With demand for derivatives surpassing the desire of issuers to sell them, underwriters are hoping that two proposals under consideration in Washington will help restore the balance.
When issuers are reluctant to include derivatives in their primary market issues, underwriters go to the secondary market and, using somewhat convoluted structures, engineer secondary market derivatives. But the secondary market products are hobbled by limitations contained in tax and securities laws.
To avoid legal hang-ups, most derivatives are sold as private securities, limiting sales to a few large investors and greatly depressing liquidity. And, to bypass tax law concerns and ensure that investors receive tax-exempt income, most are packaged in partnerships or trusts.
One proposal before the Securities and Exchange Commission would allow underwriters to package and sell secondary market derivatives as public securities under a new exemption to the Investment Act of 1940. Underwriters could then sell secondary market products to almost anyone, even retail investors.
A second proposal being considered by Congress would dump the partnership and trust structures in favor of a more straightforward conduit structure, known as Tax Exempt Municipal Investment Conduits -- Temics. The structure resembles the Real Estate Mortgage Investment Conduit -- Remic -- a popular structure in the mortgage derivatives market.
Neither proposal has been approved by Washington regulators and legislators.
For the Temics proposal, municipal market officials must first address the tax policy and cost issues raised, according to Treasury and Internal Revenue Service officials and congressional staff.
Temics would allow tax-exempt bonds to be securitized or restructured into derivative products that would provide streams of tax-exempt interest tailored to the needs of different classes of investors.
The concept, developed by Goldman, Sachs & Co., has since been embraced by other firms and the Public Securities Association.
Officials from Goldman and lawyers from Cleary, Gottlieb, Steen & Hamilton in New York City have drafted a legislative proposal for Temics that the firms are now discussing with Treasury and IRS officials and tax committee staff.
A key issues is whether Temics will have an impact on federal tax revenues, proponents and congressional staff say.
Generally, tax proposals that would result in losses of federal revenues are tough to push through Congress, where there is constant pressure to combat the growing budget deficit.
Most industry officials believe Temics would be revenue-neutral because they would not pass on to investors any more tax-exempt interest than the interest from the underlying bonds. The tax-exempt interest from the bonds would be carved up to attract different classes of investors, but its aggregate amount would not change.
Some say Temics, as proposed, could result in a gain of federal revenues because they would treat the gains from market discount bonds as ordinary income that accrues annually, instead of as capital gains that are not recognized until the bonds mature.
But congressional revenue estimators may conclude that federal revenues will be lost if they take seriously the industry's claim that Temics will increase investor demand for municipal bonds.
Rep. Peter Hoagland, D-Neb., a member of the House Ways and Means Committee, has asked the Joint Tax Committee to determine the revenue impacts of Temics, knowledgeable sources say. Hoagland, who is sponsoring a legislative proposal to securitize non-mortgage assets such as credit cards and car loans, could become a sponsor of the Temic legislation, the sources say.
As for tax policy issues, there appears to be support among Treasury and IRS officials for a uniform tax regime for the securitization of municipal bonds into derivatives products.
"There is an interest in having one uniform tax requirement to address these synthetic products," said one federal official. "Right now there are a variety of different securities structures that exist, but they have various problems and ambiguities regarding tax consequences."
Until now, securities firms have had to restructure municipal bonds through grantor trusts, partnerships, or other arrangements that have proved cumbersome because they were not envisioned when the current tax laws and regulations were written.
The Key Question
The key question for Treasury and the IRS is whether the Temic structure is the best way to provide a uniform tax regime for securitizing or restructuring tax-exempt bonds into derivative products, the federal official said.
An alternative approach would be for the IRS to devise a uniform set of variable stripping tax requirements under section 1286 of the tax code, the officials said.
Federal regulatory officials also will want to make sure that Temics would not create more tax-exempt interest than the interest from the underlying pool of bonds or allow taxpayers to escape from being taxed on any gains from market discount bonds. Industry officials say the Temic proposal addresses both tax policy issues.
Some federal officials question whether the Temic structure will really benefit state and local issuers. "If there's so much to be gained by using derivatives, why aren't more large issuers pushing for this?" one official asked.
Industry officials contend that Temics, by increasing demand for municipal bonds, will lower, borrowing costs for issuers.
But issuers' groups are not aggressively lobbying for the proposal. exploring it," said Catherine Spain, director of the Government Finance Officers' Association's federal liaison office.
