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City Manager's 1996 Report Goldman Sachs Interest Rate Swap

City Manager's 1996 Report Goldman Sachs Interest Rate Swap

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01/03/2013

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To:
Attn:From:Date:
Re:
CITYOF
OAKLAND
AgendaReport
Officeof
the
CityManagerCraig
G.
Kocian
Budget
and
FinanceAgencyDecember10,1996
AResolutionSelectingtheCounter-partyforExecution
of
aMaster
Swap
AgreementRelating
to
the
1988
SpecialRefundingRevenueBonds(PensionFinancing),andAuthorizingTaking
of
RelatedActionsSUMMARY.
The
proposed
transactionsoffertheCity
an
opportunity
torealizesignificant
present
valuesavings.Whileeachofthese
proposed
transactions
would
be
closedtoday,thelevelofsavingsfor
both
transactionsispredicated
on
theCity'sabilitytoissuevariableratetaxexempt
bonds
in
1998
and
swap
toafixedrate.
H
conditionschange
suchthat
theCityisunable
to
issuetax-exempt
bonds
in
1998,thesavings
would
beadverselyaffected.As
presentedin
thestaff
report
and
recommendationsofOctober15,1996,
settlementof
the
Columbus
case
has
resolved
many
ofthetax-relatedissuesfortheCity.
In
lightofProposition
218,
thepossible
impact
totheCitywill
bebudgetarypressures
if
thereislossofcertainexistingtaxes
and
assessmentsbeginning
in
July1997.
It
ispossible
that
these
budgetary
pressures
may
have
anegative
impact
on
theCity'sgeneral
fund
and
itsobligations,
and
potentially
even
limittheCity'smarketaccess.However,thereis
no
way
to
determine
at
thistime
what
theultimateeffectofProposition
218
willbe
on
theCity'scredit.Whilestaffbelieves
that
any
possible
market
accessdifficulties
in
1998
have
been
mitigated
byproviding
a
bond
insurancecommitment
today,thistransaction
shouldbe
considered
not
only
foritsbenefitstoday,
but
in
the
contextof
any
futureevents
and
outcomes.
FINANCINGALTERNATIVES.
Sincethe1988SpecialRefundingRevenueBonds(PensionFinancing)are
not
callable
untilAugust
I,
1998,
and
sincetheCity
used
itsone-time
advance
refunding
opportunity
in
1988,theCity
has
twoalternatives:
(1)
to
wait
untilthe
call
date
to
determinethe
feasibility
of
a
current
refundingtorealizesavings(only
if
interest
ratesarefavorable)
or
(2)
mitigateinterestraterisk
by
synthetically
refundingthe
1988
issuetodaythrough
either
theuse
ofa
Swaption
ora
hedge
swap.Bothare
further
definedbelow:
(1)
A
Swaption
is
the
saleoftheright,
but
not
theobligation,toaCounter-partyto
enter
into
an
interestrate
swap
(ataprice
determined
today)
on
acertaindate.
Only
if
the
optionisexercisedwilltheCitysellvariablerate
bonds
in
ordertoexchangethe
streamof
payments.
H
theoption
is
not
exercised,
then
the
City
would
keeptheup-front
payment
as
wellasitsabilitytoissue
bonds
when
interestrates
weremore
favorable.
9999.010
(2)
A
hedgeswap
(orforwardinterestswap)isacontractbetween
the
City
and
a
Counterparty
toexecute
an
interestrate
swap
which
would
begin
at
the
call
date
atwhich
time
the
Citywill
berequired
toissuevariablerate
bonds
and
swap
toafixedrate.Finance
&
LegislationCommittee#
G
December10,1996
 
