S&P - Public Finance Criteria (2007). - The Global Clearinghouse

2007Public FinanceCriteria

Public FinanceCriteria2007

Published by Standard & Poor’s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, NewYork, NY 10020. Editorial offices: 55 Water Street, New York, NY 10041. Subscriber services: (1) 212-438-7280. Copyright © 2006 byThe McGraw-Hill Companies, Inc. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information hasbeen obtained by Standard & Poor’s from sources believed to be reliable. However, because of the possibility of human or mechanicalerror by our sources, Standard & Poor’s or others, Standard & Poor’s does not guarantee the accuracy, adequacy, or completeness of anyinformation and is not responsible for any errors or omissions or the result obtained from the use of such information.Standard & Poor’s uses billing and contact data collected from subscribers for billing and order fulfillment purposes, and occasionallyto inform subscribers about products or services from Standard & Poor’s, our parent, The McGraw-Hill Companies, and reputable thirdparties that may be of interest to them. All subscriber billing and contact data collected is stored in a secure database in the U.S. andaccess is limited to authorized persons. If you would prefer not to have your information used as outlined in this notice, if you wish toreview your information for accuracy, or for more information on our privacy practices, please call us at (1) 212-438-7280 or write us at:privacy@standardandpoors.com. For more information about The McGraw-Hill Companies Privacy Policy please visitwww.mcgraw-hill.com/privacy.html.Analytic services provided by Standard & Poor’s Ratings Services (Ratings Services) are the result of separate activities designed to preservethe independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinionand not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly,any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investmentdecision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor’s may have information thatis not available to Ratings Services. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-publicinformation received during the ratings process.Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or thirdparties participating in marketing the securities. While Standard & Poor’s reserves the right to disseminate the rating, it receives nopayment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available atwww.standardandpoors.com/usratingsfees.Permissions: To reprint, translate, or quote Standard & Poor’s publications, contact: Client Services, 55 Water Street, New York, NY 10041;(1) 212-438-9823; or by email to: research_request@standardandpoors.com.

To Our ReadersStandard & Poor’s Ratings Services is pleased to present the 2007 edition of Public FinanceCriteria, which we hope you will find useful. This updated overview includes criteriadeveloped since the publication of the last edition, as well as criteria revised to reflect eventsand trends affecting public finance.Standard & Poor’s criteria are extensive and are periodically revised. Our completecriteria are available on Standard & Poor’s RatingsDirect, as well as on the Web atwww.standardandpoors.com.Standard & Poor’s also regularly publishes its new and revised criteria on RatingsDirectand on the Web, as part of our commitment to provide the most timely and comprehensivepublic finance ratings information.William L. MontroneManaging Director

ContentsI. IntroductionIntroduction to Public Finance Criteria ................................................................................6II. Cross Sector CriteriaShort-Term Debt ................................................................................................................11Commercial Paper, VRDO, And Self Liquidity ..................................................................17Bank Liquidity Facilities ....................................................................................................26Municipal Swaps ................................................................................................................29Debt Derivative Profile Scores ............................................................................................38Long-Term Municipal Pools ..............................................................................................43Investment Guidelines ........................................................................................................49Investment Agreements for Municipal Revenue Bond Financings ......................................53Joint Support To Investment Agreements ..........................................................................55Defeasance..........................................................................................................................57III. Tax-Secured DebtIntroduction to Tax-Secured Debt ......................................................................................60GO Debt ............................................................................................................................60Debt Statement Analysis ....................................................................................................66Special Tax Bonds ..............................................................................................................70Non Ad Valorem Bonds......................................................................................................75Lottery Revenue Bonds ......................................................................................................76Special-Purpose Districts ....................................................................................................78State Credit Enhancement Programs ..................................................................................86Appropriation-Backed Obligations ..................................................................................103Federal Leases ..................................................................................................................107Moral Obligation Bonds ..................................................................................................111IV. General Government UtilitiesWater and Sewer Ratings..................................................................................................113Electric Utility Ratings......................................................................................................121Solid Waste System Financings ........................................................................................127V. TransportationAirport Revenue Bonds ....................................................................................................131Stand-Alone Passenger Facility Charge Debt ....................................................................136Airport Multi-Tenant Special Facilities Bonds ..................................................................139Port Facilities Revenue Bonds ..........................................................................................142Toll Road and Bridge Revenue Bonds ..............................................................................145Mass Transit Bonds Secured by Farebox Revenues ..........................................................149Parking Revenue Bonds ....................................................................................................151

VI. Health CareNot-for-Profit Health Care ..............................................................................................153Senior Living ....................................................................................................................162Physician Groups and Faculty Practice Plans....................................................................169Human Service Providers..................................................................................................172VII. Education and Non-Traditional Not-for-ProfitsHigher Education ............................................................................................................175Private Elementary and Secondary Schools ......................................................................191Charter Schools ................................................................................................................194Non-Traditional Not-for Profits ......................................................................................200VIII. Municipal Structured FinanceIntroduction to Structured Finance ..................................................................................207LOC-Backed Municipal Debt ..........................................................................................208Municipal Applications for Jointly Supported Debt ........................................................217Forward Purchase Contracts and ‘AAA’ Defeased Bonds ................................................223Secondary-Market Derivative Products ............................................................................225IX. HousingIntroduction to Tax-Exempt Housing Bonds ....................................................................230Single-Family Whole Loan Programs................................................................................230Single-Family Second Mortgage Loans ............................................................................243Single Family Mortgage-Backed Securities Programs........................................................245Property Improvement Loans ..........................................................................................247FHA Insured Mortgages ..................................................................................................250Ginnie Mae, Fannie Mae, and Freddie Mac Multifamily Securities..................................259Unenhanced Affordable Housing Project Debt ................................................................262Affordable Multifamily Housing Pooled Financings ........................................................270Military Housing Privatizations........................................................................................276Federally Subsidized Housing Programs ..........................................................................281Public Housing Authority Debt ........................................................................................285Housing Finance Agencies ................................................................................................290X. Other CriteriaBond Insurance ................................................................................................................294Government Investment Pools (GIP) ................................................................................312Assessing Construction Risk ............................................................................................323Pension Fund Credit Enhancement And Related Guarantee Programs ............................327Public Pension Funds........................................................................................................329

IntroductionIntroduction To Public Finance CriteriaSince beginning its credit rating activities in 1916,Standard & Poor’s Ratings Services has ratedhundreds of thousands of securities issues, corporateand governmental issuers, and structured financings.Standard & Poor’s began its ratings activities withthe issuance of credit ratings on corporate andgovernment debt issues. Responding to marketdevelopments and needs, Standard & Poor’s hasdeveloped and innovated methodologies and criteriaand now assesses the credit quality of, and assignscredit ratings to, financial guarantees, recovery ratingsand bank loans, private placements, mortgage-andasset-backed securities, mutual funds, and the abilityof insurance companies to pay claims, and assignsmarket-risk ratings to managed funds.In 2005, Standard & Poor’s published more than500,000 ratings, including 294,000 new ratingsand 260,000 revised ratings. We have issued ratingson debt securities in more than 100 countries.Standard & Poor’s rates and monitors developmentspertaining to these securities and obligors fromoperations in 21 countries around the world.Standard & Poor’s believes that over the lastcentury credit ratings have served the U.S. securitiesmarkets extremely well, providing an effective andobjective tool in the market’s evaluation and assessmentof credit risk. Standard & Poor’s recognizesthe valuable role that credit-rating agencies playin the U.S. securities markets and is committedto protecting and enhancing the reputation andfuture of its credit-ratings business. In this regard,Standard & Poor’s takes great care to assure thatthe market views its credit ratings as highly credibleand relevant, and will continue to review its practices,policies, and procedures on an ongoing basis andmodify or enhance them, as necessary, to ensurethat rigorous analytics, integrity, independence,objectivity, transparency, credibility, and qualitycontinue as fundamental premises of its operations.Standard & Poor’s Role In The Financial MarketsStandard & Poor’s is the world’s foremost providerof independent credit ratings, indices, risk evaluation,investment research, data and information,and operates under the basic principles of:■ Independence■ Objectivity■ Credibility, and■ TransparencyStandard & Poor’s recognition as a rating agencyultimately depends on investors’ willingness toaccept its judgments. Standard & Poor’s believes itis important that all users of its ratings understandhow it arrives at its ratings opinions, and it regularlypublishes ratings definitions and detailed reports onratings criteria and methodology.Standard & Poor’s rates more than USD $34trillion in bonds and other financial obligations ofobligors in more than 100 countries. Despite thechanging environment, Standard & Poor’s corevalues remain the same-to provide high-quality,objective, value-added analytical information tothe world’s financial markets.Credit RatingsStandard & Poor’s began rating the debt of corporateand government issuers nearly 100 years ago. Sincethen, its credit rating criteria and methodology havegrown in sophistication and have kept pace withthe introduction of new financial products. Forexample, Standard & Poor’s was the first majorrating agency to assess the credit quality of, andassign credit ratings to, the claims-paying ability ofinsurance companies (1971), financial guarantees(1971), mortgage-backed bonds (1975), mutualfunds (1983), and asset-backed securities (1985).A credit rating is Standard & Poor’s opinion ofthe general creditworthiness of an obligor, or thecreditworthiness of an obligor with respect to aparticular debt security or other financial obligation,based on relevant risk factors. A rating does notconstitute a recommendation to purchase, sell, orhold a particular security. In addition, a rating doesnot comment on the suitability of an investmentfor a particular investor.Standard & Poor’s credit ratings and symbolsoriginally applied to debt securities. As describedbelow, Standard & Poor’s has developed credit ratingsthat may apply to an issuer’s general creditworthinessor to a specific financial obligation. Standard &Poor’s has historically maintained separate andwell-established rating scales for long-term andshort-term instruments. Over the years, these creditratings have achieved wide investor acceptance as6 Standard & Poor’s Public Finance Criteria 2007

Introduction To Public Finance Criteriaeasily usable tools for differentiating credit quality,because a Standard & Poor’s credit rating is judgedby the market to be reliable and credible.Rating ProcessStandard & Poor’s provides a rating only when thereis adequate information available to form a credibleopinion and only after applicable quantitative,qualitative, and legal analyses are performed.The analytical framework is divided into severalcategories to ensure salient qualitative and quantitativeissues are considered. The rating process is notlimited to an examination of various financialmeasures. Proper assessment of credit quality involvesan evaluation of the basic underlying economicstrength of the entity, as well as the effectiveness ofthe governing process to manage performance andaddress problems. Standard & Poor’s assembles ateam of analysts with appropriate expertise toreview information pertinent to the rating. A leadanalyst is responsible for the conduct of the ratingprocess. Several of the members of the analyticalteam may meet and/or discuss with managementof the organization to review, in detail, key factorsthat have an effect on the rating, including operatingand financial plans and management policies. Themeeting also helps analysts develop the qualitativeassessment of management itself, an importantfactor in the rating decision.Following this review and discussion, a ratingcommittee meeting is convened. At the meeting,the committee discusses the lead analyst’s recommendationand the pertinent facts supportingthe rating. Finally, the committee votes onthe recommendation.The issuer is subsequently notified of the ratingand the major considerations supporting it. A ratingcan be appealed prior to its publication, if meaningfulnew or additional information is to be presentedby the issuer. Obviously, there is no guaranteethat any new information will alter the ratingcommittee’s decision.Once a final rating is assigned, it is disseminatedto the public via Standard & Poor’s free web site(www.standardandpoors.com), through the newsmedia and through Standard & Poor’s publications.All initial ratings are assigned and released onlyby request.Rating TypesA Standard & Poor’s issuer credit rating is a currentopinion of an obligor’s overall financial capacity (itscreditworthiness) to pay its financial obligations.This opinion focuses on the obligor’s capacity andwillingness to meet its financial commitments asthey come due. It does not apply to any specificfinancial obligation, as it does not take into accountthe nature of and provisions of the obligation, itsstanding in bankruptcy or liquidation, statutorypreferences, or the legality and enforceability of theobligation. In addition, it does not take into accountthe creditworthiness of the guarantors, insurers, orother forms of credit enhancement on the obligation.The issuer credit rating is not a recommendation topurchase, sell or hold a financial obligation issuedby an obligor, as it does not comment on marketprice or suitability for a particular investor.Issuer credit ratings are based on current informationfurnished by obligors or obtained byStandard & Poor’s from other sources it considersreliable. Standard & Poor’s does not perform anaudit in connection with any issuer credit ratingand may, on occasion, rely on unaudited financialinformation. Issuer credit ratings may be changed,suspended, or withdrawn as a result of changes in,or unavailability of, such information, or based onother circumstances. Issuer credit ratings can beeither long-term or short-term. Short-term issuercredit ratings reflect the obligor’s creditworthinessover a short-term time horizon, usually one tothree years.Most Public Finance ratings are issue ratings. AStandard & Poor’s issue credit rating is a currentopinion of the creditworthiness of an obligor withrespect to a specific financial obligation, a specificclass of financial obligations, or a specific financialprogram. It takes into consideration the creditworthinessof guarantors, insurers, or other forms ofcredit enhancement on the obligation. The issuecredit rating is not a recommendation to purchase,sell, or hold a financial obligation, inasmuch as itdoes not comment as to market price or suitabilityfor a particular investor.Issue credit ratings are based on current informationfurnished by the obligors or obtained by Standard &Poor’s from other sources it considers reliable.Standard & Poor’s does not perform an audit inconnection with any credit rating and may, onoccasion, rely on unaudited financial information.Credit ratings may be changed, suspended, orwithdrawn as a result of changes in, or unavailabilityof, such information, or based on other circumstances.Issue credit ratings can be either long-term orshort-term. Short-term ratings are generallyassigned to those obligations considered short termin the relevant market. In the U.S., for example,that means obligations with an original maturity ofno more than 365 days-including commercialpaper. Short-term ratings are also used to indicatethe creditworthiness of an obligor with respect toput features on long-term obligations. The result isa dual rating, in which the short-term ratingswww.standardandpoors.com7

Introduction To Public Finance Criteriaor changing circumstances are more likely to leadto a weakened capacity of the obligor to meet itsfinancial commitment on the obligation.BB, B, CCC, CC, and CObligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’are regarded as having significant speculative characteristics.‘BB’ indicates the least degree of speculationand ‘C’ the highest. While such obligations willlikely have some quality and protective characteristics,these may be outweighed by large uncertaintiesor major exposures to adverse conditions.BBAn obligation rated ‘BB’ is less vulnerable to nonpaymentthan other speculative issues. However,it faces major ongoing uncertainties or exposureto adverse business, financial, or economic conditions,which could lead to the obligor’s inadequatecapacity to meet its financial commitmenton the obligation.BAn obligation rated ‘B’ is more vulnerable to nonpaymentthan obligations rated ‘BB’, but the obligorcurrently has the capacity to meet its financialcommitment on the obligation. Adverse business,financial, or economic conditions will likely impairthe obligor’s capacity or willingness to meet itsfinancial commitment on the obligation.CCCAn obligation rated ‘CCC’ is currently vulnerableto nonpayment and is dependent upon favorablebusiness, financial, and economic conditions for theobligor to meet its financial commitment on theobligation. In the event of adverse business, financial,or economic conditions, the obligor is not likelyto have the capacity to meet its financialcommitment on the obligation.CCAn obligation rated ‘CC’ is currently highly vulnerableto nonpayment.CThe ‘C’ rating may be used to cover a situationwhere a bankruptcy petition has been filed or similaraction has been taken, but payments on thisobligation are being continued.DAn obligation rated ‘D’ is in payment default. The‘D’ rating category is used when payments on anobligation are not made on the date due even if theapplicable grace period has not expired, unlessStandard & Poor’s believes that such payments willbe made during such grace period. The ‘D’ ratingalso will be used upon the filing of a bankruptcypetition or the taking of a similar action if paymentson an obligation are jeopardized.Plus (+) or minus (-)The ratings from ‘AA’ to ‘CCC’ may be modifiedby the addition of a plus (+) or minus (-) sign toshow relative standing within the major ratingcategories.NRAn issue designated NR is not rated.Short-Term Issue Credit RatingsNotesA Standard & Poor’s U.S. municipal note ratingreflects the liquidity factors and market access risksunique to notes. Notes due in three years or lesswill likely receive a note rating. Notes maturingbeyond three years will most likely receive a longtermdebt rating. The following criteria will be usedin making that assessment:■ Amortization schedule-the larger the final maturityrelative to other maturities, the more likely it willbe treated as a note; and■ Source of payment-the more dependent the issueis on the market for its refinancing, the morelikely it will be treated as a note.Note rating symbols are as follows:SP-1Strong capacity to pay principal and interest. Anissue determined to possess a very strong capacityto pay debt service is given a plus (+) designation.SP-2Satisfactory capacity to pay principal and interest,with some vulnerability to adverse financial andeconomic changes over the term of the notes.SP-3Speculative capacity to pay principal and interest.Commercial PaperA Standard & Poor’s commercial paper rating is acurrent assessment of the likelihood of timely paymentof debt having an original maturity of nomore than 365 days. Ratings are graded into severalcategories, ranging from ‘A’ for the highest-qualityobligations to ‘D’ for the lowest. Thesecategories are as follows:A-1This designation indicates that the degree of safetyregarding timely payment is strong. Those issuesdetermined to possess extremely strong safety characteristicsare denoted with a plus sign (+) designation.www.standardandpoors.com9

IntroductionA-2Capacity for timely payment on issues with thisdesignation is satisfactory. However, the relativedegree of safety is not as high as for issues designated‘A-1’.A-3Issues carrying this designation have an adequatecapacity for timely payment. They are, however,more vulnerable to the adverse effects of changesin circumstances than obligations carrying thehigher designations.BIssues rated ‘B’ are regarded as having onlyspeculative capacity for timely payment.CThis rating is assigned to short-term debt obligationswith a doubtful capacity for payment.DDebt rated ‘D’ is in payment default. The ‘D’ ratingcategory is used when interest payments of principalpayments are not made on the date due, even if theapplicable grace period has not expired, unlessStandard & Poor’s believes such payments will bemade during such grace period.Dual RatingsStandard & Poor’s assigns “dual” ratings to alldebt issues that have a put option or demandfeature as part of their structure.The first rating addresses the likelihood of repaymentof principal and interest as due, and the secondrating addresses only the demand feature. The longtermdebt rating symbols are used for bonds todenote the long-term maturity and the commercialpaper rating symbols for the put option (for example,‘AAA/A-1+’). With short-term demand debt, noterating symbols are used with the commercial paperrating symbols (for example, ‘SP-1+/A-1+’).CreditWatch And Rating OutlooksA Standard & Poor’s rating evaluates default riskover the life of a debt issue, incorporating anassessment of all future events to the extent theyare known or considered likely. But Standard &Poor’s also recognizes the potential for future performanceto differ from initial expectations. Ratingoutlooks and CreditWatch listings address thispossibility by focusing on the scenarios that couldresult in a rating change.CreditWatch highlights potential changes in ratingsof bonds, short-term, and other fixed-income securities.Issues appear on CreditWatch when an eventor deviation from an expected trend has occurredor is expected and additional information is necessaryto take a rating action. Such rating reviews normallyare completed within 90 days, unless the outcomeof a specific event is pending. A listing does notmean a rating change is inevitable. However, insome cases, it is certain that a rating change willoccur and only the magnitude of the change is unclear.Wherever possible, a range of alternative ratingsthat could result is shown. CreditWatch is notintended to include all issues under review, andrating changes will occur without the issue appearingon CreditWatch. An issuer cannot automaticallyappeal a CreditWatch listing, but analysts aresensitive to issuer concerns and the fairness ofthe process.A Standard & Poor’s rating outlook assesses thepotential direction of a long-term credit rating overthe intermediate term (typically six months to twoyears). In determining a rating outlook, considerationis given to any changes in the economic and/orfundamental business conditions.An outlook is not necessarily a precursor of arating change or future CreditWatch action:■ Positive means that a rating may be raised,■ Negative means that a rating may be lowered,■ Stable means that a rating is not likely to change,■ Developing means a rating may be raisedor lowered.CreditWatch designations and outlooks may be“positive,” which indicates a rating may be raised,or “negative,” which indicates a rating may belowered. “Developing” is used for those unusual situationsin which future events are so unclear thatthe rating potentially may be raised or lowered.“Stable” is the outlook assigned when ratingsare not likely to be changed, but should not beconfused with expected stability of the company’sfinancial performance. ■10 Standard & Poor’s Public Finance Criteria 2007

Cross Sector CriteriaShort-Term DebtNote RatingsShort-term debt instruments rated by Standard &Poor’s Ratings Services include cash flow notessuch as tax and revenue anticipation notes (TRANs),bond anticipation notes (BANs) and cash flow notepools. Note ratings differ from bond ratings in thatmany long-term credit risks are mitigated by thecomparatively short repayment period. Conversely,liquidity factors that enhance note security may notallay long-term credit concerns or provide additionalcomfort regarding the issuer’s ability to pay its debtobligations over the long-term.A strong liquidity position is a primary determinantin the assignment of a cash flow note rating. Thereis no exact debt service coverage benchmark thatdetermines a specific rating. Financial and cashmanagement and the quality of the pledged revenuestream, which includes the reliability of the pledgedrevenue source, are additional factors consideredwhen determining a note rating. Moreover, thequality of financial reports—including audits, issuerconstructed historic and projected monthly cashflow statements, and budget projections—areadditional credit factors.Municipal note issues are divided into two majorcategories requiring different rating approaches:cash flow notes and bond anticipation notes (BANs).Cash flow notes are generally referred to as taxanticipation notes (TANs), revenue anticipationnotes (RANs) or tax and revenue anticipationnotes (TRANs).TRANs, TANs and RANsState and local governments typically issue cashflow notes to address a mismatch between thereceipt of revenues and disbursements for ongoingoperations. Many issuers receive major revenuesunevenly during a fiscal year, while operatingexpenditures typically follow a level monthly pattern.For example, a school district may receive thebulk of its annual property taxes in June; however,it needs to make salary and benefit expendituresevenly each month. The district may issue cashflow notes to bridge the gap between receipts anddisbursements during the period when cash balancesare insufficient.The ratings on cash flow notes—TRANs, TANs,and RANs—rely on:■ The security pledged to retire the notes;■ The notes’ legal structure;■ The issuer’s historical and projected liquidityposition, as reflected by its cash management andbudgetary practices;■ The reliability of the issuer’s primary revenuesources; and■ The issuer’s overall fiscal health.Structural AnalysisSecurityThe specific security pledged to retire cash flownotes plays a role in the assignment of a note rating.State and local statutes governing short-term debtissuance and the resolution authorizing issuance ofa particular note usually define the security. Thesecurity may range from a single tax or generalfund revenue pledge, to a full faith and credit GOpledge. Broad unlimited-tax GO pledges are viewedmost favorably since all of the issuer’s resources arepledged to note repayment. While the pledge of aspecific narrow revenue source may be viewed lessfavorably than a combination of revenue sources,the analysis hinges on the quality and consistencyof the revenue in question. In most cases, a narrowbut generally reliable single tax pledge can achievethe same rating as a broader full faith and creditGO pledge.Flow of funds-segregation of pledged revenuesThe monthly flow of funds takes on added importancefor cash flow notes because of the potential strainon resources required on one maturity date torepay a note. The issuer must ensure that sufficientresources are available to make the note paymentat maturity.The segregation of pledged revenues in separatenote repayment accounts prior to note maturityreduces the likelihood that weak budget and financialperformance will interfere with full and timely paymentof debt service. However, sufficient resourcesto pay debt service at note maturity—after allexpenditures are made—is most critical in theassignment of a high investment-grade note rating.www.standardandpoors.com11

