The 81-year-old Roosevelt Middle School was on the verge of being condemned. The district was running out of money to buy new textbooks. And the school board had determined that the 100,000-resident community 125 miles north of Pittsburgh couldn't afford a tax increase. Then JPMorgan Chase & Co., the second-largest bank in the U.S., made Barker an offer that seemed too good to be true.
David DiCarlo, an Erie-based JPMorgan Chase banker, told Barker and the school board on Sept. 4, 2003, that all they had to do was sign papers he said would benefit them if interest rates increased in the future, and the bank would give the district $750,000, a transcript of the board meeting shows.
``You have severe building needs; you have serious academic needs,'' Barker, 58, says. ``It's very hard to ignore the fact that the bank says it will give you cash.'' So Barker and the board members agreed to the deal.
What New York-based JPMorgan Chase didn't tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn't understand.
``That was like a sucker punch,'' Barker says. ``It's not about the district and the superintendent. It's about resources being sucked out of the classroom. If it's happening here, it's happening in other places.''
$12 Billion in Deals
It is. During the past four years in Pennsylvania alone, 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, the records show.
JPMorgan's Chief Executive Officer Jamie Dimon declined to say if he thought the bank's fee disclosure was proper and whether the bank acted in a fair, responsible and moral manner in Erie.
Banker DiCarlo declined to comment. JPMorgan spokesman Brian Marchiony says the deal gave the school district immediate debt savings and protected it against unpredictable interest rate risk in the future. He declined to answer specific questions.
Overpaying Fees
The Pennsylvania transactions involve interest-rate swaps, which are derivatives. Derivatives are financial contracts whose value is based on other securities or indexes; interest-rate swaps are tied to future changes in lending rates.
The Pennsylvania deals show that school districts routinely lose when making derivative deals. They pay fees to banks that are as much as five times higher than typical rates and overpay advisers by as much as 10-fold. That means banks often underpay schools on upfront amounts, as JPMorgan Chase did in Erie, public records show. And school officials aren't always well served by their supposedly independent advisers, whose fees are paid by the banks selling the deals -- only if the sale is made.
`Getting Fleeced'
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, Bloomberg data show.
``The school districts are getting fleeced,'' Pennsylvania Governor Edward Rendell says. The governor, 64, a Democrat who has been in office since 2003, says the state might in the future advise schools and municipalities on derivatives contracts before they sign with banks. Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he's concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales.
``It's a serious issue, not only in Pennsylvania but across the country,'' says Cox, 55, who has headed the SEC since 2005. ``That is what we have seen repeatedly. More often than not, the municipalities aren't configured to have financial sophisticates in charge of these offerings -- and the result is that the firms are the only ones who know what's going on.''
Just five years ago, municipal derivative deals weren't sanctioned in Pennsylvania, the sixth-most-populous U.S. state. Then, in September 2003, the state Legislature adopted a law allowing schools and towns to use interest-rate swaps to lower borrowing costs and raise cash.
Exchanging Payments
In a swap, two parties agree to exchange payments over a period of time that can last as long as 30 years. Typically, one agrees to pay a fixed rate and the other to pay a variable rate that changes with a benchmark index or formula defined in the contract.
Public agencies can benefit by using derivatives to guard against swings in borrowing costs or to lock in current interest rates for bond sales they might not make for years. In many cases, school districts use swaps as a way to refinance bonds they've issued in the past.
Derivative deals can bring banks fees three times higher than the traditional selling of municipal bonds, public records show. School districts don't know whether they're getting fair market values with swaps because the contracts are private; they don't know how to compare their deals with those done by other districts.
`Profits Are Greater'
This lack of transparency is a boon for the banks, says Christopher ``Kit'' Taylor, executive director from 1978 to 2007 of the Municipal Securities Rulemaking Board, a panel that issues rules on municipal bond sales.
``Business moves from transparent and competitive markets to markets where there is less transparency and the profits are greater,'' he says. ``If you don't know how much you're paying, you're going to be paying too much.''
The Pennsylvania swap law was passed after lobbying by financial advisory firms that stood to profit from such deals.
The legislation made the state a member of an expanding club. Forty states give government bodies explicit authority to make derivative deals, up from none 20 years ago, says David Taub, a lawyer who specializes in derivatives and is a partner at McDermott Will & Emery in New York.
Derivatives aren't regulated by the SEC, the MSRB or by states. Pennsylvania offers a clear look at these deals because, by law, all the contract records must be publicly filed with the state.
Pennsylvania Adviser
One derivative advisory firm that backed the Pennsylvania swaps legislation is Investment Management Advisory Group Inc., or IMAGE. The Pottstown, Pennsylvania-based company was raided by the Federal Bureau of Investigation in November 2006 in connection with a criminal antitrust investigation of bid rigging of investment contracts that are sold to states and municipalities.
The U.S. Justice Department is also probing municipal derivative deals. IMAGE has said it's cooperating with the probe. No charges have been filed.
In some Pennsylvania transactions, banks bought from school districts rights to exercise options on an interest-rate swap, or swaptions. Banks can choose to exercise the option if they stand to make money or can let the option expire if interest rates aren't favorable to them.
Banks Hedge Risk
The banks that arrange these deals create the swap contracts before pitching them to schools. Using software programs designed for valuing swaps, they calculate prices for which they can sell them after a school signs a contract. That's how the banks make money. For example, if a bank agrees to pay a district $800,000 in a deal it valued at $2 million, it could reap $1.2 million for itself and middlemen.
``They load it off instantly,'' says Taylor, who's now on the advisory board of Rockwater Municipal Advisors LLC, an Irvine, California-based investment firm.
Banks hedge their risk in derivative deals by making trades to cover possible losses to school districts. The banks make their money from fees, regardless of interest rate movements.
The reason Erie and other districts don't know how much the bank makes from a deal is because banks don't tell them, the records show. The money isn't paid immediately out of school budgets. Fees are hidden from schools because banks include those costs in the contract by adjusting interest rates up or down.
SEC Disclosure Rules
While the SEC doesn't regulate derivatives, it has authority to oversee how banks conduct transactions. SEC Chairman Cox says all financial firms should tell clients what their fees are before signing any deals.
``Brokers and advisers should disclose their compensation and conflicts of interest to their customers, and to the extent that they are regulated by the SEC, they must,'' he says.
Cox also says school district officials have a responsibility to the public and to bond investors to ensure their advisers are actually independent and acting in the best interests of taxpayers. ``To the extent that municipalities are participating in transactions they are not qualified for, there is an obligation to get good independent advice,'' he says.
More than two dozen Pennsylvania school districts bought swaps that bet on the spread between two interest rates. Many bet wrong. Since 2006, at least 27 school districts gambled that the spread would widen between either the five- or 10-year London interbank offered rate on the one hand and weekly municipal bond yields or the one-month Libor on the other.
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