks' adjustable weekly rates, which fluctuate. That way, the district could pay less in interest over the life of the bonds because short-term rates historically perform better than fixed rates of about 5 percent or higher.

The school board listened as Bear explained in technical financial terms how a swap worked. Some members expressed confusion, but the board agreed to do the swap. This same scene would play out nine times between 2003 and 2007 as Bear sold the board on more swaps. The board seemed happy with the results, too. Liberty and Freedom were finished and the district was able to start constructing a new Broughal Middle school using the same financing.

But now the debt from those projects threatens to crush taxpayers and diminish educational services because the swaps have gone sour in the mortgage crisis. And while bond swapping has become popular among governments across the country, it also has become the focus of FBI, Justice Department and Securities and Exchange Commission probes and civil lawsuits and led to the recent default of more than $1 billion in bonds for Jefferson County, Alabama.

Skyrocketing short-term interest rates more than quadrupled last month, costing Bethlehem Area School District taxpayers an extra $1 million that month on the swap deals and solidifying that 2008 has become the worst short-term credit market in the history of the United States.

However, even before interest rates climbed from 1.9 percent to 8.5 percent in September, the swaps were not working as advertised, a Morning Call review of records shows.

''These [swaps] are very complicated and the board that accepted this made it fairly clear it did not understand all the mechanisms behind it,'' said School Board President Loretta Leeson. ''I feel the board, myself in particular, asked some meaningful questions like, is this a safe investment?''

The school board will hold a meeting at 6 p.m. Monday at the Education Center to discuss the swaps.

''We'd better be prepared to adjust very quickly to this dramatic increase in interest expense,'' School Director Gene McKeon said. ''The money has to come from some place.''

Hundreds of other school districts, municipalities and counties have entered into swaps since the financial transaction became legal in 2003, state records show.

In the Lehigh Valley region, at least seven school districts -- Allentown, Parkland, Easton, Bangor, Quakertown, Souderton and Nazareth -- took on these risky loans.

So did four counties -- Northampton, Berks, Bucks and Montgomery, according to Pennsylvania Department of Community & Economic Development records.

But no other government agency in Pennsylvania -- except for the Philadelphia School District -- has more money tied into swap agreements than the Bethlehem Area School District.

And no other local government agency has entered into more swaps than Bethlehem, which accepted nine of the risky loans involving four existing bonds.

Northampton County Controller Stephen Barron said he does not understand how the school district could have done so many swaps.

Since he was elected last year, Barron said, he has come to realize the county's one swap was bad for taxpayers.

Barron said school officials should seek help from the federal government or outside legal experts to investigate the district's swaps to see if they got fair deals. Other school districts and municipalities have taken this step in recent months.

''They do need to be open and honest with the taxpayers,'' said Barron, who lives in Bethlehem Township. ''They owe it to the taxpayers, but most importantly they owe it to the children of Bethlehem.''

Majewski stands by the decision to use swaps and contends the district will save about $55 million over the 15-30-year terms of the bonds.

If he is wrong, Majewski said, then so is most of corporate America and other municipal finance leaders who entered into the same sort of short-term swap deals with good intentions.

''I know it will save taxpayers many millions of dollars,'' Majewski said.

The school district paid more than $2 million in fees before the new firm Bear was working for, Ferris Baker Watts, was purchased in July by RBC Capital Markets, which has offices in Philadelphia and Scranton.

Bear said last week the swaps were performing badly only because the country had entered a financial nightmare.

''There's good days and bad days,'' said Bear. ''Now we are in unusual times and it will be corrected.''

Lehigh University finance professor James A. Greenleaf said the district's debt structure is like most of corporate America, with more money hedged into short-term than into long term bond rates.

''It's a calculated risk,'' Greenleaf said.

A month after acquiring Bear's firm, RBC warned the district the risk wasn't working and that it may have to budget an additional $1 million a year to cover the swaps. Two RBC employees told the school board Finance Committee in August the swaps caused the district's debt to be out of whack. The district now had more than three quarters of its entire debt ($285.5 million) tied into adjustable rates.

Last month, interest rates spiked and by the end of September, the district had lost $1 million.

Now, several new school board members, including Benjamin M. Tenaglia III, an investment banker, are questioning the financing.

''The projection of our debt in these swap exposures is much too high,'' Tenaglia said.

In June, when interest rates were low, taxpayers paid about $1.2 million in interest to bond holders and the banks -- nearly 30 percent more than if the district had used a fixed-rate bond of 5 percent, district records show. The payment was high because that month the district was hit with a semi-annual payment of $317,000 on top of monthly payments.

In August, without the semi-annual payment in play, the deals saved taxpayers $387,426 in monthly interest costs. But to get that interest savings the district shelled out $539,678 to bond holders and investment banks, JP Morgan and Morgan Stanley, who handled the swaps.

A partial list of September's bills shows that when interest rates spiked on Sept. 25, the district paid $963,914 in interest costs -- or 78 percent more than in June.

Bethlehem is not alone, said Tom Doe, founder and CEO of Municipal Market Advisors, in Concord, Mass. Many other local and state governments across the country are discovering the same problems.

But that does not make the school district the victim, he said.

''Both parties are guilty,'' Doe said. ''They entered into something with certain assumptions and ... no one in the transaction effectively outlined the potential risk.''

Now, there are real consequences for taxpayers, he said.