04 - 110 Debt Derivatives Policy

A. INTRODUCTION

1. Background - The purpose of this Debt Derivatives Policy is to establish guidelines for the use and management of all interest rate exchange transactions ("Swaps") and similar arrangements entered into by the University System of New Hampshire in connection with the incurrence of debt obligations or in furtherance of other non-speculative corporate purposes. This Policy sets forth the objectives, benefits and risks of a Swap program; discusses procurement and execution of Swap agreements; provides for security and risk mitigation strategies to be used; and requires regular monitoring and reporting; among other provisions. The terms "Debt Derivatives" and "Swaps" are used interchangeably throughout this Policy.
2. Rational for utilizing derivatives - Swaps and related financial instruments are appropriate interest rate management tools. Although not without risk, Swaps when properly used can improve USNH's financial viability, help manage its financial risks, and provide opportunities for interest rate savings. The authorized Swaps contemplated in this Policy are intended to reduce the amount or duration of interest rate risk, or produce a lower cost of borrowing when used in combination with the issuance of bonds. Swap structures will be adopted within plans of finance that are designed to maintain the tax-exempt status of USNH's debt.
3. Swaps may be used for the following purposes only:

a. To achieve significant savings as compared to a product available in the bond market. Significant savings may be deemed to occur if the use of Swaps helps to achieve diversification of a particular bond offering;
b. To prudently hedge risk in the context of a particular financing or the overall asset/liability management of USNH;
c. Synthetically to create variable rate exposure within prudent guidelines through Swap transactions in which USNH effectively exchanges with a Swap counterparty its fixed interest rate obligation on notes or bonds for an obligation to pay to the counterparty a variable interest rate;
d. To lock in fixed rates in current markets for use at a later date, through the use of forward Swaps, swaptions, rate locks, options and forward delivery products;
e. To manage USNH's exposure to the risk of changes in the legal and regulatory treatment of tax–exempt bonds;
f. To manage USNH's credit exposure to financial institutions and other entities through the use of off–setting Swaps and other credit management products; and
g. To achieve more flexibility in meeting overall financial objectives than can be achieved in conventional markets.

4. Situations where debt derivatives may not be used - Swaps may not be used for speculative purposes or to assume risks that are not prudent in light of the purposes for which the Swap transaction is being done. USNH may not enter into any Swap transaction for which there is (a) insufficient market liquidity for its transfer or termination at market, or (b) insufficient price transparency to allow realistic valuation of its market value on an ongoing basis.

B. AUTHORITY FOR DEBT DERIVATIVES AGREEMENTS

1. Board resolution - A vote of the Board of Trustees is required to incur long-term indebtedness in the form of tax-exempt bonds. The use of Swaps is limited to USNH's outstanding or anticipated debt and will be matched to specific bonds. New Swap agreements relating to new bonds require Board of Trustee authorization.
2. Existing bonds and swaps - Terminations, modifications, requests for bids, negotiations, and execution of Swap agreements related to currently outstanding bonds, or Swaps approved in B.1 above, require the joint approval of the Treasurer and the Chairman of the Financial Affairs Committee. USNH will consider the expert advice of Swap Advisor(s) and Bond Counsel as it deems relevant in the circumstances prior to its determination of whether to proceed with execution.
3. Legality - As a condition to the execution of any Swap transaction the USNH General Counsel will produce an opinion (or cause to have a recognized external bond counsel firm produce an acceptable opinion) substantively to the effect that USNH has the power to execute the agreement(s) relating to the Swap, that the agreements are legal, valid and binding obligations of USNH, and that they and their execution and delivery are not inconsistent with applicable laws.

C. PERMITTED FINANCIAL INSTRUMENTS

1. Specific approval instruments - USNH may expressly utilize the following financial instruments, after identifying financial objective(s) to be realized and assessing the attendant risks:

a. Current or forward starting floating-to-fixed rate swaps (Synthetic Fixed), designed to capture current market interest rates, for example, for a bond issue anticipation hedge or a synthetic forward refunding
b. Current or forward starting fixed-to-floating rate swaps (Synthetic Variable), designed to create additional variable interest rate exposure
c. Financial contracts (caps, collars, floors) that limit or bound exposure to interest rate volatility
d. Sale or purchase of options to commence or cancel interest rate swaps (Swaptions)
e. Floating-to-floating rate swaps (Basis Swaps) to manage basis or tax risk

