New Jersey $123 Mln Swap Fee Enriches Banks at Public's Expense
By Andrew Pratt (Bloomberg) --
New Jersey didn't find it necessaryto tell taxpayers that it was about to pay Wall Street banksalmost $123 million of their money to end a bad bet on interestrates made on an otherwise routine government borrowing. The state gave no public notice that board members of itsEconomic Development Authority would be deciding May 17 whetherto end the interest-rate wager by paying Lehman BrothersHoldings Inc. and Morgan Stanley enough money to wipe out theaverage property tax bill of 22,000 New Jersey homeowners. The penalty New Jersey paid stemmed from an interest-rategamble the state made in 2000 under then-Governor Christine ToddWhitman, using complex and unregulated contracts calledinterest-rate swaps and options. While such tools are widelyused by state and local borrowers across the U.S., officialsoften don't disclose the risks or potential costs, and taxpayers don't get the details needed to evaluate them. "Democracy depends on transparency,'' says Randall Dodd,president of the Financial Policy Forum, a Washington-basedinstitute that studies government borrowing. "There are noreporting requirements and information is hard to get onderivatives - very hard if not impossible.'' Derivatives, which include swaps, are financial obligationsderived from debt and equity securities, currencies andcommodities. Federal disclosure rules that govern municipal bondsales don't apply to derivatives. The swap contracts that New Jersey canceled in May weresold on the premise that they would lower the cost of a $375 million bond issue arranged to shore up state pension funds.Instead, they cost the state fees and a lost opportunity torefinance at lower rates.
Nationwide
New Jersey isn't alone in paying fees to cancel swaps.Taxpayers in New York and Shelby County, Tennessee, paid a totalof about $50 million this year to Wall Street bankers, whengovernment officials decided the New York MetropolitanTransportation Authority and Tennessee county needed to paycancellation fees on wayward bets in their derivative contracts. U.S. states, cities and counties are involved with morethan $400 billion of swap agreements, according to estimates byNew York-based Moody's Investors Service. At least 27 stateshave used derivatives as part of their public financing,according to New York-based Standard & Poor's. New Jersey alone has more than $5.1 billion in derivativecontracts that would have cost the state $425.7 million in feesif they were canceled in September, according to a report byBeverly Hills, California-based CDR Financial Products Inc.,which was hired by the state in 2003 to advise on its swaps.
Swap Fees
In a swap, two parties pledge to exchange interest paymentsover a period of time. Typically, a municipality agrees to pay afixed rate, while the bank pays a variable rate that changes inrelation to a benchmark rate or index. Banks usually assess a fee on swaps contracts by adding to the rate an amount that the state or locality has to pay eachyear in interest on the total dollar amount of the contract. Ifinterest-rate swings make it cheaper to borrow in other ways -as they did for New York's Metropolitan Transportation Authorityand Tennessee's Shelby County - a municipality can pay banks to end the contract. Taxpayers had little opportunity to learn about the NewJersey pension swaps or their proposed cancellation. The development authority is required under New Jersey lawto give notice to two state newspapers and the secretary ofstate's office, which keeps records of all public meetings, atleast 48 hours before a meeting. It isn't required to publicizean agenda and didn't do so before the board met to vote tocancel the swap.
One-Line Notice
A one-line notice of the meeting, held at the authority's headquarters in the state capital of Trenton, was faxed tonewspapers on May 13. The notice doesn't mention the swaps. Any members of the public who attended the meeting couldn't get background material explaining the swaps proposal untilafter the 12-to-0 vote. The authority posts minutes on its Website within a few weeks of its regular gatherings. Minutes ofthe May 17 special meeting weren't posted until mid-October and were available only by request before then. Approval was rushed because state finance officials under Treasurer John McCormac and the banks wanted to get the transaction completed before interest rates rose, says CarenFranzini, chief executive officer of the Economic Development Authority. Franzini, who isn't a voting board member, heads the staff that evaluates the proposals that go before members. Lehman Brothers spokeswoman Kerrie Cohen and Morgan Stanley spokesman Mark Lake declined to comment.
