Starting January 1st, PGW bumped up rates by over 5%, even as natural gas prices remain low and consumers elsewhere see cuts.
Why? Because CDR Financial Products, the financial advisory firm close to former Mayor Street (and previously, and currently, under FBI investigation), was paid $225,000 to set up a terrible "bond" deal with JP Morgan to finance $310 million PGW bonds in 2006 that netted JPM millions and will leave PGW’s customers holding the bag.
Part of the deal was merely a bad idea: instead of issuing traditional fixed-rate bonds, PGW engaged in an "interest-rate swap," which is a specialty of CDR, a complicated form of variable-rate financing in which the borrower generally ends up taking on some risk of interest rates rising, but not as much as if they had simply issued a variable-rate bond.
Interest rates rose and now PGW is paying an extra $6 million per year over what they could have had with a fixed-rate bond issue. The fixed rate would have been 5.25; the original ‘effective rate’ of the swap was 3.67 and is now 7.25, hence the additional payments.
That happens, it’s an accepted risk of interest-rate swaps, and a lot of entities and municipalities were still foolishly investing in variable-rate products in 2006, despite the obvious interest rate increases on the horizon.
The "biggest problem," however, as described by the Philadelphia Inquirer, is not so understandable:
When bond markets froze in the summer, FSA, like most other bond insurers, saw its credit ratings cut, and investors started fearing the bonds could default. They began dumping PGW bonds back to JPMorgan and the other banks.
JPMorgan told PGW in the fall that it couldn’t afford to keep owning the bonds indefinitely. Under the deal, if the bonds can’t be sold by July, PGW must pay the banks $60 million a year, for the next five years, until the value of the bonds is paid off. PGW says it can’t afford that with its other debt.
PGW can cancel the swap agreement but, under the deal, might have to pay JPMorgan more than $30 million to compensate the bank for ending the arrangement early.
Or it can find a new lender willing to sell new bonds, probably at higher rates, Bisgaier added. "We have six months to fix this."
None of that should be PGW’s problem. JPMorgan agreed to underwrite the bonds; at that point, the bonds should have become JPMorgan’s responsibility. Normally, if the underwriter can’t place the bonds, they hold on to them. If bondholders have clauses in their purchase agreement with JPM permitting them to rescind the deal and send the bonds back to JPM, that should be JPM’s problem.
But that’s not what happened here. For a less than 2% discount on the initial interest rate, PGW took on all of the risk of the bonds, including the risk of increased interest rates, the risk of bond insurer rating decline, and the risk of investors and their underwriter changing their minds.
That’s exactly the opposite of how a ‘bond’ is supposed to work. A bond is supposed to provide the borrower with capital under the single requirement that they make timely interest and premium payments, which PGW continues to do. It should be just like a mortgage — so long as the interest and premium is paid, a bank can’t simply call a mulligan and ask for the money back if it’s unhappy with the market for mortgages.
Indeed, the rigid nature of instruments like interest rate swaps is supposedly a big part of what’s causing so much trouble on Wall Street, and why the Federal government has already provided banks $350 billion-plus in assistance to help them with these assets, with a loss of $64 billion and counting.
More questions need to be asked about this "deal" — in the midst of systemic bank malfeasance and irrational exhuberance, how did PGW, and not JPM, end up on the losing end of a commonplace transaction?