TEXAS DEPARTMENT OF HOUSING AND COMMUNITY AFFAIRS

INTEREST RATE SWAP POLICY

The Texas Department of Housing and Community Affairs (the “Department”) has been duly
created and organized pursuant to and in accordance with the provisions of Chapter 2306, Texas
Government Code (the “Act”), as amended from time to time, for the purpose of providing a means
of financing the costs of residential ownership, development and rehabilitation that will provide
decent, safe and sanitary housing for individuals and families of low and very low income and
families of moderate income (as described in the Act as determined by the Governing Board of the
Department (the “Governing Board”) from time to time) at prices they can afford.

The Act authorizes the Department: (a) to acquire, and to enter into advance commitments to
acquire, mortgage loans (including participations therein) secured by mortgages on residential
housing in the State of Texas (the “State”); (b) to issue its bonds, for the purpose of obtaining funds
to make and acquire such mortgage loans or participations therein, to establish necessary reserve
funds and to pay administrative and other costs incurred in connection with the issuance of such
bonds; and (c) to pledge all or any part of the revenues, receipts or resources of the Department,
including the revenues and receipts to be received by the Department from such mortgage loans or
participations therein, and to mortgage, pledge or grant security interests in such mortgages,
mortgage loans or other property of the Department, to secure the payment of the principal or
redemption price of and interest on such bonds.

I. Introduction

The purpose of the Interest Rate Swap Policy (“Policy”) of the Texas Department of Housing and
Community Affairs (the “Department”) is to establish guidelines for the use and management of all
interest rate management agreements, including, but not limited to, interest rate swaps, swaptions,
caps, collars and floors (collectively “Swaps” or “Agreements”) incurred in connection with the
incurrence of debt obligations. The Policy sets forth the manner of execution of Swaps and
Agreements, provides for security and payments provisions, risk considerations and certain other
relevant provisions as well as being responsive to the proposed 2003 recommended practices of the
Government Finance Officers Association regarding the contents of an interest rate swap policy.

II. Authority

The Department is authorized by Section 2306.351 of the Act to enter into swap transactions from
time to time to better manage assets and liabilities and take advantage of market conditions to lower
overall costs and reduce interest rate risk.

This Policy shall govern the Department’s use and management of all Swaps. While adherence to
this Policy is required in applicable circumstances, the Department recognizes that changes in the
capital markets, agency programs, and other unforeseen circumstances may from time to time
produce situations that are not covered by the Policy and will require modifications or exceptions to
achieve policy goals.

The Chief of Agency Administration and the Director of Bond Finance are the designated
administrators of the Department’s Policy. The Bond Finance Division shall have the day-to-day
responsibility for structuring, implanting, and managing Swaps.

9/1/2004 Page 1 of 8
The Department shall be authorized to enter into Swap transactions only with qualified Swap
counterparties. The Director of Bond Finance, in consultation with Chief of Agency
Administration, or his designee, shall have the authority to recommend counterparties, so long as
the criteria set forth in the Policy are met.

The Chief of Agency Administration and the Director of Bond Finance shall review this swap
policy on an annual basis and implement any necessary changes.

III. Purpose

The incurring of obligations by the Department involves a variety of interest rate payments and
other risks for which a variety of financial instruments are available to offset, hedge, or reduce. It is
the policy of the Department to utilize swaps and other derivative financial instruments to better
manage its assets and liabilities. The Department may execute interest rate swaps if the transaction
can be expected to result in one of, but no limited to the following:

• Reduce exposure to changes in interest rates on a particular financial transaction or in the

context of the management of interest rate risk derived from the Department’s overall
asset/liability balance.
• Result in a lower net cost of borrowing with respect to the Department’s debt.
• Manage variable interest rate exposure consistent with prudent debt practices.
• Achieve more flexibility in meeting overall financial and programmatic objectives that
cannot be achieved in conventional markets.

The Department will not use Agreements that:

• Are speculative or incorporate extraordinary leverage;

• Lack adequate liquidity to terminate without incurring a significant bid/ask spread;
• Result in insufficient pricing transparency and therefore limit reasonable valuation.

IV. Evaluation of Risks Associated with Swaps

Before entering into a swap, the Department shall evaluate all the risks inherent in the transaction.
The risks to be evaluated will include basis risk, tax risk, counterparty risk, credit risk, termination
risk, rollover risk, liquidity risk, remarketing risk, amortization mismatch risk, mortgage yield risk,
non-origination risk, and PAC band risk. The following table outlines these various risks and the
Department’s evaluation methodology for those risks.

