Professional Documents
Culture Documents
December 3, 2009
Enclosed please find my review of your recent investigation of the Bethlehem Area School
District swap financing.
I am submitting this study to you for your review prior to distributing it to the same distribution
list you included in your study.
If you have any questions or wish to discuss my findings, you may contact me at the above
address and phone number.
Sincerely,
John G. Black
ANALYSIS OF
"A Special Investigation of the Bethlehem Area School District, Lehigh/Northampton Counties A Case
Study of The Use of Qualified Interest Rate Management Agreements ("Swaps") By Local Government
Units in Pennsylvania, With Recommendations."
On November 18, 2009, the Office of the Auditor General for Pennsylvania published a study
which purports to analyze the swap agreement entered into between the Bethlehem Area School
District and J.P. Morgan.
The investigation states that the Bethlehem Area School District entered into various interest
rate swaps and that because of those swaps, the district incurred a loss in their financing of over $10
million, versus issuing a standard, fixed rate bond issue in 2003.
The study also claims that the district incurred additional charges of over $15 million versus
financing the projects without the use of swaps. However, the study later correctly cautioned that
municipalities should not finance a long term project solely on a floating rate basis because of the
unlimited risks the issuer could incur in the event of an increase in interest rates.
Based solely upon the study, it appears that the wrong conclusion may have been reached. Not
only did the district not lose the $10 million claimed, but had the district not been "...forced to pay the
investment bank J.P. Morgan $12.3 million to terminate..." the swap on May 1, 2009, it would have
generated a $7 million profit versus issuing conventional, fixed rate bonds.
The study does not explain why the district was "forced" to terminate the swap. However, it can
be presumed that the negative publicity by both national and local news organizations may have had
some impact on the decision process. Regardless, that decision, apparently reached by coercion, did
more damage to the district than any decision they could have made relating to the financing.
The Analysis
On or about May 1, 2009, the School District issued $84,120,000 of fixed rate bonds. That issue
is shown in Exhibit I, titled "Bethlehem Area School District, Bond Issues "A" and "AA" of 5/1/2009". That
issue raised approximately $86 million and required the district to repay about $119.5 million over the
next 14 years.
Exhibit II reflects the sources and uses of funds for the issue of 2009. Approximately $86 million
was the net proceeds from which $72,344,610 was used to repay the floating rate notes, $12,410,000 to
repay the mark to market value for swap counterparty, J.P. Morgan, and to pay about $1.2 million in
costs of issuance fees such as underwriter discount, printing, rating, insurance and legal fees.
Exhibit III is a yearly present value analysis. While I certainly understand that bonds are sold with
semi-annual compounding, the data was only available on an annual basis. This exhibit reflects that
interest rate which is required to discount all the payments the district made or will make on its
financing to the present value of what the district received on April 29,2003. This is the effective net
interest the district incurred on its debt. That rate is 4.928146%
In determining the debt service payments, those payments from fiscal year 2010 to and
including fiscal year 2024 are those shown in Exhibit I. The payments from fiscal year 2004 to and
including fiscal year 2009 are from the study, page 22. In order to avoid double counting, the mark to
market fee paid the J.P. Morgan for termination of the swap is excluded from the fiscal year 2009 total,
since that payment was funded in the bond issue and is included in future debt service payments.
However, looking at only the discount rate by itself is meaningless. What matters is how does
the financing path chosen compare to what was available in the market at the same time. Fortunately, a
neighboring school district, Northampton, issued a comparable fixed rate bond issue at approximately
the same time.
Exhibit IV reflects the debt service Northampton incurred on its $59,495,000 bond issue of April
15, 2003. That district raised approximately $60.2 million, incurring cumulative debt service of
approximately $97.5 million until fiscal year 2026.
Exhibit V reflects the sources and uses of funds, showing proceeds $60,242,622.60 with
expenses of $591,502.41, giving the district $59,651,120.19 of net proceeds. Exhibit VI is the present
value analysis of the debt service showing that the effective interest rate Northampton will pay is
4.334806%, again on an annual basis. To show the impact of the fees that district had to pay on its
effective interest rate, the yield of the gross proceeds was 4.2839%, a difference of over 9 ½ basis
points.