AResolutionSelectingtheCounter-party
for
Execution
of
aMasterSwapAgreementRelatingtothe
1988
SpecialRefundingRevenueBonds(PensionFinancing),
and
AuthorizingTakingRelatedActions
-
Page2
Goldman
Sachs
hasproposed
aSwaption,
and
PiperJaffray
and
SamuelARamirez,a
hedge
swap.BoththeSwaption
and
hedge
swap
areverysimilar;
both
parties
propose
the
use
ofatriple-AratedCounter-party
and
canimplementeitheracostoffunds
swap
or
an
index-basedswap.Thesavingsassociated
with
eachalternativeare
shown
below:
...
.................................................................................................................................................................................
.
..
$20million
depending
on
~
$20MM;timingof
~
$12.65
vs
$14.43MM;
1
.....................
~ ~ ~
L.
~ . ~ . ~ ~ ~ ~ . ~ . ! . ~ ~
L . . ~ ~ . ? . ~ ~ . ~ ~ ~ . ~ ~ ~
..
~
..
! . ~ ~
j
Goldman
Sachs
(as
ofl2/04/98)
Piper
Jaffray
(as
of12/04/94)
Samuel
A.
Ramirez
(as
of
10/24)
RISKS.
ThesingulargreatestrisktotheCityisitsabilitytoaccessthe
marketin
1998.Thisriskshould
be
mitigated
with
theacquisitionofaforward
bond
insurancecommitment.BothFSA
and
AMBAChaveprovidedpreliminarycommitments
on
twostructures:apensionobligationstructure
andan
assettransfer.
Other
risks
which
are
inherent
to
both
theSwaption
and
the
hedgeswap
are
enumerated
below:
Terminationis
not
an
optionfortheCounter-party
during
the
full
term
ofthetransactionunlesstheCitydefaults
on
itsobligations.Bond
insurer
governstermination
under
adefault;optionalterminationisonly
at
the
discretionoftheCity.However,itisunlikely
that
the
respective
bond
insurers
would
electtoterminate,since
they
would
likely
owe
a
payment
totheCounter-party.WillingnesstoprovideaCostof
Funds
swapwhere
theCounter-partypaysthe
City
its
actualborrowingcost,or
an
indexed-based
swap
where
the
Counter-party
paysthe
CitythePSAindex.However,sincetheCity's
paper
is
exemptfromCaliforniaincometax,
it
islikely
that
the
City'svariableratebondswill
have
lowerinterestrates
than
the
PSAindex,
making
thePSAindexpotentiallymorecost-effective.A
Cost
of
Fundsswapwould
prove
better
if
we
believe
that
theCity'scommercial
paper
would
trade
significantlylower(i.e.,
at
higherinterestrates)
than
national
averages
in
thefuture.
...................................................................................................................
.............
~ ~
..
Bothapproaches
haveproposed
theuseof
AAA
counter-parties.
.......
u"
9999.010
Finance
&
LegislationCommittee#
G
December10,
1 ~ 9 6
II
 
AResolutionSelectingtheCounter-party
for
Execution
of
aMasterSwapAgreementRelatingtothe
1988
SpecialRefundingRevenueBonds(PensionFinancing),
and
AuthorizingTakingRelatedActions
-
Page3
Thepricingof
an
optiongenerallytakesintoconsideration
the
volatilityofthemarket.
In
thiscase,both
the
swaption
and
thehedge
swap
willbepricedas
if
theyareahedgeswap.TheSwaptionwillberequiredtoyieldgreaterorcommensuratesavings
withthehedgeswap
regardless
of
any
perceivedvolatility,
andin
thissense,theCitycanbeassured
that
volatility
will
not
adverselyaffectthepricingoftheSwaption.
OTHERISSUES
Does
not
askforachange
inpayment
if
a"flattax"isproposedorpassed.Sincetherewillbe
bond
insurance,thereisnoreasontobelieve
that
liquiditywill
not
beavailable,barringadeteriorationoftheCity'scredit.Contains
broader
language
in
regard
topotentialconsequencesassociated
with
tax
law
change,aswellasprovisionsforadversechanges
in
tradingperformance
based
on
proposed
changes
even
if
not
enacted.Proposes
the
useofaliquidityguarantee,
whereby
theCounter-party
would
assure
that
liquiditywillbe
provided
forthelifeofthetransaction.However,
the
priceof
theproposed
liquidityisabovethe
currentmarket
price
and
thereisnoreasontobelieve
that
the
expenseisa
good
investment,barringsubstantialdeterioration
in
the
City'scredit.
EmbeddedLoanandSavingsLevels.
BoththeSwaption
and
hedge
swaps
areoff-marketswaps,i.e.,theyare
not
priced
at
par.Off-market
swaps
aregenerally
used
forcashadjustments
when
attemptingtomatchcashflows
on
underlyingtransactionsas
opposed
to
currentmarket
levels.
So
theup-frontcash
payment
is
made
tocompensateforthedifference
between
theoff-marketpriceofthe
swap
and
its
current
market
rate.
It
isthis
up-front
payment
which
raises
an
embedded
loanquestion
vis-a-vistheconstitutional
debt
limitationissue,i.e.,
theCity'sauthority
to
borrow
monies
without
voter
approval.Therefore
under
eitheralternativethesavings
must
be
structuredso
that
it
cannotbeconstrued
as
anembedded
loan.Currently
bond
counsel
has
opined
that
approximatelyonly$10million
in
savings
can
betaken
up-front
toavoid
the
consideration
as
an
embedded
loan.
Interest
Rate
Volatility.
Boththeproposedtransactionsare
very
interestratesensitive.Smallfluctuations
in
interestrates
can
produce
amaterialchange
in
thelevelofsavings.
9999.010
Finance
&
LegislationCOmmittee#
__
&
_
December
la,
1996

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