Published in the Star-Ledger, Sunday, June 4, 2006
High-finance gamble haunts New Jersey
'Swaps' deals from McGreevey era enriched consultants and have cost the state millions
Sunday, June 04, 2006
BY DUNSTAN McNICHOL
Star-Ledger Staff
For two frantic minutes of a spring day in 2003, a conference room in Trenton took on the air of a Wall Street trading floor.
A dozen bankers wielding cell phones shouted offers. Bids were made. Bids were withdrawn.
When the dust settled, several state Treasury Department officials exchanged high-fives with their financial consultants and bragged that the state had just locked in historically low interest rates for $3billion in future borrowing that would be used to build schools.
It was called a swaps deal -- a high-finance maneuver in which institutions guarantee themselves a fixed interest rate on future loans.
It sounded like a great deal for everyone. The consultants reaped nearly $3million for brokering the deal. And it would be a coup for New Jersey taxpayers, now able to borrow at lower rates.
But so far, it hasn't worked out that way.
From that day in April 2003 to when the state actually needed its money, interest rates didn't rise as consultants predicted.
They actually fell.
In the years since, taxpayers have missed out on bargain-basement rates that would have saved the state tens of millions of dollars if officials had borrowed the old-fashioned way. That money -- not even state officials cannot say exactly how much -- and millions more in fees paid to the bankers could have been used to build additional schools or save programs from elimination under Gov. Jon Corzine's controversial state budget.
"The state of New Jersey put a bet down, and regardless of what they thought the odds were, they were wrong," said Robert Brooks, professor of financial management at the University of Alabama and author of a book on swaps. "At the end of the day, I don't believe states and municipalities should be in the business of rate-betting."
New Jersey leapt into swaps with the help of a politically connected Pennsylvania consulting firm during the administration of Gov. James E. McGreevey, lining up contracts on 32 loans for school construction, transportation and other projects, totaling $4.8billion.
Today 25 of those deals have come due and more than $2.5billion of that money is in play.
A Star-Ledger review of those deals -- built from information obtained through numerous public records requests -- shows:
- Over the past 21 months, investment bankers have collected $183 million more in swap payments than they have sent to the state. To understand how money flows back and forth on a loan, think of it this way: The state sends the bankers money for rates it previously locked in, and the bankers send the state payments based on prevailing rates.
- Last year, the state paid $39.8 million to cancel or postpone two swaps gone bad to avoid even more losses.
- The state is scheduled to pay $120 million in fees for underwriters that never were disclosed to the public and lawmakers.
- The consultant under contract to help New Jersey manage and evaluate its swaps, CDR Financial Products of California, has negotiated deals being probed by the Internal Revenue Service in other states for alleged improprieties.
- Just last week, six of the eight Wall Street firms that sell bonds in connection with the state's school swaps agreed to each pay $1.5 million to settle federal allegations that they improperly conducted auctions that determine the price of bonds in swap deals.
Corzine, an expert on swaps from his years at Goldman Sachs, said he will set his own comprehensive policy. He said a rise in interest rates in the future could turn swap losses into gains, and that the state can, at a cost, get out of bad deals.
"Swaps in and of themselves are not bad things," Corzine said. "You have to have a policy. It's a lot easier to do (swaps) in the private sector. But you have to be more careful when it's the public's money."
FOLLOWING SUIT
Financial experts compare swaps to insurance policies. And like insuring against potential floods or car crashes, the state used swaps to insure against potential soaring interest rates widely predicted by consultants.
"If the insured event doesn't happen, insurance always looks like you didn't need it," said Tim Blake, an analyst with Moody's Investors Service who monitors New Jersey finances.
Nancy Feldman, a former Goldman Sachs executive who took over as head of New Jersey's Office of Public Finance this month, agreed.
"We all buy insurance for things that don't happen," she said. "As a conceptual matter, when interest rates start rising and you have $8.6billion of bonds to do, it's a reasonable decision to make."
Former state treasurer John McCormac, who oversaw the rapid growth of the state's swaps portfolio, said the deals helped stabilize future borrowing costs. He said it is misleading to evaluate them at any single point.
"We're not going to worry about daily fluctuations," McCormac said before he left office earlier this year. "They are part of an overall investment strategy. For every one that's bad, I can assure you there will be others that work out well."
New Jersey is not alone in its appetite for swaps, which now account for $213trillion in financing, according to the International Swaps and Derivatives Association.
Most often used by private companies, swaps gained favor among New York, Pennsylvania and other governments early this decade, when long-term rates dropped to unprecedented lows.
But critics of New Jersey's program say the deals often were shrouded in secrecy and boards and lawmakers were told little before they approved them.
