# After the storm

## Cover Story

Louisiana's Superdome became a focal point for television news cameras last year during coverage of the devastation wreaked by Hurricane Katrina. Pictures showing the abject misery visited upon the people of Louisiana - tens of thousands of whom were forced to live in squalor at the stadium as they awaited rescue last August - made the Superdome emblematic of the inadequacy of the disaster relief effort. Now, as efforts to rebuild New Orleans gather pace, the stadium is once again at the centre of a political controversy.

Financing of the reconstruction, achieved via $300 million worth of refunding and new-money debt issuance, has pitted Louisiana's state treasurer, John Kennedy, against Louisiana's state governor, Kathleen Babineaux Blanco. "The governor refused to have the state put its full faith and credit behind these bonds. So the amount of bond insurance we are now being charged is unconscionable," Kennedy tells Risk. "And we've had to enter a fixed-payer swap that under normal circumstances we wouldn't have considered doing." Tens of billions worth of notional has been swapped by US municipalities since 2003, when state authorities began to liberalise rules that had previously prohibited derivatives use among many local entities. And as volumes have grown, so has the incidence of the kind of spat that has unfolded around the Superdome. "Suddenly, swaps have come into vogue in municipal finance. A lot (of municipalities) are doing them, and they don't understand what they are doing," says Kennedy. The explosion in the use of swaps has also left analysts somewhat concerned, and even brought New York-based rating agency Standard & Poor's into open confrontation with the International Swaps and Derivatives Association and the Bond Market Association (BMA) (see box, Rating agency berated). David Litvack, an analyst in the US public finance group at Fitch Ratings, says most municipalities are seeking to use derivatives prudently for risk management, but the rating agency remains alert to the possibility of misuse. "When we see upfront cash from derivatives trades being used to balance a budget as a source of one-shot cash, that's a great concern, and would be a credit negative," says Litvack. "Derivatives are like prescription drugs. They can be beneficial when used appropriately, but they may be habit-forming and carry the risk of unpleasant side effects." Even if trades are being put on for the best of reasons, contractual terms and other risks can cause some nasty surprises for the unwary municipality (see box, A tax-exempt taxonomy). It is just one such side effect - namely, termination risk - that soured the Louisiana state treasurer's view of swaps. "There is a time and place for them, but our experience at the state level in Louisiana with swaps has not been good," says Kennedy, adding that the last swaps trade the state did on a major issue cost Louisiana "well over$10 million" in termination fees.

Swaps contracts between dealers and municipalities typically contain provisions that allow for the trade to be terminated due to specified - typically credit-related - events, or possibly have an embedded cancellation option that may be exercised. "Termination provisions weren't, let us say, favourable," says Whitman Kling, director of Louisiana's state bond commission, the body that voted on and approved the Superdome refinancing deal. Kling declined to give further details about the terminated trade, adding that it was "a number of years ago and in the past".

Both Kennedy and Kling were opponents of the current deal structure. Kennedy says that under normal circumstances he would have objected much more loudly to the structure of the Superdome financing deal. "All things being equal, I would not do a swap if I didn't have to," he says. Of course, these are far from normal circumstances for Louisiana, with vast swathes of the state still struggling to rebuild post-Katrina. Bizarre as it may sound, the swap is effectively being used as a way of enabling the Louisiana Stadium and Exposition District (LSED) to afford continued inducement payments pledged to two sports teams - the National Football League's New Orleans Saints and the National Basketball Association's Hornets - to keep them in the city. The financial inducements also allow the city to avoid penalty payments, should the teams be unable to play due to inadequate facilities. "The refunding component, including the swap, allows for the district to free about $34 million of projected debt service payments for the next five years," says Kling. "The district simply doesn't have funds to cover its operating expenses." According to Kling, a state guarantee would have negated the necessity for the swap and led to cheaper bond insurance quotes for the deal, which involves the refinancing of around$195 million worth of the district's outstanding debt. New York-based Financial Guarantee Insurance Company (FGIC), which insures the district's outstanding debt, is also providing the new coverage. "For our new bonds, they (FGIC) raised their rates from 140 basis points to over 300bp, and for no greater coverage," complains Kennedy.

