I’ve been late to write up an important series published by the Chicago Tribune earlier this month on a costly swaps misadventure by the Chicago Public Schools. Like all too many state and local government entities, the Chicago Public Schools were persuaded to obtain $1 billion of needed ten-year financing not through the time-and-tested route of a simple ten year bond sale but the supposedly cost-saving mechanism of issuing a floating-rate bond and swapping it into a fixed rate. An impressive, expert-vetted analysis of the deal by the Chicago Tribune estimated that the school authority has in fact incurred $100 million in present-value losses on that $1 billion bond issue.
What is important about this story is that the CPS’ sorry experience has been replicated at state and local entities all over the US and abroad, yet remarkably few have been willing to sue. In some cases, it’s likely that rank corruption was involved, that the consultants hired to vet the deal were cronies and not up to the task, or worse, that key people at the issuer were overly close to the banks involved. In other cases, officials are afraid of banks, that if they sue them, they’ll be put on a financing black list and will have trouble fundraising. That’s nonsense by virtue of how competitive and fee-hungry bank are. And the more government authorities that got the nerve to sue, the less noteworthy any particular case would be.
As the series explains, entities like the Chicago Public Schools has previously been protected from their naivete by not having the authority to engage in fancy finance. But the state of Illinois passed legislation in 2003, written by a lawyer at an in-state bond firm, even though no local entity had asked for these new powers. Here is how local governments were set up to be shorn:
The bill specified that any government able to issue at least $10 million in bonds could enter an interest-rate swap, making the deals accessible to towns with populations as small as 12,000. Lawmakers did not put even that restriction on auction-rate bonds.
The law also gave municipal officials explicit permission to raise taxes in order to pay interest on swaps.
Yet despite the potential risks to taxpayers, the bill included few oversight measures or checks on towns and school districts. For example, the bill did not cap the percentage of debt that could be issued at floating rates. In CPS’ case, that amount at one point rose above 40 percent. The state of Illinois, by comparison, is restricted to 20 percent.
Few Illinois government entities took advantage of the new, um, flexibility, but the Chicago Public Schools did in a big way, issuing $1 billion of auction rate securities by 2007 and swapping them into fixed rates. That amount of auction-rate securities issuance was not only more than any other school district in Illinois issued, it was more than was sold by the state of California. Crisis followers no doubt recall that the auction-rate securities market promised investors that the instruments were almost as liquid as money-market funds, and they could get cash back in weekly auction. The reality was that there was not enough investor buying at auctions. Dealers were supporting the auctions and carrying more and more inventory. When the monoline insurers were facing downgrades, which would have left the investment banks with losses (most issues were guaranteed by monolines), dealers dumped their inventories and quit supporting the market. The deals had clauses so that if the investor was unable to get his money back at a weekly auction, the issuer, here meaning Chicago Public Schools, would have to pay a much higher interest rate.
And that’s before you get to the swap losses.
The story shows a not-surprising backstory: bankers were actively soliciting the Chicago Public Schools with proposals involving auction-rate securities, the hot product of the day. CPS hired a politically connected former banker to evaluate the deals. Any regular reader of this site no doubt has figured out that it takes a high level of expertise to evaluate derivatives, and that’s well beyond the skill level of most “bankers”. The open question here. Even so, in this case the analysis was so slipshod that it raises the question of whether the advisor ever intended to do anything more than provide a paper trial supporting going ahead with the deal. From the Tribune:
To evaluate the complicated deals, CPS officials turned to Cepeda and her firm, A.C. Advisory.
Cepeda has an MBA from the University of Chicago and spent more than 10 years as a banker before founding A.C. Advisory. She also married into one of the most influential political families on Chicago’s South Side. Her late husband, Harvard-trained lawyer Albert Maule, was a grandson of Corneal Davis, a longtime state senator known for delivering black votes for Chicago’s Democratic machine. Maule later was appointed to the city’s police board by then-Mayor Richard M. Daley.
