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Interest Rate Swap and Interest Rate Swap and Variable Rate Debt Programs Variable Rate Debt Programs Managing On-Going Responsibilities California Debt and Investment Advisory Commission April 11, 2008 Swap Financial Group Peter Shapiro 76

SLIDE 1

Interest Rate Swap and Interest Rate Swap and Variable Rate Debt Programs Variable Rate Debt Programs

Managing On-Going Responsibilities California Debt and Investment Advisory Commission April 11, 2008

Swap Financial Group

Peter Shapiro 76 South Orange Avenue, Suite 6 South Orange, New Jersey 07079 973-378-5500

SLIDE 2

Swap Financial Group 2

Agenda Agenda

What do you need to know to maintain a

variable rate program?

How do actual rates compare to market-

wide indexes?

What factors influence actual rates? How does the market value of a swap

change over time?

SLIDE 3

Swap Financial Group 3

Review of swap structure Review of swap structure

Swap Dealer Fixed Rate Bond Holder Basis Risk comes from the difference between the two Floating Rates Floating Index Bond Rate (Floating) Issuer

SLIDE 4

Swap Financial Group 4

Swap indexes Swap indexes

The floating side of a swap is usually an index Two important floating indexes are:

– LIBOR (London Interbank Offered Rate): Dominant index for taxable floating rates – SIFMA (Securities Industry and Financial Markets Association Municipal Swap Index, formerly the BMA Index): Dominant index for tax-exempt floating rates

Indexes are never exactly equal to actual rates

SLIDE 5

Swap Financial Group 5

How does LIBOR work? How does LIBOR work?

LIBOR is a rate, set once a day at 11 AM

London Time by the British Bankers Association

Every major currency Every short-term maturity (overnight to

ne year)

Reflects short-term lending rates between

highly creditworthy banks

SLIDE 6

Swap Financial Group 6

How does SIFMA work? How does SIFMA work?

SIFMA is a literal arithmetic average of

actual tax-exempt VRDO programs

Mathematically rigorous, determined

nce a week by MMD Inc.

Reflects multiple remarketing agents,

liquidity banks

Only creditworthy programs 2008 problem: Tainted insurers

SLIDE 7

SIFMA vs LIBOR, weekly since 1989

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 1-mo LIBOR SIFMA Index

SLIDE 8

SIFMA vs LIBOR, weekly since 1989 With 'Best Fit' Line, Simple Formula

SIFMA = 67.7% LIBOR R

2 = 0.8967

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 1-mo LIBOR SIFMA Index

SLIDE 9

SIFMA vs LIBOR, weekly since 1989 With 'Best Fit' Line, Compound Formula

SIFMA = 64.5% LIBOR + 18 bps R

2 = 0.8993

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 1-mo LIBOR SIFMA Index

SLIDE 10

SIFMA vs LIBOR, annualized since 1989

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 1-mo LIBOR SIFMA Index

SLIDE 11

SIFMA vs LIBOR, annualized since 1989 With 'Best Fit' line, Simple Formula

SIFMA = 67.5% LIBOR R2 = 0.968

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 1-mo LIBOR SIFMA Index

SLIDE 12

SIFMA vs LIBOR, annualized since 1989 With 'Best Fit' line, Simple Formula

SIFMA = 63.7 LIBOR + 21 bps R

2 = 0.9721

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 1-mo LIBOR SIFMA Index

SLIDE 13

SIFMA as Percentage of LIBOR

0% 20% 40% 60% 80% 100% 120% J J F F M M M A A M M J J J J A A S S S O O N N D D Last 18 years Low-rate years (2001-2004) 2008 Year-to-Date

SIFMA-LIBOR relationship is highly seasonal

SLIDE 14

Swap Financial Group

Page 14

Why bonds vary from SIFMA Why bonds vary from SIFMA

California – “Specialty State”

– Double tax-exemption – Big base of dedicated investors – “The California Premium”

Daily VRDO’s Auction Rate Securities

– Non-puttable, 90% insured – Bond insurer crisis, liquidity crisis – Market seized up this year – Will it ever come back?

SLIDE 15

BMA vs Cal VRDO's Since 1991

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 6/7/1991 6/7/1992 6/7/1993 6/7/1994 6/7/1995 6/7/1996 6/7/1997 6/7/1998 6/7/1999 6/7/2000 6/7/2001 6/7/2002 6/7/2003 6/7/2004 6/7/2005 6/7/2006 BMA Cal VRDO's Cal Premium

SLIDE 16

Swap Financial Group 16

How a swap changes in value How a swap changes in value

Like a fixed-rate bond, a swap changes in

value over time

Swap value changes based on three factors:
1. Changes in interest rates
2. Remaining years to maturity
3. Amortization

SLIDE 17

Swap Financial Group 17

Understanding valuation changes Understanding valuation changes

If you are a fixed-rate payer, if rates have risen,

the value will be positive to you (and vice versa)

Higher rates mean the swap provider would

pay you to get out of the swap (he could find a higher-paying swap in the current market)

GASB rules require you to provide information

n the current value of your swaps

Interest Rate Swap and Interest Rate Swap and Variable Rate Debt Programs Variable Rate Debt Programs

Managing On-Going Responsibilities California Debt and Investment Advisory Commission April 11, 2008

Agenda Agenda

What do you need to know to maintain a

variable rate program?

How do actual rates compare to market-

wide indexes?

What factors influence actual rates? How does the market value of a swap

change over time?

Review of swap structure Review of swap structure

Swap indexes Swap indexes

The floating side of a swap is usually an index Two important floating indexes are:

– LIBOR (London Interbank Offered Rate): Dominant index for taxable floating rates – SIFMA (Securities Industry and Financial Markets Association Municipal Swap Index, formerly the BMA Index): Dominant index for tax-exempt floating rates

Indexes are never exactly equal to actual rates

How does LIBOR work? How does LIBOR work?

LIBOR is a rate, set once a day at 11 AM

London Time by the British Bankers Association

Every major currency Every short-term maturity (overnight to

Reflects short-term lending rates between

highly creditworthy banks

How does SIFMA work? How does SIFMA work?

SIFMA is a literal arithmetic average of

actual tax-exempt VRDO programs

Mathematically rigorous, determined

Reflects multiple remarketing agents,

liquidity banks

Only creditworthy programs 2008 problem: Tainted insurers

Why bonds vary from SIFMA Why bonds vary from SIFMA

California – “Specialty State”

– Double tax-exemption – Big base of dedicated investors – “The California Premium”

Daily VRDO’s Auction Rate Securities

– Non-puttable, 90% insured – Bond insurer crisis, liquidity crisis – Market seized up this year – Will it ever come back?

How a swap changes in value How a swap changes in value

value over time

Understanding valuation changes Understanding valuation changes

If you are a fixed-rate payer, if rates have risen,

the value will be positive to you (and vice versa)

Higher rates mean the swap provider would

pay you to get out of the swap (he could find a higher-paying swap in the current market)

GASB rules require you to provide information

New rules will take effect in 2010 that will

require more thorough reporting, “effectiveness testing”