CHICAGO — Indiana would prohibit bond issuers from hedging more than 20% of their outstanding debt in a bill that passed the state Senate Tuesday and now heads to the House.

In addition to the 20% cap, the legislation restricts an issuer's interest-rate swap activity by prohibiting the use of interest-rate swaps as investments and requiring issuers' governing bodies to approve each new swap agreement with a resolution that includes a thorough analysis of potential risks.

The measure also would require issuers to adopt a comprehensive swap-agreement policy, submit the policy to the Indiana Finance Authority for approval, and give its board an annual report detailing the value of its swaps.

Sen. Brent Waltz, R-Indianapolis, said he sponsored the bill after hearing that Indianapolis was forced to pay $160 million in 2009 to terminate negatively valued swap agreements.

"I would be the first to encourage the responsible use of swap agreements to lock in lower interest rates to protect the taxpayer," Waltz said. "But when misused, one could suffer potentially catastrophic losses, and Indianapolis suffered one of those. The legislation would seek to prevent future events like that."

The Senate passed the measure 37 to 11 Tuesday and it now moves to the House.

The Indiana Finance Authority would be authorized to exempt local issuers from the cap and a state issuer could exceed the threshold if it secures approval from the state Budget Committee.

The bill would only apply to new swap agreements — issuers would not be required to terminate existing swaps that exceed the cap.

The bill excludes only the Indianapolis Airport Authority, which specifically asked to be exempted, Waltz said.

The airport has $1.25 billion of outstanding debt, of which about 30% is hedged. "They've shown far better use of swaps, but we'll be monitoring them going forward," Waltz said.

All other state-level and local issuers, including the IFA, the Indiana Bond Bank, and the Indianapolis Local Public Improvement Bond Bank, which is the city's borrowing arm, would be affected by the bill.

For the city's bond bank, the measure would mean less flexibility but have little immediate impact as Indianapolis does not plan to issue any hedged variable-rate debt anytime soon, director Deron Kintner said. "If used properly and conservatively, variable-rate debt and swaps can be a valuable tool for large issuers such as ourselves," he said. "But when overused, it puts an issuer at a lot of risk."

The Indianapolis bond bank has not entered into any new swap agreements during Mayor Greg Ballard's three-year term. But it spent much of 2009 and 2010 shedding nearly all of its hedged variable-rate bonds in favor of fixed-rate debt — and paying the large termination fees noted by Waltz in the process.

The city has shed 92% of its variable-rate debt since 2009. The bond bank has about $4.5 billion of outstanding debt, of which about $50 million is hedged, down from more than $700 million in 2008.

"We want as much flexibility as possible, but on the other hand we are now much too conservative to enter into any swap agreements anyway," Kintner said.

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