Two recent record-breaking swaps from New Jersey and California look similar, but market sources say California earned sweeter bids by adding a feature New Jersey's swap lacked.
By allowing swap providers to also act as remarketing agents on the underlying variable-rate notes, California gave bidders more control over their ultimate costs, an advantage that several dealers said translated into basis point savings for the state.
New Jersey, in contrast, sought bidders after already promising Kidder, Peabody & Co. that it would be remarketing agent, responsible for determining the new daily interest rate by reselling the notes put by investors each day. With New Jersey's would-be swap providers forced to put their fates in another firm's hands, many said they decided to bid more conservatively.
Robert Lurie, director of public finance for New Jersey, agreed that California's decision to combine the roles of remarketing agent and swap provider was "an improvement" over the New Jersey deal.
"I think the only reason we didn't do that was that by the time we came up with the structure of doing a competitively bid, variable-rate deal with a swap, we had already gone pretty far down the road with Kidder, and Kidder had already helped us a great deal with the concept," Lurie said. "We didn't feel we could then back away from them."
He said next year's note deal might include the feature.
Officials at one bank, Citicorp Securities Markets Inc., said they refused to even bid on New Jersey's $1 billion swap because they did not want to rely on another firm's remarketing effort. Citicorp won a $250 million piece of California's $1.25 billion swap the following week.
And in another indication of the increasing sensitivity among swap providers to the remarketing of the underlying bonds, market sources said J.P. Morgan Securities Inc. submitted the New Jersey bid with the stipulation that it be allowed to fire Kidder under certain circumstances. New Jersey officials said the request for the kind of agreement, which is not uncommon on swap bids, came after the decision to retain Kidder had already been made, so the bid was dropped.
In a sampling of opinion from other major municipal swap providers, most said they would not go as far as Citicorp in automatically rejecting deals that do not include the remarketing feature. But they agreed they could have shaved a few basis points from their New Jersey bids if the deal had been structured like California's swap.
"I think the issuer can get a better range of bids if they allow you to bid for the remarketing," one swap provider said.
The remarketing role is becoming a higher-profile issue with the increase in so-called cost-of-funds swaps, which set the issuer's repayment terms at exactly the rate set by the remarketing, instead of the more traditional method of pegging the swap to a market index. The cost-of-funds structure, used in both the New Jersey and California deals, eliminates the basis risk to the issuer generated when market indexes vary from an issuer's cost of funds.
But while the method eliminates basis risk for issuers, it creates basis risk for swap providers. They, in turn, have a bigger stake in successful remarketings to get the best possible rate. Many providers have decided they would rather remarket the bonds themselves than rely on a competitor who has little direct financial incentive to get the best possible rate.
"Kidder could decide three months from now they don't want to be in the remarketing business," one dealer said. "Then it could take three more months to replace them. All kinds of things could happen."
Edward Dimon, senior vice president of short-term finance and derivatives at Kidder, said that while technically it is Lehman Brothers that is on the hook for Kidder's remarketing results on the New Jersey notes, Kidder still has a strong incentive to make sure the remarketing works well.
"Everybody is monitoring the performance of whoever the remarketing agent is," Dimon said. "It's New Jersey's name that is on this deal, and any taint would potentially impact any other future borrowings."
Dimon added that Kidder plans to keep both Lehman and state officials apprised daily of market conditions for the notes to make sure each understands how the remarketings are going.
One aspect that worries swap providers about both the California and New Jersey deals is that they create risks impossible to accurately hedge. Those risks are created in any cost-of-funds swap when the issuer's cost of funds varies from market indexes. The structure is less attractive to dealers and increases their desire to act as remarketing agent.
"If we're in a situation where you have to have a non-hedgable risk, we'd feel more comfortable taking that type of risk if we're the ones who are going to remarket the paper," one swap provider said.
Cost-of-funds swaps also make it more difficult for firms without strong public finance departments to make aggressive bids, because they are less experienced in assessing where a particular credit is likely to trade in the future. Index-based swaps, on the other hand, are more easily analyzed and theoretically generate more bids.
One market source familiar with both the taxable and tax-exempt swap markets said he expects municipal providers to eventually move away from cost-of-funds swaps, which are virtually nonexistent on the corporate side. He said despite the appeal to issuers, the inability to hedge basis point risk makes them unattractive to swap desks.
But New Jersey's Lurie said he would continue to lean towards cost-of-funds swaps, because the basis point penalty is worth taking to eliminate basis risk. He said the state's 1991 swap was pegged to an index, which occasionally varied widely from New Jersey's actual costs.
"We knew we would pay a little extra this time for the actual rate swap, but it wasn't that much extra," Lurie said.
The trend toward combining the roles of swap provider and remarketing agent is also spawning new alliances among firms that offer one service or the other, but not both.
Societe Generale, for example, which is active in the swap market but does not offer extensive remarketing services, joined forces with remarketers Paine Webber and Smith Barney, Harris Upham & Co. on two separate but unsuccessful bids for California's swap.