Interest rate swaps in the municipal market have sparked new questions about competitive bidding for financial services, but most market participants say these new arrangements remain too alien for widespread bidding.
The deals still demand the kind of care and consideration only possible with a negotiated transaction, according to swap market opinion.
"Swaps are in their infancy," said one adviser to municipal governments. "We haven't had enough time to watch this develop. Issuers should negotiate them, at the present stage in the swap market, as long as they have enough people who are in there presenting plans."
From the point of view of the counter-party, the firm that enters into the interest rate swap agreement with the issuer, the competitive process in the young municipal market is also daunting.
For the interest rate swap industry, as for others, competitive bidding poses the prospect of bankers doing work that leads nowhere if they lose. The difference is that structuring a swap transaction requires much more work than submitting a bid for a competitive bond offering.
In addition, leaving a bid on the table for a long period of time can provide perilous, bankers say, as the market value of their hedging instruments fluctuates form moment to moment.
Albert C. Bashawaty, the vice president at Morgan Guaranty Trust Co. of New York and head of the bank's municipal swaps and derivative products operations, said the municipal swaps market may reach a point where competitive bidding becomes the rule rather than the exception, but not for some time.
Need for Standardization
The corporate interest rate swaps market, he said, has reached a level of standardization that permits competitive bidding of most swap agreements.
"That market's mature, and people all speak the same language, basically," said Mr. Bashawaty, who cut his derivative teeth in the corporate market. "The municipal market is just starting out, whereas the taxable market is generally mature so that you can call up three dealers and get prices."
"It took the taxable market five or six years for people to get on the same wavelength," Mr. Bashawaty said. "That was kind of the ground-breaking market."
The municipal market's evolution toward competitive bidding could prove more rapid because of the lessons left by the corporate experience. "Everybody's tearing pages out of that book," he added.
In the municipal interest rate swaps market, however, "it's tough to compare deal to deal," according to Mr. Bashawaty, unless the swap bids use a corporate format that include pegging variable rates to the London Interbank Offered Rate, as is the practice in corporate interest rate swaps.
That was how Connecticut managed to use a bidding process last year, when it successfully sought to enter into a 10- or 20-year swap agreement on notional principal of $250 million. The issuer said that in structuring their bids bidders should use both the J.J. Kenny Co. municipal bond index and the London interbank offered rate.
In the end, a Libor-based bid carried the day. The synthetic fixed rate, 65% of Libor, was submitted by two bidders: Sumitomo Banks Ltd. and AIG Financial Products Corp. So the state split the deal between them, according to Mr. Cohn.
"That gave us the option of going with one if we ran into problems" with the other, he explained.
The state's obligation on its synthetic fixed rate is 4.06%, and the average Libor-based rate has been 4.4%, and the state has received the difference between the two, leaving it $2.2 million ahead on the deal so far, according to Mr. Cohn.
But using Libor, of course, exposes municipal transactions to foreign interest rate risks, which come under the general rubric of "basis risk" in swap parlance.
Basis risk means that if the variable interest rate is pegged to one index and the synthetic variable rate -- the rate paid by the counter-party assuming the variable burden -- is pegged to some other measure such as Libor, the spreads between the indexes may widen or narrow to the advantage of one party or the other.
But for the purposes of swap agreements over 20-year periods, Mr. Bashawaty said, all interest rates move in tandem enough so that any inequities would eventually even out. "There's some pretty strong relationships so you shouldn't expect it to be a major problem over time," Mr. Bashawaty said.
Morgan hosted a seminar early this month to explain the benefits of interest rate swaps and other risk management tools. Representatives of nearly 80 municipal issuers attended. "There are a lot of people to educate," Mr. Bashawaty said, adding that the firm's intention was to help issuers "know what questions to ask.
"Everybody has to be an educated customer, capable of knowing what an opportunity really looks like, and when it goes by, being able to grab it."
Drumming up municipal swaps deals for the bank, whose high profits in the third quarter of this year relied heavily on its use of interest rate derivative products, was also a goal.
"We want to be able to be in the business of providing risk management services," Mr. Bashawaty said. And that includes the use of interest rate swaps to hedge against fluctuations in interest rates.
"It's a long process to educate people to think across their balance sheet," he said. Some of the concepts bankers have to explain include why issuers with too much outstanding variable-rate debt might want to swap some of it to fixed-rate. Or how, with the prospect of further declines in interest rates, issuers locked into fixed rates on their outstanding debt and with assets generating variable-rate income might want to swap some of their debt to variable rates to avoid an interest rate squeeze.
"Beyond educating people, you're going to have to get some product standardization" before the municipal swap market can make wide use of competitive bidding, he said.
Sizing Up Providers
Such issues as whether bids will include up-front fees will have to be addressed, Mr. Bashawaty said. And if both deals with fees and without them can be bid, what standard method could issuers use to compare bids with fees and those without?
Another question issuers will have to answer before they can benefit from competitive bidding is how to size up swap providers, or "pricing counter-party credit risk," Mr. Bashawaty said. While the effects of a double-A-rated counter-party on an issuer's own finances and credit rating might seem negligible, the counter-party credit quality can become extremely important if the issuer decides to swap out of its position.