D. SWAP RISK AND BENEFIT ANALYSIS

1. General - In connection with any Swap, USNH and its Swap Advisor, shall review the proposed transaction and outline any considerations associated with the transaction, including identification of the benefits and potential risks; an independent analysis of potential savings from the proposed transaction; fixed versus variable rate and Swap exposure to USNH as a whole; and Maximum Net Termination Exposure for all existing and proposed USNH transactions. The USNH Treasurer shall consider for execution only those proposed transactions that meet the savings thresholds described herein, or that are compelling for other reasons, without incurring undue risks. Sections E through I below describe actions designed to protect USNH interests by maximizing benefits and mitigating risks.
2. Swap risks - In reviewing proposed Swaps, USNH shall consider at a minimum each of the following risks:

a. Counterparty risk - The risk that the Swap counterparty will not fulfill its obligations as specified by the terms of the contract. Under a fixed payer Swap, for example, if the counterparty defaults, USNH would be exposed to an unhedged variable rate bond position and the additional risk that the counterparty may be unable to or fails to make an early termination payment that would compensate USNH for the value of the lost hedge.
b. Termination risk - The risk that the Swap could be terminated as a result of any of several events, which may include a ratings downgrade for USNH or the Swap counterparty, covenant violation by either party, bankruptcy of either party, Swap payment default by either party, and default events under a bond resolution or trust indenture. USNH could owe a termination payment to the counterparty or receive a termination payment from the counterparty, depending on how interest rates at the time of termination compare with the fixed rate on the Swap.
c. Basis Risk - Basis risk refers to a mismatch between the interest rate received from the Swap contract and the interest actually owed on USNH’s related bonds. The risk, for example, in a 67% LIBOR floating to fixed rate Swap is that the variable rate interest payments received at 67% of LIBOR from the Swap counterparty will be less than the variable interest payments USNH must pay on its hedged bonds (assumed to be at or near the SIFMA Index in the case of USNH’s bonds).
d. Tax risk - A potentially long-term form of basis risk resulting from changes in marginal income tax rates and other changes in the Federal and state tax systems. Such changes will affect the relative value of tax-exempt debt. If marginal tax rates decline, the after tax value of tax-exempt income declines, which could cause tax-exempt rates to increase. Tax risk exists in all unhedged tax-exempt variable rate debt. Hedging tax-exempt variable rate debt with a LIBOR-based Swap leaves USNH exposed to the tax risk inherent in tax-exempt debt while hedging with a swap based on the SIFMA index would hedge the tax risk.
e. Amortization risk - Amortization risk refers to a mismatch between the principal amount of hedged bonds and the notional amount of the associated hedging Swap at points in time.
f. Swap rollover risk - If the term of the Swap contract does not match the term of the related bonds being hedged, the risk that upon the scheduled expiration of the Swap, the interest rate risk will be unhedged unless a new Swap is procured.
g. Liquidity/Remarketing risk - The risk that USNH cannot secure a cost-effective renewal of a Letter or Line of Credit or suffers a failed remarketing with respect to the variable-rate bonds underlying a floating-to-fixed swap. This would be due to a credit deterioration of USNH or a general reduction in bank lines available to the broad market.
h. Administrative risk - The need for ongoing expertise and effort to develop documentation, assess pricing, monitor rates, calculate and make payments, manage all aspects of the Swap program, evaluate tax issues, and institute proper accounting and budgeting methodology for the term of the Swap.

3. Swap benefit expectation - Synthetic fixed rate swaps or other derivative products should generate approximately 1% greater projected savings than that which would be expected for traditional bonds. This threshold will serve as a guideline and will not apply should the transaction, in USNH's sole judgment, help to meet any of the other objectives outlined herein. The higher savings target reflects the greater complexity and higher risk of derivative financial instruments. In addition, comparative savings analyses shall include, where applicable, the probability (based on historical interest rate indices, where applicable, or other accepted analytic techniques) of realized savings for both the derivative and traditional structures. Savings are to be calculated after adjusting for (a) applicable fees, including takedown, remarketing fees, credit enhancement and legal fees, and (b) call options that may be available on the bonds. In addition, USNH should examine any other risks added to a transaction, in particular tax risk, and adjust benefit expectations for the value added by taking such risk.

  • Example - Assume a refunding of $100 million of existing bonds, where a traditional fixed rate advance refunding that does not use derivative products may have a present value savings (net of all costs) threshold of $3 million, which is 3% of the refunded par. If the refunding structure utilizes a derivative product, the threshold would have to be $4 million in net present value savings, 4% of the refunded par. Therefore, the transaction utilizing a swap or other derivative product would have to generate an additional $1 million to meet the target in this example.

