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					   National Association State Treasurers
TREASURY MANAGEMENT CONFERECNE
       Swaps and Other Derivatives
            December 6, 2004




                                    Michael J. Marz
                                    Vice Chairman
Introduction to Derivatives

      Governmental issuers use a wide range of financial derivative products to more efficiently
       manage their debt and investments

      A derivative is a financial instrument created from or whose value depends on (is derived
       from) the value of one or more separate assets or indexes of asset values
        For example, the value of an interest rate swap is derived from the values of bonds

      Common goals for using derivatives in
       the public sector include:
        Lowering interest expense               Over-The-Counter Interest Rate Derivatives Outstanding

        Hedging interest rate risk                                      $80,000

        Matching interest rate sensitive                                $70,000

          assets and liabilities                                         $60,000




                                                   Notional (billions)
        Diversifying financial risks                                    $50,000

                                                                         $40,000
      Derivative products are unique in the                             $30,000
       history of financial innovation                                   $20,000
        The first swap was executed                                     $10,000
          between the World Bank and IBM                                     $0
          twenty years ago
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        There are now more than a seventy
                                                                            Source: International Swaps and Derivatives Association, Inc
          trillion dollars of such products
          outstanding


                                                                                                                                           1
Derivatives Fall Into Three Broad Categories

       1) Over-the-Counter:
         The largest of the three categories, which includes transactions negotiated privately
           between two counterparties
         Most interest rate, currency, credit, commodity and other swaps, and most public sector
           derivative products are executed over-the-counter

       2) Exchange Traded:
         Includes futures and options contracts that are traded on an exchange like the Chicago
           Mercantile Exchange (the “Merc”) or the London International Financial Futures and
           Options Exchange (the “LIFFE”)

       3) Structured Notes:
         Includes inverse floaters and other securities whose cash flows are tied to an index or
           formula


                     Exchange-Traded                           Over-The-Counter
                                                               Over-The-Counter
                      Exchange-Traded                                         Swaps
                     Futures
                      Futures                                                  Swaps
                     Options                                                   Caps
                      Options                                                   Caps
                     Forwards                                              Swaptions
                                                                            Swaptions
                      Forwards Rate
                         Interest                                     Interest Rate
                          Commodity
                                         Structured Notes
                                         Structured Notes             Commodity
                            Currency
                                            Inverse Floaters
                                             Inverse Floaters         Currency
                               Stock     Step-Up Coupon Notes
                                          Step-Up Coupon Notes        Credit
                               Bond       Equity-Linked Notes
                                           Equity-Linked Notes        Stock


                                        Primary        Secondary
                                        Market          Market
                                                                                                    2
What Makes Derivatives in the Public Sector Special?

       Conservatism: Public sector issuers are typically conservative
         Floating rate debt was not widespread until the early 1980s
         Derivative products not used until the late 1980s
         Risk averse issuers whose primary goal is the reliable provision of services, not profit
         Bottom Line: Derivative products and applications developed for this market are
           generally simpler, easier to understand and less risky than those in the corporate market

       Tax Code: Many applications for derivative products result from the constraints,
        inefficiencies, risks and opportunities created by the tax code
         Rules forbidding second advance refundings, or any advance refundings of Private
           Activity Bonds
         Risk of tax law change
         Bottom Line: Issuers understand the tax code and the benefits of derivative products

       Tax Risk: Tax risk is related to another challenge in the tax-exempt markets: inefficiency
         Long-term fixed rate bonds can be notoriously illiquid and difficult to value
         50,000 issuers; multiple credit structures; limited disclosure
         Bottom Line: This inefficiency allows swaps to provide fixed rate borrowing at rates
           lower than traditional fixed rate bonds




                                                                                                       3
Derivative Product Applications

     For the last fifteen years, public and not-for-profit organizations have made increasing use of
      plain-vanilla interest rate swaps, forward delivery bonds and the occasional interest rate cap

     More recently, the tax-exempt swap market appears to be entering a new phase of creativity
      and sophistication while remaining true to its conservative and risk-averse roots

            Financial Product         Typical Applications
            Fixed-to-Floating Swaps   Increase variable rate exposure; improve match between assets and
            and Options               liabilities, generate interest cost savings, hedge short-term asset returns.
            Floating-to-Fixed Swaps   Hedge future refunding of non-advance refundable, high-coupon debt;
            and Options               lock-in financing cost on interest rate sensitive fixed rate issuance in
                                      process.
            Caps                      Hedge interest cost on variable rate debt.


            Collars                   Hedge interest cost on variable rate debt, increase and hedge short-term
                                      asset returns; reduce budgetary uncertainty.