Big Borrower
The authority never hands out background documents until board members can review them and make changes during the meeting, Franzini says. The development authority sold more than $4.5 billion indebt last year, making it the largest municipal borrower in the nation behind California and New York City, according to NewYork-based Thomson Financial. While New Jersey requires that voters approve largeborrowings, the state, like many others, has argued successfully in court that such state-created authorities are independent and can borrow without voter approval. New Jersey will face decisions on whether to pay toterminate other swaps if interest rates don't rise. The state had 34 active swaps totaling $5.1 billion onSept. 1, according to the CDR report. The agreements include $3.75 billion of derivatives tied to debt of the state's SchoolsConstruction Corp., which was set up in 2003 ago to overseepublic school construction. The majority of the swaps lock the state into debt at borrowing costs higher than current rates. The state would havehad to pay $425.7 million to cancel those swaps in September, the September CDR report shows. That figure will rise and fallwith interest rates.
`No Shelf Life'
Kelley Heck, a spokeswoman for acting New Jersey GovernorRichard Codey, a Democrat who isn't running in the Nov. 8 election, referred all questions about the state's swaps toThomas Vincz, spokesman for state Treasurer McCormac. Vincz saysthe state uses swaps to provide certainty about its debtexpense, and that the market value of a swap is relevant only if the state decides to cancel it. "Market values of swaps change on a daily basis, so snapshot portfolio assessments have no shelf life when measuringan issuer's long-term goals, history and position with thisfinancial tool'', Vincz says. "New Jersey has locked in historically low interest rates for many long-term borrowing needs, and its swaps strategy has already yielded debt service savings to state taxpayers.''
True Cost
Douglas Forrester, 52, the Republican candidate for NewJersey governor in next week's election, says he wants to createan elected, independent office of state auditor that wouldmonitor borrowing practices, including swaps. The state auditoris now an appointee of the legislature. "The current problems are a result of inadequate disclosure requirements that have masked the true cost of publicborrowing,'' says Sherry Sylvester, a spokeswoman for theForrester campaign. U.S. Senator Jon Corzine, 58, the Democratic candidate forgovernor, says swaps are complicated and he would hire the best people possible to see if New Jersey can manage them better. "Until I can look at it closely, I can't tell you what the state should do,'' says Corzine, a former chairman and chief executive officer of New York-based investment bank Goldman,Sachs & Co.
Access to Information
Taxpayers who want to learn about authority borrowing orthe state's derivatives program will have to do extensiveresearch. Getting access to reports by swap adviser CDR on theperformance of the state's swaps, contracts detailing the termsof the pension swaps and options, and memos and meeting minutes explaining why the agreements were canceled required filing requests under New Jersey's Open Public Records Act with boththe state and the Economic Development Authority. Bloomberg News filed its first request for information about the state's swaps on Aug. 22. On Oct. 17, it received thelast documents it requested, including CDR's financial analysisof the decision to cancel the pension swaps and minutes of theMay 17 meeting where the authority's board voted to cancel them. The U.S. Internal Revenue Service is concerned about the use of swaps in the municipal bond market. The agency is probingwhether financial advisers to states and local governments were paid excessive fees on swap contracts or allowed banks to make inflated commissions, according to Charles Anderson, a Baltimore-based manager of field operations at the IRS's tax-exempt bond office.
Alabama County
The IRS is conducting a review of a sewerage financing byJefferson County, Alabama, to determine whether the county hascomplied with federal tax laws requiring states and cities torebate arbitrage profits to the Treasury, according to a letterthe IRS sent the county on Oct. 21, 2004. The county, which includes Birmingham, the state's largestcity, bought $5.8 billion of swaps to refinance its seweragesystem and paid fees on some of the contracts that were almosttwice the national average, according to data compiled byBloomberg. Vincz, the New Jersey Treasury spokesman, says the staterarely comments on correspondence with the IRS and declines tosay whether it has received any letters about its swaps.
