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Presentation to the. Third Annual Investment Management Conference, with Consultiva Internacional, Inc. November 15, 2002. Active Debt Management – Managing Interest Rate Risk with Swaps.

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Presentation to the

Third Annual Investment Management Conference, with Consultiva Internacional, Inc.

November 15, 2002

Active Debt Management – Managing Interest Rate Risk with Swaps


Active Debt Management – Managing Interest Rate Risk with SwapsPresentation to Third Annual Investment Management Conference, with Consultiva Internacional, Inc.

Asset and Liability Management 1

Uses of Interest Rate Swaps in Debt Management13

Current Market23

Table of Contents

Merrill Lynch prohibits (a) employees from, directly or indirectly, offering a favorable research rating or specific price target, or offering to change such rating or price target, as consideration or inducement for the receipt of business for compensation, and (b) Research Analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investor clients.


Asset and Liability Management


Investing Capital

Surplus Return

Maximize

Minimize

Raising Capital

Risk Management

Asset and Liability ManagementSurplus Return

Actively manage entire balance sheet

Adopt a risk-based approach to raising and investing capital to maximize surplus returns.


6

1

2

5

3

4

Asset and Liability ManagementSummary

RESULT

Moderate-to-Aggressive risk tolerance.

Gather Information & Establish Goals

Risk Appraisal

Liquidity Assessment& Capital Segmentation

Asset/Liability

Management

Monitoring & Surveillance

RESULT

Balanced portfolio with assets allocated in 4 categories.

RESULT

Adopt a target for variable rate exposure (e.g. 50%).

Liability Optimization

Investment Optimization

Optimizing liabilities is part of a comprehensive balance sheet management process.


1. Interest Rate Exposure

Pay Fixed or Variable?

Risk v. Reward:Greater Uncertainty = Lower Expected Cost

3. Tax Law Risks

2. Liquidity Considerations

Accept or Eliminate?

Committed or Temporary?

Asset and Liability ManagementLiability Optimization

Three inter-related decisions lead to an optimal liability structure.


Low

Variable Rate

Debt

Expected Cost

Fixed Rate

Debt

High

Risk

Low

High

Asset and Liability ManagementPortfolio Approach: Getting Appropriate Fixed/Variable Balance

A mix of both fixed rate and variable rate debt reduces risk while minimizing expected debt cost.

Variable Rate Debt

100%

Fixed Rate Debt

100%


Why Variable Rate Debt and How


Why Variable Rate Debt and HowFixed Rate Debt Versus Variable Rate Debt

Historically, variable rate cost of funds has been less than fixed rate cost of funds.

Fixed Rate Debt

Variable Rate Debt

BMA Index

Revenue Bond Index


Fixed Rate Debt

Large Spread=

Savings with Variable

Variable Rate Debt

Why Variable Rate Debt and HowFixed Rate Debt Versus Variable Rate Debt

Recently the spread between fixed rate and variable rate has been unusually large.

BMA Index

Revenue Bond Index


Why Variable Rate Debt and HowMarket Volume

The use of interest rate swaps by government and non-profit organizations has steadily increased. It now exceeds the issuance of direct tax-exempt variable rate bonds by four to five times.

Billions

Bond statistics from Securities Data Corp. Swap statistics estimated as independent data are not available.


Why Variable Rate Debt and HowImportance of Variable Rate Debt and Swaps

  • Savings

    • Historically, variable rate debt is less expensive than fixed rate debt

    • Variable rate debt saves money in low interest rate environments

  • Risk management

    • Variable rate debt can reduce risk when interest rates are low

  • Swap Programs

    • Cost effective way of obtaining variable rate debt or more fixed rate debt

    • Hedge against rising interest rates

    • Simple to execute compared to bond issuance

  • Ongoing Liability Management

    • Debt programs should be actively managed, just as assets should be managed

    • Identify market opportunities to manage debt


Reduced Interest Cost

Asset-Liability Balance

Benefits of Variable Rate Exposure

Flexibility: Easy to Adjust/Restructure

Adjustable Risk Profile

Why Variable Rate Debt and HowBenefits

Issuers should determine and then achieve an optimal level of variable rate exposure.


Direct Variable Rate

Puttable and non-puttable products.

Synthetic Variable Rate

Fixed rate debt converted to variable with interest rate swaps.

Increased cash flow and protection against rising interest rates.

