A schooling in America’s finances

As the hometown of Penn State University, the municipality of State College, Penn., is no stranger to bad publicity. But its announcement last month that it was paying a Canadian bank $9 million as part of a failed plan to raise money to build a new school has placed the town at the centre of a national debate over a type of high-risk debt that critics claim has helped tip hundreds of American cities, schools and transit systems into financial ruin.

In 2006, State College’s school board planned to issue bonds to raise $58 million to replace its aging high school. The board’s financial adviser suggested it hire the Royal Bank of Canada to do the deal, and protect against the prospect of rising interest rates on its bonds by locking into a complex deal known as an interest-rate swap with the bank.

The school board would pay RBC a fixed interest rate and RBC would pay the board a floating rate, which the board would then use to pay its bond investors. If rates rose, the board would pocket the difference. If they fell, the school would owe the bank. But in a twist, the community voted not to build a school and the board never issued the bonds. After interest rates plunged in the wake of the 2008 financial crisis, the board missed its first interest payment of nearly $1 million to RBC. It launched a lawsuit to try and back out of the agreement but lost the court case and last month announced it had reached a settlement to pay RBC $9 million of a termination fee between $10 and $11 million.

“Obviously, no one is happy about the conclusion of this, and I think that’s entirely understandable,” says long-time State College director David Hutchison. “It’s money that’s not being spent on education.” RBC spokesman Kevin Foster said the deal was vindicated in court and the school board never attempted to renegotiate the agreement before the filing of the suit. “We were pleased to have reached a resolution with the district after their decision to sue us, rather than engage us in a business discussion that could have addressed this matter without the district incurring the cost of litigation,” Foster said in a statement.

State College’s debt fiasco is one that is playing out in municipalities across the U.S., as cities suffer from severe cases of buyer’s remorse after hastily getting into these agreements. Interest-rate swaps were big business before the financial crash. The Bank for International Settlements reports that by 2009 there were outstanding rate swaps on more than $340 trillion of global debt, making swaps the largest segment of the derivatives market.

Virtually every major Wall Street bank, from Goldman Sachs to J.P. Morgan, sold interest-rate swaps, with American municipalities among their largest clients. U.S. cities, hospitals and universities eagerly piled into an estimated $500 billion worth of swaps in the hope that the agreements would offer a quick fix to their chronic budget crises and pension shortfalls. When interest rates fell to historic lows, and the anticipated paydays never arrived, municipalities began looking for ways out, triggering billions in termination fees and a flurry of lawsuits.

RBC had built up one of the largest municipal financing and swap dealerships in the U.S. It wouldn’t comment on the size of its municipal swap business south of the border, although it has previously said it was the leader in municipal financing in Pennsylvania and Arizona and among the leaders in several other states.

A Pennsylvania auditor general’s report found the state capital, Harrisburg, had paid above-market rates for swap agreements with RBC as part of a deal to fund a new incinerator. The community tried unsuccessfully to file for bankruptcy protection in 2011 under the weight of more than $300 million in debt because of the failed incinerator project.

The College of Santa Fe, New Mexico’s oldest liberal arts college, collapsed in 2009, owing $25 million to RBC for a bond deal that included an interest-rate swap. The college, which had fewer than 600 students, was eventually bought out by the state and local government.

Banks heavily promoted municipal swap agreements in the lead-up to the financial crisis, since they could charge higher fees on the arrangements than in a typical municipal bond deal, says Andrew Kalotay, a quantitative analyst and debt-financing expert. Proponents of such deals argue that, had interest rates actually risen, municipalities would have benefited greatly at the expense of the banks. But Kalotay argues that local governments either didn’t understand, or simply ignored, the risks attached to them. He estimates American municipalities, which were not sophisticated financial clients but behaved as if they were, paid as much as $4 billion a year in swap fees.

Few municipalities have financing experts on staff, so they require an independent financial adviser to guide them through a deal. Kalotay says advisers were poorly regulated and hopelessly conflicted, since they only made money if the deals got done. One school board in Denver signed a “conflict waiver” so that RBC could act as its financial adviser on an exotic $750-million deal involving a swap, even though RBC was also participating in the deal.

In the case of State College, less than a year after the school district finalized the swap agreement, its financial adviser took a job with RBC. (RBC refused to comment on the hiring, but told the Wall Street Journal in 2011 that such a move “is not uncommon in the industry.”)

Since agreeing to the $9-million payout to RBC, directors at State College have called on state legislators to ban municipal interest-rate swaps, echoing an earlier call by the state’s auditor general. “They’re very complex and a lot of people on the board would not be aware of the intricacies of them,” says college director Hutchinson.

The board still needs to find a way to raise money to build a new school. When it does, Hutchinson expects it will be done with a long-term mortgage. In other words, the way such deals used to be done.