SEC Hearing on The State of Municipal Securities Market
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Birmingham, AL
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July 29, 2011
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Prepared Remarks of:
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Andrew Kalotay, Ph.D. 

President, Andrew Kalotay Associates, Inc., New York NY 

My name is Andrew Kalotay. In 1990 I founded a debt management advisory firm with clients including the 

Tennessee Valley Authority and the Federal Farm Credit Banks. Previously I worked at Salomon Brothers and 

at Dillon Read in fixed income research, and before that I was at Bell Labs and at AT&T. My involvement in 

municipal finance goes back to 1979. I have a Ph.D. in mathematics from the University of Toronto, and I 

have taught graduate finance at Wharton, Columbia, and Fordham University. I was also the founding 

director of the graduate financial engineering program at Polytechnic University in 1995, and in 1997 I was 

inducted into the Fixed Income Analysts Society’s Hall of Fame for my contributions to debt management. 

I would like to thank Commissioner Walter and the SEC for inviting me to comment on the state of municipal 

derivatives. I believe that we stand at a crossroads where the SEC can have a significant impact by shining a 

light on the inefficiencies and waste that exist in municipal finance. I’m referring to what I see as Wall Street’s 

multi-billion dollar hidden tax on Main Street, through poorly structured bond and swap transactions. 

I’m not talking about fraud per se. The financial press understandably concentrates on the periodic blowups 

and perp walks arising from fiascos such as Jefferson County. I am referring to a much more pervasive 

problem that goes virtually unrecognized amidst the tales of incompetence and greed. 

SLIDE 1
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I have been a vocal critic of municipal finance practices for some time. As I said in a Bond Buyer article 

published earlier this year, swaps are badly mispriced against the municipalities. I will illustrate this with a 

recent transaction that I believe is typical, and then extrapolate the damage to a national scale. As you see, I 

put the blame for the current troubling state of affairs squarely on the municipalities’ swap advisors, who are 

hopelessly conflicted. 

The scales are tilted in favor of the banks due to the kind of arcane knowledge required to price these 

custom swap products. But the valuation of swaps is not rocket science; the market information and the 

analytical software are readily available. The problem with swap advisors is not the lack of technical 

expertise, but how they get compensated. The incentives are skewed: the deal must go through in order for 

the swap advisors to get paid. If we cannot force them by regulation to behave as true fiduciaries, then 

clearly they should not represent themselves as advisors — ‘agents’ or ‘fixers’ would be a more accurate 

appellation for their role in municipal finance. 

Let me turn to a 30-year $750 million variable-rate bond deal by Denver Public Schools in 2008, which has 

been extensively covered in the press. DPS swapped these bonds to fixed rate, with three major banks, on 

identical terms. Swaps packaged with variable-rate bonds are common in the municipal market, and they are 

aggressively promoted by the banks. The New York Times quoted me on March 8, 2010: “When 

municipalities enter into these swaps they end up paying more and receiving much less.” 

As an aside, this was a taxable bond deal, putting it in the same realm as corporate issues. To my knowledge, 

no respectable corporation has ever done such a deal. If this is such a good idea, wouldn’t the banks use it to 

fund themselves? What is truly scary is that municipal issuers such as DPS don’t seem to realize that they are 

unwitting guinea pigs in these dubious experiments. 

Getting back to swaps, there is a key concept called ‘fair value’, which can be determined from the prevailing 

(observable) mid-market swap curve. 

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SLIDE 2
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As you can see from this slide, the difference between the bid and ask rates is very small, usually less than 1 

basis point (100th of a percentage point). For example, the so-called bid-ask spread for a 10-year swap is two 

tenths of a basis point. I can tell you that our advisory clients routinely transact within one basis point of 

mid-market rates. 

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SLIDE 3
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This slide shows the fair value of the DPS swap as reported in its 2010 comprehensive annual financial report. 

Interest rates had moved against DPS; collectively, the three counterparties reported the fair value as 

approximately -$143 million. This is very close to the value calculated by us; the difference is a mere 0.17% of 

the notional amount. The point to take away is that when it comes to fair value, there is consensus among 

experts. 

Now let’s take a look at the swap when it was executed in 2008. 

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SLIDE 4
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Here we see that at the time of entry, the value of the swap was about $13.6 million, nearly 2% of the 

notional amount, against the school district. This does not include the $425,000 expense paid to the so-called 

swap advisor, and another $100,000 paid to the swap counsel. So the aggregate cost of the swap to Denver 

taxpayers at the time of execution was well in excess of $14 million. 

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I believe that, in percentage terms, the economics of the DPS swap are typical. Let’s estimate what this 

means on a national scale. 

SLIDE 5 

I conservatively assumed that $1 trillion municipal swap transactions occurred in the last 5 years, including 

many unwinds, where the municipalities are also overcharged (they get you coming and going). Assuming a 

2% mark-up, the hidden cost of swaps to the taxpayers on a national scale adds up to $20 billion. 

