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Analysis: Both sides right in DPS pension debate

Education News Colorado asked an experienced financial journalist to take a look at recent questions raised about Denver Public Schools’ pension refinancing. Here’s his take:

To a group of dissident school board members and their allies, a DPS financial transaction entered into just two years ago has become a costly and complex trap, costing the district millions of dollars when things went wrong.

To Superintendent Tom Boasberg, the transaction has already accomplished its main goals and has saved DPS from putting millions of dollars each year into its pension plan.

They are both correct.

At issue is a series of financial decisions made by former Superintendent Michael Bennet and Boasberg, then DPS’ chief operating officer, in early 2008. The transaction they chose, and the DPS board unanimously approved, included an interest-rate “swap” that ultimately cost the district unbudgeted millions in the 2008-2009 school year.

Now, some DPS board members, including two who voted yes on the transaction, have been publicly agitating to find out more about the costs of the deal and whether it makes sense for the district to continue.

Seeking a PERA merger

In early 2008, Bennet and Boasberg were eager to get DPS out from under an ever-increasing series of payments to prop up the Denver Public Schools Retirement System, also known as DPS-RS. The ultimate goal was a merger with Colorado PERA, the state pension system that serves school employees in every other district besides DPS.

At the time, DPS estimated its pension fund had a shortfall of roughly $400 million. If DPS intended to chip away at that unfunded liability, it would need to jack up its annual out-of-pocket costs to the pension fund by millions of dollars. And, previous merger negotiations with PERA had stumbled as the two sides wrestled with issues of how to combine two under-funded plans.

After an aborted attempt to borrow against the pension plan’s assets, Bennet and Boasberg decided on a more traditional financing plan: DPS would put up some of its school buildings as collateral and issue $750 million in Pension Certificates of Participation, or PCOPs.

Certificates of participation entitle the holders to a certain dedicated stream of payments; in this way, they’re different from a general-obligation bond. In DPS’ case, the school district will make rental payments for the use of the schools backed by the PCOPs, and the PCOP holders get the payments.

Tom Boasberg / File photo

Denver Superintendent Tom Boasberg

The proceeds would be used to inject $400 million into the pension plan, plus pay off about $265 million in previously-issued pension-related debt. The rest would go to the cost of issuing the new debt – about $29 million – plus various reserve funds that were required as a condition of the bonds.

Making a 30-year deal

Given DPS’ desire to defer its pension costs and find more money in the near term for classroom instruction, it didn’t make sense to do a short-term borrowing, where DPS would need to refinance nearly the entire principal a few years down the road.

So DPS looked to a long-term maturity: 30 years. Here, however, is where Bennet and Boasberg made a decision about interest rates that went substantially wrong in the short term.

In an April 6 interview, Boasberg said DPS could have paid somewhere around 7 percent to 7.25 percent if it had issued fixed-rate debt for the life of the borrowing. Or, it could shave off around 1.5 to 1.75 percentage points from its interest rate by issuing a specialized series of notes that went to auction on a weekly basis at market rates.

A fixed rate over the life of the debt compensates the lender for the risk DPS might default. By chopping the debt into a series of very short-term notes, Boasberg said, DPS saved the extra interest it needed to pay to compensate lenders for credit risk. “We made the decision we were willing to take the risk on our own credit,” he said.

However, says Boasberg, it would have been “extraordinarily irresponsible” to let the interest rate float for the full 30 years of the debt: “For a public entity to be at the risk of fluctuations in interest rates is absolute folly. To suggest we’d be better off running the risks of the vagaries of the market is foolish.”

So DPS entered into what’s known colloquially as an “interest rate swap,” where two parties swap their obligations to make interest-rate payments.

Overlapping a flailing market

DPS agreed to pay 4.859 percent annual interest on the $750 million in principal to a consortium of investment banks. That’s roughly $36 million per year.

The banks pay DPS a floating interest-rate payment equal to what’s called one-month LIBOR, or the London Inter-Bank Offered Rate. LIBOR is one of the select worldwide interest rates that are used as the basis of any number of bank agreements and transactions.

DPS then planned to pay the investors whatever amount above LIBOR the bonds sold for each week. DPS expected, and budgeted, to pay 0.1 percent to 0.25 percent above LIBOR. That would have been about $2 million to $3 million for the 2008-2009 school year, which began July 1.

That school year overlapped almost perfectly with one of the worst financial markets of the last century, a crisis that threatened to pull every one of America’s major investment banks into bankruptcy. Stock markets spiraled downward. Credit froze to an unprecedented extent as corporate bonds spiked and a money-market mutual fund “broke the buck” by slipping below $1.

And supposedly safe short-term corporate borrowings called “auction-rate securities” suddenly became illiquid and completely unsalable on the open market.

Confronting a worst-case scenario

It was the worst-case scenario for DPS since its PCOPs were similar to auction-rate securities and were supposed to go to market every single week. The good news was that there was a provision in the DPS debt agreements that solved the problem. The bad news was that it was extraordinarily expensive.

