Swap Services

SCM offers advisory services to clients who are in the process of evaluating or considering their options in the derivatives market. Our swap advisory package consists of the following services:

Approach to Swap Advisory Services

SCM employs a collaborative approach in working with the underwriting and financing team. Over the last 10 years, SCM has developed strong working relationships with numerous swap providers, investment banks, bond counsel, and tax counsel. While we lead and manage the derivatives process, we work in the context of the overall financing and involve all working group members as necessary. We ensure timing and structure are commensurate with the overall financing goals and strategy. The duration of the process varies and depends upon a number of factors, including the scope of the project, complexity of transactions, market conditions, deal pricing methodology, and nature of the client’s staff and Board.

SCM is the only swap advisory firm in the country that has designed and built its own proprietary pricing platform for derivatives that has both front office and back office functionality and provides live, real-time pricing.

There are many facets of each swap advisory assignment. SCM is experienced at guiding clients through the following concerns using a highly effective, proven approach to interest rate risk management:

Discovery

The first phase of each engagement entails review of the related financing documents, including the Trust Indenture, Reimbursement or Loan Agreement, Authorizing Resolution, Official Statement, Rating Agency Reports and any Debt Management or Derivative Policies that may exist. If the issuer has not adopted a resolution permitting the use of swaps and derivatives, SCM will work with the client and counsel to create and adopt an appropriate resolution to fit the organization’s financing goals.

Developing a Derivative/Swap Policy

An integral part of any swap advisory engagement is the development (or review if one exists) of a Derivative Policy or Swap Management Plan. The implementation of a policy sends a clear signal to the capital markets, credit sources, and rating agencies of an issuer’s careful approach to the use of derivatives. SCM reviews each client’s swap policy to ensure the policy meets or exceeds the rating agencies’ requirements. If a client does not have a swap policy in place, SCM can assess the client’s needs, and then help to create a customized policy based on long-term financing plans. Typically the end result is three to 15 pages in length and addresses the relevant scoring criteria listed under Standard & Poor’s Debt Derivative Profile (DDP) as well as the criteria considered by Moody’s and Fitch.

Strategy Development

We then work with our client’s finance team to determine the appropriate use of swaps in light of their overall debt strategy, risk tolerance, and financial picture. We consider how much fixed and variable rate exposure the client prefers, the risks the client seeks to hedge, and the level of cash flow variability and risk the client is able to tolerate. Creating and managing a swap portfolio requires a dynamic approach because markets change over time. Successful strategies in today’s environment may be different from strategies that worked well in the past, and they must consider future rate environment implications. SCM also conducts in-depth discussions with our clients to evaluate counterparty risk, termination risk, rollover risk, basis risk, tax event risk and amortization risk. We then identify strategic alternatives and help the client select the approach most appropriate for their situation.

Swap Structuring

At a more detailed level, SCM compares alternative swap structures. We use quantitative models to conduct a cash flow analysis of each alternative and illustrate the present value and basis spread implications in various rate environments. Clients are able to apply this hands-on education to model their own "what-if" scenarios. Structures are then selected to balance the cost of financing and the effectiveness of the hedge while mitigating risk according to the client’s risk tolerance and rate environment viewpoint.

Swap Documentation

All swaps are governed by standard documentation prepared by the International Swaps and Derivatives Association (ISDA). SCM conducts a thorough review of each section and clause in the client’s ISDA Master, Schedule, and Credit Support Annex, and confirms standards for the 1992 or 2002 version as appropriate. We hold detailed educational sessions to ensure that our clients have a complete understanding of critical business issues, such as termination events, collateral thresholds, and calculation methodologies. We then negotiate on our client’s behalf to ensure that they receive the most favorable business terms possible.

Executing the Swap Transaction

As an active participant in the derivatives market, SCM has established a well-defined process for negotiating and bidding out swaps. There are a myriad of factors that determine the appropriateness of competitive or negotiated methods of procuring derivatives. SCM understands the fine line issuers must walk in managing counterparty relationships. Issuers are compelled to procure derivatives at a competitive level, but it is also important for issuers to maintain strong banking relationships. These relationships enable an issuer to benefit from the banks’ intellectual capital and entertain new strategies focused on the issuer’s particular needs. Competitively bidding derivative products can often produce a more favorable rate for a single transaction; however, negotiating with a single counterparty can create a stronger relationship, leading to idea flow, better service, and favorable economics for the issuer in the long term. SCM helps clients to make the most appropriate decision for each transaction and ultimately manage these counterparty relationships to their fullest.

Whether negotiated or competitively bid, SCM builds the trade on our own proprietary platform, conducts preliminary indicative pricing with the counterparty, and prices the trade on a live basis in our system to achieve maximum transparency. For competitively bid transactions, we develop term sheets or RFPs and evaluate all responses. In negotiated transactions, we negotiate with the counterparty to achieve a fair spread to cover the dealer’s credit cost and profit. For either method of procurement, our independence coupled with the rigor of the process ensures fair pricing for the client.

Price Verification

After each swap transaction is completed, SCM provides the client with a comprehensive Price Verification Report (Fairness Opinion) that describes the market environment, historical perspectives, pricing methodology, software, and analytical resources used to price the transaction and determine fair market value. We also provide comprehensive integration certificates as required by tax counsel.

