SAN FRANCISCO - "When there are sharks in the water, swim close to the shore."
That's the advice Edward J. De La Rosa, president of De La Rosa & Co., gave issuers and other muni market professionals gathered for The Bond Buyer's 18th Annual California Public Finance Conference in San Francisco this week.
For the muni market, that means issuers should focus on simple, fixed-rate deals and especially avoid swaps that force local governments to manage basis and counterparty risks that are far from their core missions, bankers and financial advisers said at the conference and a pre-conference hosted by the California Debt and Investment Advisory Commission.
Some large California issuers like the Bay Area Toll Authority, San Francisco International Airport, and the East Bay Municipal Utility District have been active users of swaps, and they saved huge sums by using derivatives to parcel out credit and interest rate risk to the investors who wanted to take those specific risks.
But many of their "less sophisticated" counterparts around the state have seen their more conservative debt management vindicated this year. They're the ones with relaxed smiles on their faces at this year's conference.
They aren't scrambling to figure out what to do about swaps with bankrupt Lehman Brothers. They didn't have to decide between paying huge swap termination fees and doing a difficult variable-rate refinancing after the spring meltdown in the auction-rate securities markets. Best of all, they didn't have to go back to the City Council and explain what happened.
"I'm glad that I don't have any swaps today," said Julia Cooper, deputy director of finance and debt manager for San Jose, the Bay Area's biggest city. "I don't even want to think of who my counterparties might be."
The basic risk aversion of government bureaucrats and elected officials will limit the appeal of swaps for years to come after this crisis, long-time muni market professionals predicted.
"My view is that the general muni swap business is over, dead, gone, adios," said Robert Larkins, managing director at Wedbush Morgan Securities. While he said some health care issuers will stick with the market, he sees little broad appeal.
"I don't know a city or county finance director right now that would do swaps," he said. "We had towns with 5,000 people with synthetic fixed. I mean, the industry really got out there."
While big swaps users continue to tout the savings that synthetically fixed rates have brought, they realize they will want to reconsider how they use swaps in light of evolving market conditions.
Gary Breaux, finance director at the East Bay Municipal Utility District, said he has traditionally hedged the bulk of his variable-rate debt. That has saved his district as much as 1.3 percentage points versus traditional fixed-rate bonds in recent years, he said.
On Monday, he was scrambling to figure out what would happen to the swaps he had outstanding with Lehman Brothers. He said he will consider using more unhedged variable-rate bonds in the future, accepting interest-rate risk on a portion of his debt portfolio instead of worrying about basis and counterparty risk.
"I think swaps are very valuable to have in our portfolio," Marcia Maurer, chief financial officer for the Sacramento Regional County Sanitation District said at a CDIAC panel.
That doesn't mean they didn't complicate her life this year.
When she saw the ARS meltdown in February, her swaps were in the money. She rushed to get permission to terminate, but by the time she could ask her board for permission the swaps, the district owed a termination payment. Since the district couldn't afford to pay a large termination fee to get out of them, she refinanced with variable-rate debt, swallowing large letter of credit fees.
"My board would love it if we could get out" of those swaps and variable-rate bonds, she concluded.
It's going to take a while - and the return of some semblance of stability - to change such minds, said veteran west coast financial adviser Jerold Gold, a senior vice president at First Southwest Co. Issuers have learned that they'll have to pay more attention to counterparty risk and termination provisions when they go back out for new swaps, but lower rates will always have an allure.
"If there's anything I've learned in my 400 years here, it's that everything is cyclical," he joked. "The market one day will come back and people will be doing swaps again - but not too soon."
