Interest Rate Swaps for Educational Institutions by pvg14029


									Presentation on:

Interest Rate Swaps
for Educational Institutions

                               ADVISORY TEAM
                                     Kevin Quinn
                               Christopher Wienk
                                       Oz Bengur
                                  Robert Doherty
                                 Charlene Quinn
                                   Jacob Hughes
                                    Aileen Panitz
                                                                Slide 1

Table of Contents
   Introduction to Interest Rate Swaps                   2-3

   Applications of Interest Rate Swaps                   4

   Key Considerations in Using Interest Rate Swaps       5

   Swap Index Alternatives                               6

   Risks in a Variable Rate Financing                    7

   Risks Inherent in Interest Rate Swaps                 8

   The Mechanics of a Swap                               9

          Floating-to-Fixed Rate Swap (Fixed Payor)      10

          Fixed-to-Floating Rate Swap (Fixed Receivor)   11

   Floating-to-Fixed Rate Swap Example                   12-13

   Flexibility on Effective Date of Swap                 14

   Procurement Alternatives for an Interest Rate Swap    15

   Interest Rate Hedging Alternatives to a Swap          16

   Frequently Asked Questions                            17-20
                                                                                                                 Slide 2

Introduction to Interest Rate Swaps

   What is a Swap?
         an agreement to exchange interest payments based upon a specific notional amount
         issuer of swap can contract to pay a floating rate and receive a fixed rate, or vice versa
         the notional amount of the swap can match the amortization of the underlying bonds (an amortizing swap)
         no exchange of principal; coupon flows only
         floating rate typically linked to SIFMA (Securities Industry and Financial Markets Association) or LIBOR
          (London Interbank Offered Rate)
         fixed rate is typically a spread over the Treasury yield for a given maturity, with the amount of the spread
          based upon the relative creditworthiness of the parties

                                                   Fixed Rate
                             Party                                             Party
                               A                                                B
                                                 Floating Rate
         Swaps can be executed
                 in advance of the issuance of either fixed rate or variable rate debt,
                 simultaneously with the proposed financing, or
                 at any time during the outstanding life of the associated bonds
                                                                                                             Slide 3

Introduction to Interest Rate Swaps (cont’d)

   How do Swaps provide lower or more predictable funding costs?
         swaps can capitalize on inefficiencies both within the tax-exempt bond market and between the taxable and
          tax-exempt markets
         upfront costs can be considerably less than a bond transaction

   How flexible are Swaps?
         can be executed over the phone, like fixed income investments
         can be unwound at any time (but possibly at a penalty or a premium depending on interest rate levels at the
         can be structured on a forward commitment basis
                                                                                                  Slide 4

Applications of Interest Rate Swaps

   Interest Rate Management:       adjust the duration of assets or liabilities to reflect interest
                                    rate management strategy

   Enhance Asset Yield:            create synthetic fixed or floating rate assets with higher yields

   Arbitrage:                      capitalize on relative inefficiencies between two markets

   Lock in Future Interest Cost:   reduce or eliminate interest rate risk for floating rate debt or
                                    structure synthetic advance refunding

   Asset/Liability Management:     achieve the desired balance sheet match of fixed rate
                                    or variable rate assets and liabilities
                                                                          Slide 5

Key Considerations in Using Interest Rate Swaps
   Legal
            Statutory authority
            Swap Agreement documentation and terms

   Policy
            Interest rate risk
            Risk/reward profile

   Mechanics and Structuring
            Proposed application
                    Market neutral
                    Hedge
                               Against potentially higher future rates
                               Against potentially lower future yields
            Credit quality of counter party
            Procurement Process
                    Negotiation
                    Competitive bid

   Cost
            Swap Fees
            LOC/Remarketing Fees (for an associated VRDB issue)
            Advisory/Legal Fees
                                                                                                             Slide 6

Swap Index Alternatives

   Tax-exempt variable rate borrowers hedge their variable rate risk with an interest rate swap based
    usually upon one of two indices:

          SIFMA Index
                 SIFMA Municipal Swap Index is a tax-exempt, weekly reset index composed of 650± different
                  high-grade, tax-exempt VRDBs (variable rate demand bonds)
                 SIFMA Index is a widely used benchmark for borrowers and dealer firms of variable rate tax-
                  exempt paper
                 A SIFMA Index swap provides reasonably good protection against interest rate risk, tax risk and
                  other market movement risks with respect to VRDBs

          Percentage of LIBOR
                 LIBOR is the rate that the most creditworthy international banks dealing in Eurodollars charge
                  each other for large loans and is the commonly used taxable variable rate index
                 A percentage of LIBOR swap (eg. 67% LIBOR) usually produces a lower synthetic fixed rate than
                  SIFMA, but does not protect against interest rate risk as efficiently as a SIFMA-based swap
                 The basis of the variable rate received under a percentage of LIBOR swap often differs from the
                  basis of the rate paid on the variable rate debt, a risk called “basis risk”
                 Borrower generally compensated through lower fixed rate on the swap for increased interest rate
                  risk as well as tax risk
                                                                                               Slide 7

Risks in a Variable Rate Financing

   Interest Rate Risk:       The risk that the general level of interest rates rise

   Tax Rate Risk:            The risk that interest rates rise due to a decline in income tax rates,
                              causing the tax exemption to be worth less to investors

   Credit Provider Risk:     Credit ratings / market acceptance of the LOC bank decline
                              causing investors to demand a higher rate on the VRDBs

   Remarketing Agent Risk:   The remarketing agent fails to remarket the VRDBs competitively
                                                                                                    Slide 8

Risks Inherent in Interest Rate Swaps

   Basis Risk:
          The risk that the rate the borrower receives from the swap counterparty does not fully
           offset the rate the borrower has to pay on the VRDBs
          Potentially mitigated by structure and use of closest VRDB index (ie. SIFMA) on which
           swap is to be based

   Counterparty Risk:
          The risk that the swap counterparty may be subject to a downgrade in credit rating, or
           unable to meet its obligations under the swap agreement
          Mitigated by contracting with only highly rated counterparties

   Termination Risk:
          The risk that a swap could be terminated prior to the expiration of the term of the
           agreement and the borrower is required to make a termination payment. Counterparty can
           terminate only as documented in the swap agreement
          Mitigated by executing swaps only with highly rated counterparties, developing termination
           payment contingency plans and maintaining borrower credit quality
                                                                                     Slide 9

The Mechanics of a Swap

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

                                                                     Rate Debt

                                                                             Fixed Rate
                     Fixed Payor                    Fixed Receivor
                         Rate                            Rate
      Party A                        Counterparty                     Party B
                     Variable Rate                  Variable Rate
          Variable       Index                          Index

     Rate Debt
                                                                                                  Slide 10

  Floating-to-Fixed Rate Swap (Fixed Payor)

                Fixed Payer Swap:                                      Fixed Payer Swap:
                   Cash Flows                                             Applications

                                                            Achieve “synthetic” fixed rate (ie. financing
                   Fixed Rate
                                                             without accessing the traditional fixed rate
   Borrower                                                  market)
                                                            Refund existing fixed rate debt or fund new
                    Variable                                 money needs more cost effectively vs. fixed
                   Rate Index
                                                             rate bonds
Interest                                                    More readily change fixed-vs.-floating rate debt
  Rate                                                       mix
                  1) Borrower pays a floating rate on
                     the bonds

     Floating     2) Borrower receives a floating rate
    Rate Debt        payment from the Swap
                  3) Borrower makes a fixed rate
                     payment to the Swap Counterparty
                                                                                     Slide 11

Fixed-to-Floating Rate Swap (Fixed Receivor)

        Fixed Receiver Swap:                             Fixed Receiver Swap:
             Cash Flows                                      Applications

                   Fixed Rate                     Synthetically convert fixed rate debt to
                                                   variable rate debt
 Borrower                                         Add variable rate exposure
                                                  Achieve reductions in interest expense
               Variable Rate
                   Index                          Produce variable rate exposure without the
                                                   need for LOCs or liquidity facilities
      Fixed Rate

 Fixed Rate
                                                                                                                      Slide 12

Floating-to-Fixed Rate Swap Example

   Borrower desires to issue long term variable rate bonds (eg. 25 to 30 years) and “synthetically” fix
    interest cost on its borrowing for the next 10 years