The step-up coupon structure of the swap - which was due to be executed as Risk went to press - allows the district, as fixed-rate payer, to pay a below-market rate during the early years of the trade, before a step-up in the coupon at the back end of the trade. In this way, the cash-strapped district effectively receives an early cash boost from the swap.

In the past 18 months, US public finance entities - from state-level entities right down to local authorities and even school districts - have embraced swaps and, to a lesser extent swaptions, as they seek to better risk manage their issuance and achieve cheaper financing and refinancing of debt. Dealers say 2005 was a bumper year for tax-exempt interest rate derivatives desks, as municipalities sought synthetic refinancing via swaps. But activity has continued into 2006 at a more sedate pace.

There is no comprehensive data available to put a concrete figure on the level of derivatives activity, but rating agencies do offer some insight. According to Moody's Investors Service, a "sizeable and growing proportion" of variable-rate municipal debt issuance is being swapped to create synthetic fixed-rate obligations. A total of $407 billion worth of municipal bonds were brought to market last year. Susan Fitzgerald, a public finance analyst at Moody's, estimates that in the education sector, for example, around 15% of public colleges and universities have engaged in debt-related derivatives activity. Among private educational institutions, the figure is around 33%. Alongside the desire to lock in low interest rates, surging swaps activity has, in part, been driven by more states allowing local entities to enter into derivatives trades. Texas's state legislature, for example, is expected to pass legislation next year that will liberalise current rules and allow entities with less than top-notch credit ratings to enter into swaps. Doug MacFaddin, New York-based head of JP Morgan's tax-exempt derivatives group, says it's likely there will be a lot of swaps activity among the three states most heavily affected by Hurricane Katrina - Louisiana, Alabama and Mississippi - where debt issuance and refinancing will be widespread in 2006. "Alongside standard instruments, there will probably be more step-up swaps used for cashflow reasons, as they allow the fixed-rate payer to receive more cashflow relief in the earlier years," he says. So the LSED's use of the step-up swap in the Superdome deal may be just the first in a wave of such trades in the South. Douglas Carter, president of North Carolina-based public finance advisory firm DEC Associates, says many municipal issuers are currently considering putting on forward-starting trades, with so-called BMA swaps - that is, swaps where municipalities receive a floating rate equal to the BMA's municipal swaps index, which tracks the high-grade municipal debt market. This provides a more natural basis than Libor for tax-exempt entities. "Issuers are looking at those trades because the cost of the forward premium for a BMA fixed-rate hedge is currently very low," says Carter. "As the yield curve has continued to flatten, and on occasion has inverted, you can buy an interest rate 24 months from now for only 10bp." During the past 12 months "a dozen or more sizeable issuers have moved into forward-starting swaps trades totalling hundred of millions of dollars" in North Carolina, adds Carter. Meanwhile, around 500 miles north, Pennsylvania has become another hotbed of swaps activity. The state government estimates more than$6 billion in notional has been swapped since governor Edward Rendell signed House Bill 1148 into law at the General Assembly of Pennsylvania in September 2003, which permits local entities, including school districts, to use interest rate derivatives. Montgomery County was one of the earliest to exploit the new laws, entering into a swaption trade to help close a $5 million budget gap in December 2003. More recently, the county entered into a complex trade in June 2005, encompassing a BMA swaption alongside a basis swap - where the county pays Bear Stearns a rate determined by the BMA's municipals index and receives a percentage of Libor in return. The trade, associated with a refunding, sought to compensate the county for a shortfall in youth programme funding from the state budget. The synthetic refinancing in question related to$37.3 million in general obligation bonds that were issued in 2001, which federal law dictated could not be refunded until 2011. According to the county commission's chairman, James Matthews, "complex transactions" such as the recent derivatives trade have "added up to millions of dollars in savings for taxpayers".

