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Policy Manual

6146 - Derivative Debt Management

Purpose
The purpose of this Derivative Debt Management Policy ("Policy”) of the Board is to establish guidelines for the use and management of all interest rate exchange agreements, ("derivatives”) entered into in connection with the incurrence of debt obligations.  The Policy sets forth the manner of execution of derivatives, provides for security and payment provisions, risk considerations and certain other relevant provisions as well as being responsive to the recommended practices of the Government Finance Officers Association regarding the contents of an interest rate swap policy.

Compliance with Dodd-Frank
It is the intent of the Board to conform this Derivative Debt Management Policy to the requirements relating to recent legislation and regulations for over-the-counter derivatives transactions under the Wall Street Transparency and Accountability Act of 2010, as supplemented and amended from time to time (herein collectively referred to as "Dodd-Frank"), enacted in response to the financial markets crisis of 2008.  Pursuant to Dodd-Frank, the Commodity Futures Trading Commission ("CFTC”) has adopted rules regulating "swaps” (as defined in Section 1a (47) of the Commodity Exchange Act and in the CFTC Rules).

The School District will be categorized as a non-ERISA Special Entity under the swap rules adopted by the CFTC. As a result of that categorization and CFTC Rule 23.450, no Swap Dealer ("SD”) or Major Swap Participant ("MSP”) can enter into swaps with the Board unless such person has a reasonable basis to believe that the Board is represented in the swap by a qualified independent representative ("QIR”).
 
Qualified Independent Representative
 
The Board’s Independent Registered Municipal Advisor (or such other firm designated by the Board) be designated as the Board’s QIR.  The QIR agrees to meet and meets the requirements specified in Commodity Futures Trading Commission Regulation 23.450(b)(1) or any successor regulation thereto (herein referred to as the "Representative Regulation"). The designated QIR shall provide a written certification to the Board to the effect that such designated QIR agrees to meet and meets the requirements specified in the Representative Regulation. School District staff shall monitor the performance of the QIR consistent with the requirements specified in the Representative Regulation. School District staff exercise independent judgment in consultation with the Board‘s designated QIR in evaluating all recommendations, if any, presented by any counterparty with respect to transactions authorized pursuant to this policy.  The School District staff shall rely on the advice the Board's designated QIR with respect to transactions authorized pursuant to this policy and do not rely on recommendations, if any, presented by any counterparty with respect to transactions authorized pursuant to this policy.
 
End User Exception
 
The Board will use the End User Exception as required to exempt itself from the Central Clearing requirements of Dodd-Frank and the CFTC rules.  As such, the Board represents that it meets, and will meet the following criteria:
  • The School District is a non-financial entity;
  • The Board uses swaps only to hedge or mitigate commercial risk; and,
  • The Board will comply with CFTC notification requirements regarding how the Board meets its financial obligations associated with its swaps.

The Conditions Under Which Derivatives May Be Entered Into 

Purpose

Derivatives may be used for the following purposes only:

  1. To achieve significant savings as compared to a product available in the bond market.  Significant savings shall be calculated after adjusting for (a) applicable fees, including takedown, remarketing fees, credit enhancement and legal fees, and (b) call options that may be available on the bonds.  Examples may include synthetic fixed rate debt and synthetic variable rate debt.  Alternatively, significant savings are deemed to occur if the use of derivatives helps to achieve diversification of a particular bond offering. 
  2. To prudently hedge risk in the context of a particular financing or the overall asset/liability management of the Board. 
  3. To incur variable rate exposure within prudent guidelines, such as entering into a swap in which the Board’s payment obligation is a floating rate.
  4. To achieve more flexibility in meeting overall financial objectives than can be achieved in conventional markets. 

Legality

The Board must receive an opinion acceptable to the market from a nationally recognized bond counsel firm that the agreement relating to the derivative is a legal, valid and binding obligation of the Board and entering into the transaction complies with applicable Board, State and Federal laws.

Speculation

Derivatives shall not be used for speculative purposes outside of prudent risks that are appropriate for the Board to take.  Also, the Board will not enter into derivatives that lack adequate liquidity to terminate and that provide insufficient price transparency to allow reasonable valuation.

Methods of Soliciting and Procuring Derivatives

In general, the Board should procure derivatives by competitive bidding.  The competitive bid can limit the number of firms solicited to no fewer than three.  The Board shall determine which parties it will allow to participate in a competitive transaction.  In situations in which the Board would like to reward a particular firm or wishes to achieve diversification of counterparty exposure, the Board may allow a firm or firms not submitting the bid that produces the lowest cost to match the lowest bid and be awarded up to a specified percentage of the notional amount of the Interest Rate Exchange Agreement.  In addition, to encourage competition, the Board may allow the second and third place bidders to match the winning bid up to a specified amount of the notional amount as long as their bid is no greater than a specified spread from the winning bidder.  The parameters for the bid and any matching bid permitted must be disclosed in writing to all potential bidders.