And Mr. Bashawaty also said that before competitive bidding can become the norm, financial advisory firms are going to have to learn more about interest rate swap procedures. "Financial advisers need to come up to speed if they want to run municipal swap auctions," he said.
For Connecticut, one of a handful of issuers to solicit bids for a swap, the risk of taking the competitive route seems to have paid off. "We were the ones who pioneered the competitive process for picking the swap provider, and we did very well by it," said Benson R. Cohn, Connecticut's assistant treasurer for debt management.
Although he declined to say how much money the state saved, Mr. Cohn explained that when he began considering an interest rate swap, the up-front 1% fees mentioned by prospective counter-parties seemed prohibitively high.
"We had a lot of proposals, and one thing that really put me off was the size of the fees suggested or demanded," Mr. Cohn said. "The fees that we were quoted up front seemed excessive."
That is especially the case, he said, in view of counter-party risk--the risk issuers assume by entering into such a long-term financial marriage with the swap provider. In addition, some of the first proposals that Connecticut received fell below the state's minimum credit quality level.
The number of suitors that lined up for the state's business boded well for some sort of competition, Mr. Cohn said. "The situation was ripe for a competitive process," he recalled. "A lot of firms were interested in breaking into the municipal swap area.
In July 1990, he said, "It became known through The Bond Buyer that we were looking at swaps, and the proposals came pouring in." The state was approached by about 10 firms, he said.
One issuer now trying to use competitive bidding to enter into an interest rate swap agreement is Louisiana. When it refunds the $125 million outstanding from a 1985 variable-rate issue, the state would issue $25 million as fixed-rate college saver bonds, and swap to variable.
Cheryl E. Jones, president of Jones Municipals, the state's financial adviser, said she decided to pursue competitive bidding of the swap agreement for the same reasons Connecticut officials did.
"We've seen these incredible upfront fees," Ms. Jones said.
So the rules are no fees before, and also, no payoffs after. "We will ask that all parties sign certificates at closing tha say they have not participated in the swap providers' profit," Ms. Jones said. So far, she said, 12 firms are potential bidders.
"We plan to have documents and the basic structure available to potential bidders," Ms. Jones said. Then next step would involve creating a "short list" of "a handful of bidders who would be the more serious competitors. You can presumably prescreen bidders for credit level and also for some indication of where they might be on price."
What happens if bidders say they will provide swaps for a lot less than they ultimately bid? "If someone low-balled just to get into the select group and then came in with a bid that was so far off where they said, I think we'd have the right to reject that bid."
Doubts About Bidding
Not all municipal issuers are even sure that competitive bidding is the best approach when it comes to selecting partner for an interest rate swap.
Philip N. Shapiro, the chief financial officer and director of finance and development at the Massachusetts Water Resources Authority, said he falls into that category.
First of all, most municipal finance officials lack the know-how needed to choose among swap bids. "There are very few issuers who can actually generate the terms and conditions of a swap and say, 'This is what I want and need,'" Mr. Shapiro said.
The authority does have that sophistication, Mr. Shapiro said, but competitive bidding is still not the answer for several reasons.
"We certainty don't want to discourage innovative and creative ideas that would save the ratepayers money," Mr. Shapiro said. "So that if someone approaches us on a proprietary basis, I think it would be unfair of us to then turn around and put that idea out to bid with our own nameplate on it."
Not soliciting bids for specific transactions, he said, leaves the door open to creative interest rate transactions all year long, without the possibly stifling effect of competitive bidding.
"It's a far more competitive atmosphere on an ongoing basis if you do have people feeling comfortable to bring you creative ideas and looking for new ways to bring value to a new issuer," Mr. Shapiro explained. "That's competitive on a 365-day-a-year basis, as opposed to the two-hour basis when you open the bids."
What will competitive bidding to to the already competitive municipal swaps market? According to Mr. Bashwaty, it may lead to a winnowing, with displacement of firms that are smaller and have less overal experience in derivative products.
"What it boils down to is, competition always identifies at the end of the day, who's got the competitive advantage? "And J.P. Morgan, Mr. Bashawaty said, is already the leader in the taxalbe interest rate swaps arena.
"If you're trying to come into this game and saying you can be a niche player, you probably will be able to make some money for a couple of years," Mr. Bashawaty said. But, he added," as the product gets more and more standaradized, you're going to find these people having a tougher and tougher time doing business."
That is particularly true because the municipal market generally requires longer-term arrangements than the corporate market, where borrowers have shorter obligations. Larger firms and banks with long histories will prove more attractive as counter-parties over the long haul, Mr. Bashawaty predicted.
That will leave some of the niche players forced to team up with other firms that have compelementary attributes, he said.
But that will not be acceptable, either, Mr. Bashawaty said, because having more than one counter-party on one side of an interest rate swap would add what he called a "middle-man fee" to the transaction.
"At the end of the day," he said, "both parties have to make a profit at it."