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AGENDA ITEM NO. 14
Meeting Date: February 12, 2008
Subject/Title: Adopt a Resolution approving City Council/Administrative Policy
Number 10-14 Interest Rate Swap Policy
Prepared by: Jim Malberg, Assistant Director of Finance and Information Systems
Submitted by: Pamela Ehler, Director of Finance and Information Systems
Adopt a Resolution approving City Council/Administrative Policy Number 10-14 Interest Rate Swap Policy.
The City of Brentwood has several options for long-term financing of the Brentwood Water Treatment Plant currently under construction by the Contra Costa Water District (CCWD). One option for consideration is the issuance of synthetic fixed rate bonds which involve entering into an interest rate swap. Swaps are complicated transactions which is why the City would need to adopt a Swap Policy to mitigate risks prior to entering into an agreement. The attached policy was reviewed by the Sewer and Water Rate Study Subcommittee and they have recommended moving the policy forward for full Council consideration.
An interest rate swap is “an arrangement whereby two parties (called counterparties) enter into an agreement to exchange periodic interest payments.” The payments are based on a fixed principal amount, called the “notional amount” because no principal amount is actually exchanged between the parties; only interest is exchanged. In a typical interest rate swap, one party pays interest on the notional amount at a variable or “floating” rate, which fluctuates over time. The other party pays interest on the notional amount at a fixed rate for the life of the swap. The fixed rate is either bid or negotiated as the swap is executed. Swaps can be negotiated for a variety of terms and are generally not less than 2 years and not more than 30 years.
Objectives in the Use of Interest Rate Swaps
Properly used, interest rate swaps, and related financial instruments such as swap options, can be beneficial interest rate management tools that can assist the City as part of its overall debt and investment management program. Interest rate swaps are appropriate for use when they are designed to achieve specific financial objective(s) consistent with the City’s overall financial policy and strategy. Swaps may be used to lock-in current market fixed interest rates, or to effectively create a variable interest rate portion of the City’s debt portfolio. As a result, swaps can be implemented with the objective of:
• Producing net interest rate savings;
• Generating increased net investment returns;
• Altering the pattern of debt service payments;
• Capping or hedging variable interest rate payments, or
• Providing a better match between the interest rates on the City’s debt and investments
Interest rate swap options (“swaptions”) granting the right to another party to commence or cancel an interest rate swap with the City may be used to the extent that the underlying swap is consistent with the City’s financial policy.
The Finance Director must obtain the approval of the City Council prior to entering into any interest rate swap, swap option or related transaction. The Finance Director shall determine whether a proposed swap agreement complies with any applicable provisions of the Commission’s bond resolutions and agreements with respect to its outstanding debt.
The City Council may execute an interest rate swap, swap option or related transaction only if the transaction can be reasonably expected to achieve one or more of the following objectives:
• Result in a lower net cost of borrowing with respect to the City’s debt, or achieve a higher net rate of return on the investment of City’s moneys.
• Reduce exposure to changes in interest rates either in connection with a particular debt financing or investment transaction or in the management of interest rate risk with respect to the City’s overall debt and investment portfolios.
There is no fiscal impact associated with the adoption of this resolution.
Interest Rate Swap Policy No. 10-14
A RESOLUTION OF THE CITY COUNCIL OF THE CITY OF BRENTWOOD ADOPTING CITY COUNCIL/ADMINISTRATIVE POLICY NO. 10-14 INTEREST RATE SWAP POLICY
WHEREAS, the City desires to have the ability to have the ability to enter into Swap financing transactions for the purposes of reducing the cost of capital for debt financings; and
WHEREAS, the City must adopt a Swap policy to mitigate risk factors prior to entering into any type of Swap financing transaction; and
WHEREAS, the Swap financing policies of the City have been prepared and a copy is on file with the City Clerk and is presented to the City Council for consideration; and
NOW, THEREFORE, BE IT RESOLVED by the City Council of the City of Brentwood, that Policy No. 10-14, the Interest Rate Swap Policy is hereby adopted as detailed in the attached Exhibit “A”.
