National Association of State Treasurers Conference

1
National Association of State Treasurers
Conference

• Overview of the Municipal Swap MarketplaceGrowth
  , Usage, and Future
• December 6, 2004

2
The U.S. Swap MarketContinuing 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)
2
3
Growth of the Corporate Swap Market

• Corporate use of Derivatives have fueled the
  growth in the overall market over the last 10
  years.
• Approximately 92 of the Worlds 500 Largest
  companies utilize Derivatives.
• The various derivatives used by Corporates are
  for Asset Liability Management or ALM.

2
4
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

• Alabama
• Arizona
• California
• Colorado

• Florida
• Illinois
• Iowa
• Maryland
• Massachusetts

• New Jersey
• New Mexico
• New York
• North Carolina
• Ohio

• Oklahoma
• Oregon
• Pennsylvania
• Puerto Rico
• 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
5
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

Indicative Yield Curve Comparison
Yield
Traditional Fixed Rate Bonds
BMA Swap
68 of LIBOR Swap
Savings of 68 LIBOR Swap
Maturity (Years)
Fixed Rate Bond Yield ()
68 of LIBOR Swap Rate
BMA Swap Rate
vs. Bonds
vs. BMA Swap
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 30 4.67 4.41 3.66 101 75
Year
15
6
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

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

4
7
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)

5
8
What does the Fixed Swap Rate represent?

• The fixed swap rate is derived from the markets
  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 ()
Forward BMA Index
Present Value of Fixed Rate Payments
Present Value of Floating Rate Payments
BMA Index Projected by Forward Rates
5-Year BMA Swap Rate
5-Year BMA Swap Rate
Maturity
6
9
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
20-year BMA Swaps
20-year BMA/LIBOR Ratio
10
10
Interest Rate Swap Spectrum
Floating-to-FixedFixed Payer Swap
Fixed-to-FloatingFixed Receiver Swap
FixedRate Debt
Fixed RateCoupon
Fixed ReceiverRate
Fixed PayerRate
Party A
Party B
Variable RateIndex
Variable Rate Index
BMA
FloatingRate Debt
11
11
Fixed Payer SwapMechanics and Applications
Fixed Payer SwapApplications
Fixed Payer SwapCash Flows

• Achieve fixed rate financing without accessing
  the traditional fixed rate market
• Refund existing fixed rate debt or fund new money
  needs more cost effectively vs. fixed rate bonds
• Have the ability to easily change
  fixed-vs.-floating rate debt mix

Fixed Rate
Issuer
BMA or LIBOR
BMA
12
12
Fixed Receiver SwapMechanics and Applications
Fixed Receiver SwapApplications
Fixed Receiver SwapCash Flows

• Convert fixed rate debt to variable rate debt
• Add variable rate exposure
• Achieve immediate reduction in interest expense
• Produce variable rate exposure without the need
  for LOCs or liquidity facilities

Fixed Rate
Issuer
BMA Index
Fixed Rate
Fixed Rate Debt
13
13
Swaps Within the Overall Municipal Debt Framework
Financing Type
Structure
Benefits and Costs
14
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 riskthe 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
15
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 1Issue TraditionalFixed Rate Debt
Strategy 2Issue Synthetic Fixed Rate

• Fixed Rate Bonds
• Alternative CallFeatures

• Issue floating,swap to fixed
• Option-basedstructures

DebtManagement
17
16
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 1Issue TraditionalVariable Rate Debt
Strategy 2Issue Synthetic Variable Rate

• Auction Rate Securities
• VRDBs
• Commercial Paper

• Issue fixed,swap to floating
• Option-basedstructures
• Basis Swaps

DebtManagement
18
17
The Bigger PictureWhere 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

19
18
The Bigger PictureWhere 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 optionalityboth buying and
  selling it
• Significant strides will be made with regard to
  systems that monitor derivative exposure

20
19
The Bigger PictureDerivative 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 systems expertise
• Policies should address issues such as leverage,
  credit exposure to counterparties, and ongoing
  exposure management

21