Cross Sector CriteriaPledged revenues typically are segregated by anissuer in its own accounts. In some cases, pledgedrevenues may be segregated in accounts in thecustody of a third party. Accounts held by a thirdparty do not necessarily strengthen a note issue’sstructure, especially if funding of the accountdepends on the issuer’s timely transfer of funds tothe third party. If the issuer does not have sufficientfunds to transfer, the third party will not haveadequate resources for note repayment.Standard & Poor’s does not consider debt servicesegregation structures as substitutes for the soundliquidity and financial positions of issuers.Standard & Poor’s considers debt repayment capacityto be enhanced only marginally by the early segregationof pledged revenues. However, the earlyprepayment and segregation of pledged revenuesfor note repayment can be an indication of the cashflow strength of an issuer and, in that respect, mayaffect a note rating.Fiscal and paying agent requirementsIssuers sometimes use fiscal agents and payingagents to hold and invest funds or to hold securitiespledged and segregated for debt service of TRANs.The fiscal agents and paying agents are introducedinto a TRAN structure to provide comfort toinvestors that pledged funds and securities segregatedfor note repayment are not subject to potentialinvestment risk, even in the event of insolvency ofthe issuer.Standard & Poor’s does not view the segregationof pledged funds and/or securities with a paying orfiscal agent as enhancement of a TRAN rating, provisionof additional security, or protection frominvestment losses because funds segregated forTRAN debt service repayment and held by a fiscalor paying agent continue to be general funds of theissuer. Thus, Standard & Poor’s does not considerthe use of a paying agent or fiscal agent to be a mitigatingfactor that reduces credit risk for a TRANTable 1 Sample Projected Cash Flow Fiscal July–DecemberGeneral fund ($000) July August September October November DecemberBeginning balances ($) 25,647 30,360 21,661 14,260 12,529 5,270Receipts property taxes 0 0 0 2,192 694 36,676Other taxes 674 423 1,123 425 709 953Licenses/permits 1,854 3,549 4,517 4,376 3,027 3,536Interest income 109 72 1,199 50 80 1,504Intergovernmental 17,853 11,343 11,245 16,157 10,649 14,613Other revenue 20,7991 4,724 3,870 4,748 2,604 2,880Note proceeds 35,000 0 0 0 0 0Total 76,289 20,111 21,954 27,948 17,763 60,162DisbursementsGeneral government 5,921 2,895 3,192 3,324 2,305 2,780Public safety 14,957 6,298 6,267 6,579 6,673 6,604Health & sanitation 14,879 8,296 8,973 9,316 5,534 6,444Human services 16,724 10,285 10,000 9,503 9,826 9,300Education 752 491 426 503 501 488Other expenses 18,3431 545 496 454 182 317Note repayment 0 0 0 0 0 17,905Total 71,576 28,810 29,354 29,679 25,021 43,838Ending balance 30,360 21,661 14,261 12,529 5,271 21,594Available resourcesSpecial revenue funds 7,653 8,120 8,530 7,742 8,760 9,120Ending balance including special revenue funds 38,013 29,781 22,791 20,271 14,031 30,714Includes accrued monies. Monthly general fund ending balance covers December segregation 2.2x and May segregation 1.6x Monthly ending balance includingspecial revenue funds covers December segregation 2.7x and May segregation 2.1x.12 Standard & Poor’s Public Finance Criteria 2007

Short-Term Debtissue in the event of an issuer’s investment losses oreven its insolvency.Liquidity AnalysisCash flow statement analysisThe credibility and reliability of cash flow projections,which forecast the amount and timing of thereceipt of resources pledged to note repayment, arecritical to the assignment of a note rating. Cashflow statements, together with the underlyingassumptions upon which the projections are based,provide a foundation for analysis of the reliabilityand quality of the revenue stream available to paynote debt service. Standard & Poor’s analyzes bothhistoric and projected monthly cash flows in thecontext of the issuer’s operating budget, financialstatements, cash management practices, pledgedrevenue segregation, and against prior forecasts.Standard & Poor’s analyzes cash flow projectionsfor prior fiscal years, which outline changes inreceipt and disbursement patterns over time (seetables 1a and 1b for an example of a monthly cashflow statement). The trend of cash flow borrowingis also important if increases exceed the rate ofbudget growth, as it may signal deterioration inoverall liquidity or a growing structural imbalance.The sensitivity of the pledged revenue stream toadverse external events over time is evaluated. Anote with a property tax pledge usually has amore stable revenue stream than one secured bysales or income taxes. Revenues derived fromother governmental entities, such as state aidfunding, could exhibit historical volatility, especiallyin the face of an adverse budget climate,that could make timing and amount of futurereceipts uncertain. To the extent issuers are relianton external funding sources with some historicalvolatility, other revenue sources or cash reservescould serve as mediating factors if those revenuesare pledged to debt repayment.Cash flow projections that are in line with historicalprojections provide comfort regarding the reliabilityof an issuer’s cash flow projections. Cash flow resultsthat differ significantly from prior-year projectionsTable 2 Sample Projected Cash Flow Fiscal January–JuneGeneral fund ($000) January February March April May June TotalBeginning balances ($) 21,595 15,766 6,777 6,399 36,595 11,976 25,647Receipts property taxes 0 168 0 36,185 0 9,604 85,519Other taxes 450 690 4,016 1,400 151 1,056 12,070Licenses/permits 4,214 3,473 3,618 4,056 3,626 1,179 41,025Interest income 128 69 1,562 124 66 2,569 7,532Intergovernmental 11,679 8,673 13,391 11,265 13,332 5,116 145,316Other revenue 2,214 3,569 2,410 2,598 2,484 283 53,183Note proceeds 0 0 0 0 0 0 35,000Total 18,685 16,642 24,997 55,628 19,659 19,807 379,645DisbursementsGeneral government 2,514 2,672 2,861 2,673 2,854 1,473 35,464Public safety 6,848 6,325 6,531 6,356 6,727 1,823 81,988Health and sanitation 5,050 6,517 5,596 5,950 5,419 31 82,005Human services 9,427 9,474 9,628 9,701 9,549 1,929 115,346Education 459 450 491 502 459 158 5,680Other expenses 216 193 268 250 223 50 21,537Note repayment 0 0 0 0 19,047 0 36,952Total 24,514 25,631 25,375 25,432 44,278 5,464 378,972Ending balance 15,766 6,777 6,399 36,595 11,9762 26,3191 26,319Available resourcesSpecial revenue funds 8,871 7,954 7,320 8,516 9,416 10,987 10,987Ending balance including special revenue funds 24,637 14,731 13,719 45,111 21,3923 37,306 37,306Includes accrued monies. Monthly general fund ending balance covers December segregation 2.2x and May segregation 1.6x. Monthly ending balance includingspecial revenue funds covers December segregation 2.7x and May segregation 2.1x.www.standardandpoors.com13

Cross Sector Criteriamay be an indication of historically volatile revenuesor inconsistent management forecasting abilitiesand can raise questions about the issuer’s ability tomanage its cash and, therefore, pay note debt servicefully and in a timely manner.The basis for Standard & Poor’s analysis of anissuer’s ability to forecast its cash flows reliably willbe the issuer’s own historic accuracy, when available.For statements of monthly operating cash flows,Standard & Poor’s will conduct variance analysesof current fiscal cash flow projections submitted inthe prior year against actual year-to-date and projectedcurrent year-end cash flow performance.This “actual-versus-projected” performance willthen be compared to the most recent fiscal yearprojected cash flows currently being submitted inconjunction with TRAN rating requests for theensuing fiscal year. For issuers with projected coverageof less than 1.25x at maturity, a detailed analysisand explanation of the reliability of projected cashflows will be important. Moreover, scrutiny will beapplied to issuers who present cash flows that projecthigher than 1.25x coverage but whose coveragefalls to less than 1.25x if actual historic variance isapplied to the projected fiscal cash flows. In thesecases, Standard & Poor’s, in the ratings process,will conduct a thorough review of what caused thevariance between projected and actual cash flowsand debt service coverage levels.While this analysis of variance is an importantstarting point for the rating process, variance andcoverage levels alone will not dictate the rating. Theactual underlying causes of changing patterns in themonthly cash flows and year-end cash balances isalways a central feature to the rating process. Insome cases, one-time events that cause a variancein cash flows may not reflect potential future riskor a lack of management foresight, whereas inother cases, such variances may either reflectvolatile revenues in general, or problems withforecasting or financial management overall.Calculating debt service coverageStandard & Poor’s begins the analysis of debt servicecoverage by measuring debt service due againstavailable cash balances at month’s end, after normaloperating expenditures are made and without theinclusion of proceeds from additional note borrowings.For debt repayment or early segregation ofpledged revenues during the first days of the month,coverage will be measured against the prior month’sending balance. Revenues received early in themonth will be considered when detail is availableand substantiated. When monies are due late in themonth, coverage is measured against the currentmonth’s ending balance.Alternative liquidityAlternative liquidity refers to unrestricted cash andliquid investments that may not be legally pledgedtoward TRAN repayment, but are available to betemporarily used—or borrowed through interfundborrowing and repaid to the fund—for that purposeat the discretion of the issuer. In the case of aGO TRAN pledge, all resources of an issuer areavailable to repay the note. However, when thepledge is more restricted—such as CaliforniaTRANs, which are secured by current year generalfund monies—alternative liquidity can providecomfort to noteholders if an unforeseen eventoccurs that could affect TRAN repayment. Suchevents could include delays in the receipt of stateaid or an unexpected increase in operating expenditures.The utilization of alternative liquidity to payTRAN debt service, however, is extremely rare.Generally, sources of alternative liquidity consideredassessible by Standard & Poor’s include anyfunds not subject to legal or other restrictions andnot expected to be needed for any other purposeprior to TRAN maturity. Standard & Poor’srequires documentation from the TRAN issuerexpressly stating the sources of alternative liquidityand the amounts that are expected to be availableat TRAN maturity or segregation dates to makeup any deficiency in the note repayment account.Typical sources of alternative liquidity includeoperating funds accumulated in a reserve fund tofinance future capital projects or deposit of proceedsfrom an asset sale or other unrestrictedone-time revenues into a reserve fund for unspecifiedfuture uses.Sources of alternative liquidity not consideredby Standard & Poor’s as available include bond orother debt proceeds and monies held in trust or ina fiduciary capacity. While legal under certain circumstances,Standard & Poor’s does not viewreliance on these sources of funds for alternateliquidity as enhancing short-term credit quality. It isimportant to emphasize that alternative liquiditysources are not a substitute for very strong financialand liquidity fundamentals.Alternative liquidity will rarely, if ever, impact aTRAN rating in cases where the issuer has poorcredit fundamentals. Lower-rated TRANs—’SP-2’and ‘SP-3’—have fundamental credit weaknessesthat generally cannot be offset with alternative liquidity.For example, a TRAN issuer that expects toincur a general fund operating deficit and whichdoes not have sufficient year-end general fund cashreserves to fully compensate for its expected deficitgenerally cannot strengthen its TRAN rating with alternativeliquidity to reach an ‘SP-1’ or ‘SP-1+’ rating.14 Standard & Poor’s Public Finance Criteria 2007

Short-Term DebtCash Flow Note PoolsMultiple-issuer TRAN pools are most often structuredas several obligations of various participants—meaning that each participant is responsible foronly its own debt service payments. Standard &Poor’s bases a TRAN pool rating on either an overcollateralizationor weak-link approach. Under theweak-link approach, the TRAN pool rating isequivalent to the creditworthiness of the weakestissuer in the pool—the so-called “weak link.”Under the overcollateralization approach, theTRAN pool rating is assigned according to a blendedapproach of individual issuer quality and commondebt service reserve provisions that overcollateralizethe total borrowing. In addition, note pool ratingsinclude analysis of a pool’s structural and legalstrengths, and liquidity facilities, such as state andcounty guarantees and intercepts that provide forrepayment of note debt service. TRAN pool ratingsalso may be enhanced through liquidity facilities—such as irrevocable bank letters of credit—andbond insurance that unconditionally transfers thecredit risk to a higher-rated entity.Weak-link approachThe weak-link approach assesses each participant’sability to repay its share of the TRAN pool financing.Each participant is evaluated and assigned aTRAN rating as if it were issuing TRANs on astand-alone basis and not as a member of a pooledfinancing. Because full and timely debt servicerepayment is reflected in the rating, this approachresults in TRAN pool ratings that are only asstrong as the creditworthiness of the weakest participantregardless of the relative size of that issuer’sparticipation in the financing. Where all participantsare strong enough to be rated at least ‘SP-1’individually, the pool rating assigned is ‘SP-1’. Inanother example, where one pool participant israted ‘SP-1’, and the rest of the participants arerated ‘SP-1+’, the rating assigned to the pool wouldbe ‘SP-1’. The ‘SP-1’ rating based on the creditworthinessof the weakest issuer would be assignedregardless of the magnitude of borrowing by theweakest participant.Overcollateralization approachThe overcollateralization approach allows issuers toachieve strong TRAN pool ratings even if a widedisparity of credit quality exists among the participants,including, in some cases, noninvestment-gradeissuers. This approach also allows TRAN poolscomprising very small issuers to achieve higherratings through structural enhancement.A common debt service reserve that overcollateralizesthe total borrowing results in higher ratingswithout issuer reliance on a third party to guarantee100% of principal and interest payments. Cashreserves, a surety bond, or other forms of financialguarantee provide the extra security reflected in thehigher rating. While each participant’s obligation torepay only its share of the total borrowing remainsunchanged, all reserves must be available for notepayment on shortfalls from any participant.Standard & Poor’s determines the common debtservice reserve level necessary to address the principalportion of a pool that would be rated lower thanthe desired pool rating. The establishment of thereserve level begins with analysis of the pool’sunderlying credit quality. The pool participants aresegregated into four credit quality categories correlatingto ‘SP-1+’, ‘SP-1’, ‘SP-2’, and ‘SP-3’. Theavailability of statutory protections, intergovernmentalaid distributions, and institutionalized financialpractices will determine the depth of analysis on theindividual pool participants. Many pools require afull cash flow analysis of each participant.Standard & Poor’s identifies those pool participantsrated lower the desired rating on the entirepool. Please refer to Standard & Poor’s criteria forExample: Reserve Pool LevelsTo illustrate the basic approach to establishing a pool’s reserve level (see table 3), consider a $100 million pool. The desired rating is‘SP-1+’, and total principal due comprises 65% ‘SP-1+’, 25% ‘SP-1’, 7% ‘SP-2’, and 3% ‘SP-3’. Reserves are necessary only for 35% ofprincipal, or that portion of the pool below ‘SP-1+’. The level of reserves for each portion of principal below ‘SP-1+’ is calculatedaccording to the ratios displayed in the table. Reserves to raise the ‘SP-1’ portion to ‘SP-1+’ are set at 20% of the ‘SP-1’ principal, or5% of the total pool (20% of 25%). Reserves for the ‘SP-2’ portion are set at 25% of the ‘SP-2’ principal, or 1.75% of the total pool (25%of 7%). Reserves for the ‘SP-3’ portion are set at 35% of the ‘SP-3’ principal, or 1.05% of the total pool (35% of 3%). As a result, totalreserves necessary to achieve an ‘SP-1+’ rating for the pool financing are 8% of $100 million, or $8 million. This reserve level isdetermined by adding the total of 5% + 1.75% + 1.05%.Alternatively, consider a $100 million pool comprising 10% ‘SP-1+’, 40% ‘SP-1’, 35% ‘SP-2’, and 15% ‘SP-3’. The rating desired is‘SP-1’. Reserves are needed to cover only the portion of the pool below ‘SP-1’ or 50% of the par amount. Using the ratios shown inthe table will yield reserve levels of 20% for the ‘SP-2’ portion, or 7% of total principal (20% of 35%); plus 30% of the ‘SP-3’ portion,or 4.5% of total principal (30% of 15%). Total reserves required to achieve the desired ‘SP-1’ rating are 12% or $12 million, the sum of7% + 4.5%.www.standardandpoors.com15

Cross Sector Criteriarating TANs and TRANs for detail on the analysisof the individual cash flows. Once that principalportion is determined, the reserve level needed toovercollateralize to the desired rating level is establishedaccording to standard requirements. Reservelevels for ‘SP-1+’ rated pools have ranged between8%-20%, reflecting the underlying credit quality ofthe participants or other structural enhancementsPool StructureAs with stand-alone cash flow note ratings,Standard & Poor’s evaluates the legal security, thelien position, and the flow of funds, including thesegregation of pledged revenues into separate debtservice repayment accounts for each participant. Inaddition, for cash flow note pool ratings,Standard & Poor’s confirms that all participants arerequired to make full repayment of principal andinterest prior to the maturity date of the note poolitself. In the case of note pools, it is important thatsegregated pledged revenues are held in accountsunder the custody of a third party.Similar to stand-alone cash flow note ratings,when repayment accounts are held with a thirdparty paying or fiscal agent, Standard & Poor’s alsoconfirms that the legal documents insulate the issuefrom paying agent or fiscal agent risk. All investments,including Guaranteed Investment Contracts,are restricted to maturities that mature no laterthan the maturity date of the TRANs.A common approach to investing note proceedsand repayment amounts is to place the money in aguaranteed investment contract—or GIC. Theseinstruments offer the investor a guaranteed returnon the amount invested at a time certain. Pleaserefer to Standard & Poor’s investment guidelinesfor information on permitted investments.Bond Anticipation NotesBond anticipation notes (BANs) are generally usedas an interim financing vehicle for capital projects.BAN debt service is typically repaid with bond proceeds,which requires the issuer to access the capitalmarkets. Standard & Poor’s assumes that mostinvestment-grade issuers have access to the publiccredit markets to sell bonds to retire BANs and theBAN ratings reflect that assumption. BorderlineTable 3 TRAN Pool Reserve Requirements (%)—Pool rating—Participant rating SP-2 SP-1 SP-1+SP-3 25 30 35SP-2 20 25SP-1 20investment-grade credits or those on CreditWatchor with negative outlooks, however, are notassumed to have ready market access and the BANrating assigned may reflect those risks.When assigning a rating to BANs, Standard &Poor’s will consider these factors:■ The issuer’s fundamental credit strengths, asreflected in its bond rating; and■ The issuer’s demonstrated experience in the publiccredit markets, including frequency of its debtissuance and the historical demand for its paper.In all cases, regardless of other strengths, thelegal authority to refinance the notes with longterm debt or cash must be in place prior BANissuance. In addition, the issuing entity must carry aStandard & Poor’s long-term bond rating, an indicationof market access, to secure a BAN rating.BANs are rated based on an approach that blendsthe issuer’s fundamental credit factors with likelyaccess to the public credit markets to issue debt. Theapproach emphasizes the issuer’s long-term bondrating as a measure of both these factors. Issuerswith healthy. stable long-term bond ratings and theappropriate authorization to issue additional longtermdebt can ususally achieve a high BAN rating.In most cases, BAN issuance takes place withinthe context of a well-managed capital plan withparticular timing constraints for long-term debtissuance; therefore, BAN issuance does not in andof itself pose a long-term credit concern. In somecases, however, BAN proceeds may be used to fundongoing expenses unrelated to capital outlay or tofinance accumulated deficits. Issuers who use BANproceeds as the first step in a plan to ultimatelybond out these non-capital costs are often experiencingfiscal stress and, possibly, the first stages oflong-and short-term credit deterioration. In suchinstances, BAN issuance may be an indication ofpotential pressure on the issuer’s long-term ratingand, in occasions of significant fiscal stress, lack ofready access to long-term capital markets to repayoutstanding BANs. In such instances, credit concerncould be reflected in a lower short-term BAN and,ultimately, long-term bond rating.Market accessIn certain cases, issuers with lower investmentgrade bond ratings but ample demand for theirpaper and market experience may achieve highinvestment grade BAN ratings. For example, a veryactive issuer in the long-term credit markets, due toa sizable ongoing capital program or other factors,may exhibit long-term credit risks reflected in along-term rating that may not necessarily curtaildemand for that debt in the public markets. Thekey factors in such circumstances is the frequencyof long-term debt issuance and predictability of16 Standard & Poor’s Public Finance Criteria 2007

Commercial Paper, VRDO, And Self-Liquiditymarket demand. Since the maturity of a BAN is significantlyshorter than a series of bonds, the creditrisk of a downgrade that would deny an issueraccess to the market to issue bonds to retire BANsis significantly reduced, short of BAN issuance fornon-capital costs which might actually be a sign oflong-term distress.Cash liquidityA last factor that can support a high BAN rating isthe availability of cash reserves sufficient to repayBAN issuance in case long-term debt cannot or isnot issued, providing sufficient cash to repay BANsat maturity without the need to access the long-termcapital markets. Such instances are rare, however,given that issuers with sufficient cash reserves onhand to pay off short-term debt would generallyalso exhibit healthy long-term credit characteristicsand, by default, ability to issue long-term debt ondemand. In such scenarios, though, adequate comfortshould be achieved the sufficient cash would bein place at the time of BAN maturity, and use ofcash for repayment should not significantly impactoperations. Availability of cash, however, whereother credit factors are weak does not on its ownguarantee a high BAN rating. ■Documentation RequirementsThe following note documentation requirements are intendedas general guidelines. Standard & Poor’s will requestadditional information when appropriate. Supportinginformation will vary depending on the nature of theparticular financing. For example, documentation for cashflow notes issued in anticipation of property taxes shouldinclude relevant tax collection data.For cash flow notes and BANs:■ Offering memorandum or official statement;■ Note indenture or resolution;■ Audits for two years; and■ Current and proposed budgets.For cash flow notes only:■ Cash flow statements, including cash based receipts anddisbursements (see example);■ Current projection through note maturity;■ Historical projections and actual results (when available);■ Documentation of resources in other funds available fornote repayment;■ Fiscal and paying agent agreement, if applicable;■ Investment agreement, if applicable; and■ Legal opinion.Commercial Paper,VRDO, And Self-LiquidityStandard & Poor’s Ratings Services PublicFinance department rates the commercial paper(CP) programs and variable rate demand obligations(VRDOs) of governmental entities and nonprofitorganizations (including colleges, universities, andhospitals). CP program ratings can be based on theissuer’s creditworthiness or a third-party creditfacility. Issuers in all sectors are increasingly issuingVRDOs and other types of variable rate debt, suchas auction rate and index bonds. These issuers seekto lower their borrowing costs as they encounter asignificant difference between short- and long-termtax-exempt interest rates. Also, the efficient pricingof derivative products by broker-dealers, such asinterest rate swaps, has also impacted issuer’swillingness to enter the short-term debt markets.Interest rate swaps in particular can potentially lockin interest rate savings to issuers that choose to syntheticallyfix interest rates on VRDOs. Issuers canalso use swaps to lower fixed debt service costs byconverting fixed rate debt into variable rate debt.Standard & Poor’s typically rates the tender obligationson VRDOs based on third-party liquidityfacilities, such as LOCs and standby bond purchaseagreements (SBPAs), although some highly capitalizedissuers are increasing issuing “unenhanced” VRDOs,where tender obligations on the debt are supportedby the issuer’s own liquidity sources.Issuers have the option of using their own assetsto provide liquidity support as a substitute for traditionalliquidity facilities both for CP programs orVRDO tender obligations. An issuer may alsochoose to use its own liquid assets in combinationwith liquidity facilities to provide support for liquiditydemands. An issuer's assets and other forms ofliquidity must be sufficient, liquid and creditworthyenough to meet all payment obligations on timeand in full. For VRDOs, self-liquidity must involveat least 100% backup of outstanding principal andinterest through a combination of the issuer's assetsor credit facilities. Sources to back unenhanced CPprograms do not have to account for 100% of CPwww.standardandpoors.com17

