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Swap Market Update

Swap Market Update. The PFM Group. Credit Spreads Widened on Lehman Bankruptcy, Bailouts. The yield difference or spread between risk-free (Treasury bills) and risky (LIBOR deposits) assets historically widens in times of financial stress.

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Swap Market Update

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  1. Swap Market Update The PFM Group

  2. Credit Spreads Widened on Lehman Bankruptcy, Bailouts • The yield difference or spread between risk-free (Treasury bills) and risky (LIBOR deposits) assets historically widens in times of financial stress

  3. Long-Term Tax-Exempt Yields Decoupled from Taxable Yields • Long-term tax-exempt yields decoupled from taxable yields in the credit crisis remaining elevated as investors dumped municipal bonds for more liquid Treasurys and LIBOR swaps • This trend reversed in 2009 as markets healed but resurfaced in recent Greek debt crisis

  4. Ratio of Municipal to LIBOR Swap Rates Rose During Credit Crisis • Tax-exempt (SIFMA)/LIBOR swap ratio fell sharply after spiking in Q4 2008 but has crept back up • Renewed credit fears have caused municipal yields to rise relative to more liquid LIBOR swap rates

  5. Long - Term Debt/Counterparty Ratings Financial Institution Moody’s S&P Fitch Bank of America Aaa AA+ AA Long - Term Debt/Counterparty Ratings Bank of New York Aaa AA - AA - Financial Institution Moody’s S&P Fitch Bank of America Aa3 A+ A+ Citibank Aa1 AA AA Bank of New York Aaa AA AA - Deutsche Bank Aa1 AA AA - Dexia Bank Aa1 AA AA+ Citibank A1 A+ A+ Goldman Sachs Capital Markets Aa3 AA - AA - Deutsche Bank Aa3 A+ AA - J.P. Morgan Chase Aaa AA AA - Dexia Bank A1 A A+ Lehman Brothers Special Financing A1 A A+ Goldman Sachs Capital Markets A1 A A+ Merrill Lynch Capital Services A1 A A+ J.P. Morgan Chase Aa1 AA - AA - Morgan Stanley Capital Services Aa3 A+ AA - Lehman Brothers Special Financing A1 A A+ Royal Bank of Canada (RBC Dain Rauscher) Aaa AA - AA Merrill Lynch Capital Services A2 A A+ Sumitomo Bank Capital Markets Aa2 A+ A+ Morgan Stanley Capital Services A2 A A Wachovia Bank Aa1 AA - AA - Royal Bank of Canada (RBC Dain Rauscher) Aaa AA - AA Wells Fargo Bank Aaa AAA AA+ Sumitomo Bank Capital Markets Aa2 A+ A Wachovia Bank Aa2 AA AA- Wells Fargo Bank Aa2 AA AA- Major Municipal Swap Providers Barclays Bank PLC Barclays Bank PLC Aa1 Aa3 AA- AA AA AA- as of 07/13/2010 as of 06/26/2008

  6. Risk Management

  7. For the past twenty years, there has been at least one significant market “break” nearly every other year. • 1987 – Stock market crash • 1990 – Nikkei crash; high yield tumble • 1992 – European currency crisis • 1994 – Orange County/Procter & Gamble derivatives losses • 1997 – Asian crisis • 1998 – Russian/Long-Term Capital Management crisis • 1999 – Brazil crisis • 2001 – Bursting of tech bubble • 2002 – Stock market “crash” • 2008 – Sub-prime housing bubble, Lehman Bros. bankruptcy, AIG bailout • 2010 – Greek/European sovereign debt crisis?

  8. Key principles of risk management • Risks should not be taken without being properly understood and managed. • Risks should not be taken that are too large relative to overall capital. • Risks should not be taken without proper compensation.

  9. Lessons of Recent Financial Crisis for Tax-Exempt Issuers • Credit crises tend to be strongly correlated with lower rates (flight to quality) • Issuers discovered the risks of declining interest rates including…. • Potential liquidity risk of large negative swap termination values in the form of collateral posting requirements or ratings downgrade ATE under ISDA Agreement • Extreme basis risk between swap floating index and failed ARS or insured VRDO’s • Opportunity cost due to inability to refund non-call synthetic fixed rate debt • Counterparties will enforce their rights under the ISDA Agreement • The costs of restructuring swap contract provisions, e.g. increasing collateral Threshold Amounts or lowering ratings downgrade trigger, in the midst of a credit crisis can be exorbitant (“like trying to buy an umbrella in a monsoon”)

  10. Lessons of Recent Financial Crisis for Tax-Exempt Issuers (con’t) • Diversify (credit, liquidity and interest rate) risk! • Possible alternatives to gain financial flexibility in future credit constrained, low-rate environments are: • Increase proportion of committed, term funding (traditional fixed-rate bonds, index notes) in the capital structure • Add debt or investments that perform well when rates decline • Callable fixed-rate bonds or callable (at issuer’s option) swaps • Fixed-receiver swaps • Add synthetic variable-rate debt (fixed-rate bonds + fixed-receiver swap) • Eliminates LOC “rollover” (renewal ) risk • Expand # of swap counterparties • Increases swap “credit line”, e.g. executing 3 ISDA Agreements @ $20MM collateral Threshold Amount creates a $60MM unsecured swap credit line (versus a $20MM line with only 1 ISDA) • Reduces credit risk of a payment default by counterparty • Smaller notional per counterparty makes it easier to novate (transfer) swaps if one defaults • Plan an “Exit Strategy” for Swaps, e.g. • Identify termination payment source, other unhedged debt or investments to allocate swaps

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