DEC Associates' Carter says basis swap-swaption combination trades are catching on in the South. "It's just a potentially more price-efficient way of doing a synthetic advanced refunding," he says. The traditional alternative to this trade is to use Libor-based swaps, where the rate is specified as a percentage of Libor.

Elsewhere in Pennsylvania, however, derivatives are eliciting less positive sentiment. "There is a general push here to (execute) a forward-starting swap," says Laura Clampitt Douglas, a member of Lancaster County Convention Center Authority's board. The swap in question, some board members argue, should be used to lock in low interest rates on a planned debt issue that would help finance construction of a convention centre complex. "Financial advisers are painting a pretty picture that sounds highly aspirational to me. Being an entrepreneur, I'm not risk-averse, but that doesn't mean I'm suicidal," she adds.

According to Douglas, she, alongside two other board members, are "trying to put the brakes on" as other board members are swept up in the rush among public finance entities to put on swaps. "It's not even certain that the development project will go ahead. It would be stupid to lock in a rate now for a financing that might not come together and then have to pay several million dollars to exit the trade," Douglas says, adding that a surge in the cost of materials since the last hurricane season may make the proposed construction prohibitively costly.

Beyond the problem of potentially being left with a naked swaps position that would have to be terminated, Douglas is concerned by several other factors. First, there is a lack of clarity over the swap's terms and potential risk-reward profile, she claims. Details of the trade's terms have so far been scant and only given verbally, and the whole process has lacked transparency, she adds. "One firm (RBC Dain Rauscher - part of Royal Bank of Canada) came forward with the bid to handle the swap, and our advisers are separate from the dealers as far I can tell - but I just don't know for sure," says Douglas. "And then we have a number of people on the board who do not understand (derivatives), so they back away from asking the kinds of questions I have."

Fitch's Litvack says one of the rating agency's main concerns about derivatives use in public finance is the over-reliance on external swaps advisers. "We would prefer that the issuer has the in-house expertise and knowledge to be aware of the risks themselves and monitor those risks as time goes on, rather than be dependent," he says.

Sophistication

Nonetheless, many public finance entities have achieved a high-level of sophistication when it comes to risk management. Take New York's Metropolitan Transit Authority (MTA), for example. "We have an extensive book of swaps that we have done - mostly in the context of synthetic fixed-rate refundings," says Patrick McCoy, chief financial officer of the MTA, which currently has around $20 billion worth of debt outstanding. "At the MTA, we issue quarterly reports in which we provide our mark-to-market valuations - this is not common among municipal issuers. We monitor valuations here and have everything modelled-up. I can check my mark-to-market at the snap of a finger," he says. The MTA's openness about its derivatives activities has made it, on occasion, the subject of criticism among some politicians and advocacy groups - something McCoy says he is well aware of but that, in his opinion, misses the bigger picture. In June 2005, for example, the MTA stumped up$22 million in termination fees to exit two forward-starting swaps it had put on just nine months earlier. "We were actually able to issue the debt associated with that transaction below our budgeted cost. Obviously, to the uninformed eye, just the optics of the termination payment can generate criticism," says McCoy. "On the other hand, the transaction behaved as intended: providing budgetary certainty in the context of a very large debt service budget." Last month, the MTA selected 15 firms to populate its first official pool of approved swaps counterparties.

As the MTA was exiting a swaps trade last June, the entity responsible for the transportation system in another major northeast city, Boston, was executing its first forward-starting trade associated with a new money issue. "We liked the way interest rates were, and felt it was prudent to manage that risk for the 2007 new-money issue," explains Jonathan Davis, chief financial officer of the Massachusetts Bay Transportation Authority (MBTA). But with the flattening and inverting yield curve, the MBTA is now strongly considering bringing its new money issue to market early. "We are not sure, but we would then probably just terminate the forward-starting swap," he says.

