Swap option spares power agency from savings setback.

Customized derivatives can sometimes turn misfortune into opportunity.

In the case of the M-S-R Public Power Agency in California, the agency had spent months planning a forward swap transaction to refund $183.6 million of debt that could not be advance refunded. But after the Federal Reserve Board moved to raise short-term rates, swap rates shot up and eliminated the savings created by the forward structure.

The fixed rate that the agency would have had to pay on the swap was too high to meet the agency's savings target.

Agency officials began considering alternatives, but told their bankers at J.P. Morgan Securities to be sure to notify them if rates moved lower again and the savings reemerged.

They were somewhat surprised by Morgan's response.

"We said, ~We'll pay you for that.' We would purchase from them an option to enter a swap at their savings target by the call date," Stephen Sloan, a managing director at J.P. Morgan, said.

Swap documents had already been hammered out for the proposed forward swap transaction. At the call date of the outstanding bonds, the agency would issue long-term variable-rate bonds and begin exchanging payments under a swap with Morgan's banking affiliate, Morgan Guaranty Trust, to lock in a synthetic fixed rate.

Morgan would provide liquidity support for the bonds, and AMBAC Indemnity Corp. was slated to insure the agency's obligations on the bonds and the swap.

But with the swap deal out of the money, the documents were headed for the nearest recycling bin.

Instead, they became part of the option. The option agreement, which will close Friday, gives Morgan the right to enter a swap with the agency based on the previously negotiated terms. If Morgan exercises its right, the agency would have to enter the swap.

But the strike price of the option - the fixed rate the agency would have to pay on the swap - is set at 5.11%, low enough to achieve the agency's savings target on the original deal. Current swap rates are about 100 basis points over the strike price, according to Morgan officials.

"We were comfortable with the risks from the swap. We had insurance, liquidity arrangements, and collateral agreements," said Wayne Truxillo, the chairman of the agency's finance committee. "So we're comfortable with this approach. We think it's a conservative approach."

The agency had established clear guidelines and a savings target for derivatives transactions, according to John Dey, the agency's financial adviser at Public Resources Advisory Group. Although the agency had never entered a swap, its members had experience with derivatives.

The agency is comprised of the Modesto Irrigation District and the cities of Santa Clara and Redding. The joint action agency financed the purchase of the San Juan coal-fired generating station in New Mexico and associated transmission lines.

Morgan agreed to pay the agency $2.3 million as a premium for the option. The option expires in October 1996, 90 days before the call date on the agency's outstanding bonds.

The premium was enhanced by the market's recent volatility. Volatility is an essential ingredient in the Black-Scholes option pricing model. The more volatile the market, the higher the premium paid for options.

Under the option structure, it is still possible that the swap will never occur. If rates do not decline by the end of 1996, Morgan will not exercise the option, since the fixed rate of 5.11% that it would receive would be below the market rate. In that case, the agency would have the $2.3 million and could either leave the bonds outstanding or perhaps refinance them using them a more cost-effective current refunding deal.

If rates are well above the strike price, there would be no need to call the bonds.

If rates decline to the strike price, however, Morgan would exercise the option. The agency is then in the same position it would have been in had it completed the original forward swap deal, plus it collects the $2.3 million.

If the option is exercised and the $183 million of outstanding bonds are refinanced with variable-rate debt, the agency will save $34.9 million, or $14.0 million on a present value basis, according to J.P. Morgan.

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