Exotic Deals Put Denver Schools Deeper in Debt
In the spring of 2008, the Denver public school system needed to plug a $400 million hole in its pension fund. Bankers at JPMorgan Chase offered what seemed to be a perfect solution.
The bankers said that the school system could raise $750 million in an exotic transaction that would eliminate the pension gap and save tens of millions of dollars annually in debt costs — money that could be plowed back into Denver’s classrooms, starved in recent years for funds.
To members of the Denver Board of Education, it sounded ideal. It was complex, involving several different financial institutions and transactions. But Michael F. Bennet, now a United States senator from Colorado who was superintendent of the school system at the time, and Thomas Boasberg, then the system’s chief operating officer, persuaded the seven-person board of the deal’s advantages, according to interviews with its members.
Rather than issue a plain-vanilla bond with a fixed interest rate, Denver followed its bankers’ suggestions and issued so-called pension certificates with a derivative attached; the debt carried a lower rate but it could also fluctuate if economic conditions changed.
The Denver schools essentially made the same choice some homeowners make: opting for a variable-rate mortgage that offered lower monthly payments, with the risk that they could rise, instead of a conventional, fixed-rate mortgage that offered larger, but unchanging, monthly payments.
The Denver school board unanimously approved the JPMorgandeal and it closed in April 2008, just weeks after a major investment bank, Bear Stearns, failed. In short order, the transaction went awry because of stress in the credit markets, problems with the bond insurer and plummeting interest rates.
Since it struck the deal, the school system has paid $115 million in interest and other fees, at least $25 million more than it originally anticipated.
To avoid mounting expenses, the Denver schools are looking to renegotiate the deal. But to unwind it all, the schools would have to pay the banks $81 million in termination fees, or about 19 percent of its $420 million payroll.
John MacPherson, a former interim executive director of the Denver Public Schools Retirement System, predicts that the 2008 deal will generate big costs to the school system down the road. “There is no happy ending to this,” Mr. MacPherson said. “Hindsight being 20-20, the pension certificates issuance is something that should never have happened.”
A spokesman at JPMorgan, which led the Denver deal, declined to comment. Royal Bank of Canada, which acted as the school system’s independent adviser even though it participated in the debt transaction, declined to comment. Denver school officials said that they had agreed to sign a conflict waiver with Royal Bank of Canada.
Denver isn’t the only city confronted with budgetary woes aggravated by esoteric financial deals that Wall Street peddled in the years before the credit crisis. Banks have said the deals were appropriate for the issuers and that no one could have predicted the broad financial collapse that put pressure on the transactions.
Still, some municipalities have found such arguments wanting and are pushing back.
Last March, the Los Angeles City Council told its treasurer and city administrative officer to renegotiate interest-rate deals the city had used to try to lower its debt payments with the banks that sold them. “If they are unwilling to renegotiate, then those financial institutions should be excluded from any future business with the City of Los Angeles,” noted a report by the City Council.
In Pennsylvania, some school districts have unwound interest-rate deals, and the state’s auditor general, Jack Wagner, has urged other issuers to follow suit. “For the sake of Pennsylvania taxpayers, I call on the other school districts that have entered into similar swaps contracts to get out of these risky agreements as soon as they possibly can,” he said in a statement in February.
Financial stress from these deals could not come at a worse time for cities, towns and school districts already saddled with high costs and falling revenue. Although it is difficult to tally how many public entities entered into interest-reduction deals, a recent analysis by the Service Employees International Union estimated that over the last two years, state and local governments have paid banks that arranged these transactions $28 billion to get out of the deals, seeking to avoid further crushing payments.
Many transactions remain on public issuers’ books. S.E.I.U. estimates that New Jersey would have to pay $536 million to get out of its derivatives contracts, while California faces $234 million in such payments. Chicago is looking at $442 million in termination fees to unwind its transactions, and Philadelphia would have to pay $332 million.
