Letter to Pa Auditor General Jack Wagner

8/14/2019 Letter to Pa Auditor General Jack Wagner

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JOHN GARDNER BLACK

1446 Centre Line RoadWarriors Mark, Pa. 16877

814-632-8631

December 3, 2009

The Honorable Jack Wagner

Auditor General for the State of Pennsylvania

229 Finance Building

Harrisburg, Pa 17120-0018

Dear Mr. Wagner:

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 distributionlist you included in your study.

This study will be distributed on December 14 , 2009.

If you have any questions or wish to discuss my findings, you may contact me at the above

address and phone number.

Thank you for your time.

Sincerely,

John G. Black


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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.


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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.


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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 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 servicefor 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 by70 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


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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 $86million, 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.


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Bethlehem Area School District

Bond Issues "A" and "AA" of May 1, 2009

Gross Bond Proceeds

Principal Amount Bonds Sold 84,120,000.00

Original Issue Premium/Discount 1,888,818.63

86,008,818.63

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 II


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Present Value Analysis

Proceeds from 2003 Issue 74,175,000.00

Paid to District at Settlement (net of fees) 2,935,035.00

Net Proceeds Available to District 77,110,035.00

Annual Debt Service Paid and to be Paid by District

Fiscal Year Payment P/V Factor P/V Debt Svc

6/30/2004 * 3,872,006.89 0.953033 3,690,150.87

6/30/2005 * 3,361,176.13 0.908272 3,052,862.70

6/30/2006 * 3,035,052.06 0.865613 2,627,181.92

6/30/2007 * 2,699,070.52 0.824958 2,226,620.66

6/30/2008 * 3,408,319.86 0.786213 2,679,664.05

6/30/2009 * 4,300,656.14 0.749287 3,222,424.31

6/30/2010 4,990,754.31 0.714095 3,563,872.81

6/30/2011 4,993,831.25 0.680556 3,398,582.91

6/30/2012 5,299,831.25 0.648593 3,437,431.47

6/30/2013 5,297,631.25 0.618130 3,274,626.21

6/30/2014 4,765,918.75 0.589099 2,807,596.18

6/30/2015 4,767,506.25 0.561431 2,676,623.47

6/30/2016 4,770,331.25 0.535062 2,552,422.41

6/30/2017 12,075,731.25 0.509932 6,157,798.186/30/2018 13,082,856.25 0.485982 6,358,030.14

6/30/2019 13,085,981.25 0.463157 6,060,860.77

6/30/2020 14,058,156.25 0.441404 6,205,322.83

6/30/2021 14,060,081.25 0.420672 5,914,688.07

6/30/2022 14,056,525.00 0.400915 5,635,467.97

6/30/2023 2,411,543.75 0.382085 921,414.75

6/30/2024 1,775,121.88 0.364140 646,392.33

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%

* From Page 22 of the Study

Exhibit III


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Northampton School District

Dated Date 4/15/2003

Date Par Coupon Price Proceeds Interest Debt Svc Annual Debt Svc

8/15/2003 857,062.08 857,062.08

2/15/2004 1,285,593.13 1,285,593.13 2,142,655.21

8/15/2004 625,000 3.000 102.2560 639,100.00 1,285,593.13 1,910,593.13

2/15/2005 1,276,218.13 1,276,218.13 3,186,811.25

8/15/2005 1,300,000 2.000 101.0460 1,313,598.00 1,276,218.13 2,576,218.13

2/15/2006 1,263,218.13 1,263,218.13 3,839,436.25

8/15/2006 1,910,000 2.500 101.8270 1,944,895.70 1,263,218.13 3,173,218.13

2/15/2007 1,239,343.13 1,239,343.13 4,412,561.25

8/15/2007 1,960,000 2.500 100.6530 1,972,798.80 1,239,343.13 3,199,343.13

2/15/2008 1,214,843.13 1,214,843.13 4,414,186.25

8/15/2008 2,015,000 2.750 100.0000 2,015,000.00 1,214,843.13 3,229,843.13

2/15/2009 1,187,136.88 1,187,136.88 4,416,980.00

8/15/2009 2,075,000 3.500 102.7430 2,131,917.25 1,187,136.88 3,262,136.88

2/15/2010 1,150,824.38 1,150,824.38 4,412,961.258/15/2010 2,155,000 3.750 102.2490 2,203,465.95 1,150,824.38 3,305,824.38

