Not everyone believes bond swaps equal free money

NEW YORK: Carole Heffley is skeptical about interest-rate swaps. Heffley is a councilwoman in the city of Easton, Pennsylvania, and last week she listened to a financial advisor discuss swap options with the City Council’s Finance and Administration Committee, of which she is a member.

Michael Setley of Concord Public Financial Advisors in nearby Reading, Pennsylvania, said the city could get $1.3 million upfront if it did one of these deals. Easton is a city of 26,000, the county seat of Northampton County in the Lehigh Valley, about 60 miles north of Philadelphia. Founded in 1752, Easton is one of those picturesque little towns with a Civil War memorial in the town square.

It is also, according to Standard & Poor’s, a city of below-average wealth and income levels, a small and stagnant tax base and high debt. The company rates the city’s bonds A-, with a negative outlook.

Financially strapped, the city is in the midst of the ominously titled state Early Intervention Plan, designed to forestall declaration of distressed municipality status, according to the rating company. There are probably dozens of municipalities just like Easton out there, and free money is being dangled in front of them, in return for a bet on interest rates.

These options are all the rage in Muniland right now, and have been for the past few years. Free money! Who can resist it, especially if your city or school district is having a problem balancing what goes out with what comes in? The idea behind these things, at least from a small municipality’s viewpoint, is that you’re making a bet. You’re betting that the rate you agree to pay to a counterparty will be lower than the rate the counterparty pays you.

Over the life of the bet, the money can add up. Setley estimated that Easton could make almost $5 million. The amount depends on the final terms, Setley said on Thursday. He also said that lots of Pennsylvania municipalities were engaging in such transactions.

Of the $1.3 million he estimated Easton would receive upfront — this is the amount a bank would pay the city for the option to make it engage in the swap — $300,000 would be put aside for those times the city is on the wrong end of the bet. Interest rates, after all, are unpredictable things. Carole Heffley is skeptical. I called her because I recognised her type from the story about the Finance and Administration Committee meeting in the Morning Call newspaper of Allentown, Pennsylvania.

“Councilwoman Heffley pressed Setley to further explain the transaction and its costs to the city,” the story said, and I knew right away I wanted to speak to her. Public finance can use more Carole Heffleys, the skeptics who ask critical questions and who demand explanations in straight English. “I’m financially challenged,” she told me in a telephone interview this week. “I have no depth of understanding of why some bank would do one of these deals, which seem to be a sure bet in your favour.” Under the terms of the swap outlined by Setley, the city would pay 165% of the short-term tax-exempt Bond Market Association index, and would receive 100% of the 10-year London Interbank Offered Rate, or Libor.

More often than not, it costs you more to borrow for 10 years than it does for, say, a month. Over the last 15 years, the average of Libor has been 6.09%, Setley explained, while 165% of the short-term index was 4.62%.

That’s the 15-year average. Under current market conditions, the city would pay 5.74%, and receive 4.9%. As Setley put it in the presentation he made to the committee, “The recent Fed tightening cycle has caused the yield curve to flatten significantly and recently actually become inverted,” meaning that short term rates are higher than long-term rates.

If the city goes ahead with the deal, it is betting that interest rates will revert to the 15-year norm. If that happens, the city will receive almost $4 million more than it pays to the swap counterparty from 2008 to 2033. If rates stay where they are, the city pays out almost $3 million more than it receives. Heffley, 63, founder of a local arts newspaper, says her gut feeling is not to do the transaction.

“You put $300,000 aside, and then another $300,000, and then another $300,000,” she said. “That upfront million will be gone pretty quickly, because it never works out the way you think, believe me. And then the taxpayers are stuck with it,” shwe added.

Carole Heffley doesn’t know about swaps and derivatives. She doesn’t know how to evaluate the option. She didn’t know that right now the Justice Department is looking into the whole field. She doesn’t know about any of those things.Heffley knows that she doesn’t know, and is asking questions. She isn’t about to be rushed. If Easton decides to go ahead with the swap, she wants another financial expert who is not Michael Setley to analyze the transaction. Not everyone is Carole Heffley. Most swaps being pitched to municipal officials aren’t this simple.