            Rate Locks/Caps           Hedging financing cost on interest rate sensitive, fixed rate issuance in
                                      process.
            Debt Service Caps         Cap financing cost on interest rate sensitive fixed rate issuance in process
            Forward Delivery Bonds    Refund non-advance refundable high coupon debt; lock-in financing cost on
                                      future fixed rate issuance
            Basis Swaps               Generate swap income and partially hedge existing variable rate risk
            Conversion Options        Lower interest cost on outstanding variable rate bonds by selling an option
            Structured notes          Fixed income instrument with tailored risk/reward characteristics
            Total return swaps        Establish synthetic position in an investment



                                                                                                                     4
Today: Debt and Asset Management Uses of The Swap Market

                     A                                                                   B
                                Fixed Swap Rate                  Fixed Swap Rate
                   Fixed                             Swap                              Fixed
                  Receiver                        Counterparty                         Payer
                                       BMA                            BMA


   Debt managers                                                       Debt managers
    Create low-cost synthetic variable rate                            Create low-cost synthetic fixed rate
                                                                            (hedge tax-exempt variable rate debt)
    Arbitrage call option value on new issue
                                                                        Hedge future fixed rate issues
    Hedge against higher tax rates
                                                                        Monetize existing call options
    Shorten effective duration of fixed rate
     bonds

   Asset Managers                                                      Asset Managers
    Hedge variable rate investments                                    Hedge fixed rate investments

    Earn positive carry                                                Hedge tax-risk on tax-exempt issues

    Earn spread between Swap Ratio and and                             Relative value trades
     Cash Ratio

    Benefit from improving technical
     conditions in tax-exempt money market

    Relative value trades

                                                                                                                    5
Swap Counterparties Act as Intermediaries Between End-Users

       When an Issuer and a Swap Counterparty engage in a transaction, the Issuer is not
        betting against the Swap Counterparty or vice versa

       The Swap Counterparty serves as an intermediary between clients who wish to hedge
        opposite exposures
         The Swap Counterparty may seek to fully hedge its interest rate exposure,
           achieving a “matched book”
         To provide liquidity and timely execution, Swap Counterparty’s will often hedge a
           new swap with other instruments such as bonds, futures, and options


                                                                                 Variable Rate Bonds
     A’s objective: create low cost
         floating rate financing
                                                                                              Variable
                                                                                             Bond Rate
                                           Variable                   Variable
                                             Rate                       Rate
                      MUNICIPAL                          Swap                       MUNICIPAL
                      ISSUER “A”                      Counterparty                  ISSUER “B”

                                      Fixed Swap                      Fixed Swap
            Fixed Bond
                                       Rate Bid                      Rate Offered
               Rate

                                                                           B's objective: create low
                                                                           cost fixed rate financing
               Existing Fixed Rate Bonds



                                                                                                         6
Interest Rate Swaps Have True Liquidity

   A typical tax-exempt interest rate swap may be terminated early by the Issuer at practically any
    time
     In contrast, the Swap Counterparty is usually severely restricted in its right to terminate early

   Value is tied to changes in the market for the fixed swap rate for the remaining swap term

   Issuer Pays Fixed Interest Rate Swap: Issuer would make a termination payment in lower rate
    environment, receive a payment if rates are higher

   Issuer Pays Floating Interest Rate Swap: Issuer would receive a termination payment in lower rate
    environment, make a payment if rates are higher

   The example below is for a fixed-to-floating interest rate swap, i.e. the issuer receives a fixed rate
    and pays a floating rate (BMA Index)

                       REVERSING SWAP                                                ORIGINAL SWAP
                                              3.15%                            4.15%
                          Swap                                                               Swap
                         Counter-                           Issuer                          Counter-
                          party                                                              party
                                           Floating                          Floating
                                            Index                             Index
                        NET EFFECT


                                                                              Swap
                                       Issuer                                Counter-
                                                        PV of 1.00%           party
                                                        annually for
                                                     remainder of term

                       For illustration purposes only; actual results will depend on future market conditions
                                                                                                                7
            Components of Tax-Exempt Swap Pricing
`
FSC Municipal Swap Market Indications                                                12/1/04 6:52 AM

                                        BMA/          BMA         BMA         BMA/                       BMA
                            LIBOR       LIBOR         Swap        Swap        LIBOR         MMD          Ask -
    Year        UST          Swap        Bid           Bid         Ask         Ask          AAA          MMD

