INTRODUCTION TO SWAPS -- New Ways to Manage Your District’s Debt Service Obligations Presented By Christopher Brewer, Esq. Partner Suite 1400 One Oxford

INTRODUCTION TO SWAPS --

New Ways to Manage Your District’s Debt Service Obligations

Presented By

Christopher Brewer, Esq.PartnerSuite 1400One Oxford CentrePittsburgh, PA 15219412-394-2452

Jay WengerManaging DirectorSuite 150830 Sir Thomas CourtHarrisburg, PA 17109717-561-8089

March 14, 200752nd Annual ConferencePittsburgh, Pennsylvania

Susquehanna Group Advisors, Inc.

Financial Management and Business Consulting Specialists

Since 2003, certain amendments to Pennsylvania’s Local Government Unit Debt Act have enabled School Districts to modify their debt service obligations in respect of existing bond issues through a variety of Interest Rate Management Agreements. Known in the industry as “Swaps” (and also as Swaptions, Interest Rate Locks, Basis Swaps and other such names), these contracts overlay and modify the net interest expense of a School District’s debt. These contracts are not debt themselves. As should be expected, these contracts bring their own set of risks and rewards.

This seminar will introduce you to the basic mechanics of Swaps with the intent of enabling a School District business official to better analyze proposals which come to his or her attention from the investment banking community.

3Introduction to Swaps

I.I. What is a Swap?What is a Swap?

A contract by which two parties exchange interest rate payments

Traditionally, one rate is fixed and the other is variable

Due to recent market conditions, variable to variable rate swaps are increasingly common

Payments are established by identifying a rate of payment (or a basis for calculating payments) and a principal amount (referred to as “notional amount”) upon which the rate(s) or calculations are applied

Only the interest rates are “swapped” between parties. The principal/notional amount applies only as the basis for the interest calculations


II.II. What is the Legal Basis for What is the Legal Basis for Swaps?Swaps?

Act 23 of 2003 amended the Local Government Unit Debt Act in order to allow Pennsylvania counties, cities, townships, boroughs, intermediate units and school districts to enter into Swap Agreements

Exception: Local Governments declared distressed by DCED are not eligible to enter into Swaps.

In the jargon of Act 23, Swaps are called “Qualified Interest Rate Management Agreements” or “QIRMAs”


III. Why a Swap?III. Why a Swap?

Fixed rate debt may not be the best way to fund a project Issue variable rate bonds or notes Then hedge rate volatility by swapping to a fixed rate

Often provides a superior alternative to a fixed rate loan Usually lower overall rate

Greater efficiency in the international swap market More flexibility

Easier to adjust to changing marketsEasier to refund/redeem/terminate prior to maturity


School Districts must produce a written “Interest Rate Management Plan” (“IRMP”)

An “Independent Financial Advisor” (independent of the Swap provider) must be employed to develop and/or review the Interest Rate Management Plan

The Swap provider or “Counterparty” may be selected by a negotiated or a competitive process

This Counterparty must be rated A-, at a minimum

Fortuitously, for School Districts, the interest rate payments (“Scheduled Payments”) under the Swap qualify for the “State Intercept”

IV.IV. What are the Key Features and What are the Key Features and Requirements of Act 23?Requirements of Act 23?


The Board must advertise and adopt a resolution approving the Interest Rate Management Plan as well as authorizing the Qualified Interest Rate Management Agreement

Transactions must be reported to/filed with the Department of Community and Economic Development

The Swap must relate to specific bond issue(s) (whether pre-existing or authorized concurrently), and must advance the School District’s debt management needs and goals

Term of swap may not exceed term of related debt, and must expire if debt paid



A maximum rate of interest must be specified for a School District which is making a variable rate payment

Swap agreement may be subject to termination at will by School District

Swap agreement may not be subject to termination at will by Counterparty

School District may pledge full faith, credit and taxing power for payment of Scheduled Payments

Cannot pledge full faith, credit and taxing power for payment of termination payment, but School District may borrow for it

Borrowing to make termination payments requires court approval (unless termination is part of a refunding)



V. Interest Rate Management Plan V. Interest Rate Management Plan ComponentsComponents

Interest Rate Management Plan is a plan prepared by or reviewed by independent financial advisor

Must include the following schedules:

outstanding debt issues

notional amounts for any prior Swaps

consulting, advisory, brokerage or other fees related to the Swap as well as consulting, brokerage, finders fees and other fees relating to the Counterparty

payments to be paid by and to be received by the School District under the Swap

analysis of various risks involved in entering into the Swap and relating to all Swap agreements of the School District


VI.VI. What Are Main Advantages and Reasons What Are Main Advantages and Reasons for for

Entering Into a Swap Agreement? Entering Into a Swap Agreement? Swaps can create low fixed or variable rate debt

Swaps can lock-in rates for a financing one to two years prior to the issuance of the debt

Swaps can seize current market conditions to realize savings from a refunding of an existing bond issue that could not otherwise be advance refunded

The following slides illustrate three scenarios that a School District could encounter where a Swap Agreement could be a benefit.



