"Educate and inform the whole mass of the people...They are the only sure reliance for the preservation of our liberty." ~Thomas Jefferson

Gambling with Taxpayers' Money in Northampton Co.

Last week Northampton County Council voted to spend more than $25 million to buy the county's way out of a swaption deal gone bad.

In June 2004, the Council approved the risky refinancing of a $111 million, 30-year bond from 2001.  In return for swapping the fixed-rate bond for a variable-rate bond starting in October 2012, the county received an up-front payment of $1.9 million, less $300,000 in fees, to help ease short-term budget pressure. The hope was that a future rise in interest rates would mitigate the cost of the debt.  However, that didn't happen.  Interest rates have sunk to an all-time low and recent testimony from Federal Reserve Chairman Ben Bernanke indicates that rates will remain near zero until late 2014.  In the end, the county rolled the dice with taxpayer money and ended up losing $6.8 million.

The deal was controversial from the beginning.  Councilman Ron Angle (R) was a strong critic of the swaption and joined with fellow Council members Peg Ferraro (R), Ann McHale (D) and Wayne Grube (D) to vote against the deal on June 3, 2004.  Preliminary research shows that with the absence of Councilman Nick Sabatine (R), the voted ended up in a 4-4 tie with Councilpersons Michael Corriere (D), Timothy Merwarth (R), Mary Ensslin (R), and J. Michael Dowd (R) voting in favor of the gamble.  It appears that County Executive Glenn Reibman (D) broke the tie vote and the deal went though later that month (more research required).  Reibman's involvement in the swaption was scrutinized because of potential financial shenanigans involving bond consultant Mossie Murphy, who was involved with other swaption controversies in Bethlehem.

Last week's decision to buy out the swaption was no less controversial.  Council had taken a wait and see attitude for many years regarding the buy-out.  In that time, the payoff has climbed from $10 million in 2009, to $14 million in 2010, to $22.3 million in 2011, to more than $25 million today.  Though Council has set aside $14 million to help with the payoff, the additional $11 million hit in the 2012-2013 county budget is hefty.  Councilman Lamont McClure (D) argued that "cutting such a large check would hamstring county operations and future budgets, [warning] he would not vote for a tax increase next year if the council chose the $25 million option."  In the end the vote for the costly buy-out passed 5-4, with Councilpersons Scott Parsons (D), Bob Werner (D), Peg Ferraro (R), Barbara Thierry (R), and Bruce Gilbert (R) voting in favor, and council members Lamont McClure (D), Ken Kraft (D), John Cusick (R), and Tom Dietrich (R) opposed.  According to MClure, the $25 million buyout may set a record for the state.

What's most frightening is that this gambling with taxpayer money is happening throughout the country and especially here in Pennsylvania.  Just last year, taxpayers in the Bethlehem Area School District payed $8.2 million to terminate one

of their many outstanding swaption deals "in ongoing efforts by the district to get its financial house in order after heavy investment in swaps erased millions in district tax revenue." But, local school districts and municipalities in the Lehigh Valley in not alone.  An article on Bloomberg.com in 2008 highlighted derivative problems throughout Pennsylvania.  In the Erie School District, for example, the board had to pay $2.9 million to get out of a swaption deal gone bad.  The article states that between 2004 and 2008,

...banks have pitched at least 500 deals totaling $12 billion like the one JPMorgan Chase sold to Erie, according to records on file with the state Department of Community and Economic Development. Most of the transactions -- which occurred outside the state's largest cities of Philadelphia and Pittsburgh -- have been made without public bidding, which means that banks and advisers privately arranged the deals with small school districts...In 15 Pennsylvania school districts, officials entered into interest-rate-swap deals worth $28 million since 2003, according to data compiled by Bloomberg. Of that dollar amount, the schools took in $15 million, and banks and advisers got the rest as fees...

Though risky swaption deals were occurring prior to 2003, such transactions were not sanctioned in Pennsylvania.  That is until Harrisburg got involved.  In response to the emergence of financial crises being experienced by counties, municipalities and school districts who entered into these bad deals, the government, as usual, with nothing but the best intentions, stuck their fingers into the mess.  In September 2003, the state Legislatures passed Act 23 (H.B. 1148), sometimes called the SWAP Act by a unanimous and bi-partisan vote of 197-0 in the House and 45-0 in the Senate.  This law "defines, and allows a local government to negotiate, an interest rate management plan, qualified interest rate management agreement, and qualified prepayment agreement."  In other words, local governments now felt they were permitted to enter into such deals.  According to the October 2008 PSBA Bulletin,

Pennsylvania has been relying on compliance with Act 23 and the diligence of elected and appointed local officials to avoid the "speculative" risks of derivatives. The primary question being asked today is whether the law and the actions by the applicable elected or appointed governing bodies are effective in reigning in the unwise use of derivatives. The answer is not clear at this time, in that the financial impacts of transactions that have failed or may fail may not have manifested themselves at this time but remain a substantial cloud over the issuing local entities. Act 23 of 2003 provides a valuable framework for decision-makers to engage in better informed public discussion, deliberation and decision-making regarding swaps.

Given the data, the questions posed by the PSBA have been clearly answered.  Instead of curtailing the "epidemic of sizable losses by public entities resulting from [swaptions]," the problem has expanded.  According to the Federal Register,

...a review of Pennsylvania Department of Community and Economic Development records revealed that 185 school districts, towns and counties in Pennsylvania have engaged in derivative transactions since 2003, when the State's law was explicitly changed to allow for such transactions.

Once again, instead of helping, government intervention expanded the crisis and brought great financial harm to additional counties, districts and municipalities who had probably never thought about gambling with their constituents' money before the state "sanctioned" it.  Had the state educated local governments about the dangers of derivative deals, siting the many examples of their failure, and passed a resolution discouraging such transactions, instead of passing a law that appeared to sanction the risky behavior, they might have nipped the problem in the bud.  In a recent article in the Morning Call, Vic Mazziotti was asked if swaptions should be illegal.  He answered:

In my opinion, local governments should not be permitted to enter into swap agreements. They are too dangerous. Governments should not be in the businessof gambling with taxpayers' money. If you go to the Sands and bet $1 million on "red," you could lose a million dollars, but only a million dollars. With a swap you may be paid a million dollars, but the potential loss could be, oh I don't know, say, $25 million! Not a good bet!

There are several lessons to be learned:

  1. As Ronald Reagan always said, "In this present crisis, government is not the solution to our problem; government is the problem."
  2. Instead of allowing public entities that engaged in this risky behavior to be burned and letting their failure set the example, the government exacerbated the problem by appearing to sanction the bad behavior.
  3. The government doesn't always know best, and instead of local governments "looking up" to them at the state and federal level and trusting their decrees, they should make their own decisions based upon common sense and what is best for their local constituents.
  4. This failure, not only in Northampton County, but in Pennsylvania is a bi-partisan one.  Both Republicans and Democrats are equally to blame.
  5. Taxpayers should never trust in the "diligence of elected and appointed local officials" and need to be intimately involved with their local governments and engaged in the process by expressing their their expertise and opinions in such financial dealings.  As Thomas Jefferson said, "Whenever people are well-informed they can be trusted with their own government."
  6. And, as Thomas Jefferson also said, "When a man assumes a public trust, he should consider himself as public property."  Elected officials must not forget it is not their money that they are gambling with, but their elderly neighbor's.

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