Spokane has become the first city in Washington to enter an interest rate swap under the state's two-year experiment with derivatives.
In April, the state enacted a law allowing counties, cities, and utility districts to enter into interest rate swaps under certain conditions. The law expires after two years, although the swaps are not limited to two-year maturities.
Other issuers in the state are expected to follow Spokane's lead. "Spokane is viewed as a very cautious and conservative issuer," said Roy Koegen, the city's bond counsel. "We think you will now see more swaps in the state of Washington."
Under the authorizing statute, only issuers with at least $100 million of outstanding debt or $100 million in annual revenues may use swaps.
"This is for sophisticated issuers," said Robert Campbell, a managing director in Lehman Brother's Seattle office who worked on the Spokane transaction. "Smaller cities and school districts can't use them."
The law requires that the issuer hire a financial adviser to evaluate a swap and determine that the deal is commercially reasonable, Koegen said. The issuer must also document. the savings from using the swap, and the adviser must confirm the issuer's analysis.
Further, unless the swap counterparty is rated AA or higher, the swap must be at least 102% collateralized.
The safeguards will rein in some issuers, but market participants said the rules were appropriate.
"The statute is pretty circumspect. It doesn't give issuers broad authority," said Kevin Doyle, assistant general counsel at AMBAC Indemnity Corp., the insurer of the Spokane deal. "But it's probably a good way to get started."
Spokane used its swap transaction to generate an additional $231,000 in present-value savings on a $37 million refunding issue two weeks ago. Including the swap savings, present-value savings on the refunding totaled almost $3 million.
About $16.6 million of the issue was structured as inverse floating-rate notes maturing in 2010. The notes will pay investors 12.7% minus twice the J.J. Kenny bond index for the next seven years. After that, the notes will pay investors a fixed rate of 5.20% until 2010.
The city entered a swap with Lehman Brothers to lock in a synthetic fixed rate on the notes of 5.20%, about 12 basis points less than the city would have paid on ordinary bonds. AMBAC insured the city's payments on the swap and the notes.
The swap includes a one-way collateral agreement designed to reduce the city's credit exposure. If the city is receiving payments from Lehman on the swap, Lehman will also have to put in escrow government securities worth 105% of the swap's market value. The swap will be valued monthly to determine how much collateral, if any, needs to be posted.
If Lehman defaults on the swap, the city will be liable to take the collateral and use it to buy a replacement swap.
The safeguards helped reassure AMBAC. "Typically, we look through the counterparty to evaluate the worst case - what if the bond goes to its maximum rate and the counterparty defaults?" Doyle said. "We did that in this case, but with [the safeguards] it was probably an academic exercise."
The only other swap-related transaction by a Washington issuer was a forward swap by the Chelan County Public Utility District. At least six or seven other issuers in the state have considered and rejected swap transactions under the new law, Koegen said.
But Spokane went ahead with the deal because of the safeguards included and the savings achieved.
"The swap is only for seven years, so the risk is limited and they don't have to give up their call," Koegen said. The city also favored the structure because it did not create basis risk - the possibility that the variable-rate payments that the city will receive on the swap will fall short of the payments it owes on the bonds.
Spokane is considering a forward swap for another $76 million of bonds that could not be advance refunded because they are subject to the alternative minimum tax, Koegen said. The bonds are not callable until 1999, a very long period in the world of forward swaps. "A forward swap is one possibility, but we're much more skeptical about it," Koegen said.
Cities and states across the country have entered swaps, sometimes without explicit authorizing legislation. But court rulings in Washington State applied "Dillon's Rule" to municipal issuers. According to Koegen, the rule states that "generally, a public entity can only do what it is explicitly authorized to do by legislation."
In some states, public entities may take actions that are implied or that are not prohibited. Bond counsel in some states have authorized swaps based on the implied power to enter contracts facilitating bond issuance, for example.
Spokane finance officials who worked on the deal were not available for comment.