`Considerable Risk'
Martha Haines, head of public finance regulation at theU.S. Securities and Exchange Commission in Washington, saysstates and cities aren't always equipped to evaluate the risksinvolved in using swaps. ``Swaps and other derivatives are sophisticated productsthat entail considerable risk,'' Haines says. ``I am concernedthat many of the small issuers now considering derivatives donot have the knowledge or the resources necessary to safelyengage in these products or to hire experienced advisers toassist them.'' Fees paid to cancel swap contracts can eat away at theresources available for public services and projects, includingschools, roads and fire trucks. The $123 million paid by New Jersey could have coveredthree-quarters of the state's annual costs for NJ FamilyCare, aprogram that provides health care to uninsured children in105,000 families, according to state figures. Michael Decker, senior vice president and head of researchand policy at the New York-based Bond Market Association, saysswaps used properly can save the public millions of dollars. ``Swaps are all about managing risk,'' Decker says.``They're not necessarily for everybody and for everytransaction. But they do in many cases save state and localgovernments money, which is why their use is growing.''
Upfront Fee
New Jersey's swap was paired with an option agreement. Inan option contract, the bank pays the municipality an upfrontfee. In exchange, the bank gains the right to require themunicipality to begin a swap at a specified interest rate by anagreed date. Long-term swap options were risky for New Jersey because itis impossible to predict interest-rate movements over extendedperiods, says Robert Brooks, 44, a finance professor at theUniversity of Alabama in Tuscaloosa. ``These were essentially bets about what interest rateswould be over the horizon, and municipalities are not equippedto make those kinds of forecasts,'' Brooks says. ``That may beappropriate behavior for a hedge fund, but it's not for amunicipality.''
New Jersey's Plan
State officials sold the interest-rate swap options in 1998and 2000 as part of a plan to refinance $375 million of fixed-rate pension bonds with new debt and a swap when they becamecallable three years later. The bonds are used to replenish funds used to pay publicretirement benefits. Unlike most of the state's municipal debt,this type of debt is taxable because proceeds are used to makeinvestments, rather than for capital projects. The swap options looked like safe bets, says JamesDiEleuterio, who was New Jersey's treasurer from July 1997 toAugust 1999, when many of the decisions about the options werebeing made. The options locked the state into a rate that wasconsidered a low cost of debt, says DiEleuterio, 52. The statetook bids to make sure it got the largest possible payments forthe options, and netted $65.8 million from the sales,DiEleuterio says. ``When it was presented to me based on the potential of$65.8 million in upfront cash, we did evaluate it as a gooddeal,'' DiEleuterio says.
Three-Year Bet
State officials erred in 2000 by placing a three-year beton interest rates, far longer than a municipal borrower shouldconsider, says the University of Alabama's Brooks, who is co-author of ``Interest Rate Risk Management: The Banker's Guide toUsing Futures, Options, Swaps and Other Derivative Instruments''(Probus Publishing, 1993). New Jersey's option contracts with Lehman Brothers andMorgan Stanley allowed the banks to start a swap with the statebeginning in February 2003. The terms called for the state to pay a fixed interest rateof 7.6 percent on $375 million, the same rate it paid on the oldpension debt. In exchange, banks would pay the state a floatingrate that would cover interest payments on the new bonds. If rates had stayed the same or climbed, the banks probablywouldn't have exercised their right to force New Jersey into theswap, and the state wouldn't have gone ahead with the relatedrefinancing. New Jersey would have been ahead by $65.8 million,the amount of the upfront fees.
