POLICY STATEMENT 139

INTEREST RATE SWAP AGREEMENT

POLICY PURPOSE:

The Town of Cary, North Carolina (Town of Cary) has determined to compile in a single written instrument the policies and practices to be used in connection with the Town procurement of and entering into interest rate swap agreements (also known as interest rate exchange agreements) and related transactions.  For such purpose, Town staff has reviewed the relevant policy adopted for the State of North Carolina and has consulted the Local Government Commission and the Town’s swap advisor and bond counsel.  Specific legislative authorization for these agreements and transactions exists in G.S. Chapter 159, Article 13, §§ 159-193 to 200, inclusive, as enacted by Chapter 388, Session Laws of 2003.

This policy will govern the use by the Town of interest rate exchange agreements.  An “Interest Rate Swap Agreement” or “Interest Rate Exchange Agreement” is a written contract entered into in connection with the issuance of debt obligations for the Town or in connection with Town debt already outstanding with a counterparty to provide for an exchange of payments based upon fixed and/or variable interest rates.  The failure by the Town to comply with any provision or condition of this policy will not invalidate or impair any Interest Rate Exchange Agreement.  Prior to entering into any interest rate swap agreement, the town council will pass a resolution authorizing the same.

Independent Financial Advisor

The Town will retain an experienced, independent financial advisor prior to entering into an Interest Rate Swap Agreement. Duties of the financial advisor will include advice with respect to the structure, terms and provisions of any proposed interest rate exchange transaction and provision of an opinion to the Town that any interest rate swap agreement approved by the Town provides fair market value to the Town as of the date of its execution.  In appropriate circumstances, the Local Government Commission may serve as financial advisor for these purposes.

Conditions Under Which Interest Rate Swap Agreements May Be Entered Into

Purposes

Interest Rate Swap Agreements may be used for the following purposes including but not limited to the following:

1. To achieve significant savings as compared to a product available in the bond market.  Savings gained by executing an interest rate swap agreement shall be calculated after adjusting for a) applicable fees, including takedown, remarketing fees and credit enhancement fees and b) call options that may be available on the bonds.  Examples may include synthetic fixed rate debt and synthetic variable rate debt.  Alternatively, significant savings are deemed to occur if the use of derivatives helps to achieve fixed or variable rate diversification of a particular bond offering.
2. To enhance investment returns within prudent risk guidelines.
3. To prudently hedge risk in the context of a particular financing or the overall asset/liability management of the Town.  Examples may include buying interest rate caps and entering into delayed start swaps.
4. To incur variable rate exposure within prudent guidelines.
5. To achieve enhanced flexibility in meeting overall financial objectives than available in conventional markets.  An example may include the sale to a counterparty of an option to require the Town to issue or incur particular obligations to retire other obligations (swaption) with an upfront payment to the Town.

Legality

The Town will abide in all respects with the provisions of G.S. Chapter 159, Article 13 as may be amended from time to time.  In addition, the Town must receive an opinion acceptable to the market from a nationally recognized law firm that the interest rate swap agreement is a legal, valid and binding obligation of the Town and entering into the transaction complies with applicable law.

Speculation

Interest rate swap agreements will not be used for speculative purposes. Associated risks will be prudent risks that are appropriate for the Town to take.

Methods by Which Contracts Will Be Solicited and Procured

The Town will procure interest rate swap agreements by either competitive bidding or through negotiations with one or more counterparty.  The Town, with the advice of the Local Government Commission if necessary, will determine which parties are qualified and may participate in a competitive or negotiated transaction. When the Town wishes to achieve diversification of counterparty exposure in a competitively bid transaction, the Town may allow a firm or firms not submitting the bid that produces the lowest cost to match the lowest bid and be awarded up to a specified percentage of the notional amount of the interest rate swap agreement. In addition, to encourage competition, the Town may allow bidders to match the winning bid up to a specified amount of the notional amount as long as their bid is no greater than a specified spread from the winning bidder. The parameters for the bid will be disclosed in writing to all potential bidders.

Notwithstanding the competitive parameters outlined above, the Town may procure interest rate swap agreements by negotiated methods in the following situations:

1. The Town makes a determination that, due to the size or complexity of a particular swap, a negotiated transaction would result in the most favorable pricing and terms.  The Town will use an independent financial advisory firm and/or the Local Government Commission to assist in the price negotiations in the development of terms and in risk assessment.
2. The Town makes a determination, in light of the facts and circumstances, that doing so will promote its interests by encouraging and rewarding innovation.

If procured through negotiation, the Town shall obtain an independent opinion from its financial advisor that the terms and conditions of the interest rate swap agreement reflect a fair market value of such agreement as of the date of its execution.

