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Michigan Defies Harvard Losses by Boosting Swap Bets on Rates

Michigan State University, the 11th-largest college in the U.S. with more than 46,000 students, plans to place new bets in the derivatives market even as it seeks to unwind existing interest-rate swaps linked to its debt.

The university, which raised in-state undergraduate tuition 5.2 percent last year as its endowment returns tumbled, will acquire $162 million of so-called basis swaps that wager on the difference between tax-exempt and taxable bond rates, according to Moody’s Investors Service. It is also set to borrow about $229 million in tax exempts this week, using some of the proceeds to refinance floating-rate bonds and terminate other derivatives, said Glen Klein, the school’s director of investments and financial management.

“It’s a risk that we understand and are comfortable taking,” said Klein regarding the basis swaps. He declined to say how much they will pay to terminate swaps.

Michigan State, based in East Lansing, historically “pursued an aggressive strategy” using derivatives in an attempt to lock in low fixed rates after selling floating-rate bonds, said Moody’s, which has a negative outlook on the credit.

Like other schools that embraced derivatives, it is restructuring bonds and unwinding agreements that no longer produce savings. Unlike most other tax-exempt borrowers, it is also adding new swaps, said Andrew McKendrick, a managing director at PFM Asset Management LLC in Philadelphia.

Debt Refinancing

Wesleyan University in Middletown, Connecticut, last month sold $186.6 million of fixed-rate bonds as it sought to refinance all its debt, replacing floating-rate securities linked to derivatives, according to Moody’s. David Pesci, a spokesman, declined comment.

Northeastern University in Boston paid $40 million to exit $296 million of contracts earlier this year, Moody’s said in a separate report. Michael Armini, a spokesman, didn’t return calls.

Top-rated Harvard University in Cambridge, Massachusetts agreed in December 2008 to pay almost $1 billion to JPMorgan Chase & Co. and Goldman Sachs Group Inc., which are both based in New York, to exit swaps tied to existing and planned floating-rate securities, according to the university.

“Anybody that’s been through the volatility of the last three years has a natural reaction to reduce risk just in case,” said PFM’s McKendrick, a municipal swap adviser who isn’t working on the Michigan State financing. “Most borrowers have looked at that and said we’re going to back off all that risk at this time.”

Peak of Swaps

As much as $300 billion of swaps were completed in the municipal market a year before the credit crisis, according to estimates from the Municipal Securities Rulemaking Board. Typically borrowers sold floating-rate bonds and in private, unregulated agreements, exchanged payments with investment banks to pay a fixed rate that was lower than conventional tax-exempt rates.

Those unraveled because the direction of lending rates reversed as the financial crisis ensued. Banks have also increased fees they charge to serve as buyers of last resort for tax-exempt floating-rate securities, undermining savings from the derivatives, Michigan State’s Klein said.

Derivatives Legislation

Derivatives are based on the value of another security or benchmarks such as stock options. They have been blamed for aggravating the financial crisis that led to the longest recession since the Great Depression. Wall Street banks would be held responsible for steering municipal borrowers into derivatives under legislation proposed by U.S. Senator Blanche Lincoln, an Arkansas Democrat who heads the agriculture committee.

Michigan State had 12 separate agreements tied to $476.1 million of its $535 million in long-term bonds at the end of June, according to its annual report. The school pays fixed annual rates ranging from 3.5 percent to 5.3 percent to Frankfurt-based Deutsche Bank AG, Zurich-based UBS AG, London- based Barclays Plc, and JPMorgan.

Klein declined to specify which of the contracts may be terminated with proceeds from its bond sale this week. Charlotte, North Carolina-based Bank of America Corp. and JPMorgan are underwriting the offering, according to bond documents.

Savings Estimate

“If you look at it over a 30-year bond issue we fully expect to realize savings” from swaps, Klein said. He said the savings are projected to be about 50 basis points, or 0.5 percentage point, in interest costs. “It isn’t a short term strategy.”

The university has another $430 million in such agreements that bet on differences between short-term and long-term bond rates, both from tax-exempt and taxable markets, according to its annual report. Klein declined to say whether these existing agreements have produced gains or losses. He confirmed that the school is planning to add another $162 million of basis swaps, “markets permitting.”