The banks tend to defend their profit margin by claiming exposure to municipal credit risk. But what is the 

justification for a high margin on unwinding, when credit risk is non-existent? 

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SLIDE 6
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So what to do? Swap valuation is not in the skill set of most municipal decision-makers, and swap advisors 

have not served them well. As Justice Louis Brandeis said in his book, Other People’s Money, “sunlight is the 

best of disinfectants; electric light the best policeman.” In that spirit, at a minimum, the banks should be 

required to disclose the swap curve at the time of execution. Also, any side agreements with the swap 

advisor should be disclosed as a matter of course. More broadly, perhaps a Municipal Finance Protection 

Bureau should be set up to provide municipalities with fair values of swaps, on demand, prior to entry or exit. 

It will be a step in the right direction but I would be naïve to assume that it would solve the whole problem. 

I thank you for your time and hope that some of the ideas in my talk will be of use. 

[A more detailed examination of the 2008 Denver Public Schools transaction is attached] 

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Appendix to Prepared Remarks of Andrew Kalotay
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SEC Hearing on The State of the Municipal Securities Market
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Birmingham, AL
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July 29, 2011
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Case Study: Denver Public Schools (DPS)
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$750 Million Variable Rate Taxable Bonds Swapped to Fixed
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Background 

I first heard of this transaction through a 2010 interview by Gretchen Morgenson of the New York Times.
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Here is what I said:
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“... a deal like Denver’s would be highly unusual among private sector issuers like corporations ... I’m not
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aware of any corporations trying to get a better fixed rate by issuing long-term instruments such as those
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used by Denver. Why would the school district want to do this transaction with all the attendant risks of
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mispricing and the possibility of unfavorable unwind costs when they could have done a conventional,
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taxable fixed-rate deal?”
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(New York Times, August 5, 2010)
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I became interested in this deal when someone on the Denver Public Schools board subsequently asked me
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to elaborate.
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Structured Variable Rate Bond Transactions 

In April 2008 DPS issued $750 million of 30-year variable-rate amortizing bonds. The bonds had to be 

remarketed periodically (every 7 days or every month, depending on the ‘interest rate mode’ chosen by 

DPS); such bonds require a remarketing agent and a liquidity provider (both collecting ongoing fees). In the 

event a remarketing fails, the liquidity provider steps in and buys the bonds but typically charges an 

exorbitant interest rate. In the DPS case, the rate was 9% per annum for the first remarketing failure. 

(Denver Business Journal, August 15, 2010). 

The interest rate of a remarketable issue varies over time, due to changing market conditions and possibly 

due to issuer-specific developments. Because DPS’s ultimate objective was to lock in a fixed rate over time, it 

entered into a $750 million LIBOR-based interest rate swap whose amortization structure mirrored that of 

the bond issue. In this swap DPS paid a fixed 4.859% rate and received in exchange the 1-month LIBOR rate. 

While the focus of this note is on swaps, first a few words are in order regarding the basic structure of this 

transaction, i.e. issuing variable rate bonds and then ‘fixing’ them via an interest rate swap. Until recently, 

such transactions were common in municipal finance. The volume of tax-exempt variable rate bonds issued 

during the past 5 years is over $1 trillion, and I assume that most of these were swapped. 

As I said in my August 5, 2010 New York Times interview, I consider these transactions unsuitable for longterm funding: they are much too risky, not to mention the fact that they entail considerable ongoing 

servicing costs. For example, the term of the agreement with the liquidity provider normally runs for only 2 

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or 3 years, while the maturity of the bonds may be 30 years. In the absence of a new liquidity provider, the 

deal could blow up. (This was in fact the subject of Ms. Morgenson’s New York Times article; DPS’s liquidity 

provider Dexia was experiencing severe financial problems). 

If the variable-rate bonds are insured (as used to be the norm) the bonds’ interest rate depends on the credit 

of the insurance company. If the insurance company subsequently runs into problems, the market will charge 

a higher rate on remarketing. In extreme cases, when there is no market demand for the bonds, the issuer 

may have to pay a double-digit interest rate to the liquidity provider to keep the bonds alive. It was the 

downfall of the bond insurance companies, as a result of the 2008 financial crisis, that essentially shut the 

door on these transactions. 

Taxable DPS Deal Has No Analog Among Corporate Issues 

DPS Board President Nate Easley, Jr., in a letter to board members, called the 2008 deal “far from exotic,” 

saying it was structured exactly like a 2005 transaction. He continues, “Despite the high-pitched rhetoric 

currently surrounding the issue, the financing structure the district used is very commonly employed. Over 

100 public entities in Colorado have issued over 500 variable-rate issues in the last decade alone.” 

(Bond Buyer, August 12, 2010). 

