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Derivatives Put Denver Schools In Peril

When the Denver public school system needed to eliminate a $400 million pension gap, it turned to JP Morgan Chase and the bank’s recommendation to issue pension certificates. The problem was that the certificates involved exotic derivatives in the form of interest-rate swaps. If prevailing interest rates fell, Denver was on the hook to make up the difference to the banks. If interest rates rose, the deal would protect the school system from having to pay higher debt costs.

The latter didn’t happen, however, and Denver has since come to regret its decision with JP Morgan Chase and the Royal Bank of Canada, which served as independent adviser for the school system. Denver made the deal with JP Morgan in 2008; since then, the school system has paid $115 million in interest and other fees – an amount that’s at least $25 million more than it initially bargained for.

As reported Aug. 6 by the New York Times, Denver schools now want to renegotiate the deal entirely. To do so, however, means they will have to pay the banks $81 million in termination fees, or about 19% of its $420 million payroll.

John MacPherson, a former interim executive director of the Denver Public Schools Retirement System, predicts that the 2008 deal will ultimately mean big costs to the school system in the future. “There is no happy ending to this,” MacPherson said in the New York Times article. “Hindsight being 20-20, the pension certificates issuance is something that should never have happened.”

Joseph S. Fichera, chief executive of Saber Partners, a financial advisory firm specializing in structured finance, echoes those sentiments, adding:

“The issuer made a simple financing highly complex and took on substantial risk without knowing how large its downside could be,” he said. “The advisers and bankers may have disclosed that there were risks, but apparently did not help the issuer truly understand them. They typically present economic outcomes to the issuer only on projected savings and assume away any chance of the risks happening.”

The situation in Denver mirrors that of homeowners who elected variable-rate mortgage for their lower monthly payments. What they didn’t foresee were the significant potential risks.

According to some school board member, that’s because those risks were never clearly articulated by the banks involved in the deal. As reported in the New York Times story, banks outlined any risks only in broad terms during presentations to board members. Instead, the focus was on the benefits of the deal: lower debt costs and a potential savings of $129 million in pension costs over the next 30 years.

Denver isn’t the only municipality facing financial problems from exotic deals gone awry.  According to the New York Times, New Jersey would have to pay $536 million to get out of its derivatives contracts; California faces $234 million in such payments. Chicago faces $442 million in termination fees to unwind its deal, while Philadelphia would have to pay $332 million.

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