THE MISSISSIPPI LEGISLATURE

The Joint Committee on

Performance Evaluation and Expenditure Review

Report # 569

A Review of County Governments’ Utilization of Bond Interest Rate Swap Instruments

Executive Summary

Introduction

The PEER Committee received a legislative request to inquire into counties’ use of bond interest rate swaps. In making this request, the legislator referred to an FY 2009 audit report that detailed that a particular county had paid approximately $7.36 million in swap termination fees. The legislator’s concern was that county governments might be utilizing these complex financial derivatives without the necessary knowledge and expertise to ensure quality decisionmaking pertaining to such transactions.

The purpose of this review was to determine whether counties have policies and procedures in place to guide decisionmaking regarding entering into bond interest rate swaps, monitoring the swap agreements in effect, and mitigating the inherent risks associated with utilizing bond interest rate swap instruments.

Background

A bond interest rate swap is an agreement between two parties to exchange or “swap” cash flow commitments related to a corresponding bond issue for a specified period. The county’s intent for entering into bond interest rate swaps is to reduce borrowing costs and improve cash flows. Bond interest rate swaps also have the potential to negatively affect the issuer’s net revenues and cash flows, its overall financial position, the relationship between the issuer and third parties, and future debt management options.

Controls and Best Practices for Bond Interest Rate Swaps

What is the regulatory environment for counties’ engagement in swap transactions?

While state law contains certain requirements that counterparties must meet in order to participate in interest rate swap transactions involving state-issued debt, Mississippi statutes do not address the requirements or standards that counties, or any other local government entity, must meet when considering the execution of interest rate swap agreements. Each county or other local government entity is free to determine, based on its own standards and policies, whether to consider and enter an interest rate swap agreement.

What standards should counties have relating to the use of interest rate swap agreements?

In order to mitigate the risks of bond interest rate swap utilization, counties should adopt best practices for swap utilization. PEER compiled the following list of best practices for using bond interest rate swaps based on a study by the California Debt and Investment Advisory Commission1 and a Moody’s publication:2

• Develop a comprehensive written policy for bond interest rate swap agreements--In accordance with generally accepted public finance practices and in order to mitigate the inherent risks associated with bond interest rate swap agreements, any debt issuer considering entering into a bond interest rate swap agreement should adopt and maintain a written comprehensive bond interest rate swap policy.
• Ensure that individuals managing swaps have appropriate knowledge and expertise--Counties must have adequate financial expertise to manage swap transactions effectively in order to mitigate the inherent risks associated with bond interest rate swap agreements. If counties do not have staff that possess the technical knowledge and skills to manage and monitor the use of swaps effectively, they should solicit the assistance of professionals with the skills, knowledge, and expertise to do so.
• Commit to oversight monitoring--Adequate monitoring and oversight of a bond interest rate swap transaction helps to ensure that the swap’s performance continues to affect the county’s overall financial position positively and that any changes are effectively communicated to all interested parties.

If counties choose to use the Mississippi Development Bank (MDB) when issuing bonds, what requirements does MDB have for interest rate swaps?

Counties that utilize the assistance of the Mississippi Development Bank when issuing bonds must have any subsequent interest rate swap transactions for those bond issues approved by MDB’s governing board. Although MDB had no standards for the engagement of and/or management of interest rate swaps prior to 2006, it subsequently adopted such policies for counties and counterparties and strengthened them in August 2011. MDB’s current derivatives policy requires local governments using MDB for bond issues to submit a uniform credit package and to demonstrate their understanding of the risks associated with swap transactions.

No counties utilizing the MDB’s services have sought a bond interest rate swap transaction since MDB revised and adopted its current derivatives policy in 2011. MDB officials assert that if the occasion arises in which a county becomes interested in engaging in a bond interest rate swap transaction, failure to comply with the current derivatives policy would result in a denial from the bank’s Credit Review Committee and governing board.

Counties’ Use of Bond Interest Rate Swap Transactions

What Mississippi counties have participated in bond interest rate swaps?

According to the most recent county audits released by the Office of the State Auditor, at the time of those audits, only Harrison and Hinds counties had bond interest rate swap agreements in effect. Since 2002, Harrison County has entered into nineteen bond interest rate swap agreements. Since 2005, Hinds County has modified two original bond issues to include swap agreements and these agreements are still in effect, although payments have been suspended until 2015.

