WASHINGTON -- State and local issuers that want to leap into the growing municipal swap market must first face two major state law hurdles: Do they have authority to enter into a swap contract, and would the swap be considered debt under constitutional debt limits and other statutory restrictions?
The importance of having clear authority to participate in swaps was underscored earlier this year when the United Kingdom's House of Lords invalidated billions of dollars of swap agreements in the U.K. by ruling that local governments did not have power to enter into them.
Most of the swaps in question were speculative, but the ruling offected nonspeculative swaps as well and left swap dealers facing huge losses. The effects of that ruling have rippled across the Atlantic , several lawyers said.
"It's made people more cautious and made them more aware of the need to assure themselves that governments are acting responsibly within the scope of their authorities in their swap activities," said Thomas A. McGavin Jr., a lawyer with Rogers & Wells in New York.
Model Statute Being Drafted
The International Swap Dealers Association, which represents about 140 swap dealers, is drafting an outline of a model statute that can be used to provide state and local issuers with the authority to participate in municipal swaps.
"It's our view that if governments are to use swaps effectively to manage their risks, they need to have unambiguous authority to enter into them," said Mark Brickell, chairman of the swap dealers' group and a vice president of Morgan Guaranty Trust Co., a subsidiary of J.P. Morgan & Co.
Most bond officials and lawyers say the municipal swap market would benefit if issuers had model legislation for swaps.
"Legislation is something we all want," said Samuel B. Corliss, managing director of municipal products for Merrill Lynch & Co. Standardized legislation and documentation "would be good for market liquidity" and would save issuers money because dealers and lawyers would not have to do extensive research on what authorities exist or are needed for a transaction, he said.
While some states, such as California and Nevada, already have enacted laws that specifically authorize their participation in interest rate swaps and other derivative products, most states have no such laws.
But the absence of specific authorities has not precluded participation in the swap market. An increasing number of states, like Texas and Louisiana, are interpreting or amending existing laws for authority to enter into interest rate swaps. And others are obtaining authorities for specific transactions.
According to industry officials and lawyers, more than a dozen states have authorities allowing some state and/or local participation in swaps. Besides the four already mentioned, some of these include Arkansas, Connecticut, Florida, Hawaii, Illinois, Maine, Massachusetts, Michigan, Minnesota, Ohio, Rhode Island, Tennessee, and Washington.
"I don't think I've been associated with a transaction that made economic sense [and] that couldn't be done somehow," said one investment banker who did not want to be identified. "Most of the major states have something they can rely on to participate in the swap market, either something they've specifically enacted, or existing powers or a process by which they can get authorization for a particular transaction," he said.
California by far has been the most progressive among those states and localities that have adopted laws providing specific authority for swaps and other derivative transactions. "California was the first state to have express authorities, and they are quite broad," said Roger L. Davis, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco.
Legislation enacted in 1987 allows all governmental entities in California to enter into a variety of hedging transactions, including interest rate and currency swaps, caps, floors, puts, calls, options, forwards, and futures.
Nevada may be the most recent state to adopt authorities for swaps. Earlier this year, the state enacted legislation authorizing municipalities to enter into interest rate swaps of $10 million or more.
The Nevada legislation was driven by Clark County's recently completed $318 million forward swap that was designed to generate about $64 million in present-value savings for the McCarran International Airport in Las Vegas.
New York officials have just begun to discuss the possibility of statewide legislation for swaps and other derivatives, but they caution that such discussions are still in the embryonic stages.
"I think there is a beginning interest to explore this on a statewide basis," said one New York official who added, "Most of the authorities are looking at it."
New York Seeking Balance
Much of the impetus for statewide legislation comes from the fact that while a few issuers in New York have the power to participate in swaps, others have not been able to convince state officials or law-makers that they, too, should have such powers.
"In general, the trend for swaps in New York has been kind of a mixed bag," said David Liebschutz, a financial specialist with the New York State budget division.
The Local Government Assistnce Corp., one of few issuers in the state with swap authority, was given that power in the legislation last year that authorized its establishment. The authority was created to issue up to $4.7 billion of tax-exempt bonds to finance the elimination of the state's annual short-term spring cash-flow borrowings. "They wanted to give the corporation as much flexibility as possible when they set it up," said a state official who also did not want to be named.
The Port Authority of New York and New Jersey, a bistate authority created in the 1920s, also has swap authority and participated in a swap with a $10 million notional amount last February.
"In our case, we looked at [our existing authorities] and there was nothing that prohibited swaps," said John E. Haupert, the Port Authority's treasurer. "The powers to manage our resources, including investment and banking, is all delegated to our finance committee or our board," he said.
