Q: and A: with Michael W. Kelly, Steven Dymant, and W. Dayle Nattress of


In July, AMBAC Inc. took the wraps off AMBAC Financial Services LP, the vehicle for its diversification into interest rate swaps.

Few observers were surprised by the introduction of the AMBAC offshoot, having seen two derivatives professionals join the company earlier this year.

Michael W. Kelly came over from Smith Barney where he had worked closely with AIG Financial Products on long-dated swap transactions. Kelly, a managing director, is head of financial products for the new firm.

Steven Dymant joined from Merrill Lynch where he helped oversee one of the largest municipal swap books on Wall Street. Dymant, also a managing director, is head of trading.

Both were recruited by W. Dayle Nattress, president of the new company and of AMBAC Capital Management Inc.

Nattress says the swap company is part of a three-year diversification strategy for the bond insurer.

After rolling out a guaranteed investment contract business and the swaps company, AMBAC will continue developing new products, Nattress says.

"I would say that we will be introducing one major product a year. That is the plan," he told staff reporter Aaron Pressman in an interview last month.

Some analysts and competitors have questioned AMBAC's latest move. Nattress, Kelly, and Dymant sat down to make their case and discuss their strategy for the new company.

Q: The municipal swaps business has been dominated by commercial and investment banks. Why is AMBAC, a bond insurer, getting into swaps?

Kelly: I think it's the natural progression of the marketplace. You have municipal bonds, which are basically a retail-driven market. And that market has been very parochial and very inefficient in terms of pricing, so there are opportunities that present themselves to the Street to use derivatives.

So the question becomes: How do people do it? Well, most of the people who are underwriters are single-A rated entities, and the market developed with them doing swaps of 10 to 12 years.

But the municipal borrower is a 30-year borrower. So when long-term interest rates swaps started to be written in 1990, that offered an opportunity for higher-rated credits to come in.

We think it's a natural fit for AMBAC because we have the credit rating, and we have the relationships that go back 24 years dealing with all these municipal issuers. It's something that they feel comfortable with. We also have relationships with the people who are the intermediaries, the underwriers.

Q: So will you mainly be offering long-term swaps?

Dymant: We can go across the board in terms of long-dated swaps with issuers. We're also finding that there are investment banks and commercial banks out there that do not want to run a Kenny book and have the few trades that they do in the shorter end of the curve. They want a counterparty where they can take their municipal basis risk and lay it off on someone else.

For example, on [a recent] deal, we received a few phone calls from banks. They wanted to participate in the transaction but they didn't want to take the municipal interest rate risk. So they look to us to actually execute a hedge for them.

Q: There has been a host of new swap providers over the past few years. How is AMBAC going to make a profit offering swaps?

Nattress: The short answer is, it's a spread business. We are not out there taking big positions to take risk. It is a spread where we take a fixed rate and receive a fixed rate, and if the spread is higher on received bids than on the paid bids, then that's basically the business.

Now, it's a very complex business and it's a very analytical business. To do it right, to get to the point where you can say we run a hedged book and our business is to take the spread, that is a very complex analytical process. We had to convince the rating agencies and ourselves of th same thing: that we are absolutely comfortable with our measurements

Q: There's been a lot of negative publicity about derivatives lately. In talking to issuers on swaps, what are you hearing?

Kelly: They run the whole gamut, as you said. And I've been talking to them about swaps in particular since 1989. You can generalize, but there's always exceptions. The people that have more of a corporate incentive towards products, like public power authorities, health care systems, water and sewer utilities, those kinds of people tend to have had a greater incentive to get up the curve and be more comfortable with the product. And, so far, they have been the greatest users of the product.

Government people on the other hand -- straight government people -- haven't had as strong an incentive to do it. But as deficits increase, you have a mirror image of the corporate incentive. Not so much to increase efficiency or make a profit, but to decrease the deficit or the cost that it takes to run government. Decreasing the cost of borrowing helps.

Q: Has the type of issuer been changing over the years?

Kelly: It's growing, definitely growing. If you look at the number of [long-term] swaps executed, there were none in 1989. In 1990, I think there were probably $200 million [in notional value]. That probably grew to about $1 billion in '91, $2 billion in '92, and I think there was probably $3 billion in '93.

I would say the notional principal amount is going to be smaller this year because the issuance is down. But it's grown from probably 1/4% of all borrowing to 1%, and now to about 1 1/2%. Where should that be in the end? Maybe it's 5%, maybe it's more. I think it should at least be 5%, given the arbitrage available.

Q: But has the adverse publicity this year had any impact on issuers?

Kelly: There's a perception problem that's definitely out there. You're on the cover of Time magazine, you're being bombarded with newspaper articles about people who -- like Piper Jaffray, PaineWebber -- have run into trouble using derivatives. Procter & Gamble.

But derivatives are a very large umbrella. A lot of things come under that umbrella. Typically, the problems in the marketplace have been where people used certain derivative instruments to increase leverage.

But the interest rate swap which has been fashioned for use by a municipal party, is a very conservative instrument. It doesn't leverage anybody's balance sheet.

The focus has been, in fact, to take out all the risk. The whole development of the muni swap product has been to take these issuers who really aren't paid or aren't supposed to take risk and give them a product that takes advantage of the economic benefit but without incurring additional risk.

Q: AMBAC works with underwriters to provide insurance, but in the swap area you may be competing with those same firms you usually cooperate with. Won't that cause some tension?

Kelly: It may. I have not confronted much tension individually, but theoretically I don't think there should be. We are not in competition with those particular desks. The swap counterparty that you're talking about are typically terminating subsidiaries and we are not. And Moody's has stated, I believe, that terminating subs are probably unsuitable counterparties for long-term deals with municipal issuers.

I view our role as somebody who comes in and, like the insurance, providing an ancillary service for the issuer that typically is transacted through working with the underwriter. The underwriter can be a swap agent for us. So I think it's a very similar role. But we don't work with the insurance. We're totally separate.

Q: Totally separate?

Kelly: As you can see, we're 30 miles or 36 miles apart from them. We have our own operations and analytics up here. And we go out, in terms of soliciting business and executing our transactions, separate and apart from what AMBAC Indemnity does.

Our link is that the person who looks at credit and approves transactions for us is the same person who will look at credit and approve transactions for AMBAC Indemnity. We rely on that expertise which has been developed. If you get approval for a swap, you're probably in a position of getting approved for insurance, but it's not tied in. It's a totally separate thing. And indeed, we expect to execute swaps on bonds that have MBIA and FGIC insurance.

Q: That brings up an interesting question. Will AMBAC's insurance business be affected? How can you guarantee that the swap business won't put AMBAC's triple-A rating at risk?

Kelly: We contemplate running a fully hedged book so we don't see ourselves taking on extraordinary risk. The main risks in the business are basis risk between markets that we might be hedging our book with, or basis risk that we may be paying out on a floating rate.

But we've looked at those risks, we've examined certain stress scenarios and we've capitalized. We reserve against worst-case scenarios. We feel that we have a reasonable assessment and judgment of that risk, that the reward pays us off for taking that risk on.

But we're not doing something that's going to jeopardize the triple-A. And if there is an extraordinary set of circumstances, the reserves in capital that we've built in should protect the triple-A in any case.

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