THIS SPACE INTENTIONALLY BLANK

9/1/2004 Page 2 of 8
 Risk Description Evaluation Methodology
Basis Risk The mismatch between actual The Department will review
variable rate debt service and historical trading differentials
variable rate indices used to between the variable rate bonds
determine Swap payments. and the index.
Tax Risk The risk created by potential tax The Department will review the
events that could affect Swap tax events in proposed Swap
payments. agreements. The Department will
evaluate the impact of potential
changes in tax law on LIBOR
indexed Swaps.
Counterparty Risk The failure of the counterparty to The Department will monitor
make required payments. exposure levels, ratings thresholds,
and collateralization requirements.
Credit Risk The occurrence of an event The Department will ascertain and
modifying the credit rating of the monitor the ratings of its
issuer or its counterparty. counterparties and issuers.
Termination Risk The need to terminate the The Department will compute its
transaction in a market that termination exposure for all
dictates a termination payment by existing and proposed Swaps at
the issuer. market value and under a worst-
case scenario.
Rollover Risk The mismatch of the maturity of The Department will determine its
the Swap and the maturity of the capacity to service variable rate
underlying bonds. bonds that may be outstanding
after the maturity of the Swap.
Liquidity Risk The inability to continue or renew The Department will evaluate the
a liquidity facility. expected availability of liquidity
support for swapped and unhedged
variable rate debt, if any.
Remarketing Risk The risk that a remarketing agent The Department will obtain a
may be unable to remarket standby bond purchase facility to
VRDBs. provide the funds necessary to
purchase the VRDBs.
Amortization Mismatch The mismatch of outstanding swap The Department may incorporate
Risk principal versus the outstanding one or a combination of the
bond principal subject to the following features par termination
hedge. options, PAC or lockout bonds.
Mortgage Yield Risk The bond issue may not comply The Department will obtain legal
with yield restrictions if the swap opinions and or certificates as
is terminated. appropriate.
Non-origination Risk The bond proceeds may not The Department will evaluate
originate within the prescribed bond and mortgage market
timeframe and require an unused conditions and quantify the
proceeds call and possible potential termination payment due
termination payment. upon non-origination.
PAC Band Break Risk The targeted PAC bonds may The Department will rely upon
amortize faster than anticipated credit rating agency cashflows to
based on the PAC amortization ensure adequate PAC/companion
schedule. bond structural integrity.
9/1/2004 Page 3 of 8
The Department will diversify its exposure to counterparties. To that end, before entering into a
transaction, the Department will determine its exposure to the relevant counterparty or
counterparties and determine how the proposed transaction would affect the exposure. The
exposure will not be measured solely in terms of notional amount, but rather how changes in
interest rates would affect the Department’s exposure (“Maximum Net Termination Exposure”).
For purposes of these limits, “Maximum Net Termination Exposure” shall equal the aggregate
termination payment for all existing and projected swap transactions that would be paid by an
individual counterparty. For purposes of this calculation, the aggregate termination payment is
equal to: (i) the termination payment based on the market value of all existing swaps as of the first
day of the month prior to the execution of any proposed transaction, plus (ii) the reasonably
expected worse case termination payment of the proposed transaction.

The Department will base the Maximum Net Termination Exposure on all outstanding derivative
transactions. Limits will be established for each counterparty as well as the relative level of risk
associated with each existing and projected swap transaction.

The Director of Bond Finance shall determine the appropriate term for an interest rate swap
agreement on a case-by-case basis. The slope of the swap curve, the marginal change in swap rates
from year to year along the swap curve, and the impact that the term of the swap has on the overall
exposure of the Department shall be considered in determining the appropriate term of any swap
agreement. In connection with the issuance or carrying of bonds, the term of a swap agreement
between the Department and qualified swap counterparty shall not extend beyond the final maturity
date of debt of the Department, or in the case of a refunding transaction, beyond the final maturity
date of the refunding bonds.

The total “net notional amount” of all swaps related to a bond issue should not exceed the amount
of outstanding bonds. For purposes of calculating the net notional amount, credit shall be given to
any swaps that offset for a specific bond transaction.

V. Long Term Financial Implications

In evaluating a particular transaction involving the use of derivatives, the Department shall review
long-term implications associated with entering into derivatives, including costs of borrowing,
historical interest rate trends, variable rate capacity, credit enhancement capacity, liquidity capacity,
opportunities to refund related debt obligations and other similar considerations.

