In order to maximize a loan, a local government may agree to a variable rate bond, which means the interest goes up or down depending upon market conditions.
The local government may then enter into an arrangement with a third party, usually a financial institution, whereby the government pays the third party a fixed 4% in interest and the third party agrees to pay whatever the variable interest rate comes to over the term of the bonds.
If the variable interest rate on the bonds rises above 4%, the third party loses the amount equivalent to whatever interest is above 4%. If the variable interest rate on the bonds drops below 4%, the third party profits by the amount the interest is below 4%.
When the variable interest rates exceed 4%, the third party benefits by canceling the SWAP and there probably would be little or no penalty to do so if the government so chose. But when the variable interest rates drop below the 4%, the third party is profiting and will demand a penalty to cancel the SWAP agreement. That penalty is normally based upon a ‘yield maintenance’ formula, which takes into consideration all of the third party’s future potential profits due to the interest rate differential at time of cancellation after adjusting for the future value of money.
The amount the Lancaster County Convention Center Authority would have to pay to cancel its SWAP arrangement was in the low $20 million a few months ago, when interests were at their lowest level. The cost now is around $15 million. This is because interest rates are rising, although still much lower than what the LCCCA would have had to pay had it retained a variable interest rate rather than entering into the SWAP arrangement.
The sponsors and the majority board members of the LCCCA were ‘hell bent’ to maximize its borrowings in order to overcome an announced $20 million shortfall and to commence construction. Powerful forces were eager for the opportunity to ‘dip their beaks’ into the overall convention center feeding trough.
The convention center project was so highly leveraged (too much money borrowed for the expected return on investment) that conventional financing would have never been sold. Only a higher risk interest rate swap provided enough funds to build the inappropriately oversized facility that exists today.
Had the project been delayed by even a few months, financial markets became so volatile that there was no way they could have borrowed so much money for such a risky venture.
I wonder if those same powerful forces will be expecting (demanding) that the newly appointed CRIZ authority board will pursue major dollars for the (already existing) convention center/hotel refurbishing/debt reduction rather than investing those dollars in for the targeted blighted and underutilized properties within city limits?
Will the public be allowed any input into possible projects?? T
he public will be watching!!!!!!