Interest Rate Swap

1
Interest Rate Swap Related Transactions
Application to Student Loan Financing

• Education Finance Council / NCHELP
• 2005 Student Loan Finance and Legal Issues
  Meeting

Presented By George Majors August 1, 2005
2
Presentation Outline
Section 1
Derivative Products Basics
Section 2
Synthetic Fixed Rate Swap Applications
Section 3
Basis Swap Applications
3
Section 1 Derivative Products Basics
The What and Why of Derivative Products

• Value and cash flows derived from reference to
  underlying asset or index
• Most common fixed income derivatives are, swaps,
  caps, floors, forwards, futures, and options
• Flexible tools for tailoring solutions to
  specific circumstances
• Maximize spread between loan portfolio and
  financing cost
• Manage volatility in that spread

• Swaps and other derivative products are used
  globally by public and private entities to manage
  their interestrate, currency, and other
  exposures
• The vast majority of derivative products have
  common, standardized terms, (i.e., are so-called
  plain vanilla)
• Some derivative products, however, can be very
  complex

4
Interest Rate Swap Mechanics
Section 1 Derivative Products Basics

• An interest rate swap is a contract between two
  parties to exchange cash flows
• Cash flows are calculated based on the product of
  a fixed or floating rate and a set notional
  amount
• No principal is exchanged

• Swap referred to from Issuers perspective -
  Issuer pays fixed rate
• Most common variable rate reference indices
• BMA The Bond Market Associations 7-Day
  Tax-Exempt Index
• LIBOR London Interbank Offered Rate -
• CPI
• T-Bills

5
Interest Rate Swap Cash Flow
Section 1 Derivative Products Basics
6
Swap Dealer Profit and Pricing
Section 1 Derivative Products Basics

• Swap dealers work for a spread
• Rate on offsetting transaction
• Compensation for risks and expenses
• Gross profit
• Counterparty is making market, not taking
  position
• Swap markets pricing very transparent
• Most LIBOR-based transactions ½ basis point
• Most BMA-based transactions 1½ basis points
• Exotic options can be an exception
• Advisors assist with structuring, pricing,
  documentation

7
Interest Rate Caps
Section 1 Derivative Products Basics

• Cap on loan rates creates potential for borrowing
  costs to increase more than loan-related revenues
• Counterparty pays issuer if the market rate of
  the floating rate index exceeds the strike rate

• In tax-exempt programs cost unlikely to cause net
  spread to fall below allowable maximum
• 10-Year LIBOR Cap _at_ 8.25 Cost 13.3 bps annually
  (103 bps PV)
• 10-Year LIBOR Cap _at_ 9.00 Cost 9.9 bps annually
  (76 bps PV)
• Floors Pay if rates decline below strike rate
• Collars Combine cap and floor to reduce cost of
  cap

8
Synthetic Fixed Rate Debt
Section 2 Fixed Payer Swap Student Loan
Applications

• Issuers floating rate payments to bond holders
  offset by floating rate receipts on swap.
• Net result is fixed rate (approximately)
  obligation

Fixed rate
Issuer
Counterparty
Variable rate
Variable rate
Variable rate bondholders
Issuer pays Fixed rate (10-Year
Term) 3.70 Support cost .20 Variable
bond rate BMA Issuer receives Variable
swap rate BMA All-in cost 3.90
9
Rationale for Fixed Payer Swaps
Section 2 Fixed Payer Swap Student Loan
Applications

• When fixed-rate debt is appropriate
• Portion of loan portfolio with fixed-rate
  characteristics
• Fixed rate loans
• 9.5 floor loans
• Simpler execution process
• Particularly for small portion of overall issue
• Lower expected financing costs
• Embed call features to address pre-payment risk
• Match Variable Bonds to 1-Year Term of Loan
  Resets

• Tailoring to underlying loan portfolio
• Can be simpler and/or less expensive than
  conventional, or cash market fixed rate bonds

10
Synthetic Fixed Rate Debt
Section 2 Fixed Payer Swap Student Loan
Applications

• All-in costs assume receipts on swap are equal to
  bond holder payments
• Several risk factors can cause that assumption to
  prove overly optimistic

Counterparty
11
68 of LIBOR As BMA Proxy
Section 2 Fixed Payer Swap Student Loan
Applications

• Historically, 68 of LIBOR has been reasonable
  proxy for tax-exempt variable rate cost of funds
• Generally, the BMA/LIBOR ratio has increased in
  low interest rate environments where the negative
  carry is minimized alternatively, the ratio
  would increase from a decrease in federal tax
  rates

12
Quantifying Basis Risk
Section 2 Fixed Payer Swap Student Loan
Applications

• An issuer will pay more on its bonds than it
  receives on the floating leg of the swap if and
  when the BMA/LIBOR ratio exceeds 68
• Issuer is not immediately worse off if average
  ratio exceeds 68 because of initial 45 basis
  point advantage over fixed rate bond alternative
• What probability is assigned to that (or worse)
  outcome?
• A breakeven can be calculated (e.g., If LIBOR
  averages 7 and the BMA/LIBOR ratio averages 81,
  then the synthetic structure will have the same
  cost as the cash bond alternative