   Borrower enters into a 10 year Interest Rate Exchange Agreement with a highly rated financial
    institution under which Borrower pays a 10 year fixed rate (eg. 3.10%* tax-exempt) and receives a
    variable rate payment

   Borrower continues to pay weekly variable rate, annual letter of credit (eg. 1.25%) and
    remarketing fees (eg. 0.10%) on its VRDBs

   Total approximate annual borrowing cost equals 4.45%* (assumes 3.10% interest cost and 1.35%
    for remarketing and letter of credit fees)

   Borrower can extend interest rate swap beyond 10 years at any time prior to swap maturity but
    there is no assurance of low interest rate levels in the future

    * Hypothetical SIFMA swap rate as of late-March, 2009. Rates will vary based on market conditions and transaction details
                                                                                                        Slide 13

Floating-to-Fixed Rate Swap Example
                             Tax-Exempt VRDB Financing

                            LOC &                          Fixed Rate
                          Remarketing                       (3.10%)**
           Letter of         Fees                                              Swap
            Credit                       Borrower
                            (1.35%)                                         Counterparty
                                                         Variable Rate
                                                Variable Rate             * SIFMA Index rate as of late-March, 2009.
                                                   (Actual)                Rate will vary based on market conditions at
                                                  (0.57%)*                    the time of the transaction. Assumes
                                                                            variable rate paid by Borrower on its debt
                                                                          equals SIFMA Index rate (ie. zero basis point
                                                                                         spread to SIFMA).
                                          Rate Debt                      ** Assumes hypothetical 10 year SIFMA swap
                                                                                 rate as of late-March, 2009.

    Floating Rate Received on Swap (SIFMA)                      +   0.57%
    Floating Rate Paid on Bond Issue (assumes SIFMA)            -   0.57%
    Letter of Credit Fee on Bond Issue                          -   1.25%
    Remarketing and other Fees on Bond Issue                    -    .10%
    Fixed Rate Paid on Swap                                     -   3.10%
         Total Effective Rate                                       4.45%
                                                                                                  Slide 14

Flexibility on Effective Date of Swap (for forward swaps)
   Borrower can secure a swap that activates on a scheduled future date (the “effective date”) in
    order to hedge against future interest rate risk

   On the effective date of the swap, the borrower can either:

       1)   leave the swap in place and issue variable rate bonds to achieve synthetic fixed rate
            debt, or

       2)   terminate the swap for a gain or loss (market driven) and issue traditional fixed rate
            bonds incorporating the termination payment or receipt as an adjustment to the size of
            the fixed rate bond issue. The resulting debt service will approximate the original
            projected debt service.

                                              Counterparty makes a               Receipt of termination
                                In            termination payment               payment offsets the cost
                              Rates               to Borrower                  of issuing in a higher rate
        Rates                                                                    Cost of termination
                                                 Borrower makes
                             Decrease         termination payment to           payment offset by gain of
                               In                 Counterparty                    issuing in low rate
                              Rates                                                  environment
                                                                                                                 Slide 15

Procurement Alternatives for an Interest Rate Swap
   Competitive Bid
           Borrower develops swap specifications and issues RFP to derivatives marketplace for competitive bids
           Most appropriate for
                   forward swaps

                   swaps secured after VRDB financing closes

           Best structured as a general, unsecured obligation of Borrower (to avoid future potential conflict with bank
            letter of credit terms)
           Usually produces lowest rate
           But swap “integration” rules can pose a challenge in a competitive bid situation depending on bond counsel

   Negotiation
           Borrower determines to negotiate terms of swap with a specific financial institution, often the same bank
            providing the letter of credit for the VRDBs
           Although competitive bid is preferable in theory, negotiation is often advantageous in situations where swap
            is being negotiated contemporaneously with LOC and executed contemporaneously with sale of VRDBs
                   inclusion of swap can help lower overall level of bank fees for various services

                   avoids complexities of multiple credit parties (more often the case with non-rated versus
                     investment grade rated borrowers)
                   helps assure “integration” which impacts permitted yield on pledged investments and eligibility of
                     termination fee (if any) for future tax-exempt financing
           Biggest challenges:
                   controlling profit aspirations of bank and lack of pricing transparency

                   negotiating terms (security, default provisions, margin provisions)
                                                                                                                      Slide 16

