Derivatives

Derivatives 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 Page 8 of 38 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 Page 9 of 38 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 Page 10 of 38 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 Page 11 of 38 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.