MBIA Inc. yesterday announced plans to enter the world of municipal derivatives, unveiling a program to synthetically create shorterm paper for tax-exempt money market funds and other investors.
The program, which is an attempt to meet what MBIA sees as a shortage of short-term tax-exempt securities, will be offered through a new company, MBIA Investors Capital Corp.
The company is a joint venture between MBIA and Caisse des Depots et Consignations, one of the largest financial institutions in France.
Money market fund managers say they sometimes face a shortage of short-term investments, and the securities that are available often concentrate exposure in undesirable areas.
Topstar, as the new program is called, offers long-term bonds that carry a right to tender at a given short-term maturity, effectively turning bonds into notes and offering fund managers a highly rated alternative investment. The program will not be enhanced by MBIA, and the underlying bonds may or may not carry financial guaranty insurance, company officials said.
It mirrors programs underway at several major money center banks, including Bankers Trust Co. and Morgan Guaranty Trust Co. of New York.
"Topstar was developed to meet the strong, growing demand for high quality short-term, tax-exempt securities by portfolio and money market fund managers," said David H. Elliott, president and chief executive officer of MBIA. "[It] will enhance the efficiency of public finance by creating a new supply of short-term securities for investors while expanding the market for long-term bonds."
Ian MacKinnon, head of the fixed-income group at the Vanguard Group of Investment Cos., said the supply shortage has not been as big a problem for him as the lack of diversity. He called Topstar an "excellent way of improving both credit quality and diversity."
He said much of the short-term paper available is backed by Japanese banks, which have recently faced severe credit quality problems. Synthetic paper backed by highly rated European institutions will provide a valuable way to generate a better mix of exposure in portfolios, MacKinnon said.
But others said they were unlikely customers.
Gregory Harrington, a portfolio manager at Franklin Advisers Inc., said his company has a policy against using any kind of derivative product and has been rejecting tender-option bonds for almost 10 years.
"We have trouble with it," Harrington said. "Our attorneys feel that we cannot get an opinion that the pass-through is tax-exempt."
Harrington said Franklin has asked the Internal Revenue Service for a ruling as to whether these kinds of synthetic short-term instruments are tax-exempt, but the IRS declined to decide the issue.
MacKinnon of Vanguard said the IRS position is not a concern for him and is in fact not surprising, since the derivative product involved does not create tax-exempt income. The only reason the IRS would get involved, MacKinnon said, would be if the product took taxable income and made it tax-exempt.
He said there may actually be a net revenue gain for the federal government from tender-option programs, because they feed the taxable bottom lines of the companies offering the service.
Other market sources said there has been so much of this kind of paper marketed and even if the IRS suddenly decided to take on the issue, its ruling would likely not retroactively affect outstanding deals.
To find out how big a problem the supply shortage has become, officials at MBIA say they recently conducted a survey of the market. Marc D. Morris, a senior product manager for the new venture, said the study focused on 1991, when there was a demand of about $154 billion for short-term securities.
That year, he said, there was only about $52 billion in straightforward notes offered in the tax-exempt market. The $102 billion gap was filled mostly with variable-rate demand notes, but about $13 billion of the shortage was overcome through derivative products like inverse floaters and tender option bonds.
Morris said he expects Topstar to compete with the variable-rate demand-done market, as well as in the derivative niche.
Officials from the two companies involved said it will capitalize on MBIA's strength in selecting and monitoring municipal securities to use in the program, in conjunction with the risk management experience of CDC Capital, the subsidiary of Caisse des Depots that will help manage the joint venture.
To meet the credit quality demands of money market funds, only double-A or triple-A rated securities will be selected, according to Peggy Garfunkel, a managing director of the new company. Credit quality is also vital because in the event of severe rating downgrades investors loss the right to tender.
Besides the triple-A ratings of MBIA and Caisse des Depots, the program is backed by liquidity facilities from Banque Nationale de Paris and Banque Francaise du Commerce Exterieur.
