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Senate of Pennsylvania
Session of 2013 - 2014 Regular Session


Posted: May 8, 2013 02:45 PM
From: Senator Mike Folmer and Sen. Rob Teplitz, Sen. John H. Eichelberger, Jr., Sen. John P. Blake, Sen. Lisa M. Boscola, Sen. Patrick M. Browne
To: All Senate members
Subject: Bipartisan Municipal Debt Bill #3: LGUDA Swap Ban
Act 23 of 2003 amended the Local Government Unit Debt Act (LGUDA) to permit local governments, including counties, cities, boroughs, townships and school districts, to enter into interest rate management agreements, commonly known as “swaps” or “derivatives.” In addition, the Municipality Authorities Act has been interpreted to permit municipal authorities to enter into swaps.

Swaps are contracts under which parties agree to exchange (or swap) cash flow payment obligations. Under Act 23, a swap is required to relate to specific debt being issued by a local government under LGUDA. The swap is entered in between the local government and a financial institution, commonly referred to as the counterparty.

The most generic swap structure involves the local government issuing variable rate debt, and then entering into a swap under which the counterparty makes a variable rate payment to the local government, and the local government makes a fixed rate payment to the counterparty. The goal is to create a “synthetic” fixed rate issue at a lower rate than if the local government issued regular fixed rate debt.

There are many other variations of swaps. One is a “basis swap” in which the local government makes payments to the counterparty based on one type of variable rate, and the counterparty makes payments to the local government based on another type of variable rate. This produces a winner and a loser at any point in time.

Even more complicated swap structures include “synthetic refundings” or “swaptions” in which a counterparty makes a payment up front to the local government for a refunding that could not be accomplished today, and the local government agrees to issue variable rate refunding bonds and enter into a swap at a future date.

Swaps have also been done under which the counterparty pays the local government an upfront payment to give the local government short term cash, and the swap is then priced to have the local government pay back the upfront amount over time.

All of these swap structures involve the local government assuming risks it does not assume when it does a normal fixed or variable rate bond issue. In addition, if the local government wants to get out of a swap early, the local government can end up having to pay a large termination fee to the counterparty.

When the Great Recession hit in 2008, and interest rates went low and stayed low, many of the risks inherent in the swap structures came to pass and caused multi-million dollar losses for local governments and authorities.

From October 2003 to June 2009, Pennsylvania local governments, authorities and schools entered into 626 swaps transactions on $14.9 billion in debt and a number of them lost millions in taxpayer dollars due to swaps. In 2009, then Auditor General Jack Wagner called swaps “gambling with the public's money," and recommended they be banned. As chief counsel to Auditor General Wagner at the time, Senator Teplitz was instrumental to this effort.

These losses were not just limited to small municipalities. Large local governments, such as the City of Philadelphia and the Philadelphia School District, have incurred hundreds of millions of dollars of losses. Swaps are too complicated and involve too much risk. Taxpayers cannot afford, in these difficult economic times, to pay losses incurred by their local governments on risky financial products.

We believe swaps represent gambling with the public’s money, which is why we are introducing two pieces of legislation. Senator Folmer’s is similar to his previously introduced Senate Bill 293 cosponsored by Teplitz, Rafferty, Vulakovich, Pileggi, and Eichelberger. This measure will ban swaps for all local government units and municipal authorities through amendments to LGUDA. (Senator Teplitz will ban swaps through separate legislation for Cities of the First Class through an amendment to that Code.)

Introduced as SB903