The Board adopted the U. T. System Interest Rate Swap Policy to govern the use by The University of Texas System of interest rate swap transactions for the purpose of either reducing the cost of existing or planned Revenue Financing System debt, or to hedge the interest rate of existing or planned Revenue Financing System debt.

U. T. SYSTEM INTEREST RATE SWAP POLICY

I. Authority

State law authorizes the U. T. System (System) to enter into interest rate swap transactions and related agreements (Chapter 55 of the Texas Education Code and Chapter 1371 of the Texas Government Code). Pursuant to this authority, the U. T. Board of Regents (Board) approved the Eighth Supplemental Resolution to the Master Resolution, authorizing the System to enter into Master Swap Agreements with certain counterparties, in 1999.

II. Purpose

This policy will govern the use by the System of interest rate swap transactions for the purpose of either reducing the cost of existing or planned Revenue Financing System debt, or to hedge the interest rate of existing or planned Revenue Financing System debt. By using swaps in a prudent manner, the System can take advantage of market opportunities to reduce costs and reduce interest rate risk. The use of swaps must be tied directly to System debt instruments. The System shall not enter into swap transactions for speculative purposes.

III. Legality/Approval

To enter into a Master Swap Agreement (which governs each swap transaction), the System must receive: 1) approval from the Board; 2) approval by the Texas Attorney General, 3) approval from the Texas Bond Review Board, and 4) an opinion acceptable to the Authorized Representative from bond counsel that the agreement relating to the swap transaction is a legal, valid, and binding obligation of the System and that entering into the transaction complies with applicable State and federal laws.

IV. Form of Swap Agreements

Each new Master Swap Agreement shall contain terms and conditions as set forth in the International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement, as amended, and such other terms and conditions including schedules and confirmations as deemed necessary by an Authorized Representative.

V. Methods of Soliciting and Procuring Swaps

Swaps can be procured via competitive bids or on a negotiated basis. The competitive bid should include a minimum of three firms with counterparty credit ratings of ‘A’ or ‘A2’ or better from Standard & Poor’s or Moody’s, respectively. An Authorized Representative may allow a firm or firms not submitting the bid that produces the lowest cost to match the lowest bid and be awarded up to 40% of the notional amount of the swap transaction.

An Authorized Representative may procure swaps by negotiated methods in the following situations:

1. A determination is made by an Authorized Representative that due to the complexity of a particular transaction, a negotiated bid would result in the most favorable pricing.

2. An Authorized Representative makes a determination that, in light of the facts and circumstances, doing so will promote the System’s interests by encouraging and rewarding innovation.

VI. Management of Swap Transaction Risk

Certain risks are created when the System enters into any swap transaction. In order to manage the associated risks, guidelines and parameters for each risk category are as follows:

Counterparty Credit Risk

To limit and diversify the System’s counterparty risk and to monitor credit exposure to each counterparty, the System may not enter into a swap transaction with an otherwise qualified counterparty unless the cumulative mark-to-market value owed by the counterparty (and its unconditional guarantor, if applicable) to the System shall be less than or equal to $30 million.

The $30 million limitation shall be the sum of all mark-to-market values between the subject counterparty and the System regardless of the type of swap transaction, net of collateral posted by the counterparty. Collateral will consist of cash, U. S. Treasury securities, and Federal Agency securities guaranteed unconditionally by the full faith and credit of the U. S. Government. Collateral shall be deposited with a third party trustee acceptable to System, or as mutually agreed upon between System and each counterparty.

Specific limits by counterparty are based on the cumulative mark-to-market value of the swap(s) and the credit rating of the counterparty. The limits are as follows:

Counterparty Long-Term Debt Rating (lowest prevailing rating from Standard & Poor’s / Moody’s)	Maximum Cumulative Mark-to-Market Value of Swaps Owed to System by Counterparty (net of collateral posted)
AAA / Aaa	$30 million
AA+ / Aa1	$25 million
AA / Aa2	$20 million
AA- / Aa3	$15 million
A+ / A1	$10 million
A / A2	$5 million

If a counterparty’s credit rating is downgraded such that the cumulative mark-to-market value of all swaps between a counterparty and the System exceeds the maximum permitted by this policy, the counterparty must either terminate a portion of the swap, post collateral, or provide other credit enhancement that is satisfactory to the System and ensures compliance with this policy.