Cross Sector Criteriaauthorized since ratings reflect the issuer's ongoingability to provide funds to meet maturing CP. Also,the issuer does not have to provide sources that arerated equivalent to the CP rating. This is not thecase, however, with VRDOs. The distinguishingfactor between unenhanced CP and VRDOs is theissuer's control over the timing of payment events.CP programs have predictable maturity schedules,whereas VRDOs are subject to tenders at theoption of the bondholders at any time. The unpredictablenature of VRDO tenders necessitates amore conservative approach towards the qualityand sufficiency of liquidity reserves for VRDOs.Therefore, short-term ratings on VRDOs willreflect the lowest-rated liquidity sources backingthe tender obligation.Issuers that elect to issue unenhanced CP orVRDOs and back these obligations with their ownliquid assets rather than a credit facility providedby a rated entity, must undergo a formal LiquidityAssessment review by Standard & Poor's(see Self Liquidity).Extendible Commercial PaperExtendible commercial paper is almost identical totraditional commercial paper, with one major difference:the issuer can choose to extend the maturitydate of the CP beyond the initial maturity date ofone to 270 days from issuance. Extendible CPallow an issuer to cover the liquidity risk of a failedor potential failed remarketing of its paper andavoid default by exercising its option to extend thematurity date, thus precluding a need for liquidity.Extendible CP is rated the same as traditional CP.The rating does not address the likelihood of extension—onlypayment in accordance with terms. Anextension does not constitute a default of the paper.Extendible CP Extension PeriodStandard & Poor’s does not have specific extensionperiod requirements for rating extendible CP. Theextension period for each individual extendible CPfinancing will vary on a case-by-case basis. Thequestion is: how much time does an issuer need toarrange financing to retire extendible CP? Theamount of time required will depend, in large part,upon the overall credit strength of the issuer with atrack record of market access. A higher-rated issueris less likely to be denied access to the CP marketthan a lower rated entity. Since the vast majority oftraditional CP issuers and likely ECN issuers inpublic finance are major market players (such asstates, major counties, cities, universities, hospitals,utilities and housing agencies) and rated at least ‘A’,denial of market access is remote. At the time of theECP issuance, borrowers should have taken allneeded steps to put long term financing in place, inorder to ensure a smooth take out of the CP at theend of the extension period.Partially enhanced CP programsIssuers may provide partial enhancement of CP programsby providing a credit facility for payment ofCP principal only. In most partially enhanced structures,the issuer pledges to cover interest only andrepay the enhancer bank for CP principal draws. Ifthe issuer has secured a bank facility as partialcredit replacement, and is pledging its own creditfor interest only, Standard & Poor’s will rate the CPbased on a weak-link approach, using the lower ofthe bank’s short-term rating or the issuer’s short-termrating equivalent. The reason for this is due to thefact that both principal and interest of CP must bepaid upon maturity and neither the bank nor theissuer is obligated to pay both components. If, however,the issuer is pledging its own credit support asa secondary source of payment for CP principal,Standard & Poor’s can rate the CP program basedon the issuer’s short-term rating equivalent, irrespectiveof the credit bank’s rating because theissuer is ultimately obligated to repay both principaland interest upon CP maturity.If a partially enhanced CP program rating is ultimatelybased on the bank’s short-term rating, allconditions of the LOC backed CP criteria discussedabove will apply. If the CP program rating is to bebased on the issuer’s short-term rating equivalent,all conditions of the unenhanced CP criteria shouldbe met as described above. Additionally, if theissuer is serving as a source of payment for CPprincipal, Standard & Poor’s will look to see thatthe credit facility and bond documents meetStandard & Poor’s criteria for “confirming”LOCs (see "Confirmation LOC Rating Criteria"section of "Public Finance Criteria: LOC-BackedMunicipal Debt").Commercial PaperEvaluation of an issuer’s commercial paper (CP)reflects Standard & Poor’s opinion of the issuer’sfundamental credit quality. The analytical approachis virtually identical to the one followed in assigninga long-term credit rating, and there is a strong linkbetween the short-term and long-term rating systems.Indeed, the time horizon for CP ratings is not afunction of the typical 30-day life of a commercialpapernote, the 270-day maximum maturity for themost common type of commercial paper in theU.S., or even the one-to-three-year tenor typicallyused to determine which instrument gets a short-termrating in the first place.To achieve an ‘A-1+’ CP rating, the obligor’scredit quality should be at least the equivalent of an‘AA-’ long-term rating. Similarly, for CP to be rated18 Standard & Poor’s Public Finance Criteria 2007

Commercial Paper, VRDO, And Self-Liquidity‘A-1’, the long-term credit rating would need to beat least ‘A-’. When an obligor has multiple lienpositions, Standard & Poor’s will look to the longtermrating on the intended takeout financing toevaluate the correlation between the short-andlong-term ratings. For example, if an obligor issuessubordinate lien CP but intends to ultimately retirethe CP using senior lien debt, it is the long-termrating on the senior lien debt that will determinethe short-term rating. (See chart “Correlation OfCP Ratings With Long-Term Credit Ratings”).Conversely, knowing the long-term rating willnot fully determine a CP rating, considering theoverlap in rating categories. However, the range ofpossibilities is always narrow. To the extent thatone of two CP ratings might be assigned at a givenlevel of long-term credit quality (e.g., if the longtermrating is ‘A’), overall strength of the creditwithin the rating category is the main consideration.For example, a marginal ‘A’ category credit likelywould have its commercial paper rated ‘A-2’, whereasa stronger ‘A’ category will likely receive an ‘A-1’.Backup PoliciesStandard & Poor’s deems it prudent for obligorsthat issue commercial paper to make arrangementsin advance for alternative sources of liquidity. Thisalternative, backup liquidity protects an obligorfrom defaulting if they are unable to roll over theirmaturing paper with new notes, because of ashrinking overall CP market or investor concernsabout the obligor that might make CP investorsreluctant to extend additional credit to the obligor.Many developments affecting a single obligor orgroup of obligors—including bad economic conditions,a lawsuit, management changes, a ratingchange—could make commercial-paper investorsflee the credit.Given the size of the CP market, backup facilitiescould not be relied on with a high degree of confidencein the event of widespread disruption. A generaldisruption of CP markets could be a highly volatilescenario, under which most bank lines would representunreliable claims on whatever cash would bemade available through the banking system to supportthe market. Standard & Poor’s neither anticipatesthat such a scenario is likely to develop, norassumes that it never will.The norm for public finance obligors is 1x coverageof outstanding CP with excess liquid assets orbank facilities in an amount that equals all suchpaper outstanding providing the backup support.Under some exceptional circumstances, Standard &Poor’s will assign a strong short-term rating withcoverage of less-than 1x, if the obligor has a longtermrating of ‘AA-’ or higher, and can demonstratethrough some combination of their own resourcesor alternative bank facilities, that they will alwayshave the capacity to cover all CP as it matures,including in the event of a call on the liquid assetsof the obligor. In these cases, it is possible thatStandard & Poor’s will assign a strong short-termrating with coverage levels in the range of, but nolower than, 50%-to-75% of CP outstanding as longas they have 1x coverage of all maturing CP.Determinants in the acceptable level of coverage ofCP are the planned use of CP proceeds and intendedtakeout financing. Standard & Poor’s will generallylook for relatively higher coverage ratios if thepurpose of the CP issue is to finance operations andto manage intra-year cash flows. Higher coveragelevels will also be expected when the issuer intendsto retire the CP with its own cash. Coverage can belower when the obligor intends to issue long-termdebt to retire outstanding CP.Available cash or marketable securities are idealto provide backup, although it will likely be necessaryto “haircut” their apparent value to accountfor potential fluctuation in value. Marketability ofliquid assets is also critical. The vast majority ofcommercial paper issuers rely on bank facilities(lines of credit) for alternative liquidity.This high standard for back-up liquidity has provideda sense of security to the commercial-paperCorrelation Of CP Ratings WithLong-Term Credit Ratings*AAAAA+AAA+AA-BBB+BBBAA-BBB-*Dotted lines indicate combinations that are highly unusual.A-1+A-1A-2A-3www.standardandpoors.com19

Cross Sector Criteriamarket—even though backup facilities are far from aguarantee that liquidity will, in the end, be available.For example, an obligor could be denied funds if itsbanks invoked “material adverse change” clauses.Alternatively, an obligor with insufficient liquiditymight draw down its credit line to fund other cashneeds, leaving less-than-full coverage of paper outstanding,or issue paper beyond the expiration dateof its lines.Obligors rated ‘A-1+’ can provide 50%-75%coverage of CP outstanding, once again, if theissuer can demonstrate they always have the capacityto cover CP as it matures. In practice, this may behard to demonstrate on an ongoing basis, especiallyfor an issuer that is an active user of commercialpaper and with numerous maturity dates. The exactamount is determined by the issuer’s overall creditstrength and its access to capital markets. Currentcredit quality is an important consideration in tworespects. It indicates:■ The different likelihood of the issuer’s everlosing access to funding in the commercial-papermarket; and■ The timeframe presumed necessary to arrangefunding should the obligor lose access. A higherratedentity is less likely to encounter financialreverses of significance and—in the event of ageneral contraction of the commercial-paperInformation Requirements For Liquidity Evaluation■ A letter requesting a Standard & Poor’s variable-ratedebt rating indicating that the issuer intends to use itsassets for liquidity support.■ A copy of the current investment policies. (Please includepolicies on repurchase agreements, hedging transactions[including use of options and/or futures contracts], andleveraging of assets.)■ A list of securities approved for purchase according toasset type, credit quality, maturity, and sector.■ The range of weighted average maturities of assetsfor each month during the past three years.■ The end-of-month asset balances for the threeprevious years.■ Documented written liquidation procedures detailing thesteps to be taken to provide same-day funds to cover afailed commercial paper remarketing or tendered VRDO(see sample liquidation letter).■ A legal opinion verifying the issuer’s legal ability to use itsown assets for VRDO/commercial paper liquidity support,if necessary.Note: Monthly surveillance requirements include submission ofmonthly asset reports and notification of changes in investmentpolicies, operating procedures and personnel managing theassets. The market and par value, security identifier (CUSIPnumber), and security rating (if applicable) should be providedfor each security in the monthly assets report.market—the higher-rated credit would be lesslikely to lose investors. In fact, higher-ratedobligors could actually be net beneficiaries ofa flight to quality.Issuers Can Provide Self-LiquidityCreditworthy municipalities and nongovernmentalorganizations with good liquidity and a stronginvestment management function can use their ownassets to provide liquidity support for commercialpaper (CP) programs and variable rate demandobligations (VRDO) Rather than relying on externaldedicated bank facilities, these issuers demonstratethey have both sufficient fixed income investmentsand the policies and procedures necessary to covereither outstanding commercial paper or variablerate demand obligations. The rating processinvolves an assessment of the quality and sufficiencyof investments that would be used to cover thevariable rate debt or commercial paper and theissuer’s demonstration that they have adequate policiesand procedures in place to act as a bank facilitywould under the same circumstances. Therefore anissuer should demonstrate that it could liquidatesufficient investments and cash when necessaryunder the bond documents in order to meet either aremarketing failure of commercial paper or anoptional put for variable rate demand obligations.Standard & Poor’s Ratings Services will evaluatean organization or municipality’s fixed incomeinvestments that can be used to support short-termratings if the issuer’s assets are sufficient, liquid,and creditworthy to meet all debt obligations on afull and timely basis. Because the ability to accesssufficient moneys when necessary is not related tobank performance, commercial paper ratings andany short-term ratings assigned to variable ratedemand bonds, are thus tied to the issuer’s longtermcredit rating, rather than to external bankliquidity support. (See chart, “Correlation Of CPRatings With Long-Term Credit Ratings).Self-Liquidity For Commercial Paper And VRDOsCommercial paper ratings are a function of marketaccess and long term credit quality, the rating onthe commercial paper reflects the market accessability of the issuer to either take out the financingwith long-term paper or new commercial papernotes. In general, commercial paper is more predictableand flexible than variable rate demandobligations, because it is the issuer who decides onthe maturity of the commercial paper. Therefore,while there is remarketing risk, the issuer itselfmanages the remarketing risk. On the day thatremarketing proceeds must be settled, however, theissuer will still need to have sufficient, liquid fundson hand to cover any potential remarketing failure.20 Standard & Poor’s Public Finance Criteria 2007

Commercial Paper, VRDO, And Self-LiquidityStandard & Poor’s looks for an issuer to have onhand sufficient liquid resources, in any combinationof revolving credit agreements or liquid fixedincome investments available, to cover the amountof the commercial paper outstanding, as well as theability to cover up to 270 days of interest. Pleaserefer to the commercial paper criteria for moredetail on requirements.Because the investments may be called on to meetmarket events, such as a failed CP rollover or aVRDO tender, using these investments should notimpair an issuer’s ability to meet ongoing operatingexpenses. Therefore issuers who provide self-liquidityshould generally have a high level of liquidityavailable for debt and operations. While an ‘A’ categoryissuer could provide self liquidity for CP andvariable rate demand obligations, most issuers whowill be able to provide self liquidity will likely berated in the ‘AA’ category or ‘AAA’.Standard & Poor’s will evaluate an issuer’s abilityto provide self-liquidity through an assessment ofinvestment management policies and practices, and(2) an analysis of the fixed income portfolio. Someinstitutions, such as heavily endowed colleges anduniversities may be able to demonstrate overwhelmingcoverage of commercial paper or VRDOs withtreasury securities and cash alone. If their portfoliosare sufficiently large, or the amount of debt beingcovered is very small, the analysis of the fixedincome portfolio is narrower in scope.However, even in cases where the entire portfoliodoes not need to be evaluated, Standard & Poor’sstill evaluates the capacity of management to provideself liquidity and still asks for a liquidity proceduresletter to indicate that the cash and high quality fixedincome securities can be available when needed andto identify the steps that the institution will take tomeet its obligations. Standard & Poor’s expectsissuers to demonstrate their capacity and willingnessto make short-term debt payments by submitting adetailed written liquidation plan. The procedures lettershould conform to the timing in the legal documentssuch as when the institution or municipalityreceives notice that there is a shortfall and when thefunds are due to the paying agent or tender agent.The letter should also identify the individuals whoare responsible for these steps.In an evaluation of management’s capacity,Standard & Poor’s asks the institutions themselvesand not their financial advisors or underwriters toprepare the procedures letter. Additional documentationsuch as operating cash flows and investmentbalances available for operations throughout the yearmay be necessary, depending on the nature of cashflow for the issuers. Ultimately, Standard & Poor’swill evaluate whether the issuer’s long and short-termcredit quality is sufficiently robust to withstand a callon its assets pledged for liquidity purposes.An issuer may also choose to use a combinationof its own assets and third-party liquidity (forexample, a bank liquidity facility) to provide liquiditysupport. Strong lines that more closely resemblestandby bond purchase agreements may be used toreduce the amount of available assets to covermaturing CP or VRDOs and still allow the issuer topledge its own self-liquidity. In cases where a strongline is being used to substitute for self-liquidity,Standard & Poor’s will evaluate the strength of theline. Weak lines, which include looser events of termination,have historically been used to cover commercialpaper programs, and because of thepredictable nature of commercial paper,Standard & Poor’s accepts weak external liquidityfacilities as a source of backup for maturing commercialpaper if they are dedicated to the program.Variable rate demand bonds, however, carry anelement of unpredictability because investors canchoose to put their bonds. In these cases, weak linesExhibit AInformation Requirements For Liquidity Evaluation■ A letter requesting Standard & Poor’s to conduct a“liquidity assessment”.■ A copy of the current investment policies. (Includingpolicies on hedging transactions, [including use of optionsand/or futures contracts] and leveraging of assets).■ Current portfolio holdings report of assets identified forliquidity support with the information listed in point #7(please see below).■ A list of fixed income securities approved for purchaseaccording to asset type, credit quality, maturity,and sector.■ The weighted average maturities and/or durations forthe fixed income assets for each month during the pastthree years.■ Documented written liquidation procedures detailing thesteps to be taken to provide same-day funds to cover afailed CP remarketing or tendered VRDOs (see sampleliquidation letter—Exhibit 3).■ Monthly surveillance requirements include submissionof monthly asset reports and notification of changes ininvestment policies, operating procedures, and personnelmanaging the assets. The market and par values, securityidentifier (CUSIP number), and security specific ratings(Standard & Poor’s ratings if applicable) should beprovided for each security in the monthly assets report.Note: Verification of the issuer’s legal ability to use its ownassets for liquidity support may be necessary (i.e. legal opinionsor statutory proof in the case of state and local governments).www.standardandpoors.com21

Cross Sector Criteriamight not be an acceptable substitute for self-liquidityand the presence of the line may not reducethe issuer’s liquidity on a dollar per dollar basis.Standard & Poor’s will evaluate lines if requested todo so, and strong lines that more closely resemblestandby bond purchase agreements, even if they arenot part of the bond transaction, may be used toreduce an issuer’s self liquidity.Asset-To-Debt Coverage RequirementsAn issuer must ensure, on an ongoing basis, that itsavailable assets (whether they are cash and fixedincome investments or dedicated liquidity facilities)are sufficient, safe, and liquid enough to meet atleast 100% of maturing CP or the full amount of apotential VRDO tender. The 100% requirementprovides a minimum of 1x coverage of debt byavailable assets and assumes assets are available inthe event of a failed remarketing or optional tender.In cases where a combination of an issuer’s ownassets and bank liquidity facilities (provided theyare strong enough to provide support for the program)provide liquidity support, the minimum coveragerequirement remains 1x.When evaluating fixed income investments in aportfolio, Standard & Poor’s uses different coveragelevels of different types of investments to take intoaccount the nature of the specific assets availableand the speed with which the assets can be liquidatedwithout significant market losses. An issuer providingself-liquidity must indicate its willingness tosell assets in a down market and incur a potentialloss if Standard & Poor’s is to be comfortable withtheir ability to provide self-liquidity.When an issuer chooses to use its own assets, theamount of assets necessary to cover maturing CP or apotential VRDO tender depends upon the asset’scredit quality, volatility, and weighted average maturity.Generally, the lower the credit quality of the fixedincome security, the longer the weighted averageExhibit BPortfolio Surveillance InformationRecipient:Telephone #:Monthly Portfolio Surveillance InformationDate of portfolioPar/Face value (millions) of fixed income portionMonthly total returnEffective durationSender/Contact:Liquidity provider:Name of portfoliosMarket value (millions) of fixed income portionTotal value (millions) of equity holdings and other assetsWeighted average maturityNet asset value (per share if available)Credit Quality—Standard & Poor’s ratings (%) (Please indicate if other NRSRO ratings are used)AAABBAACCCAN.RBBBPortfolio Breakdown (%) of the Fixed Income Holdings Sector type with market value and percentages (suggested categories.)U.S. TreasuryCorporate bondsAgency discount notesAsset-backed securitiesAgency mortgage-backed securitiesCollateralized Mortgage ObligationsRepurchase agreementsMunicipal notesCommercial paperCash/Other MMFsCertificates of DepositOtherCorporate notes Total should equal to 100%Leverage (Please indicate the type of leverage used and the percentage)Maturity breakdown (%)5-10 Years0-1 Years 10-15 Years1-3 Years 15-25 Years3-5 Years 25 & OverTotal outstanding debt covered by self liquidity (millions):Commercial paperVRDNsOtherMaximum daily and weekly modesAsset to debt coverage22 Standard & Poor’s Public Finance Criteria 2007

Commercial Paper, VRDO, And Self-Liquiditymaturity, and the greater the volatility and marketrisk of the assets, then the higher the coveragerequirement such as 1.50 for investment grade corporatenotes becomes. Logically, the reverse holds true.As the asset’s weighted average maturity and marketrisk declines and credit quality increases, the lowerthe asset coverage requirement. Generally,Standard & Poor’s will discount U.S. Treasury debtobligations and highly rated money market funds at aratio of 1:10 and will apply higher discount ratios of1:20 and above for all other securities.The discount ratio is also a function of how frequentlyan issuer plans to have assets valued in themarket. While monthly valuations for high qualityassets such as U.S. Treasuries may be adequate,daily or weekly valuations are recommended forSample Liquidation LetterStandard & Poor’s CorporationPublic Finance Department55 Water StreetNew York, New York 10041Dear Standard & Poor's,In connection with the $xx million “Issuer” variable-rate demand obligation bonds series 200x, “Issuer” (the “Guarantor”) is guaranteeingthe payment of the purchase price of any of these bonds that are tendered for purchase and not remarketed. The Guarantor hasrequested that Standard & Poor’s provide its short-term ratings for these bonds, as based on the credit and liquidity of the Guarantor.The purpose of this letter (“Liquidation Letter”) is (i) to specify the available sources of the Guarantor for payment of purchase price onthe bonds in the event of a failed remarketing; (ii) to provide contact information for officials of the Guarantor responsible for activatingprocedures to provide required funding to the Transfer Agent or Trustee to cover the purchase price of bonds subject to a failedremarketing, and (iii) to outline specific procedures that would be followed in the event of a failed remarketing.Sources “Issuer” as Guarantor would have available in the event of a failed remarketing on the bonds.As summarized below, the “Issuer” has a number of potential sources of funds in which, as Guarantor on the bonds, it would accessin order to respond to a failed remarketing event for the bonds. In the event of a failed remarketing, the “Issuer” would access thesource of funds most favorable to it at the time of any failed remarketing. Among the sources of funds available to the “Issuer” arethe following:■ Liquidation of General Fund investments: The “Issuer” could elect to liquidate investments held in its General Fund in order to meetany failed remarketing funding requirement on the bonds. At Dec. 31, 2000, the General Fund approximated $1.3 billion in value andconsisted of a diversified portfolio of publicly traded equity and fixed-income investments in addition to illiquid alternative investments.The “Issuer” maintains cash and liquid assets at [NAME OF CUSTODIAL BANK], which acts as our custodial bank for all“Issuer” investments not held by a bond trustee or invested in an external commingled pool. Four senior staff the within Treasurydepartment plus the “Issuer’s” chief financial officer are authorized to direct [NAME OF CUSTODIAL BANK] in securities transactionsand/or the wiring of funds.■ Use of reverse repos: Rather than actually sell investments of our General Fund in the event of a failed remarketing on the bonds,the “Issuer” would most likely set up a reverse repo of government or agency securities from its investment funds in order to raisecash in the short term. The “Issuer” has completed reverse repos from time to time over the past few years and has agreementsin place to do them again, if necessary. Four senior staff within the Treasury department are authorized to initiate reverse repotransactions with our banks.The “Issuer” agrees to notify Standard & Poor’s in the future if these sources of potential funding are unavailable to meet any failedremarketing of the bonds, or if new funds or sources of liquidity are substituted as sources to meet the funding of the purchase priceon the bonds in the event of a failed remarketing.Principal officials of the Guarantor responsible for meeting failed remarketing funding requirements of the bonds.[NAMES][E-MAIL ADDRESSES][TELEPHONE NUMBERS][FAX NUMBERS]Summary of specific procedures in the event of a failed remarketing.The bonds may be remarketed by the Remarketing Agent in a number of potential modes ranging from one day to seven days, toa short-term period of any number of days up to 180 days under which there are optional or mandatory tender provisions for thebondholder that would require purchase of the bonds by the Guarantor in the event of a failed remarketing of the bonds. Summarizedbelow are the specified procedures for the meeting the funding requirements of a failed remarketing of the bonds under various modes:www.standardandpoors.com23