    0.25       0.00%        0.00%       72.420%       0.00%       0.00%      72.420%        0.00%        0.00%
     1         2.66%        2.97%       75.75%        2.24%       2.30%       77.50%        2.07%        0.23%
     2         2.99%        3.37%       75.25%        2.52%       2.57%       76.75%        2.19%        0.38%
     3         3.24%        3.65%       75.38%        2.74%       2.78%       76.63%        2.34%        0.44%
     4         3.45%        3.87%       75.63%        2.91%       2.96%       76.88%        2.58%        0.38%
     5         3.67%        4.07%       76.13%        3.09%       3.14%       77.38%        2.85%        0.29%
     6         3.80%        4.25%       76.38%        3.23%       3.28%       77.63%        3.08%        0.20%
     7         3.94%        4.40%       76.63%        3.35%       3.41%       77.88%        3.26%        0.15%
     8         4.07%        4.53%       77.13%        3.47%       3.52%       78.13%        3.42%        0.10%
     9         4.20%        4.64%       77.38%        3.57%       3.62%       78.38%        3.56%        0.06%
     10        4.34%        4.75%       77.75%        3.67%       3.72%       78.75%        3.66%        0.06%
     12        4.40%        4.92%       77.88%        3.81%       3.86%       78.88%        3.87%       -0.01%
     15        4.50%        5.11%       78.63%        3.99%       4.04%       79.63%        4.09%       -0.05%
     20        4.67%        5.29%       79.50%        4.17%       4.23%       80.50%        4.44%       -0.21%
     30        5.00%        5.38%       80.50%        4.30%       4.36%       81.50%        4.76%       -0.40%




The information contained in the following material ( the "Information") may include various forms of
performance analysis, security characteristics and securities pricing estimates for the securities addressed. The
The data underlyingInformation has beenbeen obtained from sources FirstFirst Southwest Company ("FSC")
data underlying the the Information has obtained from sources that that Southwest Company ("FSC")
believes to be reliable, but FSC does not guarantee the accuracy of the underlying data or computations based
thereon. As with all models, results may vary significantly depending upon the value of the As with all
FSC does not guarantee the accuracy of the underlying data or computations based thereon.inputs given.
models, used in may analysis may be proprietary making the results difficult for any third party to reproduce.
Models results any vary significantly depending upon the value of the inputs given. Models used in any
Contact may investment representative results difficult for any third party to reproduce. Contact your
analysis your be proprietary making the for detailed explanations of any modeling techniques employed in the
Information.
investment representative for detailed explanations of any modeling techniques employed in the Information.
                                                           SYNTHETIC FIXED* MMD INS
                                                                  12/1/2004
* Issue Floating rate bonds swap to Fixed/ Issuer pays Fixed BMA swap rate; BMA swap rate includes 25bps adjustment for expenses
      6.00%                                                                                                                                  0.30%
                                                             Spread       BMA      MMD INS


                                                                                                                                             0.20%


        5.00%
                                                                                                                                             0.10%



                                                                                                                                             0.00%


        4.00%
                                                                                                                                             -0.10%



                                                                                                                                             -0.20%




                                                                                                                                                      Spread
 Rate




        3.00%

                                                                                                                                             -0.30%



                                                                                                                                             -0.40%
        2.00%


                                                                                                                                             -0.50%



                                                                                                                                             -0.60%
        1.00%


                                                                                                                                             -0.70%



        0.00%                                                                                                                                -0.80%
            0 Year           5 Year              10 Year              15 Year             20 Year             25 Year              30 Year
                                                           SYNTHETIC FIXED* INS AMT
                                                                  12/1/2004
* Issue Floating rate bonds swap to Fixed/ Issuer pays Fixed BMA swap rate; BMA swap rate includes 25bps adjustment for expenses
        6.00%                                                                                                                                0.50%
                                                           Spread        BMA        INS AMT



                                                                                                                                             0.40%

        5.00%

                                                                                                                                             0.30%




        4.00%                                                                                                                                0.20%




                                                                                                                                             0.10%




                                                                                                                                                      Spread
 Rate




        3.00%

                                                                                                                                             0.00%




        2.00%                                                                                                                                -0.10%




                                                                                                                                             -0.20%

        1.00%

                                                                                                                                             -0.30%




        0.00%                                                                                                                                -0.40%
            0 Year           5 Year              10 Year              15 Year             20 Year             25 Year              30 Year
                          Under normal market conditions, there is a trade-off
                          between risk and costs
                                  Interest cost, from most expensive (  ) to least expensive (  ), under normal market
R EW AR D




                                  conditions


                                                                                                       Natural fixed rate debt is the most
AN D




                                                                                  Y%                    expensive because it sheds interest rate
                                                     Issuer             Issuer            Party A
                                                                                                        volatility (i.e., debt service is known),
                                                                                  BMA                   and put risk¹
R I SK




                                               X%
                                                     Fixed
                              Fixed                  bonds
                                                                        VRDB
B E T W E EN