Interest Rate Hedging Alternatives to a Swap

   Interest Rate Caps
           a hedging tool that protects the borrower from rises in short-term floating interest rates above a
            predetermined rate level or strike price (the “cap rate”)
           the borrower receives a payment from the cap provider when the floating rate index (usually SIFMA or
            LIBOR) exceeds the specified cap rate
           the borrower pays a premium (the “cap premium”) to the cap provider at the beginning of the agreement in
            exchange for protection from increases in short-term floating interest rates for the term of the agreement

   Interest Rate Collars
           a hedging tool which is combination of an interest rate cap and an interest rate floor
           borrower buys an interest rate cap while simultaneously selling a floor, creating a “collar”
           borrower pays difference below floor strike price; counterparty pays difference above cap strike price
           offsets cap premium cost and protects borrower against increases / decreases in interest rates within the

   Swaptions (“Swap Option”)
           an option that gives the borrower the right, but not the obligation, to enter into a swap at a specific date in
            the future
           borrower pays the counterparty an upfront premium upon execution of the swaption agreement
           if swaption is exercised, the swap begins
           if swaption is not exercised, the counterparty keeps the premium and has no other obligations to the
                                                                                                                    Slide 17

Frequently Asked Questions
Parties to a Swap
What entity is on the other side of the interest rate swap?
“Counterparties” are generally special purpose subsidiaries of investment grade rated financial institutions or insurance
companies. Normally, the obligations of such a subsidiary is guaranteed unconditionally by its parent. The
counterparty is obligated to make all payments to the non-profit entity under the swap agreement. At the time of
executing a non-profit entity’s swap, the counterparty will either execute an offsetting swap or hedge its position through
other means. The counterparty’s financial guarantee to the non-profit entity is not contingent on the performance of the
reverse swap or the hedge.

Is the counterparty speculating on interest rates?
Normally, counterparties do not enter into an interest rate swap as a way to speculate on interest rates. Counterparties
mitigate their interest rate exposure by matching executed swaps with other financial institutions or through internal
hedges. As principal to the transaction, a counterparty will position the swap internally using financial hedges until an
appropriate counterparty is identified. This ability to position swaps internally provides liquidity to clients.

Why would a party want to be a Fixed Payor?
The motivation of a party to be a fixed payor is usually to hedge its floating rate debt. Such an entity can effectively
convert floating rate obligations to a fixed rate by executing a floating-to-fixed swap. The floating payments from the
counterparty are used to offset the entity’s floating rate debt payments. The fixed rate obtained in the swap market is
traditionally lower than the fixed rate attainable in the debt market.

Why would a party want to be a Fixed Receivor?
The primary motivation for a party to be a fixed receivor is to obtain the lower capital cost associated with variable rate
debt. In converting fixed rate debt to “synthetic” variable rate, the entity avoids paying letter of credit or remarketing
fees. Furthermore, the fixed rate bonds underlying the swap guarantee a fixed rate funding cost at the swap’s
                                                                                                                  Slide 18

Frequently Asked Questions

Legal and Credit Issues

Does an interest rate swap affect a Borrower’s credit rating?
Interest rate swaps ordinarily have a less direct impact on ratings than variable rate debt. Since variable rate debt has
become more common for non-profit entities, ratings agencies view a certain percentage of the variable rate debt as
prudent financial management. The percentage varies depending on the specific circumstances of each borrower.
Standard & Poor’s and Moody’s have issued formal guidelines on interest rate swaps and the resulting credit impact on
a borrower’s balance sheet.

How should the non-profit entity account for a swap on its balance sheet?
Swaps are generally referenced in a footnote on the entity’s balance sheet. Typically, the swap is also “marked to
market” at least once annually and the unrealized gain or loss is noted on the financial statements.

Does the swap impact the yield on the Borrower’s new or existing bonds?
A swap is traditionally viewed as a separate transaction distinct from any bond issue to which it relates. If the swap and
bonds are executed simultaneously, integration of the yields may result for tax purposes. This question should be
reviewed with bond counsel.

