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Commentary by Joe Mysak Dec. 23 (Bloomberg) — State and local finances are in the worst shape since the Great Depression, according to the National Association of State Budget Officers , and you can’t blame it all on the economy. Irresponsible and negligent borrowing practices that wouldn’t be tolerated in Singapore are costing school districts and municipalities across the nation millions of dollars in extra financing costs and termination fees. Nobody wants to talk about it. This was illustrated in a report published in November by Auditor General Jack Wagner of Pennsylvania. The report shows how the Bethlehem Area School District used swaps . Since the state authorized school districts and local governments to use swaps and derivatives in 2003, Bethlehem has entered into 13 Qualified Interest Rate Management Agreements, the most of any school district in the state. Like so many municipalities across the nation, Bethlehem’s swaps have wound up costing it money. On the two swap agreements examined by the auditor (they have been terminated, the bonds refinanced), the district paid $10.2 million more than if it had sold a fixed-rate bond, $15.5 million more than variable-rate debt without a swap. That $15.5 million would buy a new Dell Studio 15 model laptop for each of the district’s approximately 15,000 students. People, even those who had nothing to do with the original transactions, don’t want to talk about it. Edit Out The auditor’s Office of Special Investigations interviewed the school district’s current financial adviser, Scott Shearer of Public Financial Management in Harrisburg, who had nothing to do with the deals in question. He called one transaction extremely complicated and risky. Upon reviewing a draft of the report, he asked that the words “and risky” be edited out. Shearer called some fees paid by Bethlehem “almost unheard of and not normal.” After reviewing a draft of the report, he asked that this be changed to “above average.” The auditor also interviewed Jens Damgaard of Rhoads & Sinon, Bethlehem’s current bond counsel. He said the district “crossed any and all normal lines” of debt structure. Upon reviewing a draft, he retreated, and asked that this sentence be cut. Auditor Wagner writes that he accepted most of the district’s requests on behalf of its professionals for changes, and footnoted other instances where to do so would result in a material change to their original statements, which is why we have this little collection of second thoughts. Why is everyone so afraid of offending everybody else? Thin-Skinned The municipal market is conflicted. Bankers don’t want to criticize other bankers, because they might work with them or for them some day. Lawyers and financial advisers don’t want to upset the bankers or their issuer clients. Analysts work for the banks selling stuff to the issuers, and the final product to bond buyers. They like to be agreeable: All is well! The same goes for the analysts who work for the rating companies, who are, after all, paid by the issuers. Even the institutional buyers, who used to be forthcoming, are afraid that if they say something untoward, they might not get allotments of bonds they can then flip out to the market at a tidy profit. The issuers are in thrall to the industry that pays to play, and offers the prospect of high-paying jobs, post- politics. It’s no wonder everybody declines to comment. Amateur Financiers The height of the swaps mania that is wreaking such damage in Muniland can be traced to Sept. 25, 2003. That’s when Governor Ed Rendell of Pennsylvania signed a bill amending the Local Government Debt Act to allow the state’s 501 school districts to engage in swaps. Can we all agree that this experiment of allowing the most amateurish issuers to use some of the municipal bond industry’s most complicated products was a bad idea for everyone except the financial services industry? Of course not. Even as swaps were blowing up in 2008, ex- treasurer of Pennsylvania Robin Wiessmann (also an ex-banker) said the problem wasn’t with swaps, but in how they were used. Auditor General Wagner is having none of it. He says the problem is with swaps themselves, and he asks that the General Assembly “clearly and unequivocally” prohibit municipalities from engaging in swaps, or as state law terms them, “Qualified Interest Rate Management Agreements.” ‘Immediate Profits’ The 73-page Wagner report concludes that small governments and school districts should never have been allowed to play the swaps and derivatives game. “We conclude that QIRMAs are highly risky and impenetrably complex transactions that, quite simply, amount to gambling with public money,” Wagner writes. “Moreover, they are susceptible of being marketed deceptively, and they principally benefit the investment banks and the multitude of intermediaries who sell them to relatively unsophisticated public officials.” Among the things that Wagner found in his study of the school district’s use of swaps were hidden fees, conflicts of interest, big profits. “Obviously, the huge fees and immediate profits generated by these agreements, in combination with their inherent complexity, present a powerful temptation to sell them in a fashion that over-emphasizes the financial benefits and minimizes the risks,” writes Wagner. No weasel words here! It would have been nice to hear and read more of them back in 2003, as Pennsylvania was considering “a statute written primarily for the benefit and protection of the financial services industry,” as Wagner puts it. “Where seldom is heard a discouraging word, and the skies are not cloudy all day,” as the old song has it, may be fine for the range, not for public finance. ( Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.) Click on “Send Comment” in the sidebar display to send a letter to the editor. To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net