The legislature giveth, and the legislature taketh away.
On Monday, the Senate Local Government Committee heard testimony on a package of bipartisan bills that seek to still the rough waters of municipal debt. Two of the bills—SB 903, sponsored by Sen. Folmer, and SB 904, sponsored by Sen. Teplitz—impose a statewide ban on interest-rate management agreements, also known, in the sporting parlance of finance, as “swaps.” The ban would reverse a bill, exactly one decade old, whose overriding purpose was to permit them.
Swaps, like fireworks, come in many shapes and colors. In their simplest form, their function is to trade a fixed interest rate on a quantity of debt for a potentially more favorable variable one. (Or vice versa.)
Like fireworks, swaps can explode. When they do, the results can be catastrophic: as former Auditor General Jack Wagner testified on Monday, bad swap agreements have led to the loss of “huge sums of public money”—by SEPTA, the Bethlehem School District, and the Turnpike, to name a few—in the “area of tens of millions of dollars.”
When swaps were first permitted, in 2003, the outlook was sunny. Rick Frimmer, then an attorney at Greenberg Traurig, who helped craft the legislation, described them as a “favorite tool of tax-exempt bond issuers and their advisors.” (Frimmer is now a partner at a firm in Chicago, specializing in, among other things, restructuring troubled public debt.) Variable interest rates tended to be lower than fixed ones; by entering into a swap, a local government (or a school district or authority) could realize substantial savings.
So why the intensified interest in a ban? The immediate spur for the new legislation is Harrisburg’s debt crisis, which produced a pair of hearings last fall to investigate where laws governing municipal debt had failed. In the course of those hearings, legislators learned about inadequate oversight by the Department of Community and Economic Development—whose staff, apparently overworked, was essentially rubber-stamping the debt filings it was supposed to vet—and a semi-incestuous league of elected officials and their legal and financial advisors. Some of the proposed legislation seeks to curb these offenses, by bolstering DCED’s regulatory role and by strengthening conflict-of-interest provisions.
But additionally, during the hearings in 2012, the senators heard testimony explicitly warning against the use of interest-rate swaps. David Unkovic, Harrisburg’s former receiver, referred to their allowance in municipal finance as a “failed experiment.” Swaps, he said, are incompatible with the pressures of public office: too often, they offer enticing upfront gains and push the pain onto future administrations. And their potential for harm extends well past the confines of the capital city, as Wagner detailed in Monday’s litany of losses.
Despite this, swaps still have ardent advocates. Charles Linderman, the director of business affairs for Great Valley School District, in Chester County, testified that Great Valley’s swaps over the past eight years have “resulted in positive cash flow.” Noting that there are “many successful swaps,” he urged the legislature to “preserve the flexibility of local government officials to have access to all the tools of the financial markets.”
Nancy Winkler, treasurer for the city of Philadelphia, likewise testified that the swap ban “would harm Philadelphia’s ability to manage effectively its own financial affairs.” Repeating the favored metaphor for utility, she referred to the swaps as “important tools” that “allow the city to generate savings, reduce risks, manage our investments and access the financial markets.”
It may be true that, managed well, swaps can produce savings on government debt. But what’s the guarantee they’ll be managed well?
At various points throughout the hearing, it was observed that swaps present elected officials with decisions they don’t understand. As a result, they’re forced to rely on professional advice. And an important sentiment simmering beneath Monday’s discussion was taxpayers’ lingering distrust of financial professionals.
Folmer, for instance, questioned Lucien Calhoun, the president of Calhoun Baker, Inc., a financial and management consulting firm, over what happens when an advisor “fails.”
“If a swap does go bad, who pays that bill? The taxpayer,” Folmer said. “And it seems like there’s no risk for the investment advisor.”
Judith Dexter and Michele Cann, who served on the board of the Bethlehem Area School District during a period in which it lost millions in swap transactions, spoke about officials’ susceptibility to bad advice. “We wanted to understand the transaction, and we thought we did,” Dexter said. “I do not feel that in Bethlehem we got any truly independent financial advice, because if we had, someone would have unraveled the kind of risks that we could face and the potential devastation to our district.”
Suspicion of high finance, whatever its benefits to rhetoric, is not always a reliable route to good legislation. (“Wall Street never loses,” Teplitz said after the hearing, as he took questions from reporters. “I think what we’re really doing is privatizing the profit and socializing the risk.”) Whether or not the swap ban succeeds, elected officials will continue to be shepherded by financial experts who will collect substantial fees.
But the concern about compromised guidance is relevant here. After all, in the tally of swap transactions, who really stands to gain? When Folmer asked about the cost of swaps to Philadelphia taxpayers, Winkler’s response was that, all told, “it turned out to be about a wash.” For taxpayers, perhaps. But what about for the industry that invented and sold the products that yielded the wash?
The 2003 legislation on swaps included a definition of an “independent financial advisor.” Such an advisor was to be a “person or entity experienced in the financial aspects and risks of interest rate management agreements.” Greenberg Traurig, the law firm that helped shape the bill, announced its passage with an article on its website; at the bottom, they note that their public finance lawyers “are experienced in these sophisticated transactions.” It’s not hard to see why the senators were intent on questioning the impartiality of advisors.
The immediate weakness of the swap-ban bills, judging by much of Monday’s testimony, is that they legislate caution where many would argue caution is already observed. Linderman, with the Great Valley School District, noted that his team has “always proceeded very slowly.” Winkler said that, though swaps come with risk, “we are highly conservative and prudent in using them.”
The trouble with this line is that it addresses the wrong question. The goal is not to ensure care after calamity: it’s to ensure care when calamity is far from everyone’s mind. This legislation would turn temporary prudence into lasting policy.
In so doing, it would mimic existing state law regarding municipal investments, which already prevents the staking of public money on highly speculative risks. The same logic—that stability and transparency are preferable to experimentation, however lucrative it might be—should apply here. Public money is public money, whether it’s spent on debt service or investments. The gains of such an approach may be less spectacular. But the losses will be, too.