Notwithstanding the above, the Board may procure derivatives by negotiated methods in the following situations:

  1. The Board may enter into a derivatives transaction on a negotiated basis if the Board makes a determination that due to the size or complexity of a particular swap, a negotiated transaction would result in the most favorable pricing. In this situation, the Board should attempt to price the derivative based upon an agreed-to methodology relying on available pricing screens to obtain inputs to a mathematical model.  If appropriate, the Board should use a financial advisory firm to assist in the price negotiations.
  2. The Board may enter into a derivatives transaction on a negotiated basis if a derivative embedded within a bond issue is proposed and meets the Board’s savings target.
  3. The Board may enter into a derivatives transaction on a negotiated basis if it determines, in light of the facts and circumstances, that doing so will promote its interests by encouraging and rewarding innovation.

Regardless of the method of procurement, the Board shall obtain an independent finding that the terms and conditions of any derivative entered into reflect a fair market value of such derivative as of the date of its execution.

Form and Content of Derivatives

To the extent possible, the derivatives entered into by the Board shall contain the terms and conditions set forth in the International Swap and Derivatives Association, Inc. ("ISDA”) Master Agreement, including any schedules and confirmation.  The schedule should be modified to reflect specific legal requirements and business terms desired by the Board.  If possible, the Board should attempt to negotiate the master agreement and schedule with qualified counterparties to facilitate the use of derivatives in situations in which their use is desirable.

Optional Termination

The Board shall consider including a provision that permits the Board optionally to terminate the agreement at the market value of the agreement at any time.  In general, the counterparty shall not have the right to optionally terminate an agreement.

Events of Default

Events of default of a counterparty shall include the following:

  1. Failure to make payments when due
  2. Breach of representations and warranties
  3. Illegality
  4. Failure to comply with downgrade provisions
  5. Failure to comply with any other provisions of the agreement after a specified notice period

An event of default by the counterparty shall lead to termination of the agreement with the Board being the affected party for purposes of calculating the termination payment owed.   

Aspects of Risk Exposure Associated with Such Contracts

Before entering into a derivative, the Board shall evaluate all the risks inherent in the transaction.  These risks to be evaluated should include counterparty risk, termination risk, rollover risk, basis risk, tax event risk and amortization risk.

Type of Risk Description Evaluation Methodology
Basis Risk The mismatch between actual variable rate debt service and variable rate indices used to determine swap payments. The Board will review historical trading differentials between the variable rate bonds and the index.
Amortization Risk Refers to the cost of servicing debt or making swap payments due to a mismatch between the bonds and the notional amount of swap outstanding. The Board will match the bond amortization with the swap amortization.
Tax Event Risk The risk created by potential tax or market events that could affect swap payments. The Board shall discourage the use of products which will result in the assumption of tax risk. The Board will review the tax events or trading range (BMA as a % of LIBOR) in proposed swap agreements. The Board will evaluate the impact of potential changes in tax law on LIBOR indexed swaps and BMA swaps linked to a % of LIBOR.
Counterparty Risk The failure of the counterparty to make required payments. The Board will monitor exposure levels, ratings thresholds, and collateralization requirements.
Termination Risk The need to terminate the transaction in a market that dictates a termination payment by the issuer. The Board will compute its termination exposure for all existing and proposed swaps at market value and under a worst-case scenario.
Rollover Risk The mismatch of the maturity of the swap and the maturity of the underlying bonds. The Board will determine its capacity to issue variable rate bonds that may be outstanding after the maturity of the swap.
Liquidity Risk The inability to continue or renew a liquidity facility. The Board will evaluate the expected availability of liquidity support for swapped and un-hedged variable rate debt.
Credit Risk The occurrence of an event modifying the credit rating of the issuer or its counterparty. The Board will monitor the ratings of its counterparties and insurers

 

Standards and Procedures of Counterparty Selection

The Board may enter into a derivative if (a) the counterparty shall have credit ratings from at least one nationally recognized statistical rating agency that is within the two highest investment grade categories and ratings which are obtained from any other nationally recognized statistical rating agencies shall also be within the three highest investment grade categories, or the payment obligations of the counterparty shall be collateralized, as described below, or unconditionally guaranteed by an entity with such credit ratings and (b) the counterparty has demonstrated experience in successfully executing derivatives.  If after entering into an agreement the ratings of the counterparty are downgraded below the ratings listed above by any one of the rating agencies, then the agreement shall be subject to termination unless (a) the counterparty provides either a substitute guarantor or assigns the agreement, in either case, to a party meeting the rating criteria reasonably acceptable the Board or (b) collateralizes its obligations in accordance with the criteria set forth in the transaction documents.

