By Tamsin McMahon - Tuesday, February 19, 2013 - 0 Comments
How complex financing deals between banks and U.S. cities went bad
As the hometown of Penn State University, the municipality of State College, Penn., is no stranger to bad publicity. But its announcement last month that it was paying a Canadian bank $9 million as part of a failed plan to raise money to build a new school has placed the town at the centre of a national debate over a type of high-risk debt that critics claim has helped tip hundreds of American cities, schools and transit systems into financial ruin.
In 2006, State College’s school board planned to issue bonds to raise $58 million to replace its aging high school. The board’s financial adviser suggested it hire the Royal Bank of Canada to do the deal, and protect against the prospect of rising interest rates on its bonds by locking into a complex deal known as an interest-rate swap with the bank.
The school board would pay RBC a fixed interest rate and RBC would pay the board a floating rate, which the board would then use to pay its bond investors. If rates rose, the board would pocket the difference. If they fell, the school would owe the bank. But in a twist, the community voted not to build a school and the board never issued the bonds. After interest rates plunged in the wake of the 2008 financial crisis, the board missed its first interest payment of nearly $1 million to RBC. It launched a lawsuit to try and back out of the agreement but lost the court case and last month announced it had reached a settlement to pay RBC $9 million of a termination fee between $10 and $11 million.