1. UNIVERSITY OF COLORADO BOULDER Prepared by: P. Jonathan Heroux Managing Director April 14, 2005 Derivatives in the Municipal Market Place Presentation to:

2. Page -2- Presentation Outline Municipal Finance Overview  Fixed Rate Obligations  Variable Rate Obligations Municipal Derivatives  Interest Rate Swaps  Swap Options (Swaptions)  Knockout Swaps  Forward Delivery Contracts  Interest Rate Locks  Caps, Floors and Collars

3. Page -3- Size of Market  Over $1.5 Trillion in tax-exempt debt outstanding  In 2004 there were 13,400 new issues totaling over $360 Billion Diverse Issuers  State and Local Governments  Government Agencies  K-12, Higher Ed. Diverse Projects  Airports  Hospitals  Water Systems  Housing  Urban Renewal Municipal Finance Overview Issuers of Municipal Bonds 2004 By Par Issued

4. Page -4- Fixed Rate Obligations Bonds are issued as Serial or Term bonds. Serial Bonds:  Most common fixed rate bonds.  Serial bonds pay a stated fixed interest and principal payment at regular intervals (one principal payment per year).  Each separate maturity has a distinct and stated interest rate.  Allow issuer to borrow across the yield curve. Example of a Serial Bond: Fixed Rate Bonds

5. Page -5- Fixed Rate Obligations (cont.) Bonds are issued as Serial or Term bonds. Term Bonds:  Term may extend for any period, typically 2 to 25 years.  Principal paid at maturity.  Term bonds have one interest rate for the entire term. Example of a Term Bond: Fixed Rate Bonds

6. Page -6- Variable Rate Obligations  Variable rate bonds have “floating” interest rates.  The interest rate on the bonds is reset to current market rates at predetermined time intervals.  The periodic reset of interest rates allows the issuer to borrow at the short end of the yield curve, thus initially lowering the cost of debt.  One unique feature of variable rate bonds is that investors are able to sell back, or “put” their bonds to the remarketing agent when the rates are reset.  Issuer must purchase a Letter of Credit from a bank. The LOC provides liquidity for the bonds.  Example savings: If an issuer can lower the interest rate by 10 bps on a $20MM 20 year loan, it will save over $260,000 in total interest costs. Variable Rate Demand Obligations (VRDO’s)

7. Page -7- Interest Rate Comparison Fixed vs Variable Interest Rates Last 10-Years

8. Page -8- Size and Swap Providers:  Current size approximately $150 Billion in notional amount.  Some major Swap providers are: J.P. Morgan, Bank of America, Morgan Stanley, Merrill Lynch, Piper Jaffray, Citigroup, Goldman Sachs Who Uses Swaps and Financial Derivatives:  501(C)3 non-profits (hospitals, private colleges, YMCA’s, Museums/ performing arts).  Public universities.  Cities, counties, and state governments.  Municipal enterprises (tolling authorities, utilities). Swap Market

9. Page -9- Interest Rate Swaps Interest rate swaps allow an issuer to exchange fixed rate payments for variable rate payments or vice versa. Interest Rate Swaps Have Four Basic Characteristics 1.Agreement is between two parties to exchange payments. 2.Each party agrees to make a fixed/floating payment in exchange for receiving a floating/fixed payment over a predetermined period. 3.Payments are based on a “notional” amount. 4.No principal is exchanged. Notional Amount Party A Party B Fixed Floating

10. Page -10- Interest Rate Swaps (cont.) The floating-to-fixed rate swap allows an issuer to convert a portion or all of an outstanding variable rate issue to a fixed rate payment structure. Issuer receives variable payments from the swap provider and pays a fixed rate of interest to the provider. The funds received from the provider are then used to pay interest on the outstanding variable rate bonds. Synthetic Fixed Swaps act as hedge against interest rate risk. Floating-to-Fixed Rate Swaps Variable Rate Bond Holders Variable Rate Issuer Swap Provider Fixed Rate Variable Rate (BMA or Percentage of Libor Index)

11. Page -11- Interest Rate Swaps (cont.) The fixed-to-floating rate swap allows an issuer to convert a portion or all of an outstanding fixed rate issue to a variable rate payment structure. Issuer receives fixed payments from the swap provider and pays a variable rate of interest to the provider. This transaction allows the issuer to use variable rate financing (historically lower cost) with out requiring a remarketing agent and liquidity provider. Fixed-to-Floating Rate Swaps Fixed Rate Bond Holders Fixed Rate Issuer Swap Provider Fixed Rate Variable Rate (BMA or Percentage of Libor Index)

12. Page -12- Swap Options  The option buyer pays the issuer a premium upon execution of the swaption agreement.  If the swaption is exercised, the swap begins.  If the swaption is not exercised, the issuer keeps the premium and has no additional obligation to the swaption buyer. What is a Swaption? A Swaption is an option that gives the buyer the right, but not the obligation, to enter into a swap at a specific date in the future.

