FY 2005 - University of Missouri System

N otes to Combined Financial StatementsF o r t h e y e a r s e n d e d J u n e 3 0 , 2 0 0 5 a n d 2 0 0 4anticipate future spot interest rates. These payments are then discounted using the spot rates implied by the currentyield curve for hypothetical zero-coupon bonds due on the date of each net settlement of the swap.In addition, the University maintains a thirty-year interest rate swap agreement on $40,000,000, notional amount, of itsvariable rate System Facilities Revenue Bonds. The purpose of the interest rate swap agreement is to convert variablerate debt to fixed rate debt. Based on the swap agreement, the University owes interest calculated at a fixed rate of3.95% to the counterparty to the swap. In return, the counterparty owes the University interest based on a variable rateset weekly. The $40,000,000 in bond principal is not exchanged; it is only the basis on which the interest payments arecalculated.The University continues to pay interest to the bondholders at the variable rate provided by the bonds. However, duringthe term of the swap agreement, the University effectively pays a fixed rate on the debt. The University will revert tovariable rates if the counterparty to the swap defaults or if the swap is terminated. A termination of the swap agreementmay also result in the University making or receiving a termination payment.As of June 30, 2005, the swap had a fair value of ($3,690,830), which represents the cost to the University to terminatethe swap. The fair value was developed using the zero coupon method and proprietary models, and was prepared bythe counterparty, J.P. Morgan Chase Bank, a major U.S. financial institution. The zero coupon method calculates thefuture net settlement payments required by the swap, assuming that the current forward rates implied by the yield curvecorrectly anticipate future spot interest rates. These payments are then discounted using the spot rates implied by thecurrent yield curve for hypothetical zero-coupon bonds due on the date of each net settlement of the swap.As of June 30, 2005, the University was not exposed to credit risk on the termination payment because the swap hada negative fair value and the University would have owed the payment. However, should interest rates change andthe fair value of the swap become positive, the University would be exposed to credit risk. The swap counterpartywas rated AA- by Standard & Poor’s and Aa2 by Moody’s Investors Service as of June 30, 2005. In the event aratings downgrade occurs, the counterparty may be required to provide collateral if the University’s overall exposureexceeds predetermined levels. Permitted collateral investments include U.S. Treasuries, U.S. government agencies,cash and commercial paper rated A1/P1 by Standard & Poor’s and Moody’s, respectively. Collateral may be held by theUniversity or by a third party custodian.The swap exposes the University to basis risk should the weekly BMA rate paid by the counterparty fall below the dailyinterest rate due on the bonds. This basis risk can be the result of a downgrade of the University’s rating, daily ratesbecoming higher than weekly rates, or the pricing of the University’s bonds by the remarketing agent at rates higherthan the BMA index.At June 30, 2005 and 2004, in-substance defeased bonds aggregating $52,205,000 and $53,620,000, respectively, areoutstanding.402 0 0 5 F i n a n c i a l R e p o r t : U n i v e r s i t y o f M i s s o u r ia c o m p o n e n t u n i t o f t h e S t a t e o f M i s s o u r i