Variable Rate Hedging

Why Variable Rate Debt and HowVariable Rate Products

Understanding the risks and mechanics of variable rate products is essential for effective liability optimization.


Issued for a term, but remarketed periodically

Letter of credit needed for liquidity or bond insurance

Principal exchanged

Simple accounting treatment

Put risk for some forms of variable rate debt

Transaction need only be completed once

Credit terms negotiated between two parties before execution; no third party required

No principal exchanged

Accounting treatment for swaps depends on structure

Why Variable Rate Debt and HowDifferences between Traditional and Synthetic Fixed Rate Debt

Traditional Variable Rate Debt (Bonds)

Synthetic Variable Debt (Swaps)


Interest Rate

Changes in interest rates will affect cost of funds.

Tax

Lower marginal tax rates may increase cost of funds.

Lower demand for bonds of comparable organizations may increase cost of funds relative to other borrowers.

Industry/Regional

Institution-Specific

Any credit deterioration may increase cost of funds.

Higher cost or unavailable bank liquidity facilities.

Liquidity

Swap counterparty unable to make periodic or reversal payments.

Counterparty

Why Variable Rate Debt and HowRisk Components

Both direct and synthetic variable rate exposure introduce multiple risk elements.


Uses of Interest Rate Swaps in Debt Management


Fixed-to-Floating Swaps


Fixed-to-Floating SwapsFixed Receiver Swaps Convert to Variable Rate

  • Fixed receiver swap: Issuer receives a fixed rate and pays a variable rate, typically the BMA Index (e.g. 3.35% for 10 years).

  • Notional amount: The size of the interest rate swap and the dollar amount used to calculate interest payments. There is no obligation to pay principal.

  • Term: The length of time payments are exchanged.

An interest rate swap is a contract between the issuer and counterparty to exchange payments--one fixed and one variable--for a period of time.

Risk Analysis

Interest Rate

Tax

3.35%(1)

Industry/

Regional

Merrill Lynch

Issuer

Institution-Specific

BMA Index = 1.50%(2)

5.00%(3)

Liquidity

Bondholders

Counterparty

(1)10-Year BMA swap rate.

(2)Approximate BMA Index.

(3)Typical fixed rate paid to bondholders.


Fixed-to-Floating SwapsCash Flow and Mark-to-Market Sensitivity

Cash Flows

Interest rate savings are affected by the BMA Index, term and notional amount.

Mark to Market on a $100 million notional amount(2)

The mark-to-market will go up or down depending on interest rate movement and the passage of time.

(1)Approximate average of BMA Index since 1992.

(2)Assumes rate movement occurs immediately after execution of 10-year swap.


Floating-to-Fixed Swaps


Floating-to-Fixed SwapsFixed Payer Swaps Convert to Fixed Rate

  • Fixed payer swap: Issuer pays a fixed rate and receives a variable rate, typically the BMA Index (e.g. 3.55% for 10 years).

  • Notional amount: The size of the interest rate swap and the dollar amount used to calculate interest payments. There is no obligation to pay principal.

  • Term: The length of time payments are exchanged.

An interest rate swap is a contract between the issuer and counterparty to exchange payments--one fixed and one variable--for a period of time.

Risk Analysis

Interest Rate

Tax

3.55%(1)

Industry/

Regional

Merrill Lynch

Issuer

Institution-Specific

BMA Index = 1.50%(2)

BMA Index + 0.40%(3)

Basis

Bondholders

Counterparty

(1)10-Year BMA swap rate.

(2)Expected BMA Index.

(3)Typical rate paid to bondholders BMA +0.40% including remarketing and liquidity fees.


Floating-to-Fixed SwapsCash Flow and Mark-to-Market Sensitivity

Cash Flows

Interest rate savings are affected by the BMA Index, term and notional amount.

Mark to Market(2)

The mark-to-market will go up or down depending on interest rate movement and the passage of time.

(1)Approximate average since 1992.

(2)Assumes rate movement occurs immediately after execution of 10-year swap.


Basis Swaps


Basis Swaps

  • Issuer receives a fixed percentage of 1-month LIBOR (i.e., 81.00% for 20 years).

  • Issuer pays the BMA Index, which is typically 64.50% of 1-month LIBOR.

