The debate about just what products should be considered derivatives turned hotter recently, following new regulatory initiatives and horror stories about unexpected losses.
And with Congress considering several bills to increase regulation of derivatives dealers and investors, the debate could be more than an academic exercise.
R. Fenn Putman, chairman of the Public Securities Association, spoke out last month with a complaint about municipal disclosure guidelines issued by the Securities and Exchange Commission.
The guidelines recommend a two-pronged approach: Issuers should disclose in their financial statements how they are using derivatives and whether their derivatives and could have a material effect on their financial condition. In addition, the guidelines said, issuers should disclose in offering statements information about the terms and risks of the derivatives products they sell to investors.
Putman is concerned that issuers will have trouble complying with the guidelines unless derivatives are more clearly defined.
The problem "is we haven't defined what the word ~derivative' means," Putman said. "We've now defined almost everything that isn't conventional passbook savings as derivatives."
The basic definition of a derivative is a product that derives its value from another security, asset, or index. Interest rate swaps, inverse floating-rate municipal bonds, and a host of other products fall under this definition.
But among this broad classification are products with very different performance characteristics, volatility, and risks.
Putman, for example, believes that the term derivatives should be applied only to interest rate swaps, caps, floors, options, and other products whose value is derived from an underlying security through a contract. Inverse floaters, he maintains, are securities with adjusted cash flows, not derivatives.
One of Putman's main concerns, is that regulators and market participants understand that inverse floaters typically are fixed-rate securities for issuers, even though they are variable-rate securities and potentially volatile for investors.
As a result, while the issuer and the broker-dealer have an obligation to describe the inverse floater and its potential volatility or risks for the investor, the issuer should not have to disclose any information about the product in its financial statements because the product will have no effect on its financial condition, Putman said.
Putman's goal, he said in an interview this week, is a better informed market. "The sentiment here is education," he said. "I think people need more education because the better informed people are, the better the markets are going to function."
The PSA, along with other industry groups, hopes to educate lawmakers and regulators in Washington. Monday, the PSA held a symposium on derivatives for Congressional staffers. It has also met one-on-one with key regulators and legislators.
More initiatives will be forthcoming, Putman said. The association is working on a handbook of municipal derivatives that will be released "shortly," he said. The association might issue guidelines for complying with the disclosure rules, similar to its release on complying with the federal ban on political contributions, he added.
Samuel B. Corliss Jr., managing director of municipal derivative products at Merrill Lynch and chairman of the PSA's subcommittee on municipal derivatives, said he is also concerned.
"We are going to look into this further," he said. "We have the feeling that more should be done for disclosure. Are we trying to describe the effect on credit of the issuer or something for investors, the price/performance characteristics? How should the [official statement] treat that question?"
Other market participants fret that their products will be unfairly tarred with the derivatives label.
"Here is a story about losses in the mortgage-backed securities market, and here is a story about a disastrous leveraged currency swap," one municipal derivatives professional said, referring to the well-publicized troubles of Procter & Gamble and portfolio manager David Askin. "None of those stories has much to do with the popular products in our market."
New regulations that mandate identical treatment of dissimilar products could increase the cost of doing business without adding much safety or disclosure to the system, Wall Street executives said.
But the industry's comments are not well received in Washington Some even said the industry is using a double standard, relying on board or narrow definitions depending on which one suits its purpose of the moment.
"They can't have it both ways," said an aide on the House Banking Committee. "They can't have something a derivative for the purpose of taking advantage of the netting provisions of the banking laws, but then not have it a derivative for other purposes."
The SEC's municipal disclosure guidelines are intended to enhance disclosure about all products, whether they are called derivatives or not, an official at the commission said.
"I don't care what label you put on things as long as the disclosure is adequate for me to understand the risks," an SEC official said. "I could say to you, ~I don't care -- call your CMOs derivatives or not -- if you have substantial risks in CMOs, you have to disclose it to me.' You don't have to call it a derivative. I would say the same thing with inverse floaters or anything else."
The regulators and the industry do seem to agree that the definition chosen for a particular law or regulation should match the goals of the rule.
"You have got to figure out what you are defining it for. You've got to figure out what you are concerned about," a federal regulatory official said. "You may have a product that may not be a derivative for capital purposes. On the other hand, it may be sufficiently complicated and risky that you may want to view it as a derivative for suitability purposes."
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