PASSED, APPROVED AND ADOPTED by the City Council of the City of Brentwood at a regular meeting on the 12 day of February 2008 by the following vote:
The purpose of this Interest Rate Swap Policy (“Policy”) of the City of Brentwood, California (the “City”) is to establish guidelines for the use and management of all interest rate management agreements, including, but not limited to, interest rate swaps, swaptions, caps, collars and floors (collectively “Interest Rate Swaps”) entered into in connection with the issuance of bonds, notes and other obligations or the management of the City’s asset/liability profile. This Policy sets forth the general manner of execution of Interest Rate Swaps and provides the basis for security and payments provisions, risk factors, and other relevant considerations.
Interest Rate Swaps can be effective interest rate management tools in helping the City to achieve its financial and policy objectives. However, the City recognizes that a swap policy is important to minimize risks and maximize the benefits of an interest rate swap program. While adherence to these guidelines is required generally, developments in the financial markets, City circumstances and/or objectives, or other unforeseen events may produce situations not adequately anticipated by this Policy. In these cases, the City will have the flexibility to deviate from these guidelines provided City Council authorization is obtained prior to taking any action that is, or could be reasonably considered, inconsistent with these guidelines. Periodically, but at least annually, the City, together with its advisors and counsel, will review the Policy and shall make modifications as appropriate due to changes in City circumstances and/or the business environment.
These guidelines are not intended to govern other instruments or transactions that the City or its departments may consider, including but not limited to, currency, fuel, power, or other energy-related derivatives. Failure to comply in any manner with this policy shall not result in any liability on the part of the City to any party.
II. Authority and Oversight
Statutory authority for City utilization of Interest Rate Swaps is derived principally from Section 5922(a) of the California Government Code. As required by the Government Code, no local agency may enter into any contracts or arrangements unless its governing body first determines that the contract, arrangement or program of contracts is designed to reduce the amount or duration of payment, currency, rate, spread, or similar risk or result in a lower cost of borrowing when used in combination with the issuance of bonds or enhance the relationship between risk and return with respect to the investment or program of investment in connection with, or incident to, the contract or arrangement which is to be entered into.
The City’s Finance Director, together with other City staff designated by the City’s Finance Director (the “City’s Staff”), shall be responsible for interest rate swap activities. In addition, appropriate personnel from any related City departments or enterprises, shall be consulted in the evaluation of and as appropriate, the on-going management of any Interest Rate Swaps. The City may utilize the services of its swap advisor or legal counsel for the evaluation, execution, and on-going risk management and reporting requirements.
Before entering into an Interest Rate Swap, the City will confirm with its legal counsel, including the City Attorney, that it has the legal authority to enter into such Interest Rate Swap. In addition, if the Interest Rate Swap will be related to existing or anticipated obligations of the City, the City will determine whether an Interest Rate Swap is permitted under the legal documents pertaining to such obligations.
III. Interest Rate Swap Utilization
To the extent utilized, Interest Rate Swaps should be considered in the context of the City’s overall asset and liability management efforts. The City shall not utilize Interest Rate Swaps for the primary purpose of speculation.
A. Rationales for Utilization
1. Reduce exposure to changes in interest rates on a particular transaction or in the context of the management of interest rate risk derived from the City’s overall asset/liability balance.
2. Achieve lower net cost of borrowing with respect to the City’s debt obligations.
3. Manage variable interest rate exposure consistent with prudent debt practices.
4. Manage exposure to changing markets in advance of anticipated bond issuances by locking in borrowing costs (through the use of forward hedging instruments).
B. Permitted Instruments
1. The City may utilize the following financial products on a current, or forward basis, after identifying the objectives to be realized and assessing the attendant risks.
a. Interest Rate Swaps, including (i) pay fixed/receive floating swaps (fixed rate swaps), (ii) receive floating/pay fixed swaps (floating rate swaps) and (iii) pay floating/receive floating swaps (basis swaps). Swaps may include option features, such as for the extension, cancellation, or index conversion of the swap.
b. Interest rate caps, floors, and collars.
c. Stand-alone options to enter into swaps (swaptions) on a particular date, series of dates, or during a particular period of time in the future.
2. The City will not enter into Interest Rate Swaps that:
a. Incorporate extraordinary leverage; (reinvesting debt at a higher interest rate)
b. Lack adequate liquidity to terminate cost-effectively.
c. Have insufficient pricing transparency limiting the City’s ability to obtain reasonable valuations.
