Interest Rate Swap Guidelines for Use With Financing Capital Projects
These guidelines will govern the use by the University of interest rate swap transactions for the purpose of hedging existing and planned General Revenue debt for financing capital items. By utilizing swaps in a prudent manner, the University can take advantage of market opportunities to reduce debt service cost and interest rate risk. The University shall not enter into swap transactions for speculative purposes.
The University has the constitutional authority to enter into swap transactions and related agreements. The University Board of Trustees (the Board) authorizes the University to enter swaps as part of the approval process for bond financings.
In order to enter into a swap transaction, the University must receive: 1) approval from the Board, 2) and an opinion acceptable to the market from a nationally recognized bond counsel firm or general counsel that the agreement relating to the swap transaction is a legal, valid and binding obligation of the University and that entering into the transaction complies with applicable State and Federal laws.
II. FEATURES OF THE AGREEMENTS
A. Form of Agreements
The Agreement will use terms and conditions as set forth in the International Swaps and Derivatives Association, Inc. (hereinafter “ISDA”) Master Agreement and related Schedule. Any Agreement between the University and each counterparty shall include security, collateral, default, remedy, termination, and other terms, conditions, provisions and safeguards as deemed necessary or desirable by an authorized representative. All Agreements shall be payable only in the currency of the United States of America. Each transaction shall be evidenced by a Confirmation setting forth the payment terms, notional amount, and amortization.
B. Terms of Agreements Relating to Interest Rate Swaps
Subject to the provisions contained herein, the terms of any Interest Rate Swap Agreement shall use the following guidelines:
1. Downgrade provisions triggering terminations or requiring collateralization shall in no event be worse for the Issuer than those affecting the counterparty.
2. Governing law: When entering into any Agreement, the Issuer may agree in the written contract or agreement that the rights and remedies of the counterparty shall be governed by the laws of any state of these United States, but the law which shall apply to the required procedures for authorization by the issuer shall be the law of the State of Michigan.
3. The specified indebtedness related to credit events in any Agreement should be narrowly defined and refer only to General Revenue indebtedness of the Issuer.
4. Collateral thresholds should be set on a sliding scale reflective of credit ratings, size and directional market risk of the transaction. Collateral requirements, including safekeeping requirements, should be established and based upon the credit ratings of the counterparty or grantor.
5. Eligible collateral shall be limited to those obligations determined by the authorized representative to be sufficiently liquid.
6. The University shall have the right to optionally terminate an Agreement at “Market” at any time over the term of the Swap Agreement.
7. Termination value should be set by utilizing a Market Quotation Methodology, Second Method (as defined in the ISDA Master Agreement), unless the authorized representative deems an alternate method as appropriate.
8. Amortization schedules of the debt and associated swap transaction should be closely matched to the duration of the swap.
C. Qualified Counterparties
The University may enter into Agreements only with qualified counterparties. A qualified counterparty must be a bank, insurance company, or other financial institution that either:
1. Has, or whose obligations are guaranteed by an entity that has, at the time of entering into a Swap Agreement and for the entire term thereof, a long-term unsecured debt rating or financial strength rating in one of the top two ratings categories, without regard to any refinement or gradation of rating category by numerical modifier or otherwise, assigned by any two of the following: Moody’s Investors Service, Inc., Standard & Poors Ratings Service, a division of The McGraw-Hill Companies, Inc., Fitch, Inc. or such other nationally recognized ratings service approved by the Issuer’s Board; or
2. Has collateralized its obligations under a Credit Support Annex Agreement in a manner approved by the authorized representative.
In addition to the rating criteria specified herein, the Issuer will seek additional credit enhancement and safeguards concerning qualified counterparties in the form of:
Contingent credit support or enhancement;
Collateral consistent with the policies contained herein;
Ratings downgrade triggers; or
Guaranty of parent, if any
D. Counterparty Exposure
The University shall endeavor to diversity its exposure to counterparties. To that end, before entering into an Agreement, it should determine its exposure to the relevant counterparty or counterparties, collateralization, or other methods of reducing counterparty exposure, and determine how the proposed transaction would affect the exposure. The exposure should be measured in terms of notional amount market to market valuation, volatility and where appropriate, a “Value at Risk” calculation. The Value at Risk should be based on all outstanding Agreements by the Issuer. It is the University’s intent to limit its range of exposure to 50 percent to 75 percent of its total swap exposure.