Counterparty Selection Criteria

The Town may enter into an interest rate swap agreement if the counterparty has at least two long term unsecured credit ratings in the double A category from Fitch, Moody’s, or S&P and the counterparty has demonstrated experience in successfully executing interest rate swap agreements.  If after entering into an agreement the ratings of the counterparty are downgraded by any one of the rating agencies below the ratings required by this policy, then the agreement shall be subject to termination unless a) the counterparty provides either a substitute guarantor or assigns the agreement, in either case, to a party that is acceptable to the Town that meets the rating criteria or b) the counterparty (or guarantor) collateralizes the interest rate swap agreement in accordance with the criteria set forth in this policy and the interest rate swap agreement.

Form and Content of Interest Rate Swap Agreements

To the extent possible, the interest rate swap agreements entered into by the Town will contain the terms and conditions set forth in the International Swap and Derivatives Association, Inc. (“ISDA”) Master Agreement, including any schedules and confirmation.  The schedule will be modified to reflect specific legal requirements and business terms desired by the Town.

The Town will consider embedding optionality including provisions that permit the Town to assign its rights and obligations under the interest rate swap agreement and to optionally terminate the agreement at its market value at any time.  In general, except in the event of the counterparty’s ratings being downgraded below the ratings required by this policy (See Counterparty Selection Criteria,) the counterparty will not have the right to assign or optionally terminate an agreement.

Events of Default

Events of default of a counterparty will include the following:

1.      Failure to make payments when due,

2.      Material breach of representations and warranties,

3.      Illegality,

4.      Failure to comply with downgrade provisions, and

5.      Failure to comply with any other provisions of the agreement after a specified notice period.

The Town will incorporate into any swap contract the right to terminate the agreement upon an event of default by the counterparty.  Such right may be conditioned on the consent of a third party such as the Local Government Commission and any person providing credit enhancement or liquidity in any related transaction.  Upon such termination, the counterparty will be the “defaulting party” for purposes of calculating the termination payment owed.

Risk Exposure Associated with Interest Rate Swap Agreements

Before entering into an interest rate swap agreement, the Town will evaluate all the risks inherent in the transaction.  These risks to be evaluated would include counterparty risk, termination risk, rollover risk, basis risk, tax event risk and amortization risk.  The Town will endeavor to diversify its exposure to counterparties.  To that end, before entering into a transaction, the Town will determine its exposure to the relevant counterparty or counterparties and determine how the proposed transaction would affect the exposure.

Provisions for Collateralization

Should the rating of the counterparty, or if secured, the entity unconditionally guaranteeing its payment obligations not satisfy the requirements of the Counterparty Selection Criteria, then the obligations of the counterparty will be fully and continuously collateralized by direct obligations of, or obligations the principal and interest on which are guaranteed by, the United States of America and such collateral will be deposited with the Town or an agent thereof.  In the case of an interest rate swap agreement, such collateral posted by the counterparty will have a net market value of at least 100% of the net market value of the agreement to the Town.

Standards for Procurement of Credit Facilities

The selection of the provider of the credit enhancement or liquidity facility in connection with an Interest Rate Swap Agreement will be based on the following criteria:

1. Credit Rating,
2. Capacity of the provider,
3. Ability of provider to make required payments,
4. Duration of the agreement relative to the duration of the Interest Rate Swap Agreement,
5. Terms of the agreement, including termination events,
6. Trading value of the provider’s facility,
7. Prior experience with provider,
8. Cost, relative to other proposals and potential savings versus unenhanced obligations,
9. Overall exposure of the Town to the provider,

10.    Overall exposure of market to provider, and

11.    Ability to accept terms and condition proposed.

The procurement of any liquidity and credit enhancement facilities will be in compliance with applicable State law.

Long-Term Implications

In evaluating a particular transaction involving the use of interest rate swap agreements, the Town will review and discuss with the Local Government Commission the long-term implications associated with entering into interest rate swap agreements, including costs of borrowing, historical interest rate trends, variable rate capacity, credit enhancement capacity, opportunities to refund related debt obligations and other similar considerations.

Reporting

The Town will reflect the use of interest rate swap agreements on its financial statements in accordance with generally accepted accounting principles.

Monitoring

The Town will monitor its use of interest rate swap agreements as follows:

1.   After each interest rate swap agreement has been completed, staff will prepare a description of the contract, including a summary of its terms and conditions, the notional amount, rates, maturity and other provisions thereof;

2.   On each payment date, staff will determine any amounts which were required to be paid and received, and that the amounts were paid and received;

3. Staff will annually determine that each counterparty is in compliance with its rating requirements, or more frequently when information is available that could negatively affect the counterparty’s ratings;
4. If a counterparty is no longer in compliance with its rating requirements, staff will determine that it is in compliance with the downgrade provisions, (See Counterparty Selection Criteria); and
5. Staff will determine, at least semiannually, that all posted collateral, if required, has a net market value of at least 100% of the net market value of the agreement to the Town (See Provisions for Collateralization).