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


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

    2. 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 Management 13 Current Market 23 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.

    3. Asset and Liability Management

    4. 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.

    5. 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.

    6. 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.

    7. 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%

    8. Why Variable Rate Debt and How

    9. 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

    10. 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

    11. 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.

    12. 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

    13. 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.

    14. 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.

    15. 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)

    16. 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.

    17. Uses of Interest Rate Swaps in Debt Management

    18. Fixed-to-Floating Swaps

    19. 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.

    20. 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.

    21. Floating-to-Fixed Swaps

    22. 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.

    23. 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.

    24. Basis Swaps

    25. 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.

    26. 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.

    27. 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.

    28. 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

    29. Swap Reversals

    30. 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

    31. 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.

    32. Current Market

    33. 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

    34. 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.

    35. 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

    36. This information is for your private information and is for discussion purposes only. We are acting solely in the capacity of an arm’s length counterparty and not in the capacity of your financial adviser or fiduciary. We or our affiliates may buy or sell instruments identical or economically related to any instruments mentioned here. We or our affiliates may have an investment banking or other commercial relationship with the issuer of any security or financial instrument mentioned here or related thereto. Generally, all over-the-counter (“OTC”) derivative transactions involve the risk of adverse or unanticipated market developments, risk of illiquidity and other risks. Unless specifically stated otherwise, any transaction terms are indicative only and are subject to change and any prices mentioned here are not bids or offers by Merrill Lynch to purchase or sell any securities or financial instruments. All trades are subject to credit approval. Prior to undertaking any trade, you should discuss with your professional tax or other adviser how such particular trade(s) affect you. This brief statement does not disclose all of the risks and other significant aspects of entering into any particular transaction. Options are not suitable for all investors. Option buyers may lose their entire investment. Option sellers may have an unlimited loss.