Every toll agency needs a Mary Z Connaughton - Swaptions 101

Smart, informed, curious, hardworking, fearless, a good speaker and a quick writer, Mary Z Connaughton is the kind of board member every public toll authority could use. An accounting teacher, she is also a partner in a business development firm. Here's her explanation of how the Massachusetts Turnpike got into a financial mess with "swaptions" - an edited version of a piece she did for a blog at the Boston Herald - full version here:

 http://www.bostonherald.com/blogs/news/toll_talk/?p=146&srvc=home&position=recent

"A swaption is an option to 'swap' interest rates. Here’s the skinny on the turnpike’s story:

"In 1997 and 1999, the turnpike issued $2.4 billion of fixed rate bonds to fund the Big Dig, with annual interest averaging about 4.8%. The bonds were structured to bar refinancing for ten years. In 2001, interest rates dropped but the Turnpike was boxed in at the higher rates by the bar on refinancing.

"The Big Dig and other costs left the turnpike scrambling for cash. Wall Street firm, UBS, offered a fix: “synthetic” refinancing. In effect, the turnpike could receive upfront amounts close to the savings it would have received over time if the bonds could have been refinanced.

"The deal was that the turnpike sold UBS an option to swap interest rates in return for $29 million in cash upfront. When UBS exercises the option the Turnpike owes interest payments to UBS at the rate of 4.8% on $800 million of debt for 30 years. It gets tricky here because no new debt is actually issued, hence the term “synthetic”.

"UBS owes the turnpike a variable market interest rate on the same debt base.

"To minimize risks if UBS exercised its option, the turnpike planned to refinance its fixed rate debt to variable rate debt so it would pass variable rate payments to bondholders and pay UBS the fixed rate it would have been paying to bondholders all along - the 4.8%.

"Theoretically, the refinancing would hedge the turnpike’s risks related to interest rate fluctuations.

"In 2007, UBS began to exercise its options but complexities erupted. Credit market woes and complexities from other swaption agreements prevented the turnpike from refinancing.

"The difference between the fixed rate the turnpike pays and the variable rate it receives widened to such an extent that payments are projected to be $3 million a month - $36 million in 2010.

"Under certain conditions, the contract could terminate and the value of the contract would be owed to UBS. What the turnpike sold for $29 million in 2001 has ranged in value to UBS between $300 million and $400 million in recent months.

"Contract provisions could make the turnpike liable for the current contract value under certain conditions. The turnpike is working with the state to try eliminate this risk.

"The current impact of all this is that the turnpike’s interest rate on a third of its debt effectively increased from 4.8% to over 9%, although the rate will likely change along with market conditions.

END Swaptions 101 by Mary Connaughton

TOLLROADSnews 2009-06-23