Tennessee Reviews Derivatives Courses

BRADENTON, Fla. - Tennessee will conduct a comprehensive review of a program required by state law that is designed to educate cities and counties about using derivatives such as swaps and forward-starting purchase agreements, the state's new comptroller said Tuesday.

Comptroller Justin Wilson, who took office on Jan. 15, said he was already reviewing the state-mandated derivatives program when it became the centerpiece of a New York Times article last week.

The article raised questions about industry professionals who taught state-required derivatives courses and later advised Tennessee communities on the use of them, as well as various roles at least one firm played in helping communities issue debt.

Firms, such as Memphis-based Morgan Keegan & Co., and the state's own financial adviser, Public Financial Management Inc., taught Tennessee's derivatives courses at various times.

"We started reviewing what should, if anything, be done before we heard from the paper," Wilson said. "Then I heard some communities were having problems, I looked further into it, and then testified before the state Senate Finance Committee."

Wilson explained to the committee on March 25 that his office is required to issue letters of compliance to ensure that local governments have taken a state-required and approved educational course on derivatives before entering into a contract.

"But the purpose of this is not to determine whether it is a good deal or a bad deal," he told the panel, "but simply to have some minimum [educational] requirements before they proceed."

The comptroller's office typically issues a letter of compliance, but it does not always know if the local government actually entered into the derivative contract, Wilson said.

"Since I've been comptroller we have not issued any compliance letters," he told the Finance Committee. "I have directed my staff to strictly construe any new applications and to have a presumption against any waivers of any sort."

Wilson said he has not frozen the issuance of compliance letters for issuers seeking to use derivatives. The comptroller's office has only received one request for a letter of compliance this year and it is still under review, Wilson said in an interview Tuesday.

Because the guidelines for the state-mandated derivatives program were developed in 2002, Wilson has asked the State Funding Board to review them. The board - which authorizes issuance of Tennessee's general obligation debt and determines economic projections for the state budget - may begin a review of the guidelines as early as its next meeting on May 4.

Wilson said his office would make recommendations for changes in the guidelines, which likely would include who teaches the derivatives courses, the appropriateness of derivatives for certain communities, and how local governments report derivatives on their financial statements.

"We want to be sure we are dealing with 2009 and forward," Wilson said. "We want to deal with the world as it will be. Not as it was."

Problems with variable- and auction-rate rate debt and derivatives, inability to renew or obtain liquidity facilities, bond insurer downgrades, and the extraordinary meltdown of the credit markets are not unique to Tennessee.

Cities, counties, and even some states across the U.S. have been forced to refinance debt because of swift changes in market conditions - including rating downgrades of triple-A bond insurers mostly linked to troubled subprime mortgage securities.

Tennessee may be the only state to mandate that local governments take educational courses about the rewards and the risks of using derivatives - a legal requirement that is discussed in detail and available publicly in documents on the comptroller's Web site at www.tn.gov/comptroller/lf/ under the tab labeled "Guidelines for Interest Rate and Forward Purchase Agreement."

The Volunteer State first enacted the law requiring such education in 1999. But the state could not get a nonprofit entity like a university to develop and offer the courses, so industry and other professionals were called upon to develop and teach the curriculum.

Those who teach the courses cannot advertise their firms, Wilson said, adding that he is not aware of any firm that has violated any rule or regulation, nor is he aware of any law that has been violated.

Wilson said someone suggested to him that Morgan Keegan may have violated Rule G-23 of the Municipal Securities Rulemaking Board, which states that a dealer serving as a financial adviser cannot become an underwriter on a negotiated deal without the issuer's consent. The dealer must also tell the issuer that there may be conflicts of interest.

Morgan Keegan managing director Joseph Ayres denied that his firm violated Rule G-23 and said that it does not apply to swap advisers.

Ayres said Morgan Keegan has from time to time done business with the three local governments mentioned in the New York Times article - Lewisburg, Mount Juliet, and Claiborne County - and the firm did advise them on interest rate swaps associated with the underlying bonds "that had been tainted because of downgrades of one or more insurer."

"Morgan Keegan did not underwrite the derivatives," he said. "The swaps were done with unrelated third-party counterparties. We just advised them on state law and the procedures to authorize and implement those swaps and negotiated the legal and financial terms."

Ayres said that Morgan Keegan did not actually underwrite bonds for those communities. But his firm did underwrite debt for a conduit issuer called the Tennessee Local Government Alternative Loan Program that Morgan Keegan developed in 1995. The communities in question received loans from the variable-rate bond program for which Morgan Keegan negotiated swaps.

Ayres also disputed the contention that his firm may have worn too many hats and said he did not believe there was a conflict with teaching the state's derivative course and advising communities about the use of them.

"We were requested by the state of Tennessee and the [former] comptroller to give input into the drafting of the legislation in the late '90s and implementation of the guidelines, which were widely disseminated ... in and outside Tennessee," Ayres said. "Nowhere in the educational seminar was any firm allowed to promote the firm or its capabilities or qualifications, nor could the firm suggest that [attendees] should do business with any of the firms teaching the educational courses."

However, some market experts believe that the communities could have benefitted from independent advice about the suitability of the transactions they entered into.

"I do think the issue boils down to appropriateness of a financial tool for a particular community and who is making the decisions that something is appropriate for a community," said Marlin Mosby, a managing director in the Memphis office of Public Financial Management.

PFM, the largest independent financial advisory firm in the U.S., taught some of Tennessee's derivatives courses - some with Morgan Keegan - and has advised local governments on swaps. PFM does not underwrite debt nor does it serve as counterparty in derivative transactions.

"I think the state's program is run fairly well but it might want to address the idea of firms wearing multiple hats," said Andrew McKendrick, a managing director in PFM's Philadelphia office who taught swap courses in Tennessee. "I'm based in Pennsylvania and Pennsylvania's law demands that there be an independent adviser."

Wilson, the comptroller, said many issues, including the suitability of using variable-rate debt, will be on the table when state officials conduct a comprehensive review of the derivative program.

He pointed to remarks two weeks ago by Federal Reserve chairman Ben Bernanke, who questioned whether variable-debt rate was a viable financing mechanism for states and local governments going forward.

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