                             interest                                                                  While synthetic fixed rate debt is not
                               rate           Natural fixed             Synthetic fixed                 subject to interest rate fluctuations, it
                                               rate debt                  rate debt                     does entail put risk, and requires bank
                                                                                                        facilities for underlying VRDB’s¹
                                                                                
RE L AT I O N S HI P




                                                       Z%
                                                                                                        Synthetic floating rate debt allows an
                                            Issuer            Party A            Issuer             
                                                                                                        issuer to enjoy floating rates while
                                         X%           BMA                                               eliminating put risk, the need for bank
                            Floating       Fixed                                                        facilities, and adverse credit events¹
                                                                                 VRDB
                            interest       bonds
                              rate        Synthetic floating            Natural variable                Natural floating rate debt is the least
                                              rate debt                                             
T H E




                                                                           rate debt                    expensive as the issuer is subject to both
                                                                                                      interest rate volatility and put risk¹
UN D E R S T AN D I N G




                                                                                                        Market opportunities arise in which a
                                               No put risk                       Put risk               structure with less risks is also cheaper




                                        ¹ Assumes normal market conditions


                                                                                                                                                     9
       GASB Strategy


The Board is researching two general approaches
to reporting derivatives

 A context-based method

 A fair value based method with hedge
 accounting

No decision has been made as to which method to
propose
Context-Based Method
                A Little Context

       We have a mixed-attribute accounting model.
      Balance sheets are a mix of historical prices, fair
      values, lower of cost or market, impaired values

       Derivatives are rarely entered in isolation. There can
      be an associated transaction. Can we measure the
      derivative by referring to its associated transaction?
Context-Based Measurement

 A derivative would be measured according to the
measurement of its associated transactions. The
two most likely measurements are historic price or
fair value.

                    Examples:

    Association                  Measurement

    Debt                         Historic price

    Investment                   Fair value
     Hedge Accounting—
  Deferring Gains and Losses

 All hedge accounting methods measure derivatives on
the balance sheet at fair value

 Hedge accounting suspends the normal accounting
rules, permitting hedging gains and losses to be either
not reported in income or to be offset.
Hedge Accounting—Possibilities

1) Deferral accounting—hedging gains and losses are
  reported as deferred gains and losses on the
  balance sheet

2) Basis adjustment—hedging gains and losses adjust
  the basis of the hedged item

3) Mark-to-market in a government environment—

a. Fair value hedges “work”

b.Cash flow hedges do not “work”
National Association of State Treasurers Conference

    Overview of the Municipal Swap Marketplace:
            Growth, Usage, and Future
                  December 6, 2004
The U.S. Swap Market—Continuing Growth


 The U.S. interest rate swap market has grown dramatically over the
  last few years. Currently the size of financial contracts in the
  marketplace is 40 times the size of the Treasury market
($ Trillion)
 $160
                                                                                                                                                     $142
 $140
 $120
                                                                                                                                              $100
 $100                                                                                                                                                       UST Notes &
                                                                                                                                                            Bonds
   $80                                                                                                                             $69
                                                                                                                        $63
                                                                                                             $59
   $60                                                                                            $51

   $40                                                                                                                                                      Total Financial
                                                                                       $29
                                                                            $25                                                                             Contracts
                                                                 $18
   $20        $3        $4        $5        $8        $11
         $2        $2        $3        $3        $3         $3         $3         $3         $3         $3         $3         $3         $3          $4
    $0
         1990      1991      1992      1993      1994       1995       1996       1997       1998       1999       2000       2001       2002        2003



                                                                                        2
Growth of the Corporate Swap Market




  Don’t Use Derivatives
           8%                  Corporate use of Derivatives have fueled the growth
                                in the overall market over the last 10 years.

                               Approximately 92% of the World‘s 500 Largest
                                companies utilize Derivatives.
        Use Derivatives
             92%

                               The various derivatives used by Corporates are for
    2003 ISDA Survey of the
                                Asset Liability Management or ALM.
      World’s 500 Largest
          companies.