Michigan State will enter into new agreements in which it will pay the Securities Industry and Financial Markets Association seven-day swap index, which was 0.3 percent on April 28, according to Bloomberg data, and receive 67 percent of one-month Libor, or 0.19 percent, based on yesterday’s 0.284 percent rate “plus a spread” according to Moody’s.

The school, which had an enrollment of 46,045 in 2007 and ranked the 11th largest according to the U.S. Department of Education, posted $16 million of collateral to counterparties as of March 17 because the value of some of its agreements fell with interest rates, according to Moody’s. It also held $10.5 million of collateral from the banks, the rating company said.

Negative Outlook

Moody’s said in an April 15 report that it is maintaining its negative outlook on Michigan State because of “concern about the risks embedded in the university’s debt and swaps portfolio as well as its exposure to the economic and financial challenges facing the state of Michigan,” which cut aid to the school 12 percent to $318 million this year. It rates the school Aa2, two steps below the top grade.

Laura Sander, the lead analyst at Moody’s based in Boston, referred questions to John Cline, a New York-based spokesman, who didn’t return calls.

Following are descriptions of pending sales of municipal bonds in the U.S.:

METROPOLITAN WASHINGTON AIRPORT AUTHORITY, which operates Ronald Reagan Washington National and Washington Dulles International airports near the nation’s capital, will offer $650 million in revenue bonds as early as next week. The securities are part of $2.9 billion of debt the authority plans to issue to help fund an extension of the Washington Metropolitan Area Transit Authority’s rail system, according to S&P. Citigroup Inc. will market them to investors. The debt is rated Baa1 by Moody’s and BBB+ by S&P, the third-lowest investment grades. (Updated May 5)

NORTH TEXAS TOLLWAY AUTHORITY, which builds, maintains and repairs turnpikes such as the Dallas North Tollway, plans to offer $400 million in tax-exempt revenue bonds tomorrow. Proceeds will go toward funding the construction and development of 11.5 miles of State Highway 161 in Dallas County and other capital projects, according to preliminary offering documents. JPMorgan Chase & Co. will lead the group underwriting the securities, rated Baa3 by Moody’s, the lowest investment grade. (Updated May 5)

VIRGINIA’S COMMONWEALTH TRANSPORTATION BOARD, which oversees the third-largest system of state-maintained highways in the U.S., plans to offer $492.7 million in revenue bonds in a competitive sale May 12. Buyers will have the option to bid for the debt as tax-exempt or Build America Bonds. Proceeds of the sale will go to matching certain federal highway funds and projects on state highways and public transportation. The securities, rated Aa1 by Moody’s and AA+ by S&P and Fitch, the second-highest rankings, mature serially from 2011 through 2035. (Added May 5)

LONG ISLAND POWER AUTHORITY, which provides electricity to 1.1 million customers, will issue $210 million in taxable Build America Bonds today to fund capital needs. Underwriters led by Morgan Stanley marketed $200 million in tax-exempts yesterday, with four-year bonds priced to yield 2.15 percent and five-year notes offering 2.49 percent. Citigroup will lead the underwriting group for today’s taxable issue. Both portions are backed by electric-system revenue and are rated A3 by Moody’s and A- by S&P, fourth-lowest investment grade, and A by Fitch, one level higher. (Updated May 5)

SEATTLE CITY LIGHT, a municipally owned utility that provides power to about 1 million people, will sell about $811 million in electric revenue bonds as soon as this week to refinance existing debt and fund capital improvements. The sale comes in three issues, with $590 million in tax-exempts, $207.7 million in Build Americas and $13.3 million in taxable Recovery Zone Economic Development bonds. Citigroup will lead underwriters in marketing the securities, which are rated Aa2 by Moody’s, third-highest, and AA- by S&P, one level lower. (Added May 5)

SISTERS OF CHARITY OF LEAVENWORTH HEALTH SYSTEM, made up of 11 hospitals and four clinics spanning four states, will sell about $1 billion in tax-exempt bonds as soon as this week through the Colorado Health Facilities Authority, the Kansas Development Finance Authority and the Montana Facilities Finance Authority, according to S&P. Proceeds from the offering will be used to refund prior debt issued by the authorities. The bonds are rated AA by S&P, its third-highest grade, and one level lower, AA-, by Fitch. JPMorgan Chase & Co. and Morgan Stanley will lead underwriters in marketing the sale to investors. (Added May 5)

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