Few Issuers Use Products, Expressing Concern About Limited Knowledge of Complicated Market

Only 6% of municipal issuers have used derivative products in connection with debt sales, while another 38% would consider using derivatives, according to a survey of members of the Government Finance Officers Association.

Most derivatives users are big issuers of debt. More than 53% of users said they annually issue over $50 million of bonds, and 87% said their jurisdictions serve over 100,000 people. In the sample, only 11% issued more than $50 million of debt, and just 34% served more than 100,000 people.

"The overall theme is that state and local governments are approaching this very prudently and cautiously," said Robert R. Godfrey, executive vice president at Municipal Bond Investors Assurance Corp. "The challenge to the industry is to get this down to the lower volume [issuers] but also to make sure everybody understands it."

More than 1,600 finance officers responded to the survey, which was sponsored by the GFOA and MBIA. The survey was sent to 10,369 members of the finance officers group.

Although derivatives users were situated in 25 states, more than one-third of them were in California or Florida. The two states have large, active issuers and laws that are conducive to derivatives, market participants said.

Many issuers, about 58%, remain unconvinced of the merits of derivatives They said they had never used derivatives and would not consider using them.

The findings are consistent with a recent survey done by the General Accounting Office in connection with its two-year study of derivatives. The survey, which also questioned GFOA members, found that in 1992 4% of local governments and 17% of state governments had used derivatives. The GAO also surveyed pension fund managers and securities dealers.

The GFOA/ MBIA study did not specify that a year, but asked issuers if they had ever had ever used derivatives.

The GAO study had a higher response rate than the GFOA/MBIA study. The GAO sent out surveys to 4,468 issuers. Almost 80% of local governments and 74% of state governments returned the survey.

The GFOA/MBIA survey's response rate was about 15%. Among the finance officers who responded to the survey, 64% worked for municipalities, 17% worked in county governments, 14% worked at special districts, 3% worked in state government, and 2% worked at other levels.

Like the GFOA/MBIA survey, the GAO survey found that users of derivatives were larger, on average, than nonusers. At the local governments level,derivatives users had average assets of $490 million compared to an average of $80 million for nonusers. The GAO found that state users had average assets of $14.3 billion, compared to assets of $2.8 billion for nonusers.

Among all those that had not used derivatives in the GFOA/MBIA survey, 51% said they were not convinced that the products would benefit their jurisdictions.

Risk, Complexity Cited

Excessive risks were cited by 36% of those that had not used derivatives while excessive complexity was cited by 38%. Just 25% of nonusers said they were not legally authorized to use derivatives.

Among nonusers, one-fifth said they had been approached by financial advisers or underwriters about derivatives "as part of debt issuance plans."

Finance officers that had used derivatives reported a higher level of understanding of the products, the survey found. Among issuers that had used derivatives, 22% said they were very knowledgeable about derivatives and another 57% said they knew "the basics." About 17% said they "have some knowledge," and 2% confessed they knew little or nothing about derivatives.

Among non-users, 2% said they were very knowledgeable about derivatives and another 18% said they knew basics. About 36% said they had "some knowledge," and 44% confessed they knew little or nothing about derivatives.

Swaps and forward swaps are the most popular derivatives, the GFOA/MBIA survey found. Among derivatives users, 48% had entered a "simple" interest rate swap. 37% had entered a forward interest rate swap, and 14% had sold with embedded swaps.

In an embedded swap issue, the issuer sells variable-rate bonds with an unusual formula for calculating the interest rate. The issuer then enters a swap or similar hedging agreement to offset its risk on the transaction. The result is an almost perfect hedge for the issuer. The bondholder, however, faces significant market risk on many such transactions.

Less popular products included inverse floating rate issuance, cited by 24% of users and interest rate caps, floors, and collars, which were used by 17%.

The findings are similar to those of the GAO study. The agency said interest rate swaps were used by 49% of local governments that used some derivatives in 1992. The second most popular product, options, were used by only 16%.

But at the state level, the GAO found that foreign exchange products were the most popular derivative, with a 41% usage rate. Futures and options, both cited by 33% of state users, were second in popularity. Swaps were cited by only 25% of state users.

The average term of the transactions in the GFOA/MBIA study was 8.6 years for swaps, 9.7 years for embedded swaps, and 13 years for forward swaps. The average term for inverse floaters was 19 years and the term for caps, floors, and collars was 5.5 years.

Most derivatives users said that use of the products helped them accomplish their goals. About 87% said they fully achieved their goals, while 10% said they partially achieved their goals, and 3% said they did not achieve their goals.

A similar proportion of derivatives users felt that the products were well explained to them. About 89% felt the benefits were clearly explained, 11% felt the benefits were partially explained, and none felt that the benefits were not explained.

About 87% felt that the risks of using the products were clearly explained, while 11% felt the risks were partially explained, and 2% felt the risks were not explained.

Survey Studies User Goals

And what goals were issuers hoping to achieve? The most popular answer in the GFOA/MBIA study, cited by 62% of derivatives users, was to lower borrowing costs. Including embedded derivatives on a bond issue typically results in a savings of 5 to 10 basis points for issuers. The savings on synthetic fixed rate deals are even higher.

About 49% of users said they opted for derivatives to lock in today's interest rates. Forward swap deals, for example, allow issuers to execute synthetic fixed-rate transactions at close to today's rates for bonds that will not be sold until later. Issuers can also take advantage of interest rate caps, floors, and collars to lock in rates.

About 37% of users said they turned to derivatives to reduce interest rate risk, and 30% said they wanted to reduce debt service uncertainty.

The percentages for issuer goals do not add up to 100% because some users cited more than one goal for derivatives use.

Less popular goals were to adjust the mix of variable-rate and fixed-rate liabilities, cited by 14% of users, and to better match assets and liabilities, cited by 9% of users.

The survey also asked about termination payments. One-half of swap users said their termination payments are legally on a par with outstanding debt.

If a swap is terminated early, one side of the transaction usually must pay the other side an amount reflecting the most future payments. Bondholders worry that an issuer may be forced to make a large termination payment, causing a default. If the termination is subordinate to the bonds, however, the bondholders will be protected in the event of a default.

In addition, just over half of derivatives users said they included credit enhancement on a derivative transaction. Such credit support can enhance bonds or the underlying swap or both.

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