                                            2
Growth of the Municipal Swap Market


  Municipal usage has been growing as rapidly if not more than the Corporate market
   over the last few years.
  States which have utilized swaps or have implemented derivatives legislation
   include:          • Florida             • New Jersey         • Oklahoma
     •   Alabama        •   Illinois             •   New Mexico       •   Oregon
     •   Arizona        •   Iowa                 •   New York         •   Pennsylvania
     •   California     •   Maryland             •   North Carolina   •   Puerto Rico
     •   Colorado       •   Massachusetts        •   Ohio             •   Texas

 Other Municipal Issuers using swaps include:
     •   501(c)(3) Entities – Hospitals and Higher Education Institutions
     •   K -12: School Districts in MI, PA and TX
     •   State Housing Agencies
     •   Public Power Utilities


                                             3
Why have swaps grown popular in the municipal
marketplace?

  The swap market currently offers a significantly lower cost of borrowing than traditional
   fixed rate bonds
  Yield                                       Indicative Yield Curve Comparison
                                                                                                                          Traditional Fixed Rate Bonds
  5.0%


  4.5%


  4.0%
                                                                                                                                                BMA Swap

  3.5%


  3.0%
                                                                                                                          68% of LIBOR Swap

  2.5%                                            Maturity     Fixed Rate             BMA              68% of LIBOR          Savings of 68% LIBOR Swap
                                                  (Years)     Bond Yield (%)        Swap Rate           Swap Rate            vs. Bonds      vs. BMA Swap

  2.0%                                            5               2.78%                 3.17%                2.80%               (2) bp            37 bp
                                                  10              3.56                  3.73                 3.23                33                50
                                                  20              4.35                  4.28                 3.60                75                61
  1.5%                                            30              4.67                  4.41                 3.66               101                75


  1.0%
         1   2   3   4   5   6   7   8   9   10    11   12   13   14    15    16   17   18   19   20    21   22      23    24    25   26   27    28   29   30

                                                                       Year




                                                                        15
What is an Interest Rate Swap?


  A contract which commits two counterparties to exchange cash flows:
     • Amortizing or non-amortizing notional amount
     • No exchange of principal
     • Coupon flows only
     • Floating Rate for tax-exempt issuers typically is BMA or LIBOR
     • Fixed Rate is the combination of a spread over a Treasury yield of certain maturity
       and in the case of BMA swaps, a multiplicative BMA/LIBOR ratio

                                            Floating Rate
                           Party                                       Party
                             A                                          B
                                              Fixed Rate

  In an interest rate swap, the Municipal Issuer can contract to pay a floating rate and
   receive a fixed rate, or vice versa



                                              4
What floating swap indices are used in the municipal marketplace?


  Interest rate swaps in the municipal swap marketplace are based on one of two indices – LIBOR
   and BMA
      • LIBOR, or the London Interbank Offer Rate
      • BMA, or the Bond Market Association Index, a composite of approximately 200 highly rated
        short-term tax-exempt programs actively traded in the bond market
  Over the last 20 years, the BMA tax-exempt short-term index has traded at approximately 65-
   67% of its taxable equivalent, 1-Month LIBOR (a good proxy for the value of ―tax exemption‖)

                                                                                                              Average
       12.0%                                                                       BMA Index                    3.84%
                                                                                   1-Month LIBOR                5.89%
       10.0%
                                                                                   Implied BMA/LIBOR Ratio     65%
        8.0%

        6.0%

        4.0%

        2.0%

        0.0%
           Sep-82   Sep-84   Sep-86   Sep-88   Sep-90   Sep-92   Sep-94   Sep-96   Sep-98   Sep-00   Sep-02   Sep-04




                                                             5
What does the “Fixed Swap Rate” represent?


 The fixed swap rate is derived from the market‘s projections of forward rates and
  represents the ―indifference point‖ between receiving variable or fixed for a given time
  period
     • For example, the 5-year fixed-vs.-BMA swap rate of 3% is the present value-
       weighted average of the BMA Index (as projected by forward rates) over five years

                                            Yield (%)
                                                7.00                      Forward BMA Index
  Present Value       Present Value
  of Fixed Rate        of Floating              6.00

    Payments          Rate Payments             5.00

                                                4.00
                       BMA Index
   5-Year BMA                                   3.00
                      Projected by
   Swap Rate
                     Forward Rates              2.00

                                                1.00                             5-Year BMA Swap Rate

                                                0.00
                                                   Jan-05   Jan-06   Jan-07     Jan-08    Jan-09    Jan-10
                                                                          Maturity




                                            6
Where have we been in the last 10 years?

   Swap rates have declined in the past 10 years and are currently near their historical lows
   Current low rates have led to substantial issuing and synthetic advance refunding activity
   BMA ratios are near historic high levels
   This results in Municipal Issuers receiving LIBOR (rather than BMA) and accepting more ―tax risk‖
                                20-year LIBOR Swaps
      Yield                                                                                                                  Ratio

        8.0%
                                                                                                                            85.0%
        7.0%

        6.0%                                                                                                                83.0%


        5.0%                                                                                                                81.0%

        4.0%
                                                           20-year BMA Swaps                                                79.0%
        3.0%
                                                                                                                            77.0%
        2.0%

