With more and more issuers considering derivatives in a volatile bond market and the call for more disclosure of swap contracts by the Governmental Accounting Standards Board, debt-issuing entities and bondholders need to know what risks such products carry.
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That is one of the ideas behind GASB Technical Bulletin No. 2003-1, as well as others in the marketplace.
The bulletin, which is technically called "Disclosure Requirements Not Reported at Fair Value on the Statement of Net Assets," calls for requiring issuing bodies to give more comprehensive reporting on a derivatives deal, including why it was done, its fair value, and the risks assumed.
"You will see more extensive reporting of where that money [associated with the derivative] will go,"said Gary Heinz, a vice president at Goldman, Sachs & Co. who also spoke at the conference. "Including the associated debt, that debt associated with the derivative, not just the underlying debt."
Heinz also believes derivatives will be a main force to be reckoned with in the municipal market this year. "The GASB board met this week [last week] and discussed swaptions. Keep your eyes out for a bulletin on them as well," he said.
Tyler Smith, a partner with Haynsworth Sinkler & Boyd who spoke recently at The Bond Buyer's 3d Mid-Atlantic Public Finance Conference in Charlotte, N.C., believes issuers need to know more about the risks involved in such transactions.
Since the bulletin went into effect in June 2003, issuers have had to learn more about how derivatives work, and in many cases have had to come up with their own swap policy management plan, Smith said. He points out the many risks for both issuers and counterparties involved in a derivative contract, which include tax risk, termination risk, put risk, legal risk, counterparty risk, rating risk and basis risk. While not saying one risk is more important than another, Smith did point out what is being done by issuers to mitigate some of them.
"Issuers are starting to require [counterparties posting collateral]," Smith said. "It's called a credit support annex. It can protect either side as one or both of the parties get more and more out of the money [on the swap]."
As for determining the amount of such collateral, he said "it is a function of the value of the termination fee," which is what an issuer pays to unwind a swap if necessary.
It is because of such risks that many issuers have been hiring swap advisers and monitors. GASB 2003 No. 1 also gives the issuer an important checklist of what it needs to properly track a derivative and what it should disclose to the public.
There are five points the bulletin spells out:
-- Objective of the derivative.
-- Significant terms of the transaction, such as its notional amount, effective dates as well as maturities being swapped, and the amount of upfront cash paid or received.
-- Associated debt, such as if an issuer issues variable-rate debt then swaps it to fixed rate, the derivative's net cash flow, and debt service requirements should be disclosed.
-- The risks involved.
-- Fair value of the derivative.