Both Mr. Bennet, whom the White House has praised for his innovative approach to education, and Mr. Boasberg defend the deal they recommended in Denver back in 2008. They say that it has saved the school district $20 million it would have otherwise had to pay to cover the pension shortfall, and they maintain that no one could have predicted the credit crisis of 2008 that elevated the deal’s costs.
But the savings cited by the two men do not take into account termination fees associated with the complex deal. And had the school district issued fixed-rate debt, Wall Street would not have received the cornucopia of fees embedded in the more complex deal.
While the expenses associated with more complex transactions vary depending on the terms of the deal, Denver offers an example of the additional costs they can impose. So far, Denver has paid about $9.7 million more in fees for its deal than it would have had it chosen a simpler transaction.
Joseph S. Fichera, chief executive of Saber Partners, a financial advisory firm that specializes in structured finance, said that the type of transaction pursued by the Denver schools was a false solution for what the issuers want to achieve — lower long-term costs — because the banks selling the deals rarely quantified all of the potential risks involved.
“The issuer made a simple financing highly complex and took on substantial risk without knowing how large its downside could be,” he said, referring to the Denver deal. “The advisers and bankers may have disclosed that there were risks, but apparently did not help the issuer truly understand them. They typically present economic outcomes to the issuer only on projected savings and assume away any chance of the risks happening.”
$400 Million Gap In a Pension Fund
The Denver public schools needed to do financial contortions because, like many other public agencies nationwide, its pension plan did not have enough funds to meet the payments due to retirees. And for years, the school system had not met its required annual pension payments to ensure a fully funded plan; by 2007, the school system faced a $400 million gap.
The school system solicited advice from several banks on how to handle this problem and ultimately decided to issue bonds that allowed it to refinance its existing debt of $300 million, which had a fixed interest rate. It also raised an additional $450 million, most of which went into the pension to fill the gap in that plan. Together, $750 million was raised using the riskier pension certificates.
The Denver certificates contained debt issues that had variable rates and were to be resold to investors in weekly auctions; the arrangement carried an annual interest rate of around 5 percent, not counting fees and costs associated with that type of debt. Fixed-rate debt would have cost 7.2 percent.
Denver schools had issued pension certificates before, but this time the banks added a little spice to the recipe: an interest-rate swap that made the variable debt mimic a fixed-rate instrument. If prevailing rates fell, the school system would have to make up the difference to the banks. But if interest rates rose, the swap would protect the school system from having to pay higher debt costs.
It was a heady brew, one that required an unusual amount of financial expertise to assess. In that regard, Denver had an apparent advantage: Mr. Bennet and Mr. Boasberg.
Unlike many school district officials, both men were financially sophisticated and had worked together in the private sector. Mr. Bennet handled investments and structured financial deals for the Anschutz Investment Company, a private concern owned by the billionaire Philip Anschutz that has stakes in telecommunications and oil. Mr. Boasberg, meanwhile, was a deal maker in mergers and acquisitions at Level 3 Communications, a telecommunications concern.
“We looked at what the risks were,” said Mr. Boasberg, who has been superintendent of the Denver public schools system since early 2009.
But according to several members of the board of education, the bankers’ presentations for the 2008 debt deal outlined its risks only in broad terms, discussing, for example, what would happen if interest rates shifted or the economy weakened a bit. The banks provided no full-blown worst-case situations to the board, focusing instead on the transaction’s upside: lower debt costs and a potential saving of $129 million in pension costs over the next 30 years.
School board members also said that bankers had not discussed problems in the variable-rate debt market that arose the previous year — a development that would have alerted them to troubles they might have had securing a manageable rate on the debt that they were refinancing.
Nor, they said, had the bankers discussed the outright collapse of trading in auction-rate securities, a $330 billion market that ran aground in mid-February 2008. Auction-rate securities are very similar to the variable-rate debt the Denver schools were considering at the time; both types of securities involve periodic auctions sponsored by financial institutions to determine what interest rates will be paid by the issuer.