Several state officials said these two authorities were able to obtain or recognize existing powers to participate in swaps, in part because their boards are made up of some heavy hitters from Wall Street and New York.
The Port Authority's 12-member board is chaired by Richard C. Leone, a managing director of Twentieth Century Fund who was formerly with Dillon, Read & Co. The LGAC's three-member board is chaired by Gedale Horowitz, a senior executive director of Salomon Brothers Inc., and includes the state's comptroller and budget director.
But municipal issuers like New York City and the state's Metropolitan Transportation Authority have not been successful convincing state legislators that swaps can provide substantial interest rate savings and risk management.
"We went to the state Legislature to try to get authority to do swaps, and that went over like a lead balloon," one New York City official said. He said that the city will have to do more to educate the state lawmakers on swaps before pushing such legislation again.
The Metropolitan Transportation Authority could not even get approval from the New York governor's counsel to go to the Legislature with propoposals to allow it to enter into interest rate and commodity swaps.
"What probably killes us was that we tried to go for the kitchen sink," said Edward Armendariz, director of finance for the MTA. He said the authority will try again but will limit its legislative proposals to interest rate swaps, which got a better reception than commodity swaps from the lawyers.
Most swap market participants agree that one of the major challenges they face is to better educate state lawmakers and members of the municipal market about the benefits and risks of swaps.
"So many legislators and local leaders tend to view these things as some form of gambling and [as] very risky, not realizing that in the corporate world all businesses hedge everything, and this is a hedge tool," said Richard Porter, a lawyer with McCall, Parkhurst & Horton in Dallas, Tex.
The terminology of these transactions has not helped, said Mr. Armendariz. "If we'd just called them something other than swaps. The word swap has such a risky sound," he said. Investment bankers prefer to call them interest rate exchange agreements, but they concede the term swap is probably here to stay.
According to several lawyers, state and local issuers have more of a chance of success in a state legislature if they are pushing a particular transaction.
John Swendseid, a bond lawyer with Sherman & Howard in Reno, said Nevada lawmakers at first reacted to proposed swap legislation for that state by asking," 'Isn't this just a roll of the dice?'" But "the fact that the McCarran airport transaction was proposed and had a lot of savings helped" to convince them the legislation was a good idea, he said.
The District of Columbia recently was authorized by its city council and Congress to enter into a swap in connection with a financing to eliminate its accumulated deficit of $332 million and the need for other short-term borrowings. "No one really knew what swaps were. We had a lot of explaining to do," said Kenneth J. McGhie, the district's debt manager.
A number of states have determined that laws enacted during the last decade to give issuers the power to issue variable-rate demand obligations or to enter credit agreements in connection with commercial paper programs alo can be interpreted or amended to authorize interest rate swaps.
The Texas Attorney General, for example, last year approved a $365.8 million deal involving a forward swap for the Dallas/Fort Worth International Airport after finding that an existing law authorizing issuers to enter into credit agreements for commercial paper programs and variable rate demand obligations was broad enough to include swaps. That law authorizes only swap agreements that were reached or contemplated when the debt was issued.
Louisiana officials said they plan to soon participate in a swap under an existing law that allows public entities to use credit enhancement devices in connection with debt issuances. That law was amended two years ago to define credit enhancement devices as including interest rate swaps, forwards, futures, and other derivatives, state officials said. The swap will involve about $25 million of bonds from a $125 million general obligation refunding issue.
"But even if there's authority for a swap, that doesn't solve all of your problems," said Mr. Davis, the lawyer from Orrick Herrington. Issuers still face another state law hurdle.
They have to determine if a swap would be treated as debt under state laws and therefore would be subject to constitutional debt limits or the need for voter approval.
Most investment bankers, lawyers, and federal regulatory officials say swaps are contracts and should not be considered debt. But they may be defined as debt as debt under state laws.
"I think there are jurisdictions where swaps are clearly considered debt," said Mr. McGavin, from Rogers & Wells. "In most jurisdictions, if you do a contract with a city that unconditionally obligates the city to make payments in future years, the contract will be treated as debt for state law purposes," he said.
Swap market participants said such state law hurdles are not insurmountable. As the swap market continues to grow, they said, states will be looking at the laws they have, or need to adopt, to participate in these transactions.
"I would not be surprised to see more activity at the state level to authorize the use of swaps. It's becoming an attractive option for issuers," said Tom McLoughlin, assistant director of the Government Finance Research Center.