Q: The municipal derivatives market has developed in a lot of ways over the last few years, with increasingly sophisticated products. What's the next step?

Rozsman: In general, we're heading to more tailor-made products for investors to get into their portfolio for hedging purposes or for investing purposes. I think that you're going to see more products designed around investors' needs.

Q: Is that what drives the innovation?

Rozsman: Yes. I think the investors are the key to new products all across the board. We have something they need,, wbich is an issuer. It's the only way to generate tax-exempt interest. If they want a product that performs in a certain way and they're willing to give the issuer a benefit to do it with a below-market rate, we can create that product and tailor it to their needs. I think there's going to be a lot more of that.

Gray: It seems like the pace of development is occurring, quicker and quicker. More people are getting into it. More people are understanding how to value these things, how to create inverse floaters. We're seeing new structures introduced more frequently. It's going to be, more important that the community become more quantitative, understand the structures, and be capable of valuing those structures. We're seeing an increased awareness and an increased quantitative bent. I think that's good.

Q: Issuers are sometimes hesitant to get involved in derivatives. They're afraid they might not understand a structure. Do you find that to be a continuing problem as the market evolves?

Rozsman: Well, I think the base of issuers that are issuing derivative products is obviously getting larger and larger. They pretty much started out in the private sector with health care and housing as your structured issues, and more and more general obligation issuers are doing it now.

There's always a problem of education. They are worried about the complexity of the structure and what the documents look like, but those documents are becoming more and more boilerplate. And some of them are always concerned about, "Am I getting something for nothing here or are there hidden risks?"

Q: Well, are they?

Rozsman: With the non-swap derivative products there really are no additional risks. It's just their credit risk that's out there, which is normal in a bond.

Q: And what about on the swap-related products? They do take some risks there.

Rozsman: With the swap-driven products there are some trade-offs. There is some counterparty risk that can be alleviated through collateral or through insurance or through mark-to-market pricing, but all of these issues can be dealt with. It's getting easier.

Q: Last month I heard about an issuer asking for insurance on a swap counterparty, and the counterparty involved in the swap was AIG Financial Products, which is triple-A rated. Is that necessary?

Rozsman: I don't know the particulars of that deal. But often on swap-driven products, the issuers will ask for either insurance or the posting of collateral, which is, in my opinion, a much better way to go. It's better than putting the swap into one of these triple-A subsidiaries, because there's a lot of restrictions to keep that triple-A. I think the issuer gets more security out of a properly collateralized deal with the counterparty, if that's what he's looking for.

Q: And what about buyers? Have they also moved up the learning curve?

Gray: To give you an idea of the base of development of derivative products in the market, when we started doing RIB/SAVRS three years ago, we spent several months developing the product and probably four or five months in premarketing the product to potential RIB buyers - a very long period of time. [On Aug. 5], when we did the pricing of the Philadelphia bull-forward, bear-forward transaction, we had developed the financing structure over the previous month. We presented it to our salesmen on a Monday and by Tuesday, when it was priced, the thing was entirely sold to outside buyers, and these are very sophisticated instruments.

Q. The Wall Street Journal had a story recently that widows and orphans were being sold derivatives, and that has generated a lot of controversy about the sale of derivatives to retail investors. What is Lehman's policy?

Rozsman: Well, we at Lehman, we have not sold any of our derivatives retail at an. Every one of our derivative products, be it RIBs, be it SAVRs, Bulls, Bears, [bond payment obligations], whatever, is an institutional product. Nothing has gone to retail. That's been our policy. That's not to say that they don't think that there are products that retail should buy. We just have not done that yet.

Merrill has put out a [Tax-Exempt Enhanced Municipal Security] product, but the way I looked at that structure, I thought that was a very, very interesting and secure structure, because they had [an interest rate] floor on it and it was a high credit quality. So I personally thought it was a good buy for retail investors. But we at Lehman have not at this point done that. And, of course, with the sale of our retail system we probably won't, because we don't have have much of a retail system at this point. Gray: I'd like to comment on the TEEMs. I think the TEEMs approach that Merrill took was a very good approach. I think if you looked at what the TEEMs investor has received on that product it has been an exceptionally good return, and if properly structured you can limit your risks on the derivative product.

