While other agencies embraced the concept, the Alaska Housing Finance Corp. took a skeptical view of derivatives. Entering into a long-term swap contract on floating-rate bonds that have to be called when home loans are paid back, it figured, seemed too risky a proposition.
So when the agency did a $170 million floating-to-fixed interest-rate swap on mortgage revenue bonds in May with Lehman Brothers, it did so only after paying Lehman for call options, giving it the extra security that it could call parts of the swap if the bonds were called.
"I just felt more comfortable with this approach," said Joseph M. Dubler, chief financial officer at the AHFC. "It is a logical solution to the problem that swaps present to housing issuers. It's an idea whose time has come."
Since the spring, Alaska Housing has become at least the fourth state housing agency to enter into floating-to-fixed swaps that are structured with call options, joining the California Housing Finance Agency, the Connecticut Housing Finance Authority, and the Pennsylvania Housing Finance Agency.
The agencies are using options to increase their comfort with swaps and expand their exposure to synthetic fixed rates. The development promises to further expand the use of derivatives in the housing sector, which has struggled with the problem of the unpredictably of designing swaps tied to highly callable mortgage revenue bonds.
"This is the latest evidence of housing authorities trying to extract more value out of the derivatives market," said Kemp J. Lewis, vice president in the capital markets group at Goldman, Sachs & Co. "Now they are using call options to more finely manage the optionality of their balance sheets."
Indeed, while the use of options has been expanding across the municipal derivatives market, the call option seems tailored for mortgage revenue bonds, which have a much higher rate of retirement than other bonds, as a result of the frequency of mortgage refinancing. This is particularly true in today's low rate environment.
Embedding options in swaps precludes housing agencies from having to pay hefty termination fees to dealers to end swap agreements as prepayments force them to call bonds.
However, there are mitigating factors to the benefits of call options. First off, they are not free. Issuers pay up front for the increased flexibility by paying higher synthetic fixed rates than they would otherwise pay dealers in swap agreements. If the cost of the option is too high, issuers could lose the incentive to do the swap.
Balancing the price of the option against the rate savings is an issue for the entire municipal market, as is the use of floating-to-fixed-rate swaps, which for most issuers require credit enhancement on the floating-rate bonds.
"The downside of selling more variable debt and taking advantage of swaps is you need to use up more bank liquidity for these transactions," said Kenneth R. Carlson, director of financing at California Housing Finance. "Eventually there could be a limit to how much bank liquidity is available to an issuer."
Also, call options only mitigate some of the myriad risks that crop up when issuers enter into these side agreements to manipulate the interest rates on their bonds. They do not remove them entirely.
Alaska maximized its flexibility by embedding a series of options into its swap. It sold $200 million in variable-rate demand bonds in the spring, and swapped to synthetic fixed rates on $170 million of the bonds. Both the bonds and swap mature in 2034.
The agency has call options embedded in $120 million of the $170 million swap, and pays a synthetic fixed rate of 4.34% to Lehman on the $120 million. With the options, it can call $20 million of the swap in each of the years between 2012 and 2014, $15 million in both 2015 and 2016, and $30 million in 2017. In 2012 and 2013, it paid a call premium. From 2014 to 2017, the option was priced as though the swap was callable at par.
It did not embed an option in $50 million of the $170 million swap and is paying a synthetic fixed rate of 4.103% on that piece of the deal. While it has call options on most of the swap, it can terminate any of the $170 million swap for a penalty throughout the life of the deal.
For this flexibility, Alaska Housing said it paid around 20 basis points more in synthetic fixed rates, which it said were around 70 basis points lower than conventional fixed rates. Under the swap, it pays the synthetic fixed rates to Lehman, while it gets 68% of the London Interbank Offered Rate from Lehman, which is used to pay the holders of the variable-rate debt.
While the floating-to-fixed swap has become an increasingly popular way for agencies to lower their financing costs, the Alaska option was a little more complicated. As opposed to staggering in a number of options, agencies have priced in one call option in their long-term swap contracts in two of the other deals done since the spring.
"There's a lot of benefit to it," said Robert A. Lamb, president of Lamont Financial Services Corp., financial adviser to the Connecticut HFA. "You get the rate benefit of the swap and the financial flexibility to call it if you need to."
Connecticut Housing did two $5 million swaps with 10-year call options with Goldman Sachs in a recent deal and paid around 25 basis points, Lamb said. Pennsylvania Housing recently did a $30 million swap with a 10-year call, also with Goldman as the counterparty.
"It's not that expensive," said Brian Hudson, deputy executive director of the Pennsylvania HFA. "It's pretty much a gimme in this market."
In the case of California Housing, it sold $44 million in synthetic fixed-rate bonds with staggered call options as part of a recent $170 million deal with Salomon Smith Barney Inc., as opposed to $44 million in conventional fixed rates with calls. It said it did so because conventional fixed-rate housing bonds with call options are "less economical" in this low rate market compared to synthetic fixed-rate bonds with calls.
The options are also being done in the other direction. For instance, earlier this year Goldman Sachs paid an up-front fee to the Texas Veterans Land Board in order to add a conditional option to a floating-to-fixed swap on single-family housing bonds that lets the dealer end the swap if Libor rates average a certain level.
"As swaps evolve, dealers are tailoring them to the issuer's needs," said Peter Block, Standard & Poor's associate director. "They are customizing them more."