DPS had a European bank named Dexia that agreed to be the “liquidity provider” and buy the district’s debt any time the auction failed. The auctions failed consistently in 2008, and Dexia bought the bonds at a penalty rate of 9 percent.

Instead of paying just 0.1 percent to 0.25 percent over LIBOR, DPS ended up spending from 4.64 percent to 8.59 percent above LIBOR during that period, district spokesman Michael Vaughn said.

And instead of paying $2 million to $3 million in interest costs over the course of the 2008-09 school year, as both anticipated and budgeted, DPS paid $24.3 million, according to a spreadsheet prepared by DPS financial staff.

That’s on top of the $36 million in fixed interest-rate payments to the investment banks. Add in other fees to Dexia and its investment banks, and DPS paid $64.4 million in the 2008-09 school year.

What makes the transaction look even worse with the benefit of hindsight is that interest rates fell, not rose, after the deal.

Had DPS not entered the swap, run the risks of the vagaries of the market and managed to pay a rate based on LIBOR plus 0.25 percent more, they’d likely have paid in the range of $12 million for the school year, rather than the $36 million in fixed-rate interest. That’s because one-month LIBOR sank below 1 percent for the second half of the school year.

Understanding the district’s perspective

To Boasberg, the $64.4 million DPS paid is still about break-even. Understanding his thinking is key to evaluating his argument that the borrowing and swap deal is now saving the district millions of dollars a year.

When Boasberg looks at DPS’ costs on the new debt issue, he compares them to both the old debt the district paid off and the unfunded liability in the pension.

He looks at what was a nearly $400 million shortfall in the pension plan, and notes the pension assumed an 8.5 percent annual return on its investments. In Boasberg’s mind, not having the $400 million at work earning 8.5 percent is no different from taking out a $400 million loan at 8.5 percent interest. And that’s $34 million in interest costs a year.

Add it to the roughly $30 million in annual payments on the previous round of debt, and DPS would have faced more than $60 million in annual costs without the April 2008 refinancing, Boasberg argues.

So the $64.4 million paid in 2008-09 in one of the worst markets since the Great Depression is about a wash, from his perspective.

Seeing it a different way

The school board members who are now asking questions haven’t embraced that calculus.

They’re looking at the real, out-of-pocket costs of more than $115 million and comparing them to interest on just the old outstanding debt – which they estimate at around $50 million to $60 million. They’re not factoring in that $34 million annual cost to the under-funded pension because DPS wasn’t paying it out in real dollars.

And in their eyes, that means DPS has lost upward of $60 million on this financing transaction.

The crux of any disagreement going forward, then, will be what price to place on that under-funded pension.

It’s “incredibly important,” Boasberg said, to remember the purposes of the transaction: Save tens of millions of dollars to put into the classroom; fully fund the pension to accommodate the PERA merger; and fully fund the pension for the retirement security of DPS employees. “The financing has been very, very successful on all three fronts,” he said.

Board member Jeanne Kaplan, who voted for the deal in 2008, now says she didn’t understand the downside risks and wants an accounting that will help her understand what went wrong. If DPS has a successful swap, she says, it needs to tell the world what it did right.

School board member Andrea Merida, who is also asking questions but who was not on the board at the time, is less sure. “I think you guys were sold a bill of goods,” she said to Kaplan in a recent interview.

Looking ahead over a longer term

Now, in the 2009-2010 school year, the weekly auctions of DPS debt are returning to normal and the district has paid just under $3 million on its swap in the first nine months – well under budget and well under the $24.3 million of the prior year.

DPS projects financing costs of $45.5 million this year – compared with $62.3 million of payments on prior debt and the annual cost of the pension obligation.

If DPS continues to sell its debt securities successfully, its annual costs should settle in at those levels going forward.

With 28 more years to go, there’s a great chance interest rates will rise to make DPS’ fixed rate of 4.895 percent look much more palatable. While LIBOR has fallen to 1 percent or less in times of recession and low interest rates, it’s also easily topped 5 percent and 6 percent in times of economic expansion – to say nothing of what happened in the sky-high interest rate environment of the late 1970s and early 1980s.

All of which is good, since DPS estimates it would need to pay $48 million to its investment-bank partners to terminate the swap.

There are two caveats to the good news, however.

While the financing math works now, the PCOP repayment schedule is back-loaded so that most of the principal payments come in the final 10 years of the debt. By 2025, DPS will owe nearly $60 million per year, and by 2038, the payment will top out around $70 million.

Secondly, DPS raised the money for the pension fund immediately before a steep drop in the markets. The DPS division of PERA is no longer fully funded but audited numbers as to where it stood at year-end 2009 are not yet available. And its long-term funding problem, along with PERA’s, remains unsolved.

Both problems may end up making last year’s rate-swap problem look like small potatoes.

David Milstead wrote about corporate finance at the Rocky Mountain News for eight years until it closed in February 2009. He previously worked at the Wall Street Journal, among other publications. He now writes for the Report On Business section of The Globe and Mail, Canada’s national newspaper. He passed the Level I exam in the Chartered Financial Analyst program in December 2007.