Proponents of Temics will have several months to shore up support and find a sponsor for the their legislative proposal. Congress will not consider any tax bill to which it could be attached until next year.
In addition to the Temic legislation, some firms have proposed creating secondary market derivatives using 1992 amendments to the Investment Company Act of 1940, commonly referred to as the '40 Act.
Dean Witter submitted the first filing to the Securities and Exchange Commission in February. By April, Merrill Lynch and Lehman Brothers had filed their own'40 Act proposals, and some market players predicted a wave of similar filings.
The 1992 amendments were designed to encourage the issuance of securitized debt. Many investors want to sell illiquid assets by issuing securities backed by a pool of the assets. But securitized debt structures have frequently run afoul of the '40 Act, which is actually intended to regulate mutual funds.
For example, some insurance companies have issued securities backed by pools of below-investment grade corporate bonds. But such issues had to be sold as private, unregistered securities. And that places considerable limits on who can buy them.
The same regulatory hurdles also interfered with firms' creating secondary market derivatives using municipal bonds. Firms were forced to use partnership and grantor trusts structures, and the derivatives they issued were considered private, unregistered securities.
By creating an exemption from the '40 Act for securitized financings, called rule 3a7, the SEC hoped issues could be sold as registered public securities, greatly expanding the universe of potential investors.
For the municipal market, Dean Witter, Merrill, and Lehman hope to issue securities backed by pools of tax-exempt bonds under rule 3a7. The firms would acquire the underlying bonds in the secondary market and place them in a trust or partnership, or even a Temic. The firm would then sell derivatives, issued by the trust, that funnel tax-exempt interest and principal from the underlying bonds to investors.
The 3a7 exemption would allow the derivatives to be sold as public securities, although the firms would still use a trust or partnership structure. Under the Temics proposal, the secondary market framework would be far more straightforward and efficient, derivatives professionals said.
Merrill Lynch and Dean Witter officials had planned to pool tax-exempt housing bonds and create derivatives similar to the complex mortgage-backed derivatives that have long been available in the taxable market.
Lehman officials said they had planned to use their '40 Act filing only to create derivatives similar to their existing primary market structures.
SEC officials have discussed the proposals with officials at the firms and their lawyers. But the SEC has not acted on any of the three filings. The commission must declare a filing "effective" before an issuer can sell any securities, giving the regulators ad hoc veto power over the proposals.
Over the summer, some of the firms went so far as to make second filings, hoping to address the regulators' concerns. But officials at some of the firms involved now say they do not expect action until several larger issues concerning the regulation of the municipal market are resolved.
No Crystal Ball
Others involved decline to make any predictions about the SEC's decision. "We just don't know when they'll decide, and I don't have a crystal ball," one official said.
SEC officials have asked the firms to address a wide range of potential concerns. The commission has not released rules or minimum guidelines for disclosure of the underlying bonds or of any credit enhancement included, nor for ongoing disclosure about the bonds.
Much of the controversy, some officials said, arose from disclosure concerns that have plagued the municipal market for years.
The amendments to the'40 Act include disclosure provisions for pooled financings that might not be met in some instances by poolings of municipal bonds.
"Some of the concern, I think, was not that these specific proposals were bad, but more, what kind of precedent would be set," an attorney who worked on one of the filings said. "And given the [SEC's] stated concerns about municipal disclosure, I think they were hesitant to act hastily here."
To some extent, the objections also reflect the differences between ordinary mortgage loans made to home buyers by commercial banks, and loans made by tax-exempt housing authorities.
Each tax-exempt issuer operates under different rules. Series of bonds issued by one issuer in different years may also be guided by different rules. The lack of uniformity complicates the task of designing standard disclosure rules.
One official said the regulators were also concerned about the pooling of municipal bonds, which are technically unregistered securities, to create derivatives that would be legally registered securities.
The proposals have also been set back by recent bad publicity surrounding mortgage-backed derivatives, lawyers said.
"When Salomon Brothers and [J.P.] Morgan report big losses from trading in mortgage derivatives, the commission almost has to go slower on a structure that would put more of these things on the street," one lawyer said.
The SEC might require suitability rules for the new derivatives that would limit sales to sophisticated investors.
Dean Witter, for example, is considering selling products created under rule 3a7 to retail investors.