Derivatives Q: and A: Donald Carey, managing director & D. Jeffrey Penney, director, CS First Boston.

Q: There have been a number of recent horror stories where corporate derivatives users got burned. Are the derivatives that municipal issuers use safe? What about derivatives held by municipal investors?

Carey: A lot of people have focused on the volatility of some of these derivative instruments and where the risk resides. In terms of the structured note area, the issuer has very limited risk. It's the investors that have taken the position of risk.

And in many cases, it has been very quantified risk, it has been a suitable investment and it has worked out quite well for them.

A lot of people are unaware that the municipal market is completely different in terms of its structure and in terms of the way portfolios are structured. [Portfolio managers] needed these products to try to compensate for the amount of bonds that were going to be leaving their portfolios much earlier than anticipated.

So as far as safety, from the investors' side, what we've seen is very good use -- being able to manage duration better, being able to maintain yield in a very low-yield environment, and basically substituting some interest rate yield curve risk for credit risk.

Penney: From the issuers' side, we seem to be contending with a notion that derivatives are in a room and if you go in that room, bad things will happen to you. You will somehow be affected by the activities of other people in the derivatives market, some of those that you're reading about in the paper.

That's really not the case. There's a complete disconnect between what some people do with derivatives and what municipalities do with derivatives, and that disconnect goes so far as to say if one person has a bad experience, that does not necessarily mean the municipality will.

It comes down to application. We are very highly focused on suitability and we're very highly focused on the notion of using derivatives for hedging purposes, not for speculative purposes.

It may be useful to distinguish a hedge that a municipality uses from the activity of so-called hedge funds. That terminology has cast some confusion over what is a true hedge. Municipal derivative transactions tend to be designed to limit risk, to transfer risk, to save money, to improve flexibility, to provide options, to provide alternative access to capital. Whereas a speculative type of an arrangement would be one that was making some assumptions about things that could happen in the future.

It's also important to note, when you look at derivative transactions, how they are designed and what they promise to do. With derivatives that you may have read about in the paper where someone has lost money, the derivative didn't break. The derivative is working as it was designed. Nothing happened that went wrong, except the underlying assumptions about why that was a good transaction.

In the municipal transactions, look at how [derivatives] were designed to work: to provide a fixed rate of return, or to provide cost-effective floating-rate debt or to create a fixed rate of interest. As long as they work as they're designed, they will do that.

Q: Inverse floaters were designed to outperform other bonds in a falling rate environment. How have they weathered this year's rising rates?

Carey: If you look at the early generation, they worked out as exceptionally well-performing products in a period where you had a bull market and limited access to bonds and you had a need for current income. People leveraged, and in some cases bought bonds that made it through the entire cycle. The bonds were actually de-leveraged because they were prerefunded so that they really wound up with phenomenal securities. Prerefunded bonds are the most sought after bonds in the market because they also can be stripped and sold off.

Even now, with the market disruptions in the spring of 1994, in cases where [investors] looked to rebalance their portfolio and have linked some of the securities, they've seen a very good outperformance in terms of the linked bond. That higher coupon is in demand given the problem that some discounts have had in the market.

Q: What are the latest trends in the inverse floater market?

Carey: As the product has evolved, the disclosure has improved in terms of the secondary market. People are more comfortable now being able to put these securities out for the bid and get numerous bids. I know that on the programs we're involved in -- the issues that we've [taken part in] structuring and then in general, whenever we see them for the bid -- we're a very competitive bid.

From a disclosure point of view, the information is out there to a wider group of the market, which is good from the investor's side. And from the liquidity point of view, the products have become more accepted and more understood. It's clear that with the need for short-term tax-exempt paper, the ACES market [of auction rate securities] has held up quite well, able to hold its spread to other short-term pieces of paper, and the investors have wound up still enjoying good current income as a result of that.

Q: So the market was moving in the opposite direction but the liquidity was still there?

Carey: Liquidity was there and it was important that there had been wider disclosure and that there were more people and there were investors looking for those types of coupons.

