When York County wanted to build a new courthouse and upgrade its emergency communication system, officials knew they would need to borrow tens of millions of dollars, and pay it back over decades.

They wanted to pay as little as they could for borrowing that money. Generally, the more counties spend on those types of projects, the more they have to raise taxes -- or the less money they have for running parks, nursing homes, prisons and other services they provide.

So county officials years ago turned to a financial tool known as an interest-rate swap. When swaps work, counties, school districts and other public entities can save taxpayer money.

But they're riskier than the conventional way of borrowing money. And when they don't work, they can cost public entities millions of dollars.

Right now, County Commissioner Chris Reilly said the county's swaps have worked out.

But Commissioners Steve Chronister and Doug Hoke are uneasy about them and think government entities shouldn't be able to use them. Hoke said he'd like the county to get out of swaps, but not right now.

For one of its swaps, York County could cancel it and be paid money from a bank. But for three of its swap deals, it would have to pay about $23.37 million to cancel them, as of Nov. 30.

"I would never entertain them again," said Chronister, who has approved them before. "I've learned more about them since."

How they work

A common version of a swap works like this:

Normally, the county would borrow from bondholders or a bank and pay the money back with interest, say 4.5 percent.

With a swap, the county still borrows money from, say, bondholders. But it also enters a separate agreement with a bank, such as the Royal Bank of Canada.

York County used interest-rate swaps for its 911 center in Springettsbury Township, and the 911 radio system, among other projects.
York County used interest-rate swaps for its 911 center in Springettsbury Township, and the 911 radio system, among other projects. (DAILY RECORD/SUNDAY NEWS -- File)

In that agreement, the county makes interest rate payments to the Royal Bank of Canada at a fixed rate, say 4 percent, as if the bank had lent the county the same amount it actually borrowed. At the same time, the Royal Bank of Canada pays the county interest, based on a variable rate, as if the county had loaned the bank that amount of money.

If the variable rate that the Royal Bank of Canada pays the county is equal to the variable rate the county pays the bondholders, the county ends up essentially paying a 4 percent interest rate.

That's known as a fixed-for-floating rate swap.

The idea is that the county can either get a lower net interest rate with a swap than through the conventional way, or protect itself from rising interest rates. The bank can benefit if interest rates fall or in other ways, such as using the swap as hedge for other contracts it has.

Former Auditor General Jack Wagner and others have compared it and other swaps to gambling, saying they amount to bets on whether interest rates will go up or down.

York County administrator Chuck Noll said Wagner, who called for a ban of swaps in November 2009, painted everyone with too broad a brush.

He said York County didn't use swaps to gamble, but to reduce its risk, by hedging against the possibility of interest rates rising, which could have made borrowing money more expensive.

"You need to be very careful with these types of transactions," Noll said. "But to deny large counties and those that have the capacity and the ability to utilize them well, I think, is taking a tool away from us that is critical to reduce the overall cost of borrowing for the county and the taxpayers."


Gary Gray, a finance professor in the Smeal College of Business at Penn State, said many public entities entered swaps to protect themselves from rising interest rates.

But interest rates fell and stayed low.

Swaps appeared to be a cheaper option years ago, Gray said. But he said they came with risks that conventional fixed-rate bonds don't have. With most conventional fixed-rate bonds, you can essentially refinance after a certain period of time, say 10 years, and reduce your interest rate, Gray said. But swaps can be harder to get out of.

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The variable rates involved in the deal can also get out of sync in ways that hurt the public entities.

The costs can be in the millions.

"I think a lot of municipalities got involved in these transactions thinking that they were getting a much better deal than they did and not really knowing enough to see the type of really obscure risks that are out there," said Gray, a former investment banker and financial engineer.

'can't unwind'

York County has three of those fixed-for-floating rate swaps, and they are connected to about $77.42 million in debt that dates back to the early 2000s. That borrowed money went toward the York County Judicial Center, which opened in 2004, to begin financing the new 911 system and other smaller projects, according to Noll.

For all three, the county receives variable-rate payments from the Royal Bank of Canada, based on different percentages of a financial benchmark known as the Libor.

In return, the county gives the Royal Bank of Canada a fixed-rate payment: 4.335 percent for one, 4.06 for another and 4.443 percent for the third. The end dates for the agreements range from June 2030 to June 2033.

Those are three swaps that would cost about $23.37 million to terminate, as of Nov. 30.

"We can't unwind them now, because of the amount that would have to be paid," Chronister said. "We have to just stay the course."

Generally, the lower interest rates drop, the more the county would have to spend to cancel those agreements. If interest rates rise high enough, the county could be paid instead.

The county has another swap that's tied to about $67.33 million worth of debt and dates back to 2006. Because it's structured differently than the other swaps, the county would receive money if it canceled it.

In the past, the county has made money from either partially or fully terminating other swaps -- between $5 and $6 million, which was used to pay down debt, according to Noll. Commissioners raised real estate taxes for 2013, but Noll said those swap transactions helped the county avoid tax increases in prior years.

"We've profited marvelously from them," Reilly said.

Hoke and Chronister support bans on swaps for public entities. But they said they don't plan to terminate York County's swaps if it costs millions to do so.

Others have lost

Swaps have cost other public entities.

