A derivative structure previously used only in private secondary-market transactions made its debut in the primary market Monday as part of Detroit's $199 million issue.
Goldman, Sachs & Co. included $30 million of derivatives in the 2013 maturity, consisting of inverse floating-rate securities and corresponding variable-rate demand notes, or VRDNs.
Detroit will pay a fixed rate on the $30 million, which will be divided between the two securities. The rate is about 10 basis points lower on that portion than the city would have paid without the derivatives, a Goldman official said.
In all previous primary market deals, the floating-rate security is reset at a periodic auction, but does not carry the put right and credit enhancement of a VRDN. The VRDN structure has been used occasionally on secondary market derivatives.
Money market funds, which operate under strict investment limitations, can buy variable-rate demand notes, but not the usual floating-rate security reset at an auction. The funds require the put right, market sources said, for the securities to qualify for purchase under their limitations.
With a larger Pool of potential investors, the VRDNs often yield 10 to 20 basis points less than similar securities that do not have puts and credit enhancement, at least among securities not subject to the alternative minimum tax, market sources said.
A Goldman official said VRDNs typically yield 25 to 30 basis points less.
The lower yield on the variable-rate demand notes saves issuers money compared to a standard auction rate product.
Financial Guaranty Insurance Corp. insured the entire issue and provided a five-year liquidity facility on the VRDNs under its Securities Purchase Inc. program.
The cost of the credit enhancement is borne by the inverse floating-rate security holders. The city pays a fixed amount. The interest first goes to the VRDN holders, then to cover fees for liquidity and remarketing, and the remainder to inverse floater holders.
After five years, Detroit may renew the FGIC facility or acquire an alternate facility. Holders of the VRDNs will have a final put opportunity at that time.
If the city cannot find liquidity support, the securities could be remarketed at a fixed rate.
In another transaction, Chicago sold $649 million of general airport second lien revenue refunding bonds on Oct. 19 for the Chicago-O'Hare Interational Airport.
Chicago and senior manager Goldman Sachs considered selling inverse floating-rate securities and corresponding auction-set floating-rate securities for the deal, but did not.
John Holden, a spokesman for Chicago Comptroller Walter Knorr, said the derivatives were not used "when the market moved more in our favor." Knorr set a threshold savings of 10 basis points to keep the derivatives in the deal. Chicago has never included derivatives in a new issue.
Kidder, Peabody & Co. included $32 million of derivatives on the $410 million Puerto Rico housing bank and Finance Agency issue that closed last week. The derivatives, in the 2006 maturity, consisted of $24 million of floating-rate securities reset by auction and $8 million of corresponding inverse floating-rate securities. The agency saved 10 basis points over issuing ordinary bonds.
Regional Firms Build Up
Regional firms are increasing their presence in the derivatives area. Some firms are merely brokering derivatives transactions. Others, especially the securities subsidiaries of large commercial banks, are getting more involved, acting as swap counterparties.
Wachovia Corp., for example, is setting up a derivatives operation that may provide swaps to municipal issuers.
Richard Roberts, the bank's treasurer, said the derivatives department will be built up over the next four months, after policies and control systems are in place.
"We would entertain any transactions for municipals consistent with the products we will offer," Roberts said. The bank will act as a swap counterparty on some transactions and as an agent on others.
PNC Securities, a Pittsburgh-based underwriting and advisory firm, is considering increasing its municipal derivatives operation. The firm has already provided derivatives to some issuers, after focusing on the area this summer.
"We have done some transactions and we are exploring getting larger," an official at PNC said. The firm is a subsidiary of Pittsburgh National Bank Corp.
First Union Corp. plans to hire additional professionals for its derivatives department, market sources said. The First Union derivatives shop, which is run by Terry Turner, formerly at Bankers Trust Co., and Steven Kohlhagen, formerly at AIG Financial products, has entered swaps with municipal issuers.
Over the summer, John Nuveen & Co. hired Steve Wafer, formerly at Goldman Sachs, to start a derivatives products group. Wafer did not return calls yesterday.
