When Philadelphia signed a groundbreaking swap agreement 1990, the city hoped to save half a million dollars a year in debt service over an ordinary bond issue. Instead. little of the savings have materialized, and the city is out the $1.5 million in fees it paid Merrill Lynch & Co. for the swap.

But was the swap deal, which accompanied a $148 million bond issue, fundamentally flawed? Or could any financing arrangement have survived the city's unprecedented fiscal woes and brush with bankruptcy?

"You have to look at the financing options that were available," Benjamin Blakney, then Philadelphia's treasurer, said in an interview last week. "Given all the available Information, [the swap structure] was a good choice. And, I think, all things considered, it is still a good deal."

Other financing options might have weathered the fiscal storms of 1990 better, but they probably would cost the city more over the life of the issue.

The city could have sold fixed-rate bonds, for example. No matter how the city's finances teetered, the interest cost would have remained fixed.

But Blakney, now president of Boston-based Innova Securities, says Philadelphia would have had higher debt service costs if it had simply sold fixed-rate bonds and not used a swap.

Because of problems with the swap, the city has had to pay about $592,000 a year since 1990 on its bonds. The swap was supposed to completely cover the cost of the bonds. Even though the swap has not performed as expected, it probably will end up performing well enough to provide minimal savings to the city.

But the swap also eliminates an advance refunding of the debt, according to Blakney's successor, Kathryn Engebretson.

Derivatives professionals who did not work on the Philadelphia transaction said the lost savings do not indict the use of swaps and synthetic fixed-rate transactions.

"One thing that no municipality can hedge against is mismanagement on its own part," said the head of derivatives at a firm that did not work on the Philadelphia deal. "The body politic might simply decide not to pass enough taxes to make it work and there's a price to be paid for that. I would say then swap is an incidental victim of much bigger problems within the entity."

Engebretson says municipal analysts and issuers considering swaps should carefully examine the Philadelphia experience.

She has delivered a speech about the city's experience to conference audiences across the country this year. In November, Engebretson delivered her warnings at The Bond Buyer's All-American Municipal Analysts Conference in New York.

"As issuers are embracing the derivatives market, I believe it becomes important for analysts to factor the additional risks posed by derivatives, as well as the various potential outcomes posed by these products, into their overall credit analysis for an issuer." she told those attending the conference. "The city of Philadelphia has had a very mixed experience."

In an interview last week, Engebretson said, "It's cost us more than the projections."

And the swap complicates the task of advance-refunding the bonds. "We're basically stuck at this very high rate," she said.

"It's not Merrill Lynch's fault that we can't refund. The city made the decision to do a swap. People, when they issue bonds that aren't callable for 10 years, make the same decision. But it would cost us about $20 million to unwind it," Engebretson said.

Before becoming treasurer, Engebretson worked at Lehman Brothers, one of Merrill's top competitors in the municipal derivatives area. And she has announced that she plans to resign her position at the end of this year and return to the firm.

Derivatives experts have worked on new safeguards to avoid a repeat of the Philadelphia experience. For example, some underwriters now offer zero basis risk" swaps, designed to avoid mismatches between an issuer's interest cost on its variable-rate bonds and the amount it receives on its swap.

Officials at Merrill Lynch, the firm that underwrote the 1990 bond issue and handled the swap, declined to discuss the transaction.

What Went Wrong?

In 1990, officials with the city and its financial adviser, P.G. Corbin & Co., decided to use the swap instead of a fixed-rate issue. At the time, Merrill Lynch officials predicted the structure would save the city more than $4 million on a present value basis.

The city would issue 30-year bonds, but instead of paying a fixed amount of interest, the, rate on the bonds would be periodically reset, reflecting changes in the overall market. Since Philadelphia's credit ratings were at the lower end of the investment-grade range, the bonds were backed by a letter of credit from Fuji Bank, at the time rated triple-A.

Merrill Lynch then entered a 10-year interest rate swap with the city. In the swap, the city agreed to pay Merrill a fixed rate of 6.85% and Merrill agreed to pay the city the rate on the J.J. Kenny high-grade note index, a widely followed market index showing composite yields on numerous variable-rate municipal securities. The notional amount of the swap, the amount that was used to calculate the interest payments, was $148 million, matching the bond issue.

The city also paid Merrill a $1.5 million fee up-front for the swap.

The amount Merrill Lynch would owe the city on the swap was supposed to equal about the same amount the city would owe bondholders. The city's net cost for debt service would then be the 6.85% fixed rate it paid on the swap, plus remarketing and credit fees on the bonds totaling 0.4%.

Merrill officials expected that the Philadelphia bonds, backed by the strong Fuji Bank letter of credit, would yield about 0.1% less than the J.J. Kenny index.

So the city expected to pay about 7.15% on its $148 million of debt for the 10-year life of the swap.

It didn't quite work out that way.

The first problem emerged in June 1990, when the city's financial condition worsened, and Moody's Investors Service cut the city's rating to Ba - junk bond status.

Then in August, Fuji lost its coveted triple-A ratings.

These two events led investors to reconsider the value of the city's variable-rate bonds, and they began demanding a higher yield. The swap, which was supposed to cover that variable yield, was based on the composite Kenny index. The downgrades of a single city and a single credit provider had no effect on the Kenny index.

