Deutsche Bank Swap Makes Pennsylvania Taxpayers Lose $230,000 

By Martin Z. Braun

Jan. 17 (Bloomberg) -- The third-poorest city in Pennsylvania is a lot poorer because of a 28-year bet on interest rates that already has gone awry. 

The Reading, Pennsylvania, school district, which has 18,323 students, this week must pay $230,000 to Deutsche Bank AG, Germany's largest bank, because it's on the losing side of a wager that long-term interest rates will rise faster than short- term interest rates. In April, the board rushed approval of the so-called interest rate swap in eight days after its adviser said the transaction may earn the district $16 million by 2034. 

While Reading's taxpayers are liable for the loss, bankers and advisers already have pocketed $1 million in fees for arranging the swap, enough to buy 11 Mercedes-Benz S-550 sedans. This week's payment to Deutsche Bank would have covered the school district's monthly utility bill. 

``It was all done in a real hurry,'' said Keith Stamm, the only member of the board to vote against the deal. ``The whole board is so desperate to try to find a way to raise money, they see this floated in front of them as a big-time amount of money and they want to go forward with it.'' 

Local governments from Augusta, Georgia, to Oakland, California, are being lured by similar opportunities to speculate with derivatives created by the world's biggest banks. Most of the $400 billion of private agreements sold to municipalities escape taxpayers' notice and are little understood by the public officials and administrators who approve them. 

Risky Practice 

``It's a recipe for disaster and it's also a recipe for sharp practices by charlatans,'' said James Cox, the Brainerd Currie Professor of Law at Duke University and a securities law specialist. ``The gains that a community stands to derive from this are at the margins and the risks they're exposing themselves to, frequently, are greatly in excess of what the expected rewards are.'' 

While financial firms often promote the agreements as a way for municipalities to lock in borrowing costs for future projects, the swap bought by Reading amounts to a bet on the relationship between short-term and long-term interest rates. If long-term rates rise higher than short-term rates, the municipalities will profit from the agreement and vice-versa. 

Trading, Not Hedging 

``It's more of a trading strategy than a hedging strategy,'' said Peter Shapiro, managing director of South Orange, New Jersey-based Swap Financial Group, which advises governments on derivatives including interest-rate swaps. ``All transactions include an element of speculation. The ones which are more speculative, like the yield-curve swap, are only suitable for issuers who are more sophisticated.'' 

A derivative is a financial contract whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather. A swap is a type of derivative, where parties agree to exchange interest payments, usually a fixed payment for one that varies based on the movements of benchmark indexes. 

The school board paid Frankfurt-based Deutsche Bank $575,000 to arrange the contract, known as a constant maturity swap, and awarded $400,000 to its financial advisers, including Reading-based Concord Public Financial Advisors Inc. and lawyers for arranging the trade, school officials said. 

Ted Meyer, a spokesman for Deutsche Bank in New York, declined to comment on whether the agreement, also called a yield-curve swap, was suitable for the school district. Concord principal Mike Setley didn't return calls seeking comment. 

Unemployment Rate 

Dennis Kelley, the school district's director of finance, said he was ``surprised'' to learn he owes $230,000. He said the district would pay the money using proceeds from another interest-rate swap. 

Reading is a town of 80,000 about 60 miles (96.5 kilometers) northwest of Philadelphia where the unemployment rate is almost twice the U.S. average. 

The town depends on state funding for $106 million of its $162 million school budget. Enrollment has grown 24 percent in the past decade, while the tax base dropped by about 6 percent, according to school district documents. Almost 70 percent of the students come from poor families. Schools are overcrowded and some are more than 80 years old. 

The contract was approved after Concord said the swap ``would allow us to get some cash now to help the district,'' said Pierre Cooper, a social worker and the former board president. ``I don't know the particulars off the top of my head.'' 

William Cinfici, another board member and a registrar for the state's division of vital records, said Concord didn't provide enough financial information to evaluate the transaction. 

`Nobody Questioned It' 

``It was arcane, nobody questioned it,'' Cinfici said. ``Everything was presented to us at the last minute. I said, `Well, I'll trust in the guys' judgment.''' 

Stamm, a real estate broker and the current president of the nine-member board, said Concord told the board the swap was ``a roll of the dice.'' 

Reading, like most municipalities, borrows with long-term bonds. The most recent bond the school district sold in December 2005 has a final maturity of 2036. The interest-rate swaps that Reading and other borrowers are purchasing are typically matched to the maturities of bonds that have been issued. 

Reading Swap 

The Reading contract is based on $103 million of zero-coupon bonds issued by the district in 2003 that come due from 2026 to 2034. Reading is required to pay Deutsche Bank the equivalent of 67 percent of the one-month London interbank offered rate, a lending benchmark, plus 0.3 percent every Jan. 15 and July 15. That amounts to about $2 million for the period ending this week. 

In return, Deutsche Bank must give the district a rate equivalent to 66 percent of the so-called five-year swap rate, which is the interest rate a borrower is willing to pay to exchange fixed payments for those that reset each month. That totals about $1.77 million for the period. The difference amounts to the $230,000 the district owes Deutsche Bank. Only the net payment changes hands. 

