The Nevada Housing Division has warned the U.S. Treasury Department that if it does not make changes to its proposed arbitrage regulations, the division may not be able to obtain the best possible interest rates for mortgages for first-time homebuyers.
In a four-page letter sent to Treasury officials on March 7, the housing agency asks department officials to reconsider one of the proposed regulations' two tests for determining whether variable rate bonds hedged with taxable index-based interest rate swaps can be treated as variable yield bonds for purposes of determining if arbitrage was generated.
Swaps with floating payments based on taxable rates, such as the London Interbank Offered Rate, have become commonplace in the muni market. The Nevada Housing Division told the Treasury that it typically issues a portion of its qualified mortgage bonds as variable-rate demand obligations. The division then hedges those obligations with variable-to-fixed rate swaps because it is averse to variable interest rate risk. To obtain the best price, the division said it often enters into Libor-based swaps.
However, under the proposed rules, such transactions must first pass both a "snapshot" test and a "historical" test, to determine whether the floating rate on the Libor or other taxable index-based swap and the variable rate on the underlying bonds are "substantially the same."
The snapshot test must show that the rates are no more than 0.25% apart on the date the swap was entered into. The historical test must show that the average difference between the interest rate on the bonds and the rate on the Libor-based swap did not exceed 0.25% for the three-year period before the issuer entered into the swap.
The Nevada agency had trouble meeting the "snapshot" test and asked the Treasury to remove it from the proposed regulations.
John Swendseid, a partner at Swendseid & Stern in Reno who authored the letter on behalf of the Housing Division, said he was approached by the agency after it discovered that if the proposed regulations had been finalized, it would have failed the snapshot test.
"I think the housing division just wanted to add a 'me too' letter. They had an experience last fall where exactly what we hope won't happen happened, and they failed a snapshot test ... but were fine on the historic test," he said.
In the letter, the agency contended that since the interest rate it can give on mortgages is directly tied to the interest rate on its bonds under the tax code, it would have a problem because it must pursue the best possible interest rate. If the agency cannot pass both tests, it must opt for more conservative strategies to ensure compliance, driving up rates on mortgages.
"The end result would be a higher cost of capital for the Nevada Housing Division and a correspondingly higher mortgage interest rate for the first-time homebuyers whose home mortgages are financed by the Nevada Housing Division - a very undesirable result in the days of a difficult credit market for mortgages," the letter stated.
Treasury officials could not be reached for comment on the letter or the status of the regulations.