`Risky Swap'
Instead, rates fell, and the banks started the swap,locking New Jersey into a higher rate than it could haveobtained in the open market. ``It was a risky swap because the pension bonds were issuedwith such a high interest rate, and rates went downsignificantly after that,'' says New Jersey's McCormac. Vincz, the Treasury spokesman, says the state doesn'tcollect the records needed to determine how much banks make fromNew Jersey's swaps. Banks usually lock in their profit byentering a second agreement with a third party immediately afterentering a swap with a local government. The bank pays the third party a fixed rate of interest thatis lower than what it received from the state or localgovernment. The difference between the two payments is thebank's profit. The terms of the second swap, known as a hedge,aren't on public record and aren't kept by the state, Vinczsays. The state could have gotten a rate of 5.7 percent to 6percent in 2003 had it been able to sell conventional fixed-ratedebt instead of refinancing with variable-rate debt and theswap, according to a Bloomberg index of taxable municipal bondrates.
Converted
As rates fell this year, Lehman Brothers and Morgan Stanleyagreed on a plan that would allow New Jersey to cancel the swapwithout taking money from the state budget. Under the plan, state officials converted the $375 millionof variable-rate pension bonds to debt paying a fixed rate of7.4 percent. They were able to do so because the terms of thebonds allowed for the debt to be tendered, or bought back by thestate, and then resold with new interest-rate terms. Investors were willing to pay a premium of $1.33 for every$1 of the converted bonds because the new fixed rate on the debtwas higher than prevailing interest rates. That premiumgenerated $123 million in cash that the state used to pay thebanks to get out of the swaps.
Best Way
Selling the bonds at a premium was the best way for NewJersey to get out of the swap agreement without taking moneyfrom other state programs, state Treasurer McCormac says. Vincz says the state canceled the swap to save $5 millionin interest costs and eliminate risk and expenses associatedwith the contracts. Debt payments on the premium bonds areslightly lower than the state made under the agreement, allowingthe swap to be canceled without any additional expense,Franzini, the development authority's chief executive, says. The premium bonds also locked the state into paying a ratethat will result in at least $136 million more in interest costsover the next 25 years compared with the rate it could haverefinanced at in 2003 if it hadn't had swap options in place,according to Bloomberg data. ``You hope to God they didn't set out to run theirportfolio this way because they ended up with a big bunch oftransaction costs,'' says Dodd of the Financial Policy Forum.``They tried to cloak these losses by selling bonds at apremium.''
`Absorbed'
Records of the May 17 meeting, when the authority voted tocancel the swap, show then-state Finance Director Ann Flynn, whois now a managing director at RBC Dain Rauscher Inc., tellingboard members that the $123 million termination fees wouldn't berecovered. The cost would be ``absorbed'' into the newly issuedbonds, with the premium going to pay the termination, Flynn saysat the meeting. Because the fixed rate on the converted bonds is lower thanthe rate on the canceled swap, New Jersey's debt payments on the$375 million of bonds aren't any higher after terminating theagreement, Franzini says. Cancellation won't bring back the opportunity to refinancethe debt at the lowest possible rates, Franzini says. James Poole, a former state finance director who helpedmake the decision to sell the swap options in 1998 and 2000,wouldn't comment on the agreement. Poole now works for theSchools Construction Corp., which oversees $8.6 billion in stateschool construction projects. Roland Machold, 69, who took over when DiEleuterio quit astreasurer and signed the agreement authorizing the swap options,says he doesn't recall the details of the transaction. Macholdis now retired.
Not for All
David Moore, an Orlando, Florida-based managing director atfinancial advisory firm Public Financial Management who hasarranged swaps for Florida school districts in Orange, Hillsborough, Pasco and Lee counties, says he wouldn't recommendthem to all his customers. "Swaps are a good financial tool that can significantlybenefit our clients but must always be entered into by clientsthat have been educated and understand all of the features", Moore says. "There are many of my clients that at this point in time Iwould not encourage to enter into swaps,'' he says.
-With reporting by Eddie Baeb in Chicago, Martin Z. Braun inNew York and Judith Mathewson in Washington. Editors: Williams,Neumann, Henkoff, Chan.
To contact the reporter on this story: Andrew Pratt inTrenton, New Jersey, at (1)(609) 278-1270 orapratt@bloomberg.net.