Instead of trading 0.1% below the Kenny index, the yield on the Philadelphia bonds crept above the Kenny index. On July 26, the bonds yielded almost 0.3% more than the index. Instead of paying 7.15%, the city was paying closer to 7.55%.

In September, the city's political turmoil exploded. With the politicians unable to get the city's finances in order, a scheduled sale of short-term city notes had to be canceled. Standard & Poor's Corp. dropped the city's rating from BBB-minus to CCC.

The yield on the city's bonds leaped to as much as 1.15% over the yield on the Kenny index by November.

During the next three years, the city's credit improved somewhat, but Fuji Bank's ratings continued to deteriorate.

Battered by bad real estates loans and tighter international capital requirements, Fuji dropped to the single-A credit category.

Currently, the Philadelphia bonds yield about 0.2% more than the Kenny index. City treasurer Engebretson attributes the 0.2% premium investors demand now to the weakened Fuji letter of credit.

Replacing the letter with one from, a higher-rated bank would help, she said, but "even though our credit is better, there may not be people who want to give us a seven-year commitment."

Weighing the Alternatives

The professionals who put together the Philadelphia swap defend their actions by comparing the deal to the city's available alternatives in 1990. They maintain that Philadelphia will still come out ahead for the 10-year period covered by the swap.

Other issuers with ratings similar to Philadelphia's sold fixed-rate bonds in March 1990. For example, an insured Massachusetts 20-year general obligation issue, sold in late March 1990, yielded 7.41%. An uninsured 13-year bond on the same deal yielded 7.60%.

But although Massachusetts had the same mediocre ratings as Philadelphia, the credit markets viewed the two issuers differently. Philadelphia's credit had been in decline for years, while the Massachusetts miracle seemingly evaporated overnight. The market would have demanded a higher yield from Philadelphia, despite the similar credit ratings, market players agree.

The city might have been able to sell ordinary fixed-rate bonds carrying bond insurance, paying an all-inclusive rate of about 7.62% for the life of the bonds, said officials who worked on the deal. The all-inclusive rate includes the rate on the bonds plus the insurance premium. At that rate, the city would pay about $112.8 million in interest and fees for the first 10 years.

By contrast, the swap deal was projected to cost the city 7.15% for 10 years. Merrill Lynch officials believed the variable rate on the city's bonds would average about 0.1% less than the amount the city would be paid on the swap. Including the up-front fee, the city would have paid a total of $107 3 million over 10 years.

Market participants generally use present value analysis to compare different interest costs. Because of inflation and interest rates, paying $1 today is more costly than paying the same amount in the future. So, present value analysis is used to discount future payments.

Despite the large up-front fee, the swap deal w;is projected to cost Philadelphia about $3 million to $4 million less than the insured fixed-rate deal on a present value basis.

In reality, for the first three and one-half years the swap and bond deal has averaged an all-in rate of about 7-65%, about 50 basis points more than expected. Currently, the all-in cost is about 7.45%, Philadelphia officials say.

If the all in costs stay at 7.45% for the remaining six and a half years, the city will have paid about $112.8 million.

On a present value basis, the insured deal is slightly more advantageous, because the premium paid by the city at the start is smaller than the premium paid by the city at the outset of the swap deal.

That comparison might not be relevant, however, since the city might not have been able to get bond insurance. Due to the city's mediocre credit ratings, city officials did not have a solid agreement with any bond insurance company to provide a policy on the 1990 deal.

According to Blakney, the city had lined up two companies to provide insurance on the issue. But the day before the city planned to sell the bonds, one insurer backed out. And the remaining insurer would not commit to the deal without further review.

"They were asking for more time than we were comfortable waiting," he recalled.

Officials in the bond insurance industry declined to speak on the record about the 1990 Philadelphia deal. An official at one of the insurers quipped, "We wouldn't have touched that deal with a 10-foot pole."

In fact, the insurers were worried because they had previously insured a substantial amount of Philadelphia bonds. Stock of MBIA Inc., the only publicly traded insurer at that time, dropped precipitously during the city's 1990 crisis.

And if the city had been unable to get bond insurance, the projected savings from the swap deal would have been even higher.

Uninsured fixed-rate bonds would have yielded about 7.80%, according to former city treasurer Blakney. At a fixed rate of 7.80%, the city would have paid $115.4 million in interest. On a present value basis, the projected cost of the swap deal was about $5 million lower. If the swap deal continues to cost 7.45% until it expires, the present value calculation still slightly favors the swap - by a $1.5 million.

Comparing the city's actual experience to a hypothetical uninsured issue puts the swap deal clearly in the black - except for the loss of advance-refunding opportunities.

Officials involved also said that the derivative structure allowed them to bring the deal to market quickly. If the deal had been structured as fixed-rate bonds, the attempt to arrange insurance would have delayed the pricing.

The Bond Buyer's 20-bond index yielded 7.32% on March 15, 1990. The yield stayed in a narrow range of a few basis points until April 26, when it rose to 7.51%. But two weeks later, the yield fell 7.29% and stayed below the March 15 level until Aug. 23, 1990.

Then again, had the city waited too long there would have been no bond deal of any kind. In June 1990, Philadelphia was effectively shut out of the bond market after Moody's downgrade of the city to junk bond status.

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