The Auditor General of the Commonwealth of Pennsylvania’s recently released audit of the Hamburg Area School District contains a “finding” that Hamburg Area School District “lost approximately $4.4 million” on an interest rate swap. In press discussions that followed the release of the report, the Auditor General stated “Every possible dollar needs to get into the classroom. Four million dollars could have gone towards improving education in the Hamburg area without placing an additional burden on taxpayers.”
The District would like to make clear that the methodology and conclusions of the Auditor General’s report are deeply flawed. The report calculates that the District lost $2.05 million while the swap was in effect and lost an additional $2.386 million when the District chose to terminate the swap. The Auditor General calculated the $2.05 million loss by comparing the difference the District paid on the fixed rate portion of the swap with the variable rate portion the District received from the initiation of the swap in 2005 through its termination in 2011. The District is unaware of any known financial accounting standard under which this constitutes a loss. The $2.05 million represented the Districts’ cost of interest on the debt to which the swap related under the Local Governmental Debt Act. This is how the District reported that cost in its financial statements as reviewed by its independent Certified Public Accountants and the Commonwealth’s Department of Education, neither of whom treated the expenditure as a loss. The Attorney General’s conclusion is akin to a homeowner selecting to finance their home at a fixed rate for 25 years instead of using a more risky variable rate loan and then having the Auditor General looking back after six years and saying the homeowner had lost money.
In order to undertake the building of the Perry Elementary project, the District determined in 2011 it was in its’ best financial interest to terminate the swap and pay the associated $2.386 million termination payment, as required by the Local Governmental Unit Debt Act, when it refinanced the original debt as part of a consolidated borrowing that included $18.62 million for the Perry project. The District’s debt service following this borrowing was actually reduced by $200,000 from the existing budgeted amount.
The idea that $4.4 million did not get into the classroom or caused the District to raise taxes is simply not accurate. The District’s financial health from 2005 to present is strong. During the period the Auditor General is claiming the District “lost” $4.4 million, the District’s fund balance increased despite rising costs across the board. The District was able to accomplish this with tax increases of 1% or less per year, an amount well below each relevant Commonwealth Act1 index limiting tax increases. Further, Hamburg Area School District is in the bottom 1/2 of all Berks County school district tax rates.
Immediately prior to the Auditor General’s June report, the District received a credit rating upgrade of A+ to AA-from Standard and Poor’s, one of the two largest worldwide credit rating organizations. In the report, Standard and Poor’s cites “Solid financial operations, resulting in what we view as very strong finances” and “what we consider solid with strengthening reserves supported by consecutive operating surpluses.” They also recognize “Officials have not had to use layoffs or furloughs to maintain structural balance.”
These results fly in the face of any idea that the District somehow “lost” $4.4 million in the same time period.
2005 Decision to Enter into Swap Agreement
The District’s decision to enter into the swap agreement in 2005 was well thought out and supported by due consideration. The District was undertaking a $25 million building project for the Tilden Elementary School with a twenty year repayment period and wanted a fixed interest rate obligation in order to budget with certainty for debt service. The District considered using fixed rate bonds or achieving a synthetic fixed rate using variable rate debt with a swap agreement.
As required by the Local Governmental Unit Debt Act, the Board retained the services of an independent swap advisor who met multiple times with the Board and administration over a six month period to review both the benefits of the swap and the related risks. In the swap advisors report, the rationale for entering into the swap is clearly enumerated: “As a result of the current interest rate environment, the synthetic fixed rate that will be established on the 2005 Swap is expected to be (1) extremely low based upon historical averages, (2) below the fixed rate the School District would be able to achieve through a traditional fixed rate bond issue…”
The 20 year swap rate of less than 4% was lower than the rate which could have been achieved using fixed rate bonds.
2011 Decision to Terminate the Swap Agreement
As stated previously, the District chose to terminate the swap agreement in 2011 as part of a consolidated borrowing which provided for the refunding of the remaining balance of the 2005 Bonds, payment of the swap termination and $18.62 million for the construction of the Perry Elementary School. The Perry project was the last new construction on the District’s master plan and had been considered for several years prior to 2011.
Beginning in January of 2010, the Board received presentations during their regular public meetings from the District’s underwriter and financial advisor of the various options available to finance the Perry project. There were six presentations made from January 2010 through March of 2011 when the final decision was made. The Board considered three possible options for financing the Perry project: (1) Leave 2005 Bonds and swap agreement in place and issue level debt; (2) Leave 2005 Bonds and swap agreement in place and wrap new money for Perry around 2005 Bonds; (3) Refinance 2005 Bonds, terminate swap and issue consolidated debt to pay those costs plus Perry project. Both option 1 and option 2 would have required significant tax increases to implement.
The District would like to make clear that the $2.386 million termination payment was not a fee as characterized by the Auditor General’s report. The termination payment is not an extra charge, fee or penalty but rather represents the total value of the differential between the swap rate at initiation in 2005 and the lower rate in effect in 2011. The termination payment was made in order to allow the District to take advantage of the substantially lower rates that existed in 2011 for the refinancing of the 2005 Bonds. The potential of having to pay a termination payment was clearly addressed in the 2005 independent swap advisor report and to the Board in 2011. To continue the prior analogy, the termination payment is equivalent to a homeowner paying “points” in order to obtain a lower interest rate on a mortgage versus not paying the “points” and paying a higher annual interest rate.
Following over 14 months of consideration, the Board chose the third option and terminated the swap agreement as a part of that process. As a result of the 2011 transaction, including the cost of the termination payment, the District was able to build the Perry project while reducing its debt service by $200,000 annually from the existing budgeted figure.
-The 2005 decision to initiate the swap was a prudent and well-reasoned decision, resulting in a lower rate than could have been achieved using fixed rate bonds.
-The 2011 decision to terminate the swap was the correct decision following significant consideration, resulting in the District being able to fund the Perry project and achieve annual savings of $200,000 to prior budgeted debt service.
-The District does not agree with the claim of the Auditor General that it lost $4.4 million on the swap agreement.
-The District’s refinancing decisions were as appropriate to the economic conditions of the times as they were to homeowners’ decisions to refinance their own mortages.
-The District’s fund balance has increased since 2005 with small annual tax increases.
-The District’s overall strong financial condition is reflected in its upgraded rating of AA- by Standard and Poor’s.