Cross Sector Criteriaassets that have greater volatility due to poor creditquality and longer maturity. Market valuation periodsgreater than weekly will lead to larger discountfactors for most assets. Standard & Poor’s alsoneeds to understand the actions an issuer will takeif the valuation falls short of expected level. Oncecollateral levels and valuation periods are determined,including these requirements in the legaldebt documents will be viewed positively in theassignment of ratings.What Are Available Assets?Available assets are defined as cash and fixedincomeinvestments that are not needed to meetdaily operating needs. Should an issuer need toliquidate its assets to cover a failed commercialpaper rollover or VRDO tender, the reduction inthe issuer’s liquidity position should not impair theissuer’s ongoing ability to meet its daily cash flowneeds, including the payment of long-term debtobligations. In short, the liquidation and use ofSample Liquidation Letter (continued)Daily period mode. Optional tender date of one day.To be completed by■ 10:00am–Holder delivers optional tender notice to Tender Agent■ 10:15am–Tender Agent notifies Guarantor, Trustee, and Remarketing Agent of receipt of notice■ 12:00 noon–Remarketing Agent notifies Tender Agent of bonds remarketed and registration instructions■ 12:30pm–Tender Agent notifies Guarantor and Trustee of purchase price and projected additional funding amount■ 1:15pm–Remarketing Agent and Guarantor, if necessary, deliver monies to Tender Agent to be applied for purchase oftendered bonds■ 1:30pm–If necessary, Tender Agent notifies Guarantor of additional funding amount■ 4:30pm–If necessary, Guarantor shall deliver additional funding amount to Tender AgentWeekly period mode. Optional tender ("OTD") of seven days.To be completed by■ 4:00pm–Holder delivers optional tender notice to Tender Agent. OTD of six days.■ 12.00pm–Tender Agent notifies Guarantor, Trustees, and Remarketing Agent of receipt of notice. OTD of one business day.■ 4:00pm–Remarketing Agent notifies Tender Agent of bonds remarketed and registration instructions.Optional tender day. To be completed by■ 10:00am–Holder delivers bonds to Tender Agent; Tender Agent notifies Guarantor and Trustee of purchase price and projectedadditional funding amount■ 12:00pm–Tender Agent makes available to Remarketing Agent new bonds for redelivery■ 1:15pm–Remarketing Agent and Guarantor, if necessary, deliver monies to Tender Agent to be applied for purchase oftendered bonds■ 1:30pm–If necessary, Tender Agent notifies Guarantor of additional funding amount■ 4:30pm–If necessary, Guarantor shall deliver additional funding amount to Tender AgentShort-term period. Mandatory tender date.To be completed by■ 10:00am–Holder delivers bonds to Tender Agent■ 12:00pm–Remarketing Agent notifies Tender Agent of bonds remarketed and registration instructions■ 12:30pm–Tender Agent notifies Trustees of purchase price and projected additional funding amount■ 1:15pm–Remarketing Agent, if necessary, deliver monies to Tender Agent to be applied for purchase of tendered bonds■ 1:30pm–If necessary, Tender Agent notifies Trustees of additional funding amount■ 4:30pm–If necessary, Trustees shall deliver additional funding amount to Tender AgentIf you have questions regarding any of the above, please contact me. Thank you.Sincerely,[NAME]["ISSUER"]24 Standard & Poor’s Public Finance Criteria 2007

Commercial Paper, VRDO, And Self-Liquidityinvestments should not result in a liquidity crisis forthe institution or municipality. Therefore, assetsavailable for liquidity support must be above andbeyond the assets needed to meet its daily ongoingobligations. Issuers should not have to delay thepayment of obligations in the event of asset liquidationto meet tenders. In light of the cyclical natureof many portfolios Standard & Poor’s analysis willstart at the historically lowest asset point during theyear to determine the level of excess liquidity availableto the obligor (Since many obligors do nothave “excess” liquidity, only a select group of highlycreditworthy, and liquid, obligors are able to usetheir own assets to support their variable-rate debt.What types of assets are eligible forliquidity support?The bulk of the assets intended for liquidity-supportedprograms include investment-grade fixedincomesecurities that are highly liquid and have alow-market-risk profile. Examples are highlyrated short-term securities (securities rated ‘A-1+’or ‘A-1’ that mature in one year or less) or longtermpaper of equivalent credit quality such asU.S. governments and agencies, ‘AAA’, ‘AA’, or‘A’ Standard & Poor’s rated fixed-income securities.Longer-maturing assets (one year or greater)are eligible for inclusion, but coverage requirementswill be higher. Equities will not be countedtoward liquidity requirements. All securitiesshould be marked-to-market frequently (at leastmonthly) and depending on price volatility dailyvaluations may be recommended. Monthly surveillanceasset reports (Exhibit B) to be submittedto Standard & Poor’s will include the market andpar values of each security, the security identifier(CUSIP number), and the security’s rating, ifapplicable. In addition to the types of assets eligibleto be used for liquidity support, an issuermust ensure that it has the legal authority to useits own assets for liquidity support. In somecases, state constitutions or state and localstatutes may not permit an issuer to use its ownassets for liquidity support. Standard & Poor’smay require a legal opinion if necessary from theappropriate counsel—whether it is bond counsel,a state attorney general, or other legal representative—asto an issuer’s legal authority to use itsown assets for liquidity support.Exhibit A outlines the information issuers submitto initiate a portfolio evaluation for a liquidityassessment. If Standard & Poor’s has already evaluatedtheir investment portfolio, no further action isrequired. Issuers that have complex investment portfoliosmay be referred to Standard & Poor’s FundServices Group for liquidity evaluation and ongoingsurveillance requirements indicated in Exhibit B.However, the liquidity review and surveillancerequirements are substantially the same. Issuersmust be prepared to discuss the portfolio’s ongoingmanagement and surveillance.Asset management and documentation requirementsThe ability of an issuer’s investment managementteam to liquidate assets or raise cash on a same daybasis (if necessary) are key factors in the evaluationof an issuer’s ability to provide its own liquiditysupport. Very specific written liquidation proceduresare required and should detail:■ Persons responsible for executing theasset liquidation;■ The sequence of steps that must be undertaken byall parties to effect liquidation (including any thirdparties such as the tender or paying agents actingon the issuer’s behalf); If particular investments,such as fedwire securities, are custodied securitiesmust be liquidated by a certain time to qualify forsame day monies, these deadlines should be identifiedin the liquidation procedures letter;■ The timing of notifications to the appropriateparties to ensure that sufficient funds are availableto pay CP and VRDO investors on a samedaybasis, if necessary.The liquidation procedures must mirror timingrequirements specified in CP resolutions and VRDOtrust indentures for full and timely payment of debtservice. The chain of events to liquidate assets will beevaluated. The evaluation starts with a bond trustee’sreceipt of a tender notice from a bondholder or thestop issuance order executed by the CP issuing andpaying agent to an issuer’s broker-dealer. The chain ofevents ends with the deposit of liquidated assets inimmediately available funds, with the tender or payingagent to pay the purchase price of tendered bondsor maturing CP. The investment management teamwill be evaluated based on its documented proceduresto provide the required funds by the end of the daythat the trade is initiated. This liquidation letter, (Seesample letter) should be updated annually and shouldbe prepared by the institution or municipality ratherthan by a financial advisor or underwriter.Capable monitoring, frequency of portfolio valuationand oversight are vital to a successful program.An obligor’s success or failure in providingself-liquidity depends on their ability and willingnessto take on these proactive roles.Liquidation letterEach issuer of unenhanced VRDOs will be askedto provide a letter addressed to Standard &Poor’s describing its liquidation procedures indetail with the major players named and theirroles defined. The procedures described by theletter must indicate a strong likelihood of samedayliquidation.www.standardandpoors.com25

Cross Sector CriteriaThe acceptability of the obligor’s proposed liquidationmechanics, especially with regard to timing,will be based on Standard & Poor’s follow-up investigationinto the procedures described by the letter.The chain of events—starting with the bond trustee’ssell order to the obligor’s broker-dealer account representativeand ending with the deposit of liquidationproceeds in immediately available funds withthe tender or paying agent to pay the purchase priceof tendered bonds—will be scrutinized for its abilityto generate the required cash by the end of the daythat the trade is initiated.Among the factors that will be considered in analyzingthe obligor’s proposed liquidation proceduresare the number of steps and parties in the liquidationprocess, a reasonable time frame in which toaccomplish the liquidation, the experience level ofthe parties involved, whether the party holding thesecurities has direct access to FedWire, and theFedWire closing time.The credibility of the obligor’s management onthe issue of its ability to liquidate its availableassets within the timing requirements of theVRDO structure is extremely important.Management’s experience in managing and liquidatingits assets will be considered in Standard &Poor’s evaluation of the obligor’s proposedliquidation procedures. ■Bank Liquidity FacilitiesMost municipal issuers lack the liquidity necessaryto fund optional and mandatory tenders ordo not wish to restrict the investment of their availableresources. If an obligor does not have sufficienthigh-quality liquid assets, such as cash and cashequivalents, to fund the tenders set forth in itsprogram, a liquidity facility must be provided topay the purchase price of bonds that cannot beremarketed. Whether Standard & Poor’s RatingsServices can assign a liquidity rating to a variablerate demand obligation (VRDO) without banksupport to cover these tenders is determined on acase-by-case basis.These VRDOs may have credit ratings derivedfrom the obligor, or have credit support providedby bond insurance policies. Liquidity support canbe provided by lines of credit or standby bondpurchase agreements (SBPAs).Lines Of CreditLines of credit are conditional, revocable liquidityfacilities that may be terminated without priornotice to the holders upon the occurrence of variousevents of default under the related agreement.Based on its structure, a line of credit can be viewedas strong or weak. Although the events that lead toa weak line of credit terminating its commitmentwithout prior notice to the holders can includeevents Standard & Poor’s has deemed a remoteoccurrence or concluded is factored into the longtermcomponent of the bond issue, it generallyincludes other termination events that are moreexpansive in scope. Termination events for weaklines generally include covenant defaults, failure topay fees, and failure to pay based on trustee negligence.Because a weak line of credit can terminate forreasons beyond the obligor’s ability to pay principalof and interest on the bonds, a line of credit providesonly supplemental liquidity coverage to an obligor’sown liquidity.If the liquidity facility is to be considered a strongline of credit, the SBPA criteria detailed below willbe met. Although the line can be used to supportthe obligor’s existing liquidity rating, the strong linecould also provide liquidity enhancement for thebonds even if the obligor does not have a liquidityrating. The short-term component of the rating onthe VRDOs will be derived from the short-term ratingof the entity providing the strong line of credit.Standby Bond Purchase Agreements (SBPAs)Ratings criteria for SBPAs closely follow that forletters of credit (see “LOC-Backed MunicipalDebt”). The major difference from LOCs is thatSBPAs are conditional, revocable facilities thatmay be immediately terminated or suspendedwithout notice upon the occurrence of certainevents of default as specified under the relatedagreement. Standard & Poor’s restricts the permissibleevents of default to those deemed to be remoteor where the likelihood of the events of defaultoccurring is factored into the long-term rating ofthe issue. Any other termination of the SBPA mustbe preceded by a mandatory tender with the purchaseprice for the bonds provided by remarketingproceeds and ultimately, the SBPA provider. Events26 Standard & Poor’s Public Finance Criteria 2007

Bank Liquidity Facilitiesthat immediately suspend the SBPA provider’s obligationto purchase are viewed the same as immediatetermination events.As a result of the limited number of terminationor suspension events, the SBPA provider’s shorttermissuer credit rating becomes the short-termrating on the bond issue. Note that Standard &Poor’s will apply the same restrictions to the conditionsprecedent to purchase section of the SBPA, asthat section can have the same effect on the provider’spayment obligation. If two or more SBPA providerscombine to severally support a bond issue, theshort-term rating will reflect the lowest short-termissuer credit rating of any of them.Unless additional self-liquidity is provided andevaluated, a liquidity rating based on an SBPAcannot be higher than the equivalent long-termbond rating of the issue (see chart, “Correlation OfCP Ratings With Long-Term Ratings”), since thebank’s obligation to fund the purchase price fortendered bonds is conditioned on the obligor orinsurer’s ability to meet its debt obligations. Theliquidity rating of the issue will be based on thelower of the short-term rating assigned to the bankor the short-term rating correlating to the long-termrating of the bond issue. Therefore, the likelihoodof the bank terminating its obligation to purchaseCorrelation Of CP Ratings WithLong-Term Credit Ratings*AAAAA+AAA+AA-BBB+BBBAA-BBB-*Dotted lines indicate combinations that are highly unusual.A-1+A-1A-2A-3the tendered bonds is correlated to the long-termrating of the bond issue.The SBPA(s) must provide principal coverage ofthe full par amount of the issue, and interest coveragefor the longest interest accrual period for themodes that the SBPA is covering. Interest coverageshould be calculated at the maximum rate permittedon the bonds. The interest accrual periodextends from the day any interest mode becomeseffective or from the last interest payment date toand including the day before a regularly scheduledinterest payment date. If a mandatory tender canoccur on a day other than a regularly scheduledinterest payment date, additional coverage may beneeded. The SBPA agreement should specify thatthe provider would pay with immediately availablefunds. In addition, as with the LOC criteria, theSBPA provider must specifically state that they willpay with their own funds.Permitted Automatic Termination EventsUninsured liquidity facilitiesStandard & Poor’s allows the following events toresult in a termination or suspension without noticeof an SBPA providing liquidity enhancement touninsured bonds:1. Failure to pay principal of or interest on thebonds being rated (including bank bonds).2. Failure to make payment on any debt onparity with, or senior to, the bonds being rated(including bank bonds).3. The issuer or obligor challenges the validity orenforceability of the bond documents or liquiditydocuments, or any court or governmentalauthority having jurisdiction over the transactionfinds or rules that the bond documents or liquiditydocuments or any material provision thereofrelating to the payment of principal and intereston the bonds being rated (including bank bonds),are not valid and binding. This includes, in certaincases, a similar determination by the obligor,court, or governmental authority that the definedpledged security for the bonds, as stated in thebond documents, is no longer valid or enforceable.4. The obligor begins proceedings relating to bankruptcy,insolvency, reorganization, or relief fromdebtors, or admits its inability to pay its debts inwriting, or the occurrence of an involuntarybankruptcy event.5. Standard & Poor’s reduces the bond rating tobelow investment grade (below ‘BBB-’), or therating is suspended or withdrawn for creditrelatedreasons.6. The IRS declares the bonds taxable.www.standardandpoors.com27

Cross Sector Criteria7. The occurrence of a final, non-appealable judgmentagainst the obligor requiring payment bythe obligor and such judgment is not satisfiedwithin a period of at least 60 days from the dateon which such judgment was rendered. In thecase of bonds rated based solely on pledgedrevenues, such judgment must be determined tobe payable from the pledged revenues serving asthe security source for the bonds.8. A debt moratorium, debt restructuring, debtadjustment or comparable extraordinary restrictionis declared by, or imposed on, the obligor’s paritybonds. Such imposition should be as a result of afinding or ruling of a governmental authoritywith jurisdiction over the obligor.Standard & Poor’s factors the likelihood of thefirst two events into the long-term rating on thebonds, and considers the occurrence of events 3,4and 8 to be remote. Termination without notice forevent 5 is permitted only for issues that are rated atleast ‘A+’. Should the bank’s obligation terminatewithout notice due to event 5 and bondholdersretain tender option rights, the obligor should bethe next source to fund unremarketed tenderedbonds. If the obligor is unwilling to be a source fortenders, then the tender option rights should beterminated in the bond documents should event 5occur. For event 7, the fact that the decision is finaland non-appealable, coupled with the 60 day period,gives the obligor sufficient time to arrange for thesatisfaction of the judgment.Insured liquidity facilitiesStandard & Poor’s allows the following events toresult in a termination or suspension event withoutnotice of an SBPA for issues that have an insurancepolicy securing the principal and interest onthe bonds:1. Insurer declaration of insolvency or admission ofinability to pay its debts in writing, or a proceedingis commenced against the insurer by an oversightbody or court of appropriate jurisdictionthe effect of which would be to declare theinsurer insolvent.2. Insurer default under any bond insurance policy,fee surety bond associated with the issue, or suretybond issued by it insuring or supporting thepayment of principal and interest onmunicipal obligations.3. Issuer substitution of the insurer or cancellationof the insurance policy without the liquiditybank’s written consent, provided that a correspondingcovenant requiring the issuer to receivethe liquidity bank’s consent is included inthe documents.4. Insurer contests or repudiates the validity orenforceability of the bond insurance policy, orfee surety bond associated with the issue, or anyprovision thereof affecting the obligation of theinsurer to pay thereunder.5. A finding or ruling by a court or governmentalauthority with jurisdiction to rule on the validityof the bond insurance policy that the policy, orany provision thereof affecting the obligation ofthe insurer to pay thereunder, is not valid andbinding on the insurer.6. Standard & Poor’s reduces the insurer’s financialenhancement rating to below investment grade(below ‘BBB-’), or the rating is suspended orwithdrawn for credit-related reasons.7. The IRS declares the bonds being rated taxable.The likelihood of events 1 and 2 has been factoredinto the rating on the bonds. Standard & Poor’sconsiders events 3 through 5 remote. Event 6 ispermitted only for issues that are rated atleast ‘A+’.Standard & Poor’s does not allow events such asfailure to pay fees under the SBPA, failure to payany subordinate debt or debt not rated byStandard & Poor’s, or covenant defaults to lead totermination without notice of the bank’s obligationto purchase tendered bonds. The likelihood of theseevents occurring is not factored into the long-termrating. If such events exist, either the bank maydeclare an event of default under the liquidity documentand bondholders will be required to tendertheir bonds pursuant to a mandatory tender, whichis ultimately funded by the SBPA provider, or thedocument will be reviewed as a line of credit insupport of an obligor’s own liquidity coverage.Standard & Poor’s requires a mandatory tenderto occur before the expiration or termination of theSBPA because the short-term rating of the issue isbased on the bank (other than in the case of thetermination events without notice outlined above),thus bank funds need to be available to take outall bondholders.Termination By The BankThe SBPA may only permit its obligation topurchase tendered bonds to terminate “upon theoccurrence” of the permitted automatic terminationevent. In certain agreements, attempts havebeen made to define the SBPA provider’s terminationtime as “on the day of the occurrence of theevent of termination” or “on the business dayprior to the occurrence of the event of termination”.Both of these constructions leave open the possibilitythat the SBPA provider may fund a tender payment,but then could attempt to recover thatpayment from the bondholder by virtue of the28 Standard & Poor’s Public Finance Criteria 2007

Municipal Swapsoccurrence of the automatic termination eventwithin the specified period. The termination bythe SBPA provider can happen no earlier thanupon the occurrence of the permitted automatictermination event.Other Concerns Regarding InsuredLiquidity TransactionsIn insured liquidity transactions, all payment eventsfor bondholders should be covered either by thebond insurance policy or the SBPA. Careful attentionis paid to the optional redemption, purchase in lieuof redemption, and tender provisions of the trustagreement. If obligor funds can be used to paybondholders (a common example is optionalredemptions which are not covered by the bondinsurance policy or SBPA), the source of such fundsshould be limited to those sources deemed preferenceproof by Standard & Poor’s (see the “LOC-BackedMunicipal Debt” criteria).Another payment event is acceleration of thedebt. Unless specifically noted in the bond insurancepolicy, insurers will not fund accelerated debt unlessthe acceleration happens with their prior writtenconsent. Therefore, it should be clearly stated in thetrust agreement that acceleration can only occurwith the bond insurer’s prior written consent.Another possible payment event is a specialmandatory redemption of bonds held by the SBPAprovider. Unless specifically covered under the bondinsurance policy, insurers will not fund this specialmandatory redemption. Therefore, Standard &Poor’s will review the endorsement or rider to thebond insurance policy that evidences coverage ofthis redemption. ■Municipal SwapsInterest-rate swaps are being used in conjunctionwith bond issues to save interest costs, increasefinancial flexibility, synthetically refund bondissues, and access various investor markets.However, swaps expose issuers to counterpartycredit risk, termination risk, basis risk, rolloverrisk, and for many housing bond issuers, amortizationrisk. If used to speculate on the direction ofinterest rates, or if they are not structured properly,swaps can reduce an issuer’s ability to pay debtservice on time, thereby affecting its credit quality.Standard & Poor’s Ratings Services assigns DebtDerivative Profiles (DDP) to all U.S. municipalbond issuers that have engaged in swap or otherderivative transactions. The DDP scoring methodologycodifies the following Swap Criteria and is discussedin an accompanying section.Swap StructuresThe most common types of swaps in the municipalmarket are floating-to-fixed-rate swaps and fixed-tofloatingrate swaps. The floating-to-fixed rateswaps are typically used to create synthetic fixedratedebt while the fixed-to-floating rate swaps aretypically used to create synthetic variable rate debt.Other common swap structures are also describedbelow, including forward starting swaps, rate locks,basis swaps, and swaptions.Floating-to-fixed swapsSynthetic fixed rate debt is created through use offixed payer, or floating-to-fixed-rate swaps. Thisstructure provides a low cost alternative to issuingconventional fixed-rate debt, by allowing the issuerto access the short-term debt market. The issuerissues variable rate debt and hedges its floating-rateexposure with floating-to-fixed-rate swaps. Underfloating-to-fixed swaps the variable rate indexreceived by the issuer from the counterparty matchesor closely approximates the variable rate on thedebt, leaving the issuer with a fixed-rate exposurefor the term of the swap and, in most cases, termof the bonds.Fixed-to-floating swapsSynthetic variable rate debt is created through useof floating payer, or fixed-to-floating-rate swaps.The synthetic floating-rate debt structure provides alow cost alternative to issuing variable-rate debt. Itcreates nonputable variable rate debt and allowsthe issuer to avoid variable-rate program costs,such as credit, liquidity, and remarketing or auctionagent fees. This structure is used to convert existingfixed-rate debt to a variable rate or as part of anew issuance. Some issuers take advantage of thisstructure to hedge negative arbitrage on large cashand short-term asset positions.www.standardandpoors.com29

