Q: Among issuers, there is a wide range of knowledge about swaps and derivatives. How do you approach the topic with issuers?

Williamson: We focus on swaps from a risk management approach. Looking at any type of derivative, you have to understand the risks that initially the issuer is already exposed to on their balance sheet. Part of the education process is to examine their balance sheet, identify those risks, and then educate them on the type of products that are available so they can hedge those risks.

Rai: There's a resistance level to derivatives, as you know. People think they are riskier or present new risk, compared to things they're familiar with. And the fact is, when you sit down and carefully go through what a swap is or a cap or any derivative, the risks entailed in that are no different than the risks that the issuer is familiar with.

They have credit risk. They're familiar with credit risk. They invest their money in bonds. Interest rate risk - they take interest rate risk any time they issue a fixed- or floating-rate bond or invest in a fixed- or floating- rate asset. So a lot of what we do is take the cover off and show them that these are the risks involved. They're not scary risks or unusual risks. They are risks that you're familiar with, and they can think about them in ways that they normally do.

Q: Some people in the market have called for greater disclosure of swap transactions. Is that a good idea?

Rossman: I don't see any reason why they shouldn't fully disclose the swap, what was involved, the costs involved, and the thinking process involved. It's part of the normal risk management activities of the firm, and I don't think there needs to be any secret about it.

Rai: It kind of implies that people are trying to hide things or that there are sort of scary things going on behind the scenes. And again, our view is completely that that's not the case, that swaps and derivatives are 100% legitimate risk management tools and certainly on the corporate side are viewed as very run-of-the-mill things to do to manage your company better. We don't think municipalities are any different.

Rossman: I believe that full disclosure in the long run is better for everybody. There should be no reason not to.

Q: How has the reaction of issuers changed over the last year or so? Are you hearing different responses when you make presentations?

Williamson: I think there's been a transition. I think that they have shifted away from a perception that swaps are very risky, that derivatives are a business that they are not paid to be a part of, to a different position. To a certain degree, it's a function of inquiries from their board or their finance committee.

That's not to say that people are any less careful about entering into the transactions. But they are much more receptive to considering them than they were, say, a year to a year and a half ago.

Rai: Just anecdotally, I don't think there is a medium-sized to larger issuer that is not considering derivatives. Every single request for proposal - or 99 out of 100 - ask questions about derivatives.

Williamson: It's on all different levels. We've assisted people in putting together board presentations to get approval for swaps, assisted in the process of obtaining swap legislation in a few states, and also worked with the financial advisers. We can provide some benchmark pricing and indications of where the market is to educate them on both the legal and documentation side as well.

Rossman: And we do go as far with the client just to show them how we are pricing. We invite them to satisfy themselves that they're getting fair pricing. It hasn't been unknown to take out your calculator in an interview and show them how you get your price, particularly when you're dealing on unwind scenarios.

Rai: And that extends to some of the things that have kind of sprung up unique to the municipal market, such as the cost of funds swap and so-called guaranteed liquidity structures on long-term swaps. I think some people approach that, and they just look at the package and they say, "Oh, the package looks good, I'll do it."

Our approach has been a more detailed and sophisticated approach. We zero in on the cost of funds aspect and say. "Here's the cost of it; here are the benefits: here are the risks." And it's not necessarily a 100% certainty that that's the best thing to do for a particular issue at a particular time. And we try to get them to understand when the cost of funds swap works, when the commitment of the cost of funds swap provider goes away and it reverts to an index, what the cost is and the advantages and disadvantages of guaranteed liquidity.

So our whole approach is, rather than submit a proposal that says here's our deal with guaranteed liquidity and cost of funds swap, we say here is the basic structure, here's a choice - cost of funds swap or not cost of funds swap, and the pros and cons of each.

Q. Is it difficult to feel comfortable that an authority or municipality has authorization, and is it getting any easier?

Rai: We go through a fairly rigorous process to be comfortable that whoever our counterparty is, is authorized and that the obligation is enforceable. Even after going through that rigorous process, it's rare that they're unable to.

Rossman: If at any time we get the sense that somebody is not authorized to do it, we stop the process.

Q: What are the elements of credit risk that issuers need to consider, generally?

Rossman: Our clients are becoming very sensitive to the credit risk as swaps are becoming more of an everyday financing activity. We still believe that the high credit-rated counterparty is the safest way to go.