                                                                                                   20-year BMA/LIBOR        75.0%
        1.0%
                                                                                                           Ratio
        0.0%                                                                                                                73.0%
              Aug-95   Jun-96   Apr-97   Feb-98   Dec-98   Sep-99    Jul-00    May-01   Mar-02   Jan-03   Nov-03   Sep-04




                                                                    10
Interest Rate Swap Spectrum


            Floating-to-Fixed              Fixed-to-Floating
           “Fixed Payer Swap”           “Fixed Receiver Swap”


                                                           Fixed
                                                         Rate Debt

                                                              Fixed Rate
                   Fixed Payer          Fixed Receiver         Coupon
                       Rate                  Rate

      Party A                                             Party B
                   Variable Rate        Variable Rate
                       Index                Index
           ~ BMA



      Floating
     Rate Debt




                                   11
Fixed Payer Swap—Mechanics and Applications


              Fixed Payer Swap:                  Fixed Payer Swap:
                 Cash Flows                         Applications

                                        Achieve fixed rate financing without
                  Fixed Rate
                                         accessing the traditional fixed rate
   Issuer                                market
                  BMA or
                  % LIBOR
                                        Refund existing fixed rate debt or
                                         fund new money needs more cost
         ~ BMA                           effectively vs. fixed rate bonds

                                        Have the ability to easily change
                                         fixed-vs.-floating rate debt mix
   Floating
  Rate Debt




                                  12
Fixed Receiver Swap—Mechanics and Applications


        Fixed Receiver Swap:                  Fixed Receiver Swap:
             Cash Flows                           Applications

                     Fixed Rate
                                        Convert fixed rate debt to variable
    Issuer                               rate debt

                     BMA Index          Add variable rate exposure

        Fixed Rate                      Achieve immediate reduction in
                                         interest expense

                                        Produce variable rate exposure
   Fixed Rate                            without the need for LOCs or
      Debt
                                         liquidity facilities




                                  13
Swaps Within the Overall Municipal Debt
Framework

                       Financing Type                 Structure                             Benefits and Costs

                                             Issue fixed rate bonds with a           Interest rate, Credit, Tax, and
 Risks Transferred      Fixed Rate            20- to 30-year final maturity            Funding risk transferred to Investor
    to Investors      Municipal Bonds        Priced off a municipal index (―MMD‖)    Costliest but least risky structure


                                             Issue fixed rate tax-exempt bonds       Tax and Credit risk transferred to
                     Synthetic Variable       (20- to 30-year final maturity)          Investor and Swap Provider
                        Rate Bonds           Simultaneously, execute a               Interest rate risk retained
                                              receive-fixed swap to increase
                                              exposure to variable rates


                                             Issue variable rate tax-exempt          Interest rate and Credit risk
                     Synthetic Fixed Rate     bonds (20- to 30-yr final maturity)      transferred
                           Bonds             Simultaneously, execute a pay-          Tax risk retained by Issuer in the
                                              fixed swap to hedge out exposure         case of a LIBOR-based swap
                                              to variable interest rates              Counterparty risk retained


                                             Issue variable rat tax-exempt           Historically, most cost-effective
 Risks Retained         Variable Rate         bonds on an insured or standalone        but also riskiest structure
    by Issuer              Bonds              basis                                   Issuer retains Interest rate, Tax,
                                                                                       Credit, and Funding risk




                                               14
Why are LIBOR-based swaps popular in the
marketplace?

 LIBOR-based synthetic fixed rate structures have been popular because:
     • Structure provides lowest fixed rate borrowing cost
     • Structure reduces interest rate risk but introduces ―tax risk‖
     • Authorizing Boards and finance committees have gotten comfortable with swaps and
       exposure to swap counterparties
     • Issuers and financial advisors have grown familiar with retaining tax risk—the inherent risk for
       any LIBOR-based structure
     • The ―worst-case‖ scenario for these structures is takes place if tax-exempt debt trades at
       100% of LIBOR for extended periods of time:
        > This could occur as a result of a major revision in the U.S. Tax Code, where tax
          exemption is either significantly diminished or removed in its entirety
        > If that occurs, the Municipal Issuer will experience a permanent shortfall on swap receipts
          vs. bond payments of up to 30-35% of the variable rate cost
        > While a possibility, it is unlikely



                                                    16
Swaps as Debt Management Tools


  Municipal Issuers can use derivative products to dynamically manage their
   balance sheet
  If the goal is to achieve:



                            Fixed Rate Debt Obligations

                                                 Strategy 1:        Strategy 2:
                                             Issue Traditional   Issue Synthetic
                                              Fixed Rate Debt       Fixed Rate

