This is the second of two installments of excerpts from a talk given by J. Chester Johnson on the risks that governments can face in municipal interest swaps. Mr. Johnson, president of Government Finance Associates Inc. spoke before the Institute for International Research in New York City.
Government B has sold a series of bonds issues over the years, some of which could be advance refunded at very attractive economic gains, except for a prohibition against advance refunding of private-activity debt.
In 1991, Government B decided to enter into a delayed swap arrangement that had the following features:
In 1993, Government B would issue variable-rate debt, using the proceeds to retire the then-outstanding, but callable bonds, and swap to a fixed rate (with that rate having been decided upon in 1991). The counterparty would then pay Government B's variable-rate debt, although not the precise variable-rate obligation that Government B would owe from time to time. Rather, the counterparty pays an amount, based on an assumed differential to the index. As in the first example, we choose the J.J. Kenny index.
Then, in turn Government B is responsible for the fixed-rate charges over the term of the swap agreement - again, for a 10-year period from the original swap date, not from the date that the bonds become callable.
Some of the principal issues that were necessary for Government B to address included:
* Basis Risk: As stated above, the variable rate that the counterparty would pay, subsequent to the issuance of variable-rate debt by Government B, reflected an assumed rate against the J.J. Kenny index. Of course, if for any reason the credit quality of Government B or its letter of credit institution deteriorated, or for any other reason this differential were to change to Government B's detriment, then the actual savings that had been envisioned might be less, because Government B's overall cost would be greater.
In this case, Government B concluded that the negative margin or basis risk exposure, under a conventional set of reasonable circumstances, would be no greater than 10 basis points. Conversely, Government B decided that there was even upside potential to offset the uncertainty from the downside basis risk.
* Tax/Issuance Risk: Government B concluded that the greatest risk in the transaction probably consisted of the possible inability to issue tax-exempt variable-rate debt in 1993.
For example, if, in the interim, federal tax law were to change, Government B could possibly be prohibited from issuing debt for this purpose in 1993. Of course, if this possibility were to occur, it could potentially be quite costly.
Government B determined that the tax/issuance risk was acceptable, considering the options that would, practically speaking, be available before and at the time of issuance.
* Tail Risk: Because Government B decided to limit the length of the swap to 10 years, there was a portion of the maturity on the bonds that was called that had not been covered by the term of the swap, that is, the portion that would remain following the termination of the 10-year swap. Government B concluded that over the period of the swap, it had sufficient flexibility to adjust to that portion, such as an extension of the swap, issuance of an alternative form of debt, among other options.
* Forward Commitment Alternative: An alternative to a delayed refunding swap is a forward interest rate commitment, which guarantees a long-term interest rate at a predetermined future date.
To gain this agreed-upon interest rate at the time it is needed in the future, a rather high up-front fee is required. The fees for forward interest rate commitments have recently declined, and if this transaction were to be done today, Government B would probably look a bit closer at the forward interest-rate commitment as an alternative, even though the refunding swap still, in most cases, represents a more attractive approach.
Counterparty Risk: Of course, if the counterparty were to withdraw at any time over the period of the swap, the refunding savings that Government B anticipated could decrease in a meaningful way. Nevertheless, it concluded that while the swap market is not as deep as the municipal bond market, if the transaction were structured in a marketable fashion as a desirable product, there would be sufficient counterparties to replace one that went into bankruptcy and was removed from the swap.
Of course, if the master swap agreement did provide the requirement that if the counterparty were absorbed or otherwise was incorporated into another entity, then that subsequent, parent corporate entry would take on the obligations of the counterparty.
While other important issues were addressed during the course of the development of this transaction, such as the rating agency perspective, the use of the proper index, the length of the swap, and so on, the manner in which these issues were handled by Government B did not depart dramatically from the manner used by Government A presented in last week's example.
As a final comment, I would like to say that there are several general concerns that I have about the municipal interest rate swap market, and I would suggest extra caution be applied to these areas when a swap transaction is considered as part of a debt management and related investment strategy.
* Uncertainty of General Government Appropriations: One factor exists with the government swaps that generally would not apply to corporate finance swaps. As long as the participating governments are making money on the swaps in accordance with the anticipated arrangements, the political downside of the transaction has been contained. However, whenever general purpose governments must go through the appropriation process to make unanticipated net payments to the counterparty, it is my belief the swap environment departs from the conventional corporate swap.
Interest rate swaps are often more complex than a normal general purpose debt issue, even though the paperwork tends to be less comprehensive and extensive. It is my opinion that the more complex it becomes for government finance officials to explain to city councils and county councils the reasons that the government owes unanticipated payments under a swap agreement, the more difficult it will be for the officials to always get the right result from the government. Therefore, it can be more politically perilous for general purpose governments to participate in interest rate swaps through the requisite appropriation process, with the likely outcome less certain than with special purpose authorities or with corporations.
* Thinness of the Market: It is normally difficult to get truly comparable market quotes for municipal swap transactions because of the thinness of the market and the different ways that swap products are offered to municipal borrowers, but it is very important for market quotes to be gathered from as many available and reliable sources as possible when the transaction is being finalized.
* Compensation: Adding to the problem of comparability in analyzing market prices is that some counterparties incorporate fees in the swap rate, and other counterparties place the fees on top of the rate. Until the marketplace develops some consistency, it will be important for the municipal borrower to have a detailed knowledge of the total compensation being paid to the counterparty, whether it is all in the rate, all in the fee, or a combination of the two.
* Lure of Steep Yield Curve: At present, municipal borrowers can receive very attractive proposals for interest rate swaps. While this environment will probably continue for a period in the future, it is very important for the governments using swaps to structure them very carefully and cautiously, so that as the rates increase and flatten, the provisions of the master swap agreement and the original economic program will not work substantially to their disadvantage.
* Absence of Inverted Yield Curve in Municipal Market: There is often a comment made by professionals in the swap market that if the swap proves expensive to the government in the future, the government could, at that point, decide to extend the swap (taking advantage of a longer term, presumably at relatively higher rates at the time) without any damage.
This conclusion is based on the history of a traditional yield curve in the municipal marketplace. Because there has not been an inverted yield curve in the municipal market, this comment to remove concern for governments in considering swaps has some justification. However, should an inverted yield curve be present in the municipal market for a period of time, a lot of transactions now being developed could become enormously expensive for governments in the future.
The comments that have been made here suggest that interest rate swaps can be employed effectively for a variety of purposes. Nevertheless, swaps should be considered in the context of available resources and practices. Those governments, in our opinion, that can take maximum advantage of swap activity are those that have the financial and debt management flexibility to handle the realistic opportunities and attendant risks.