Recognizing that the burgeoning municipal derivatives market is being hampered by a mishmash of different forms and ill-adapted indexes, the Public Securities Association says it hopes to bring some degree of uniformity and greater efficiency to the field by early next year.
The first step in that process began in April, when the PSA formed a new Municipal Derivatives Committee to address concerns by numerous dealers about problems with the flagship derivatives product -- municipal swaps.
George Brakatselos, a vice president at the association and staff adviser to the committee, earlier this month said the committee hopes to announce significant progress on its two major swap initiatives -- developing a new index and standardizing documentation -- by the first quarter of 1992.
That timetable is a pleasant surprise to dealers, who say they expected the complicated process to take much longer.
"People have been quite pleased at the speed that this seems to be moving along," said Donald C. Carey, director of First Boston Corp.'s municipal financial products group. He said he and many of his counterparts at the 29 other member firms of the committee thought the process would take at least two years.
"Now we think we'll see something happening in the next six months," he said.
Since the inception of municipal swaps in the mid-1980s, the standard index used to peg deals has been a J.J. Kenny short-term municipal index. But the Kenny index does not directly reflect actual variable-rate deals and is more of a theoretical approach approximating where the variable-rate market is for the week, dealers say.
For the past several months, the PSA has been working with market participants including J.J. Kenny and Municipal Market Data, a Boston-based data and research firm, to find a methodology that better reflects where actual deals are coming to market.
Sources involved in the effort say the PSA is leaning toward using Market Data's data base and resources to tackle the new index, although no final decision has been announced. The firm has more than 5,000 active issues in its data base, and repricings are updated as they occur. Market Data officials say that would enable them to devise an index that tracks the swap market more closely than the current Kenny index.
The problem with using the Kenny index in its current form, market sources say, is that while it is a fair representation of where rates are for the week, it does not track the market closely enough for swap clients' needs.
"If a client has a weekly floater out, and you want to pay them some other variable rate, you want to get them a rate that correlates strongly with their own," one swap provider said. "The Kenny index doesn't correlate very well with weekly floaters."
Mr. Brakatselos said officials at the PSA are confident they "can come up with an index that will closely track the short-term market, rather than a theoretical index that's currently being used."
Document Standardization
The group's standardization project is another area of great interest among members of the dealer community.
Working closely with the International Swap Dealers Association, which is the main trade organization for global swaps, the PSA has surveyed dealers to try to find common ground on which to build standard swap documents.
The survey found most swap providers alter the swap association's documents to fit the unique needs of the tax-exempt market. The differences between each firm's deals, however, are enough to create liquidity concerns as the market expands.
Samuel B. Corliss Jr., a managing director at Merrill Lynch & Co., said the document standardization effort should be helpful of the liquidity issue. But he said it will be difficult to devise anything approaching the degree of standardization that the taxable market enjoys.
"I'm not sure how standard you can get with public entities because they are subject to so many more tax and regulatory questions," Mr. Corliss said. "But any attempts will greatly help liquidity."
Mr. Carey at First Boston said the survey results will help the market get a sense of the different documentation alternatives being used. But he agreed the municipal market will never see complete uniformity in documentation. Swap documents will always be negotiated contracts tailored to the needs of individual issuers, Mr. Carey said.
One issue related to the standardization effort is how fees are explained to clients. When Merrill Lynch launched municipal swaps in the mid-1980s, the firm attached up-front fees to most of its deals, a practice not found in any other swap market.
"A lot of effort goes into creating a swap program, and since that effort is front-end, we feel the compensation should be front-end," Mr. Corliss explained.
But the practice has generated concern among Merrill Lynch's competitors, many of which do not use up-front fees.
Issuers Must Understand Fees
Albert C. Bashawaty, a vice president at J.P. Morgan & Co. in charge of muni swaps and derivative products, said that if the practice of charging up-front fees is to continue for municipal swaps, then the market has to do a better job of explaining to issuers how they work.
"I think what's happening now is that people are confused first of all as to who charges them and who doesn't, and whether it's a market practice," Mr. Bashawaty said. "Even when they realize one has an up-front fee, they have a hard time converting what rate they would have gotten had there been no up-front fee."
Mr. Bashawaty explained that the difficulty stems from differences in the way the dealer community discounts cash flows and how issuers are likely to make the calculations. That problem impedes the competitive bidding process, he said.
Mr. Corliss said Merrill Lynch carefully explains to issuers how the up-front fee works, and he said the firm has not had any trouble with issuers not understanding the pricing of a deal.
The Public Parking Authority of Pittsburgh, however, did express concern earlier this year about how the up-front fee affected the price of its 1989 Merrill Lynch swap deal, after a report by Lehman Brothers suggested Merrill Lynch's deal cost authority officials much more than they were led to believe.
Mr. Corliss noted the authority recently asked Merrill Lynch to handle a new swap, implying authority officials still have faith in the firm.
But D. Jeffrey Penney, vice president of municipal financial products at First Boston, said fees in general are not well understood by issuers. Issuers are often oblivious, for example, to broker fees between two firms handling different aspects of remarketing efforts on a swap deal, Mr. Penney said.
"I've yet to be 100% confident that issuers going into a swap transaction have their arms around these fees," Mr. Penney said.
Mr. Carey added that educating issuers about fees "could be one of the real positives to come out of the standardization effort."