13. Page -13- Swap Options (cont.) Mechanics of a Swap Option “Swaption” Issuer Variable Rate Swap Option Fixed Rate* Bond Holders Swap Provider Today: Swap provider pays issuer for the one time right to direct Issuer to enter into a Swap on the call date. Call Date: Option Exercised – the Issuer and swap provider enter into swap and begin exchanging variable and fixed rate payments. Option Not Exercised - the Issuer retains the up-front payment and the ability to refund bonds in the future. * Assume for this example the swap is a fixed payor swap

14. Page -14- Interest Rate Swaps and Swap Options Advantages:  Change Payment Characteristics – issuer is able to change payments on fixed rate issue to resemble payments on variable rate issues and vice versa.  Cost Savings – the swap procedure usually provides lower borrowing costs. Disadvantages: Counter Party Risk The risk that the party on the other side of a swap transaction does not fulfill its obligation under the swap. If the counter party defaults on its payment to the issuer then the issuer is left with un-hedged variable rate payments. The Value of Interest Rate Swaps and Swap Options

15. Page -15- Interest Rate Swaps and Swap Options (cont.) Disadvantages (cont.): Basis Risk (1) the degree to which the difference between two prices fluctuates; (2) the residual risk that remains after a hedge has been placed; (3) the risk from receiving one floating rate, such as BMA or a percentage of LIBOR and paying another, such as the interest rate on your own obligations. Example: Average Index (68% of LIBOR) is 1.50% Average cost of variable rate debt is 1.40% Difference.10% Difference of.10% is Basis Risk. In this example the issuer receives 1.50% but only pays 1.40%. This basis differential could also be a negative amount in which case the issuer would pay more than it received, thus increasing its cost of borrowing.

16. Page -16- Interest Rate Swaps and Swap Options (cont.) Disadvantages (cont.): Tax Risk The risk that a change in Federal or State tax law changes the issuer’s borrowing cost. In Swaps, the risk can be identified and shared between Provider/Issuer. Any change in tax law may impact borrowing cost. An Issuer takes Tax Risk on variable rate bonds even when a Swap is not contemplated. As marginal tax rates DECREASE, floating rates on tax-free bonds will increase.

17. Page -17- Knockout Swaps The knockout swap is a swap which is terminated periodically or permanently if the variable interest rate moves above or below an agreed upon level based on a specified floating rate index, generally Libor or BMA. Advantages:  Lowers Cost – when the issuer sells this option it receives a lower swap rate or an upfront premium.  Increased Financial Flexibility – Option can be repurchased if market conditions are favorable. Disadvantages:  Uncertainty – if knockout rate is exceeded then issuer is back to un-hedged variable rate payments.  Higher Interest Costs – if swap is canceled the variable rate may be higher than the swap rate.

18. Page -18- Knockout Swaps (cont.) Mechanics of a Knockout Swap Knockout Swap Issuer Variable Rate Fixed Rate Bond Holders Swap Provider Today: Swap provider pays issuer or offers a lower swap rate for the option of canceling the swap if variable rate rises above a certain “knockout” rate. Knockout rate exceeded: The swap is canceled. The issuer pays the variable rate to the bond holders and no payments are exchanged between the bond holders and swap provider. Fixed Rate Variable Rate Bond Holders Swap Provider Issuer No Payments Exchanged

19. Page -19- Forward Delivery Contracts Advantages:  Lock in Costs - issuer locks in the cost of borrowing today; helps with future budgeting of interest costs.  Hedge Interest Rate Risk - issuer locks in rates so it is no longer at risk if rates begin to rise. Disadvantages:  Cost of Premium - issuer must pay the forward premium.  Non-Cancelable - once agreement is entered into by issuer, the issuer must provide the bonds or make a payment to the provider on the specified date. Thus, the issuer must be certain of the amount of funds it will need prior to entering into the Forward Delivery Contract. Forward Delivery Contracts are fixed rate debt obligations with a settlement date sometime in the future. The Issuer pays a premium over today’s market rates.

20. Page -20- Forward Delivery Contracts (cont.) Mechanics of Forward Delivery Contracts Forward Delivery Bonds Today: Issuer sells bonds with extended delivery. Delivery: The Issuer delivers bonds to bond holders in exchange for purchase price agreed upon when purchase contract was signed (Today). Result: The Issuer locks in the negotiated interest rate starting on the delivery date through the maturity of the bonds. Issuer Determine Purchase Price Negotiate Interest Rate Underwriter Today Issuer Purchase Bonds Deliver bonds Begin paying Negotiated Interest Rate Underwriter Delivery Date (I Year Later) Negotiated Interest Rate = Today’s Yields + Forward Premium

21. Page -21- Interest Rate Locks Issuer agrees to an interest rate based on the current market (MMD index in municipal finance) plus a premium. At the settlement date a differential payment is exchanged between the two parties. The payment is based on the difference between the current rate and the locked rate. This difference is used to calculate the present value of some principal amount. Advantages:  Hedging Interest Rate Risk – issuer locks in current rates plus premium.  No Up-front Fees – issuer may receive a payment on settlement date.  Budget Planning – securing current rates for future debt issuance also assists with planning future debt service payments as the cost of borrowing is known. Disadvantages:  Contract must be Executed – even if bonds are not issued, the terms of the contract must be settled, which could mean a cash payment by the issuer.  Political Ramifications – if rates fall and issuer makes a payment, outsiders may view the transaction as speculative rather than risk management.