Many derivative products create for the University a continuing exposure to the creditworthiness of financial institutions that serve as the University’s counterparties on derivative transactions.
E. Methods of Soliciting and Procuring Swaps
Agreements can be procured via competitive or on a negotiated basis as determined by the University on a case-by-case basis. The competitive process should include a minimum of three firms with counterparty ratings as set forth herein:
The University may procure Agreements on a negotiated basis when the University makes a determination that:
1. Due to the complexity of a particular financing, a negotiated transaction would result in the most favorable pricing.
2. In light of the facts and circumstances, doing so will promote the University’s interest by encouraging and rewarding innovation.
3. Marketing of the swap will require complex explanations about the security for repayment or credit quality.
4. Market timing is important, such as coordination of multiple components of the financing is required.
5. Participation from minority or women owned firms is enhanced.
6. Based on the recommendation of the Swap and Derivatives Advisors, special circumstances exist such that a negotiated transaction would result in the most favorable pricing.
7. If it determined that negotiations might allow greater flexibility in changing Swap Agreement terms in the future
Regardless of the method of procurement, the University shall obtain an independent finding that the terms and conditions of any derivative entered into reflects a fair market value of such derivative as of the date of its execution.
F. Term and Notional Amount
The maximum term, including any renewal periods, of any Swap Agreement may not exceed the latest maturity date of the bonds, notes, debt, or prospective debt referenced in the Agreement.
The notional amount of any Swap Agreement shall not exceed the outstanding principal amount of the debt to which such agreement relates, or in the case of a refunding transaction, beyond the final maturity date of the refunding bonds.
G. Pledging of Collateral
As part of any Agreement, based on credit ratings of the counterparty or as may be requested by the counterparty or the University, collateralization or other forms of issuer credit enhancements to secure any or all payment obligations of the counterparty or the University under the Agreement may be required. As appropriate, the University may require of the counterparty, or grant thereto, collateral or other credit enhancement to be posted subject to the collateral threshold amounts specified for such Agreement. Additional collateral for further decreases in credit ratings of each counterparty and/or increases in threshold market to market exposure shall be posted by each counterparty in accordance with the provisions contained in the Agreement or collateral support agreements related thereto.
Threshold collateral amounts shall be determined by the Issuer on a case by case basis. The Issuer will determine the reasonable threshold limits for the initial deposit and for increments of collateral posting thereafter. Collateral shall be pledged to the trustee, an independent third-party, or as mutually agreed upon between the Issuer and the counterparty. A list of acceptable securities that may be posted as collateral and the valuation of such collateral will be determined and mutually agreed upon under the Agreement. The market value of the collateral shall be determined on a not less than a monthly basis, or more frequently if the University determines it is in its best interest given the specific collateral security.
H. Prohibited Agreements
The Issuer will not enter into Agreements:
1. That are speculative or create extraordinary leverage or risk;
2. That are equity derivative agreements as defined in the ISDA Master Agreement, as amended;
3. For which the University lacks adequate liquidity to terminate without incurring a significant bid/ask spread
4. That provide insufficient price transparency to allow reasonable valuation
III. MANAGEMENT OF SWAP TRANSACTION RISK
Certain risks are created when the University enters into any swap transaction. In order to manage the associated risks, guidelines and parameters are as follows:
A. Interest Rate Risk
Interest rate risk is the risk that interest costs on a variable rate bond or an Agreement will increase and cost more than the rates associated with a fixed-rate obligation. Interest rate risk can also arise from variable or short term investments where income may be reduced as interest rates fall. The initial financing program for each bond issue will attempt to hedge the interest rate risk exposure in a manner that results in a net interest cost that is lower than that associated with a fixed-rate obligation. An annual evaluation of interest cost will be conducted.