4. Other considerations - In evaluating a particular Swap transaction, USNH will review long-term implications associated with entering into the Swap, including the costs of borrowing, historical interest rate trends, variable rate capacity, credit enhancement capacity, opportunities to refund related debt obligations and other similar considerations. When considering the relative advantage of using a Swap to synthetically create a fixed rate bond obligation versus the issuance of conventional fixed rate obligations, USNH will take into consideration the value of any call option on fixed rate obligations. USNH shall consider the impact of any variable rate obligations issued in combination with a Swap on the availability and cost of liquidity support for other additional variable rate obligations that may be issued by USNH in the future.

E. LEGAL AND CONTRACTUAL REQUIREMENTS

1. Prior to entering, amending, or terminating any swap, USNH will consider and meet all applicable regulatory requirements for swap transactions in consultation with its advisors and legal counsel.  USNH will consider relevant advisories and maintain full compliance prior to entering, amending, or terminating any swap and provide ongoing monitoring of compliance with the applicable regulations of the CFTC (Commodity Futures Trading Commission) and/or any other body with regulatory oversight of the swap market.
2. Standard documents - USNH will use standard ISDA swap documentation including the Master Agreement, Schedule to the Master Agreement, and a Credit Support Annex. USNH may use additional documentation if the product is proprietary or USNH deems in its sole discretion that such documentation is otherwise in its interest.
3. Terms and notional amount of swap agreement - USNH shall determine the appropriate term for an interest rate swap agreement on a case-by-case basis. In connection with the issuance or carrying of bonds, the term of the swap agreement between USNH and a qualified swap counterparty shall not extend beyond the final maturity date of existing debt of USNH for the related bonds, or in the case of a refunding transaction, beyond the final maturity of the refunding bonds. For purposes of calculating net exposure, credit shall be given to any fixed versus variable rate swaps that offset termination exposure for a specific bond transaction. For variable rate transactions, credit may also be given for any assets that are used to hedge a transaction as long as in USNH’s judgment such assets are reasonably expected to remain in place on a coterminous basis with the swap.
4. Provisions to be included - The swaps between USNH and each counterparty shall include, as appropriate, payment, term, security, collateral, default, remedy, termination, and other terms, conditions and provisions as USNH, in consultation with its Swap Advisor and Bond Counsel, deems necessary or desirable. USNH swap documentation and terms should generally include the following:

a. Downgrade provisions triggering termination shall in no event be worse than those affecting the counterparty.
b. Governing law for swaps will be New York law, but should reflect New Hampshire authorization provisions.
c. The specified indebtedness related to credit events in any swap agreement should be narrowly drafted and refer only to specific debt.
d. Collateral thresholds should be set on a sliding scale reflective of credit ratings (see Collateral below).
e. Eligible collateral shall be as set forth in Attachment A, the Collateral section below.
f. Termination value should be set by "market quotation" methodology, when USNH deems appropriate.
g. USNH should only agree to an Additional Termination Event for USNH to the extent that the ratings on the applicable bonds fall below a ratings trigger acceptable to USNH and the counterparty and no form of credit support or enhancement is in place.

5. Termination provision - All swap transactions shall contain provisions granting USNH the right to optionally terminate a swap agreement at any time over the term of the agreement. Such a provision shall be required even if any termination is at market. In general, exercising the right to terminate an agreement should produce a benefit to USNH, either through the receipt of a payment from a termination or, if the termination payment is made by USNH, in conjunction with a conversion to a more beneficial debt obligation of USNH, as solely determined by USNH.
6. Collateral - As part of any swap agreement, USNH may require collateralization or other forms of credit enhancements to secure any or all swap payment obligations. As appropriate, USNH, in consultation with its Swap Advisor, may require collateral or other credit enhancement to be posted by each swap counterparty under the following circumstances:

a. Each counterparty to USNH may be required to post collateral if the credit rating of the counterparty or parent falls below the “AA” category. Additional collateral for further decreases in credit ratings of each counterparty shall be posted by each counterparty in accordance with the provisions contained in the collateral support agreement to each counterparty with USNH.
b. Threshold amounts shall be determined by USNH on a case-by-case basis. USNH will determine the reasonable threshold limits for the initial deposit and for increments of collateral posting thereafter.
c. In determining maximum uncollateralized exposure, USNH shall also consider and include, as applicable, financial exposure to the same corporate entities that it may have through other forms of financial dealings, such as securities lending agreements and commercial paper investments.
d. Collateral shall be deposited with a third party trustee, or as mutually agreed upon between USNH and the counterparty.
e. A list of acceptable securities that may be posted as collateral and the valuation of such collateral will be determined and mutually agreed upon during negotiation of the swap agreement with each swap counterparty. A complete list of acceptable securities and valuation percentages are included as Exhibit A.
f. The market value of the collateral shall be determined on at least a monthly basis, or more frequently if USNH determines it is in USNH's best interest given the specific collateral security.
g. USNH shall determine on a case-by-case basis whether other forms of credit enhancement are more beneficial to USNH.

