This section sets forth the State's policy as it relates to
derivatives, which may be entered into prior to, simultaneously with or
subsequent to any related fixed or variable rate transaction. The use of
derivatives is intended to reduce the State's exposure to fluctuations in
interest rates incurred through the issuance of variable-rate debt or to hedge
interest rates on the future issuance of general obligation debt. However,
these instruments can be used in certain instances to reduce the burden of
high-interest, fixed-rate debt by converting State's obligations from
fixed-rate to variable-rate.
A.
Guidelines
1. Permitted Instruments - The
State may use the following instruments on either a previously issued, current
or forward basis in connection with state-supported debt with the objectives of
lowering the cost of borrowing and/or interest rate risk:
a. Interest Rate Swaps - including
fixed/floating swaps, basis swaps and constant maturity swaps;
b. Interest rate caps, floors and collars;
c. Options associated with
interest rate swaps (swaptions), caps, floors and collars;
d. Forward swap agreements; or
e. Other interest rate hedge agreements.
2. Term Limit - The
term of any derivatives agreement shall not extend beyond the final maturity
date of the underlying debt related to such derivative agreement.
3. Counterparties
a. Credit Rating Requirement - The
counterparty shall have a credit rating that is within the two highest
investment grade categories from at least one nationally recognized rating
agency and ratings which are obtained from any other nationally recognized
rating agencies shall also be within the highest three investment grade
categories, or the payment obligations of the counterparty shall be
unconditionally guaranteed by an entity with such credit ratings.
b. Collateral Requirement - The obligations
of the counterparty shall be fully and continuously collateralized by direct
obligations of, or obligations the principal and interest on which are
guaranteed by the United States of America with a net market value of at least
102 percent of the net market value of the contract (subject to minimum
threshold amounts specified by the State) if the ratings of the counterparty or
guaranteeing entity fall below the required levels.
c. Net Worth Requirement - The counterparty
must either have a net worth of at least $100 million or the counterparty's
obligations under the derivative contract must be guaranteed by an entity
having a net worth of at least $100 million.
d. Diversification - In managing the State's
overall derivative risk position, an effort should be made to diversify the
State's exposure to any single counterparty.
4. Security and Source of Repayment
The State may establish a fund that maintains a minimum
balance of one month's payment to alleviate any cash flow issues by the timing
of any transaction payments related to its outstanding derivative agreements.
5. Structure of the
Derivatives Contract
The State will use the terms and conditions set forth in the
International Swap and Derivatives Association, Inc. ("ISDA") Master Agreement,
including the Schedule to the Master Agreement, its related Confirmation(s) and
an ISDA Credit Support Annex, if necessary (collectively the "Agreement").
Final documentation of a derivative contract shall include
at a minimum the following:
a.
Authorizing Resolutions and Certificates;
b. ISDA Master Agreement;
c. Schedule to the Master Agreement;
d. ISDA Credit Support Annex, if
necessary;
e. Confirmation(s) of
transaction(s) covered by the Agreement;
f. Guarantee of the Counterparty's
obligations, if necessary;
g.
Validation Order Documents;
h.
Legal Opinions from Associated Counsel;
i. Counterparty (and guarantor, if
applicable) Net Worth and Ratings Certificate; and
j. In negotiated transactions, a fair pricing
opinion from the financial advisor or swap advisor.
6. FMV Certificate
The State will obtain from its financial advisor or swap
advisor a certificate stating that the terms and conditions of the derivatives
contract reflect market value of such agreement as of the date of execution.
The State's advisor will perform due diligence to determine the market value of
the derivatives contract based on the type of credit, the complexity of the
derivative structure and the underlying debt obligation, and the market at the
time of the transaction.
7.
Termination Provisions
a. Optional
Termination - Any derivative contract procured on behalf of the State may
include an Optional Early Termination Provision, which will permit the State to
unilaterally terminate the agreement if it is deemed financially advantageous
to do so.
b. Mandatory Termination
- In the event that a derivative contract is terminated due to a termination
event such as a default or decline in credit quality, the State will determine
if it is feasible or beneficial to attempt to find a replacement counterparty
or if the better option would be to make or receive a termination payment.
In determining the structure of a derivative contract, the
State should evaluate the costs and benefits of incorporating a provision that
would allow for termination payments by the State to be made over time as an
alternative to lump-sum payment. The State will continuously monitor its
termination payment exposure to ensure that if a termination event occurs on
the State's outstanding derivatives contracts, the termination payments would
not be overly burdensome.