Cross Sector CriteriaForward starting swapsForward starting swaps are typically structured asfloating-to-fixed swaps for synthetic advancerefundings of fixed-rate debt. This structure providesan alternative to conventional advance refundings.Some municipal issuers—such as utilities, airports,and health care issuers—that are precluded fromcarrying out an advance refunding or have used uptheir advance refunding capacity can syntheticallyadvance refund bonds using a forward startingswap. Under this structure, the issuer enters intoa forward starting floating-to-fixed rate swap contractto lock in a fixed rate. On the swap’s effectivedate, which coincides with the bond’s call date,refunding variable rate bonds are issued, and theproceeds are used to call the outstanding highercouponfixed rate bonds. The swap paymentsbegin on the call date, effectively converting thefloating-rate exposure of the issuer to a fixed rate.Rate locksInterest rate locks structured as floating-to-fixed rateswaps are gaining popularity for advance or currentrefundings as well as new money issues where theissuer wants to lock in a current low fixed interestrate. In the rate lock swap structure, the issuer entersinto a long-dated floating-to-fixed rate swap with apredetermined early termination date at market. Thefixed rate for the issuer’s financing is locked in onthe date on which the issuer enters into the floatingto-fixedrate swap, whereas the pre-determined earlytermination date under the swap coincides with thedate of planned issuance of fixed rate debt. Upon termination,the issuer pays or receives a terminationamount equal to the fair value of the swap on thetermination date. Issuers either receive a terminationamount from the counterparty (to the extent rateshave risen higher than the locked in fixed rate) orpay a termination amount to the counterparty (ifrates have declined lower than the locked in rate).Upon termination of the swap, the issuer will issuefixed rate debt at the prevailing market rate. Theswap’s termination amount paid to the counterpartyor received from the counterparty causes the issuer’stotal debt service (principal and interest) to beeconomically equivalent to having issued fixed ratebonds on the date the rate lock swap was executed.Because termination payments are specificallydesigned to mitigate interest rate risk and do not,in and of themselves, materially impact the issuer’sfinancial condition, Standard & Poor’s is notgenerally concerned about termination risk underrate lock structures.Basis swapsIn recent years, some issuers have entered into basisswaps to hedge fixed rate or floating rate debtexposure. Basis swaps, or floating-to-floatingswaps, are crossing positions where the issuer paysa floating rate, usually equal to the BMA index,and in exchange, receives another floating rate, usuallyequal to a percentage of LIBOR (e.g. 68%). Insome cases, different percentage points (e.g. 20basis points) are added to the payer or receiverrates; these swaps are referred to as fixed spreadbasis swaps. Another type of basis swap structureare leveraged basis swaps, which apply a leveragefactor to the payer and receiver rates effectivelyincreasing cash flow volatility.All basis swap structures involve the risk that theprevailing floating rate paid to the counterpartywill be higher than the prevailing rate received fromthe counterparty. Issuers that use basis swaps tohedge fixed rate exposure typically do so as a syntheticcurrent refunding of fixed rate bonds that fortax law reasons cannot be refunded, or bonds forwhich the issuer does not want to incur costs associatedwith a traditional refunding. Under thesynthetic current refunding structure, the issuer’sgoal is to achieve an economic return under thebasis swap, which approximates the debt servicesavings that would have occurred if the targetedfixed rate bonds were traditionally refunded. Issuersthat use basis swaps to hedge floating rate exposuretypically do so with the goal of eliminating basisexposure by modifying the floating receiver leg ofexisting floating-to-fixed rate swaps. In this structure,the issuer enters into a basis swap with a floatingreceiver rate that better matches the floating ratepaid on outstanding variable rate debt.Because of the dynamic interplay between BMAand LIBOR over time, all basis swaps entail ahigh degree of cash flow volatility. Therefore,issuers that enter into basis swaps must have arevenue stream sufficient to absorb year-to-yearlosses or lower than expected returns under thesestructures without materially affecting cash flowand liquidity.SwaptionsA swap option, or swaption, is an option to enterinto or terminate a swap in the future. Swaptionsassociated with off-market swaps are priced basedon option pricing theory, which involves timevalue and volatility, among other metrics. Issuersoften use swaptions to hedge the expectedissuance of debt in the future for specific purposes.In exchange for entering into a swaption, theissuer is paid an upfront premium, which representsthe time value of the option to enter into afuture swap with the counterparty and the offmarketnature of the swap. Issuers tend to useswaption premiums for reserves, operations, orcapital financing needs. Once a counterparty has30 Standard & Poor’s Public Finance Criteria 2007

Municipal Swapspurchased a swaption, it now has the right toexercise the option based on future dates and/orinterest rate conditions. The issuer, as option seller,has a liability equal to the premium receivedfor the swaption, which will be amortized overthe life of the swap, should the swap becomeeffective. However, the liability will disappear tothe extent the swap is not effectuated and theoption expires worthless. Also, depending uponthe credit characteristics of the issuer, a large terminationpayment liability exists to the extent thedebt financing does not occur and the swapbecomes an unusable hedge. Therefore, issuersthat sell swaptions should be certain that thefinancing for which the swaption was written willoccur to coincide with a potential exercise of theoption by the counterparty.Source Of Swap Payment And Swap LienBefore entering into a swap, the issuer’s managementshould identify the revenue source for making netswap payments and budget for them. The source oftermination payments should also be identified.Revenue bond issuers should include the fixed orvariable swap payments in the rate covenant andadditional bonds test covenants to avoid swapshaving a negative impact on the ability of the issuerto pay debt service. Typically, for GO bond issuers,the swap payment source is the general fund, andfor revenue bond issuers, the swap payments comefrom the same revenue source that supports thedebt service on the bonds. The net swap paymentsshould be structured so that they are junior to oron parity with the debt service obligation to ensurethat debt service payments are not affected.Termination payments are typically on parity orsubordinate to debt service. Termination risk andmitigation strategies are discussed in detail below.LegalityIt is important that the issuer has the appropriatelegal power to enter into and properly authorize allswap contracts. Illegality can result in the swapbeing terminated, exposing the issuer to a potentiallylarge termination payment and/or floating-rateexposure. Most states have statutes that give theissuers the authority to enter into swap agreements.However, if the law is ambiguous, Standard &Poor’s suggests that an issuer verify its legal authorityfor swaps.Swap structure risksStandard & Poor’s has identified six general risksassociated with swap contracts for municipal bondissuers. These risks include:■ Counterparty risk;■ Rollover risk;■ Economic viability (basis/tax risk);■ Amortization risk;■ Termination risk; and■ Collateral posting risk.Standard & Poor’s will focus on all of these creditfactors when analyzing a swapped bond transaction.As part of this process, Standard & Poor’s mustreceive various documents necessary to analyzethe terms of the contracts (see “Swap LegalDocumentation Review Process” below).Furthermore, we will ask all issuers who enter intoswaps or other hedging contracts to prepare a SwapManagement Plan (see “Swap Management Plan”below). A discussion of the risks associated withswaps follows.Counterparty riskCounterparty risk is the risk that the swap counterpartywill not fulfill its obligation to honor itsobligations as specified under the contract. Under afloating-to-fixed swap, for example, if the counterpartydefaults, the issuer would be exposed to anunhedged variable rate bond position, and in thecase of full two-way termination and negative swapvaluation, could owe the counterparty a terminationpayment. The creditworthiness of the counterpartyis indicated by its issuer credit rating (ICR).Standard & Poor’s looks for swap counterpartiesthat are rated at least ‘BBB/A-2’ for swap-independenttransactions and at least ‘A/A-1’ for swap dependenttransactions. Most swapped municipal bonds ratedby Standard & Poor’s are considered swap-independentsince failure of the swap counterparty doesnot preclude the issuer from paying the debt. Thedegree of swap-dependence for any given transaction,however, is determined by the creditworthiness ofthe pledged revenue source as well as the structureof the bonds. Many structured finance transactions,for example, are considered highly swap dependentsince bond debt service is structured assuming theswap remains in place for the life of the transaction.In cases where a counterparty is a “terminating”derivative product company (DPC), as opposed to acontinuing entity, Standard & Poor’s ICRs for theseentities will include a ‘t’ subscript (e.g. ‘AAAt’). The‘t’ subscript indicates that the DPC could terminateits existence upon short notice to bond issuers withno penalty. If an issuer enters into a swap contractwith a terminating DPC, Standard & Poor’s willassume that termination of the DPC itself couldoccur at any time and that the swap would have anegative valuation, thereby requiring the issuer tomake a termination payment to the counterparty.Therefore, issuers that enter into a swap with a terminatingDPC should demonstrate sufficient liquidityto handle termination payments at any time. Swapdependentbonds and non-plain vanilla swaps arewww.standardandpoors.com31

Cross Sector Criteriaheld to a higher rating threshold due to the potentialfor decreased liquidity of the swap should the swapcounterparty need to be replaced. In order to mitigaterating concerns following a counterparty downgradeto below the minimum rating threshold, counterpartiesshould provide collateral, if swap terminationor replacement of the swap provider by the issuer isnot possible or economic. Many counterparties arein fact required to post collateral at relatively higherrating levels under credit support documents, therebymitigating counterparty risk for the issuer.Standard & Poor’s will determine the appropriatecounterparty-rating threshold for each transactionbased on whether or not the issue is swap-dependentor if the swap is plain vanilla. The applicable counterpartyrating thresholds should be defined in thebond and swap documents, as well as the issue’sswap management plan, as the minimum rating foran eligible swap provider, with appropriate triggermechanisms for replacement, collateralization, swapinsurance, or termination.Although most counterparties that participate inthe municipal swap market are highly rated, above‘A’, as the municipal swap market has grown,Standard & Poor’s is concerned that some issuershave a growing and significant swap portfolio andsingle-entity credit exposure, some with lower ratedcounterparties. For this reason, Standard & Poor’slooks for issuers to manage its counterparty exposureto lower rated counterparties in absence of lowcollateral thresholds. Therefore, for counterpartiesrated lower than ‘A/A-1’ the concentration limit is50% of risk adjusted notional (the concept of riskadjusted notional amounts is discussed in the DDPsection). Concentration above 50% of risk adjustednotional for counterparties rated lower than ‘A/A-1’may be mitigated by full value collateral posting bycounterparties, if swap termination or replacementof the counterparty by the issuer is not possible oreconomic, under the terms of the swap contract.Basis riskBasis risk refers to a mismatch between the interestrate received from the swap contract and the interestactually owed on the issuer’s bonds. Basis risk canoccur with any type of debt derivative, specificallyfloating-to-fixed and fixed-to-floating swaps. Forexample, in a floating to fixed rate swap, the risk isthat the counterparty’s variable interest paymentswill be less than the variable interest paymentsactually owed on the issuer’s bonds. Most floatingto-fixedrate swaps require the issuer to pay a fixedinterest rate and in return receive a floating ratebased on a percentage of one month LIBOR or theWeekly BMA Municipal Swap index. Most “taxexempt”swaps are referred to as “BMA swaps”or “percentage of LIBOR” swaps. In some cases,issuers secure “cost of funds” swaps, where thecounterparty pays the exact interest rate on thebonds. If the swap is not a cost of funds swap, themismatch between the actual bond rate and theswap interest rate could cause financial loss in theform of additional debt service for the issuer. Thismismatch could occur for various reasons including,increased supply of tax-exempt bonds, credit qualitydeterioration of the issuer, or a reduction of federalincome tax rates for corporations and individuals.Tax event and market riskAll issuers which issue variable rate bonds thattrade based on the BMA index inherently acceptrisk stemming from changes in marginal income taxrates. This is due to the tax code’s impact on thetrading value of tax-exempt bonds. This risk is alsoknown as “tax event” risk, a form of basis riskunder swap contracts. Percentage of LIBOR, certainBMA swaps, and basis swaps, can also exposeissuers to tax event risk. Some BMA swaps havetax event triggers which can change the basis underthe swap to a LIBOR basis from a BMA basis.Based on historical evidence, Standard & Poor’sbelieves that any downward shift in the top federalincome tax rate for individuals and corporationscould cause all variable rate bond issuers to experience“tax event” risk. In addition to tax event risk,extremely low interest rates could expose issuersengaging in swaps based on BMA and LIBOR toexperience losses due to rate compression betweenthe two indices. For this reason, Standard & Poor’sroutinely reviews its variable rate tax-exempt bondprice assumptions in order to determine a stressfulrelationship between BMA and LIBOR to accountboth for tax and market event risk. Under thesecriteria, all variable rate debt issuers should assumethat income tax rates are lowered over time suchthat the ratio of Weekly BMA to one month LIBORincreases to 75%. This assumption is incorporatedinto the Economic Viability component ofStandard & Poor’s DDP analysis (see “PublicFinance Criteria: Debt Derivative Profile”).Rollover riskRollover risk is the risk that the swap contract is notcoterminous with the related bonds. In the case of thesynthetic fixed rate debt structure, rollover risk meansthat the issuer would need to re-hedge its variable ratedebt exposure upon swap maturity and incur re-hedgingcosts. The issuer should have concrete strategy toaccount for rollover risk. Otherwise, Standard &Poor’s will assume that bonds will be unhedged at thetime of swap maturity. The issuer can mitigate rolloverrisk by closely monitoring the interest rates and byhaving policies in place to extend the swap or enterinto a new swap if the rates drop. The strategy ofusing medium- term swaps to fix the variable rate fora five-to-10-year period does not eliminate the rollover32 Standard & Poor’s Public Finance Criteria 2007

Municipal Swapsrisk, but gives the issuer additional financial flexibility,reduces termination risk, and could result in alower fixed rate than can be obtained through along-dated swap.The issuer can fully avoid rollover risk by enteringinto long-dated swaps (those with a greater than 10years) whose term matches that of the bond term,thus locking the rates for the life of the bonds.However, this strategy contains hidden costs.Issuers using long-dated swaps give up some abilityto refund the debt and to take full advantage ofdeclining interest rates, unless the swap is structuredwith an optional cancellation clause.Amortization riskAmortization risk represents the cost to the issuerof servicing debt or honoring swap payments due toa mismatch between bond principal amortizationand the swap notional amount amortization.Amortization risk is characteristic of swaps used tohedge variable rate bonds issued by state housingfinance agencies for single-family mortgages,although it can also occur with variable rate bondsissued by other revenue bond issuers to financeother amortizing assets. Amortization risk occurs tothe extent bonds and swap notional amountsbecome mismatched over the life of a transaction.This could occur to the extent an issuer has usedbond proceeds to finance an asset that is liquidatedor prepaid and used to redeem bonds in advance ofthe swap notional schedule, causing an unhedgedswap position.In this case, the issuer would continue to owepayments under the swap with no asset to coversuch payments. Conversely, the issuer could befaced with some unhedged variable rate bonds tothe extent the financed asset does not prepay asoriginally intended or generate the expected cashflow to repay bonds in accordance with the pre-setswap notional schedule. This scenario is most commonin single-family mortgage bonds where principalprepayments are lower than expected. Amortizationrisk is a potential risk, which could expose theissuer to additional payments, and potentially forcethe issuer to terminate the swap prior to maturityunder unfavorable market conditions. The amountof loss exposure due to amortization risk is determinedon a case-by-case basis depending on thepurpose of the issue and the issuer’s intendedtechnique to mitigate this risk.Standard & Poor’s must be comfortable that theissuer will still be able to service the debt or swapin the absence of the hedge or financed asset respectively.Assuming the issuer will not terminate theswap in the event of a mismatch, reserves or cashflows must demonstrate sufficiency to cover theworst-case amortization risk scenario.Termination riskTermination risk is the risk that the swap could beterminated early by the counterparty due to any ofseveral credit events, which may include issuer ratingsdowngrades, covenant violation, bankruptcy, swappayment default, and default events as defined inthe issuer’s bond indenture. These events arereferred to as involuntary termination, as opposedto voluntary termination. (Discussed below inTermination Analysis).Standard & Poor’s will analyze each swap contract’slegal provisions prior to execution to ensurethat the events of default or termination that triggeran involuntary termination are remote possibilities.The events of default and termination, whichcould lead to involuntary termination of thecontract should ideally only include the “big four”termination clauses:■ Failure to pay;■ Bankruptcy;■ Merger without assumption; and■ Illegality.The aforementioned events are typically consideredremote events since Standard & Poor’s factorsthese aspects into the rating on the debt.Standard & Poor’s may consider other events ofdefault and termination to be remote events on acase-by-case basis, depending on the credit profileof the issuer and the ratings on the bonds.These events may include:■ Additional Termination Event of a RatingsDowngrade to below a certain rating;■ Breach of agreement;■ Misrepresentation;■ Cross default; and■ Default under a specified transaction.To the extent that Standard & Poor’s cannotestablish the remoteness of an event of default orevent of termination, which would trigger involuntarytermination of the swap contract, this possibilitywill be assumed under the swap and scored a ‘4’in the termination and collateral posting risk sectionof the DDP. In this case, Standard & Poor’swould assume that bonds are unhedged and furthermore,that the issuer would have to pay a terminationfee to the counterparty. Standard &Poor’s will also analyze the conditions under whichthe issuer entered into the swap to determine thelikelihood of voluntary termination under adversemarket conditions, such as in the case of a swaptionsold to a dealer under fiscal duress. If this isthe case, this swap will also be scored a ‘4’ duringthe DDP process.Remedies available to the swap counterpartyresulting from an issuer defaulting on its swap obligationshould not infringe on bondholders’ rights.www.standardandpoors.com33

Cross Sector CriteriaThese remedies should be limited to the swap agreementand should not be written into or cross-defaultedto the bond indenture. Depending on how interestrates at the time of termination compare with thefixed rate on the swap, the issuer could owe a terminationpayment to the counterparty or receive a terminationpayment from the counterparty.Collateral posting riskCollateral posting risk is the risk that the issuer isrequired to post collateral in favor of the swapcounterparty in advance of a swap terminationevent and final bond repayment. Collateral postingrisk is a double-edged sword for many issuers. Onthe one hand, collateral postings can be a creditpositive since these reserves mitigate a sudden liquiditydrain of having to make a large terminationpayment in the event of swap termination. On theother hand, collateral posting poses a credit risk assome issuers credit quality would be impacted bycollateral posting in the same way credit would beimpacted following a termination payment.Many swap documents have symmetrical creditprovisions, requiring issuers to post collateral atidentical rating thresholds as the swap counterparties.Although important from a swap counterparty’sperspective for protection against issuertermination, collateral posting in advance of terminationis problematic from a ratings perspective.This is because in the event of collateralization bythe issuer, swap providers effectively become seniorsecured creditors, thereby impairing bondholderprotection. To the extent collateralization byissuers impairs bondholder protection materially,Standard & Poor’s will take this into account duringthe ratings process. However, in the event collateralizationdoes not impact liquidity materially,termination risk would be fully mitigated andtherefore, represent a credit positive. Standard &Poor’s DDP scoring methodology captures the likelihoodof collateral posting risk as more fullydescribed below.Involuntary termination analysisIf Standard & Poor’s considers involuntary terminationto be a possibility, as indicated by a overallDDP score of ‘3’ or ‘4’ or a termination and collateralposting risk score of ‘3’ or ‘4’, this risk must bequantified through analysis of the swap’s maximumpotential exposure (MPE) provided by the issuer.Analysis of termination risk and its impact on theissuer’s rating is covered in the DDP criteria.Voluntary terminationsAlthough any swap is callable at any time if bothparties agree to the cancellation and cash settlementhas occurred, municipal swaps typically are notoptionally callable at any time for any reason byeither party, without the other party’s consent,unless a specific option to do so is built into thecontract itself. Issuers typically need to purchasethis option from counterparties. Standard & Poor’slooks to see that issuers build market price optionaltermination clauses into swap documents, whichwill give them flexibility for cancelling the swapshould this become necessary, either for the refundingof associated bonds or other market-driven reasons.In most cases, optional terminations of swapsoccur to the extent the termination results in aneconomic benefit to the issuer, even if a terminationamount is paid to the counterparty.Termination payment source and lienMuch focus is placed on the early termination ofswap contracts. While the probability of this riskwill be scored in the DDP through a rating transitionanalysis, it is important for issuers to thinkthrough a contingency plan if the swap doesunwind and the issuer will owe a settlementamount that is due immediately. Many bond transactionsthat include a swap make the lien of theswap payments and termination payment on paritywith the debt service. This does not causeStandard & Poor’s great concern if the issuer hasrevenue-raising capability and good liquidity. It alsois not a concern if the swap termination events havebeen limited to credit events that are being reflectedin the rating on the bonds. However, on the otherend of the spectrum are the balance sheets thatcould not withstand a large cash outflow in amonth’s notice.Involuntary termination risk mitigation strategiesTwo of the most common ways to mitigate theeffect of termination payments to an issuer are subordinatingtermination payments to the debt serviceon the bonds and including provisions in the swapagreement that allow the issuer to stretch out thepayments over a period of time.Subordinated lienSince the termination payment can be large, and itis difficult to predict the timing and size of the payment,cash settlement of a termination payment canbe subordinate to debt service. While a subordinatedlien will get the issuer over the hurdle of paymentof debt service for that period of time, it isimportant to note that the settlement payment tothe counterparty still must be paid in full. Thiscould hurt the issuer’s liquidity and thereforeimpair its ability to pay debt service in the future.Amortization of termination paymentThis alternative focuses on the issuer’s financialflexibility to withstand the cost of an early terminationregardless of its capacity to increase rates and34 Standard & Poor’s Public Finance Criteria 2007

Municipal Swapscharges. An issuer that has limited liquidityresources should include provisions in the swapagreement that allows the issuer to pay the terminationvalue over a period of time. A stress test of anissuer’s income and cash flow statements is done todetermine the amount of cushion that is availableto pay additional unexpected cash settlement. Theworst-case termination value would be used indetermining the amount and term of the paymentstructure. For example, repayment terms could be afive-year term with an annual maximum paymentof $10 million.The issuer can also reduce termination risk by:■ Entering into a swap with a strong counterparty;■ Limiting the termination triggers and eventsof default;■ Reducing the term of the swap; orDeveloping contingency plans for making thetermination payment.ManagementOne of the most important aspects of the analysisof the use of swaps is the evaluation of the understandingand expertise that management contributes.Managing derivatives like interest rateswaps requires an ongoing commitment from theissuing entity’s senior executives. All senior management—notjust the chief financial officer—shouldbecome familiar with the risks and rewards of thederivatives being considered. Because of the complexitiesinvolved, some small issuers may not be ina position to develop the necessary expertise andsystems to adequately manage some derivatives. Infact, smaller issuers’ capital needs generally are notlarge enough to justify the sizable fixed costsassociated with putting together these types oftransactions. Therefore, Standard & Poor’swill request a discussion of the issuer’s SwapManagement Plan and Policies as part of theDDP process.Swap Management Policies Versus Swap PlansIt is important to distinguish between a swap managementpolicy and a swap management plan. Aswap policy is a formally approved written documentintended to guide management decisions over time,whereas a swap plan is similar to a plan of finance,intended to rationalize or explain specific transactionsdone within the swap policy’s parameters.Because of this distinction, the two serve differentpurposes and are viewed differently in the DDPscoring process. A formally adopted swap policydetails operating parameters for entering into andexecuting swaps, outlines exactly what types oftransactions can and cannot be entered into, laysout credit decision matrices and levels of maximumrisk exposure, and is part of institutionalizedmanagement and financial policies.Swap Management PolicyIssuers can adopt formal swap management policiesand procedures that simultaneously minimize therisks and maximize the rewards from swaps. Ameaningful and effective swap policy includes thefollowing components:■ Purpose■ Authorization■ Controls■ Oversight■ Disclosure■ StrategyPurposeA swap policy should include a purpose statementthat indicates the reasons for entering into interestrate derivative transactions. Answering the question,“why does using swaps and other debt derivativesmake sense?” will allow the issuer to outline thegoals and expectations of hedging fixed or variablerate exposure with swaps in relation to its portfolioof debt instruments. Issuers should state underwhat scenarios and opportunities derivatives mightbe used to hedge interest rate risks. With thesegoals, the issuer provides an important measureof transparency regarding the use of swaps inthe broader context of the municipal entity’sfinancial operations.AuthorizationIt is important that the issuer have the appropriatelegal power to enter into swap contracts. Anissuer’s swap policy should clearly cite the legalreference or statute that provides authorization.Also, the issuer should outline any formal authorizationprocess for entering into interest rateswap agreements.Risk controlsManagement should outline policies designed tominimize the liquidity and cash flow risks associatedwith swaps. The revenue source for making netswap payments should be identified and budgetedfor once the swap structure is stressed against differentinterest rate scenarios and payments can beestimated. The source of termination paymentsshould also be identified with an attendant “liquidityat-risk”policy, outlining the maximum amount ofliquidity reserves, which could be placed at riskshould a collateral posting or terminationevent occur.Risk mitigation strategies could include thefollowing parameters:www.standardandpoors.com35