A BMA/LIBOR basis swap is the exchange of payments based on two variable interest rates:

Risk Analysis

Interest Rate

Tax

81.00% of 1-Month LIBOR = 1.91%(1)

Merrill Lynch

Issuer

Industry/

Regional

Gross

Institution-Specific

BMA Index = 1.50%(2)

Merrill Lynch

Issuer

0.41%

Liquidity

Net

Counterparty

On a $100 million notional amount, 0.41% equals $410,000 of annual cash flow. At the 1992-date average BMA Index of 3.18%, annual cash flow would be $861,000.

(1)In the form “x% of 1-month LIBOR = y%,” x% is the ratio between a 20-year BMA swap and a 20-year LIBOR swap. 1-month LIBOR assumes a BMA Index/1-month LIBOR ratio of 64.50%, and is adjusted to an Act/Act day count.

(2)Approximate BMA Index.


Basis SwapsHedging Effect/Combined with Receiver Swaps

Basis swap cash flows partially hedge the interest rate risk of variable rate debt. Cash flows also increase when BMA Index/1-month LIBOR ratios are low.

Ratios are primarily and inversely affected by marginal tax rates.

(1)Current approximate BMA Index.

(2)Approximate average since 1992.


Basis SwapsMarket Value

Projected Value Based on $100 Million Notional Amount in ($000s)(1)

The mark-to-market will decrease to zero as the swap nears maturity.

(1)Assumes rate movement occurs immediately after execution of 20-year swap.


Basis SwapsBasis Swap Ratio History

20-Year Basis Swap Ratio

Basis swap ratios are currently high due to the exceptionally high municipal supply.

+1 stdev

-1 stdev


Swap Reversals


Swap ReversalsRates

Current and Historical Yield Curves

The current yield curve is steeper than average.

Short swaps offer the greatest incremental benefit.

10-Year Average vs. Current BMA Swap Rates


Swap ReversalsLockouts

On a $100 million notional amount, execute a 5-year BMA receiver swap today at 2.59% lockout the first year at 1.58%. Receive an upfront cash benefit of $1 million for this 1-year “lockout.”

Cash Flows

2.59%(1)

Merrill Lynch

Issuer

BMA Index = 1.50%(2)

Upfront Cash Benefit: $1,010,000 (1-Year “Lockout”)

$1,467,000 (2-Year “Lockout”)

Timeline (2-Year “Lockout”)

Swap cash flows are temporarily suspended. In return, the issuer receives an upfront cash benefit equal to the anticipated savings during the lockout period.

2002

2003

2007

No variablerate exposure

during thelockout period

Execute transaction

Cash flow begins

Swapmatures

When interest rates rise in the future, the issuer can extend the swap at a higher rate.

(1)5-year swap rate.

(2)Approximate BMA Index.


Current Market


Current MarketFactors Dictating Swap Opportunities

BMA Index — Historic Lows

10-Year Payer Swap Rates — Historic Lows

20-Year Basis Swap Ratios — High

Option Volatility — High


Current MarketCapitalizing on Recent Market Conditions

Fixed Receiver Swaps

  • Execute short swaps (5 years or less) to take advantage of low variable rates for the next few years.

  • Extend to longer maturities when rates increase.

    Fixed Payer Swaps

  • Issue variable and swap to fixed.

  • Resulting cost of “synthetic” fixed rate debt is less than that of AAA GO bonds.

    Basis Swaps

  • Current BMA/LIBOR ratios at record highs due to excess municipal supply and lowest Fed funds in 40 years.

  • Consider delaying start for one year to avoid current negative cash flows.

    Options

  • Consider selling swap options to counterparty while volatility is high and options are historically expensive.


Current MarketCase Study: Swap Program Management

Fixed-to-Floating Swap Program

Fixed Receiver Overview

Swaps Reversal

Reversal of 1996 Swap

Execution of 4 New Swaps

  • “BBB” hospital wanted to obtain variable exposure and used fixed receiver swaps to do so.

  • Swaps “tranched” to minimize market timing risk.

  • When interest rates declined, and mark-to-market values of the swaps were favorable, hospital “reversed” swaps, generating up-front cash payments of $7.2 million.

Total Profit & Upfront Payments: $7,260,000

$90 Million Basis Swap Program

Basis Swap Overview

  • Basis swaps also “tranched.”

  • Basis swaps further reduced cost of funds and hedged receiver swaps against rise in interest rates.

  • Even after fixed receiver swaps reversed, the basis swaps were maintained because they have generated $730,000 for the hospital to date and they are expected to continue to do so.

Swap #1

Swap #2

Swap #3

Total Profit & Accrued Interest to Date: $731,000


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