Provisions for Collateralization

If the rating (a) of the counterparty, if its payment obligations are not unconditionally guaranteed by another entity, or (b) of the entity unconditionally guaranteeing its payment obligations, if so secured, does not meet or falls below the rating required by "Standards and Procedures of Counterparty Selection” above, then the obligations of such 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 or any agency thereof with a net market value of at least 102% of the net market value of the contract (subject to minimum threshold amounts specified by the Board) to the authorized issuer and such collateral shall be deposited with the Board or an agent thereof.

Long-Term Implications

In evaluating a particular transaction involving the use of derivatives, the District shall review long-term implications associated with entering into derivatives, including costs of borrowing, historical interest rate trends, variable rate capacity, credit enhancement capacity, opportunities to refund related debt obligations and other similar considerations.

Impact of Use of Liquidity

The Board shall consider the impact of any variable rate bonds issued in combination with a swap on the availability and cost of liquidity support for other Board variable rate programs.

Call Option Value Considerations

When considering the relative advantage of a swap versus fixed rate bonds, the Board will take into consideration the value of any call option on fixed rate bonds.

Qualified Hedges

The Board understands that, (1) if payments on and receipts from the Agreement are to be taken into account in computing the yield on the related bonds, the Agreement must meet the requirements for a "qualified hedge” under federal tax law (sometimes referred to as an "integrated” swap); and (2) if one of the goals of entering into the Agreement is to convert variable yield bonds into fixed yield bonds (sometimes referred to as a "super integrated swap”), then certain additional requirements must be met.  In both of these situations, the terms of the Agreement and the process for entering into the Agreement must be reviewed and approved in advance by tax counsel.

Methods to be Used to Reflect Such Contracts in the Board’s Financial Statements

The Board shall reflect the use of derivatives on its financial statements in accordance with generally accepted accounting principles.

Monitoring and Reporting

Staff shall issue a report to the Board at least once per year and as requested by the Board.  Such report shall include the following:
  1. A summary of key terms of the agreements, including notional amounts, interest rates, maturity and method of procurement.
  2. The marked to market value of each agreement.
  3. The full name, description and credit ratings of each counterparty or the applicable guarantor.
  4. The amounts that were required to be paid and received and any amounts that were actually paid and received.
  5. Listing of any credit enhancement, liquidity facility or reserves and accounting of all costs and expenses associated with the credit enhancement, liquidity facility or reserves.
  6. The aggregate marked-to-market value for each counterparty and relative exposure compared to other counterparties.
  7. A calculation of the Board’s Maximum Termination exposure to each counterparty.
  8. Discussion of other risks associated with each transaction.
  9. A summary of all actions required of the Board by the CFTC.
Conformance to Dodd-Frank

It is the Board’s intent to conform this policy to the requirements relating to recent legislation and regulations for over-the-counter derivatives transactions under the Wall Street Transparency and Accountability Act of 2010, as supplemented and amended from time to time (herein collectively referred to as "Dodd-Frank"), enacted in response to the financial markets crisis of 2008.  Pursuant to such intent, it is the Board’s policy that:  the designated QIR agrees to meet and meets the requirements specified in Commodity Futures Trading Commission Regulation 23.450(b)(1) or any successor regulation thereto (herein referred to as the "Representative Regulation"); the designated QIR provide a written certification to the District to the effect that such designated QIR agrees to meet and meets the requirements specified in the Representative Regulation; (iii) District  staff monitor the performance of each designated QIR consistent with the requirements specified in the Representative Regulation; (iv) District  staff exercise independent judgment in consultation with the District‘s designated QIR in evaluating all recommendations, if any, presented by any counterparty with respect to transactions authorized pursuant to this policy; and (v) District  staff rely on the advice of the District 's designated QIR with respect to transactions authorized pursuant to this policy and do not rely on recommendations, if any, presented by any counterparty with respect to transactions authorized pursuant to this policy.

GLOSSARY OF TERMS

Amortization Risk – Amortization risk refers to the cost of servicing debt or making swap payments due to a mismatch between the bonds and the notional amount of swap outstanding.

Basis Risk – Basis risk refers to a mismatch between the interest rate received from the swap contract and the interest actually owed on the Board’s bonds.  The risk, for example, in a floating to fixed rate swap is that the variable rate interest payments will be less than the variable interest payments actually owed on the hedged bonds.

SIFMA Index – The Securities Industry and Financial Markets Association Swap Index.  The principal benchmark for short-term, tax-exempt rates among municipal issuers.  A market basket index of over 200 actively traded, highly rated, non-AMT tax-exempt variable rate issues that reset their rates every Wednesday.