13
Identifying and Evaluating Risk Factors
Section 2 Fixed Payer Swap Student Loan
Applications
Level of Indicated Risk
Low
High
Description
Supporting Examples
On-going mismatch between variable leg of Swap
and variable interest rate on debt
Change in Tax Policy causes BMA to trade much
higher than historical averages
Basis Risk
Failure of Swap Counterparty to fulfill
contractual obligations
Swap counterparty defaults requiring issuer to
replaceswap in current marketplace or to have
unhedged variable rate bonds
Counterparty Risk
Decline in Credit Qualityincreases borrowing
costs
Issuer downgrade triggers an automatic
termination on swap in addition to higher
short-term borrowing costs
Credit Risk
Risk on non-renewal of liquidity facility
Consolidation in banking industry creates fewer
bankswilling to provide liquidity
Liquidity Risk
14
Addressing Prepayment Risk
Section 2 Fixed Payer Swap Student Loan
Applications

• Swaps can incorporate cancellation and other
  options
• Purchase options you have the right to exercise
• Sell options your counterparty has the right to
  exercise
• Purchase cancellation option(s) to reduce
  fixed-rate loan pre-payment risk

• Cost of options can be paid in the swap rate
  (i.e., over time) or in the form of an upfront
  cash premium
• Option pricing in the swap market is efficient
• In tax-exempt programs cost unlikely to cause net
  spread to fall below allowable maximum

15
Forward-Starting Swap
Section 2 Fixed Payer Swap Student Loan
Applications

• Issuers offering fixed rate loans can protect
  against rates rising during marketing,
  commitment, and funding period
• Swap can start any number of months in advance
• On the issue date of the new bonds the
  Commission can
• Unwind the swap and issue fixed rate bonds
• or
• Issue variable rate and enter into swap

Counterparty
Execute Swap and lock in forward fixed swap rate
Issue floating rate bonds fixed rate swap
payments commence
Issue fixed rate bonds swap is unwound
Final Maturity of swap or bonds
or
Maturity
Today
Issue Date
16
Matching Bond and Loan Rate Terms
Section 2 Fixed Payer Swap Student Loan
Applications

• Variable rate bond costs can rise during the
  one-year loan reset period.
• On each annual T-Bill Auction reset date, issuers
  can enter into one-year swaps to match bond cost
  term to loan rate term
• On May 31st, 3.81 rate was available for July 1,
  2005 to July 1, 2006 Term vs. LIBOR. 2.77 vs.
  BMA
• Current rates to July 1, 2006 are 4.10 and 2.99,
  respectively

Counterparty
Time-Line
Swap becomes effective on July 1st, fixed rate
swap payments commence
Execute Swap Agreement and lock in 1-Year fixed
swap rate
Next Annual Reset Date
or
July 1st
May T-Bill Auction
July 1st
17
Addressing Basis Mismatches
Section 3 Basis Swap Student Loan Applications

• Maximize and manage expected loan / bond spread
• Threats to loan / bond spread
• SAP T-Bill to LIBOR, CPI to BMA
• Loan Rates 1-Year T-Bill to LIBOR or BMA

• Relationship between 91-day T-Bills and 3-Month
  LIBOR is not constant
• T-Bill auction is in advance of reset date
• T-Bill-based rate is for one year, while variable
  rate bond costs continue to fluctuate
• From July 1994 to July 2005, significant
  volatility in net loan / LIBOR spread
• Best result, loans 1.22 higher than average
  LIBOR
• Worst result, loans 1.53 worse.
• Standard Deviation 0.83

18
Addressing Basis Mismatches
Section 3 Basis Swap Student Loan Applications

• Graphical representation of basis exposure.
• In rising short-term rate environment, variable
  rate borrowing costs increase without offsetting
  increase in loan-related revenues

19
Addressing Basis Mismatches
Section 3 Basis Swap Student Loan Applications

• One-year fixed payer swap transaction described
  earlier partially addresses basis mismatch
• Does not, however, address T-Bill / LIBOR spread
  volatility
• Resulting average spread of 0.88 (0.51 worse)
• Standard deviation of 0.52 (0.31 better)
• Max / Min spread 1.52 (1.23 better)

1-Year Fixed Rate
Issuer
Counterparty
3-Month LIBOR
20
T-Bill / LIBOR Basis Swap
Section 3 Basis Swap Student Loan Applications

• Issuers can enter into a longer term (5 to
  20-year) basis swap to address loan reset,
  financing cost mismatch
• Issuer pays 91-Day T-Bill Rate from auction plus
  spread
• Issuer receives LIBOR (or other) to match bond
  payments
• Depending on term and other factors, spread of
  0.55 to 0.90 available
• No year-to-year volatility

• Basis Swaps are agreements to exchange cash flows
  based on two floating-rate indices
• Eliminates year-to-year volatility
• Does not change (for better or worse) risk of
  legislative changes

21
BMA / LIBOR Basis Swap
Section 3 Basis Swap Student Loan Applications

• A BMA/LIBOR basis swap is a combination of two
  interest rate swaps
• The net result of the basis swap is an exchange
  of two floating rate payments
• Counterparty pays Issuer a percentage of LIBOR
  (e.g. 77.5)
• Issuer pays Counterparty BMA
• Issuer expects BMA to average less than 77.5
  (e.g., 68)
• Similar to risk incurred when issuing floating
  rate tax-exempt debt
• Issuers comfortable with that risk apply basis
  swap to taxable floating (or fixed) rate bonds

1. Assumes 10-year term