Early in 2006, First River Advisory observed that the Series 2001 Bonds issued on behalf of Ottumwa Regional Health Center (ORHC) could, under a certain set of circumstances, become candidates to be advance refunded. The Series 2001 Bonds had been issued shortly after the events of September 11, when bond insurers and letter of credit banks were especially risk-averse, fixed-rate market conditions were soft and credit spreads for BBB-rated hospital revenue bonds were wide. Although the Series 2001 Bonds had achieved their balance sheet management objectives, ORHC would have, naturally, preferred a lower interest rate.

Although yields on BBB-rated hospital revenue bonds had improved, present value (PV) savings which could be achieved from a traditional advance refunding remained only marginal. First River Advisory calculated that a synthetic fixed-rate approach would produce sufficient PV savings to warrant the expense and hassle. The resulting transaction was among First River Advisory’s most legally and mathematically challenging.

The cornerstone of the synthetic fixed-rate approach was the availability of a bond insurance policy. Radian Asset Assurance had insured ORHC’s Series 2004 Bonds, which were secured on a parity with the Series 2001 Bonds. First River Advisory created a “win-win” situation for both ORHC and Radian whereby ORHC would, of course, reduce its debt service requirements. First River Advisory pointed out to Radian that it was already at risk for a default on the Series 2001 Bonds, but without having received any compensation. Insuring the Series 2006 Bonds, designed to extinguish the debt evidenced by the Series 2001 Bonds, would enable Radian to earn a premium without appreciably increasing its credit exposure. Radian approved the issuance of a bond insurance policy at a more favorable premium than that which applied to the Series 2004 Bonds, and with only one inconsequential covenant change.

With the commitment for the bond insurance policy in place, First River Advisory’s next task was to explain to the ORHC Board the various alternatives and their associated costs, benefits and risks. The presentation drafted by First River Advisory was especially detailed in its description of the interest rate swaps which would become an essential ingredient of the synthetic fixed-rate approach. In fact, ORHC’s auditors commended First River Advisory on the thoroughness and clarity of this presentation. After vigorous discussion, the Board authorized proceeding with the synthetic fixed-rate approach, though with an added dimension providing for upside potential.

Relatively few synthetic fixed-rate advance refundings have been accomplished because of their legal and mathematical complexity. To advance refund the Series 2001 Bonds, a defeasance escrow would need to be funded from proceeds of the Series 2006 Bonds in an amount sufficient to pay, when due, all interest and principal on the Series 2001 Bonds until their first optional redemption date on October 1, 2012 (the Call Date). The deposit to the defeasance escrow would then be invested in special U.S. Treasury securities known as “SLGS” whose yield is limited by the Internal Revenue Code (IRC) to that of the Series 2006 Bonds. If the Series 2006 Bonds had been fixed-rate instruments, measuring the allowable yield limit would have been a straightforward task. The variable-rate nature of the Series 2006 Bonds complicated matters significantly. One or more interest rate swaps would be necessary to synthetically fix the yield on the Series 2006 Bonds, at least through the Call Date.

To complicate matters further, the ORHC Board inquired whether a barrier swap which had been arranged in connection with the Series 2004 Bonds could be applied to this transaction. The Series 2004 Bonds were issued in the form of variable-rate Auction Rate Securities (ARS) whose main purpose was to refund ORHC’s fixed-rate Series 1993 Bonds. In that context, the barrier swap enabled ORHC to limit its exposure to rising interest rates and ensured that ORHC would be no worse off than if the Series 1993 Bonds had never been refunded. As long as the interest rates on the ARS, determined weekly, remained moderate, ORHC would benefit financially. However, because of the flat (or even inverted) yield curve at the time the Series 2006 Bonds were issued, a barrier swap would not have been effective. As an alternative, First River Advisory ascertained that a constant maturity (CM) swap would achieve the same objective.