Impact of Use of Liquidity

The Department shall consider the impact of any variable rate bonds issued in combinations with a
Swap on the availability and cost of liquidity support for other Department variable rate programs.

Call Option Value considerations

When considering the relative advantage of a Swap versus fixed rate bonds, the Department will
take into consideration the value of any call option on fixed rate bonds.

Qualified Hedges

The Department understands that, (1) if payments on and receipts from the Agreement are to be
taken into account in computing the yield on the related bonds, the Agreement must meet the
9/1/2004 Page 4 of 8
requirements for a “qualified hedge” under federal tax law (sometimes referred to as an “integrated
swap”); and (2) if one of the goals of entering into the Agreement is to convert variable yield bonds
into fixed yield bonds (sometimes referred to as a “super integrated swap”), then certain additional
requirements must be met. In both of these situations, the terms of the Agreement and the process
for entering into the Agreement must be reviewed and approved in advance by tax counsel.

VI. Form of Swap Agreements

Each interest rate swap executed by the Department shall contain terms and conditions as set forth
in the International Swap and Derivatives Association, Inc. (“ISDA”) Master Agreement, including
any schedules and confirmations. The swap agreements between the Department and each qualified
swap counterparty shall include payment, term, security, collateral, default, remedy, termination,
and other terms, conditions and provisions as the Director of Bond Finance deems necessary,
desirable or consistent with industry best practices.

VII. Qualified Swap Counterparties

The Department will make its best efforts to work with qualified Swap counterparties that have a
general credit rating of: (i) at least “A3” or “A-” by two of the nationally recognized rating agencies
and not rated lower than “A3” or “A-“ by any nationally recognized rating agency, or (ii) have a
“non-terminating” “AAA” subsidiary as rated by at least one nationally recognized credit rating
agency. The nationally recognized rating agencies are Moody’s Investors Services, Inc., Standard
and Poor’s Rating Services, and Fitch Ratings.

In addition to the rating criteria specified herein, the Department will seek additional credit
enhancement and safeguards in the form of:

i. Contingent credit support or enhancement;

ii. Collateral consistent with the policies contained herein;
iii. Ratings downgrade triggers; and/or
iv. Guaranty of parent, if any.

In addition, qualified Swap counterparties must have a demonstrated record of successfully

executing Swap transactions as well as minimum capitalization of at least $150 million. The
Department will only execute Swap transactions with qualified Swap counterparties who offer
Swaps on a principal basis.

VIII. Termination Provisions

The Department shall consider including in all swap transactions provisions granting the
Department the right to optionally terminate a swap agreement at any time over the term of the
agreement. The Chief of Agency Administration and Director of Bond Finance shall determine if it
is financially advantageous for the Department to terminate a swap agreement.

A termination event is deemed to occur should the Department’s swap provider (or its swap credit
support provider) fail to maintain either:

1. A Credit Rating of at least A- from Moody’s; or

2. A Credit Rating of at least A3 from S&P; or,
3. An equivalent rating determined above by a nationally recognized ratings
service acceptable to both parties; and,
9/1/2004 Page 5 of 8
 4. The swap provider has not delivered any collateral as required under any
related credit support annex.

A termination payment to or from the Department may be required in the event of termination of a
swap agreement due to a default or a decrease in credit rating of either the Department or the
counterparty.

It is the intent of the Department not to make a termination payment to a counterparty that does not
meet its contractual obligations. Prior to making any such termination payment, the Chief of
Agency Administration and Director of Bond Finance shall evaluate whether it is financially
advantageous for the Department to obtain a replacement counterparty to avoid making such
termination payment or finance the termination payment through a long-term financing product.

For payments on early termination and optional termination, Market Quotation and the Second
Method will apply, allowing for two way mark-to-market breakage (assuming the swaps are
documented under the 1992 form of the ISDA swap documents).

IX. Security and Source of Repayment

The Department may use the same security and source of repayment (pledged revenues) for Swaps
as is used for the bonds that are hedged or carried by the Swap, if any, but shall consider the
economic costs and benefits of subordinating the Department’s payments and/or termination
payment under the Swap. The use of the same security and source of repayment (pledged revenues)
is subject to the respective bond indenture’s covenants and the prior approval of the Department’s
bond counsel.

X. Specified Indebtedness

The specified indebtedness related to credit events in any Swap agreement should be narrowly
defined and refer only to indebtedness of the Department that could have a materially adverse effect
on the Department’s ability to perform its obligations under the Swap. Debt should typically only
include obligations within the same lien as the Swap obligation.