Credit risk is something that people enter into all the time. It's a risk they're familiar with. We believe that a counterparty should deal with a counterparty with a high credit rating as opposed to worrying about collateral. I don't think collateral is any substitute for good credit analysis on their part. Collateral is always open to operational risks - if it doesn't get posted in time or [isn't] the right amount.

A credit rating is open for all to see. It also aids in the liquidity of the swaps. One of the things that we try to tell our clients is that swaps are assignable. It's much easier to assign a highly rated name than it is one that is not well rated.

Q: What do you mean by assignable?

Rossman: There are various ways to unwind a swap. One of the ways is go to your counterparty and say. "How much do I pay you or do you pay me to unwind the swap?" What you could also do is go to another swap counterparty and say, "How much do I pay you or do you pay me for you to step into my shoes and for me to step out?"

The net effect to that particular entity is he does not have that swap exposure anymore. And a swap exposure can be looked at much like a bond exposure. The economics are pretty well the same.

Williamson: The key thing with an assignment is that a swap can only be assigned with consent of both parties. You have to get the approval of your counterparty to actually execute the assignment.

Rai: Originally many issuers focused on a swap as something they got into today and they would stay in till it ended. I'll do it today and forget about it. And we think that it's much more likely, as people become more sophisticated and learn more how they can use swaps to manage different types of risks, that the liquidity of these instruments will become much more important to them - as it is on the corporate side.

That's why we focus in on assignability. That enhances liquidity. One of the drawbacks of the cost of funds swap [is that it] will generally be less liquid than a swap based on a generic index. Depending on the terms of guaranteed liquidity and how that is all wrapped into the swap agreement, that could also diminish your liquidity. People's focus starts to shift from thinking of swaps as kind of like a bond deal where I issue it and I never think about it again, to a much more dynamic risk management tool. Then the trend will be away from the kind of customization that diminishes liquidity, such as cost of funds or guaranteed liquidity to more flexible structures.

Q: Sometimes people have the impression that if they do a swap they have fewer options down the road to advance refund. Is that the case?

Rai: That is almost the opposite. I mean for example, say you issue a fixed-rate bond deal, callable in 10 years, which is sort of a standard 30-year bond deal. Yes, you can advance refund that bond issue, but that's about all you can do with it.

Now you can structure a 30-year swap with the exact same call feature in it, sort of a parallel call feature, so you would retain sort of the quality of the bond deal on that structure. Then you get all kinds of additional flexibility. Anyday you can come to us.

Let's say you issued bonds at 6% and rates have gone up. You've done a good job, you have an attractive level of financing. However, with a bond deal, primarily the only way to accrue that benefit is over the life of the bond issue. You sit there and say, "Great, I have a below-market coupon." If depending on your needs or a changing interest rate view, you can unwind the swap and get the present-value benefit of that below market rate. You reconfigure yourself to position yourself for what's going on with you now. Whereas it's very difficult in the bond market to go out and tender for bonds in the open market.

Williamson: Our approach is not necessarily driven by a bond transaction. Another example would be a swap on the asset side of your balance sheet. If, either for policy reasons or because of some type of constraints imposed where you have to be invested very short term, it's possible to enter into an interest rate swap. [On the swap,] You're paying floating and receiving fixed for say five years - it's very similar to going out and buying a five-year bond.

J.P. Morgan & Co. is one of a handful of firms able to offer municipal issuers interest rate swaps with a triple-A-rated counterparty.

And the bank's sterling credit ratings have proven a significant attraction for municipal issuers worried about counterparty credit risk.

Robert Rossman, vice president in the municipal swaps department, says the bank presents swaps to issuers as part of a larger strategy for risk management.

"We don't really pitch a product, so to speak, and say, 'Here's the rate and here's how much you're saving,'" he said, "We say, 'Here's what you're getting into. Here's the cost benefits of it, here's scenarios if things change, here's the risk you're looking at."

Rossman says the firm's municipal swaps department includes professionals with experience from the corporate side as well as the municipal side.

While the swaps desk sometimes works closely with bankers in the public finance area, Rossman emphasized that his department will also work with outside firms on transactions.

"The outside community knows that, when they deal with us, they have a private relationship with us, and we are one of the biggest market makers out there in swaps," Rossman said.

The bank also attempts to teach issuers the ins and outs of swap transactions.

"The first thing we try to do with swaps is to educate our clients. We want to take the mystery out of it," Rossman said.

Rossman, along with Morgan vice presidents Shaun Rai and Patricia Williamson, sat down with staff reporter Aaron Pressman earlier this month to discuss the swaps market.

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