Two years ago, virtually every major municipal bond firm on the Street boasted of a strong presence in the derivative products arena. Now more and more of them are actually telling the truth.
In the past 18 months alone, at least six major firms have established and staffed new divisions devoted exclusively to developing municipal derivatives business. The Public Securities Association in April formed a new Municipal Derivatives Committee, and 29 firms quickly joined up.
Products that used to be considered exotic bells and whistles for traditional municipal bond deals are becoming virtual standard fare to top-tier issuers, and the market as a whole is developing a new comfort with the idea of their use, according to derivatives experts at several firms. They say dealers unable to provide clients with direct access to these money-saving devices will be left behind in the face for new business.
"Over the last two years, all the major financial houses have slowly but surely decided they need to focus on derivative products," said James Bedell, municipal swaps product manager at Morgan Stanley & Co.
The dramatic increase in derivatives activity is feeding on itself, with hesitant issuers taking comfort from the fact that sophisticated market regulars like California, New Jersey, and Connecticut are signing up for the products.
Industry participants say those developments, along with the rise in the number of firms ready and eager to sell the deals, have led to big volume gains for derivatives.
There is still no independent reporting mechanism to gauge derivatives volume, but dealer estimates on 1991 municipal swaps volume range from a low of about $12 billion to a high of more than $30 billion.
Merrill Lynch & Co., which had a widely acknowledged dominance in the municipal swaps market in the late 1980s, says the recent entry of several of its competitors to the derivatives business is not a problem, and in fact is helping by increasing liquidity.
"This is by no means a market that has started to peak, where we're fighting among ourselves for business," said Samuel B. Corliss Jr., a managing director at Merrill Lynch. "The business is growing rapidly and more and more issuers are being made aware of the opportunities in tax-exempt swaps by ourselves and by our competitors."
Defining what constitutes a derivative product is a complex matter in itself, and many firms include some products under this heading while others do not. Regardless of how the category is defined, the municipal interest rate swap is the cornerstone of the business.
In a swap, issuers and their counter-parties at a securities firm or bank effectively trade interest rate terms. If the bonds are sold as variable-rate securities, for example, the issuer would pay its counter-party a fixed rate and receive floating payments in return.
In theory, the idea is relatively simple. But some dealers say they are concerned the big increase in derivatives use now taking place might lull unsophisticated issuers into taking them for granted, ignoring the unique risks the products carry that plain vanilla bond deals do not.
"There is a fundamental difference between doing a bond underwriting and entering into a derivative relationship," said Lee K. Barba, managing director of BT Securities public finance group, referring to the long-term nature of the derivatives commitment compared with the relatively brief amount of time needed for a simple bond underwriting.
Because of the ongoing relationships swaps create. Mr. Barba and most other providers say counter-party credit should be foremost on the minds of issuers considering municipal swaps. "But these risks are not understood by issuers," Mr. Barba said.
Weak Ratings a Barrier
Weak credit ratings, however, do keep certain firms from booking swaps with maturities longer than a few years. Conversely, top-rated providers have an edge in developing deals with much longer maturities. This is witnessed by two recent transactions that received a great deal of market attention: a $293 million swap by the Southern California Public Power Authority in March; and last month's $318 million forward swap by McCarran International Airport in Las Vegas. The power authority swap is for 28 years, and the McCarran deal will last 21 years.
Both were engineered by a partnership between AID Financial Products Corp. and Smith Barney, Harris Upham & Co. The pair has formed a loose alliance in the municipal derivatives field, though each stresses they can and do cooperative with other firms as well.
The arrangement reflects the realization that Smith Barney's ability to attract a large municipal client base and AIG's triple-A rating and strong presence in the global swaps market are worth more together than apart, according to Alan D. Marks, executive vice president and managing director at Smith Barney.
"We didn't want to expose our clients to undue credit risk, and we didn't want to expose our clients to tail risk at the end of a swap that might be shorter than the final maturity of the debt that's being swapped," Mr. Marks said, explaining the reasoning behind the relationship with AIG.
Market sources say the team's two major swaps are remarkable for their extremely long maturities, which were made possible in part by AIG's triple-A rating. In addition, AIG, unlike many other firms active in the municipal market, has booked swaps in the global market with maturities that long, and can use those deals to determine appropriate pricing.
Despite Smith Barney and AIG's success with McCarran and the California power authority, most market participants still believe swaps with maturities beyond 20 years will continue to be relatively rare. The most common swap is still only about five years, but swaps in the 10- to 20-years range are becoming more popular.
Longer deals are problematic for several reasons. For one thing, the market for such maturities is extremely small, so liquidity is virtually nonexistent, except through the original counter-party. And if the deal does not include options to unwind, it could lock an issuer into a transaction that is effectively a 30-year noncallable bond.
But Steven S. Strauss, managing director of derivative products for MTK Global Capital, said the municipal market is dominated by issues longer than 10 years. "If they swaps market is going to grow and expand, it's going to have to go into maturities longer than 10 years," Mr. Strauss said.
Only a Few Can Go Long Term
Albert C. Bashawaty, vice president in charge of municipal swaps and derivative products at J.P. Morgan & Co., said, "We shouldn't tell issuers that the best we can do for them is 10 years." Only a few dealers -- the ones that are active in long-term swaps in the global market and that have the strong credit ratings needed to support these transactins -- will be able to offer issuers such long-term deals, he said.