To contact the editor responsible for this story:Beth Williams at (1)(212) 617-2307 orbewilliams@bloomberg.net
New Jersey didn't find it necessaryto tell taxpayers that it was about to pay Wall Street banksalmost $123 million of their money to end a bad bet on interestrates made on an otherwise routine government borrowing. The state gave no public notice that board members of itsEconomic Development Authority would be deciding May 17 whetherto end the interest-rate wager by paying Lehman BrothersHoldings Inc. and Morgan Stanley enough money to wipe out theaverage property tax bill of 22,000 New Jersey homeowners. The penalty New Jersey paid stemmed from an interest-rategamble the state made in 2000 under then-Governor Christine ToddWhitman, using complex and unregulated contracts calledinterest-rate swaps and options. While such tools are widelyused by state and local borrowers across the U.S., officialsoften don't disclose the risks or potential costs, and taxpayers don't get the details needed to evaluate them. "Democracy depends on transparency,'' says Randall Dodd,president of the Financial Policy Forum, a Washington-basedinstitute that studies government borrowing. "There are noreporting requirements and information is hard to get onderivatives - very hard if not impossible.'' Derivatives, which include swaps, are financial obligationsderived from debt and equity securities, currencies andcommodities. Federal disclosure rules that govern municipal bondsales don't apply to derivatives. The swap contracts that New Jersey canceled in May weresold on the premise that they would lower the cost of a $375 million bond issue arranged to shore up state pension funds.Instead, they cost the state fees and a lost opportunity torefinance at lower rates.
Nationwide
New Jersey isn't alone in paying fees to cancel swaps.Taxpayers in New York and Shelby County, Tennessee, paid a totalof about $50 million this year to Wall Street bankers, whengovernment officials decided the New York MetropolitanTransportation Authority and Tennessee county needed to paycancellation fees on wayward bets in their derivative contracts. U.S. states, cities and counties are involved with morethan $400 billion of swap agreements, according to estimates byNew York-based Moody's Investors Service. At least 27 stateshave used derivatives as part of their public financing,according to New York-based Standard & Poor's. New Jersey alone has more than $5.1 billion in derivativecontracts that would have cost the state $425.7 million in feesif they were canceled in September, according to a report byBeverly Hills, California-based CDR Financial Products Inc.,which was hired by the state in 2003 to advise on its swaps.
Swap Fees
In a swap, two parties pledge to exchange interest paymentsover a period of time. Typically, a municipality agrees to pay afixed rate, while the bank pays a variable rate that changes inrelation to a benchmark rate or index. Banks usually assess a fee on swaps contracts by adding to the rate an amount that the state or locality has to pay eachyear in interest on the total dollar amount of the contract. Ifinterest-rate swings make it cheaper to borrow in other ways -as they did for New York's Metropolitan Transportation Authorityand Tennessee's Shelby County - a municipality can pay banks to end the contract. Taxpayers had little opportunity to learn about the NewJersey pension swaps or their proposed cancellation. The development authority is required under New Jersey lawto give notice to two state newspapers and the secretary ofstate's office, which keeps records of all public meetings, atleast 48 hours before a meeting. It isn't required to publicizean agenda and didn't do so before the board met to vote tocancel the swap.
One-Line Notice
A one-line notice of the meeting, held at the authority's headquarters in the state capital of Trenton, was faxed tonewspapers on May 13. The notice doesn't mention the swaps. Any members of the public who attended the meeting couldn't get background material explaining the swaps proposal untilafter the 12-to-0 vote. The authority posts minutes on its Website within a few weeks of its regular gatherings. Minutes ofthe May 17 special meeting weren't posted until mid-October and were available only by request before then. Approval was rushed because state finance officials under Treasurer John McCormac and the banks wanted to get the transaction completed before interest rates rose, says CarenFranzini, chief executive officer of the Economic Development Authority. Franzini, who isn't a voting board member, heads the staff that evaluates the proposals that go before members. Lehman Brothers spokeswoman Kerrie Cohen and Morgan Stanley spokesman Mark Lake declined to comment.