Cross Sector CriteriaRequired Documentation ForVariable Rate Debt And Swaps(1) Cash flow projections as discussed under “Cash Flows.”(2) Dbt Management Plan(3) Swap Management Plan(4) Swap legal documents:■ Bond Trust Indenture■ ISDA Master Agreement■ Schedule with Confirmation■ Acceptable additional termination events, includingmaximum rating triggers;■ Use of insurance or collateral to protectcounterparties, and if so, what are theminimum thresholds;■ Cross default provisions;■ Termination payment terms (subordinate and/orpayout as lump sum or amortized over time); and■ Counterparty rating minimums and other creditprotection provisions, such as collateral requirementsor third-party guarantees.OversightManaging derivatives, such as interest rate swaps,requires an ongoing commitment from the issuingentity’s senior executives and governing body. Allsenior management and officials—not just the chieffinancial officer—should become familiar with therisks and rewards of the derivatives. As part of aswap policy, an issuer should delineate whatprocess it will follow to consider entering intoswaps and which positions have direct and indirectoversight of the real-time management of swaps. Interms of ongoing oversight, issuers should routinelymonitor swaps under current and forecasted interestrate environments, in order to gauge potential cashflow gains and losses as well as market opportunitiesfor voluntary terminations and restructurings.Market valuations of derivatives should also beroutinely calculated.DisclosureIssuers should commit to continually disclose allaspects of derivatives position in accordance withGASB guidelines, or FASB, as applicable. Currently,GASB’s 2003 Technical Bulletin (“2003-01-DisclosureRequirements for Derivatives Not Reported at FairValue”) provides guidelines for adequate disclosureof pertinent information related to derivatives. Inaddition, at the time of a rating review, managementshould be prepared to discuss the details of theswap plan and plan of finance and state the currentand future economic viability of the swaps in additionto the likelihood of voluntary or involuntarytermination during the course of the current andupcoming fiscal year.StrategyThe issuer should outline the different types ofswaps or derivatives that would be included withina swap plan; that is the types of structures thatcould be considered when presenting an opportunityfor risk management (e.g., in which interest rateenvironments) and how they should be used (e.g.natural hedges, basis swaps or synthetic refundings,rate locks, synthetic fixed and variable, etc.) in thebroader context of the capital financing plan. Thedesirable capital structure of variable to fixed-ratedebt should also be determined as a percentage oftotal debt outstanding (net variable exposure).Management Check ListAddressing the following issues will strengthen theswap management policy:■ Formal approval of written documents by theissuer’s governing body;■ Swap risks identified and discussed in the contextof the issuer’s financing plans;■ Annual management review and discussion ofhedging strategies;■ Commitment to complete and comprehensivedisclosure of swaps in audited financial statementsabove and beyond required GASB orFASB parameters;■ Monitoring of swaps with semi-annual valuationby a third party■ Policies on legal provisions, including optionalswap terminations, collateral, or swap insurance;■ Counterparty diversification or a minimumratings policy for counterparties; and■ A net variable rate exposure policy.Net Variable Rate Debt CalculationStandard & Poor’s believes that quantification ofboth balance sheet and cash flow risks associatedwith variable rate debt is necessary to properlyevaluate an issuer’s financial flexibility resourceswhen entering into swaps. The quantificationprocess includes determining net variable rate andshort-term debt. Once quantified, the overall creditimpact of variable rate debt and swaps can be factoredinto an issuer’s rating. This evaluation processwill be made on a case-by-case basis.Net variable rate and short-termdebt exposure ratioStandard & Poor’s monitors an issuer’s use of variablerate debt as part of the ratings process through anet variable interest rate exposure ratio, which36 Standard & Poor’s Public Finance Criteria 2007

Municipal Swapsmeasures the potential risk to an issuer’s revenuestream and reserve levels resulting from rising variablerates. The ratio is calculated on a current and proforma basis to gauge prospective levels of variableexposure, given either proposed derivatives oradditional bonds.The net variable interest exposure ratio primarilyfocuses on debt and debt derivatives. Variable rateand short-term debt includes commercial paper,unhedged variable rate bonds, and synthetic variablerate debt. Unhedged variable rate bonds includethose bonds, which are not hedged through floating-to-fixed interest rate swaps or variable rateinvestment assets. Synthetic variable rate bondsconsist of traditional fixed rate bonds, which areconverted to variable rate bonds through fixed-tofloatingrate swaps. Any variable rate bonds thatare converted to fixed rate debt through a swap canbe netted from variable rate liabilities.In addition, if the issuer can demonstrate historicalsufficiency of offsetting principal and interestcoverage from short-term and variable rate investmentassets held in unrestricted, non-operatingaccounts, these assets may be netted from variablerate liabilities. Earnings on short-term or variablerate investments are typically well correlated tovariable interest owed on bonds. We consider nonoperatingaccounts, those accounts, which theissuer holds as unrestricted funds for true surplusreserve or hedging purposes only. Investments inthose accounts should be highly liquid and investedin short-term securities with maturities of one yearor less. Assets held in operating, capital, or debtservice purposes are not considered available on anongoing basis due to the variability of balancesover time. Qualifying investment securities mayinclude short-term Treasury notes, commercialpaper, repurchase agreements, and guaranteedinvestment contracts with low volatility of mark-tomarket.Revolving lines of credit and other forms of“soft capital” are typically not counted as shortterminvestments due to the fact that issuers arerequired to reimburse the provider for any drawsmade under the facilities.Swap InsuranceSwap insurance polices are similar to bond financialguarantees in that policies guarantee payments to abeneficiary, in this case a swap dealer, for failure topay by the insured, in this case the issuer. Also similarto bond insurance, issuers are required to reimburseinsurers for any payments made tobeneficiaries under swap policies and must live withinsurer legal restrictions. Under regular swap insurancepolicies, the insurer will make regularly scheduledswap interest payments if the issuer fails to doso. The majority of policies issued by insurers todate have been regular swap insurance policies, asthey present immaterial, incremental risk to insurers,since in most cases the insurer is also insuringregularly scheduled payments on the issuer’s bonds.Swap and bond payments are typically on paritywith one another. In addition to regular swap paymentinsurance, some issuers have purchased swaptermination coverage through a policy endorsementfor an additional premium. Termination coveragetends to become expensive, as this coverage doespresent incremental risk for the insurer over scheduledpayments on bonds and swaps. Swap terminationinsurance provides further, although notcomplete, protection against termination exposuredue to issuer and insurer credit events (ratingdowngrades). Under swap termination policies,insurers will make swap termination payments, upto a specified amount, to the extent that a terminationevent under the swap is triggered and theissuer has failed to make the termination payment,or in lieu of termination, failed to post collateral orsecure a third-party enhancer.BenefitsThe benefits of swap insurance to an issuer arenumerous, including significant, although not complete,mitigation of counterparty, collateral posting,and termination risks. Standard & Poor’s DDPscores to date indicate that if not for regular swapinsurance, many issuers—notably lower-ratedhealth care issuers—would have been exposed tomuch greater levels of these risks. Of the approximate210 issuers that have received a DDP score todate, about 15% have benefited from swap insurancethrough a lower overall DDP score as a resultof scoring lower in the termination and collateralposting risk section of the DDP. The significance ofswap insurance in the health care and transportationsectors is greater, with about 25% of issuershaving benefited from insurance through lowerDDP scores.Regular swap insurance mitigates terminationand collateral posting risk in several ways. In termsof collateral posting risk, the issuer is spared fromhaving to post collateral under a credit supportannex, due to the joint obligation of swap paymentsby both the issuer and the insurer. If theinsurer has suffered significant ratings downgrades,collateral postings by the issuer are typicallyrequired, however. Furthermore, involuntary terminationrisk becomes more remote with regular swapinsurance despite the fact that policies do not covertermination payments. This is because underinsured swaps, the issuer’s rating trigger for earlytermination becomes applicable only to the extentthat the insurer has also suffered a significant ratingsdowngrade. The extremely low ratings volatili-www.standardandpoors.com37

Cross Sector Criteriaty of ‘AAA’ rated monoline bond insurers combinedwith the overall stability of municipal ratings indicatesthat a termination event due to coincidentalrating downgrades is an extremely remote possibility.In terms of counterparty risk mitigation, swapinsurance can be beneficial to the issuer becauseinsurers may require swap dealers to post collateralunder credit support annexes, to the extent thecounterparty suffers a credit event.RisksThe primary risk under swap insurance policies isthe credit risk of the insurer. If the insurer’s creditdeteriorates significantly, the issuer is likely to haveto post collateral in order to maintain the hedge;otherwise, the swap may be subject to termination.Some issuers will purchase swap termination policiesto mitigate this risk. However, the monolinebond insurer industry has had an extraordinary historyof credit stability and presents a very lowprobability of an issuer experiencing this risk. Asecondary risk of swap insurance includes the oversightand legal restrictions imposed by insurersunder swap policies. Because the insurer is assumingthe issuer’s credit risk for the duration of theswap transaction—often 20 years or more—insurersmaintain certain control rights under theinsured swap and insert various legal provisionsinto an issuer’s bond documents. For example, solong as the insurer has not suffered a credit event,insurers reserve the right to allow voluntary terminationof swaps and sometimes place limitations onadditional swaps. These restrictions may becomeproblematic if the issuer needs to restructure theswap or enter into additional swaps for economicreasons. Insurers also typically require that a seriesof credit protection provisions be inserted directlyinto the schedule to the International Swaps andDerivatives Association (ISDA) agreement, includingcollateralization by the counterparty. These protectionsare typically positive for the issuer’s creditquality, although they may impact the economics ofthe transaction. Also, in some cases the insurer hasthe right to direct the issuer to terminate the swapearly if the issuer has experienced an event ofdefault (as defined under ISDA swap documents).Standard & Poor’s is not overly concerned aboutinsurer-directed termination clauses due to an eventof default since these risks are already reflected inthe issuer’s rating. ■Debt Derivative Profile ScoresStandard & Poor’s Ratings Services has revised itscriteria for Debt Derivative Profile (DDP) scoring18 months after having implemented themethodology. Standard & Poor’s developed DDPscoring for U.S. Public Finance in September 2004to enhance the analysis and transparency of municipalderivative structures and their impact on creditquality. We believe these revisions will add value toour derivative analysis, within the context of ouroverall credit analysis.The revisions place more emphasis on near andintermediate term risks and relatively less emphasison longer-term risks that do not add or detractmaterially from an issuer’s rating.We received numerous and varied responses to ourrequest for comments on the proposed revisions to theDDP from all sectors of the municipal bond market,including issuers, dealers, investors, and financial advisors.We considered all comments in making our finaldetermination of the criteria revisions. This criteriapiece supersedes all prior criteria reports on the DDP.Revisions To Scale And WeightingsStandard & Poor’s is revising the DDP scale to an“enhanced” four point numerical scale from a fivepoint numerical scale. The enhancement consists ofeliminating the score of ‘5’ and adding half points(1.5, 2.5, 3.5) to the 1, 2, and 3 risk categories.Furthermore, all numerical scores will be pairedwith a risk descriptor that will be consistently usedto characterize the numerical DDP score. Theenhancements provide greater granularity withinthe ‘1’ through ‘4’ scale. The revised DDP scoresare as follows:Additionally, Standard & Poor’s has revisedweightings for component scores and eliminatedseveral scored factors within the collateral andtermination risk analysis. Details of all therevised DDP scoring methodology are describedbelow. The revised criteria results in recalibratedscores for all issuers (see accompanying article,“Current List Of DDP Scores”, March 27, 2006,RatingsDirect).38 Standard & Poor’s Public Finance Criteria 2007

Debt Derivative Profile ScoresDue to the criteria revisions discussed in thisreport, 271, or 54% of the 505 scores changed. Ofthe 54% that changed, 26% were revised upward(got worse), and 28% were revised downward (gotbetter). Eight issuers, or less than 2% of the totalscores changed more than a half-point (0.5) as aresult of the recalibration. All others changed up ordown by a half point only.Although many factors are considered, the DDPscores principally indicate an issuer’s potentialfinancial loss from over-the-counter debt derivatives(swaps, caps, collars) due to collateralization of atransaction or, worse, early termination resultingfrom credit or economic reasons. DDPs are integratedinto Standard & Poor’s rating analysis forswap-independent issuers and are one of manyfinancial rating factors. Standard & Poor’s considerstax-secured GO bonds and general revenuebonds—health care, higher education, transportation,and utility—as swap-independent, as absenceof the swap would not preclude the issuer fromrepaying its bonds. Swap dependent issuers, mostlyhousing and structured financings, are not eligiblefor DDPs since ratings on these transactions alreadyincorporate cash flow stress testing of all derivativerisks. However, state housing finance agencies, thelargest issuers of swap dependent issues, are eligiblefor DDPs as part of issuer credit ratings, since theseratings apply to the agency’s general credit and notto any structured financing specifically.BackgroundOver-the-counter debt derivatives, such as interest rateswaps and caps, have for decades been used as hedgesin the capital markets, but appreciably by municipalissuers only in the last several years. Issuers, investors,regulators, and citizens have become increasinglyfocused and concerned about public purpose entities’involvement in what was once exclusively a corporaterisk management tool. Many issuers—traditionally,fiscally conservative entities—spurred by risingexpenses, restrictive refunding rules, and revenue limitations,have started to use derivatives as hedges tolower borrowing costs and reduce interest rate risk. Asa fixed cost, debt service is a difficult budget item tocontrol and swaps can provide some expenditurerelief. Several states, including Pennsylvania,Michigan, and North Carolina, have granted statutoryauthority to local jurisdictions to enter into hedges fordebt, further fueling the surge in municipal derivativesactivity. In the health care, nonprofit, and utility sectors,derivatives have provided competitive advantageswhen used in conjunction with traditional financingtechniques. In all cases, debt derivatives have introducednew risks and altered the credit profiles ofissuers. However, as evidenced by the preponderanceof DDP scores of ‘2’ or less (75%), it is evident thatmost issuers scored to date have prudently approachedtheir derivatives activities.Standard & Poor’s originally developed DDPscores to enhance the transparency of municipalderivative structures and their overall impact oncredit quality. Derivative impact has always been apart of Standard & Poor’s analysis; the DDP scoringmethod incorporates existing municipal swaprating criteria and codifies that criteria into an easyto-understandrisk score.InterpretationFinal DDP scores of 1, 1.5, and 2 indicate that thecredit risk from debt derivatives is minimal to low,whereas DDPs above 2 indicate that there is a moderateor high degree of risk from the swap transactions.Low DDP scores are one factor of many included inthe credit analysis that determines a rating and arenot in and of themselves an indication of upward ratingpotential or an endorsement of any specific derivativetransaction as being beneficial to the issuer’sfinancial position.Furthermore, moderate to high DDP scores arealso one factor of many and do not in and of themselvesindicate a potential rating downgrade duespecifically to derivatives, or that any specific transactionwill not benefit the issuer’s financial position.As part of the rating analysis, Standard &Poor’s will cite an issuer’s overall DDP score in conjunctionwith the net variable interest exposureratio. In some cases, we may also cite DDP componentscores to highlight high component scores,speculative transactions, or transactions enteredinto under fiscal stress, that may be indicative ofother fundamental credit weaknesses.To determine whether a moderate to high finalDDP score, high net variable exposure, or any noteworthycomponent scores are sufficient to influencean issuer’s rating, we will seek to determine anissuer’s derivatives portfolio’s maximum potentialexposure (MPE), which is a value-at-risk (VAR) calculationof a derivatives transaction. Net variableinterest rate exposure, on the other hand, measuresthe potential risk to an issuer’s revenue stream andreserve levels resulting from rising interest rates (seeDDP Score1.0 Minimal1.5 Very low2.00 LowRisk Descriptor2.5 Low-to-moderate3.0 Moderate3.5 Moderate-to-high4.0 Highwww.standardandpoors.com39

Cross Sector CriteriaAdditional Factors below). A high overall DDPscore, component scores, high net variable exposureratio, or a speculative transaction can be partiallyor fully mitigated as negative rating factors to theextent an issuer has sufficient liquidity reserves or arobust cash flow stream to offset the worst-casefinancial risk. On the other hand, if financial exposureis not offset at the issuer’s current rating level,this is a cause for concern and could be a reasonfor a negative rating action.Debt Derivative Profile Scoring CriteriaThe DDP is a weighted average of four factors,each of which is scored on a scale from 1 (minimalrisk) to 4 (high risk). The four factors that comprisethe DDP are:■ Issuer collateral posting and termination risk(35% weight);■ Counterparty termination credit risk (15%weight);■ Economic viability of the swap structure (15%weight); and■ Quality of swap and debt management policiesand procedures (35% weight).Standard & Poor’s has determined that moreweight should be placed on management and therisk of termination and collateral posting due tothe near and intermediate term risks inherent inthese factors. Furthermore, counterparty credit riskand the economics and cash flow strength of anindividual trade (economic viability), while importantover the long-term, are both relatively lessimportant from a near to intermediate term creditrisk perspective.We perform the DDP analysis using documentationand representations provided by the issuer(swap management policies, business plans) and theswap dealer combined with proprietary statisticalmodels. Due to the single agreement concept, scoresfor issuer collateral posting and termination riskand counterparty termination credit risk are derivedby evaluating the International Swap DealersAssociation Inc. (ISDA) document, since the legalterms and conditions are consistent for an unlimitedamount of related transactions.Termination and collateral posting riskTermination and collateral posting risk is scored ona 1 through 4 scale based on the risk that the issuerCounterparty RatingCounterparty Risk Score‘AAA’ ‘AA+’, ‘AA’, or ‘AA-’ 1‘A+’ 2‘A’ and ‘A-’ 3‘BBB+’ and lower 4will be required to post collateral or terminate aswap on an involuntary or voluntary basis. Theweighting for termination and collateral postingrisk is 35% due to the potential impact on anissuer’s liquidity reserve position.Analytically, collateral posting in favor of a swapdealer is equivalent to payment of a termination feedue to the restricted nature of collateral on anissuer’s balance sheet. To determine a final terminationand collateral posting risk score to be used inthe DDP, Standard & Poor’s will score and weightthree factors that could lead to a collateral postingor early swap termination. The three scored terminationand collateral posting risk factors include:■ The likelihood of an involuntary event of defaultor termination or collateral posting due to ratingsdowngrades, or a likelihood of voluntary terminationunder unfavorable market conditions(50% weight);■ The issuer’s historical ratings volatility (numberof downward rating or negativeoutlooks/CreditWatch listings in last three years;30% weight); and■ Average swap durations applicable to the ISDAdocument (less than 10 years, 10-15 years, 15-20years, greater than 20 years; 20% weight).We will assign the lowest termination and collateralposting risk scores for swaps with a relativelywide ratings trigger spread, low ratings volatility,and overall short swap durations (reduced likelihoodof a rating transition). There may be mitigatingfactors that would warrant a termination andcollateral posting risk score of either 1 or 4 forspecific transactions. In these cases, these transactionswill be separated apart from the other transactionsapplicable to the ISDA document forscoring purposes.Factors that warrant a termination and collateralposting risk score of 1, include:■ No material events of default or termination;and/or■ Issuer has an option to terminate the swap at anytime, for any reason, at little or no cost.Factors that warrant a termination and collateralposting risk score of 4, include:■ Events of default or termination, other than ratingstriggers, that are considered likely to occurover the life of the transaction; and/or■ Speculative transactions where there is a distinctpossibility of early, voluntary termination by theissuer (if such an option exists) under adversemarket conditions, and/or■ Unfavorable swap options (swaptions), where thedealer owns the option to impose an unfavorableor speculative transaction on an issuer.40 Standard & Poor’s Public Finance Criteria 2007

Debt Derivative Profile ScoresOf the myriad credit events contained in a municipalinterest rate swap, the “additional terminationevent” of a rating downgrade trigger, or collateralposting under a credit support document, are themost likely to occur since they are triggered byinvoluntary credit events. Other standard ISDAevents of default and termination—failure to pay,bankruptcy, merger without assumption, and soforth—are incorporated into ratings. For this reason,we will score, as a key factor for this component,the likelihood of an issuer (or swap insurer)triggering termination or collateral posting basedon our rating transition and default data. The credit“spread” or gap between the issuer’s (or swapinsurer’s) current rating and the meaningful collateralor termination rating trigger level is determinedand scored appropriately. For swaps with collateralprovisions, Standard & Poor’s attempts to discernthe meaningful collateral rating trigger throughanalysis of the swap’s actual maximum potentialexposure compared to the issuer’s liquidity reservelevels. Once the meaningful collateral rating triggeris determined, Standard & Poor’s is able to accuratelyscore termination and collateral posting riskusing the appropriate rating trigger.The final score for the termination and collateralposting risk section is the product of the weightedaverage of ISDA swap document scores.Weightings are based on the risk-adjusted notionalamount of swaps provided by a counterparty relativeto the issuer’s total risk-adjusted swap notionalamount outstanding. Standard & Poor’s adjustseach swap’s notional amount based on its interestrate sensitivity relative to a baseline swap’s sensitivity,effectively placing less emphasis on swaps ofshorter durations and more emphasis on swaps oflonger durations. The baseline swap is a fullyamortizing swap with an average life of 19 years.This “dollar duration” methodology capturesswaps’ sensitivity to changes in interest rates and isused as a proxy, for scoring purposes only, of theswap’s maximum potential exposure. Swaps withhigher volatility, therefore, have a greater impacton the termination and collateral posting riskanalysis than swaps with lower volatility.If an issuer has scored a 3 or 4 on any of its ISDAdocuments or on the termination and collateral postingrisk score itself, Standard & Poor’s will evaluatethe actual MPE under the applicable transaction(s)and compare it to the issuer’s unrestricted reserves;that financial analysis will be factored into the rating(see Interpretation above for more details).Counterparty riskThe counterparty risk section of the DDP isscored on a 1 through 4 scale based on the likelihoodof a counterparty default, that could causethe issuer to lose its ability to replace its hedgeposition. Counterparty credit risk is generallylow for the majority of issuers due to usage ofhighly rated counterparties (typically rated ‘A+’or higher) and provisions for full collateralizationof swaps prior to significant rating counterpartydowngrades. For this reason, and the factthat most municipal bond transactions are notswap dependent—in the sense that the loan doesnot require the swap for repayment—counterpartycredit risk is weighted at 15% in the overallDDP analysis.To determine a final counterparty risk score tobe used in the DDP, Standard & Poor’s will scoreand weight the likelihood of a counterparty creditdeterioration based on a rating transition to the‘BBB’ rating level. The ‘BBB’ rating level is usedsince this is the lowest rating permitted underStandard & Poor’s rating criteria for counterpartiesin U.S. public finance swap transactions.Furthermore, to the extent a counterparty is downgradedto below ‘BBB’ the likelihood of terminationpayment recovery is significantly diminisheddue to the potentially massive collateral calls fromthe counterparty’s other creditors. Similar to thetermination and collateral posting risk scoring section,Standard & Poor’s does not consider standardISDA swap event of default and terminationfactors as significant termination events since theyare already incorporated into counterparty ratings.Therefore, a ratings downgrade is the credit eventmost likely to occur. The counterparty risk scoringmethodology gives issuers credit for securing highlyrated counterparties and penalizes issuers forsecuring lower rated counterparties. Similar to thetermination and collateral posting risk section,counterparty risk scores are assigned by ISDA documentand weighted according to risk-adjustednotional amounts. The final score for counterpartyrisk will be the weighted average of each counterparty’sISDA swap document score, with weightingsbased on the risk-adjusted notional amount ofswaps provided by a counterparty relative to theissuer’s total risk-adjusted swap notional amountoutstanding. If an issuer has scored a 3 or 4 on thecounterparty risk component, or on any specificISDA document, Standard & Poor’s will evaluatethe MPE under the applicable transaction(s) andcompare it to the issuer’s unrestricted reserves; thatfinancial analysis will be factored into the rating(see Interpretation for additional information).At this time, our rating transition and default dataindicate that counterparty risk scores are as follows:Notwithstanding these counterparty risk scores,mitigating factors that would warrant a counterpartyrisk score of 1, include:www.standardandpoors.com41

