MUNICIPAL INTEREST RATE SWAPS

1. MUNICIPAL INTEREST RATE SWAPS Strategies to Balance Assets and Liabilities and Reduce Interest Expense

2. Municipal Debt Management • Historically, most municipal entities have managed their liabilities through the issuance and refinancing of debt instruments, usually on a fixed interest rate basis. • Recently, some municipal entities, particularly larger government units, have begun to investigate and implement interest rate swaps as interest rate management tools.

3. General • An Interest Rate Swap is a contract between two parties to exchange cash flows for a specified period of time. • The exchange of cash flows can start immediately upon execution or at a later date, can be for the duration of the debt or for a shorter period and can be entered into at the time of the issuance of the bonds or at an earlier or later date.

4. Using Interest Rate Swaps to Balance Assets and Liabilities and Fix Interest Rates -- Spot-Starting Floating to Fixed Rate Swaps: • Generally entered to “fix” interest rates on floating rate debt.

5. Mechanics of Floating to Fixed Rate Swap

6. Using Interest Rate Swaps to Hedge Against Rising Interest Rates -- Forward Starting Floating to Fixed Rate Swaps: • Generally entered in anticipation of long-term debt issuance in perceived rising rate environment.

7. Hedge Swaps • Often entered into in anticipation of long-term debt issuance to protect against increases in long-term interest rates. • At “Effective Date,” the Municipality can either issue variable rate debt, thereby fixing its interest cost at the forward swap rate plus variable rate debt costs – or – can terminate the swap and “settle” with the swap counterparty.

8. Using Interest Rate Swaps to Balance Assets and Liabilities and (Hopefully) Reduce Interest Cost Reverse Swap:

9. Mechanics of Fixed to Floating Rate Swap

10. “Cash Out” Interest Rate Swaps • Rather than taking full advantage of the difference between the Municipality’s average bond interest rate and the prevailing fixed swap rate over time, a Municipality can take part or all of the present value of such difference in cash at the time the swap is executed. • For example, rather than paying a net interest rate of BMA, the Municipality could choose to take cash at execution and pay a net interest rate of BMA plus 50 basis points. (Is this a loan subject to Debt Act compliance?)

11. “Cash Out” Interest Rate Swaps (cont.) • The advantage of taking cash at execution is apparent. A contractual payment is made to the Municipality which it can spend for current priorities. • The disadvantage of taking cash at execution is the increase in the net interest rate for the duration of the swap. This reduces the interest rate cushion in higher interest rate markets.

12. Factors Impacting on Benefits of Swap • Prevailing fixed interest rates in swap market. For a Fixed-to-Floating Rate Swap, higher prevailing interest rates favor the Municipality. The inverse is true, generally, for floating-to-fixed rate swaps. • Current and future floating rates. See RISK FACTORS.

13. Risk Factors • Variable Rate Exposure for Municipality in Reverse Swap Transaction. The floating nature of variable rates, while providing a means to balance interest expense with a municipality’s short-term investments, also presents risk. Effective net interest cost could increase precipitously in a rising interest rate environment, causing the swap transaction to become uneconomic. Although historical interest rate data regarding LIBOR and BMA are instructive, no assurances can be given that interest rates will behave as they have in the past.

14. Risk Factors (cont.) • Counterparty Risk. The Counterparty to the swap could default, thereby depriving the Municipality of the benefit of its bargain. Rating requirements, collateral provisions and other terms will be included in the Swap Agreement can reduce Counterparty risk. • Basis Risk. Unless the variable rate side of a swap is tied directly to the Municipality’s bonds, the index selected for the swap will not move in lock step with the Municipality’s bonds.