Posted on 12/11/2002 10:39:18 AM PST by AdamSelene235
NEW YORK, Dec 11 (Reuters) - U.S. state and local governments searching for a way out of tight budgets are increasingly turning to derivatives, the black sheep of Wall Street, in pursuit of new revenues.
Financial advisers, bond lawyers and Wall Street dealers agree that the use of derivatives contracts has doubled this year in part because they have become the latest weapon local governments have unleashed against the worst drop in tax revenues since World War Two.
"Governmental issuers are saying, 'we are looking for any way to save money that we can. We're laying off cops, we're closing schools, we're cutting back library hours -- now it's time to get the last ounce of value out of our debt portfolio,'" said Matthew Roggenburg, a derivatives banker with JPMorgan in New York.
Roggenburg estimates the municipal derivatives market is larger than $400 billion, about the size of India's economy.
Derivatives are financial tools based on underlying cash securities such as stocks or bonds used for managing risk or taking leveraged positions.
But unlike the high-risk derivatives investments that led wealthy Orange County, California, into bankruptcy in 1994, this time around, municipalities like Hillsborough County, Florida, -- the home of Tampa -- are entering relatively safe contracts that do not make bets with public money, but are contracts that essentially lower interest rates on outstanding municipal bonds.
Kapil Bhatia, debt finance manager with Hillsborough County, converted $264 million of the county's fixed-rate long-term debt into short-term floating-rate securities this year, saving the county $12.1 million.
Hillsborough County's derivative agreements -- called swaptions -- took advantage of dropping rates and allowed the county and its swap partners to drop the interest rate being paid on the bonds.
Hillsborough continues to pay interest on its high-yielding debt to the banks, who in turn paid $12.1 million in an upfront payment to the county for the right to exchange, or swap, the fixed-rate payments for much lower-yielding floating-rate bonds. The bank that conducts the swap assumes all the risk, but can expect to earn well over the $12.1 million for its trouble.
Using derivatives "is part of our overall debt strategy to hedge against interest rate risk," Bhatia said.
Bhatia is happy with the complex arrangement, but he warned it is essential for municipal bond issuers looking at derivatives to have a good financial adviser.
The biggest risk in the transaction is the derivatives provider could go bankrupt. But because it is mostly banks and other highly rated financial institutions that set up swap agreements, bankruptcy concerns are minimal.
DERIVATIVES USE FUELED BY LOW RATES
Swaptions, which pay state and local governments a lump sum up front, are increasingly popular this year, according to Peter Shapiro, a managing director with Swap Financial Group of South Orange, New Jersey.
"The economic problems we have now caused a lot of budgetary stress for state and local governments that make it very attractive to use a swaption to generate money right now to help deal with budget problems," Shapiro said.
In 2002, California used swaps to lower borrowing costs on more than $1 billion as part of its massive power bond sale, joining New York, Massachusetts and Colorado in the derivatives market.
Low interest rates, which hit levels in 2002 not seen in 40 years, make derivatives even more compelling. "Officials across the country are asking themselves 'how do I take advantage of this extraordinary opportunity in the market,' and the best opportunity is by using derivatives."
Municipalities can realize far greater benefits in the swap market than can be achieved in the regular municipal bond market, Shapiro pointed out.
On top of that, two recent reports published by Wall Street credit ratings agencies Moody's Investors Service and Standard & Poor's Ratings Services approved municipalities having derivatives on their balance sheets -- when used properly. That further strengthened the reasoning behind derivatives transactions in the eyes of local lawmakers and their financial advisers.
I see, it's the old free lunch trick. Let's all get into that there structured fianace and then go party.
Richard W.
I'd say that I'd go along with that idea only because the new debt is a floating rate, so if interest rates rise during the term, your payments will go back up, while my portfolio value will not drop as would the longer term fixed rate bonds.
My market risk is not increased but your credit worthiness is decreased because your redemption date, the day you have to pay the $246 is sooner and you could actually end up paying more interest if rates rise.
I would bet with the bankers every day against a municipal employee.
Under these circumstances what a municipality should do is float a new long term bond issue and put the money in escrow, invested in Treasury securities until the old (higher) rate bonds become callable or are due for redemption. This is a legal arbitrage called "pre-refunding" and has been done by municipal bond issuers for decades.
This "Swaption" business is to finance as wool is to eyes.
Yet another reason to stay out of California, Colorado, Massachusetts, and New York.
This is worse than the home refinacing goons on TV. I cannot believe that municipal and state-wide budgets are using these methods of finance because they will wind up owing even more on the original debt when (not if) interest rates go up.
jriemer
This would imply that the banks anticipate that rates are going to rise considerably in the not-too-distant future.
Another interesting perspective on the California power crisis and the power bonds.
Reading comprehension is way down today...
jriemer
Miss Marple - Check out this thread and the California angle.
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