In the News: Recent Developments

May 4, 2009

Tennessee Seeks to Curb Derivative Deals

By Andrew Ackerman

WASHINGTON – Tennessee Comptroller Justin Wilson on Friday proposed sweeping changes to municipal finance guidelines in an attempt to restrict small, unsophisticated issuers in the state from entering into complex derivatives and other transactions they may not understand.

The proposed guidelines, which the State Funding Board released for a 30-day public comment period, may become the most stringent in the country if implemented. They would effectively prohibit all interest rate swaps tied to bond deals smaller than $50 million or forward bond-purchase agreements for deals less than $25 million.

In a statement, Wilson warned that cities and counties have turned to increasingly sophisticated types of financing, exposing their constituents to potential risks. He also said he would consider additional limits on variable-rate demand obligations, which are typically entered into in connection with swaps.

“We have to respond to a fundamental shift in the way in which local governments have been paying for parks, schools and other public works projects over the last few years,” he said. “Some local governments have been relying exclusively on variable-rate debt, which can be as dangerous as a homeowner financing a mansion with an adjustable-rate mortgage and no down payment up front.”

Before the proposed guidelines can be implemented, the five-member state funding board, which includes Wilson and Gov. Phil Bredesen, must vote on them again.

In addition to establishing a minimum size limit on swaps and forward purchase agreements, the proposed guidelines seek to boost reporting and monitoring by requiring localities that engage in them to submit both quarterly and annual financial information as well as disclose 14 different types of material events. They would also be required to hire full-time staff that could prove they understand the deals.

As with the existing guidance, the issuer would have to submit a report to the comptroller before entering into the swap or forward purchase agreement. But unlike the existing guidelines, only “an independent financial adviser, independent swap adviser or independent swap counsel” – and not the underwriter – may assist the issuer in preparing its report. The change is an attempt to restrict conflicts of interest, state officials said.

If the comptroller deems the issuer’s report is not in compliance with the guidelines, the issuer could not go ahead with the swap but could still issue debt without it. But on a forward purchase agreement, a noncompliant issuer would be blocked from proceeding with the transaction.

Friday’s proposed guidelines stem from a review of the state-mandated derivatives program after it became the centerpiece of a New York Times article last month. Wilson stressed that the proposed guidelines are the first phase of a broader overhaul of muni finance in his state.

Robert E. Brooks, a professor of financial management at the University of Alabama, said that to eliminate conflicts in these transactions, issuers should be willing to pay for independent financial advice from an FA serving in a fiduciary capacity. They should also do a better job demanding for dealers to disclose their potential fees for swaps and other transactions, he said.

Meanwhile, Joseph Fichera, senior managing director and chief executive officer of Saber Partners, said that the proposed guidelines reveal the need for a level playing field nationally, in terms of the skill and sophistication among market participants.

“The problems of Tennessee are not just the problems of Tennessee, they occur everywhere,” Fichera said. He added that the thoroughness of the analysis used to determine whether a transaction is in an issuer’s interest is as important as it coming from an independent, conflict-free adviser.

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 VRDN 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 versus fixed-rate deal -typically 5% or more. The commission also requires that swaps are used strictly to hedge against interest rate risks and to control costs. In some states, issuers can enter swaps as investments.

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.

Patrick Temple-West contributed to this story.

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