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 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 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. 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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 email@example.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.