Exhibit VII is a present value analysis of the Bethlehem debt service from Exhibit III discounting
those payments at the yield of the Northampton bond issue. It shows that the value of the debt service
for Bethlehem, discounted at the Northampton yield, was worth $82,434,230.69. Bethlehem received
$77,100,035.00 for those payments, meaning they "lost" $5,324,195.69 versus doing a "conventional"
fixed rate bond issue.
But this loss is after paying J.P. Morgan $12,410,000 for a mark to market loss that the district
was "forced" into paying. If this "loss" in mark to market is excluded because the district was forced into
making the payment, the financing path chosen by the school board would have actually saved the
district over $7 million.
While the study failed to include any analysis prepared by J.P. Morgan, a brief review of interest
rates during the period April 2003 to September 2009 reflects exactly what happened and suggests that
the termination "fee" was not a payment to J.P. Morgan which it counted as income, but rather the
amount of market value losses the district incurred by terminating the swap early.
On April 29, 2003, municipal rates, according to the Federal Reserve were 4.58% while ten year
U.S. Treasury Rates were 3.88%. With these two yields, since municipal rates exceeded Treasury rates by
70 basis points, the district should have been paid approximately $3.5 million dollars to enter into the
swap. According to the analysis they were actually paid $3,465,000.
By May 1, 2009, municipal rates had risen from 4.58% to 4.70% while Treasury rates had
declined from 3.88% to 3.08%. The difference in rates, which was beyond the control of the district, had
moved adversely by 92 basis points. This would have produced a mark to market loss in excess of
$12,300,000. Had Northampton been required to mark to market their bonds, their comparable loss
would have been over $9 million.
However, by September 30, 2009, municipal rates had fallen to 3.94% while treasury rates had
risen to 4.02%. This was a net move of over 160 basis points in the district's favor. Had the district
waited only 4.5 months, instead of paying $12 million it would have collected over $1 million in
termination fees.
The last exhibit, Exhibit VIII shows the funds the district would have gotten had it sold its
refunding bonds on September 24, 2009 at the same rates as Upper Saint Clair School District, issued the
same day. Had the school district waited those four and one-half months, it could have sold a bond issue
with the identical debt service of the April 2009 issue of $119,491,000 but instead of proceeds of $86
million, it would have received $90.9 million, a difference of $4.9 million.
In summary, had the district not been forced into selling its bonds in April of 2009 and waited
until September of 2009, less than five months, it could have gained $4.9 million in additional bond
proceeds for the same debt service; instead of paying $12.4 million to terminate the swap it would have
collected about $1 million. In total, almost an $18 million swing in the fortunes of the district, all
because they were "forced".
Conclusion
In my opinion, not only did the Bethlehem Area School District pursue a conservative path in
financing its capital expenditures, excluding the 2009 refinancing it was coerced into doing, the financing
option chosen actually saved the district almost $7 million over the last five years.
Instead of focusing on some sort of wrong doing in an instance where it in all likelihood does not
exist, a more useful role for the office of Auditor General may be in educating local municipalities and
their advisors on financing options, including the use of swaps. Instead of blaming the board, the
administration and the business manager for having chosen a financing option they thought was in the
best interest of the local community, maybe more education would be a better choice.
In my opinion, based solely upon the report, the investigation submitted should be withdrawn. I
believe it is unsubstantiated and draws erroneous conclusions and is more of a political statement
rather than an audit investigation.
Sincerely,
* Series AA
Exhibit II
Less:
Prepay 2003 WCTMA Notes 72,344,610.66
Mark to Market Termination Fee 12,410,000.00
Costs of Issuance 1,196,827.84
Rounding 57,380.13
86,008,818.63
Exhibit III
140,168,082.78 77,110,035.00
The Net Interest Rate Required to Discount the Debt Service Payments
To the Net Proceeds Received by the District is 4.928146%
Date Par Coupon Price Proceeds Interest Debt Svc Annual Debt Svc
Less:
Total 591,502.41
97,455,149.58 59,651,120.19
The Net Interest Rate Required to Discount the Debt Service Payments
To the Net Proceeds Received by the District is 4.334806%
The Costs of Financing Raised the Effective Cost by 9.6 basis points
Exhibit VII
140,168,082.78 82,434,230.69
Fiscal Year Par Coup Price Proceeds Interest Debt Svc Prior Diff