B. Basis Risk
Basis risk is the risk of a mismatch between the actual variable interest rate on the University’s debt and the floating rate option index under the Agreement. A review of historical relationships and trading differentials between the variable rates on similar bonds and the index will be conducted when deciding whether the relationship is sufficiently close to accept such risk. Any index chosen as part of an interest rate swap agreement shall be a recognized market index including but not limited to The Bond Market Association (TBMA) or the London Interbank Offered Rate (LIBOR).
C. Tax Risk
Tax risk is a special element of basis risk, which is created by potential changes in the tax laws that could affect payment under the Agreement. The University will evaluate the impact of potential changes in tax law on proposed agreements and on payments under current agreements based on taxable indices and shall take into account the reduction in the University’s fixed payer rate in return for accepting tax risk.
D. Termination Risk
Termination risk occurs when there is a need to terminate the Agreement in an interest rate environment that dictates a termination payment by the University to the counterparty. Termination risk also occurs if the Agreement terminated even without a payment by the University because it would thereby eliminate the hedge that the Swap Agreement provided. Termination events may occur which are beyond the control of the issuer or the counterparty. Risk will be assessed by an annual review of the market value for all existing and proposed Agreements.
The termination provisions of any swap agreement shall be bilateral; however, the University shall have the right to optionally terminate a swap agreement at any time over the term of the agreement (elective termination right). In general, exercising the right to optionally terminate an agreement should produce a benefit to the University, either through receipt of a payment from a termination, or if a termination payment is made by the University, a conversion to a more beneficial debt instrument or credit relationship.
E. Counterparty Risk
Counterparty risk occurs when there is the failure of the counterparty to make required payments under the Agreement. The University will take a three-tiered approach to protect its interest in the event of a credit problem:
Use of highly rated and experienced counterparties: Standards of creditworthiness, as measured by the credit ratings, will determine eligible counterparties. Differing standards may be employed depending on the term, size and interest-rate sensitivity of a transaction, types of counterparty, and potential for impact on the Issuer's credit ratings. In addition, eligible counterparties should have demonstrated experience in successfully executing derivative transactions.
Collateralization on downgrade: If a counterparty's credit rating is downgraded below a specified threshold, the University will require that its exposure to the counterparty be collateralized as per an ISDA Credit Support Annex.
Termination: If a counterparty's credit is downgraded below a second (lower) threshold, the University may exercise a right to terminate the transaction prior to its scheduled termination date. The University will seek to require, whenever possible, that terminations triggered by a counterparty credit downgrade will occur on the side of the bid-offered spread which is most beneficial to the University, and which would allow the University to go back into the market to replace the downgraded party with another suitable counterparty. The University will monitor exposure levels, ratings thresholds and collateralization requirements and will immediately address remedies.
F. Liquidity Risk
Liquidity risk occurs when there is an inability to renew a liquidity facility on a floating rate bond issue. In the event that a current provider has liquidity problems or will not renew its agreement, the University would request bids from other liquidity facility providers in addition to considering alternative bond structures, such as auction rate bonds.
IV. SWAP INSURANCE
In recognition of the considerable protection against an unfavorable early termination of a swap agreement afforded by swap insurance or credit intermediation, the Issuer shall evaluate the use of swap insurance or credit intermediation to enhance the Issuer's obligations to the counterparty under the swap agreement. The University shall also inform the Board on the status of such insurance or the need of such insurance on an annual basis.
Swap insurance may be considered where the savings from reduced rates and favorable terms would exceed the cost to purchase insurance.
V. REPORTING REUIREMENTS
An annual report prepared will be presented to the Board that will discuss the status of all interest rate swaps. The report shall include the following:
· A list of all swaps with notional value and interest rates, a list of providers and their respective credit ratings, and other key terms.
· Market valuation
· Information concerning any material event involving outstanding Agreements, including a default by a counterparty, a counterparty downgrade, or termination.
· Actual collateral postings by counterparty, if any, per Agreement and in total by swap counterparty