Entering Into a Swap Agreement? Entering Into a Swap Agreement? Scenario #1The School District has an outstanding bond issue with a notional value of $30,000,000.

By entering into a Swap Agreement the School District will receive a one-time, upfront cash payment of $1,500,000 or 5% of the notional value of the bonds.

The School District elects to use the upfront payment over the remaining life of the bonds to assist with semi-annual interest expense payments, thus reducing the obligation to the general fund and effectively reducing the interest rate of the bond.

The following graph depicts the original general fund debt service obligation on the bonds, and the effective general fund debt service obligation after utilizing the upfront cash payment





The School District determines that it is in need of additional funds to complete a capital project, but does not want to issue additional debt.

By entering into a Swap Agreement the School District will receive a one-time, upfront cash payment of $1,500,000 or 5% of the notional value of the bonds that it can use to complete the capital project.

The following graph depicts the general fund debt service obligation on the initial bonds, and the general fund debt service obligation if the School District were to issue additional bonds.

This is additional debt service that would not exist if the School District were to enter into the Swap Agreement.





By entering into a Swap Agreement the School District, instead of receiving an upfront cash payment, elects to receive ongoing cash payments.

These ongoing payments may be used for any purpose, however, in this example they are used to offset some of the interest expense associated with the original bond issue.

The following graph depicts the original general fund debt service obligation on the bonds, and the effective general fund debt service obligation after utilizing the ongoing cash payments.



VII.VII. Applications for SwapsApplications for Swaps

- Low, Synthetic Fixed Rate

Local

Government

Bondholders

Swap Provider

(Counter-Party)

Fixed Rate

Variable Rate

Variable Rate + costs



- Low, Synthetic Variable Rate

Local

Government

Bondholders

Swap Provider

(Counter-Party)

Fixed Rate

Variable Rate

Fixed Rate



- Basis Swap

Local

Government

Variable Rate (% of LIBOR)

Swap Provider

(Counter-Party)Variable Rate (BMA)

Fixed Rate

Bondholders


VIII. Various Risks Associated with SwapsVIII. Various Risks Associated with Swaps

Counterparty Risk – risk that the Counterparty will not honor its payment obligations under the Swap agreement

Termination Risk – sometimes referred to as liquidity risk: refers to the potential costs associated with a termination of the Swap agreement

Basis Risk – the difference between different types of variable rates

Interest Rate Risk – risk associated with future changes in interest rate and market conditions

Market Access Risk – risk that the School District will be unable to borrow from the capital markets, due to its financial condition, legal restrictions or the like


FAQs 1FAQs 1

1. What types of indices can be hedged? Floating and Variable Rate Indices LIBOR (“London Interbank Offered Rate”) is the most

commonly used rate in the international market -- also Prime, Fed Funds, others The Tax-exempt market commonly uses the BMA

(“Bond Market Association”) swap index, or a Percentage of a taxable index as a proxy for tax-exempt rates

2. Is there a minimum or maximum size? Minimum, depends on Counterparty policy

Some counterparties will not execute below $10 mm Maximum limited only by credit exposure

3. Is there a minimum or maximum maturity? No minimum, but under one year is rare Maximum up to 30 years; 10+ years is not uncommon


FAQs 2FAQs 2

4. Do Swaps amortize? Yes, any stream of cash flows - - constant, accreting,

amortizing, roller coaster, forward starting or any combination.

5. Can a School District lock-in a rate today to start in the future? Yes (one of the real advantages of Swaps)

6. What if School District anticipates prepaying the debt? School District can unwind the Swap at any time prior

to maturity at market value (may be positive or negative)

7. Does the School District have to lock-in for the full debt amount or the full term? No, Swap may be sized to meet a financial goal

8. When are settlements made? On a net basis at the end of each period


FAQs 3FAQs 3

9. Are there any costs? Financial advisor, legal, insurance Typically paid out of the trade

10. What is the Counterparty’s risk? A bank will also hedge its position

Documents

INTRODUCTION TO SWAPS -- New Ways to Manage Your District’s Debt Service Obligations Presented By Christopher Brewer, Esq. Partner Suite 1400 One Oxford