Rozsman: I think the floor on the TEEM structure, actually the minimum rate that an investor could get, was higher on a very high-quality credit bond than a retail investor would get through a [certificate of deposit]. So the way I looked at that, the worst thing that could happen to that investor is he's getting a tax-exempt rate that is higher than the taxable CD rate. The upside is very good. If rates stay low, they're really going to get a nice rate. So I did not see a lot of risk in that to a retail investor at all because of the floor. I thought it was a very conservative product, really.

Q: I think a lot of horror stories have come out of the mortgage-backed market, where some products were marketed as triple-A but without explaining the market risk. Has. that caused a problem for municipal derivatives?

Rozsman: Well, in the mortgage market, there was a lack of education from the retail investor's point of view that prepayments are involved. We weren't talking about that with TEEMs. I just don't think they're the same at all because there were no prepayments on these.

Gray: The mortgage market-type problems that have occurred have occurred in secondary market transactions, too. When you're talking,about pricing something properly out of the jump, like a TEEMs deal, that's one thing. When you're talking about trading obscure derivative securities in the secondary market, that's quite another thing. I don't think that's a good comparison at all.

Q: Which leads to another topic. There have been a couple of proposals floated to either change the tax laws or use some of the amendments to the Investment Company Act of 1940 to facilitate structuring derivatives in the secondary market of municipals. What do you think of those proposals?

Gray: We've been doing a lot of secondary market things on a private placement basis and we, as much as any other investment bankers, have taken structures that we've developed in the primary market and applied them to the secondary market and done so very successfully. Anything that makes the markets more efficient, we advocate.

This [tax-exempt municipal investment conduits] legislation that's being supported by the [Public Securities Association] is certainly a position that we advocate. But whether it's passed or not, we'll continue to do business in the secondary market.

Q. Issuers like to use derivatives because they can shave 10 or more basis points off their interest costs. If the market became more efficient, would that mean that the savings for the issuer in the primary market would decline?

Rozsman: It all depends on the level of interest rates, as to the savings to an issuer. If we could get more efficient in a higher interest rate environment, there would be more savings to the issuer.

Gray: That's right. Savings levels are dependent on a lot of things. With higher interest rates, there could be higher savings on derivatives.

Q: Mark Ferber, when he was at Lazard Freres & Co., and Merrill Lynch & Co. had some side agreements to split fees on swaps. It's not clear what was divulged to issuers. Do you think there's a place for these side agreements or do people need to be more upfront?

Rozsman: I don't know enough about the agreement that they had and what constitutes a side agreement. Certainly there are a lot of co-accounts in a deal. Just from a senior manager to a co-manager on a normal deal, there is fee-splitting going on. That's done all the time.

So, I don't see anything wrong with a fee-splitting arrangement that happens all the time in the market. Now, what went on up there, I have no idea about. I don't know what was disclosed and what wasn't disclosed. I can't comment on that.

Gary Gray and J. Nicholas Rozsman are keeping themselves busy. The two managing directors in the Lehman Brothers municipal finance department have introduced an assortment of new products just this year.

Gray is widely credited with developing the Residual Interest Bond and its counter-part, the Select Auction Variable Rat Securities. Widely copied, the product is now known simply by its acronym, RIB/SAVRS.

But the product has had its ups and downs. The latest arbitrage rules released by the Treasury Department, for example, have created some uncertainty about the use of RIB/SAVRS structures for refundings.

On a refunding, issuers generally prefer to have their debt categorized as "fixed rate" to avoid unpleasant tax side effects. Even though a RIB/SAVRS locks in a fixed rate for the issuer, the arbitrage rules imply that the product could be treated as floating-rate debt.

"The Treasury has admitted that that was an oversight, that a RIB/SAVR is a fixed-rate bond. But the way they wrote the regs, everybody would say it's a variable-rate bond," Rozsman said during an interview at the end of the summer with staff reporter Aaron Pressman.

"I think at this point pretty much the bond community is willing to find that it is a fixed-rate bond, and I think the Treasury is committed to changing it. But who knows where or when or how they'll do that," Rozsman said.

In addition to discussing RIB/SAVRS, Rozsman and Gray considered the overall state of the municipal derivatives market.

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