Cross Sector Criteria■ Full collateralization of swaps by the counterpartyprior to a downgrade to below ‘BBB’; or■ A provision for the counterparty to secure, at itscost, a third-party guarantee or replacementcounterparty rated at least ‘BBB’ in the event of adowngrade of the original counterparty to below‘BBB’; and■ Provision for mandatory counterparty terminationbelow ‘BBB’, or■ A provision that allows the issuer to optionallyterminate the swap, at any time, for any reason.Economic viabilityEconomic viability is scored on a 1 through 4 scalebased on whether the issuer could have an incentiveto restructure or voluntarily terminate all or a portionof its swap transactions due to the ineffectivenessof the hedges over the long term. We havedetermined that it is important to analyze the economicsand long-term cash flow strength of derivativestructures since the voluntary termination orrestructuring of the hedge through execution ofadditional hedges is potentially costly and time consuming,accompanied by real economic and opportunitycosts. These costs are in addition to theunexpected interest costs resulting from the ineffectivehedges. However, economic viability is of relativelyless importance from a near to intermediateterm credit risk perspective relative to terminationand collateral posting risk or management. For thisreason, the economic viability component of theDDP score will be assigned a 15% weighting, similarto counterparty risk.To determine long-term economic viability, wewill stress test the potential ineffectiveness of anissuer’s swap portfolio through a proprietary basis,or variable interest expense, model. The modelincorporates our high and low stress interest ratecurves and tax-exempt bond price assumptions.Scores are assigned based on the overall amount oflong-term basis exposure. The lower the overallbasis exposure on a portfolio level, the lower theeconomic viability score (scores of 1 or 2), whilethe higher the overall basis exposure, the higherthe scores (3 or 4). Lower scores reflect the potentialfor higher economic viability of the issuer’sswap structure over the long term while higherscores indicate lower economic viability over thelong term. In some cases, issuers with high economicviability scores may in fact have achievedhigh economic viability at least in the short-termsince the derivative structure itself made the transactionpossible in the current market environment.While this is a valid argument in the short run,high potential ineffectiveness or basis exposure canbe problematic in the long-term as a variable, orunknown, budget expenditure leading to or exacerbatingcash flow stress.ManagementManagement is scored on a 1 through 4 scale basedon our assessment of management knowledge andsophistication through analysis of its swap and debtmanagement policies and overall strategy.Management is weighted at 35% due to the significanceof an issuer’s knowledge and sophistication instructuring its derivative contracts to both minimizerisks and achieve the intended purpose of the hedgingprogram. We consider various factors in assessingthe quality of management of the swapprogram, including the quality of the issuer’s writtenpolicy and hedging strategy. The written policyshould be original and tailored to the issuer’sunique situation and incorporate near, intermediate,and long-term strategies and parameters. Factorsconsidered in assessment of the overall quality ofmanagement and the written policy and planinclude:■ Formal approval of written documents by theissuer’s governing body;■ Swap risks identified and discussed in the contextof the issuer’s financing plans;■ Annual management review and discussion ofhedging strategies;■ Commitment to complete and comprehensive disclosureof swaps in audited financial statementsabove and beyond required GASB or FASBparameters;■ Monitoring of swaps with semi-annual valuationby a third party■ Policies on legal provisions, including optionalswap terminations, collateral, or swap insurance;and;■ Counterparty diversification or a minimum ratingspolicy for counterparties;■ A net variable rate exposure policy.A comprehensive swap management policy willinclude the above consideration and should alsoinclude a discussion of risks and rewards of swapsand variable rate debt, senior management personnelresponsible for monitoring swap risks, maximumlevel of variable rate debt and swap exposure,counterparty exposure limitations, collateral policiesand procedures, and a detailed description ofand rationale for all derivative transactions enteredinto or that are contemplated.Additional FactorsSwap valuationAn issuer’s swap portfolio may be stress tested todetermine the maximum potential exposure if theissuer has a high final DDP score, high net variable42 Standard & Poor’s Public Finance Criteria 2007

Long-Term Municipal Poolsexposure, or any noteworthy component scores.The MPE measures how much a counterparty couldexpect to lose on a transaction over the life of thetransaction if the other counterparty failed to performits obligations on the swap. MPEs are typicallytwo standard deviation value-at-risk calculationsusing relatively standard techniques for projectingpotential paths of future interest rates. MPEs areinfluenced by the swap’s notional amount, averagelife, and the terms of the trade—fixed-to-floatingswap, floating-to-fixed, floating-to-floating—andthe optionality embedded in the swap. We will askthe issuer to calculate a MPE for swaps that are indanger of terminating early. If necessary, we willuse the MPE and measure it against the issuer’s liquidityreserves to determine the credit impact ofswap termination.Net variable rate exposureWe will calculate a net variable-rate interest exposureratio for all issuers of variable rate debt and/orswaps for use in conjunction with any DDP score.The net variable exposure measures the potentialrisk to an issuer’s revenue stream and reserve levelsresulting from rising variable rates. Net variablerate exposure ratio incorporates all current interestrate derivatives, fixed and floating rate debt, andany natural hedges (i.e., qualified investment assetsdesigned to offset interest rate risk). The exposureratio will also be calculated on a pro forma basis togauge prospective levels of variable exposure, giveneither proposed derivatives structures or futurebond issuance. For example, some issuers haveentered into swaptions that may become effective inthe future, depending upon the level of interestrates. If we are concerned that a counterparty mayhave an incentive to terminate a fixed-to-floatingrate swaption on an issuer, we will assess the potentialexposure of future variable interest rates for theissuer through the net variable rate exposure calculation.Another example is an issuer that partiallyhedges a 30-year variable rate issue for 10 yearswith a floating-to-fixed rate swap. Through thissimulation, we are able to determine the impact ofrollover risk, or the risk that the issuer will not beable to re-hedge its variable rate exposure uponexpiration of the swap.ConclusionIn an effort to hedge risks, many entities are enteringinto derivative instruments that have a long,successful history. Understanding the risks associatedwith these types of agreements is critical. Withour DDP, Standard & Poor’s adds an independentevaluation of the risks associated with certain derivativesand the potential impact on credit qualityand ratings. ■Long-Term Municipal PoolsStandard & Poor’s Ratings Services criteria for ratingpools of municipal obligations reflects the fact thatthe likelihood of default of bonds secured by a pool ofassets is a function of both the expected distribution ofdefaults within the asset pool, and the level of over-collateralizationavailable to cure those defaults. The likelihoodthat an obligor will cause a bond pool todefault depends on the obligor’s credit quality and theinfluence of that obligor on the total performance ofthe pool (the pool’s relative concentration or diversity).To the extent that additional funds (through reserves orcoverage) can provide protection against a certain levelof obligor defaults, then a rating commensurate withthe probability of exceeding that amount of loss maybe assigned to the pool bonds. Higher pool ratingstherefore require higher over-collateralization to protectagainst higher cumulative default probabilities.In the absence of any over-collateralization, stepupobligations on the part of participants, or otherstructural enhancements, pool ratings will typicallyfall to a level at or near the rating of the lowestratedparticipant. Pool programs without step-upprovisions are not eligible for ratings above the ratingof the weakest participant if the pool containsfewer than 10 separate obligors.While the theory behind the pool criteria wouldappear straightforward, the application provesmore difficult. Determining the cumulative defaultprobability distribution for a pool of obligationsbecomes extremely difficult as the size of the port-www.standardandpoors.com43

Cross Sector Criteriafolio increases, especially when one allows for correlationamong participants.Modeling Loss RatesMore incremental analyses of pools became possibleas computers became faster, and the value ofiterative statistical methods was better understood.While often the actual default probability distributionof a specific pool may not be determined theoretically,it can be approximated and observedthrough repeated random trials, just as the repeatedflipping of a coin will reveal the true probability ofheads to be 50%. Standard & Poor’s quantitativegroup within structured finance has developed softwarethat uses a Monte Carlo methodology, featuringsuch an iterative process to estimate the defaultrate probability distribution for any pool entered.The software has now been adapted to allow forthe analysis of municipal pools as well. From thisdistribution is derived a set of stressed default rateswhich vary according to the pool rating desired.This methodology fully captures the effects ofobligor concentration, correlation, and obligorcredit quality in a simultaneous manner, thus permittingmore insight into incremental changes inpool credit quality as pool composition evolves.To derive the portfolio default probability distribution,a default matrix is used to assign a specificdefault probability to each participant obligationbased on the nature of the participant, its creditquality, and the obligation’s maturity.Model InputsTo run the simulation, the model requires each participant’sasset type, par amount, rating, and maturities.For most governmental entities, the asset typewill be the postal abbreviation for the state inwhich the participant is located. For non-profitorganizations and certain other sectors, a sectorspecificcode should be used (see table 1). The assettype designation helps determine the correlationbetween participants. Model inputs, or assets, areat the maturity level, so a pool of 20 participantswith amortizing loans, each with 20 years remainingon their obligations under the pool would have20 x 20 or 400 assets. Alternatively, each loan maybe entered as a single asset, using the final maturityor the weighted average maturity. Maturities arerequired as the model uses the participant’s rating,security, and length of maturity to arrive at participantdefault probabilities. The model then runs aseries of trials from which the default probabilitydistribution and resulting stressed default rates aregenerated. While Standard & Poor’s will distributeversions of the model so that pool programs mayuse and become familiar with the software, we willalso require that participants provide the necessarydata so that we may run the default analysis inhousebefore issuing a rating.Cash Flow AnalysisOnce default stress levels have been established, theissuing agency will be asked to prepare cash flowsincorporating the default assumptions. Because themodel produces aggregate portfolio default rates,default rates should be applied against aggregaterepayments available to service debt each year thatdefaults are recognized. To translate the percent ofasset or loan portfolio defaults into amounts neededto absorb these defaults, recovery rates must alsobe considered. Recovery rates will vary based onthe nature of pool participants and the securitybeing pledged (see table 1). For state revolvingfunds (SRFs) and other government or quasi-governmentpublic purpose pools backed by water andsewer utility pledges or GOs, the assumption thatobligors remain in default for four years and thenbegin paying principal, interest, and other requiredpayments in full (at 100%) will continue. Poolsconsisting of other types of obligations or that lackgovernment motive and oversight will have recoveryrates less than 100% after the four-year defaultperiod. The methodology employed by the programadministrators in granting loans to participatingentities and monitoring the ongoing financial andoperating status of the borrowers may also influenceduration assumptions.While the Monte Carlo model reveals how muchof the pool should be expected to default, it revealsnothing about the expected timing of defaults.Standard & Poor’s will assume that all defaultsbegin to occur over a four-year period, with 25%occurring each year over the period. The end resultis that default scenarios will show some level ofdefault over a seven-year period (rather than a fouryearperiod), but 100% of the assumed defaults willoccur in only one year (rather than four years). Putanother way, if the assumed default rate for a givenportfolio at a given rating is 40%, then 25% x40%, or 10% of aggregate debt service should bedefaulted in the first year of defaults, 50% x 40%,or 20% in the second year, 75% x 40%, or 30% inthe third year, and 100% x 40% in the fourth year.Finally, recovery levels should be factored in toarrive at net defaulting amounts in each year. Inyear five of the previous example, if we assume90% recovery, then of the 10% of defaults thatbegan in year one, 10% x 90%, or 9% wouldbegin paying again, resulting in a net default rate of40%-9%, or 31% (see table 2).A pool’s vulnerability to participant defaults mayvary over the life of the rated bonds, so cash flowruns should also demonstrate that the pool canwithstand the stressed default rate at any point in44 Standard & Poor’s Public Finance Criteria 2007

Long-Term Municipal Poolsthe program during which bonds are outstanding.The number and type of runs needed to demonstratethis fact can vary depending upon the program’sstructure. If the most vulnerable point in aprogram’s amortization schedule can be specificallyidentified, then cash flows demonstrating amplereserves or coverage over that period will suffice.For programs that allow the release of funds asbonds mature or rely on coverage from investmentearnings to survive assumed participant defaults,this may be more difficult and additional runs maybe necessary.Management ConsiderationsThe ability of a pool program to survive associatedstressed default rate assumptions remains the backboneof Standard & Poor’s criteria. Program managementaspects, however, do play a role,particularly in placing the pool rating within therating category and in establishing the rating for anew program. Management factors analyzedinclude underwriting criteria and procedures, loanservicing track records and capabilities (includingthe sensitivity of these capabilities as the programgrows), marketing processes, and participant monitoringand control procedures. Strong managementpractices may overcome weak legal provisions ifStandard & Poor’s believes such practices will continueand thus better predict the long-term performanceof the program.Legal Structure And Required DocumentationStandard & Poor’s will review all relevant documentsassociated with each transaction to assess thelegal structure and ensure that it corresponds to theassumptions presented by the program sponsor.Documentation required to rate a pool programincludes:■ List of each asset in the pool includingobligor/borrower name, state, security pledged,maturity, par outstanding as of closing, and ratingsor credit estimates.■ Cash flows summarizing total annual paymentsand balances available for the life of the pool,both with and without assumed default rates.■ All trust/legal documents, including an officialstatement or offering memorandum.■ Underwriting criteria, loan or lease terms, servicingguidelines and history of loan/lease performance.■ Information regarding program sponsor (forexample, management practices).Additional documentation may be required dependingon the nature of the transaction. Typical issuesassociated with the review of legal documents include:■ Does the flow of funds outlined in the indenturematch the intended management plan?■■■Does it provide sufficient timing to insure thatsufficient funds will be in desired accounts tomeet shortfalls in the event of participantdefaults?What is the nature of the participant loan agreement(security terms, etc.), and what are theimplications for the credit quality and ongoingfunctioning of the program?Do the legal provisions leave bondholders exposedto extraordinary risks such as investment risk orsudden changes in program composition or administrationsuch as through loan prepayment, loande-pledging, or the release of other funds.Investment IssuesTo the extent that program reserves are relied on toprovide the over-collateralization necessary to sustaina particular rating, the investment of thesereserves should not pose additional risks relative tothe bond rating. Accordingly, reserves should beinvested with entities rated at least as high as theprogram’s bond rating, although ‘AAA’ rated programsmay use investment agreement providersrated as low as ‘AA-’ in certain instances.If programs utilize investment agreements thatallow the issuer to terminate the agreement, withouta penalty to the remaining principal within 30days, Standard & Poor’s will treat the instrument asa short-term investment and look to the provider’scommercial paper rating to determine the eligibilityof the investment—but only if program cash flowsare not dependent on being able to achieve thesame interest rate on a subsequent investmentagreement. Alternatively, ‘AAA’ programs may useproviders rated as low as ‘AA-’ if certain downgradeprovisions exist within the investment contract(See Public Finance Criteria: InvestmentAgreements For Municipal Revenue BondFinancings).Finally, issuers may choose other investmentoptions, such as secondary guarantors or joint guaranteeagreements to ensure a high rating for theirinvestment and minimize the risk of substitution.State Revolving FundsThe SRF financing vehicle has become an importanttool in many states to fund water and wastewaterinfrastructure projects. Since the establishment ofthe clean water SRF through revisions made in 1987to the Clean Water Act (which targets the need torepair or construct wastewater infrastructuredesigned to handle growing populations and morestringent environmental measures), the program hasgrown and is arguably one of the most successfulfederal programs of the past 20 years in terms ofprojects funded per federal dollar allocated. Inwww.standardandpoors.com45

Cross Sector Criteria1996, with the inclusion of the Safe Drinking WaterAct, the breadth of projects funded using thisrevolving fund vehicle expanded to include potablewater-related projects as well. SRFs are consideredto be the strongest municipal pools, as programadministrators, along with associated state environmentaland health agencies, usually have significantregulatory powers with which to compel participantcompliance. In addition, programs enjoy large equitypositions due to state and federal contributionsand the relative inability of states to raid these fundsfor other purposes.Many state revolving fund programs have implementedcross collateralization features betweentheir clean water and drinking water programs toenhance credit quality. If Standard & Poor’s hasdeemed the method effective through an analysis ofthe flow of funds and timing of payment releases,then stressed default rates will be determined as ifall participants were part of one large program,even if multiple indentures are involved, resulting inlegally separate pledges. Such mechanisms, however,can make cash flow analyses more difficult, asrevenue streams under different indentures may besubject to severe stresses at different points in time.Determining what period over the life of the combinedprogram is most susceptible to participantdefaults may therefore prove extremely difficult,and a more incremental cash flow analysis mayprove useful. Presenting cash flows on an incrementalbasis, however, does not require the re-estimationof pool stressed default rates on an incrementalbasis as well. Standard & Poor’s analysts will assistissuers in determining what analyses are needed ormost appropriate.Because of the stability and strong state and federalprotection associated with these programs,Standard & Poor’s may give credit for other programmaticfunds available to cure defaults, eventhough they may not be part of the trust estatedirectly securing the bonds. For these funds to beconsidered in the analysis, the program should havewritten policies in place that provide for the timelytransfer of these other funds to replenish bond dedicatedreserve draws once drawn upon. Standard &Poor’s will review the asset quality and liquidity ofthese funds as well as the program’s treasury managementpractices as part of its ongoing surveillanceto ensure that sufficient funds remain available toreplenish draws.Although Standard & Poor’s may give credit toother funds available, it still expects that a majorityof funds needed to maintain the rating will bepledged to bond holders and invested accordingly.Should this not be the case, the analysis would shiftaway from the focus on the pledged loan portfolioTable 1 Municipal Pool/CDO SectorsSector Sector Code Recovery Range (%)GO State of obligor 80-100General fund pledge/lease appropriation State of obligor 70-85Moral obligation State of obligor 40-55Water-sewer/solid waste State of obligor 80-100Sales/income tax/gas tax State of obligor 80-100Other special tax State of obligor 70-85Tax increment State of obligor 70-85Spec assessment State of obligor 70-85Public power/gas State of obligor 70-85Charter schools State of obligor 40-55LOCs Industry code 40-55IRBs Industry code 40-55Public universitites State of obligor 80-100Private schools and universities Industry code 40-55Health care Industry code 40-55Other 501C3s Industry code 40-55Housing State of obligor VariesAirports Industry code 70-85Toll roads/parking/garvees/ports/transit Industry code 70-8546 Standard & Poor’s Public Finance Criteria 2007

Long-Term Municipal Poolsand assets that provides the dominant support formost state revolving fund ratings. In such a caseStandard & Poor’s analysis would expand toinclude not only the asset quality and liquidity ofrelated funds, but also overall program income andbalance sheet performance, including non-leveragedprogram areas. Management practices, state-specificregulations, and statewide economic conditionscould also play a larger role in these instances.Other Municipal Public Purpose PoolsA variety of pool financing programs have beenestablished over the years to help local governmentsfund various types of improvements. Some programsfocus on specific types of projects, others onspecific types of organizations; some are instrumentalitiesof states, while others are single-purposeorganizations supported by quasi-governmental orother organizations dedicated to serving local governmententities. Each type of organization can playan important role within the context of a state’spublic safety, economic development, or other publicinterest needs.The state-sanctioned municipal bond bank structurebegan in the late 1960s, and through a varietyof names state bond banks have offered varied programsover the past 35 years. Although the numberof bond banks has not risen substantially, manyhave seen a significant evolution and expansion oftheir programs. While the security and structure ofbond bank pools varies considerably, these poolstypically benefit from the fact that a state agencyadministers the program; this often brings strongeroversight powers or special security features containedin statutes. Bond banks may be more willingor more able than nonprofit or quasi-governmentalentities to cure program imbalances if shortfallsoccur. Relative to state revolving fund programs,however, bond banks may be more susceptible tochanges in levels of state support.Quasi-governmental pools are typically sponsoredor administered by state level organizationsTable 2 Example Of Applied Default And Recovery Rate For Municipal PoolAssume pool default rate of 40%, with 90% recovery after four yearsA B C D E F GPayments Recovery Net Defaulted(due to be Default rate (%) rate (%) default Defaulted debtreceived before Debt 25% of 40% Four-year rate (%) payments ($) service ($)Year defaults) ($) service ($) each year recovery lag (C–D) (E–A) B–(A–F)1 5,000,000 4,000,000 10 N/A 10 500,000 N/A2 5,000,000 4,000,000 20 N/A 20 1,000,000 N/A3 5,000,000 4,000,000 30 N/A 30 1,500,000 500,0004 5,000,000 4,000,000 40 N/A 40 2,000,000 1,000,0005 5,000,000 4,000,000 40 9 31 1,550,000 550,0006 5,000,000 4,000,000 40 18 22 1,100,000 100,0007 5,000,000 4,000,000 40 27 13 650,000 N/A8 5,000,000 4,000,000 40 36 4 200,000 N/A9 5,000,000 4,000,000 40 36 4 200,000 N/A10 5,000,000 4,000,000 40 36 4 200,000 N/A11 5,000,000 4,000,000 40 36 4 200,000 N/A12 5,000,000 4,000,000 40 36 4 200,000 N/A13 5,000,000 4,000,000 40 36 4 200,000 N/A14 5,000,000 4,000,000 40 36 4 200,000 N/A15 5,000,000 4,000,000 40 36 4 200,000 N/A16 5,000,000 4,000,000 40 36 4 200,000 N/A17 5,000,000 4,000,000 40 36 4 200,000 N/A18 5,000,000 4,000,000 40 36 4 200,000 N/A19 5,000,000 4,000,000 40 36 4 200,000 N/AN/A—Not applicablewww.standardandpoors.com47