State College Area school board members in Centre County agreed last month to pay about $9 million to settle a lawsuit with the Royal Bank of Canada over such an agreement.

Also in January, a report from the auditor general's office said that the Pennsylvania Turnpike Commission's involvement in interest-rate swaps had cost state taxpayers and turnpike motorists at least $108.9 million.

That's compared to what the commission would have paid if it had used conventional fixed-rate bonds, according to the report, which was completed while Wagner was still in office.

Last year, a report from the Pennsylvania Budget and Policy Center said that swap deals had cost Philadelphia city government and its school district $331 million in net interest payments and cancellation fees.

David Unkovic, a lawyer and former state-appointed receiver for Harrisburg, recommended banning them when he testified before a state senate committee in November.

Unkovic said it's not that there haven't been good swaps. And he said maybe even most swaps are good. But he said when they're bad, they create multi-million dollar problems for entities that are funded by taxpayers.

Unkovic compared them to a game of Russian roulette.

"Every once in a while, the bullet's going to go off," Unkovic said.

' as far into these as it ever would be'

Statewide, 108 of 500 school districts and 101 local governments had $17.5 billion in public debt tied to swaps, according to information from the auditor general's office last month.

Jens Damgaard, an attorney with Rhoads & Sinon and bond counsel for the county, said some entities should stay away from swaps. But he said entities with good credit, and healthy economic conditions, can assume the risk.

He said it also matters how much debt entities have connected to swaps. He said some of "the horror stories" of swaps involved school districts and other entities that had almost all of their debt connected to them.

He said for the county's three fixed-for-floating rate swaps, it already had variable-interest rate debt, and the swaps were used to hedge against the possibility of interest rates rising.

"It was the classic structure," Damgaard said. "...It's about as vanilla as these things get."

In 2011, the county adopted debt management policies that say that the county will limit the amount of long-term debt connected to swaps, so that it won't exceed 30 percent of it general obligation debt.

The guidelines noted that the county's debt exceeded that 30 percent threshold, but the county would gradually reduce that level.

"Right now, the county is about as far into these as it ever would be," Damgaard said.

Proposed ban

State Sen. Mike Folmer, R-Lebanon, is proposing a ban on swaps for public entities, as part of a larger package to address issues that caused financial problems for Harrisburg and Dauphin County.

Co-sponsors include state Senate Majority Dominic Pileggi, a Republican who represents parts of Delaware and Chester counties, and state Sen. Rob Teplitz, a Democrat whose district includes parts of York and Dauphin counties.

"You're basically guessing whether or not rates are going to go up or down with the big boys up in Wall Street," said Folmer. "And if it doesn't work, then you're in trouble."

The proposed swap legislation was referred to the Senate's local government committee on Friday.

Elisa Barsotti, a spokeswoman for the Royal Bank of Canada, said in a statement that interest rate hedging products, when used thoughtfully, have proven to be a useful tool for local governments across Pennsylvania. She said they have helped them "manage their financing costs ... thereby benefiting taxpayers by reducing borrowing costs and managing risks."

The county's other large swap

The county has another large swap that's tied to about $67.3 million worth of debt that dates back to 2006.

That money went toward the renovation of the York County Administration Center and the new 911 facility and radio system.

Because that swap is set up differently than its other swaps, the county would receive money if it terminated that one: $219,716, as of Nov. 30.

For that agreement, the county makes a variable-rate payment based on the Securities Industry and Financial Markets Association municipal swap index to the Royal Bank of Canada, and it receives a variable-rate payment based on a percentage of the one-month Libor rate in return.

At the same time, the county pays a 4.44 percent fixed-rate yield to the bondholders -- the entities that lent the county money.

It's known as a basis swap.

Terms to know

Here are some key terms to help you understand the county's financial situation:

--- Bonds and notes: When counties borrow money, they issue bonds or notes. The county pays back the money, plus interest.

--- Direct debt: Refers to money York County owes to entities that financed capital projects. The county's direct debt is about $250 million, with close to $145 million of that connected to swaps.

--- Fixed-rate debt: Refers to interest rates that are set when a loan is taken out. They don't change, even as market rates fluctuate.

--- Local Government Unit Debt Act: The state law that was amended in 2003 to explicitly permit school districts and other public entities to enter into swap agreements.

--- Libor: An acronym for the London Interbank Offered Rate, which is the rate that international banks charge for short-term loans to each other. It's used as a financial benchmark.

--- Interest-rate swaps: They're also known as qualified interest rate management agreements. Two parties agree to exchange cash flows.

--- Termination payments: If a public entity decides to cancel a swap, it will either pay money to the financial institution it has an agreement with or receive a payment. Which entity has to pay, and how much it has to pay, depends on changes in interest rates.

York County can decide at any time to terminate its swaps, said county administrator Chuck Noll. But the bank can't do the same.

The county's debt management policies say it will use those lump sum payments only to reduce debt.

--- Variable-rate debt: The interest rate that the borrower pays changes. When rates drop, the borrower's payments drop, too. When rates rise, so do the payments.

Many entities entered swaps to hedge against the possibility that interest rates would rise.

York County had variable-rate debt years before it entered the swaps. Noll said the county saved a great deal in interest costs by using variable-rate debt from the time variable-rate debt was issued until the date the swaps began accruing fixed payments on January 2, 2004, and June 1, 2006.

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