- 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
Derivatives may be used for the following purposes only:
- 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.
- To prudently hedge risk in the context of a particular financing or the overall asset/liability management of the Board.
- 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.
- To achieve more flexibility in meeting overall financial objectives than can be achieved in conventional markets.
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.
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:
- 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.
- 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.
- 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.
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:
- Failure to make payments when due
- Breach of representations and warranties
- Failure to comply with downgrade provisions
- 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|
- A summary of key terms of the agreements, including notional amounts, interest rates, maturity and method of procurement.
- The marked to market value of each agreement.
- The full name, description and credit ratings of each counterparty or the applicable guarantor.
- The amounts that were required to be paid and received and any amounts that were actually paid and received.
- 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.
- The aggregate marked-to-market value for each counterparty and relative exposure compared to other counterparties.
- A calculation of the Board’s Maximum Termination exposure to each counterparty.
- Discussion of other risks associated with each transaction.
- A summary of all actions required of the Board by the CFTC.