NEW YORK -- The third-poorest city in Pennsylvania is a lot poorer because of a 28-year bet on interest rates that already has gone awry.
The Reading, Pa., school district, which has 18,323 students, must pay $230,000 this week to Deutsche Bank AG, Germany's largest bank, because it's on the losing side of a wager that long-term interest rates would rise faster than short-term interest rates.
In April, the district board rushed approval of the so-called interest-rate swap in eight days after its financial adviser said the transaction might earn the district $16 million by 2034.
While Reading's taxpayers are liable for the loss, bankers and advisers have pocketed $1 million in fees for arranging the swap, enough to buy 11 Mercedes-Benz S-550 sedans.
This week's payment to Deutsche Bank would have covered the school district's monthly utility bill.
"It was all done in a real hurry," said Keith Stamm, the only board member to vote against the deal. "The whole board is so desperate to try to find a way to raise money, they see this floated in front of them as a big-time amount of money and they want to go forward with it."
Local governments from Augusta, Ga., to Oakland, Calif., are being lured by similar opportunities to speculate with derivatives created by the world's biggest banks.
Most of the $400 billion of private agreements sold to municipalities escape taxpayers' notice and are little understood by the public officials and administrators who approve them.
"It's a recipe for disaster and it's also a recipe for sharp practices by charlatans," said James Cox, the Brainerd Currie Professor of Law at Duke University and a securities law specialist. "The gains that a community stands to derive from this are at the margins and the risks they're exposing themselves to, frequently, are greatly in excess of what the expected rewards are."
While financial firms often promote the agreements as a way for municipalities to lock in borrowing costs for future projects, the swap bought by Reading amounts to a bet on the relationship between short-term and long-term interest rates. If long-term rates rise higher than short-term rates, the municipalities will profit from the agreement, and vice versa. Long-term rates fell.
"It's more of a trading strategy than a hedging strategy," said Peter Shapiro, managing director of South Orange, N.J.-based Swap Financial Group, which advises governments on derivatives including interest-rate swaps. "All transactions include an element of speculation. The ones which are more speculative, like the yield-curve swap, are only suitable for issuers who are more sophisticated."
A derivative is a financial contract whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather. A swap is a type of derivative, where parties agree to exchange interest payments, usually a fixed payment for one that varies based on the movements of benchmark indexes.
The school board paid Frankfurt-based Deutsche Bank $575,000 to arrange the contract, known as a constant maturity swap, and awarded $400,000 to its financial advisers, including Reading-based Concord Public Financial Advisors Inc. and lawyers for arranging the trade, school officials said.
Ted Meyer, a spokesman for Deutsche Bank in New York, declined to comment on whether the agreement, also called a yield-curve swap, was suitable for the school district. Mike Setley, a principal at Concord, didn't return calls seeking comment.
Dennis Kelley, the school district's director of finance, said he was "surprised" to learn he owes $230,000. He said the district would pay the money using proceeds from another interest-rate swap.
While Reading is paying now, it may earn money on the swap over time.
"So long as interest-rate relationships return to normal conditions, this transaction should provide a significant financial benefit to the school district," Concord said in a memo to the district May 22.
Reading is a city of 80,000 about 60 miles northwest of Philadelphia where the unemployment rate is almost twice the U.S. average.
The city depends on state funding for $106 million of its $162 million school budget. Enrollment has grown 24 percent in the past decade, while the tax base dropped by about 6 percent, according to school district documents. Almost 70 percent of the students come from poor families. Schools are overcrowded and some are more than 80 years old.
The contract was approved after Concord said the swap "would allow us to get some cash now to help the district," said Pierre Cooper, a social worker and the former board president. "I don't know the particulars off the top of my head."
William Cinfici, another board member and a registrar for the state's division of vital records, said Concord didn't provide enough financial information to evaluate the transaction.
"It was arcane, nobody questioned it," Cinfici said. "Everything was presented to us at the last minute. I said, 'Well, I'll trust in the guy's judgment.'"
Stamm, a real estate broker and the current president of the nine-member board, said Concord told the board the swap was "a roll of the dice."