Big Borrower
The authority never hands out background documents until board members can review them and make changes during the meeting, Franzini says. The development authority sold more than $4.5 billion indebt last year, making it the largest municipal borrower in the nation behind California and New York City, according to NewYork-based Thomson Financial. While New Jersey requires that voters approve largeborrowings, the state, like many others, has argued successfully in court that such state-created authorities are independent and can borrow without voter approval. New Jersey will face decisions on whether to pay toterminate other swaps if interest rates don't rise. The state had 34 active swaps totaling $5.1 billion onSept. 1, according to the CDR report. The agreements include $3.75 billion of derivatives tied to debt of the state's SchoolsConstruction Corp., which was set up in 2003 ago to overseepublic school construction. The majority of the swaps lock the state into debt at borrowing costs higher than current rates. The state would havehad to pay $425.7 million to cancel those swaps in September, the September CDR report shows. That figure will rise and fallwith interest rates.
`No Shelf Life'
Kelley Heck, a spokeswoman for acting New Jersey GovernorRichard Codey, a Democrat who isn't running in the Nov. 8 election, referred all questions about the state's swaps toThomas Vincz, spokesman for state Treasurer McCormac. Vincz saysthe state uses swaps to provide certainty about its debtexpense, and that the market value of a swap is relevant only if the state decides to cancel it. "Market values of swaps change on a daily basis, so snapshot portfolio assessments have no shelf life when measuringan issuer's long-term goals, history and position with thisfinancial tool'', Vincz says. "New Jersey has locked in historically low interest rates for many long-term borrowing needs, and its swaps strategy has already yielded debt service savings to state taxpayers.''
True Cost
Douglas Forrester, 52, the Republican candidate for NewJersey governor in next week's election, says he wants to createan elected, independent office of state auditor that wouldmonitor borrowing practices, including swaps. The state auditoris now an appointee of the legislature. "The current problems are a result of inadequate disclosure requirements that have masked the true cost of publicborrowing,'' says Sherry Sylvester, a spokeswoman for theForrester campaign. U.S. Senator Jon Corzine, 58, the Democratic candidate forgovernor, says swaps are complicated and he would hire the best people possible to see if New Jersey can manage them better. "Until I can look at it closely, I can't tell you what the state should do,'' says Corzine, a former chairman and chief executive officer of New York-based investment bank Goldman,Sachs & Co.
Access to Information
Taxpayers who want to learn about authority borrowing orthe state's derivatives program will have to do extensiveresearch. Getting access to reports by swap adviser CDR on theperformance of the state's swaps, contracts detailing the termsof the pension swaps and options, and memos and meeting minutes explaining why the agreements were canceled required filing requests under New Jersey's Open Public Records Act with boththe state and the Economic Development Authority. Bloomberg News filed its first request for information about the state's swaps on Aug. 22. On Oct. 17, it received thelast documents it requested, including CDR's financial analysisof the decision to cancel the pension swaps and minutes of theMay 17 meeting where the authority's board voted to cancel them. The U.S. Internal Revenue Service is concerned about the use of swaps in the municipal bond market. The agency is probingwhether financial advisers to states and local governments were paid excessive fees on swap contracts or allowed banks to make inflated commissions, according to Charles Anderson, a Baltimore-based manager of field operations at the IRS's tax-exempt bond office.
Alabama County
The IRS is conducting a review of a sewerage financing byJefferson County, Alabama, to determine whether the county hascomplied with federal tax laws requiring states and cities torebate arbitrage profits to the Treasury, according to a letterthe IRS sent the county on Oct. 21, 2004. The county, which includes Birmingham, the state's largestcity, bought $5.8 billion of swaps to refinance its seweragesystem and paid fees on some of the contracts that were almosttwice the national average, according to data compiled byBloomberg. Vincz, the New Jersey Treasury spokesman, says the staterarely comments on correspondence with the IRS and declines tosay whether it has received any letters about its swaps.