2/15/2011 1,110,418.13 1,110,418.13 4,416,242.50

8/15/2011 2,250,000 5.000 109.7650 2,469,712.50 1,110,418.13 3,360,418.13

2/15/2012 1,054,168.13 1,054,168.13 4,414,586.25

8/15/2012 2,365,000 5.000 109.3450 2,586,009.25 1,054,168.13 3,419,168.13

2/15/2013 995,043.13 995,043.13 4,414,211.25

8/15/2013 2,485,000 5.000 108.5630 2,697,790.55 995,043.13 3,480,043.13

2/15/2014 932,918.13 932,918.13 4,412,961.25

8/15/2014 2,600,000 4.000 99.2750 2,581,150.00 932,918.13 3,532,918.13

2/15/2015 880,918.13 880,918.13 4,413,836.25

8/15/2015 2,710,000 4.250 100.3940 2,720,677.40 880,918.13 3,590,918.13

2/15/2016 823,330.63 823,330.63 4,414,248.75

8/15/2016 2,830,000 4.250 99.4910 2,815,595.30 823,330.63 3,653,330.63

2/15/2017 763,193.13 763,193.13 4,416,523.758/15/2017 2,955,000 4.500 100.7850 2,978,196.75 763,193.13 3,718,193.13

2/15/2018 696,705.63 696,705.63 4,414,898.75

8/15/2018 3,090,000 4.500 100.0000 3,090,000.00 696,705.63 3,786,705.63

2/15/2019 627,180.63 627,180.63 4,413,886.25

8/15/2019 3,235,000 4.500 98.8540 3,197,926.90 627,180.63 3,862,180.63

2/15/2020 554,393.13 554,393.13 4,416,573.75

8/15/2020 3,385,000 4.600 99.2860 3,360,831.10 554,393.13 3,939,393.13

2/15/2021 476,538.13 476,538.13 4,415,931.25

8/15/2021 3,545,000 4.625 98.5950 3,495,192.75 476,538.13 4,021,538.13

2/15/2022 394,560.00 394,560.00 4,416,098.13

8/15/2022 3,710,000 4.700 98.6190 3,658,764.90 394,560.00 4,104,560.00

2/15/2023 307,375.00 307,375.00 4,411,935.00

8/15/2023 3,895,000 5.000 100.6100 3,918,759.50 307,375.00 4,202,375.00

2/15/2024 210,000.00 210,000.00 4,412,375.00

8/15/2024 4,095,000 5.000 100.6100 4,119,979.50 210,000.00 4,305,000.002/15/2025 107,625.00 107,625.00 4,412,625.00

8/15/2025 4,305,000 5.000 100.6100 4,331,260.50 107,625.00 4,412,625.00 4,412,625.00

Totals 59,495,000 60,242,622.60 37,960,149.58 97,455,149.58 97,455,149.58

Exhibit IV


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Composition of the Issue

Gross Bond Proceeds 60,242,622.60

Less:

Costs of Issuance 591,502.41

Total 591,502.41

Available for Construction Projects 59,651,120.19

Exhibit V


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Present Value Analysis

Net Proceeds Available to District 59,651,120.19

Annual Debt Service Paid and to be Paid by District


6/30/2004 2,142,655.21 0.958453 2,053,634.15

6/30/2005 3,186,811.25 0.918632 2,927,506.81

6/30/2006 3,839,436.25 0.880466 3,380,491.27

6/30/2007 4,412,561.25 0.843885 3,723,693.19

6/30/2008 4,414,186.25 0.808824 3,570,298.95

6/30/2009 4,416,980.00 0.775220 3,424,129.24

6/30/2010 4,412,961.25 0.743011 3,278,880.70

6/30/2011 4,416,242.50 0.712141 3,144,989.50

6/30/2012 4,414,586.25 0.682554 3,013,193.89

6/30/2013 4,414,211.25 0.654196 2,887,759.17

6/30/2014 4,412,961.25 0.627016 2,766,997.44

6/30/2015 4,413,836.25 0.600965 2,652,562.63

6/30/2016 4,414,248.75 0.575997 2,542,594.00

6/30/2017 4,416,523.75 0.552066 2,438,212.606/30/2018 4,414,898.75 0.529129 2,336,052.16

6/30/2019 4,413,886.25 0.507145 2,238,482.53

6/30/2020 4,416,573.75 0.486075 2,146,786.45

6/30/2021 4,415,931.25 0.465880 2,057,294.42

6/30/2022 4,416,098.13 0.446524 1,971,894.36

6/30/2023 4,411,935.00 0.427972 1,888,186.21

6/30/2024 4,412,375.00 0.410191 1,809,918.08

6/30/2025 4,412,625.00 0.393149 1,734,819.56

6/30/2026 4,412,625.00 0.376815 1,662,742.87

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 Interest Rate Required to Discount the Debt Service Payments

To the Gross Proceeds of the Bond Issue is 4.238900%

The Costs of Financing Raised the Effective Cost by 9.6 basis points

Exhibit VI


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Present Value Analysis, Using Northampton Yield