22. Page -22- Interest Rate Locks (cont.) Illustration of MMD Rate Lock Assume that in today’s market the MMD 30 year rate is 5.10% and that the present value of a basis point is $10,000. Counterparty Borrower Effective Date 5.10% Rate Lock Bond Pricing Date Rates Fall 30bps MMD = 4.80% Rates Rise 30bps MMD = 5.40% Differential payment = $300,000 ($10,000 *30 bps) Counterpart y Borrower $300,000 Bond Purchasers Market Rate Bonds Counterpart y Borrower $300,000 Bond Purchasers Market Rate Bonds

23. Page -23- Caps, Floors and Collars An interest rate cap is an agreement between an issuer and a interest rate cap provider that places an upper limit on the risk exposure for an issuer’s variable rate bonds. While the interest rate on the bonds may increase above the cap, the cap provider will pay the issuer the difference in interest cost on a notional principal amount any time a specified index (BMA, 1-month LIBOR) rises above a specified “cap strike rate.” To purchase a cap, the issuer pays an up-front premium to the cap provider. Interest Rate Caps

24. Page -24- Caps, Floors and Collars (cont.) An interest rate floor is an agreement between an issuer and the purchaser of an interest rate floor that places a lower limit on the rate of an issuer’s variable rate bonds. While the rate on the bonds may drop below the “floor strike rate,” the issuer agrees to pay the floor purchaser the difference in interest payable on a notional principal amount when a specified index rate (e.g BMA, 1-month LIBOR, etc.) falls below a stipulated minimum, or “floor strike rate.” The Issuer receives a premium from the floor purchaser for this agreement. Interest Rate Floors Exposure After Floor 0%2%4%6%8%10% Interest Rates Unhedged Exposure 0%2%4%6%8%10% Interest Rates Variable Rate Interest Expense Payment to Floor Buyer Variable Rate Interest Expense Floor Strike

25. Page -25- Caps, Floors and Collars (cont.) An interest rate collar combines the use of a cap and a floor. The collar sets an issuer’s variable rate exposure to a predetermined range. The payment received from the floor often is used to offset the premium on the cap. Interest Rate Collars Collar Exposure 0%2%4%6%8%10% Interest Rates Variable Rate Interest Expense Payment from Cap Provider Cap Strike Floor Strike Payment to Floor Buyer

26. Page -26- Advantages:  Limit Risk Exposure – through the use of caps, issuer sets the upper limit on its variable debt service thus setting the maximum interest rate payment.  Termination of Cap or Floor – issuer can sell or extend the contracts at any time.  Premium from Floor – issuer receives a premium from the floor agreement.  Combine Cap and Floor for Collar – issuer may limit variable rate exposure to a predetermined range and apply the payment from the floor to the premium on the cap. Disadvantages:  Cost of Contract – issuer must pay an up-front premium for cap.  Floor Limits Potential Benefit – if rates fall below the floor strike rate, the issuer loses the savings benefits from lower interest payments. The Value of Caps, Floors and Collars Caps, Floors and Collars (cont.)

27. Page -27- Summary  Using Financial Derivatives is not for every issuer or every circumstance. Municipal Issuers use derivatives for hedging only and not for market speculation.  Properly executed, financial derivatives can help municipal debt issuers lower borrowing cost and manage risk exposure.  As financial derivatives have become more popular, many municipalities have begun using derivatives as part of their financial management strategy. "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.“ - Alan Greenspan, 1999

28. Page -28- Terms BMA The Bond Market Association Municipal Swap Index, produced by Municipal Market Data, is a 7 day high grade market index comprised of tax-exempt VRDOs from MMD's extensive database. This is the standard variable rate index for municipal finance. LIBOR The London Interbank Offering Rate is the rate that most creditworthy international banks dealing in Eurodollars charge each other for loans. Maturity or Maturity Date The date upon which the principal security becomes due and payable to the security holder. MMD Municipal Market Data. This companies compiles municipal bond market statistical information and publishes daily statistics.

29. Page -29- Terms Notional Amount The amount SWAP payment calculations are based on. The notional amount is usually the same or very close to the principal amount of the underlying bonds. The notional amount is a calculation basis only, as principal is not exchanged in a swap transaction. Swap A sale of security and the simultaneous purchase of another security, for purposes of enhancing the investor's holdings. The swap may be used to achieve desired tax results, to gain income or principal or to alter various features of a bond portfolio, including call protection, diversification or consolidation, and marketability of holdings. Swap Spreads The fixed spread (to Treasuries) on a Libor based fixed to floating interest rate swap. Swap spreads are effectively a proxy for spreads between Treasuries and very high-grade taxable non-Treasury bonds.

30. Page -30- Questions?