INTEREST RATE SWAPS: THE GOOD, BAD

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INTEREST RATE SWAPS THE GOOD, BAD UGLY

• OHIO GFOA CONFERENCE September 18, 2008
• Elizabeth C. Hruby, Debt Manager
• City of Cleveland
• Barbara L. Hawley, Partner
• Squire, Sanders Dempsey L.L.P.

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Whats an interest rate swap?
An interest rate swap is an agreement by two
counterparties to exchange a set of cash flows
over an agreed upon period of time, each
calculated with respect to a different rate or
rate index over a notional schedule of
principal amounts. A common type of swap is
one in which (a) a city agrees to pay a fixed
rate to a counterparty on a notional amount equal
to the principal amount of its variable rate
bonds in exchange for (b) the counterparty paying
the city amounts equal to (or expected to
generally track) the interest owed by the city on
the variable rate bonds. Under such a
variable-to-fixed interest rate swap, a city
may synthetically fix its interest rate on the
bonds.
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Conventional Bond Financings
Conventional Variable

• Conventional Fixed

Issuer
Issuer
Fixed Rate on Bonds
Variable Rate on Bonds
4.6
??
Bondholder
Bondholder
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A bond rate or cost of funds swap
Conventional Variable
Swap Agreement
Fixed Rate 4.3
Issuer
Swap Provider
Variable Rate on Bonds
Variable Rate on Bonds
(EQUAL)
Bondholder
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Cost of Funds Swap

• Floating to Fixed Rate - Example
  of Cash Flows
• 
  Notional Amount 50,000,000
• City Net Payment Amount Paid
• City Pays
  Receives By City for Week
• Variable Fixed Swap Actual Rate
• Rate Bonds Rate on Bonds
• Week 1 1.45 4.88 1.45 4.88 47,444.45
• Week 2 1.60 4.88 1.60 4.88 47,444.45
• Week 3 2.20 4.88 2.20 4.88 47,444.45
• Week 4 4.00 4.88 4.00 4.88 47,444.45
• Week 5 6.00 4.88 6.00 4.88 47,444.45
• Week 6 6.00 4.88 6.00 4.88 47,444.45

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An index based swap
Conventional Variable
Swap Agreement
Fixed Rate 4.0
Issuer
Swap Provider
Variable Rate (MARKET INDEX)
Variable Rate on Bonds
(NOT IDENTICAL)
SIFMA or LIBOR or Variation
Bondholder
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MARKET INDEX

• SIFMA Securities Industry and Financial Markets
  Association Municipal Swap Index) (f/k/a BMA,
  the Bond Market Association)
• A percentage of LIBOR (the London Interbank
  Offered Rate), typically 67
• Variations on LIBOR

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SIFMA SWAP

• Floating to Fixed Rate Example of
  Cash Flows
  Notional Amount
  50,000,000
• City Net Payment Amount Paid
• City Pays
  Receives By City for Week
• Variable Fixed Swap
• Rate Bonds Rate SIFMA
• Week 1 1.45 4.17 1.47 4.15 39,794.52
• Week 2 1.60 4.17 1.60 4.17 39,976.71
• Week 3 2.20 4.17 2.17 4.20 40,264.38
• Week 4 2.45 4.17 2.50 4.12 39,497.26
• Week 5 4.00 4.17 2.30 5.87 56,278.08
• Week 6 6.00 4.17 2.85 7.32 70,182.19
• Week 7 7.00 4.17 2.75 8.42 80,730.14
• Week 8 8.00 4.17 3.00 9.17 87,921.92

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An index based swap
Conventional Variable
Swap Agreement
Fixed Rate 4.0
Issuer
Swap Provider
Variable Rate (MARKET INDEX)
Variable Rate on Bonds
(NOT IDENTICAL)
SIFMA or LIBOR or Variation
Bondholder
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LIBOR Based Swap

• Floating to Fixed Rate Example of Cash
  Flows
• 
  Notional Amount 50,000,000
• City Net Payment Amount Paid
• City Pays
  Receives By City for Week
• Variable Fixed Swap 67 of
• Rate Bonds Rate 1 mo. LIBOR
• Week 1 1.45 4.17 1.50 4.12 39,506.85
• Week 2 1.60 4.17 1.60 4.17 39,976.71
• Week 3 2.20 4.17 3.00 3.37 32,305.48
• Week 4 2.45 4.17 2.39 4.23 40,552.05
• Week 5 4.00 4.17 2.90 5.27 50,524.66
• Week 6 6.00 4.17 3.30 6.87 65,867.12
• Week 7 7.00 4.17 3.30 7.87 75,456.16
• Week 8 8.00 4.17 2.95 9.22 88,401.37

