A $35 million interest rate swap between the Texas Veterans' Land Board and GB Derivative Products Co. L.P. last Friday marks the first swap with a minority or regional firm acting as a principal.

GB Derivatives, an affiliate of Grigsby Brandford & Co., was set up at the beginning of this year to give the minority-owned firm the capability to enter swaps directly.

In the past, minority firms have taken an advisory role in swap transactions. In all of those cases, another party, such a large commercial bank or insurance company, entered the swap and agreed to make the required exchange of payments.

The land board's swap "represents the first time that a minority-owned or regional firm has moved beyond arranging or advising on swaps that were actually executed by other firms and executed an interest rate swap transaction directly itself," said J. Donald Rice Jr., president of GB Derivatives.

"We are especially pleased that we were able to execute this transaction with a firm that is owned and operated entirely by minority men and women," Garry Mauro, the Texas land commissioner, said in a statement released this week. "I think the innovative structure of this financing shows that minority firms are capable of providing outstanding service on complex transactions."

The land board issues tax-exempt bonds and uses the proceeds to make mortgage loans to veterans for land purchases at below market. The board then uses the veterans' interest payments to pay the interest due on the bonds.

The swap will help the board avoid losses it normally accrues after a bond is sold but before all of the proceeds have been loaned out.

Typically, the board sells long-term, fixed-rate bonds. Proceeds are initially put in short-term, floating-rate investments. Over the next few years, as veterans come to the board for loans, the money is withdrawn.

But during the early years, the investment interest on the unloaned proceeds does not always meet the debt service due on the bonds. And if the investment rate declines during the early years, the board's losses multiply.

The losses are a result of a classic mismatch of assets and liabilities. The board's assets produce a short-term, floating rate of return, while the board's liabilities require long-term, fixed-rate payments.

The swap was used to convert the assets to a fixed rate of return.

First, the board sold a $35 million, 30-year bond issue. It pays a fixed rate of 6.31% on the bond issue, according to Bruce Salzer, director of funds management for the board.

Then the board entered the swap. For two years, the board will pay GB Derivatives a floating rate based on the Public Securities Association's Municipal Swap index. In return, the board will receive a fixed rate of 4.27%.

The $35 million of bond proceeds was invested with the Texas Treasury. The treasury pays a floating rate, currently about 4.70%, Salzer said.

The board will use the 4.27% receives on the swap to pay a portion of its 6.3% debt service. That leaves the board with about 2% to make up from other sources.

The board will use the floating rate it receives from the state treasury to make floating-rate payments due on the swap. Because the tax-exempt swap rate should always be lower than the rate paid by the state treasury, the board can use the extra interest to make payments on the bonds.

Last week, the PSA rate was 3.04%. So the board would pay 3.04% on the swap while receiving 4.70% from the Texas Treasury. The 1.66$ difference would further limit the board's losses until the proceeds are loaned out.

Without the swap, the board would be losing the difference between the fixed rate on the bonds and the floating rate paid by the Texas Treasury, or about 1.61%. With the swap, the loss is reduced to 0.38%.

As long as the Texas Treasury pays the board a rate higher than the PSA swap rate, the board's losses will be lower thanks to the swap. If the treasury's rate were to drop below the PSA rate - an extremely unlikely event - the board would face greater losses than if it had not used the swap.

Salzer said the board chose GB Derivatives for several reasons in addition to the board's desire to use minority-owned firms.

"Grigsby demonstrated the knowledge and the strength to do this transaction," Salzer said. In addition, General Re, a triple-A rated insurance company, provided credit support for the swap, he said.

GB Derivatives was also able to close the deal late on Friday afternoon, after most market participants had closed up shop for the weekend.

Severe weather was one of the factors that prolonged the closing. Tornado warnings and thunderstorms delayed the plane carrying a board member and board lawyer, who hoped to attend a Friday meeting to sign off on the swap.

"The significant market volatility that occurred during the past week coupled with the late hour of execution presented a challenge," Rice of GB Derivatives said. "But we were still able to hold to the pricing level we had indicated to [the board] several hours earlier."

The transaction was reviewed by the Texas attorney general, but did not require the approval of the Texas Bond Review Board, Salzer said.

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