8. Evaluation and Management of Risks
Prior to the execution of any derivative transaction, the
State shall evaluate the proposed transaction and report the findings using the
Derivatives Checklist in Exhibit B. Such review shall include the
identification and evaluation of the proposed benefits and potential risks and
the measures that may be taken to mitigate these risks. The following areas of
potential risks shall be considered:
a. Amortization Risk - the mismatch between
the amortization schedule of the underlying debt obligation and the
amortization of the notional amount of the derivative contract. This can be
mitigated by matching the amortization of the notional amount of the derivative
contract to the amortization of the underlying debt obligation.
b. Basis Risk - the mismatch between indices
used to calculate debt service payments and the payments due under the
derivatives contract. This risk is minimized by using the same index to
calculate both the debt service and the derivatives contract payments. Basis
risk also includes the mismatch between the interest actually paid on variable
rate bonds and the variable rate payments received under a derivative
agreement, such as a floating-to-fixed interest rate swap, entered into as a
hedge of the variable rate exposure.
c. Counterparty Risk - the risk that the
counterparty will be unable to make its required payments. This is particularly
important if the State has more than one derivative contract with the
counterparty and the documents contain cross-default provisions. This risk can
be mitigated through the credit rating requirements, collateral requirements,
net worth requirements, and diversification requirements set forth in this
policy.
d. Credit Risk - the
occurrence of an event modifying the credit rating of the State or the
counterparty. This risk is mitigated somewhat by the established credit
standards in this policy; this risk can also be addressed through minimizing
cross defaults; posting of collateral, net worth requirements, and
diversification requirements set forth in this policy.
e. Interest Rate Risk - how the movement of
interest rates over time affects the market value of the instrument after
execution. Changes in the market value of the derivatives contract after
execution may change the accounting treatment of the derivatives contract for
financial reporting purposes and have an effect on the State's financial
statements. Careful monitoring of the value of the contract is necessary after
execution.
f. Market Access Risk -
the risk that the State will not be able to enter credit markets or that credit
will become more costly. For example, to complete a derivative's objective, a
new money issuance or a refunding may be planned in the future. If at that
time, the State is unable to enter the credit markets, the expected costs
savings may not be realized while the State will continue to be subject to its
obligations required by the derivative contract. This risk can be mitigated by
careful negotiation of the optional termination provisions and termination
payment provisions of the derivative contract.
g. Ratings Risk - the risk that the execution
of a derivative contract would have an adverse effect on the State's credit
rating. It is anticipated that credit rating agencies would look favorably upon
the types of derivative contracts that have as their objective the reduction of
interest rate risk and the cost of borrowing such as interest rate swaps, caps,
floors, collars, and options associated with such derivatives. However, careful
attention should be paid to any potential impact on the State's rating and any
long-term implications of any derivative contract under consideration.
h. Tax Event Risk - the risk of
potential changes to the Federal and/or State income tax laws, regulations,
etc. affecting the interest payments on debt obligations. All issuers who issue
tax-exempt variable rate debt, the interest rate on which is periodically reset
at levels reflecting the tax-exempt market, inherently accepts risk stemming
from changes in marginal income tax rates. Decreases in marginal income tax
rates for individuals and corporations could result in tax-exempt variable
rates rising faster than taxable variable rates. This is the result of the tax
code's impact on the trading value of tax-exempt bonds. This risk is a form of
basis risk under swap contracts. Percentage of LIBOR and certain BMA swaps can
also expose issuers to tax event risk. Some BMA swaps have tax event triggers
which can change the basis under the swap from BMA to a LIBOR basis.
i. Termination Risk - the risk that the
transaction may be terminated by either party in a market that dictates a
termination payment by the State. This risk may be mitigated through the
identification of revenue sources for and budgeting of potential termination
payments, structuring the derivative transactions so that bond proceeds can be
used for termination payments (i.e. assuring that the derivative is a
"qualified hedge" under tax rules), deferral of such payments over time, and
subordinating the lien status of potential payments. This risk may also be
minimized by recommending the selection of counterparties with strong
creditworthiness, under certain circumstances requiring the counterparty to
post collateral in excess of the contract's market value, negotiating limits on
the circumstances under which a payment may be required (particularly mandatory
terminations triggered by the counterparty's bankruptcy or credit downgrade)
and permitting the assignment of the contract to a creditworthy entity in lieu
of termination. When considering the relative advantage of adding provisions to
the contract that would mitigate risks, the State will evaluate these
provisions for their cost effectiveness.
9. Independent Third Party Advisors
The State may retain the services of an independent third
party advisor or manager to evaluate the risks and market value of any proposed
derivative contract and to assist the State with the monitoring and reporting
requirements for executed contracts.