            Debt                           Fixed Rate Bonds      Issue floating,
         Management                                                swap to fixed
                                           Alternative Call
                                            Features              Option-based
                                                                   structures




                                        17
Swaps as Debt Management Tools (cont.)


  Municipal Issuers can use derivative products to dynamically manage their
   balance sheet
  If the goal is to achieve:



                           Floating Rate Debt Obligations

                                                  Strategy 1:         Strategy 2:
                                               Issue Traditional   Issue Synthetic
                                              Variable Rate Debt     Variable Rate

             Debt                          Auction Rate            Issue fixed,
          Management                        Securities               swap to floating
                                           VRDBs                   Option-based
                                                                     structures
                                           Commercial
                                            Paper                   Basis Swaps




                                         18
The Bigger Picture—Where are we going?


   Relatively low interest rate environment
   Ratios remain historically high
   Public budgets will remain under pressure
   The forward curve continues to predict a significant rate rise

                                3-Month LIBOR         10-Year Treasury

                   2003 Q1            1.29%                 3.81%
                   2004 Q2            1.12                  3.33
                        Q3            1.14                  4.27
                        Q4            1.17                  4.27
                   2004 Q1            1.11                  3.83
                        Q2            1.50                  4.73
                        Q3            1.90                  4.13
                        Q4            2.55                  4.50
                   2005 Q1            3.05                  4.75
                        Q2            3.25     Forecasted   5.00    Forecasted
                        Q3            3.50                  5.00
                        Q4            3.75                  5.00




                                              19
The Bigger Picture—Where are we going?


  Continued use of floating-to-fixed swaps for synthetic advance refundings
   and synthetic fixed rate debt

  Increased use of fixed-to-floating swaps as Municipal Issuers move from
   100% fixed to 80% fixed/ 20% floating rate debt profiles

  Increased customization, as more Municipal Issuers utilize their own
   floating rate data to reduce basis risk associated with swap strategies

  Increased use of optionality—both buying and selling it

  Significant strides will be made with regard to systems that monitor
   derivative exposure



                                      20
The Bigger Picture—Derivative Policies


  Given the rise in debt and derivative use, formal debt and derivatives
   policies are systematically being put in place. Increasingly:

    • Policies are evaluating the fixed-v.-floating debt portfolio mix

    • Basis risk is being noted in policies as acceptable, given various
      parameters such as tax integration, manageable cash flow risk,
      and expected return

    • Policies are just beginning to prioritize operational expertise and
      system‘s expertise

    • Policies should address issues such as leverage, credit
      exposure to counterparties, and ongoing exposure management


                                     21
National Association of State
   Treasurers Conference

    ―Debt Derivative Profiles‖
  Eden Perry, Associate Director
     Public Finance Ratings
            New York
           212-438-7967
      eden_perry@sandp.com
               Rating Process

Analyze:
• Issuer / issue credit fundamentals
• Transaction and swap contract documents
• Issuer debt and swap management plan
• Assign DDP based on swap portfolio of issuer
• Description of the DDP score within the rating analysis
• Assign rating and outlook
              Debt Derivative Profiles (DDP)
• Analytical / rating enhancement for all municipal bond issuers
• Risk score for debt-related derivatives scored through a five
  point system:
   – 1, 2 (low risk)
   – 3 (moderate risk)
   – 4, 5 (high risk)
• All factors scored from 1 to 5 and equally weighted at 25% in
  most cases.
              Swap Documents—Needed for DDP

• ISDA master agreement
• Schedule
• Credit Support Annex
• Confirmation (draft or term sheet acceptable)
• Swap Management plan or policy
                DDP Factors

•        Scored DDP factors include:
    –   Issuer termination / collateral posting risk,
    –   Counterparty termination risk,
    –   Economic viability (basis risk), and
    –   Management
                  Termination / Collateral Posting
                  Risk

• Score based primarily on the risk that the issuer would default under
  the swap or trigger a collateral posting under credit support
  documents.
• Collateral posting is identical to payment of termination due to the
  typically long-dated nature of municipal swaps and the restricted
  nature of collateral
• Fifty percent (50%) of the termination and collateral posting risk score
  is comprised of the likelihood of an issuer triggering an event of
  default or termination or collateral posting.
• Likelihood of an issuer being downgraded to one rating notch below
  the rating trigger is scored using Standard & Poor‘s rating transition
  data for the municipal issuer‘s applicable sector (tax secured, utility,
  healthcare, higher education, transportation, housing).
•
                    Termination / Collateral Posting Risk
                    (continued)