Accounting

Issuers need to be aware of the accounting treatment for derivative transactions. SCM is familiar with the principles of hedge accounting and the specific requirements of FAS-133 and the developing GASB equivalent. Depending on the issuer, FASB hedge accounting treatment could be elected, thereby muting income statement volatility created by the change in value of derivatives. SCM is a member of the GASB Derivatives and Hedging Project task force. The goal of this group is to determine the GASB’s direction for treatment of derivatives in financial statements. The project team has in-depth knowledge of both FAS Statement 133 and GASB reporting requirements. Currently, GASB only requires an annual footnote disclosure regarding the change in value of your derivatives; however, they are following in the footsteps of FAS-133 to develop hedge accounting rules. We provide advice on the pros and cons of using hedge accounting as well as the mechanics of creating a GASB Disclosure document or hedge designation document at inception and performing effectiveness testing throughout the life of the hedge.

Ongoing Swap Monitoring

SCM provides clients with ongoing swap surveillance services through the DerivActiv web site. Clients will have access to an independent source of derivative valuation and cash flow information. DerivActiv will provide independent valuation data for management decisions and for accounting statements, will provide independent cash flow calculations, will send notifications when credit or collateral triggers are breached, and will provide portfolio-level analysis of your risk exposures.

Specialized Swap Services

SCM can also provide highly specialized services that are useful for planning and monitoring:

Value at Risk (VaR)

SCM has conducted VaR calculations at a portfolio as well as individual deal level for our clients. VaR is essentially a statistical measure of a probabilistically determined change in expected value of an instrument or portfolio due to fluctuations in market factors over a defined time horizon. The calculation encompasses an analysis of interest rates relative to volatility measures, within defined statistical confidence intervals. Several simulations are run across these measures to arrive at a useful measure of Value at Risk. VaR measures are useful as both a planning and monitoring tool.

Shock Analysis

A more simplistic measure of risk is a simple shock analysis. The analysis involves shocking interest rates and identifying the impact of the change in rates on a swap’s Market to Market Value. We have the ability to shock interest rates several different ways from simple parallel curve shifts (upwards or downwards) to more custom defined curve shifts with curve steepeners, flatteners as well as curve inversions. We also have the ability to shock municipal rates for changes in SIFMA ratios. Again, these can be custom defined to the extent of having a different shift parameter defined for each point on the forward curve. Again our clients have found this to be an indispensable tool, both for purposes of planning, when entering into new transactions, as well as for ongoing monitoring and management of counterparty risk.

QRATE Analysis

SCM subscribes to QRATE, a service provided by Moody’s Investors Service. QRATE enables us to estimate the rating that would be assigned to a non-rated credit based on a small number of variables. By obtaining an estimated rating, we are able to determine appropriate comparable transactions and achieve greater pricing transparency for our non-rated clients.

Additional Swap Considerations

Tax Related

SCM is well versed on various tax issues affecting issuers, including, but not limited to, integration, super integration and arbitrage issues. SCM remains current on recent developments in federal tax laws and works closely with our outside counsel and the relevant bond counsel in advising a specific issuer. SCM is also aware of unsettled tax issues regarding LIBOR swaps and works closely with our outside counsel to resolve any issues raised by such swaps or other unique swap products.

Legal

SCM understands the various legal and credit issues unique to swap transactions, including the ability and the authority of various types of issuers to enter into swap agreements under applicable law and other authorizing documentation. In addition, SCM regularly analyzes credit issues specific to issuers, including, but not limited to, the sources of payment for the regularly scheduled and termination payments, whether such payments are secured or unsecured and whether such payments are made on parity or subordinate to the related "obligations." SCM also advises issuers on the creditworthiness and appropriateness of swap providers.

SCM is familiar with the appropriate level of disclosure for swap agreements, including, but not limited to, requirements found in MSRB Rules, NFMA's White Paper on Disclosure of Swaps and other applicable securities laws and regulations. SCM regularly coordinates appropriate disclosure with underwriter's counsel.

Credit Rating

SCM helps each client assess the impact of derivative transactions on their credit ratings. The first step in being prepared for the rating agencies is to develop a Derivative Policy or Swap Management Plan. A policy sets forth an approach for future transactions, and it creates an institutional memory for the issuer’s staff. When implemented, it sends a clear signal to the capital markets, credit sources, and rating agencies of an issuer’s careful approach to the use of derivatives.

SCM has helped numerous issuers create swap policies, ensuring the policy meets or exceeds the rating agencies’ requirements. A general outline for a Rating Agency Presentation should contain at minimum the following points.

• Source of Payment and Lien
• Legality
• Swap Structure Risks
• Early Termination Analysis
• Termination Risk Mitigation Strategies
• Quantifying Net Variable Rate Debt and Swap Risk

Standard & Poor’s has developed a “Debt Derivatives Profile” to help identify the general risk level associated with an issuer’s exposure to derivatives. The DDP score is part of the overall credit rating assigned to the issuer. It is expressed on a scale ranging from 1 to 5, with 1 representing the lowest risk and 5 representing the highest risk. They are currently revising the scale based on their experience over the last year. On the 1 to 5 scale, obtaining a score of 1 or 2 required a favorable assessment of each of the following four components:

• Issuer termination and collateral posting risk;
• Counterparty termination credit risk;
• Economic viability of the derivative portfolio;
• Management/Quality of swap and debt management policies and procedures

SCM has interfaced directly with S&P regarding the DDP process and with the other agencies as part of the overall credit rating process. We are intimately familiar with the DDP scoring system and criteria. An important part of our job includes negotiating on the issuer’s behalf with the rating agencies early in the swap structuring and document negotiation processes, as the structure and legal terms may ultimately impact the DDP score and/or credit rating.

At this time, the other rating agencies are incorporating their assessment of derivatives within the overall rating assigned to an issuer. They have published memorandums with guidelines, but they have not developed distinct derivatives rating systems like S&P. The factors they consider include goals for entering into the swap, market risk exposure, operating flexibility, debt levels, access to additional capital, likelihood of an issuer downgrade triggering a collateral call or termination payment, and financial management capabilities.