Termination Risk

The System shall consider the merits of including a provision that permits it to optionally terminate a swap agreement at any time over the term of the agreement (elective termination right). In general, exercising the right to optionally terminate an agreement should produce a benefit to the System, either through receipt of a payment from a termination, or if a termination payment is made by the System, a conversion to a more beneficial debt instrument or credit relationship. If no other remedies are available, it is possible that a termination payment by the System may be required in the event of termination of a swap agreement due to a counterparty default or following a decrease in credit rating.

Amortization Risk

The amortization schedules of the debt and associated swap transaction should be closely matched for the duration of the swap. Mismatched amortization schedules can result in a less than satisfactory hedge and create unnecessary risk. In no circumstance may the term of a swap transaction extend beyond the final maturity date of the affected debt instrument, or in the case of a refunding transaction, beyond the final maturity date of the refunding bonds.

Basis (Index) Risk

Basis risk arises as a result of movement in the underlying variable rate indices that may not be in tandem, creating a cost differential that could result in a net cash outflow from the System. Basis risk can also result from the use of floating, but different, indices. To mitigate basis risk, any index used as part of an interest rate swap agreement shall be a recognized market index, including but not limited to the Bond Market Association Municipal Swap Index (BMA) or the London Interbank Offered Rate (LIBOR).

Tax Risk

Tax risk is the risk that tax laws will change, resulting in a change in the marginal tax rates on swaps and their underlying assets. Tax risk is also present in all tax-exempt debt issuances. The Office of Finance will need to understand and document tax risk for a contemplated swap transaction as part of the approval process.

VII. Reporting Requirements

The Annual Financial Report prepared by the System and presented to the Board will discuss the status of all interest rate swaps. The report shall include a list of all swaps with notional value and interest rates, a list of counterparties and their respective credit ratings, and other key terms.

VIII. Definitions

Authorized Representative: For purposes of this policy, an Authorized Representative includes the Vice Chancellor for Business Affairs, the Vice Chancellor and General Counsel, the Associate Vice Chancellor for Finance, and the Director of Finance.

BMA Index: The Bond Market Association Municipal Swap Index, the principal benchmark for the floating rate payments for tax-exempt issuers. The index is a national rate based on a market basket of high-grade, seven-day, tax-exempt variable rate bond issues.

Counterparty: A participant in a swap or other derivatives agreement who exchanges payments based on interest rates or other criteria with another counterparty.

Hedge: A transaction entered into to reduce exposure to market fluctuations.

Interest Rate Swap (or Swap): A transaction in which two parties agree to exchange future net cash flows based on predetermined interest rate indices calculated on an agreed notional amount. The swap is not a debt instrument and there is no exchange of principal.

ISDA Master Agreement: The International Swaps and Derivatives Association, Inc., is the global trade association for the derivatives industry. The ISDA Master Agreement is the basic governing document that serves as a framework for all interest rate swap, swap enhancement, and derivative transactions between two counterparties. It is a standard form used throughout the industry. It is typically negotiated once, prior to the first transaction, and remains in force for all subsequent transactions.

LIBOR: The London Interbank Offered Rate. The rate of interest at which banks borrow funds from other banks in the London interbank market. It is a commonly used benchmark for interest rate transactions ranging from one month to one year.

Mark-to-Market: Calculation of the value of a financial instrument (like an interest rate swap) based on the current market rates or prices of the underlying indices.

Master Resolution: The Amended and Restated Master Resolution Establishing The University of Texas System Revenue Financing System, adopted on February 14, 1991, amended on October 8, 1993 and August 14, 1997, and each supplemental resolution thereto authorizing parity debt.

Notional Amount: The size of the interest rate swap and the dollar amount used to calculate interest payments.

Last reviewed October 2003