To address these complications, First River Advisory collaborated extensively with Bond Counsel in order to ensure compliance with the IRC and related regulations and pronouncements, yet preserve the objective of maximizing PV debt service savings. First River Advisory responded to these legal constraints by designing a financing which featured the following elements:

1. The foundation of the synthetic fixed-rate approach was the issuance of variable-rate demand bonds (VRDBs) instead of ARS. Bond insurance policies do not provide the ready cash needed to purchase VRDBs which are tendered but not remarketed. A standby bond purchase agreement (SBPA) was procured from a bank for this purpose. Bond Counsel agreed that the cost of the SBPA, together with the fees of legal counsel to the bank and to Radian, could be included in the allowable yield limit. The greater the yield on the SLGS in which the defeasance escrow was invested, the lower the initial deposit necessary to meet debt service requirements on the Series 2001 Bonds through their Call Date, and, therefore, the greater ORHC’s PV savings.
2. The first Call Date of the Series 2001 Bonds, October 1, 2012, was more than one five-year arbitrage rebate period from the date of issuance of the Series 2006 Bonds. Bond Counsel required that the synthetic fixed-rate yield determined by the interest rate swap(s) be limited to one such five-year period. First River Advisory’s suggestion to establish an initial (nearly ten-month) fixed-rate period for the Series 2006 Bonds was accepted by Bond Counsel. The yield on the Series 2006 Bonds was set at 3.60 percent, less than eight basis points greater than the yield determined by the interest rate swaps.
3. Bond Counsel required that the interest rate swap in effect during the five years between the end of the initial fixed-rate period and the Call Date be an “integrated” swap. First River Advisory demonstrated that because the BMA Index exhibited a high degree of correlation with yields on bonds similar to the Series 2006 Bonds, Bond Counsel approved its use as a basis for the swap. ORHC executed an interest rate swap with a financial institution (the Counterparty) whereby it will pay a fixed rate and receive from the Counterparty amounts equal to the BMA Index. The fixed rate of 3.525 percent reflected the 2012 maturity of the swap. If the swap based on the BMA Index were to remain in place through the 2031 maturity of the Series 2006 Bonds, the fixed rate would have been approximately 3.90 percent.
4. The ORHC Board found the risks inherent in the CM swap, as calculated First River Advisory, to be tolerable. After the Call Date, ORHC will continue to pay the fixed rate of 3.525 percent, but will then receive from the Counterparty amounts equal to 57.44 percent of 10-year LIBOR. This percentage of LIBOR was calculated to be that which enabled the continuation of the 3.525 percent fixed rate. Assuming that the receipt of 57.44 percent of 10-year LIBOR will be sufficient to pay the interest on the Series 2006 Bonds, the advance refunding will produce approximately $1.6 million of PV debt service savings. First River Advisory calculated that based on nearly 1,000 weekly observations of the relationship between 57.44 percent of LIBOR and the BMA Index (as a proxy for the actual weekly interest rate), there would be only a four percent probability that ORHC would be worse off by having elected to utilize the CM swap. The CM swap exhibited tremendous upside potential – the probability is approximately fifty percent that ORHC’s PV savings could be doubled.
5. First River Advisory observed that ORHC’s execution of the interest rate swaps would be more meaningful in the maximization of PV savings than the sale of the Series 2006 Bonds. To take advantage of favorable market conditions, First River Advisory arranged for the swaps to be priced and executed one month prior to the sale of the Series 2006 Bonds. To satisfy Bond Counsel’s concerns, First River Advisory also arranged for the liquidation of investments held in funds relating to the Series 2001 Bonds in order to reduce the number of variables in calculations.

In addition to its customary functions, First River Advisory also performed statistical analyses to support the integration of the BMA Index swap. Also, because the swaps were negotiated with the Counterparty rather than competitively bid, First River Advisory’s quantitative analyses ensured that they were priced by the Counterparty in a manner consistent with the market. First River Advisory executed and delivered the certificates on which Bond Counsel relied to deliver its legal opinion.

This transaction represented a first for the bank which provided the SBPA, because that bank had just authorized issuing SBPAs in connection with both Radian bond insurance policies and in connection with hospital financings. First River Advisory’s nearly twenty-year relationship with the senior banker was a meaningful factor in obtaining a competitive proposal. This bank’s characteristics are expected to enable the VRDBs to be remarketed at lower yields, compared to its competitors. In addition, the recruitment of a new bank to provide SBPAs in connection with Radian bond insurance policies is expected to benefit the market as a whole. Radian was especially appreciative for adding a new bank to its ranks of SBPA providers.

This transaction exceeded ORHC’s expectations, without transcending its tolerance for risk. The “all-in” interest rate on the Series 2006 Bonds of approximately 4.50 percent was approximately 60 basis points less than that which would have been applicable to Radian-insured natural fixed-rate bonds. Based on First River Advisory’s statistical analyses, the $1.6 million of PV savings has only a remote possibility of being eroded. As consequence of the CM swaps upside potential, ORHC will have a 50/50 chance of doubling those PV savings.

Reference: Dave Recupero, Chief Financial Officer
(641) 684-2585
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