6/30/2004 * 3,872,006.89 0.958453 3,711,136.32

6/30/2005 * 3,361,176.13 0.918632 3,087,683.96

6/30/2006 * 3,035,052.06 0.880466 2,672,258.72

6/30/2007 * 2,699,070.52 0.843885 2,277,704.48

6/30/2008 * 3,408,319.86 0.808824 2,756,730.27

6/30/2009 * 4,300,656.14 0.775220 3,333,952.71

6/30/2010 4,990,754.31 0.743011 3,708,187.55

6/30/2011 4,993,831.25 0.712141 3,556,314.41

6/30/2012 5,299,831.25 0.682554 3,617,421.49

6/30/2013 5,297,631.25 0.654196 3,465,688.97

6/30/2014 4,765,918.75 0.627016 2,988,307.46

6/30/2015 4,767,506.25 0.600965 2,865,106.05

6/30/2016 4,770,331.25 0.575997 2,747,696.45

6/30/2017 12,075,731.25 0.552066 6,666,600.666/30/2018 13,082,856.25 0.529129 6,922,522.20

6/30/2019 13,085,981.25 0.507145 6,636,496.46

6/30/2020 14,058,156.25 0.486075 6,833,319.47

6/30/2021 14,060,081.25 0.465880 6,550,311.83

6/30/2022 14,056,525.00 0.446524 6,276,577.57

6/30/2023 2,411,543.75 0.427972 1,032,074.06

6/30/2024 1,775,121.88 0.410191 728,139.65

140,168,082.78 82,434,230.69

Amount Actually Received 77,110,035.00

Net Loss 5,324,195.69

Exhibit VII


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Bethlehem Area School DistrictIf Refunding Bonds had been Issued 9/24/2009

the same asUpper St Clair Bonds Issued 9/24/2009

Fiscal Year Par Coup Price Proceeds Interest Debt Svc Prior Diff

6 /30/2010 2,290,000.00 0 .750 100.0000 2,290,000.00 2,700,773.75 4 ,990,773.75 4 ,990,754.31 -19.46 /30/2011 2,310,000.00 1 .000 100.0000 2,310,000.00 2,683,598.75 4 ,993,598.75 4 ,993,831.25 232.56 /30/2012 2 ,640,000.00 1 .500 100.0000 2 ,640,000.00 2 ,660,498.75 5 ,300,498.75 5 ,299,831.25 -667.5

6 /30/2013 2 ,675,000.00 2 .000 101.3690 2 ,711,620.75 2 ,620,898.75 5 ,295,898.75 5 ,297,631.25 1 ,732.56 /30/2014 2 ,200,000.00 2 .250 101.4630 2 ,232,186.00 2 ,567,398.75 4 ,767,398.75 4 ,765,918.75 -1 ,480.06 /30/2015 2 ,250,000.00 2 .500 101.5890 2 ,285,752.50 2 ,517,898.75 4 ,767,898.75 4 ,767,506.25 -392.56 /30/2016 2 ,310,000.00 2 .300 99.4590 2 ,297,502.90 2 ,461,648.75 4 ,771,648.75 4 ,770,331.25 -1 ,317.56 /30/2017 9 ,665,000.00 2 .600 99.3800 9 ,605,077.00 2 ,408,518.75 12,073,518.75 12,075,731.25 2 ,212.56 /30/2018 10,925,000.00 2 .875 99.1330 10,830,280.25 2 ,157,228.75 13,082,228.75 13,082,856.25 627.56/30/2019 11,245,000.00 3.100 99.2350 11,158,975.75 1,843,135.00 13,088,135.00 13,085,981.25 -2,153.76/30/2020 12,565,000.00 3.300 99.1690 12,460,584.85 1,494,540.00 14,059,540.00 14,058,156.25 -1,383.76 /30/2021 12,980,000.00 3 .450 99.1050 12,863,829.00 1 ,079,895.00 14,059,895.00 14,060,081.25 186.2

6 /30/2022 13,425,000.00 3 .600 99.0460 13,296,925.50 632,085.00 14,057,085.00 14 ,056,525.00 -560.0

6 /30/2023 2,265,000.00 3 .700 98.9890 2,242,100.85 148,785.00 2 ,413,785.00 2 ,411,543.75 -2 ,241.26/30/2024 1,710,000.00 3.800 98.0000 1,675,800.00 64,980.00 1,774,980.00 1,775 ,121.88 141.8

91,455,000.00 90,900,635.35 28,041,883.75 119,496,883.75 119,491,801.18 -5,082.5

Letter to Pa Auditor General Jack Wagner

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Transcript of Letter to Pa Auditor General Jack Wagner