Washington, D.C., Explores Using Swaps To Hedge $332 Million Deficit Bonding

WASHINGTON - Finance officials in the District of Columbia are contemplating the use of interest rate swaps in connection with the city's expected mid-September sale of $332 million of deficit bonds.

Stressing that "this isn't a done deal at all," Ellen M. O'Connor, the district's deputy mayor for finance, said officials are querying investment bankers on the tactic's viability and have sent out a request for qualifications to those firms that might wish to participate in the deal.

"What we're trying to do is to recognize what the market does, what the market uses as vehicles," Ms. O'Connor said. "We want to see how these vehicles could be used to benefit the district in terms of reduced interest payments and debt service requirements."

The deal would be the district's first foray into the nascent municipal swap market. Popular in the corporate realm since the 1980s, swaps are slowly beginning to take hold among municipal issuers as a way of reducing financial exposure.

Options currently under consideration include: issuing the bonds at a variable rate, backed by a letter of credit, and then swapping for a fixed rate; issuing the bonds at a fixed rate, backed by bond insurance, and swapping for a variable rate; or issuing insured bonds at a fixed rate, and swapping for a variable rate on a portion of the issue.

"We're literally trying to play out the various options to see what the issue would look like and try and see what the cost and the risk to the district would be," Ms. O'Connor said.

Investment bankers said debt holders "won't know the difference" should the district enter an interest swap agreement.

For example, if the city decided to issue variable-rate notes, and then swap for a fixed rate with a counterparty, it would make variable-rate payments to the noteholders. The city also would pay a fixed rate to the counterparty, which in turn would pay the district a variable rate tied to a mutually agreed upon index.

In the above example of a "plain vanilla" swap - the derivative market is capable of producing much more complex permutations - the district could come out ahead financially if the variable rate it pays noteholders is less than the variable rate the counterparty pays it.

By contrast, the city could lose money if the variable rate it is paying is greater than the income stream it is receiving from the counterparty, a phenomenon known in the business as "basis risk."

A perfectly hedged transaction would provide the city with a "synthetic fixed rate" because the two variable-rate payments would cancel each other out, leaving just the fixed interest payment the city made to its counterparty, according to William Chew, a senior vice president at Standard & Poor's Corp.

Analysts at both Standard & Poor's and Moody's Investors Service said their respective ratings agencies frown upon the use of swaps as a means of generating revenue instead of serving as a hedge.

Other factors the agencies examine include basis risk, the risk that the counterparty selected by a municipality could renege on its swap agreement, and the risk that the swap agreement could be terminated prematurely.

In addition, analysts and investment bankers also examine whether the municipality has the legal authority to enter swap agreements, generally relying upon the opinion of bond counsel. Such concerns were heightened in early 1989 when Hammersmith and Fulham, a British municipality, was rebuffed in court on a number of swap agreements deemed speculative in nature.

"The Hammersmith and Fulham case illustrates the necessity for U.S. tax-exempt issuers and their counterparties to ascertain - prior to execution - whether the issuer has the legal authority to enter into swap agreements," Moody's warned in its Dec. 17, 1990, "Perspective on Structured Finance."

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