F. METHODS OF SOLICITING, PROCURING AND SELECTING SWAP COUNTERPARTIES

1. General - USNH will assess the benefits of competitively bidding financial products that are non-proprietary or generally available in the marketplace. On a case-by-case basis, USNH will have the authority to negotiate the procurement of financial instruments that have customized or specific attributes designed on USNH's behalf. To provide safeguards on all Swap transactions, USNH will secure professional advice of a Swap Advisor and legal counsel familiar with Swaps to assist in the process of analyzing, structuring, documenting and pricing the transaction, and to verify that a fair price was obtained.
2. Negotiated - Negotiated procurement may be used (a) for original or proprietary products, (b) for original ideas of applying a specified product to a USNH need, (c) to avoid potential market pricing effects that would be detrimental to USNH’s interests, or (d) on a discretionary basis in conjunction with other business purposes of USNH.
3. Competitively bid - If USNH determines that a Swap should be competitively bid, at least three bids will be sought. USNH may employ a hybrid structure to reward unique ideas or special effort by reserving a specified percentage of the Swap to the firm presenting the ideas on the condition that the firm match or better the best bid.
4. Counterparty selection - USNH may enter into a Swap transaction only with highly qualified and highly rated counterparties. Qualified Swap counterparties will have demonstrated experience in successfully executing Swaps and, either (a) the counterparty has a credit rating for its long-term, unsecured and unsubordinated obligations of not lower than A2 by Moody's Investor's Service or A by Standard and Poor's Ratings, or (b) the payment obligations of the counterparty are unconditionally guaranteed by a bank or non-bank financial institution with credit ratings that comply with clause (a) above at the time of execution of the Swap agreement. USNH will not enter into Swap agreements with counterparties rated below A2/A by any rating agency. Each counterparty shall have minimum capitalization of at least $150 million.
5. Protection from credit deterioration - USNH shall structure all Swap agreements to protect itself from credit deterioration of counterparties, including the use of credit support annexes or other forms of credit enhancement to secure counterparty performance. Such protection shall include any terms and conditions which, in USNH's sole discretion, are necessary or appropriate or in its best interests. If after entering into an agreement the ratings of the counterparty or its guarantor or credit support party are downgraded below the ratings listed above by any one of the rating agencies, then the agreement should be subject to termination unless (x) the counterparty provides either a substitute guarantor or assigns the agreement, in either case, to a party meeting the rating criteria reasonably acceptable to USNH or (y) collateralizes its obligations in accordance with the criteria set forth in the transaction documents.

G. COUNTERPARTY EXPOSURE LIMITATIONS

1. Diversification of counterparty risk - In order to diversify USNH’s counterparty credit risk, and to limit USNH’s credit exposure to any one counterparty, limits will be established for each counterparty based upon both the credit rating of the counterparty as well as the relative level of risk associated with each existing and proposed swap transaction. The guidelines below provide general termination exposure guidelines with respect to whether USNH should enter into an additional transaction with an existing counterparty. USNH may make exceptions to the guidelines at any time to the extent that the execution of a swap achieves one or more of the goals outlined in these guidelines or provides other benefits to USNH. In general, the Maximum Net Termination Exposure to any single Counterparty should be set so that it does not exceed a prudent level as measured against the gross revenues, available assets or other financial resources of USNH. Accordingly, these guidelines will be reviewed and revised from time-to-time.
2. Prospective analysis - Such guidelines will also not mandate or otherwise force automatic termination by USNH or the counterparty. Maximum Net Termination Exposure is not intended to impose retroactively any terms and conditions on existing transactions. Such provisions will only act as guidelines in making a determination as to whether or not a proposed transaction should be executed given certain levels of existing and projected net termination exposure to a specific counterparty. Additionally, the guidelines below are not intended to require retroactively additional collateral posting for existing transactions. Collateral posting guidelines are described in the “Collateral” section 5.5 above. The calculation of net termination exposure per counterparty will take into consideration multiple transactions, some of which may offset the overall exposure to USNH.
3. Maximum net termination exposure - USNH will set limits on individual counterparty exposure based on existing as well as new or proposed transactions. The sum of the current market value and the projected exposure shall constitute the Maximum Net Termination Exposure. For outstanding transactions, current exposure will be based on the market value as of the last quarterly swap valuation report provided by the Swap Advisor. Projected exposure shall be calculated based on the swap’s potential termination value taking into account possible adverse changes in interest rates as implied by historical or projected measures of potential rate changes applied over the remaining term of the swap. For purposes of this calculation, USNH shall include all existing and projected transactions of an individual counterparty and all transactions will be analyzed in aggregate such that the maximum exposure will be additive.
4. Exposure thresholds - The exposure thresholds will also be tied to credit ratings of the counterparties and whether or not collateral has been posted as shown in the table below. If a counterparty has more than one rating, the lowest rating will govern for purposes of the calculating the level of exposure. A summary table is provided below.


