WASHINGTON - The Texas Veterans Land Board last week unwound an interest rate swap that had served its purpose: locking in more than $5 million of savings on a $278 million refunding.
"It was a pretty classic example of taking textbook theory and applying it to the real world," said Rusty Martin, director of funds management for the board.
Although the swap was short lived, plain-vanilla, and in the taxable Libor market - all unremarkable traits - the transaction is still very interesting because it made possible a taxable refunding of outstanding tax-exempt bonds. "I don't think it's done very often," Martin said. "If you can do something on a taxable basis it opens up a lot of avenues ... particularly with regard to investments."
Generally, tax-exempt rates are so much lower than taxable ones that it is difficult to refinance the former with the latter.
In order to terminate the swap, the board had to pay counterparty AIG Financial Corp. $1.365 million because rates had fallen since December, when the swap was priced. However, even after making that payment, the board realized effective gross present-value savings of $5.76 million, Martin said.
If rates had risen, the board would have received a termination payment from AIG, which would have offset the higher issuance costs caused by higher rates. Either way, officials would have been above their $5 million minimum savings and very close to their $5.8 million of projected savings.
"We envisioned terminating the swap regardless of what happened," Martin said. "We locked in the savings we had available on Dec. 4. It made no difference to us what the market did, assuming spreads stayed the same."
He explained that a significant shift in the relationships between tax- exempt munis, taxable munis, and the Libor swap market could have hurt the board. Libor stands for London Interbank Offered Rate and reflects rates in the taxable fixed-income market.
The board is no stranger to the swap market, having completed four swaps in 1997 - both taxable and tax-exempt - and more than that in previous years, said financial adviser John Rauscher, managing director at Dain Rauscher Inc.
"They make very good use of interest-rate swaps both as a hedging tool and a risk management tool. They're a very innovative client," Rauscher said.
The transaction rests on the Veterans Land Board's status as a private- activity issuer. Tax law prohibits advance refundings of private-activity bonds. So when officials saw that rates in December were low enough to make a taxable refinancing work, they could only lock in the savings through a forward swap or a forward refunding bond issue.
"We had to come up with something creative," Martin said. The board chose a swap, deciding forward bonds would have been too expensive.
Rauscher oversaw the competitive bidding to select a counterparty on the swap. AIG, Ambac Financial Group Inc., CIBC Wood Gundy, Lehman Brothers, and Bear, Stearns & Co. all bid on the transaction.
AIG won, promising to pay a fixed rate of 6.179% once the bonds were issued in April, with payments scheduled to drop off when the original bonds would have retired, from 1998 to 2003. In return, the board agreed to pay a floating rate set exactly at the six-month Libor rate.
"The taxable swap market has evolved to such a point where you're going to achieve very efficient pricing" through competitive bidding, Martin said.
However, the swap never materialized. It was put in place merely to hedge against interest rate risk and lock in December's saving levels. "The transaction worked out as it was originally contemplated," Rauscher said. "We were very pleased with the way it worked."
In the end, the issue the board priced Wednesday had a true interest cost of approximately 5.97%, compared to the outstanding bonds' TICs of 7.48% for the 1985 series and 6.77% for the 1986 series. The swap termination and bond pricing occurred within 15 minutes of each other, Rauscher said.
And because the bonds are taxable, officials aren't restricted on their earnings from bond proceeds, which will be used to fund high-rate loans. "We keep all that excess spread" between the loans and the bond rate, he said.
The bond underwriter was Merrill, Lynch & Co. and co-bond counsel were Akin, Gump, Strauss, Hauer & Feld and Wickliff & Hall.
