Merrill Lynch & Co. says it has found a way to offer municipal derivative clients a triple-A counter-party, despite carrying only an A1 rating from Moody's Investors Service.
In a move that several swap providers say could presage similar developments by other industry participants, Merrill Lynch announced it has created a new affiliate, Merrill Lynch Derivative Products Inc., to handle its top-rated derivative clients worldwide.
Moody's Investors Service on Monday assigned as Aaa rating to the affiliate, citing its "superior structural and legal integrity." Also important, the agency said, are the firm's strict methods of controlling exposure to counterparty risk and its commitment to capitalizing the company to cover any losses.
For now, Moody's has only approved the use of swaps pegged to the London interbank offered rate, so the new company cannot yet deal in municipal derivatives keyed off of the J.J. Kenny index, by far the most popular index among municipal swappers. Other indexes will be reviewed for approval as Merrill Lynch submits them.
Samuel B. Corliss Jr., a managing director at Merrill Lynch, said it is not yet clear exactly when the firm will seek approval for the Kenny index. The Public Securities Association is working to develop a replacement for the Kenny index for municipal swaps, and Mr. Corliss said he expects Merrill Lynch to also seek Moody's approval for whatever index emerges.
Credit quality concerns have taken on enormous importance in both the $3 trillion corporate swap market and its relatively puny municipal cousin over the past few years, as potential swappers began moving toward higher-rated counter-parties for extra security.
Although Merrill Lynch is considered the dominant player in municipal swaps, competitors have increasingly pointed to its relatively weak credit ratings as a possible Achille's heel. But officials at other firms generally praised Merrill Lynch's new strategy yesterday.
"It's an impressive and forward-thinking move," said Peter Shapiro, a manager of municipal derivative products at Citicorp Securities Markets. "I think it's the direction others might certainly look at."
Alan D. Marks, executive vice president and managing director at Smith Barney, Harris Upham & Co., said the development highlights that "credit quality is an essential element driving this business, particularly as you go longer-term and particularly as you target higher-quality counterparties."
Smith Barney has lately solved the credit quality problem by passing on much of its swap business to triple A-rated AIG Financial Products Corp.
Although Merrill Lynch is the first to "create a triple-A rating synthetically," as one competitor put it, First Bostoon Corp. uses its triple-A affiliate, Credit Suisse Financial Products, as a swap counterparty for top-rated clients.
D. Jeffrey Penney, vice president of municipal financial products at First Boston, noted that there is a great deal of credit-sensitive business emerging in the derivatives field. "It's necessary to have this type of entity to compete successfully," Mr. Penney said.
Another swap professional said he will be watching the new company's swaps to see if they trade like other triple-A credits, or if the firm will have to pay a market penalty for its relationship to a lower-rated securities firm.
Much of Merrill Lynch's municipal swaps business will continue to be handled through Merrill Lynch & Co., and clients whose counterparty is the derivative unit will still deal with the same officials at the firm, Mr. Corliss said.
Under the new company's legal structure, each transaction executed with a customer must be accompanied immediately by a "mirror image" transaction between the derivative unit and Merrill Lynch, eliminating the derivative unit's exposure to fluctuations in interest rates or currency exchange rates.
Moody's, which last week upgraded Merrill Lynch to A1 from A2, noted in its analysis that Merrill Lynch Derivative Products will be exposed to potential default by either Merrill Lynch or its derivatives products customers. To offset the risk of a default by Merrill Lynch, the firm must meet several collateralization requirements.
Also, all clients of the new firm must have senior unsecured debt ratings of Aaa or Aa, Moody's said.
Merrill Lynch spent $300 million capitalizing the new firm, and sold $50 million of preferred stock. Standard & Poor's Corp. does not rate the new derivatives company.