XI. Governing Law

Governing law for Swaps will be [the State of Texas.] Issues relating to jurisdiction, venue, waiver
of jury trial and sovereign immunity will be subject to prevailing law and approval of [the Texas
Attorney General Office.] Preference will be given to language providing that the counterparty will
consent to jurisdiction in the Texas courts with respect to enforcement of the Agreement.

XII. Events of Default

Events of default of a swap counterparty shall include, but are not limited to the counterparty’s:

1. Failure to make payments when due;

2. Breach of representations and warranties;
3. Illegality;
4. Failure to comply with downgrade provisions; and
5. Failure to comply with any other provisions of the agreement after a
specified notice period.

9/1/2004 Page 6 of 8
 XIII. Collateral Requirements

As part of any swap agreement, the Department may require the counterparty to post collateral or
other credit enhancement to secure any or all swap payment obligations. As appropriate, the Chief
of Agency Administration and Director of Bond Finance may require collateral or other credit
enhancement to be posted by each swap counterparty under the following circumstances:

• Each counterparty to the Department may be required to post collateral if the credit
rating of the counterparty or parent falls below the “A-“ or “A3” category. Additional
collateral for further decreases in credit ratings of each counterparty shall be posted by
each counterparty in accordance with the provisions contained in the collateral support
agreement to each swap agreement with the Department.
• Collateral shall consist of cash or U.S. Treasury securities.
• Collateral shall be deposited with an eligible third party custodian, or as mutually agreed
upon between the Department and each counterparty.
• The market value of the collateral shall be determined on at least a weekly basis.
• The Department will determine reasonable threshold limits for increments of collateral
posting based on a sliding scale reflective of credit ratings.
• The Chief of Agency Administration and Director of Bond Finance shall determine on a
case-by-case basis whether other forms of credit enhancement are more beneficial to the
Department.

XIV. Other Criteria

The Department may use a competitive or a negotiated process to select a Swap counterparty and
price a Swap as it believes business, market or competitive conditions justify such a process. The
conditions under which a negotiated selection is best used are provided below.

• Marketing of the Swap will require complex explanations about the security for
repayment or credit quality.
• Demand is weak among swap counterparties.
• Market timing is important, such as for refundings.
• Coordination of multiple components of the financing is required.
• The Swap has non-standard features, such as one way collateral.
• Bond insurance is not available or not offered.
• The par amount for the transaction is significantly larger than normal.
• Counterparties are likely to demand individual changes in bid documents.

The Department will use a swap advisory firm to assist in the price negotiation. Also, the
Department may obtain an opinion from an independent party that the terms and conditions of any
derivative entered into reflect a fair market value of such derivatives as of the execution date.

XV. Ongoing Monitoring and Reporting Requirements

Written records noting the status of all interest rate swap agreements will be maintained by the
Bond Finance Division and shall include the following information:

• Highlights of all material changes to swap agreements or new swap agreements entered
into by the Department since the last report.
• Market value of each of the interest rate swap agreements.

9/1/2004 Page 7 of 8
 • The net impact of a 50, 100, and 150 basis point parallel shift in the appropriate swap
index or curve.
• For each counterparty, the Department shall provide the total notional amount position,
the average life of each swap agreement, the available capacity to enter into a swap
transaction, and the remaining term of each swap agreement.
• The credit rating of each swap counterparty and credit enhancer insuring swap payments.
• Actual collateral posting by swap counterparty, if any, per swap agreement and in total
by swap counterparty.
• A summary of each swap agreement, including but not limited to the type of swap, the
rates paid by the Department and received by the Department, indices, and other key
terms.
• Information concerning any default by a swap counterparty to the Department, and the
results of the default, including but not limited to the financial impact to the Department,
if any.
• A summary of any swap agreements that were terminated.

The Department will monitor its swaps exposure on a daily or monthly basis, as necessary, and will
look for ways to reduce the cost of a swap(s) or the overall swap exposure. The Department will
report its swaps exposure on a monthly or quarterly basis, as necessary.

The Department shall reflect the use of derivatives on its financial statements in accordance with
GASB Technical Bulletin No. 2003-1. The disclosure requirements include:

1. Objective of the Derivative

2. Significant Terms
3. Fair Value
4. Associated Debt
5. Risks.

The Chief of Agency Administration and the Director of Bond Finance will review the
Department’s swap policy on an annual basis.

THIS SPACE INTENTIONALLY BLANK

9/1/2004 Page 8 of 8