Q: A recent Bond Buyer editorial called for more disclosure in general and specifically in the area of swaps. What's your reaction?
Corliss: The editorial called for the disclosure of municipal swaps in much the same way as municipal bonds are disclosed. As a general matter, I think that's something that the industry should strongly consider.
I would make a distinction between truly municipal issuers and, for example, not-for-profit hospitals or other users of tax-exempt debt under the tax law, who presumably have the same right to confidentiality as they would as if they were a normal everyday type of corportion.
I think we need to explore how the issuers feel about that, through the GFOA or the National Association of State Treasurers. But to the extent that they were comfortable with that, I think we would be very comfortable.
Q: The Public Securities Association recently set up a task force on disclosure and derivatives after Dave Johnson, a porfolio manager at Van Kampen, stopped buying derivatives in part because of a lack of secondary market disclosure. What is the focus of the task force?
Barber: The PSA task force is not so much concentrating on official statement disclosure but on getting the information that's in the OS out to a wide variety of potential players in the derivative market. We're focusing on, for example making sure that all the information agencies and all the potential bidders of derivative products know exactly what product is being created on a given issue, and have all the facts on that issue, with the idea being that we'll be able to greatly enhance liquidity.
One of the potential forces that could slow down the growth of the derivative market is the lack of liquidity or the appearance of lack of liquidity. So anything that we can do to increase the information flow among both end users and market makers of derivatives is a great step forward.
Q: Why can't we just snap our fingers and increase the amount of information? Why do we need a task force?
Barber: I think Dave Johnson did the derivative community a big favor by focusing on this issue. The derivative community needs to create products that are both good in theory and good in practice.
While a lot of people come up with some very good theories, making sure that the details are taken care of is very important to the overall success of the products. Getting out that information has not necessarily been taken care of. So the committee, I don't think is coming up with any fantastically developed thoughts. It's not that difficult, it's just setting practices in place that will help the market.
The task force so far is focusing on primary market issuance. I think the next step, and it's all been agreed to by the task force, is to take the secondary products as well.
Q: Merrill is the only firm that has actually sold derivatives to the retail side, with your Tax-Exempt Enhanced Municipal Securities, or Teems. How is that working out?
Corliss: Derivatives-to-retail is an interesting question and I think that the Teems product that we used has been very effective for the investors who purchased it. We only sold that to investors for whom, in a portfolio perspective, the product made sense. The difficulty I see with derivatives-to-retail right now is the general concern in the marketplace about derivatives, the Group of 30 study, the SEC, capital issues, disclosure issues.
The question that we're wrestling with, the factor that we're considering very carefully in any product that we're contemplating using in retail, is ease of understanding for the investor, so that they know exactly what they're purchasing.
The press surrounding our introduction of Teems highlighted to us that while the individual investors who understood the product and who purchased it were fully competent, the product wasn't necessarily easily understood on a widespread basis. That's an issue that we need to be cognizant of. So we do have a couple of products that we're contemplating selling to retail and those products have the clear benefit of being easily understood and therefore, I believe, readily acceptable by the marketplace.
Q: Let's get into the issuer side a little bit. It seems as though issuers using swaps now are saving more than, say, a year ago. Why is that?
Barber: The theme of munis cheap to Treasuries is an important theme. The swap curve is richer to Treasuries than the bond curve. So, for example in the recent Puerto Rico highway issue, we were able to work with the client to capture that benefit, buying certain segments of the curve of that loan and using floating-rate debt swapped to fixed instead of selling fixed-rate debt directly. Puerto Rico benefited in a significant degree in a very large loan.
Q: Can you give me a range of the savings realized through the swap curve?
Barber: On the Puerto Rico issue, the savings number I think on the swap portion was somewhere in the range of 30 to 40 basis points.
Q: So that's considerably better than people were getting maybe six or eight months ago?