•   Remaining 50% of termination / collateral posting risk score is based on
    strengths and weaknesses of six other factors which may exacerbate or
    heighten the risk of termination, including:
     – Ratings volatility (number of rating or outlooks changes in last three
        years) – 15%
     – Swap duration (less than 10 years, 10-15 years, 15-20 years, greater
        than 20 years) – 15%
     – Termination payment methodology (first or second method, market
        quotation or loss) - 5%
     – Cross default provisions (parity debt, subordinate debt, or other debt) –
        5%
     – Lien of termination payments (parity or subordinate),
     – Source of termination payments (taxes, net revenues, etc..) – 5%
     – Provisions for payment of termination fee (term-out or lump sum) – 5%
              Counterparty Risk

• Scored based on the risk that a counterparty will default and
  terminate a swap and the issuer will lose a positive swap
  valuation, thereby diminishing its ability to replace its hedge
  position
• Credit threshold is ‗BBB-‗, which is one rating notch below
  Standard & Poor‘s minimum swap counterparty rating of ‗BBB‘
  for plain vanilla swaps used in swap-independent transactions.
• Standard & Poor‘s criteria stipulates that issuers should replace
  counterparty at ‗BBB‘ level. Collateralization or replacement
  guarantee is also acceptable.
• Likelihood of a counterparty downgrade to ‗BBB-‗ (or ‗BBB‘ as
  applicable) is scored using Standard & Poor‘s rating transition
  data for financial institutions.
              Counterparty Risk

• Mitigating factors, which would warrant a counterparty
  termination risk scored of 1, include:
   – The swap is plain vanilla (highly liquid); and
   – The counterparty has provided insurance for termination
     payments from a monoline bond insurer; or
   – The counterparty must replace itself prior to being
     downgraded to ‗BBB‘ with a higher rated counterparty,
     or
   – The counterparty must collateralize prior to being
     downgraded to ‗BBB‘, or
   – The counterparty will remain swap provider and produce
     a third-party guarantee rated at least ‗BBB prior to being
     downgraded to ‗BBB.‘
                Economic Viability (Basis Risk)
• Determination whether or not the issuer could have an incentive to
  restructure or voluntarily terminate a floating-to-fixed rate transaction
  due to ineffectiveness of a derivative transaction through potentially
  stressful economic cycles.
• Assessment of long-term viability of a hedge through economic cycles
  is important since the unwinding, restructuring, or execution of
  additional hedges is potentially costly and time consuming,
  accompanied by real economic and opportunity costs.
• These costs are in addition to the additional, unexpected interest costs
  resulting from the ineffective hedges.
• Hedge ineffectiveness of a derivative portfolio is calculated through a
  proprietary basis exposure model, which incorporates Standard &
  Poor‘s stressful interest rate curves and tax-exempt bond price
  assumptions.
• The basis exposure for an issuer‘s portfolio is measured by a ratio
  equal to the average annual additional interest paid on bonds divided
  by total derivative notional.
• Interest Rate Curves are Rating Category Dependent.
• BMA/LIBOR Assumption = 75%
                    Management
• Score based on Standard & Poor‘s assessment of management
  experience and quality of swap and debt management plan.
• Ten factors with either ―yes‖ or ―no‖, gaining one point for each affirmative
  answer.
• Scored factors incorporate existing Standard & Poor‘s rating criteria for
  swap management plans including:
   – Written Plan or Policy on Swaps and Other Debt Related Derivatives
   – Written Plan Formally Approved by Governing Body
   – Swap Risks Identified and Discussed (Verbal or Written)
   – Annual Management Review of Swaps
   – Comprehensive Disclosure of Swaps in Audited Financial Statements
   – Valuation of Swaps (Semi-Annual Minimum)
   – Counterparty Diversification or Minimum Ratings Policy
   – Optional Swap Termination Policy
   – Collateral or Insurance Policy
   – Net Variable Rate Exposure Policy
• Scoring system is as follows: 9-10 pts = 1; 7-8 pts = 2; 5-6 pts =3; 3-4 pts
  =4; 1-2 pts =5
             Factors Affecting DDP’s Rating Impact

Issuer rating and outlook
– Indicates sensitivity to high DDPs.

Value-at-Risk
– The VAR for derivatives will be factored into the rating analysis only if risk
  of derivative termination is heightened, indicated either by a final DDP
  score of 4 or 5. Otherwise, scores of 1,2, 3 do not warrant an VAR since
  swap termination is not considered likely in the near term.
– Data provided by issuer to S&P

Net Variable Rate Exposure
– Incorporates derivatives
– Measures potential risk from rising variable rates.
– Ratio calculated on a current basis
– Will model ―what-if‖ scenarios in order to gauge prospective levels of
  variable exposure, given either proposed derivatives structures or future
  bond issuance.

				
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