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U.S. tax reform pushes towns to reconsider risky interest-rate swaps

The new U.S. Senate and House tax plans would restrict tax-free municipal bond sales, forcing hospitals, colleges, and governments to consider interest-rate swaps, which were often linked with "misuse and abuse" during the last recession.

Former Pennsylvania Gov. Ed Rendell signed a law in 2003 law freeing investment bankers to sell swaps and other derivatives to Pennsylvania local governments.
Former Pennsylvania Gov. Ed Rendell signed a law in 2003 law freeing investment bankers to sell swaps and other derivatives to Pennsylvania local governments.Read moreAP

Swaps are back.

The new U.S. Senate and House tax plans would limit cities, school districts and other local governments from continuing to raise cheap funding for hospitals, private colleges, and developers. They would also keep them from refinancing high-rate debt with cheaper "advance-refunding" bonds, by restricting income tax exemptions to only apply to plain-vanilla government borrowing.

So local governments, and the investment bankers who make their living finding ways for public officials to borrow and repay at convenient terms, are considering alternatives. They're taking another look at interest-rate swaps and other creative financing — instruments sometimes associated with "misuse and abuse" during the last recession — municipal bond analyst Eric Kazatsky says in a new report to clients of Bloomberg Intelligence.

The House tax-reform bill that passed on Thursday would still allow private and nonprofit bond sales and refinancings, but at taxable interest rates, so these projects will become a lot more expensive to finance, research analyst Shawn P. O'Leary reported to clients of bond dealer Nuveen Asset Management last week. (Existing tax-free bonds would still be protected from income taxes — driving up their resale value.)

Interest-rate swaps are contracts that allow investors to trade a bond's fixed- or variable-rate interest payments for a different stream of cash. In exchange for favorable initial terms, the swaps can be used as a hedge against interest-rate changes. They also commit the borrower — taxpayers, in this case — to paying extra if interest rates move unexpectedly.

Kazatsky says swap use could be revived to help borrowers avoid tax-free borrowing limits, and lock in lower rates for future projects. Contracts like swaps are called derivatives because their value is derived from outside indicators, in this case, interest rates.

Swap contracts involve betting "on the future direction of interest rates," Kazatsky wrote. Up front, "the savings are hard to ignore." With Federal Reserve interest rates expected to go higher, towns could use swaps to help lock in minimal financing costs.

But swaps carry the risk that rates won't move as expected. That "could easily erase any savings," Kazatsky warned. When towns bet against bankers and their investor clients, "there will always be one side that wins and one that loses."

Swaps caused controversy in the last recession. Bloomberg's Martin Z. Braun and William Selway detailed how Pennsylvania towns felt ripped off when they had to pay Wall Street bankers hundreds of millions to get out of interest-rate swap contracts. So many towns got stuck paying millions to get out of swaps that then-Pennsylvania Auditor General Jack Wagner said towns should be prevented from buying swaps. Philadelphia officials resisted, arguing that swaps, used correctly, can save taxpayers money.

It was Gov. Ed Rendell who signed a 2003 law freeing investment bankers to sell swaps and other derivatives to Pennsylvania local governments. About 108 of Pennsylvania's 500 school districts bought swaps over the next nine years, according to a survey by Wagner. Pennsylvania "led all local government issuers" in swap use, Moody's found in 2009.

During those years, historically low U.S. interest rates went still lower — and stayed there — forcing governments that sought to borrow cheap using swaps to pay what amounted to expensive penalty surcharges to the bankers under terms of the swap arrangements.

Philadelphia public school officials estimated in 2012 that winding down swaps and swaptions (options to buy into a swap) inherited from the early and mid-2000s cost the city's cash-strapped schools $186 million.

Philadelphia didn't try too hard to get that money back: city officials told me they were confident a federal judge would send Bill Clinton/Rendell-era Democratic donor and swap seller David Rubin to prison. But the judge, Clinton appointee Kimba Wood, only gave Rubin probation, and city taxpayers ate the loss.

Philadelphia officials say a lot of the 2000s losses resulted from poorly negotiated contracts. Swap buyers should be able to cancel contracts when rates move against them, they say.

Indeed, "newer versions of swap contracts give borrowers an option of terminating the swap after a set time, with no termination fees," Kazatsky told me. Of course, bankers won't want to sell swaps so cheaply if they have less chance of profit.