Barber: Yes. I think it varies. In that particular loan because it was so large, it happened that the segment of the curve that we swapped to floating reduced the size of the fixed-rate bonds that were being issued into that rather difficult belly of the loan, as they say. And the fact is, it wasn't only the swap curve versus the bond curve, but we moved the whole bond curve by not forcing an unusually large volume of debt into particular maturity segments that indeed were the more difficult maturity segments to sell.
Q: What about issuers' appreciation of the credit risks of swaps? Is that changing? Are you coming up with new ways to calm their concerns?
Corliss: That issue, of course, is something that issuers have always been concerned about, as any participant in the derivative market must always be. We have done a couple of specific things.
On a programmatic basis, we are using our Triple-A subsidiary, [Merrill Lynch Derivative Products LP], as the counterparty in all embedded transactions. We want to make the benefit that the issuer gets comparable to the risk that they're asked to bear. That is to say the benefit, 10-15 basis points in the overall scheme, is relatively small and therefore the triple-A backing seems to us to make sense to induce folks to do that. But as a general matter, we're not using MLDP because Merrill Lynch's credit strength is well recognized.
And to the extent issuers are moving forward and diversifying their sources of swap providers, the risk is any given situation, we think, is not great.
Q: One way to make an end run around issuer credit concerns is to create derivatives in the secondary market. Merrill was one of the firms that filed with the Securities and Exchange Commission to issue derivatives under an exemption in the Investment Act of 1940 -- Rule 3a7 Others have proposed legislation for a conduit derivatives structure, socalled Temics. Can you update us?
Corliss: Our own filing, and several others as we understand it, got very close to happening. But the heightened awareness
As a general matter, we can understand that. We had worked quite hard and made quite an investment in doing the 3a7 subsidiary and we hope someday to utilize that investment, but there's no immediate thought that that's going to happend.
Barber: We're obviously very supportive of the efforts made by PSA and others on the Temic legislation because what it will allow is the restructuring of bond issues in a way that is embedded through the document process as opposed to trying the 3a7 process. 3a7 wasn't necessarily designed for the tax-exempt marketplace. It works, and if we can go forward that way we would because it's a good answer.
What both Temic and 3a7 do will ultimately allow investors to create products and instruments that best reflect their particular investment horizon, investment needs. And ultimately also for issuers because by being able to create more efficient cash flows the issuers will get more savings as well.
So in an environment, obviously, of full disclosure and full understanding -- the same types of issues we were talking about earlier with retail apply here -- we think we can create some very powerful products that will be very successful
Once upon a time, Merrill Lynch controlled almost all of the municipal swap market. Today things have changed and many firms offer tax-exempt issuers interest rate swaps.
But Merrill Lynch's derivatives unit, headed by Samuel B. Corliss J., is still doing just fine.
"At one point in time it was sort of agreed offhandedly that Merrill had 90% of the market," Corliss says. "But we do think that having a smaller slice of a much, much larger pie benefits us and benefits the marketplace and therefore the customers."
Corliss, a managing director at Merrill, and Robert Barber, also a managing director, recently sat down with staff reporter Aaron Pressman to discuss the state of the municipal swap market.
While new players, large and small, are constantly trying to break in, the Merrill crew believes large firms have the upper hand.
"We do see the market emerging where a handful of firms are going to dominate the municipal derivative business, primarily because only a handful of firms can offer a fully integrated approach, major relationships with issuers, major relationships with investors, ability to take risk and run a swap book," Corliss says.
"And while there will continue to be niche players, absent relationships, it's very hard to grow a derivative business," he says.
One of Merrill's advantages is its triple-A derivatives subsidiary, known as Merrill Lynch Derivative Products LP. The firm has begun using the separately capitalized subsidiary for select municipal transactions.
The subsidiary was set up two years ago with $300 million in capital from Merrill and a $50 million preferred stock issue. But the subsidiary did not receive permission from the rating agencies to engage in swaps with municipal issuers until this year.
As a condition of this interview, Corliss and Barber declined to discuss recent events that have raised questions about relationships between municipal swap providers and financial advisers.