But the DPS transactions in 2005 and 2008 were fundamentally different from the typical municipal debt 

deal: the DPS bonds were taxable, putting them in the same realm as corporate (taxable) debt. To my 

knowledge, no respectable corporation has done such a deal. Nor have the banks who propose such deals as 

a way to achieve interest savings used such transactions for their own funding needs. Apparently, DPS was an 

unwitting guinea pig in these risky funding experiments. 

Why would investment banks pitch such a complex and risky deal to a school district, but not to the more 

sophisticated corporate issuers? The answer, in my opinion, is that their primary goal is to put municipalities 

into swaps, where the mark-ups are usually in the 2% range. That would not work with more savvy corporate 

issuers. 

Analysis of the DPS Swap 

Let us take a closer look at the $750 million 4.859% interest rate swap executed by DPS in 2008. Actually 

there were three individual swaps, with three different counterparties. The swaps had exactly the same 

terms, except that the notional amounts differed, as shown in Table 1 below. 

Table 1: Counterparties to $750 million DPS Swap 

Counterparty JP Morgan Bank of America Royal Bank of Canada 

Notional Amount 

of Swap $450,000,000 $200,000,000 $100,000,000 

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The so-called fair values of swaps need to be reported for accounting purposes periodically. Municipalities 

presumably obtain estimates of these fair values directly from their counterparties. DPS’s 2010 

comprehensive annual financial report shows the fair values of the swap totaling $142,866,925 against DPS 

(rates declined between April 2008 and June 2010). Our own analysis indicates a fair value of $144,174,835, 

which differs by just 0.17% of notional amount. So when it comes to estimating fair value there is virtual 

agreement among experts. 

What was the value of the DPS transaction at inception? Our calculation, based on the swap curve at the 

close of business on April 22, 2008, indicates $13,583,213 against DPS, or almost 2% of notional amount. And 

this does not include the fees paid to the swap adviser ($425,000), swap pricing agent ($25,000) and swap 

counsel ($100,000). As an aside, the role of swap adviser was assumed by one of the banks that also 

participated in the deal, after having received a ‘conflict waiver’. 

The Chickens Come Home to Roost 

In the Denver Business Journal of August 15, 2010, the superintendent, Tom Boasberg, indicated that in April
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2008 DPS could have issued fixed rate debt, presumably with the same amortizing structure as the variable
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rate bonds, at about 7.25% — supposedly the bogey to beat. My own review of market levels at that time
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point to much lower funding rates for issuers of DPS’s credit, assuming a debt structure with an average life
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of about 22 years. (Because of the amortizing nature of the DPS issue, its average life was shorter than the
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stated maturity.)
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However, as discussed above, instead of issuing fixed rate bonds, DPS entered into the complex variable rate
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bond transaction overlaid with a swap. Dexia, a Franco-Belgian bank, acted as liquidity provider.
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According to the Denver Business Journal of August 15, 2010, both Dexia and the bond insurer Financial
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Security Assurance Inc. were downgraded during the mortgage crisis in 2008. Investors were “spooked” and
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“... DPS ended up paying nearly $25 million more in interest costs and fees in the 2008-09 school year than it
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had budgeted for.”
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The Bond Buyer article of August 12, 2010, quoted Standard & Poor’s rating analysts as saying, “The district’s
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recent all-in costs, including the spread over one-month Libor, and remarketing and letter-of-credit fees,
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have been as high as 7.10%, but this is still under its budgeted interest cost of 7.50%, according to the
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district.” It is unclear how the budgeted 7.50% relates to the 7.25% mentioned by Tom Boasberg.
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Faced with the expiration of the liquidity provider contract in April 2011, the DPS board voted to unwind part
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of the swap with one of the counterparties, at a cost of $41.7 million. DPS decided to refinance the entire
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2008 issue with proceeds from $396,045,000 of new variable debt swapped in the same manner as before,
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and $396,235,000 of new fixed rate debt. The issuance costs to financial and swap advisors, rating agencies,
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lawyers, et al, but not underwriting fees totaled $2.6 million. The size of the new debt is $792,280,000
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($42.28 million more than the original size of $750 million); consequently DPS had to put up additional
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buildings as collateral.
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(Source: Denver Public Schools documents).
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Recommendations 

In spite of the claims of DPS officials, it appears that a fixed rate deal in April 2008 (not to mention in 2005) 

would have been preferable. The myriad add-on costs and risks associated with the complex variable rate 

issue combined with a swap should have given DPS pause. 

What can be done to make municipalities aware of the true costs and risks of getting into these complex 

deals? Perhaps it is time for a Municipal Finance Protection Bureau with at least the following functions. 

•	 Provide fair values of swaps to municipalities prior to entry or exit, so that they know how much they are 

being overcharged 

•	 Randomly sample swaps done by various municipalities to quantify mark-ups 

•	 Award an annual prize to the municipality with the best-executed swap, based on submissions 

These suggestions may nudge municipal finance in the right direction but one would be naïve to expect too 

much. 

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