IV. Evaluating Proposed Transactions
Staff shall undertake an evaluation of any proposed transaction. This will include, but not be limited to, consideration of the following:
1. Assessment of all inherent risks of the transaction including, but not limited to those outlined below (see SECTION V)
2. Alternative financing options and a comprehensive evaluation of the potential risks and expected benefits of the Interest Rate Swap relative to such other options.
3. Security and source of payments, both scheduled and termination, and the integration of the swap into the City’s debt program.
4. Procurement process and the suitability of the contemplated counterparties to the swap, taking into account any existing exposure to such counterparties.
5. Impact on City’s credit and liquidity profile and how other financial arrangements, existing or expected, may be impacted by the swap.
6. Analysis of impact on the City’s net variable rate interest exposure from the contemplated transaction and any potential budgetary impact.
7. Cost and availability of on-going resources for the effective operations and risk management of the swap.
8. Tax, accounting, or other compliance requirements relative to other options.
9. If the transaction includes option components, analysis of circumstances under which the option will likely, or not likely, be exercised and the consequences of each outcome.
V. Interest Rate Swap Risks
Interest Rate Swaps may involve several risks of varying degrees, including the following:
1. Counterparty Risk – The risk of nonperformance resulting in non-payment or other default on a swap by the City’s counterparty. If the swap is terminated prior to its scheduled final cash flow date and the City’s swap position has increased in value, the City will be owed a termination amount and therefore will have credit exposure to its Counterparty for collection of any such amount. The City will minimize counterparty risk by establishing strong minimum counterparty credit standards and diversifying the City’s exposure to any single counterparty. Before entering into a transaction the City should determine how the proposed transaction would affect the City’s credit exposure to the relevant counterparty or counterparties.
2. Termination/Replacement Risk – The risk that an Interest Rate Swap agreement must be terminated prior to its stated final cash flow date and that the City cannot obtain a replacement transaction with substantially similar terms, including because of deterioration in the City’s own credit. In such a circumstance, the City could owe, or be owed, a termination payment and may not be able to affect an assignment of the transaction or enter into a new transaction with substantially similar terms that would preserve the City’s economic position.
3. Collateral Posting Risk – The risk that the City will be required to post collateral, upon a downgrade of its credit rating below investment grade or other mutually agreed upon trigger event thereby adversely affecting the City’s overall liquidly and budgetary efforts.
4. Basis Risk – The risk that the payments received (from a floating rate swap or asset) do not match, and in particular are insufficient to pay, the amounts due (on a floating rate swap or liability). In the context of floating rate bonds combined with a fixed rate swap, the risk is to prolonged periods of the rate paid by the City to the holders of its underlying bonds being higher than the rate received on the swap over the same period of time (e.g., a tax-exempt variable rate issue paying bondholders an average of 70% of LIBOR (London Interbank Offered Rate) while the City receives only 67% of LIBOR pursuant to the associated swap.)
5. Tax-Exemption Risk – Related to basis risk, tax-exemption risk is generally the risk of a reduction or elimination in the benefits of tax exemption for municipal bonds (e.g., a reduction in the highest marginal federal and/or California income tax rates) which event would increase the City’s tax-exempt floating rate borrowing cost without an offsetting increase in LIBOR-based swap receipts.
6. Liquidity / Remarketing Risk – In connection with a swap strategy that includes issuance of floating rate bonds that, absent the swap strategy would have been issued as fixed rate bonds, the risk that the City cannot secure a cost-effective renewal of a letter or line of credit or suffers a failed auction or remarketing with respect to the floating-rate bonds.
Before proceeding with an Interest Rate Swap transaction, the City must reasonably conclude that the expected benefits of the transaction outweigh the expected risks, that the risks are within acceptable levels, and that the contemplated transaction does not impose risks that threaten the City’s ability to perform its core functions. The transaction must be reasonable in relation to the City’s overall financial condition and capitalization.
The City shall, with its advisors and legal counsel, structure swap transactions with terms and provisions that will help mitigate such risks to the extent practicable and cost-effective. The City shall have a plan for the on-going monitoring and risk management of swap transactions.
VI. Interest Rate Swap Structuring and Execution
Swaps may be procured via a competitive process or through negotiation with one or more prospective counterparties. Staff will determine on a case-by-case basis which approach best addresses the City’s long-term financial objectives. Regardless of the method of procurement, the City shall obtain a finding from a qualified and independent firm that the terms and conditions of any transaction entered into reflect a fair market value of such transaction as of the date of its execution.