Bradley A. Wendt, a product manager for municipal interest rate swaps at Goldman, Sachs & Co., said long-term swaps do fill a specific need, so a market for them will always exist. But he said swaps should not be used as a surrogate for bonds.
"The overall perception is that 30 years is a long time to commit to a contract," he said.
On the other hand, swaps that do not match the maturity of the underlying bonds open issuers up to so-called tail risk. That is the risk that at the time the swap expires the cost of a new swap will be be much higher than the original deal, and the market at the time has moved to a position where the issuer cannot afford exposure to the underlying terms of the bond deal.
In addition, shorter-term variable-rate deals also carry the risk that the cost of renewing the liquidity facility needed to secure the bonds will be prohibitive if it expires prior to the term of the bonds.
"These risks should be fully disclosed during the structuring process, and generally this has not been the case," Mr. Barba said.
For dealers that do try to execute swaps longer than 10 years, one possible tool to handle the risk is swap insurance.
"The majority of brokers aren't willing to take on risk beyond 10 years," said Carolyn Leigh, a first vice president at AMBAC Indemnity Corp. "So our willingness to take term risk beyond 10 years is extremely useful."
Ms. Leigh said that although firm numbers are hard to come by because swap sureties are private transactions, the market as a whole has been abot $1 billion to $1.5 billion over the past two years.
Despite the tremendous growth of the swap market, some firms are still unable to act as principals for the deals, whether because of strategic plannin decisions or because the particular swap is considered too much of a risk.
As a result, the idea of "wholesaling" swaps business has taken shape over the past two years, dealers report. In some intances when firms find themselves unable to handle swaps for their clients, they turn to other dealers to execute the transaction. That relationship, however, is not always explained to issuers, according to some dealers.
Beyond the swap, dealers are developing and selling numerous variations on the derivatives theme.
Interest rate caps, collars, and floors, for example, allow issuers to sell floating-rate debt without exposure to peaks and troughs in the market. California recently purchased a capt on a large variable-rate deal which will exempt the state from any payments higher than the cap if the market exceeds the cap level. Morgan Stanley, the cap provider, pays the difference.
"It opens up the use of variable-rate paper to conservative borrowers," said Peter Shapiro, a manager in Citicorp Securities Markets's municipal derivative products group.
In the case of New Jersey, which recently executed a similar cap deal, the product helped state financial officials tap a market the state had never tried before. Selling floating-rate paper gave the state access to an entirely different investor base, including money market funds.
In addition, New Jersey had variable-rate income that prudent financial planning would require be matched against variable-rate liabilities.
The downside risk for an issuer is that it could pay a fee for a cap or floor tha turned out to have been unnecessary because the market never exceeded the capped rate during the life of the transaction.
In addition to offering interest rate protection, collars and caps can be used to hedge exposure to commodities. Dealers say the next big product on the horizon might be commodity swaps or collars that protect municipalities heavily dependent on commodities like oil from price gyrations in those markets.
Just Beginning to Understand
"Municipalities are only beginning to understand what kinds of exposure they have on a regular basis," said Sheldon L. Sussman, a vice president at Lehman Brothers Inc. "One of these is fuel oil price changes. But it takes a change in thinking about risk and then an understanding of the tools available to address that exposure before these products will become more widely used."
"The product is where swaps were a few years ago," Mr. Marks added.
The flip side of the transaction is when issuers such as Louisiana or Texas -- governments that actually benefit from higher fuel costs -- use the products to hedge their risks against large price swings.
The idea also can be used to control exposure to foreign exchange rates, if for example, an issuer is a large importer of foreign products.
Or equity swaps keyed off foreign stock exchanges could allow issuers to benefit from rising foreign markets without investing directly. But dealers say that idea is still extremely preliminary and directed more at public pension funds than municipalities.
Another idea still waiting for an issuer is the use of municipal forward delivery products for transactions other than synthetic forward refundings. Until now, the product has been used almost exclusively by issuers unable to advance refund private-activity bonds. In those instances, investors sign the forward contract agreeing to buy refunding bonds at the first call date of the outstanding issue, effectively advance refunding the deal and locking in current rates for the issuer.
But several dealers said there is no need to limit forwards to that use. If for example, an issuer knows it wants to finance a big construction project in two years, it can lock in current interest rates for the deal by executing a forward.
"There are some issuers so excited about these rates they want to finance something, but are unable to until next year so they're looking at forward swaps," one public finance official said.
D. Jeffrey Penney, a vice president in First Boston Corp.'s municipal financial products group, said he expects the market to develop to the point that issuers become comfortable utilizing a blend of derivative products on specific financing goals.
While First Boston has traditionally been a strong participant in the forward delivery contract field, with about 60% of the $1.5 billion market by its own estimate, Mr. Penney said the firm is also keeping abreast of alternatives like tender offers and forward swaps, in order to provide issuers with the most options possible.
If mixing derivatives on single financing goals is an industry trend, Oglethorpe Power Corp. in Atlanta is ahead of the curve. It plans to refinance more than $800 million of outstanding debt over the next several months using a combination of forwards, tender offers, and forward swaps, company officials say.
Despite the general excitement over derivatives and anticipation of their continuing growth among the dealer community, Mr. Wendt at Goldman Sachs stressed that the products will always be an adjunct to the industry's main business -- the standard municipal bond.
