The markets are functioning despite the global credit crisis and now may be the best time to structure several different types of interest rate swaps, according to panelists at The Bond Buyer's Eighth Annual National Municipals Derivatives Institute.

Historically wide spreads in the municipal market have combined to make floating-to-fixed-rate swaps a valuable transaction, said Peter Shapiro, managing director at Swap Financial Group.

Relative values for municipals versus Treasuries, or swap rates, are at some of the widest levels they have achieved in history. Thas hascreated savings of as much as 100 basis points for swaps tied to the Securities Industry and Financial Markets Association rate, and as much as 150 basis points for swaps tied to the London Interbank Offered Rate, he said.

But as issuers look to sell variable-rate bonds and take advantage of those rates, they must secure liquidity facilities, a resource that is becoming increasingly scarce in today's market. They are competing with issuers looking to refund or refinance the auction rate securities they've sold, many of whom are seeking liquidity facilities as well. Demand is far outstripping supply.

As an alternative, issuers should consider synthetic floating-rate bonds, Bryan Kern, vice president at Wachovia Bank, and Matthew Roggenburg, managing director at UBS Securities LLC, told the assembled audience. In these transactions, issuers issue fixed-rate bonds and then swap them to a floating rate.

"The strains on bank liquidity will make it difficult to issue variable rate going forward," Kern said. "The synthetic swap is a good strategy for this."

A swap that converts fixed-rate bonds into variable rate payments removes the risk associated with re-marketing agents for auction rate securities or the liquidity facility for variable-rate bonds, Kern said. It also removes credit downgrade and dislocation risk, as well as the man hours that would be needed to fix poorly functioning variable-rate programs, Roggenburg said. And it gives issuers some exposure to variable-rate debt, which many now like to have as part of their debt portfolio.

"This will be simple and cost effective as a means to get floating-rate exposure," Roggenburg said.

For issuers concerned with having long-term risk exposure to variable-rate risk, he said the swap transactions can be defined so that maximum rates would not be higher than 7% to 9%.

These attributes will make the fixed-to-floating-rate swap the next big product, despite the current environment, the bankers said.

Reeling from dislocations throughout the municipal market, issuers have lost confidence. Problems with the credit quality of bond insurers and elevated rates on short-term borrowing have made many issuers increasingly shy of risk. Many have converted into fixed-rate bonds, while others are steering clear of swaps and other derivatives.

"More and more, from boards and directors, we are hearing that, 'These complicated structures got us in trouble and we don't want to do them anymore,'" Shapiro said.

John Craford, executive vice president for finance and administration at the Connecticut Housing Finance Authority, said he is having trouble selling his board on the advantages of interest rate swap transactions in the current environment. Short-term borrowing costs shot up for the authority when investors decided they didn't want the Ambac Assurance Corp.-insured bonds that CHFA had issued.

"There is now a great deal of reluctance to do more of these transactions," Craford said. "It is probably more advantageous to do swaps because of the bond market now, but we are gun shy."

Craford spoke as part of a separate panel on swap counterparties, seen by some as the number one risk with swaps. The bond insurers have seen their ratings downgraded, Bear, Stearns & Co. sold itself to JPMorgan, and UBS said it was leaving the market, leaving many issuers with concerns about their exposure to certain counterparties.

There are a number of actions that issuers can take to protect themselves from counterparty risk, which is the question of whether they will uphold their end of the bargain in swap transactions, members of the panel said.

Issuers must use a derivatives policy to understand and know their counterparty exposure, said Michael Marz, vice chairman for First Southwest Co. Once the exposure is identified, it can then be quantified and managed, he said.

Among the important things for issuers to know about swap exposure are: what the termination agreement looks like, the details of the collateral posting triggers and how posting might work with seasonal revenue flows, whether the swap termination payments have to be paid immediately or over time, and how the swap is performing - who currently owes who and how would payment work.

Issuers should have systems to monitor their counterparty exposures and keep an eye on all of these factors, Marz said. They should also have a well-thought-out exit strategy for use in the event something goes wrong, he said.

Spreading the portfolio exposure to different counterparties can also help defray the damage if one or more of them has problems, said Brian Thomas, chief executive officer at the Metropolitan Water District of Southern California. Thomas invented the tri-party agreement, which he uses to ensure that if something happens with one counterparty, a third entity promises to take on the exposure, Thomas said.

Above all, issuers should put themselves in a place where if there is a problem with one or more of their counterparties, they are prepared.

"It's important to say the markets are working," Marz said. "But having the plan before the trade is executed is as critical as it's ever been."


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