shopyield.com

Reblogged from The Bond Tangent:

~~~~ “After some local issuers’ wayward derivative contracts received a lot of attention from the New York Times, the Tennessee comptroller has proposed some rather dramatic changes to the state’s guidelines for the use of interest rate and forward purchase agreements by local government entities.
According to the Bond Buyer, the changes would:

1. prohibit the use of derivatives in conjunction with bond deals $50 million in size or smaller or forward bond purchase agreements of less than $25 million;
2. commit local governments that elect to use derivatives to quarterly and annual financial reporting;
3. require local governments using derivatives to demonstrate that their staff is sophisticated enough to appreciate the risks involved; and
4. permit the use of independent financial and swap advisors in the preparation of reports to the state (as opposed to using the firm that served as underwriter on the deal and thereby reducing conflicts of interest).

This would basically end the use of derivatives by smaller debt issuers in the state. The comptroller is also considering adding limits to local governments’ use of variable rate debt obligations.

According to the article (with the occasional interjection from yours truly):

Though swap guidelines differ from state to state, Tennessee’s proposed guidelines are some of the most stringent.

In North Carolina, one of the most restrictive states, an oversight board requires local governments to get approval from them before entering swap contracts. The Local Government Commission, a nine-member panel that includes the state treasurer, limits [variable rate demand note] sales to high-grade issuers, making swap transactions unattainable for many.

For qualified municipalities, the commission requires an FA to analyze the swap transaction, and the issuer must show a substantial savings rate for a variable rate versus a fixed rate deal – typically 5% or more. [How would they demonstrate that a savings would be realized over the life of a bond deal?] The commission also requires that swaps are used strictly to hedge against interest rate risks to control costs. In some states, issuers can enter swaps as investments [i.e., for speculative purposes].

In contrast, issuing swaps is relatively easy in states like Pennsylvania. There, each local government that sells general obligation debt may enter into a swap as long as it gets a “fairness opinion” from an independent FA that the trade on the day it is made is “fair and reasonable.” But sources said there is always someone willing to give that opinion.

I’ve surveyed a wide variety of laws governing the use of interest rate derivatives, and the only common element is the generic way in which they treat risk. For example, many states allow issuers to use interest rate derivatives, but they restrict the use to swaps with counterparties above a certain ratings threshold. This really doesn’t capture a lot of the risk involved in derivatives, and ratings are a poor proxy for counterparty risk - ask anyone who had a swap with Lehman Brothers. For the most part, it is basis risk (a mismatch in interest rates) that has hurt state and local governments with outstanding derivatives in the current environment.”~~~~