2.3.3 Interest Rate Swaps and Synthetic Structures
An interest rate swap is not a debt obligation but can be used to change the substantive financial terms of a debt from a fixed rate obligation to a variable rate obligation or from a variable rate obligation to a fixed rate obligation or to create a “synthetic fixed rate obligation.”66 An interest rate swap is a contractual agreement between two parties who agree to exchange (or swap) certain cash flows for a defined period of time. In the case of a municipal swap, the two parties are a governmental entity and a broker dealer or financial institution as “counter party.” Generally, the cash flows to be swapped relate to interest to be paid or received with respect to some asset or liability. If a public agency issues variable rate debt and enters into a swap where what it pays the counter party is based on a fixed rate and what it receives from the counter party is based on a variable rate, the obligation of the public agency under the debt and swap together is the synthetic fixed rate. Accordingly, the swap is designed to generate a net change in the interest rate cash flow related to that asset or liability (typically investment securities or bond indebtedness, respectively), but the swap neither affects the principal of that asset or liability nor results in the creation of any new principal. As a result, the “size” of a swap, for purposes of describing the computational base on which the swapped payments are calculated, is referred to as the notional amount.
As part of any swap, both parties agree to the following:
- The notional amount.
- The rate or formula each party will use to compute the amounts to be paid to the other on that notional amount.
- The dates on which cash flows will be exchanged.
- The term of the swap.
Interest rate swaps typically do not generate new funding like a loan or bond sale, although there are swap variations that are structured to achieve altogether different financing goals, such as generating an up front cash payment.
Public agencies can use interest rate swaps to achieve the following:
- Provide better asset/liability matching. If a public agency has cash balances invested in short term obligations (variable rate assets) and fixed rate debt, a swap in which the public agency pays at a variable rate and receives at a fixed rate “hedges” the public agency’s balance sheet.
- Lock in the benefit of current interest rates. If a public agency has fixed rate debt that cannot be refunded for several years, a forward starting swap where the public agency pays at a fixed rate set at current rates and receives at a variable rate hedges against future rate increases that would reduce the savings from the refunding.
- Cap exposure. An interest rate “cap,” a swap structured to become effective only if and when interest rates are significantly higher, can limit the interest rate risk of variable rate debt.
- Generate cash. A swap can be structured so that the public agency receives an upfront payment from the counter party and pays at a higher rate (effectively, a loan embedded in a swap).
- Reduce net interest costs. Variable rate debt combined with a swap where the public agency pays a fixed rate and receives a variable rate designed to correspond to the rate expected to be paid on the variable rate debt can result in a “synthetic fixed rate” expected to be lower than the interest cost on fixed rate bonds.
INTEREST RATE SWAP RISKS – Interest rate swap transactions pose significant risks, including the following:
- Counter party credit risk. At any point a swap has a positive value to the public agency, the public agency is extending credit to the counter party.
- Termination risk. If a swap terminates early and the swap has a negative value to the public agency, the public agency could be required to make a significant payment, even if the termination payment obligation results from a default by the counter party.
- Collateralization risk. Frequently, an issuer is required under an interest rate swap agreement to post collateral in the form of cash or cash equivalents if the negative value of the interest rate swap increases above a negotiated threshold.
- Basis risk. The variable rate on the swap may not match the actual variable rate on the hedged obligation (the interest rate payable by the public agency may be higher than the variable rate it receives on the swap). A change in federal tax law is one example of an event that could create a mismatch.
- Amortization risk. If the principal amount of the hedged bonds no longer matches the notional amount of the swap (perhaps because of an early redemption of bonds), the swap is no longer an effective hedge.
Events that occurred during the financial crisis of 2008, including the Lehman Brothers bankruptcy, the loss of “AAA” ratings by bond insurers on variable rate debt that had been associated with swaps, and the collapse of the auction rate securities market, underscored the reality of these risks. Because swaps generally terminate at market value, these types of event risks could not be managed. As a consequence, municipal interest rate swaps are less common and new synthetic fixed rate transactions are rare.
California Government Code Sections 5922(a)(i) and 53534 provide clear statutory authority for swaps applicable to all state or local governments.67 However, the state, a city, a county, or a school district may not enter into a swap if the swap constitutes an “indebtedness” or “liability” within the meaning of California Constitution Article XVI, Section 1 (applicable to the State), or Section 18 (applicable to cities, counties, and school districts). There is little case law in California or other states analyzing how swaps are to be treated for such purposes; however, counsel can generally render a qualified opinion to the effect that the swap would/should not constitute an indebtedness or liability for purposes of these constitutional debt limitations.