Is it legal for non-profit entities to execute swaps?
An entity seeking to enter into a swap agreement must find the authority in its charter or debt/investment policy, or
otherwise from its Board. A swap agreement is best described as an executory contract, complete with offer,
acceptance, and consideration from both parties. The contract requires performance, which includes, among other
things, the future payment of money by each of the swap parties to the other subject to the conditions stated in the
                                                                                                                      Slide 19

Frequently Asked Questions
Liquidity and Flexibility
How would an entity terminate a swap?
To negate the effect of an interest rate swap, there are two basic alternatives. The first and preferable alternative is to
terminate the swap. Such termination may require the payment of a termination fee which may be based on (1) a fixed
formula, (2) the current value of the swap to the counterparty or (3) some combination of the two. The second
alternative is a “reverse” or “mirror” swap. Under that alternative, the entity would structure a swap with a counterparty
with payment obligations which offset the payment obligations in the original swap. The use of the second alternative
may be less expensive than the first. However, the result is two outstanding swaps with all of the associated rewards
and risks that come with each of those separate financial instruments.

What can the entity do if rates go down?
If interest rates decline, an entity that is already in a Fixed Payor swap, can extend the term of the swap to take
advantage of more attractive swap levels. To extend an interest rate swap, the entity would reverse or terminate the
original swap and execute a new swap with a longer term. If interest rates have declined, a loss is usually incurred on
the reversal of the original swap which is amortized over the term of the new, longer swap. The resulting swap would
likely have a blended rate which is slightly higher than market levels, but lower than the fixed rate on the original swap.

What can the entity do if rates go up?
If interest rates rise, the entity can either do nothing and miss out on potential positive cash flow from the fixed payor
swap market or reverse or terminate the interest rate swap for a gain. To reverse a floating-to-fixed swap transaction,
the entity would execute a mirror swap with the original counterparty (or a different institution) or terminate the swap.
The reverse swap cancels the floating payments. If interest rates have increased, the fixed rate paid by the
counterparty will be greater than the fixed rate received by the entity and a gain is realized for the remaining term of the
swap. In most cases, the stream of future payments can be settled in a lump sum up-front payment.

What can an entity do at the end of the swap term?
At the end of the swap term, the entity can either return to the floating rate on the underlying bonds, if floating rate debt
is desirable, or execute another interest rate swap if continuing to pay a fixed rate is preferred.
                                                                                                                   Slide 20

Frequently Asked Questions

Timing and Maturity

When is the best time to execute an interest rate swap?
An interest rate swap is best viewed as a financial tool to manage interest rate exposure. When a swap is used as an
integral component of a financing plan, the swap is best executed concurrent with the bond pricing. Simultaneous
execution of the swap and the bond pricing ensures that a project’s capital cost will not be negatively impacted by
adverse changes in interest rates.

What is the optimal maturity for an interest rate swap?
Numerous factors impact determining the optimal maturity for a swap including the relative level of interest rates, the
shape and slope of the yield curve and the maturity of existing assets and liabilities. Furthermore, in structured
financings, considerations such as the length of capitalized interest and construction periods and the term of the letter
of credit may also impact the desired term of the swap.

How quickly can a swap be executed?
Once the Schedule to the ISDA Master Agreement is negotiated and authorized, most counterparties will execute a
swap telephonically and finalize the transaction with a written confirmation within 24 hours.

How long does it take to prepare legal documents?
Documentation of an interest rate swap rarely takes more than 3-4 weeks to complete. Such documentation is
governed by the International Swaps and Derivatives Association (ISDA) and includes a “Master Agreement”, which is
typically no more than 25 pages in length. In addition, a “Schedule to the ISDA Master Agreement” must also be
prepared. This document contains all of terms and provisions of the swap that have been negotiated. Both the Master
Agreement and Schedule (as well as any Trade Confirmations that may be prepared in connection with the execution of
the swap) must be authorized and executed by the appropriate parties.
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                                                    ADVISORY TEAM
                                                          Kevin Quinn
                                                    Christopher Wienk
                                                            Oz Bengur
                                                       Robert Doherty
                                                      Charlene Quinn
                                                        Jacob Hughes
                                                         Aileen Panitz

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