As issuers across the country take a closer look at their auction-rate security programs, they are finding they must consider the conditions on the interest rate swaps they hold as well.

Over the past few years, deals have been structured that tie auction-rate securities into floating-to-fixed rate swaps, which allow issuers to sell short-term floating debt and swap it out for a lower "synthetic" fixed rate.

The swap is a hedge to offset the variations in the auction-rate market. In such a transaction, the issuer pays the counterparty a predetermined fixed rate, while the counterparty pays the issuer a variable rate, based on the SIFMA index or the London Interbank Offered Rate, plus a spread. This allows the issuer to keep some variable-rate exposure in its debt portfolio while also giving it a constant debt payment over the lifetime of the loan.

Over the last few years such agreements have become some of the muni market's most common interest-rate transactions. "Often times, as a proxy for issuing long-term, fixed-rate debt, a municipality will issue auction-rate securities and swap it out to a fixed rate," said Guy LeBas, fixed-income strategist at Janney Montgomery Scott LLC.

As rising illiquidity has sent yields on auction-rate securities skyrocketing, issuers have looked at a number of ways to keep their borrowing costs low. Each proposed solution is likely to have some bearing on any swaps tied to the auction-rate securities. As each agreement between issuer and counterparty is different, there is a vast array of potential ramifications, market sources said.

"It's an auction problem, it's not an insurance problem," said Kenneth Kaufman, managing partner at Kaufman, Hall & Associates. "How you respond depends on what the components of your program are."

In beginning analysis, one of the largest considerations for an issuer is whether its auction rates are insured, and if so, which insurer it is.

"If you are in a situation where the insurer is one of the double-As now, the borrower is not sure what direction they want to go," Kaufman said. "However, if you have [Financial Security Assurance Inc.] insurance, you are pretty sure you want to do something that preserves the insurance because it clearly has value."

Add to this the question of whether the borrower wants to keep its swap. In the best-case scenario, a conversion from auction rates to variable-rate demand obligations would likely keep a swap contract intact. The ability of an issuer to do this depends largely on whether it is allowed in the swap documents.

"Most of the auction rates are done with multi-modal [options], so you can basically have the same offering of the bonds but in a different mode," said Craig Underwood, president of Bond Logistix LLC. "VRDOs are one of the modes generally put into the auction rate multi-modal document."

In this case, the swap works just like it was supposed to: the issuer receives a rate on the floating leg of the swap that should be about the same as what they are paying through the fixed rate on the variable-rate bonds, Underwood said. The issuer is usually required to tell the counterparty and investors it is changing the mode, which triggers a mandatory tender event, said Bill Doyle, a partner with Orrick, Herrington & Sutcliffe LP.

The only problem is that converting to a variable-rate security requires an additional liquidity feature in the form of a line or letter of credit. This means paying another premium for credit enhancement when many of the auction rates have already been insured once, albeit by a now ailing bond insurer.

"The difficulty is if you need credit enhancement, where are you going to find it and on what terms?"" Underwood said. "Obviously credit is at a premium right now."

Several banks that provide letters of credit have said that inquiries have increased substantially, and market sources have said that some banks have already reached their entire yearly capacity for writing policies, after just a month and a half. The use of LOCs increased 244.4% in January over the same month last year, on 66 deals for total volume of $1.55 billion, according to data from Thomson Financial.

Others will look to refinance the bonds, current-refunding the auction rates at the next auction date and then issuing long-term fixed rates. This may be especially beneficial for issuers, as many are likely to find themselves "out of the money" as interest rates have fallen since they structured the swap.

"People tend to be out of the money in swaps because floating rates are so low," said Peter Block, a director at Standard & Poor's. It may, depending on the issuers' credit and the economic position of the swap, be a viable alternative."

The Securities Industry and Financial Markets Association seven-day swap index stood at 1.24% last Wednesday, while the one-month Libor stood at 3.11%.

In addition, fixed rates are lower than they have been in some time, making it more appealing to refund the variable rate debt and issue fixed-rate bonds. In this situation, the swap contract is voided and the issuer must pay a termination fee. Though this is not ideal, it could save the issuer down the road if auction rates stay high.

"You could finance the termination payment in the new bond deal. Economically that is cheaper than paying for it on the back end of the swap rate," Underwood said. "It may not look as good because one is a big dollar amount and another just changes the coupon payment by a few basis points, but on a present-value economic basis, you are better off financing the termination payment."

Other issuers may look to move the swap agreement to cover other bonds that are not yet hedged. In this case there may be an issue if the swap is moved from general obligation bonds to less creditworthy bonds, according to Block. This would then be subject to some negotiation between issuer and counterparty.

Other swaps, like many basis swaps or constant maturity swaps done when the yield curve was flat, can be moved around relatively freely, he said.

"Swaps are a negotiated contract," Block said. "Part of the restructuring of the bonds associated with the swap usually entails communication between the issuer and the dealer and the terms of the contract vary."

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