The contract became a money loser because the five-year swap rate has declined to 5.145 percent from 5.5945 percent in July. Meantime, Libor dropped to 5.32 percent from 5.37 percent, according to data compiled by Bloomberg. 

Reading's schools will profit if five-year rates are higher relative to one-month yields. That's been the case 80 percent of the time during the past 10 years, according to Citigroup Inc., the biggest underwriter of municipal debt. 

``So long as interest-rate relationships return to normal conditions, this transaction should provide a significant financial benefit to the school district,'' Concord said in a memo to the district May 22. While Reading is paying now, it may earn money on the swap over time. 

Over the Counter 

The swap market is unregulated and trading occurs over the counter, so municipalities can't be sure they are getting the best price on contracts. In Jefferson County, Alabama, one of the tens of thousands of borrowers in the municipal bond market, officials have bought $5.8 billion of swaps. Officials there have received subpoenas from the U.S. Securities and Exchange Commission asking about the swaps. 

An August 2005 Bloomberg News article reported that New York-based JPMorgan Chase & Co. overcharged Jefferson County by $45 million for swaps tied to sewer debt. The SEC has subpoenaed three current and two former county commissioners asking for records related to bond issues and swaps sold since January 2002. 

Diverging Interests 

The Internal Revenue Service has probed whether the mispricing of municipal swaps has allowed advisers and banks to make excessive fees, depriving the federal government of earnings from the investment of tax-exempt bond proceeds. The U.S. Justice Department and SEC have asked for information on swaps as part of an antitrust investigation into alleged bid- rigging in the $2.3 trillion municipal market. 

In the Reading deal, Pottstown, Pennsylvania-based Investment Management Advisory Group worked with Concord to set up the swap, according to the May 22 memo from Concord to the district. The firm, known as Image, also worked as a consultant to Deutsche Bank, records of the swap contract show. 

Federal regulators haven't said if they are probing the Reading deal. Reading hasn't been contracted by any regulator agency about the investigation, said Stamm. 

The dual roles illustrate conflicts of interest that occur in the market, said Andrew Kalotay, chief executive officer of Andrew Kalotay Associates Inc., which advises corporations, federal agencies and municipalities on debt management. 

Image Raided 

``Even though the swap adviser's client is the municipality, their financial interests are not aligned,'' Kalotay said. ``The swap adviser is paid only if there is a transaction, and the larger the transaction the larger the fee, so there is an inherent conflict.'' 

Deutsche Bank spokesman Meyer said the bank doesn't have a business relationship with Image. ``The school district directed us to make that payment,'' Meyer said. ``It's as if they had a lawyer and had to pay their attorneys.'' 

Image was among three brokers raided in November as part of the U.S. antitrust probe. The firm, which is cooperating with investigators, declined to comment on the Reading deal. Image has said it is ``confident that our business practices and employees will be fully vindicated as this investigation continues.'' 

Concord said Deutsche Bank won the business after beating proposals from four banks, according to the May 22 memo. Concord didn't arrange a public auction to get the lowest cost for taxpayers. Deutsche Bank offered to do the swap for a commission of 5.75 basis points, compared with no less than 6 basis points from the other companies, Concord said in the memo. A basis point is 0.01 percentage point. 

`Pay for Ingenuity' 

Kentucky's Louisville-Jefferson County Metropolitan Sewer District, the city of Port St. Lucie, Florida, and Augusta, Georgia have purchased similar swaps. Image made $400,000 brokering two swaps with New York-based Morgan Stanley and Deutsche Bank for the Louisville sewer district. 

Mountain States Health Alliance, a 1,100-bed hospital system in eastern Tennessee bordering the Appalachian Mountains, paid an adviser, Public Advisory Corp., almost $3 million to help arrange three swaps totaling $483 million with Merrill Lynch & Co. 

``We really act as bankers,'' said Steven Pischke, president and chief executive officer of Atlanta-based Public Advisory. ``We come up with ideas, we develop them. You need to pay for ingenuity and for new ideas.'' Pischke said the cost to Mountain States was within ``industry standards.'' 

Lowest Fees 

Marvin Eichorn, the hospital system's chief financial officer, said he understood the risk and got the best deal possible. The hospital took bids from two banks and New York- based Merrill proposed the lowest cost, Eichorn said. He declined to name the other bank and said the hospital didn't need to seek more bids because Public Advisory would ensure fair pricing. 

``We've always gone with whoever had the lowest fees,'' Eichorn said. Swaps have saved the hospital more than $1 million on its debt-service costs, he said. 

More than 70 Pennsylvania school districts have notified the state they planned swaps with banks including Morgan Stanley, Wachovia Corp. and JPMorgan since 2003, when state legislators permitted them. The law requires districts to hire an independent financial adviser to ensure the swap is appropriate and help develop an ``interest-rate management plan,'' which analyzes the benefits and risks of swaps. 

Reading has done two other swaps with Charlotte, North Carolina-based Wachovia. 

``Why are municipalities doing these swaps?'' Kalotay said. ``There may be legitimate reasons such as managing their mix of fixed- and floating-rate debt, but all too often they get talked into speculative deals. And if speculation is the goal, why not pork belly futures?'' 

To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net . 

Last Updated: January 17, 2007 00:05 EST