It’s high time that I give my own explanation of the recent financial forensics that my Board minority colleagues (Kaplan and Jimenez) and I have recently been working on.

Let me say that we don’t believe that there was anything nefarious going on, and we actually support the original intent of having gotten involved with these financial transactions.  However, we’ve gotten into a pattern in which we’re not being clear about the amount of money we may be losing that is supposed to be going into the classroom.

I’ve always believed that the first step to fixing a problem is to admit that you have one in the first place.

What’s an interest-rate swap? An interest-rate swap is an agreement between two parties to trade interest rates on a loan.  Think of like this: you and your neighbor both bought your houses for $200,000.  Your neighbor has a variable rate loan and you have a fixed rate loan. For example, let’s say your neighbor pays 3% on his mortgage this month, but that interest rate can change month to month. On the other hand, you pay 4.5% on your mortgage every month.  That rate never changes.  Both of you agree, however, to exchange interest rates, so that your neighbor sends you a check for his interest payment based on the variable rate.  You send your neighbor a check for your fixed interest rate payment.

In business, there are lots of reasons people do this, mostly to help manage their interest rate risk.  Fundamentally, however, if two parties exchange interest rates, one or the other is likely to make a profit.  Based on the example above, when you send your neighbor your check for interest at 4.5%, he will make money if his variable rate is less than this.  If his variable rate is more than 4.5%, you make money.

How is DPS involved in interest rate swaps? DPS issued bonds for $750 million in 2008 for two purposes.

1.     To raise $400 million to fully fund the teachers’ retirement system

2.     To refinance $315 million in debt from an earlier bond event that was financed at an 8.5% interest rate

When DPS did this, we entered into an interest rate swap with several banking partners.

Why did DPS enter into the swap? First, many government agencies have used interest rate swaps for a variety of reasons. It was not unusual for DPS to use this same tool.  In fact, DPS has been a part of several swap agreements in the past.

In this case, though, the swap went sour.  DPS is paying its partners 4.859% on $750 million each month.  However, the variable rate we receive in return is very low.  Last month it was 0.2%.

But doesn’t the Superintendent say that DPS is saving money? The Superintendent, depending on who he’s talking to, says we’re either saving $10 million or $18 million per year.  This part could be true, simply because the interest rate we’re paying on our pension refinance is, for the moment, lower than what we were originally paying.  This is a good thing.

The problem is that we didn’t refinance the entire $750 million.  We only refinanced around $300 million.  Had we actually refinanced the entire $750M, then yes, we could have saved $18M in interest payments.  But right now, we’re paying 4.895% on around $300M and 8.5% on around $450M.  According to our calculations, because of this, we stand to lose a total of around $56M by the close of this fiscal year.

Ouch.

More to come…