Tom Wilson, now Republican State Committee chairman, voted yes on the $3billion in school construction swaps as a member of the state's Economic Development Authority three years ago.
"At the time I remember we kept scratching our heads to remember why this was a good idea," Wilson said.
The school construction swaps struck in 2003 already have cost taxpayers more than $16.9 million in monthly payouts. (That figure represents the difference between what the state sends its bankers for rates it locked in, and what the bankers send the state based on current rates. It does not include all fees.)
In addition, the state paid $38 million to postpone a swap scheduled to take effect last September.
"That sounds like an awful lot of schools not being built," Wilson said.
Several lawmakers said state officials were slow to tell them the full picture about other swaps, and experts like Brooks say the deals are so complicated, government officials are generally overmatched by bankers who propose the deals.
"It's kind of like playing cards where the guy sitting across the table has a mirror behind you," he said. "There are certain games where you just want to walk away."
The Governmental Accounting Standards Board, a national organization that sets standards for public finance, recently proposed broad new disclosure rules for swaps.
In New Jersey, Lance has introduced legislation that would require the treasurer to draw up a swaps policy and publicize details and costs of any future transactions.
"Because this is so complicated, it is not easily explainable," he said. "But the people have a right to that, and the way to achieve that is through honest discussion between the Legislature and the treasurer."
Corzine, who inherited McGreevey administration deals that will come due during his administration, agrees.
"It has to be done carefully, with transparency," he said.
POLITICAL TIES
Under McGreevey, the state's heightened interest in swaps was spearheaded by McCormac and Raj Vakharia, a deputy treasurer who had worked on Wall Street. They touted them in news releases as a risk-free way to lock in low interest rates.
Most of the initial swaps were arranged by Investment Management Advisory Group, a Pottstown, Pa., firm that had cultivated political, personal and business ties with the incoming McGreevey administration.
IMAGE and its president, David Eckhart, donated more than $200,000 to state Democratic campaigns. Eckhart set up a subsidiary that briefly rented office space from McGreevey's biggest campaign finance supporter, Philadelphia consultant Robert Feldman. Eckhart did not respond to requests for comment.
Paul Levinsohn, McGreevey's campaign finance manager and the governor's first counsel, served on the board of a Philadelphia charity operated by Feldman's business partner, the late Ron White. White, a prolific McGreevey political backer, received a controversial $75,000 consulting contract at the University of Medicine and Dentistry of New Jersey shortly after McGreevey took office.
Within months of McGreevey's inauguration in 2002, Eckhart and Vakharia visited officials in at least three state departments to pitch swaps and other complex deals, state records obtained by The Star-Ledger show.
IMAGE assured state officials that swaps were a good deal because interest rates were almost certain to rise in the coming months: "Historic 20-year swap rates have exceeded the current rate over 99.5% of the time," IMAGE proclaimed in documents handed out at a Sept. 27, 2002, presentation to state officials.
In 2003, IMAGE coordinated 10 swaps deals -- including six $500million transactions for school construction. IMAGE collected $1.3 million for that deal alone, while 12 other consultants split $1.5 million, Treasury Department records show.
In 2004, with the state's swaps portfolio swelling, New Jersey hired CDR Financial Products to help manage the deals for a flat fee of $250,000 per year. CDR is the California company whose deals are now under federal investigation.
Over the past two years, five communities, all outside New Jersey, revealed they were told by the Internal Revenue Service that CDR set up side-deals that steered excessive fees to the company, thus jeopardizing the tax-free status of the bonds. The IRS twice cited deals between CDR and the investment bank Bear Stearns as generating excessive fees.
IRS officials declined to discuss whether any New Jersey deals are being scrutinized. CDR, in a written statement, said it had no independent knowledge of any IRS reviews.
"CDR has received no subpoenas or requests for information about its dealings with Bear Stearns, nor has the IRS or any other investigatory agency sought any information regarding financial transactions involving New Jersey state government or other New Jersey public entities," CDR wrote in response to questions from The Star-Ledger.
State officials decided in March to allow an upcoming swaps deal to take effect as scheduled, based in part on advice from CDR. The transaction would have cost $27million to cancel. By locking it in, Bear Stearns and six other underwriters are scheduled to get about $20million in fees over 25 years.
Corzine and his treasurer, Bradley Abelow, said they were unaware of the IRS issues involving CDR. The treasurer said the state's $250,000-a-year contract with the firm, which in January was extended through the end of the year, will be reviewed.
"We will pay attention to who our advisers are," Abelow said.
Corzine promised to review past swaps.
"You have to look at it to find out how it was done, why it was done," he said. "You can't just do these things speculatively."
Dunstan McNichol covers state government issues. He may be reached at dmcnichol@starledger.com or (609) 989-0341.
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