A. Eligible Counterparties
The City will do business only with qualified swap counterparties. Qualified counterparties are institutions whose long term credit rating or whose obligations are guaranteed by a financial institution whose long term credit rating, are, at the time the Interest Rate Swap is entered into, at least as high as AA- by S&P and Aa3 by Moody's and that have a demonstrated record of successfully executing Interest Rate Swap transactions. The City will structure Interest Rate Swap agreements to protect itself from the credit deterioration of its counterparties, including the use of ratings-based termination events, credit support annexes or other forms of credit enhancement. Such protection shall include any terms and conditions which the City deems necessary or appropriate to protect its interests.
Counterparties whose ratings fall below A by S&P or A2 by Moody's shall be required to post and maintain collateral for the benefit of the City in an amount equal to at least one-hundred percent (100%) of the market value of the Interest Rate Swap (i.e., pursuant to a $0.00 collateral threshold level). If the counterparty has more than one rating, the lowest rating will govern for purposes of determining the applicable collateral requirements. Higher rated counterparties shall be required to post collateral consistent with the Maximum Net Termination Exposure provisions of Section VII hereof.
B. Term and Notional Amount of Swap Agreement
The City shall determine the appropriate term and size for an Interest Rate Swap agreement on a case-by-case basis. In connection with the issuance or carrying of bonds, the outstanding notional amount of a swap agreement should relate to the amortization of the related existing or anticipated debt of the City. The City recognizes that while entering into a swap with a term less than the associated bonds may be appropriate, in such case the City might be subject to the uncertainties of then prevailing market conditions.
C. Swap Documentation
In connection with each Interest Rate Swap, the City must receive a legal opinion from Bond Counsel acceptable to the counterparty to the effect that the Interest Rate Swap is a legal, valid and binding obligation of the City. Such opinion must set forth the statutory and/or other provisions that grant the City the capacity and authority to enter into the Interest Rate Swap agreement.
Unless otherwise recommended by the City’s Staff and approved by the City Council, the City will use swap documentation based on published ISDA (International Swaps and Derivatives Association) standards, including the Master Agreement, Schedule to the Master Agreement, Credit Support Annex, and Confirmation. The City may modify these standard forms and use additional documentation as, on the advice of counsel and/or its other advisors, it deems necessary and appropriate.
Subject to the provisions contained herein, the City’s swap documentation and terms should include the following:
1. Appropriately limited definitions of Specified Entity, Specified Transactions, and Specified Indebtedness.
2. Downgrade provisions triggering termination that in no event shall be worse than those relating to the counterparty and that, for the counterparty, shall be no lower than “below investment grade” by either S&P or Moody’s.
3. Governing law for swaps will be New York State, but should reflect California authorization provisions.
4. The right for the City to terminate the swap at any time (at the then market value), but shall not provide this right to the City’s counterparty, unless specifically structured to provide the counterparty with cancellation rights.
5. A Credit Support Annex which requires counterparties to post collateral on behalf of the City as per Section VI. A above. However, the City shall seek to negotiate terms that minimize the probability that the City would have to post collateral and may further consider forms of credit enhancement to secure its swap payment obligations to the extent available and cost-effective.
6. Acceptable security types for collateral purposes shall be limited to those rated in the ‘AA’ category or higher and otherwise consistent with the City’s investment program. Valuation levels will take into account the term and liquidity of the investment as well as the valuation frequency. The market value of the collateral shall be determined no less frequently than weekly.
VII. Counterparty Credit Exposure
The City will monitor and otherwise manage its counterparty credit exposure (i.e., amounts which would become due to the City if the swaps with a particular counterparty were to terminate early, pursuant to a default or other similar event). In order to measure the City’s credit exposure, the City shall periodically calculate and review the current market valuation of outstanding swaps and review the then current long-term credit ratings and the ratings outlook for each counterparty. In the unlikely event that credit exposure to a counterparty is determined to be excessive, the City will identify and evaluate actions available to reduce or otherwise mitigate its exposure.
