Today’s Wall Street Journal had an article entitled “Swaps at Center of a Debt Standoff,” which discussed a dispute that has arisen between a school district in Pennsylvania and the Royal Bank of Canada (RBC).
The dispute revolves around an interest rate swap agreement entered into between the State College Area School District and RBC. As the WSJ cleverly points out, the dispute has arisen as a result of the school district’s “skipping an interest payment on money it never borrowed for a school it didn’t build.”
How’s that for a teaser? Even better, the swap has been dubbed by the school district as a so-called “naked swap.”
What in the world is a naked swap and how did the parties get to the point where they are now?
Well, in 2006, the school district made a decision to build a new school, although it did not plan to do so until 2007. The expected cost of the project was approximately $58 million.
Since interest rates were low at the time, the school district sought to lock in their borrowing costs by entering into an interest rate swap agreement with RBC. In effect, although the school district had not yet issued bonds or borrowed the money for the school project, it agreed to pay RBC a fixed rate of interest on a notional principal amount of $58 million (notional, because there was no actual underlying debt at the time) and RBC would pay the school district a variable or floating rate of interest on the same notional amount.
If interest rates rose, then the school district would have successfully hedged its risk against such rise by means of the interest rate swap.
Problems arose for the school district when construction bids for the proposed school project came in higher than anticipated. Ultimately, the project was cancelled, and so the school district never borrowed the money for construction, and the school was never built.
The only problem was that the interest rate swap was still in place. And with interest rates declining, the net payment due from the school district to RBC increased.
Whoops. Not a good result. On top of that, interest rate swap agreements have provisions that make terminating the swap increasingly more painful to local governments if rates are declining. After all, the value of the swap has gone up in the eyes of the swap provider–in this case, RBC.
According to the WSJ article, the termination fee that would have to be paid by the school district to get out of the swap had risen from $168,000 in June 2007 to $5.5 million in February 2010.
Now, RBC has sent a notice to the school district that it owes $10 million to RBC for skipping a payment. The school district has filed a lawsuit in federal court, alleging that the interest rate swap is void because it was entered into before (and, in this case, in the absence of) a public borrowing by the school district.
Stay tuned for further developments.