Credit Support Annex – Covers the mutual posting of collateral, if required under the ISDA.  Schedule that is based on the net mark-to-market values of the cash flows in the swap.

The Confirmation – is executed for a specific derivative transaction and details the specific terms and conditions applicable to that transaction (fixed rate, floating rate index, payment dates, calculation methodology, amortization, maturity date, etc.).

Counterparty – A principal to a swap or other derivative instrument, as opposed to an agent such as a broker.

Counterparty Risk – The risk that the swap counterparty will not fulfill its obligations as specified by the terms of the contract.  Under a fixed payer swap, for example, if the counterparty defaults, the Board would be exposed to an unhedged variable rate bond position.  The creditworthiness of the counterparty is indicated by its credit rating.  The Board has established minimum rating criteria for swap counterparties.

Forward Starting Swap – A fixed-for-floating interest rate swap in which the swap coupon is set at the outset but the start of the swap is delayed until some future date.

Hedge – A position taken in order to offset the risk associated with some other position.  Most often, the initial position is a cash position and the hedge position involves a risk-management instrument such as a swap.

Interest Rate Cap – An instrument that pays off on each settlement date based on the market value of a reference rate (i.e. BMA or LIBOR) and a specified contract rate; effectively establishes a maximum on a variable rate.

Interest Rate Collar – Provides protection within a band of interest rates; a combination of purchasing an Interest Rate Cap and selling Interest Rate Floor.  Generally, it is structured so that the net cost of the collar is zero or close to zero.  This means that the expense for the interest rate cap premium is offset by the credit received for the interest rate floor.

Interest Rate Floor - An instrument that pays off on each settlement date based on the market value of a reference rate (i.e. BMA or LIBOR) and a specified contract rate; effectively establishes a minimum on a variable rate.

Interest Rate Risk – The risk that variable rates will increase and thereby cause an increase in variable rate debt service costs and negatively impact cash flow margins.

Interest Rate Swap – An interest rate swap is a contract between two parties to exchange cash flows over a predetermined length of time.  Cash flows are calculated periodically based on a fixed or variable interest rate against a set "notional” amount (amount used only for calculation of interest payments).  Principal is not exchanged.

ISDA – The International Swap Dealers Association.  The global trade association whose members are dealers in the derivatives industry.  Most swap transactions are traded under standard documentation created by ISDA.

ISDA Master Agreement – The primary document for the terms and conditions governing the swaps market.  The ISDA Master Agreement contains the terms for events of default, termination events, representations and covenants, early termination provisions and payment calculations.

LIBOR – The London InterBank Offered Rate.  The rate at which banks will lend eurodollars to each other.  The most active dollar-based taxable interest rate benchmark utilized globally.

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 cash flows for the designated coupons.

Rollover Risk – The risk that the term of the swap contract does not match the term of the related bonds being hedged.  Upon the maturity of the swap, the risk may need to be re-hedged, causing the Board to incur re-hedging costs.

Tax Risk – All issuers who issue tax-exempt variable rate debt inherently accept risk stemming from changes in marginal income tax rates.  This is a result of the tax code’s impact on the trading value of tax-exempt bonds.  As marginal tax rates decline, the after tax value of tax-exempt income declines, forcing the tax-exempt rates to increase.  This risk is also known as "tax event” risk, a form of basis risk under swap contracts.  Percentage of LIBOR swaps and certain BMA swaps with tax event triggers, which can change the basis under the swap to a LIBOR basis from BMA, can expose issuers to tax event risk.

Termination Risk – The risk that the swap could be terminated as a result of any of several events, which may include a ratings downgrade for the Board or the swap counterparty, covenant violation by either party, bankruptcy of either party, swap payment default by either party, and default events under a bond indenture.  The Board could owe a termination payment to the counterparty or receive a termination payment from the counterparty, depending on how interest rates at the time of termination compare with the fixed rate on the swap.  The Board will make reasonable efforts to ensure that remedies available to a swap counterparty resulting from the Board defaulting on its swap obligation should not infringe on bondholders’ rights.  These remedies should not be written into the bond indenture.

Schedule to the ISDA Master Agreement – specifies what options for the various terms in the Master Agreement have been selected to govern the derivative transactions executed under the agreement.

Swaption – A swaption is an option on a swap.  The swaption purchaser has the right to enter a specific swap for a defined period of time.  This option can be exercised on a specific exercise date or series of exercise dates.

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 towards longer maturities.  It reflects the market’s views about implied inflation/deflation, liquidity, economic and financial activity, and other market forces.
 
Wall Street Transparency and Accountability Act of 2010, Section 1a (47) Commodity Exchange Act
 
NEW - HCPS - September 23, 2014
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