Five months before Maule died of cancer in 1995, he helped Cepeda start A.C. Advisory, according to a 2013 Tribune profile. The firm got its first contract with CPS months later, and Cepeda continues to advise the district and the city. A.C. Advisory received about $4.7 million in fees on CPS deals from 1996 through 2013.
Cepeda’s firm was the primary adviser on three of CPS’ four auction-rate deals, district records show; on the first such deal, she was the secondary adviser….
Spreadsheets from A.C. Advisory on three bond issues from 2003 and 2004 showed that the district stood to save nearly $90 million in interest costs over the life of the bonds by using auction-rate securities and swaps instead of traditional fixed-rate debt.
But experts consulted by the Tribune questioned Cepeda’s analysis and her depiction of the risks involved. “This is not a sophisticated analysis,” said Northwestern’s Hagerty, who reviewed the spreadsheets.
For one, the calculations were based on a worse credit rating than the district had at the time. They also ignored the fact that CPS always bought insurance on its fixed-rate bonds, which results in better interest rates. Both of those decisions drove up the predicted cost of the fixed-rate option.
In an email to the Tribune, Cepeda said the rates she used were based on the rates CPS likely would have paid.
More significantly, her analysis assumed that the interest-rate swaps linked to the auction-rate bonds would insulate the district completely from fluctuating rates. It predicted that the district would be responsible only for the fixed-rate payments specified in the swap.
But the auction rate CPS would pay on the bonds and the floating rate it would receive from the swap were unlikely to match exactly.
The swaps in A.C. Advisory’s analysis were relatively inexpensive products linked to the London Interbank Offered Rate, or Libor, the rate banks charge one another for short-term loans. Experts say that rate cannot be counted on to move in lockstep with municipal bond rates, particularly auction rates. In the years ahead, they would diverge dramatically.
Eventually auction rates would soar above Libor, reaching as high as 9 percent and eating into the projected savings. But while the bond contracts mentioned the possibility that payments could hit these maximum rates, A.C. Advisory did not point out that potential cost in any of the documents that CPS supplied in response to the Tribune’s public records requests.
That worst-case scenario should “absolutely have been clearly laid out” in any analysis comparing the cost of fixed-rate debt with auction-rate bonds, said Florida Director of Bond Finance Ben Watkins, who chairs the debt committee of the Government Finance Officers Association.
The district’s use of swaps also jacked up the cost of refinancing the bonds in the future and left the district unlikely to benefit if rates dropped — a risk Watkins said he would never take.
“You’re taking a position that rates will never be better,” he said.
The story also reports that an advisor that warned against the deals was given the cold shoulder by the Chicago Public Schools’ staff.
If you can only read one part of this series, I recommend the story on the last auction rate securities deal that CPS did, in July 2007, which also proved to be the most costly to the district. The city’s agent, Bank of America, clearly knew that the auction rate securities market was in trouble, yet pressed the Chicago Public Schools to do the deal.
The school district may well have recourse, and the Tribune series has led to calls for try to recoup some of the baked-in losses. Rahm Emanuel has pooh-poohed the idea, saying “there’s a thing called a contract,” so the idea of using the threat of withholding the city’s future business to force banks to the negotiating table won’t be deployed. But there are other options:
CTU [Chicago Teachers Union] Vice President Jesse Sharkey waved what he said was an application for arbitration with the Financial Industry Regulatory Authority, a self-regulatory organization that operates the largest dispute resolution forum in the securities industry.
It’s not clear whether the six-year window to file a FINRA claim is still open. CPS inked its last swap contract in 2006, and in 2008 the worsening economy aggravated the deals. Brad Miller, an attorney and former congressman who has worked with the Chicago Teachers Union, believes a lawsuit would be a better course of action.
“Illinois law does not apply the statute of limitations to claims by government entities,” he said in an email. “The city and CPS can bring claims in court under Illinois state law and not have a timeliness problem.”
I’m not keen about FINRA arbitration since SEC commissioner Kara Stein has called out the regulator for issuing paltry fines. But perhaps more important, local politicians need to feel more heat. If you are in Illinois, call or write your state legislator, and if you are in Chicago, write or call the mayor’s and the Chicago Public Schools’ offices.