Prior to entering into a new swap transaction, the City, as part of its evaluation of the proposed transaction, will identify the aggregate termination amount that the City would receive for all existing and proposed Interest Rate Swap transactions with an individual counterparty using reasonably expected worse case market conditions (the “Maximum Net Termination Exposure”). The calculation is intended to assist the City in evaluating its credit exposure to any single counterparty and establishing, among other things, appropriate ratings based collateral posting requirements for any Credit Support Annex(s).
The following chart provides the Maximum Net Termination Exposure to a swap counterparty based on the lowest credit rating assigned by either S&P or Moody's.
Credit Rating Maximum Uncollateralized Exposures
AAA or Aaa n/a
Below AAA or Aaa $25,000,000
Below AA or Aa2 $15,000,000
Below A or A2 $0
VIII. On-going Management
The City will seek to maximize the benefits and minimize the risks it carries by actively monitoring its interest rate swap program. This will entail, at a minimum, periodic review of the mark to market value of each of the City’s swap agreements, adequacy of posted collateral, and compliance with accounting requirements. The City will also, to the extent practicable, monitor interest rate market conditions for emergent opportunities and risks.
GLOSSARY OF KEY TERMS
Confirmation: A document related to the Master Agreement confirming the exchange between each parties transacting a swap.
Counterparty Risk: The risk that the swap counterparty will not fulfill its obligations as specified under the agreement.
Credit Support Annex: A document related to the Master Agreement containing provisions specific to credit enhancements such as collateral requirements.
Credit Risk: the risk of an occurrence of an event modifying the credit rating of the counterparty.
Interest Rate Risk: The risk associated with changes in general interest rate or yield curve.
Interest Rate Swap: The agreement whereby one party typically agrees to exchange a floating rate for a fixed coupon rate. An essential characteristic of swaps is the swapping of cashflows and not principal amounts.
ISDA: The International Swap Dealers Association (ISDA), a global trade association representing participants in the derivatives industry.
Master Agreement: An agreement developed by the International Swap Dealers Association that contains general terms and conditions related to swap transactions.
Notional Amount: The stipulated principal amount for a swap transaction. There is no transfer of ownership in the principal for a swap; but there is an exchange in the cashflows for designated coupons.
Qualified Counterparty: Qualified swap counterparty is a financial institution that is an investment bank dealing primarily with raising capital, corporate mergers and acquisitions and securities trades. The qualified counterparty must maintain minimum credit requirements as defined in the governing bond documents; however, initially no lower than stipulated in the Swap Policy.
Schedule to the Master Agreement: A document related to the Master Agreement which contains specific provisions regarding the swap transaction.
Specified Entity: Nominated third parties or generic groups which one or both of the parties to the Agreement want to join in so that in its basic form any default under another agreement between that Specified Entity and one of the parties to this Agreement would give the party not at fault the right to close out all Transactions under this Agreement, i.e. the occurrence of those mentioned defaults or Additional Termination Events by a Specified Entity would also be an Event of Default or Termination Event for the party.
Specified Indebtedness: Indebtedness of a party (whether to the counterparty or any third party) for borrowed money (e.g. bank debt) and the “Threshold” customarily is defined as a flat amount (e.g. $25,000,000) or percentage of net worth.
Specified Transactions: Swap or similar transaction between the parties to the ISDA Master Agreement that is not otherwise governed by the ISDA Master. If an event occurs with respect to a party that results in the early termination or liquidation of a Specified Transaction the other party will have the right to terminate transactions under the ISDA Master.
Swap: A customized financial transaction between two or more counterparties who agree to make periodic payments to one another. Swaps cover interest rate, equity, commodity and currency products. The can be simple floating to fixed rate exchanges or complex hybrid products with multiple option features.
Swaption: An option on an interest rate swap. The buyer of a swaption has the right to enter into an interest rate swap agreement by some specified date in the future.
Termination Risk: The risk that the swap could be terminated by the counterparty due to any of several events, which may include issuer or counterparty ratings downgrade, covenant violations by either party, bankruptcy of either party, swap payment default by either party and default events as defined in the issuer’s bond indenture. The events of default and termination, which could lead to involuntary termination of the agreement, would include failure to pay, bankruptcy, merger without assumption of obligations and legality.
Yield Curve: Refers to the graphical or tabular representation of interest rates across different maturities. The presentation often starts with the shortest-term rates and extends toward longer maturities. It reflects the market’s views about implied inflation/deflation, liquidity, economic and financial activity and other market forces.
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