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How do swaps allocate risk?
VRDO with Cost of Funds Swap
VRDO with LIBOR Swap
Conventional Fixed Rate
VRDO with SIFMA Swap
VRDO
KEY RISKS
Issuer Down- grade Risk
Risk that Issuer downgrade will increase bond
rates
YES
YES
YES
No
No
Tax Rate Risk
Risk that decrease in tax rates will increase
bond
YES
YES
Hedged
No
No
Hedging the basic risks of VRDOs
Market Rate Risk
Risk that general market interest rates will
change
YES
Hedged
No
No
Hedged
Liquidity / LC Renewal Risk
YES
YES
YES
No
YES
Other Basis Risk
Risk (caused by other than tax rate changes) that
an index used to calculate the variable swap
payment will not match the rates on the hedged
variable rate bonds
No
YES
YES
Fully Variable
No
Risks Arising from the swap itself
Counterparty Risk
YES
YES
YES
No
No
The risk that the swap counterparty defaults
under the swap
YES
YES
YES
No
No
Termination Risk
The risk that the swap terminates and the Issuer
may be required to pay a
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Types of Interest Rate Swaps

• Floating to Fixed Rate
• Fixed to Floating Rate
• Basis Swap
• Swaption (Swap Option)

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Why Use an Interest Rate Swap?

• To manage exposure to floating and fixed interest
  rates
• To lock in debt service savings now on bonds that
  cant be advance refunded
• To access the capital markets more rapidly than
  may be possible with conventional debt
  instruments
• To decrease the cost of fixed or floating rate
  debt
• To lower overall costs of borrowing
• Should NOT be used for speculative purposes

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Evaluating the Appropriateness of a Swap

• Look at the risks vs. rewards
• Review the implications under federal tax law
• What is the potential impact on your credit
  ratings?
• Will the swap impact your debt capacity?
• Do you have the ability to handle the
  administrative burdens monitoring, accounting
  and reporting?
• Evaluate whether you can ride out any bad periods
  during life of the swap

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1999 Cleveland Transaction

• Floating to Fixed Rate Swap
• relating to
• Subordinated Income Tax Variable Rate Bonds,
  Series 1994
• Objective hedge exposure against interest rate
  fluctuations
• City paid fixed rate of 4.88
• Counterparty paid City actual rate on bonds,
  subject to certain events that could have
  triggered shift from actual rate on bonds
• to SIFMA index
• Both parties payment obligations insured to
  minimize
• termination risk
• One way collateral (only counterparty subject to
  posting collateral)
• In order to protect Citys general fund, City had
  period of years to pay any amount owed on any
  early termination

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2003 Cleveland Transaction

• Swap Option for Fixed to Floating
• relating to
• Subordinated Income Tax Variable Rate Bonds,
  Series 1994
• City sold option giving right to a counterparty
  to execute interest rate swap at its discretion
  at any time until final maturity of bonds in 2024
• Objective capture savings from converting bonds
  to variable rate
• If option is exercised, City will become fixed
  receiver gets 4.88 to offset previous swap
• City then pays floating rate equal to SIFMA to
  counterparty to achieve variable rate exposure
• City received upfront payment for the value of
  the option

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2003 Cleveland Airport Transaction

• Floating to Fixed Rate Swaps
• relating to
• Airport Revenue Bonds, Series 2003AB
• City issued airport revenue bonds as auction rate
  securities and entered into floating to fixed
  rate swaps with 2 counterparties
• Airport pays fixed rate of 4.169 on Non-AMT
  Bonds and 4.273 on AMT Bonds
• Counterparties pay SIFMA on Non-AMT Bonds and
  SIFMA plus 10 basis points on AMT Bonds
• Synthetic fixed rates provided lowest cost of
  borrowing, debt relief to airlines
• Airport minimized risks by entering into SIFMA,
  rather than LIBOR based, swaps but this also
  reduced expected savings
• With collapse of auction securities market, City
  refunded the bonds with bank-supported variable
  rate demand tender bonds and kept swaps in place

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Jefferson County, Alabama Transactions

• Sewer Revenue Bonds and Related Swaps
• 3.2 Billion of debt, mostly variable rate with
  interest rate swaps
• Auction securities and VRDOs (variable rate
  demand obligations) insured by number of
  insurance companies that lost AAA ratings and are
  now rated as junk or near-junk credits
• With insurer downgrades variable interest rates
  soared
• With collapse of auction securities market,
  penalty interest rates kicked in
• 13 interest rate swaps with huge termination
  payments (over 184 million)
• Sewer rates cant go up enough to pay these
  obligations
• SEC actions against regional financial firm that
  received 6.7 million in fees and local public
  official alleged to have been bribed for 156,000
  
• Taxpayer filed litigation alleges county
  victimized by unscrupulous investment bankers and
  financial advisors