Since the autumn of 2007, the municipal market has been reeling from the crash of the mortgage market and the collateral-damage impact on the ratings of, and appetite for, bond insurers.
This cascade of events led to an avalanche of restructuring and unwinding activity in the muni derivatives market, principally related to synthetic fixed-rate bond structures. The upheaval has led many to speculate that the “fad” of municipal derivative products is at an end. Might this be true?
Without arguing cause and effect, the growth in variable-rate tax-exempt bond issuance had been mirrored by an equally impressive growth in the market to swap variable-rate bonds to fixed interest rates, generally resulting in “savings” versus conventional fixed-rate bonds.
Issuers have taken advantage of this in the primary market, and dealers and investors have similarly benefitted as surrogate issuers through tender-option bond programs. The variable-rate market had largely been built on the now-flawed premise that insurance would be cheap and plentiful, and could effectively substitute for underlying credit strength over the term of the bonds.
Similarly, issuers believed investors and banks would continue to absorb the ever-increasing amount of auction-rate securities and variable-rate demand obligations, and issuers could count on the sturdiness of these markets for long-term funding needs.
The “Valentine’s Day Massacre” of February 2008, the freezing-up of the ARS market, was the first of a cascade of events that shook the foundations of this assumption.
In appropriate size and scale, and with demonstrable underlying balance-sheet strength, the synthetic fixed-rate structure continues to prove highly attractive. Sadly, issuers with weaker balance sheets participated in these structures, even though their ability to continue to roll over the underlying debt relied solely on the market’s perception of their third-party credit support, the banks and insurers.
The upheaval among credit-support providers forced these borrowers to reach out to lenders of last resort as the cost of credit and liquidity facilities from healthy banks skyrocketed.
Once long-term variable-rate funding vehicles became more uncertain, or impossible to renew, issuers unwound or restructured many of the hedging programs (swaps-to-fixed) relating to these bonds. In certain cases (Lehman and AIG), issuers found their counterparty’s credit to be insufficient or nonexistent, leading to the need to move their trades to other, healthier dealers.
While much of the activity around these transactions has already taken place, many issuers are still grappling with the issue of unwinding, restructuring and/or moving trades executed over the last 10 to 15 years.
Against this backdrop, who could speculate that there might be brighter days ahead for derivatives within the municipal market? It’s easy to doubt the appetite of issuers for evaluating new proposals and new structures. The popular view is that issuers feel “burned,” and that these products have been discredited.
Not surprisingly, press accounts have focused on the derivative component of transactions as the cause of all the ills, and not as collateral damage driven by a failed borrowing plan. Correspondingly, financial institutions have significantly downsized staffing levels and balance-sheet allocations to muni derivatives. Decades of experience and stewardship have been eliminated from the dealer community. Are they also buying into a bleak future for municipal derivative products?
I’d like to offer a potential contrarian argument, with a cautionary note.
Derivative products originally gained favor in the muni market two decades ago as a means for issuers to access lower rates available on the short end of the yield curve, as relief from a historical over-reliance on long-term fixed-rate bonds. The yield curve was steep, underlying budgetary needs were pressing, and conventional wisdom supported the notion that a mix of fixed- and variable-rate debt seemed prudent and cost-effective over the long term.
In those early days, tax-exempt money market funds were just beginning their growth, and alternative floating-rate products, such as ARS, were still in their infancy. Issuers also didn’t have enough new bond issuance to substantially alter their fixed/floating-rate mix in a one- or two-year period, and they liked the safety and security of having their bonds permanently “put away” with investors, eliminating refinancing risk.
This confluence of preferences and market forces, coupled with a rapid increase in the community of swap providers who were also committed participants in the muni underwriting arena, led to rapid growth of fixed-to-floating municipal interest-rate swaps.
Through these swaps, issuers gained access to lower interest rates without the ongoing exposure to the funding risks associated with variable-rate tax-exempt securities. These structures were viewed as relatively risk-averse compared to conventional long-term variable-rate bonds. Perhaps that profile represents the right product for our post-crash future.
So where does that leave the market moving forward? First, all market participants must focus on the reality that hedging structures modify exposures created through funding structures. They do not substitute for prudent and appropriate decisions regarding an ability to repay debt, the ability to absorb unscheduled fluctuations in related costs, and reliance on investor markets.
Second, derivatives can be useful to alter the nature of the interest rate profile associated with the funding, if the funding leaves an issuer over-weighted in one direction or another (such as converting fixed to floating and vice versa). As funding options have become more restricted, this tool can be particularly useful.
Third, derivatives can create significant contingent liabilities — the posting of collateral or premature terminations — so balance-sheet flexibility and strength is important.
Fourth, derivatives can be much more highly customized than conventional products, making them attractive for issuers with specific needs. Hopefully, changes to the regulatory framework will not unfairly limit this flexibility.
Lastly, issuers should seek knowledgeable, independent advice from experienced sources. The downsizing of the dealer community has provided an influx of experienced and talented professionals who are now available on advisory platforms.
If the municipal derivatives market is to rise like a Phoenix from the ashes, it will begin by getting back to the basics. Complex structures and non-transparent processes will be viewed with an appropriate level of skepticism and disdain. The market needs to win back its trust and credibility with issuers and stakeholders.
That said, issuers would be foolish to simply “throw the baby out with the bath water.” Where benefits are demonstrable, and risks appropriately analyzed and mitigated, issuers should avail themselves of every tool available to meet the challenges of stretched resources. Being overly risk-averse is no substitute for prudent financial management.
Matthew Roggenburg is the managing director of Cityview Capital Solutions LLC in Millburn, N.J.