What have been these counties’ experiences with bond interest rate swaps?

Harrison and Hinds counties’ utilization of bond interest rate swap agreements demonstrates that use of these instruments can yield significantly different results. Since 2002, Harrison County’s utilization of bond interest rate swap transactions has resulted in a net loss of approximately $4.19 million. Hinds County’s utilization of bond interest rate swap agreements since 2005 has resulted in positive cash flows totaling approximately $6.5 million.

Did these counties comply with the Mississippi Development Bank’s standards for their bond interest rate swaps?

At the time that these two counties engaged in their swap transactions, the Mississippi Development Bank had no operable derivatives policy, thus the transactions were not subject to standards of the MDB. However, any future swap transactions related to these particular bond issues would be subject to MDB’s 2011 derivatives policy and approval by MDB’s Credit Review Committee.

Did these counties follow best practices for their bond interest rate swaps?

Prior to their initial swap agreements, neither Harrison County nor Hinds County had all three elements in place of what PEER believes to be best practices. Since that time, both counties have taken steps to improve their processes, but neither has competitively procured its outside financial advisors for bond interest rate swaps.

• In an FY 2009 audit of Harrison County, the State Auditor noted that the county did not have an adequate, well-informed monitoring process in place for its bond interest rate swaps. The county does not have a comprehensive swap policy and has not used a competitive process to procure its financial advisors, bond counsel, and swap counterparties.
• In an FY 2010 audit of Hinds County, the State Auditor noted that the county lacked adequate procedures to monitor swap agreements and verify the calculations. Hinds County has since hired financial advisors to execute and manage its bond interest rate swaps, but did not utilize a competitive procurement process. The county’s financial advisor recently developed a detailed swap policy.

Implications for Potential Government Users of Bond Interest Rate Swaps

Local governmental entities should exercise due diligence by developing and employing precautionary practices before utilizing bond interest rate swap agreements. The best practices described in this report should apply at any level or function of government, including municipalities, school districts, state agencies, or universities. These best practices should be in place to safeguard the governmental entity and taxpayers and mitigate the inherent risks associated with swap agreements, thus reducing the likelihood of large losses of taxpayer funds. However, considering the complexity of these financial instruments, even these best practices will not guarantee successful experiences.

Recommendations

• In view of the fact that the interest rate swap environment for local governments lacks comprehensive safeguards to ensure that local governments are properly advised on the financial implications of swaps and that counterparties meet certain standards for financial condition, the Legislature should enact legislation to address the following for any interest rate swap or exchange entered into by local governments:
  
  
  • credit rating and net worth requirements for any counterparty to an exchange or swap agreement similar to those required of state interest rate swaps found in MISS. CODE ANN. Section 31-18-11 (1972);
  • development of a risk management policy;
  • mandatory counterparty representations regarding pricing unless the counterparty was selected through a competitive process;
  • determination by the governing body that the swap agreement meets the criteria of the swap policy when approving the swap transaction;
  • quarterly monitoring of the swap transaction while it remains effective;
  • biennial reviews of the local government’s swap policy as long as the swaps remain in force and effect; and,
  • when necessary, competitive selection of legal and financial professionals to assist in overseeing and monitoring local government swaps.
• Regardless of any legislative action that might be taken to regulate the utilization of bond interest rate swap instruments by local governments, any local governmental entity considering the use of such instruments should develop comprehensive bond interest rate swap policies that, at a minimum, reflect the best practices put forth in the California Debt and Investment Advisory Commission’s October 2004 report entitled The Fundamentals of Interest Rate Swaps and Moody’s Investors Service Global Credit Research publication from October 2007 entitled Evaluating the Use of Interest Rate Swaps by U. S. Public Finance Issuers.
  
  The three key elements of these best practices are:
  
  
  • develop a comprehensive written policy for bond interest rate agreements;
  • ensure that individuals managing swaps have appropriate knowledge and expertise (either existing staff or independent, qualified swap advisors, preferably obtained through competitive procurement); and,
  • commit to careful oversight and monitoring of the swap.

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1The Fundamentals of Interest Rate Swaps, California Debt and Investment Advisory Commission, October 2004.

2Evaluating the Use of Interest Rate Swaps by U. S. Public Finance Issuers, Moody’s Investors Service Global Credit Research, October 2007.

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