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Senate of Pennsylvania
Session of 2015 - 2016 Regular Session

MEMORANDUM

Posted: December 18, 2014 09:52 AM
From: Senator Mike Folmer and Sen. John P. Blake, Sen. John H. Eichelberger, Jr., Sen. Rob Teplitz
To: All Senate members
Subject: Restricting Swaps
 
I plan to reintroduce Senate Bill 903, which was part of a bipartisan package to address the financial transactions of the Harrisburg Authority that led to the fiscal distress of the City of Harrisburg.

As introduced, SB 903 would have banned local governments (counties, cities, boroughs, townships and school districts) from entering into interest rate management agreements, commonly known as “swaps” or “derivatives.”

During the course of last Session, SB 903 was amended to restrict but not ban swaps. The amended version is what I plan to reintroduce. It would not apply to the City of Philadelphia.

Swaps are contracts under which parties agree to exchange (or swap) cash flow payment obligations. Under current law, a swap is required to relate to specific debt being issued by a local government under the Local Government Unit Debt Act (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, such as 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. Taxpayers cannot afford to pay losses incurred by their local governments on risky financial products.

I believe swaps represent gambling with the public’s money, which is why I propose legislation to establish:

---- Reasonable Limits: allow a local government to tie up 50% of its outstanding debt in swap transactions. There is no current limit. Additionally, local governments have gotten into serious financial trouble by using swaps as a means of temporary cash infusion financing, rather than as a vehicle to reduce borrowing costs. My legislation would prohibit upfront cash payments. It would also eliminate payment of a municipality’s financial advisor out of the proceeds. Financial advisors to municipalities are currently less than “independent,” since they only get paid if the transaction is consummated, and they then get paid by the other party. In practice, there is no incentive to advocate against a transaction, and municipalities are left without truly independent advice and analysis.

Some current interest rate management agreements do not take effect until years into the future, which adds volatility and risk premised on speculation as to what rates will be at that time. My legislation would place an outside limit and require that the agreement commence within three years. It would also require the agreement end within 10 years, unless the local government could terminate it without penalty after that time. The bill would also require the rate of interest be determined using either an index published by the Securities Industry and Financial Markets Association or the London Interbank Offered Rate index.

---- Disclosures: the bill would require a local government to report on the performance of the qualified interest rate management agreement quarterly at a public meeting, and would also require the other party to make certifications to the local government, essentially stating:
  • All information provided to the local government unit, whether in solicitations or in response to requests for information from the local government unit as to potential positive or negative impacts of entering into the qualified interest rate management agreement, is mathematically correct and conforms to all applicable legal standards

  • It has acted in good faith and has made full and fair disclosure of all material facts and any conflicts of interest with respect to the qualified interest management agreement



Introduced as SB342