Now, the very last inverse floaters that came before the market corrected were the ones that probably had the most volatility. People said those are the securities that they look to sell quick because they can have have the same problems with the [original issue discount] treatment.

Q: In the structured note business, some of the mutual funds on the taxable side got in trouble using structured notes, but the tax-exempt side has been pretty good.

Carey: Yeah, I think it's worked very smoothly. I know of a number of cases where on structured notes investors basically reversed out of the swap and wound up with a fixed-rate bond.

In many cases, what took place in the structured note market and tax-exempts was that it became very competitive. Investors were very astute at going around and making sure that they got the highest possible market in terms of what structure they're seeing. And in the same case they've kept abreast of the market, and when there have been some serious changes in the swap market, they've taken advantage of it and gone out and reversed the swap.

Q: What's been your experience with public sector officials?

Carey: Our experience with the public sector people is that the staffs are very informed of what they're entering into. In many cases, they have financial advisers and bond counsel that basically test these products and test the legality and so forth. And in many cases, they go out and receive competing proposals so there's clearly an understanding and a pricing that takes place that we think proves that they have adequate knowledge of the product.

Penney: There's a lot of educational material out there now. We and others provide materials at conferences and invest whatever time is required with people and answer their questions and tell them what we know about what we do.

There's obviously a tremendous amount of curiosity about what's on the other side. For example, if we're paying a municipality fixed and they're paying us floating, they assume that, well, if a big investment bank wants to do the opposite from me, what am I doing wrong?

And then we go through the process. We're actually running a matched book and where we make our money is in the bid-offer spread. If we're paying you fixed, we're going to receive fixed from someone else and what we're paying you fixed is a couple of basis points lower than what we're receiving fixed from somewhere else. And the floating leg cancels out.

You get the notion of us being a market maker, a facilitator that requires the municipality know us and not another entity on the other side of the equation, however we hedge our book.

Then we go to the step with some people and say, well, let's pull out the [International Swaps and Derivatives Association's] master agreements. Let's negotiate them. Let's make that investment. There's no obligation to use it although you may find yourself doing so in the future. It's an investment that may prove worthwhile in the future, but if not, you've not undertaken any more risk than a legal bill.

Q: Obviously, issuers are not in the swap market every day. How can they be comfortable with the prices that you're proposing?

Penney: There's a lot of ways you can do that. First of all, the market is far more evolved today than it's ever been and there are a dozen or more market makers in swaps of all stripes. Assuming you are talking about PSA and Kenny swaps, there are brokers in that market for swaps, brokering that activity. So there's information to be accessed. There's a lot of quotes, there are indications that you've got to gauge the market.

DONALD CAREY, MANAGING DIRECTOR, & D. JEFFREY PENNY, DIRECTOR, CS FIRST BOSTON

Derivatives have been much in the news in 1994, but not for reasons Wall Street dealers like to see. Some prominent corporate users and mutual fund investors have experienced losses.

That's left municipal issuers and investors asking one question: Are municipal derivatives safe?

Donald Carey and D. Jeffrey Penney have a reassuring answer.

Carey, a managing director at CS First Boston, oversees his firm's municipal financial products group. He joined First Boston in 1986. Under his direction, the firm has structured and sold derivatives such as interest rate swaps, indexed floating-rate bonds. and inverse floaters.

Carey also serves as co-chairman of the Public Securities Association's task force on derivatives information standardization. In December. the task force released a list of standard features that market participants should disclose on three popular derivatives.

Penney, a director at CS First Boston, coordinates the development of new products for municipal issuers and works closely with the firm's sales and trading professionals.

The two sat down with staff reporter Aaron Pressman earlier this month to discuss the derivatives market emphasizing-that municipal derivatives are just "the tail on the dog,"

"What the issuer has to do is determine how they want to raise capital or what problem they want to solve," Penney said. "Then it's up to them and their bankers to find the alternatives, and that may involve derivative solutions.

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