Big barn signs: A taxpayer response to Philly-area public schools’ wrong-way interest rate bets

Philadelphia Inquirer (PA)

Oct. 15--"SAVE GRANDMA'S HOME" and "STOP GAMBLING TAXPAYER $," say some of the signs posted by David Galligan, a University of Pennsylvania professor of animal health economics, on the weathered boards of the barn in Lincoln University that houses his household's three cows, three goats, six dogs, three dozen chickens, and two cats.

Galligan also put up placards showcasing the names of several candidates he considers fiscally responsible. He's urging his neighbors to support them in next month's contested school board elections in Avon Grove School District, home of a growing student population and a high school construction plan to accommodate them, whose cost has divided residents in southern Chester County.

He put up the signs last week, adding the "gambling" warning on Sunday after reading my Oct. 7 column noting that Avon Grove was among several Pennsylvania school districts -- others include Lower Merion and Colonial in Montgomery County -- that each stand to pay out a few million dollars starting next year because they bought financial hedges that they hoped would protect their construction borrowing costs from the danger that interest rates would rise.

Under the interest rate swap agreements approved by elected school boards last year, the districts pledged to pay Canadian-owned, New York-based RBC Capital Markets a fixed interest rate on the value of bonds that the district plans to sell to finance construction. The bank pledged to pay the schools a variable rate, in return.

If market interest rates rose, RBC would have to pay the schools the difference. That would compensate the schools for the cost of higher interest rates.

But instead of rising, interest rates fell. So under the terms of the swaps, the school districts at the moment owe the bank money (at least $1.8 million in Avon Grove) when they start coming due next summer, and more the next year, and more if rates fall further, according to the districts' estimates.

That's unless interest rates reverse and go up significantly -- defying cheap-money supporter President Donald Trump and the global economic slowdown that has reduced rates worldwide.

Without a big turnaround, the swaps, arranged through financial advisers from Philadelphia-based Public Financial Management (PFM), will end up costing more than not buying any protection would have.

RBC and school business managers have defended the swaps as a way to prevent out-of-control cost increases in case rates had risen.

"I have an article from December when [the Federal Reserve] raised rates last year, there were two more rate hikes expected from the Fed in 2019," said Dan Carsley, Avon Grove's business manager. He said the nine-member board reviewed the financial plans in detail. "We took a long, hard look at what was coming in terms of rate hikes and how we could mitigate that exposure."

Seven school board members endorsed the plan. The way Carsley sees it, Avon Grove wins either way: If rates stay low, it will be able to borrow cheaper.

The swaps cost might be considered a kind of insurance against a risk that didn't materialize.

"The hope is, you saved over the life of the bond enough to cover any settlement fee" to the bank, Carsley said. And rates could still reverse again -- indeed, 10-year Treasury rates have crept up a bit since last month. "To know the true interest costs, we have many years to go." He said Avon Grove spends less than other school districts in the county per pupil.

Galligan said he checked my column against statements by school officials and found that I had actually described the losses conservatively: There could be millions more.

He's worried that property taxpayers who fund schools could end up with unanticipated additional financial costs.

"School taxes are killing us," said Galligan. With a school tax rate of $31 for every $1,000 of assessed value -- higher than Tredyffrin/Easttown, Great Valley, or Unionville-Chadds Ford, but lower than Octorara or Coatesville Area -- elderly residents and those on fixed incomes "have a growing tax obligation in perpetuity."

He said the area suffers a lack of taxpaying industries. As in other Chester County communities, Reading-based nonprofit Tower Health has sought to exempt a major employer, Jennersville Hospital, one of several in the region that Tower acquired last year, from paying public school property taxes. About 30% of county property is already tax exempt, or pays reduced property taxes, much of it due to land conservation tax breaks.

Chester County is the wealthiest of Pennsylvania's 67 counties based on incomes. But even here, school spending has provoked a reaction from taxpayers such as Galligan. Property taxpayers foot the bill for new school construction, staff salaries that rise under the terms of negotiated labor contracts, and pensions for retired teachers and school administrators through the Public School Employees' Retirement System (PSERS).

The system's $50 billion-plus in assets, invested in everything from hedge funds to nut farms to a redevelopment scheme near PSERS's Harrisburg offices, don't yield enough to cover future liabilities without annual increases in state and local taxpayers' "employer contributions."

Losses related to interest rate swaps have happened before. Swaps were legalized for Pennsylvania municipalities under the administration of then-Gov. Ed Rendell and promoted by a small army of bank salespeople. But after the late 2000s credit crisis, Philadelphia and several upstate cities that had bet on rising rates faced multimillion-dollar swap payments and fees when interest rates stayed lower than expected.

That prompted former Pennsylvania Auditor General Jack Wagner and legislators from both parties to try to ban such swaps. But they have remained legal, and some school officials say it's preferable to use swaps and avoid unbudgeted interest rate increases, which could otherwise force tax increases to pay for school construction and other capital spending.

Galligan is skeptical of both the financial hedges and some of the construction they are supposed to help pay for. We'll know after next month's vote how many of his Chester County neighbors agree.

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