A tax-exempt taxonomy

But Davis has no need to steel himself to face the kind of flak his counterpart in New York has endured. "Right now with the swap there would be a payment to us (on termination)," he says. He admits, however, that the MBTA does not currently have a formal swaps policy in place - something that can set alarm bells ringing at rating agencies - but says one is forthcoming this year. "We try to manage our portfolio with a realistic amount of swap, or swaption, risk," he says. Swaption premiums garnered by the MBTA in the past have been used for both debt service capital and the operating budget, according to Davis. "The general perception about terminations is if you make a payment you have lost, and if you get one, it's just ignored. We don't look at it that way."

Alongside the numerous benefits of using swaps, the instruments carry some risks that can be particularly onerous for US municipalities - a significant proportion of which are operating with tight budgets:

- Termination risk: early termination of swaps can be triggered when either counterparty in a trade is downgraded below a specified rating level, or by exercise of an embedded cancellation option. If the issuer's exposure in a terminated swap is out-of-the-money, then it will owe payment to the dealer. And then it faces the question of what to do about its now un-hedged issuance.

- Collateralisation risk: collateral is typically used to mitigate the risk that either counterparty will be unable to make the required payment if termination events occur. Collateral calls might only come into play when specified potential termination payment thresholds are breached.

- Basis risk: this is the risk that arises due to differences in an issuer's debt service payments and the payment it receives on its leg of a swap. As they reference a municipal credit index, BMA swaps naturally create less basis risk than Libor-based swaps.

- Tax risk: the basis between the BMA's municipal index rate and Libor may collapse if the US federal government embarks on radical tax reform and municipal bonds' tax exemption is removed.

Rating agency berated

With its Debt Derivative Profile (DDP) product, Standard & Poor's (S&P) decided to tread a different path from its competitors - Fitch Ratings and Moody's Investors Service - and split out its assessment of derivatives risk arising from US public finance debt programmes. Peter Block, an analyst in the US public finance group at S&P in Chicago, says investors have told the rating agency they like the way DDP's scoring system gives a "shorthand way of telling them about risk".

The Bond Market Association (BMA) and International Swaps and Derivatives Association, however, have not been such fans. "We try hard to head off any actions that treat derivatives risks as if they are different from other risks and single out derivatives as a particularly risky category," says David Mengle, Isda's head of research in New York.

Leslie Norwood, assistant general counsel at the BMA, says the trade body has, during a series of meetings in the past 18 months, sought to "provide constructive comment to S&P, so it could improve its product".

Block's version of events is less benign: "Isda has come forth with some technical commentary and we will address a lot of their concerns. But it seems like the BMA effectively just doesn't want us commenting on derivatives, period - and we are not going to do that. Interest rate derivatives have become so pervasive in public finance that it's a part of the credit picture. It's absurd."

Block says he has repeatedly asked the BMA to back up its claim that S&P's DDP is causing bond price volatility. "I have asked the BMA on the four times we have met. Not a shred of evidence has been given," he says. When asked about the source of the claim regarding the DDP's effect on prices, Norwood tells Risk that this was the viewpoint of dealers working in the market - as expressed to the BMA.

Similarly, Block says Isda's claim that the DDP approach inherently encourages asymmetric credit provisions, where municipal issuers don't have to post collateral, but dealers do, is untrue. "I sign off on all DDP. Around two thirds of swaps have bilateral provisions - nothing has changed." Also, according to Block, there has been no lowering of collateral thresholds in Isda documents and no increase in one-way collateral arrangements.

Block believes some of the criticisms levelled at the DDP are ill founded and smack of vested interests wanting to avoid scrutiny. "You have to ask: why are they objecting? You can then make the inference that it's because this is the most important area for their businesses right now," he says.

As Risk was going to press, S&P was preparing to publish its revised DDP methodology, which, Block claims, will address some of Isda's concerns and provide "greater granularity" than is currently the case. He declined to give further details.

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The week on Risk.net, October 6-12, 2017