`Considerable Risk'
Martha Haines, head of public finance regulation at theU.S. Securities and Exchange Commission in Washington, saysstates and cities aren't always equipped to evaluate the risksinvolved in using swaps. ``Swaps and other derivatives are sophisticated productsthat entail considerable risk,'' Haines says. ``I am concernedthat many of the small issuers now considering derivatives donot have the knowledge or the resources necessary to safelyengage in these products or to hire experienced advisers toassist them.'' Fees paid to cancel swap contracts can eat away at theresources available for public services and projects, includingschools, roads and fire trucks. The $123 million paid by New Jersey could have coveredthree-quarters of the state's annual costs for NJ FamilyCare, aprogram that provides health care to uninsured children in105,000 families, according to state figures. Michael Decker, senior vice president and head of researchand policy at the New York-based Bond Market Association, saysswaps used properly can save the public millions of dollars. ``Swaps are all about managing risk,'' Decker says.``They're not necessarily for everybody and for everytransaction. But they do in many cases save state and localgovernments money, which is why their use is growing.''
Upfront Fee
New Jersey's swap was paired with an option agreement. Inan option contract, the bank pays the municipality an upfrontfee. In exchange, the bank gains the right to require themunicipality to begin a swap at a specified interest rate by anagreed date. Long-term swap options were risky for New Jersey because itis impossible to predict interest-rate movements over extendedperiods, says Robert Brooks, 44, a finance professor at theUniversity of Alabama in Tuscaloosa. ``These were essentially bets about what interest rateswould be over the horizon, and municipalities are not equippedto make those kinds of forecasts,'' Brooks says. ``That may beappropriate behavior for a hedge fund, but it's not for amunicipality.''
New Jersey's Plan
State officials sold the interest-rate swap options in 1998and 2000 as part of a plan to refinance $375 million of fixed-rate pension bonds with new debt and a swap when they becamecallable three years later. The bonds are used to replenish funds used to pay publicretirement benefits. Unlike most of the state's municipal debt,this type of debt is taxable because proceeds are used to makeinvestments, rather than for capital projects. The swap options looked like safe bets, says JamesDiEleuterio, who was New Jersey's treasurer from July 1997 toAugust 1999, when many of the decisions about the options werebeing made. The options locked the state into a rate that wasconsidered a low cost of debt, says DiEleuterio, 52. The statetook bids to make sure it got the largest possible payments forthe options, and netted $65.8 million from the sales,DiEleuterio says. ``When it was presented to me based on the potential of$65.8 million in upfront cash, we did evaluate it as a gooddeal,'' DiEleuterio says.
Three-Year Bet
State officials erred in 2000 by placing a three-year beton interest rates, far longer than a municipal borrower shouldconsider, says the University of Alabama's Brooks, who is co-author of ``Interest Rate Risk Management: The Banker's Guide toUsing Futures, Options, Swaps and Other Derivative Instruments''(Probus Publishing, 1993). New Jersey's option contracts with Lehman Brothers andMorgan Stanley allowed the banks to start a swap with the statebeginning in February 2003. The terms called for the state to pay a fixed interest rateof 7.6 percent on $375 million, the same rate it paid on the oldpension debt. In exchange, banks would pay the state a floatingrate that would cover interest payments on the new bonds. If rates had stayed the same or climbed, the banks probablywouldn't have exercised their right to force New Jersey into theswap, and the state wouldn't have gone ahead with the relatedrefinancing. New Jersey would have been ahead by $65.8 million,the amount of the upfront fees.