Counterparty Credit Exposure Limits

Credit Ratings
Maximum Collateralized Exposure
Maximum Uncollateralized Exposure
Maximum Net Termination Exposure

AAA
NA
$40 million
$40 million
AA Category
$30 million
$20 million
$40 million
A Category
$20 million
$10 million
$30 million
Below A
None
None
None

If the exposure limit is exceeded by a counterparty, USNH shall conduct a review of the exposure limit per counterparty. USNH, in consultation with its Swap Advisor, shall explore remedial strategies to mitigate this exposure.

H. ONGOING MANAGEMENT AND BUDGETING

1. USNH will manage all Swap transactions centrally for its constituent campuses and units and will charge no less than full debt service based on the all-in fixed rate cost of traditional bonds as if no Swap transaction had taken place. In addition, any net present value savings realized through execution of the Swap agreement will be invested long-term in a fund functioning as endowment under the control of the USNH Board of Trustees. The difference between the fixed rate charged to campus auxiliary units and the actual periodic debt service payments (including variations due to basis exposure) will be added to or subtracted from the funds functioning as endowment to provide a permanent offset to the risks of the Swap transaction.
2. USNH will seek to maximize its benefits and minimize its risks by actively managing its Swap program. This will entail frequent monitoring of market conditions, by both the Swap Advisor and Swap counterparties, for emergent opportunities and risks. Active management may require modifications of existing positions including, for example:

a. Early termination;
b. Shortening or lengthening the term;
c. Sale or purchase of options; or
d. Use of basis swaps

3. Accounting treatment - USNH will evaluate existing and proposed debt derivative transactions under accounting rules, such as GASB 53, to understand the full range of financial statement impacts and fully inform the decision-making process.

I. ONGOING MONITORING AND REPORTING REQUIREMENTS

1. Analysis of quarterly reports - A written report providing the status of all Swap agreements entered into by USNH will be prepared by its Swap Advisor and/or Swap counterparties and analyzed by the USNH Treasurer and Controller, at least on a quarterly basis and shall include the following:

a. A description of all outstanding interest rate swap agreements, including bond series, type of swap, rates paid and received by USNH, total notional amount, average life of each swap agreement, remaining term of each swap agreement.
b. Highlights of all material changes to swap agreements or new swap agreements entered into by USNH since the last report.
c. A summary of Swap agreements that were terminated or that have expired.
d. A summary of principal terms of the agreements, including bond series, type of swap, rates paid and received by USNH, notional amounts, average life of each swap, remaining term of each swap agreement, and method of procurement.
e. The marked–to–market value of each Swap.
f. The name, description and credit ratings of each counterparty and the applicable guarantor or other credit support party.
g. The amounts that were required to be paid and received, and any amounts that were actually paid and received.
h. Listing of any credit enhancement, liquidity facility or reserves and accounting of all costs and expenses associated with the credit enhancement, liquidity facility or reserves.
i. The aggregate marked to market value for each counterparty and relative exposure compared to other counterparties.
j. A calculation of USNH’s Maximum Net Termination Exposure to each counterparty.

2. Annual reporting - An annual summary report shall be prepared and presented by the Treasurer or Controller to the Board of Trustee’s Financial Affairs Committee.

3. Annual disclosure and accounting treatment - USNH shall adhere fully to all applicable Governmental Accounting Standards Board (GASB) requirements and recognized “best practices” for the accounting treatment and disclosure of debt derivative transactions in its audited financial statements and other relevant publications.

Exhibit A - Acceptable Collateral
Exhibit B - Glossary of Terms


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