Comprehensive Annual Financial Report (CAFR) - Johnson City

CITY OF JOHNSON CITY, TENNESSEENOTES TO THE FINANCIAL STATEMENTSFor the Fiscal Year Ended June 30, 20114. DETAILED NOTES ON ALL FUNDS (CONTINUED):A. Deposits and investments (continued)Interest Rate Risk (continued):Fair value. As of June 30, 2011, the swap had a negative fair value of ($2,854,324). The negativefair value of the swap may be countered by reductions in total interest payments required under thevariable-rate bond, creating lower synthetic rates. Because the rates on the government's variableratebonds adjust to changing interest rates, the bonds do not have a corresponding fair valueincrease. The fair value model calculates future cash flows by projecting forward rates, and thendiscounts those cash flows at their present value.Credit risk. As of June 30, 2011, the City was not exposed to credit risk because the swap had anegative fair value. However, should interest rates change and the fair value of the swap becomespositive, the City would be exposed to credit risk in the amount of the derivative's fair value. Theswap counterparty, Morgan Keegan Financial Products ("MKFP"), was rated "A+" by Standardand Poor's as of June 30, 2011, with its Credit Support Provider, Deutsche Bank, ratedAa3/A+/AA- by Moody's, Standard & Poor's and Fitch, respectively.Basis risk. As noted above, the swap exposes the City to basis risk should the r~te on theunderlying bonds increase above SIFMA, thus increasing the synthetic rate on the bonds. If achange occurs that results in the underlying rate on the bonds to be below SIFMA, then thesynthetic rate on the bonds will decrease.Termination risk. The swap agreement contract uses the International Swap Dealers AssociationMaster Agreement, which includes standard termination events, such as failure to pay andbankruptcy. The Schedule to the Master Agreement includes an "additional termination provision."The Authority or the counterparty may terminate the swap if the other party fails to perform underthe terms of the contract. If the swap is terminated, the variable-rate bond would no longer carry asynthetic interest rate. Also, if at the time of termination the· swap has a negative fair value, theAuthority would be liable to the counterparty for a payment equal to the swap's fair value.Likewise, if the swap has a positive fair value at termination, the counterparty would be liable tothe Authority for a payment equal to the swap's fair value. ·61