`Risky Swap'
Instead, rates fell, and the banks started the swap,locking New Jersey into a higher rate than it could haveobtained in the open market. ``It was a risky swap because the pension bonds were issuedwith such a high interest rate, and rates went downsignificantly after that,'' says New Jersey's McCormac. Vincz, the Treasury spokesman, says the state doesn'tcollect the records needed to determine how much banks make fromNew Jersey's swaps. Banks usually lock in their profit byentering a second agreement with a third party immediately afterentering a swap with a local government. The bank pays the third party a fixed rate of interest thatis lower than what it received from the state or localgovernment. The difference between the two payments is thebank's profit. The terms of the second swap, known as a hedge,aren't on public record and aren't kept by the state, Vinczsays. The state could have gotten a rate of 5.7 percent to 6percent in 2003 had it been able to sell conventional fixed-ratedebt instead of refinancing with variable-rate debt and theswap, according to a Bloomberg index of taxable municipal bondrates.
Converted
As rates fell this year, Lehman Brothers and Morgan Stanleyagreed on a plan that would allow New Jersey to cancel the swapwithout taking money from the state budget. Under the plan, state officials converted the $375 millionof variable-rate pension bonds to debt paying a fixed rate of7.4 percent. They were able to do so because the terms of thebonds allowed for the debt to be tendered, or bought back by thestate, and then resold with new interest-rate terms. Investors were willing to pay a premium of $1.33 for every$1 of the converted bonds because the new fixed rate on the debtwas higher than prevailing interest rates. That premiumgenerated $123 million in cash that the state used to pay thebanks to get out of the swaps.
Best Way
Selling the bonds at a premium was the best way for NewJersey to get out of the swap agreement without taking moneyfrom other state programs, state Treasurer McCormac says. Vincz says the state canceled the swap to save $5 millionin interest costs and eliminate risk and expenses associatedwith the contracts. Debt payments on the premium bonds areslightly lower than the state made under the agreement, allowingthe swap to be canceled without any additional expense,Franzini, the development authority's chief executive, says. The premium bonds also locked the state into paying a ratethat will result in at least $136 million more in interest costsover the next 25 years compared with the rate it could haverefinanced at in 2003 if it hadn't had swap options in place,according to Bloomberg data. ``You hope to God they didn't set out to run theirportfolio this way because they ended up with a big bunch oftransaction costs,'' says Dodd of the Financial Policy Forum.``They tried to cloak these losses by selling bonds at apremium.''
`Absorbed'
Records of the May 17 meeting, when the authority voted tocancel the swap, show then-state Finance Director Ann Flynn, whois now a managing director at RBC Dain Rauscher Inc., tellingboard members that the $123 million termination fees wouldn't berecovered. The cost would be ``absorbed'' into the newly issuedbonds, with the premium going to pay the termination, Flynn saysat the meeting. Because the fixed rate on the converted bonds is lower thanthe rate on the canceled swap, New Jersey's debt payments on the$375 million of bonds aren't any higher after terminating theagreement, Franzini says. Cancellation won't bring back the opportunity to refinancethe debt at the lowest possible rates, Franzini says. James Poole, a former state finance director who helpedmake the decision to sell the swap options in 1998 and 2000,wouldn't comment on the agreement. Poole now works for theSchools Construction Corp., which oversees $8.6 billion in stateschool construction projects. Roland Machold, 69, who took over when DiEleuterio quit astreasurer and signed the agreement authorizing the swap options,says he doesn't recall the details of the transaction. Macholdis now retired.
Not for All
David Moore, an Orlando, Florida-based managing director atfinancial advisory firm Public Financial Management who hasarranged swaps for Florida school districts in Orange, Hillsborough, Pasco and Lee counties, says he wouldn't recommendthem to all his customers. "Swaps are a good financial tool that can significantlybenefit our clients but must always be entered into by clientsthat have been educated and understand all of the features", Moore says. "There are many of my clients that at this point in time Iwould not encourage to enter into swaps,'' he says.
-With reporting by Eddie Baeb in Chicago, Martin Z. Braun inNew York and Judith Mathewson in Washington. Editors: Williams,Neumann, Henkoff, Chan.
To contact the reporter on this story: Andrew Pratt inTrenton, New Jersey, at (1)(609) 278-1270 orapratt@bloomberg.net.
To contact the editor responsible for this story:Beth Williams at (1)(212) 617-2307 orbewilliams@bloomberg.net
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