SWAPs and Other Derivative Products
Potential savings. Governmental issuers and conduit borrowers are increasingly turning to derivatives as a means of reducing interest costs and minimizing interest rate exposure. Derivatives are risk-shifting agreements, the value of which is derived from the value of an underlying asset. Derivative products include a wide range of instruments or features in addition to interest rate swaps, such as caps/floors/collars, collateralized mortgage obligations, currency swaps, floaters/inverse floaters, forwards, futures, interest-only and principal-only securities and options, so it is imperative that both governmental issuers and conduit borrowers consult experienced counsel to determine the appropriateness of any proposed product and to evaluate its associated risks.
Interest rate swaps. The most common derivative in public finance is an interest rate swap. In the typical "floating to fixed rate swap" governmental issuers and conduit borrowers (collectively referred to herein as the "Borrower") can take advantage of current low interest rates by issuing variable rate bonds and entering into a fixed rate swap with respect to such bonds, rather than issuing traditional fixed rate bonds. Due to efficiencies in the swap pricing market, the Borrower will usually pay a fixed interest rate under the swap that is significantly lower than the interest rate or yield it would pay if it issued traditional fixed rate bonds. This presents attractive opportunities for both new money issues and refundings.
Guidance with unfamiliar and complex derivative products. Peck Shaffer attorneys will help governmental issuers make the initial determination as to their constitutional and statutory authority to enter into derivative contracts, which varies greatly between jurisdictions. Peck Shaffer attorneys are available for meetings and seminars to provide Borrowers with the information necessary to make well-reasoned decisions with respect to these potentially advantageous, but complex products.
Experience with all aspects of documentation. Peck Shaffer attorneys are experienced in understanding the economic implications and the legal and financial risks of derivative products. Peck Shaffer attorneys are also experienced in drafting the legislation necessary for a governmental issuer to enter into an agreement with respect to derivative products, which in many jurisdictions requires the express approval of the agreement and acknowledgement of the potential risks by the governmental issuer. Documentation for such transactions includes forms prepared by the International Swaps and Derivatives Association ("ISDA"), typically a master agreement, schedule, credit support annex and one or more confirmations. Peck Shaffer attorneys are very familiar with these increasingly sophisticated documents.
Federal tax implications. Peck Shaffer's tax attorneys understand the potential federal tax implications of the use of derivative products. For example, the issuance of variable rate bonds coupled with a fixed interest rate swap may have federal tax implications with respect to the federal tax-exempt status of a Borrower's variable rate bonds. In particular, depending on the terms and conditions of the swap and whether certain procedural steps are taken to identify the swap on the books and records with respect to the Borrower's bonds within three days after execution of the swap, the yield on the governmental issuer's bonds for arbitrage rebate and yield restriction purposes may either be computed by taking into account the swap (commonly referred to as an "integrated swap") or by not taking into account the swap (not surprisingly, commonly referred to as a "non-integrated swap" or a "disintegrated swap"). Furthermore, depending upon the purpose of the bond issue (i.e., new money, current refunding or advance refunding), the need to be able to properly take into account the swap in computing the arbitrage yield could be essential to maintaining the federal tax-exempt status of the governmental issuer's bonds. Due to these implications and the complexity of the federal arbitrage regulations, Peck Shaffer attorneys can provide consultation early on in any transaction where a swap is contemplated in order to explore all appropriate strategies and to assist with the completion of all procedural steps in a timely fashion.
