Some say water authority's deals soaking the ratepayer

'Swap contracts' carry high insurance premiums, consulting fees

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For most city households, paying their water bills now means covering the principal and interest on a complex $414 million debt package that includes $18.5 million in insurance premiums, consulting fees and payments to terminate 1-year-old contracts.

Those are some of the costs of the Pittsburgh Water and Sewer Authority's foray into the world of swap contracts -- financial tools that have the authority and financiers JPMorgan Chase and Merrill Lynch making ever-changing payments to each other.

Nationally, some swap deals have won kudos for their effectiveness at raising low-cost public money, but others have become the subject of criticism and a broad federal investigation.

Water authority officials said the package, sealed last month, gets them $98 million to improve pipes and the Highland Park water treatment plant without raising rates.

"We knew we needed to make capital improvements," said state Rep. Don Walko, chairman of the authority's board. The deal "was very effective as far as saving us costs."

But city Controller Michael Lamb, who has been studying the deal, said it is anything but transparent.

"Why are we participating in these complex deals, when the board members don't understand them, they've caused huge losses in other communities in Pennsylvania and they've led to criminal [probes] in other jurisdictions?" Mr. Lamb asked, after the Pittsburgh Post-Gazette presented summaries of costs of this and other debt packages engineered by the city and its authorities since 2006.

The debt-ridden authority, which now owes $680 million, started down this complex fiscal road last year, when it entered a $158.9 million borrowing and swap package. JPMorgan Chase and Merrill Lynch each got $242,345 in fees from that deal.

It would lead to much bigger paydays, including $6 million for the bond companies in an early termination fee.

Swaps are arrangements in which two parties agree to pay each other changing amounts of money based on shifts in interest rates or other financial measuring sticks. For decades, big investors have used swaps to hedge their other financial bets.

Government agencies have long raised money primarily by selling fixed-rate and variable-rate bonds to investors. Early this decade, some started using swaps, too.

The water authority's 2007 swap was done with this year's deal in mind. It locked in some rates and costs, but only if the authority borrowed again by late spring.

And so it did, crafting the $414 million mix of new and refinanced bonds and swap contracts. It was crafted to bring in $98 million without forcing a rate increase. It did so by changing a debt schedule that had the authority's $42 million-a-year payments trailing off after 2029, extending that level of payment out to 2040.

According to Jason DiMartini, a director at PNC Capital Markets, which advises the authority on financial matters, the swaps had the effect of lowering the interest on some of the debt by half a percentage point, to 3.9 percent, saving millions of dollars.

The costs of last month's package, though, don't have recent precedent, with insurers and professionals taking $12.5 million, or 3 cents on the dollar -- double what the city and its agencies have been paying on bond deals.

"Absolutely, it's high," said Mr. Lamb. He noted that part of the rationale for the 2007 deal was that it capped costs for a future package. "When they went into the swap deal, the authority was sold a bill of goods."

The biggest payment went to global insurance firm Financial Security Assurance, or FSA, which got $10.1 million to back the authority's promise to pay the bond buyers some $880 million in principal and interest over 33 years. On a percentage basis of money borrowed, that amounts to a tripling of the $1.25 million FSA got to insure the authority's 2007 package.

Why the big jump? Mr. DiMartini said the cost was driven up by the collapse of the subprime mortgage industry. The resulting financial crisis crippled five of the seven firms that used to insure municipal debt, and the other two jacked up premiums.

Some premiums were locked in as part of the 2007 deal, he said, and if it wasn't for that, FSA would have demanded $3 million more this year. The authority could have gone without the insurance, and instead pay higher interest rates, he said, but it calculated that buying the insurance was cheaper.

PNC got $414,150 from this year's debt package for advising the authority, on top of $159,000 it was paid last year. Mr. DiMartini said he provides year-round advice for the authority, and only gets paid when it borrows, getting $1 from every $1,000.

That kind of contract goes against Government Finance Officers Association recommendations. That organization says financial advisers should get a set annual amount or an hourly fee, and that tying their payment to borrowing creates "the potential incentive for the financial adviser to recommend the issuance of bonds."

JPMorgan Chase, Merrill Lynch and Commonwealth Securities and Investments got a total of $1.27 million in fees for underwriting this year's package. That's for agreeing to buy the bonds at negotiated interest rates, and then keep or sell them.

The underwriters' seven-figure cut, though large, represents a smaller slice of the amount borrowed than underwriters got in recent borrowing deals by the city, its Urban Redevelopment Authority, or the joint city-county Allegheny County Sanitary Authority.

The water authority "was treated as a premium client and given great pricing" compared with other borrowers, Gregory Zappala, managing director of JPMorgan Chase's Cranberry office, wrote in an e-mail response to questions.

The fees are lower on a percentage basis than the $1.18 million his firm and PNC Capital Markets shared for underwriting Pittsburgh's $242 million refinance package in 2006.

Those fees, though, were not all that the players got.

Mr. DiMartini said the authority had to pay JPMorgan Chase and Merrill Lynch a total of around $6 million for early termination of some of the swap contracts signed in 2007, even though it issued the first set of bonds with plans for the second one a year later. He said swap contracts typically require such payments from one party or the other when they're ended before their decades-long terms. The $6 million came out of the $414.15 million borrowed, he said, but was more than offset by the interest rate savings.

The amount initially was estimated at as high as $11 million, but dropped when interest rates changed. The firms conceivably could have paid the authority if the rates had changed even more.

Swaps can be good deals. The New York Metropolitan Transportation Authority won governing awards for using swaps to restructure and reduce $18 billion in debt early this decade.

When interest rates and other economic measurements take unexpected turns, though, swaps can be disastrous.

Swaps engineered by JPMorgan Chase in Jefferson County, Ala. -- home to Birmingham -- have become the subject of federal Securities and Exchange Commission and Department of Justice probes. According to the Bloomberg business reporting service, the investigations focus on hidden fees from a series of 17 swaps to finance water and sewer work that left Jefferson County on the brink of default.

The agencies also are looking at whether JPMorgan Chase and others conspired to fix swap prices nationally, according to Bloomberg.

On April 30, the SEC announced its first enforcement action related to municipal swaps: a civil lawsuit against the mayor of Birmingham, a broker and a lobbyist, alleging that the three funneled secret payments stemming from the swaps. The news release announcing the action said the investigation continues.

Closer to home, in Erie, a swap contract engineered by JPMorgan Chase for that city's school district has gone awry, reportedly leading to a $2.9 million bill for the district, which only got $785,000 from the deal.

Rating agency Standard & Poor's found that the Pittsburgh Water and Sewer Authority's swaps presented low to moderate risk, with catastrophic results likely only if the credit ratings of JPMorgan Chase and Merrill Lynch plunge.

Rich Lord can be reached at or 412-263-1542.


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