Cross Sector Criteriadesigned to provide assistance and technical supportto their members—that are typically local governments.Examples of such organizations includestate-level chapters of the League of Cities, theAssociation of Counties, and the Rural WaterAssociation. While these programs often have a certainamount of technical expertise, they may alsorely on outside financial consultants to administermost of the financial responsibilities associated withthe pool program. Because these organizations areusually nonprofits with limited liquidity, fundsavailable to be pledged as over-collateralization areusually also limited. While these factors often limitratings on these entities’ pooled loan programs relativeto state revolving funds, they may still attainhigh investment grade ratings if managed effectivelywith sufficient diversity and support.Economic development pool programs differfrom other municipal pool programs in that, whilethe program sponsor and administrator is usually astate or local government agency, pool participantsare often private entities, and the credit quality ofthese participants is generally lower. Accordingly,these programs typically have some percentage ofpledged loans in default at any given time, in contrastto most government-based pools where few ifany defaults occur over the entire life of the program.Although corporate loan defaults are morelikely, this does not pose a real threat to bondrepayment if policies and provisions exist to ensurethat default rates remain manageable given creditsupport under the program. Standard & Poor’sdefault model accounts for the higher risk associatedwith private sector borrowers, resulting in higherrequired over-collateralization levels being requiredfor a given rating level. Nevertheless, this lowerparticipant credit quality, coupled with limited stateor federal equity contributions, often limits the ratingson pool programs designed to promote economicdevelopment through private lending.Lease PoolsStandard & Poor’s rates lease pools typically sponsoredby nongovernmental entities. Assets securingthese transactions are usually equipment ratherthan buildings, therefore the useful life of the equipmentrelative to bond maturity and the likelihoodthat the lessee will otherwise remain current on thelease due to their desire to maintain possession ofthe equipment are of paramount importance.Because of their typically short duration, leasepools rated to date generally enjoy lower requireddefault tolerances than do long-term debt obligations,reflecting the direct relationship betweendefault risk and maturity. The risk of nonappropriationwill lead to lower assumptions of credit qualityand recovery, however, somewhat offsetting thebenefit of the short maturity. Unlike SRFs and statebond bank pools, lease pools may also be backedby assets in different states, and the model givescredit for this additional diversification.Standard & Poor’s will discuss with the programsponsor the key criteria used in underwritingcredit risk. Staffing levels, experience of the originator’scredit personnel, and any areas of creditspecialization may also be discussed. A criticalaspect of underwriting is a review of the essentialityof the leased equipment. Standard & Poor’sconsiders the following types of equipment,among others, to be essential:■ Police and fire vehicles■ Communications equipment■ Energy management systems■ Computer hardware and software■ School busesCredit approval policies should be well documented,highlighting internal credit authorities andtransaction approval procedures. Verification ofequipment acceptance, lessee review, documentationrequirements and internal auditing are also componentsof a sound underwriting policy.The obligation of the servicer to bill and to collectis critical and can directly affect pool performance.When evaluating the strength of anequipment lease servicing operation, it is necessaryto examine the billing and collecting procedures,when and how delinquent obligors are notified, andif staffing and systems adequately handle thedemands of compliance and reporting.The substance of Standard & Poor’s legal analysisdepends on the structure of the transaction presented,but is typically akin to that for a syntheticfloater structure (see Public Finance—Structuredcriteria for more information).Municipal Collateralized Debt ObligationsCollateralized debt obligations, or CDOs, are structuredvehicles that are similar to leveraged closedend funds. A majority of CDOs are actively managedand invested in different classes. Over the lastseveral years, municipal assets have been used as aportion of the assets securing some CDOs, and afew transactions have contained only municipalsecurities as collateral. At the core of the CDO is abankruptcy-remote, special purpose entity (SPE) thatissues securities to investors in the form of severalclasses that are tranched into differently rated andsome unrated securities. Each class of securities representsa different level of risk and reward associatedwith the asset pool. The most senior securitieshave credit ratings higher than the average ratings ofthe collateral pool, with lower tranches being ratedbelow the seniors. The first-loss tranche is equity (orpreferred shares) that is typically not rated.48 Standard & Poor’s Public Finance Criteria 2007

Investment GuidelinesThe proceeds from the offering are typically usedto purchase a portfolio of assets, or may be held inthe SPE. Should some of the assets fall into defaultor trigger some of the transaction covenants, excessspread is first used to cover any losses. However,there might not be sufficient assets to cover theselosses, and the lowest level, or more junior securitiesmay take a loss. Payments to each of the liabilityclasses are dictated by a stipulated priority ofpayments that reallocates the risk and rewardsassociated with the assets. This allows the CDOissuer to tailor the liabilities to meet the risk/returnprofiles of a broad range of investors and to attractadditional groups of investors. These structuresappeal to different investors, collateral managers,and sponsors for a variety of reasons, includingparticipating in new asset types, capitalizing onarbitrage opportunities, or to transfer credit risk.The specific steps of the CDO transaction ratingprocess leading to the rating of a transaction areas follows:■ Reviewing the structural basics and the legalstructure,■ Sizing the default frequency of the proposedasset pool,■ Reviewing the collateral manager,■ Sizing the loss severity,■ Reviewing of the transaction’s collateral andstructural features,■ Establishing the required level of credit supportfor each rated tranche,■ Assigning preliminary ratings,■ Reviewing final documentation and legal opinions,if required, and finally,■ Issuing the rating(s) of the transaction.Municipal CDO ratings are a joint effort betweenStandard & Poor’s Structured CDO group andStandard & Poor’s Public Finance Department.While public finance analysts will assist in reviewingthe pledged collateral and its relevance in determiningcredit support levels, structured analysts willtypically review the other rating aspects due to thefluid and rapidly evolving nature of the CDO markets.While the treatment of municipal assets in aCDO generally mirrors the assumptions set out inthis article in terms of default and recovery assumptionsand coding for correlation purposes, generalCDO criteria is considerably more extensive.Interested readers should consult Standard & Poor’sStructured Finance Global Cash Flow and SyntheticCDO Criteria. ■Investment GuidelinesFormal rating requirements do not exist forinvesting issuers’ operating funds becausefinance officers tend to invest conservatively basedon internal policies or state-legislated restrictionsthat emphasize the safety of principal and liquidityover the desire for higher yields.In the event that losses were to occur, most governmentsand enterprises have the financial capacityto take budget balancing actions to reduce thepressures derived from lost investment earnings.Certain issuers, such as in the housing sector, havelimited revenue raising flexibility and therefore thecredit quality of investments takes on greaterimportance. Standard & Poor’s Ratings Servicesbelief in the traditional conservatism of municipalinvestment practices is grounded in experience andhas been confirmed in discussions with issuers oninvestment policy as participation in exotic andmore volatile derivative securities has increased.That is good news, because with the proliferationof new investment structures, which can shift dramatically,it would be virtually impossible to regulateinvestment requirements to keep up with thechanging environment.Standard & Poor’s rating analysis—particularlyfor short-term notes and commercial paper—isbased on the presumption that funds are investedwith the preservation of capital as the issuer’s highestpriority. The level of risk able to be tolerated isalso a function of the issuer’s level of liquidity andoverall financial strength. The following investmentguidelines are “common sense” investing policiesthat Standard & Poor’s believes are followed by thevast majority of rated public finance issuers; theymight be called “normal prudent practice.” IfStandard & Poor’s identifies issuers whose practicesdiverge from these guidelines, it would not automaticallywarrant a lower rating, but it wouldprompt further questioning and analysis of thatissuer’s cash flow and liquidity needs.Regular borrowers of short-term, seasonal cashflow notes have greater needs for liquidity and safe-www.standardandpoors.com49

Cross Sector Criteriaty of principal because of the large debt serviceexposure that occurs at maturity of the notes; forthese reasons, the guidelines presented here forinvesting operating funds take on more importancefor such issuers, and investment practices that veerfrom them could be cause for rating concern.Nonoperating funds, such as endowments and pensionfunds, can be invested long-term while ensuringthat assets and liabilities are maturity matched.The following guidelines are suggested for investinggeneral operating funds. Operating funds, as definedby Standard & Poor’s, are those needed to pay recurringexpenses, such as payroll, maintenance, debtservice, and other expenses needed to provide normalessential services during the fiscal year. Issuers thatdeviate from these guidelines will be examined individuallyto determine the effect, if any, their investmentpractices have on their credit ratings.‘Prudent Practice’Standard & Poor’s general operating fund investmentguidelines are based on what it considers “normal,prudent” investment practices with regard tomaturity and liquidity, leverage, and credit quality.Average maturity and liquidityThe weighted average maturity of the operatingfund, as well as the maturity of individual securitiesin the fund, should be limited to one year, or asneeded for the issuer’s normal disbursement patterns.Operating funds should be invested in liquidsecurities to meet withdrawals related to operatingexpenses, debt service, note payments, and so forth.Principal protection and liquidity are typically theprimary goals of an operating fund and investmentreturn a secondary goal. If the operating funds areinvested in county or state investment pools, theweighted average maturity of the county or statepool should typically be one year or less.LeverageBorrowing through reverse repurchase agreementsand other types of leveraged investments is typicallylimited and reflective of the risk profile of theissuer. If reverse repos are used for enhancing yieldon the portfolio, the money borrowed should beinvested in securities of a high credit quality andmatch the term of the reverse repos. Issuers that usereverse repos need to have the sophistication andskills in place to hedge collateral call and interestrate risks associated with reverse repos.Credit qualityAn entity’s operating fund investments should meetthe minimum credit quality standards permitted bystatute, or its own investment policy. Investmentscan include deposits in local financial institutionsthat are FDIC-insured, commercial paper issued byinvestment-grade corporations and financial institutions,bankers’ acceptances, and treasury or governmentagency securities.DerivativesFor the purposes of these guidelines, derivativeinvestments can be described as those whose yield ormarket value does not follow the normal swings ofinterest rates. They include, but are not limited to,such items as structured notes issued by agencies andcorporations, “inverse floaters,” leveraged variableratedebt, and interest-only or principal-only CMOs.These securities are volatile and can result indramatically different market values if liquidatedbefore maturity. Significant investment positions inrisky derivatives could be viewed negatively,depending on the proportion of derivatives tototal investments and the liquidity needs of theissuer. These derivatives are extremely sensitive tointerest rate changes and are highly susceptible toliquidity risks.Pools And Mutual FundsThe same guidelines regarding average maturity andliquidity, leverage, credit quality, and derivativesshould be adopted for operating fund investments inexternally managed investment pools. Exceptions canbe made depending on the amount of nonoperatingand surplus funds invested in the pool. In addition toreviewing the pool investments, the historical andprojected cash flows of the pool will be examined.While we do not require investment funds to berated by Standard & Poor’s in order to evaluate anissuer’s credit quality, a public rating on the investmentfund provides transparency as well as the initialand ongoing information that is asked for aspart of an investment review.Review And OversightIssuers should be aware of statutory investmentrequirements and may want to supplement statutoryguidelines with a written investment policy tailoredto that entity’s situation. The policies shouldaddress credit quality, maturity, market valuationfrequency, leverage, and derivative-type investments.Officials should be aware of such policies,and periodic reporting of compliance and performanceshould be in place. As part of Standard &Poor’s analysis, we may request a discussion of theinvestment practices and how they follow writtenor otherwise adopted policies.In general, the longer the maturity or duration ofpermitted investments—and the less liquid the securities—themore frequent the need for “mark tomarket” valuations of operating fund investments.50 Standard & Poor’s Public Finance Criteria 2007

Investment GuidelinesEligible Investment Criteria For‘AAA’ Rated Structured TransactionsThe most widespread criteria used for investment inthe secondary market relate to the category called“eligible investments.” Eligible investments arethose securities that the trust of a structured financetransaction is allowed to purchase for the managementof its cash flow.Fortunately, it is also the most stable category,rarely changing over time. At the same time, it isimportant to note that one qualifying investment,the debt obligations of the Student LoanMarketing Association (SLMA or Sallie Mae),will no longer qualify as an eligible investmentafter Sept. 30, 2008. The enactment of theStudent Loan Marketing AssociationReorganization Act will result in the gradual dissolutionof Sallie Mae’s GSE (government-sponsoredenterprise) status, which allows Sallie Maelimited access to U.S. Treasury funds. The finaldissolution date is Sept. 30, 2008. If additionalSallie Mae debt is issued, the debt must maturebefore that date. Sallie Mae debt obligations willcontinue to qualify as eligible investments forrated structured transactions until Sept. 30, 2008.Eligible investments are typically used to temporarilyhouse (usually 30 days or less) the cashIndenture Investment RestrictionsFully dependent financingsIn credit or liquidity enhanced transactions, and certain highly structured housingtransactions, remarketing proceeds and other monies used to pay bond debt service—whether trustee held or otherwise—should be invested in securities with ratingsappropriate for the rating assigned to the issue. (For further details see “PublicFinance Criteria: Review of Investment Agreements for Municipal RevenueBond Financings”).Partially dependent financingsIn transactions where certain funds may significantly contribute to the paymentof bond debt service, those funds should be invested in securities with ratingsappropriate for the rating of the issue. Other monies can be invested ininvestment-grade securities.Non-dependent financingsAll funds—whether trustee held or otherwise—should be invested ininvestment-grade securities.Dependency: Determined by the level of reliance of the issue on theperformance of the investments.Maturity: Investments should mature before they are reasonably expectedto be used, whether for scheduled debt service payments, or as a result ofredemption provisions.Ratings maintenance of investments: If rating of investment is downgraded,Standard & Poor’s assumes that the trustee, as fiduciary to holders, will actin a prudent manner. Investment downgrades may lead to bond ratingdowngrades, particularly in fully dependent financings.flows related to a transaction in low-risk, shortterminvestments. Eligible investments may also beused for certain reserve or cash collateralaccounts, where maturities may extend beyond thenext payment date. In instances where the investmentsmay be invested for up to 90 days or longer,the eligibility of investments may be furtherrestricted, as indicated below. In no case shouldthe following eligible investments have maturitiesin excess of one year. Any use other than contemplatedabove may not be appropriate for structuredfinance transactions.Investment requirements for escrow accounts forrefunded bonds are marked with an asterisk. Anysecurity used for defeasance must provide for thetimely payment of principal and interest and cannotbe callable or prepayable prior to maturity or earlierredemption of the rated debt (see “PublicFinance Criteria: Defeasance”).The following investments are eligible for ‘AAA’rated transactions:(1*) Certain obligations of, or obligations guaranteedas to principal and interest by, the U.S. governmentor any agency or instrumentality thereof,when these obligations are backed by the full faithand credit of the United States. As Standard &Poor’s does not explicitly rate all such obligations,the obligation must be limited to those instrumentsthat have a predetermined fixed dollar amount ofprincipal due at maturity that cannot vary orchange. If it is rated, the obligation should not havean ‘r’ suffix attached to its rating. For non-defeasanceinvestments, interest may either be fixed orvariable. If the investments may be liquidated priorto their maturity or are being relied on to meet acertain yield, additional restrictions are necessary.Interest should be tied to a single interest rate indexplus a single fixed spread (if any) and should moveproportionately with that index. These investmentsinclude but are not limited to:■ U.S. Treasury obligations (all direct or fully guaranteedobligations);■ Farmers Home Administration Certificates ofBeneficial Ownership;■ General Services Administration participationcertificates;■ U.S. Maritime Administration guaranteed TitleXI financing;■ Small Business Administration guaranteed participationcertificates and guaranteed poolcertificates;■ GNMA guaranteed MBS and participation certificates(defeasances only);■ U.S. Department of Housing and UrbanDevelopment local authority bonds; andwww.standardandpoors.com51

Cross Sector Criteria■ Washington Metropolitan Area Transit Authorityguaranteed transit bonds.(2) Federal Housing Administration debentures.(3*) Certain obligations of government-sponsoredagencies that are not backed by the full faithand credit of the United States. As Standard &Poor’s does not explicitly rate all these obligations,they must be limited to instruments that have a predeterminedfixed dollar amount of principal due atmaturity that cannot vary. If it is rated, the obligationshould not have an ‘r’ suffix attached to its rating.For non-defeasance investments, interest mayeither be fixed or variable. If the investments maybe liquidated prior to their maturity, or are beingrelied on to meet a certain yield, additional restrictionsare necessary. Interest should be tied to a singleinterest rate index plus a single fixed spread (ifany) and move proportionately with that index.These investments are limited to:■ Federal Home Loan Mortgage Corp. (FHLMC)debt obligations;■ Farm Credit System (formerly Federal LandBanks, Federal Intermediate Credit Banks, andBanks for Cooperatives) consolidated systemwidebonds and notes;■ Federal Home Loan Banks (FHL Banks) consolidateddebt obligations;■ Federal National Mortgage Association (FNMA)debt obligations;■ Student Loan Marketing Association (SLMA)debt obligations;■ Financing Corp. (FICO) debt obligations; and■ Resolution Funding Corp. (REFCORP)debt obligations.(4) Certain federal funds, unsecured certificatesof deposit, time deposits, banker’s acceptances, andrepurchase agreements having maturities of notmore than 365 days, of any bank, the short-termdebt obligations of which are rated ‘A-1+’ byStandard & Poor’s. In addition, the instrumentshould not have an ‘r’ suffix attached to its ratingand its terms should have a predetermined fixeddollar amount of principal due at maturity thatcannot vary or change. Interest may either be fixedor variable. If the investments may be liquidatedprior to their maturity or are being relied on tomeet a certain yield, additional restrictions are necessary.Interest should be tied to a single interestrate index plus a single fixed spread (if any) andshould move proportionately with that index.(5) Certain deposits that are fully insured by theFederal Deposit Insurance Corp. (FDIC). Thedeposit’s repayment terms have a predetermined fixeddollar amount of principal due at maturity that cannotvary or change. If rated, the deposit should nothave an ‘r’ suffix attached to its rating. Interest mayeither be fixed or variable. If the investments may beliquidated prior to their maturity or are being reliedon to meet a certain yield, additional restrictions arenecessary. Interest should be tied to a single interestrate index plus a single fixed spread (if any) andshould move proportionately with that index.(6) Certain debt obligations maturing in 365 daysor less that are rated ‘AA-’ or higher by Standard &Poor’s. The debt should not have an ‘r’ suffixattached to its rating and by its terms have a predeterminedfixed dollar amount of principal due atmaturity that cannot vary or change. Interest can beeither fixed or variable. If the investments may beliquidated prior to their maturity or are being reliedon to meet a certain yield, additional restrictionsare necessary. Interest should be tied to a singleinterest rate index plus a single fixed spread (if any)and should move proportionately with that index.(7) Certain commercial paper rated ‘A-1+’ byStandard & Poor’s and maturing in 365 days orless. The commercial paper should not have an ‘r’suffix attached to its rating and by its terms havea predetermined fixed dollar amount of principaldue at maturity that cannot vary or change.Interest may either be fixed or variable. If theinvestments may be liquidated prior to their maturityor are being relied on to meet a certain yield,additional restrictions are necessary. Interestshould be tied to a single interest rate index plus asingle fixed spread (if any) and should move proportionatelywith that index.(8) Investments in certain short-term debt ofissuers rated ‘A-1’ by Standard & Poor’s may bepermitted with certain restrictions. The totalamount of debt from ‘A-1’ issuers must be limitedto the investment of monthly principal andinterest payments (assuming fully amortizing collateral).The total amount of ‘A-1’ investmentsshould not represent more than 20% of the ratedissue’s outstanding principal amount and eachinvestment should not mature beyond 30 days.Investments in ‘A-1’ rated securities are not eligiblefor reserve accounts, cash collateral accounts,or other forms of credit enhancement in ‘AAA’rated issues. In addition, none of the investmentsmay have an ‘r’ suffix attached to its rating. Theterms of the debt should have a predeterminedfixed dollar amount of principal due at maturitythat cannot vary. Interest may either be fixed orvariable. If the investments may be liquidatedprior to their maturity or are being relied on tomeet a certain yield, additional restrictions arenecessary. Interest should be tied to a singleinterest rate index plus a single fixed spread (ifany) and should move proportionately with thatindex. Short-term debt includes commercialpaper, federal funds, repurchase agreements,52 Standard & Poor’s Public Finance Criteria 2007

Investment Agreements For Municipal Revenue Bond Financingsunsecured certificates of deposit, time deposits,and banker’s acceptances.(9) Investment in money market funds rated‘AAAm’ or ‘AAAm-G’ by Standard & Poor’s.(10*) Stripped securities: principal-only stripsand interest-only strips of noncallable obligationsissued by the U.S. Treasury, and REFCORP securitiesstripped by the Federal Reserve Bank ofNew York.(11) Any security not included in this list may beapproved by Standard & Poor’s after a review ofthe specific terms of the security and its appropriatenessfor the issue being rated.In addition to the permitted investments listedabove, guaranteed investment contracts are alsoeligible investments subject to certain terms andconditions. (See “Public Finance Criteria:Review Of Investment Agreements ForMunicipal Revenue Bond Financings” and“Public Finance Criteria: Joint Support ToInvestment Agreements”). ■Investment Agreements ForMunicipal Revenue Bond FinancingsAnalysis of municipal revenue bonds ofteninvolves evaluating the security or pledged collateral,and the investments. Issuing entities thathave operating revenues and other noninvestmentsources to provide ample protection against defaultsare usually exempt from formal restrictions on permittedinvestments in the ratings analysis (see“Public Finance Criteria: Investment Guidelines”).In transactions where full and timely payment ofdebt service is dependent on investment income,however, a more structured approach is necessary.Very often, these investments take the form ofinvestment agreements, and many bond issues willhave as many as three different funds invested:■ A short-term acquisition, proceeds or constructionfund (where the bond proceeds are heldprior to expenditure);■ The debt service reserve fund; and■ The revenue or “float” fund (where monthlyreceipts are held).These three funds can be held in one or moreagreements.Those agreements that are deemed necessary forfull and timely payment of debt service are subjectfor review as part of the ratings process. Reviewof an investment agreement involves considerationof the strength of the provider and the structure ofthe agreement.Dependent RatingThe first aspect of Standard & Poor’s Ratings Servicesassessment of the investment contract is the financialstrength of the provider. The provider’s certificate ofdeposit rating is used, and is an important componentof the bond rating because the transaction is dependentupon performance of the investment provider fora portion of the revenues used to pay bondholders. Inmost cases, the long-term rating of the provider mustbe as high as the rating on the bonds. Note the eligibilityof contracts to be jointly provided by more thanone provider (see “Public Finance Criteria: JointSupport to Investment Agreements”).For highly rated transactions, two sets of ratingguidelines can be used. The first set of guidelinesapplies to issuers seeking ‘AAA’ or ‘AA’ ratings onbonds with investment contracts:■ For investments with terms of less than oneyear,the provider maintains a short-term ratingof ‘A-1+’;■ For terms of at least one year but less than threeyears, the provider maintains a long-term ratingof ‘AA-’ and a short-term rating of ‘A-1+’; and■ For terms of three years or more, the providermaintains a long-term rating of at least as high asthe long-term rating on the bonds.The second set of guidelines extends the acceptableproviders for transactions rated in the ‘AAA’ or ‘AA’categories, for agreements with terms of three yearsor more, to include providers with both a long-termrating of at least ‘AA-’ and a short-term rating of‘A-1+’. To benefit from this, issuers must have legalprovisions in the investment contract should theprovider’s rating fall below either of the two benchmarks.This ensures that a credit cliff does not occurand the rating on the bonds can be preserved despitea potential downgrade of the investment agreementprovider below the required threshold. Upon adowngrade below ‘AA-’ or ‘A-1+’, the legal provisionsunder the investment contract should requirethe provider to do one of the following:www.standardandpoors.com53

Cross Sector Criteria■ Substitute to a provider with a rating of at least‘AA-/A-1+’ willing to offer substantially similarrates and terms as the original agreement;■ Secure credit enhancement to the investmentagreement from a provider rated at least‘AA-/A-1+’;■ Collateralize the agreement to a level sufficient tomaintain the rating on the bonds; or■ Terminate the agreement, only with the bondissuer’s consent, and payment to the issuer of allinvested principal plus accrued interest to thetermination date.Any of the provisions above should be resolvedwithin 30 days of the downgrade of the provider.The provision to terminate the agreement withissuer consent (fourth option) above is only acceptableto the extent the related bond document stipulatesthat in the event the issuer elects to terminatethe investment agreement, the issuer takes appropriaterating notification actions. Standard & Poor’sneeds to review the alternate investment(s) for consistencywith the original financing, and the abilityof the alternate investment(s) to support the ratingon the bonds. In all instances, Standard & Poor’swill need to be notified to verify that one of theremedies will be utilized.These guidelines shall not apply unless theprovider, under the investment agreement, agrees toeffect any of the (first through third options) aboveat its own cost, unless the termination option(fourth option) above is accepted by the issuer.Exceptions may occur only in certain instanceswhere a substantial number of investment agreementswith multiple providers lead to more thanample liquidity at a given rating level, as may bethe case with some state housing finance agencyissues under parity bond resolutions or state revolvingfund programs. A likely scenario for terminationto occur would be if market conditions resultin reinvestment rates equal to or higher than that ofthe original agreement thereby providing sufficientinvestment earnings for the bond issue.Unlike parity resolutions, stand alone issues typicallyhave minimal excesses built into the structureand therefore are less likely to have the financialcapacity necessary to withstand the consequences ofa drop in prevailing interest rates—possibly requiringan upfront payment to enter into a substituteinvestment agreement providing similar rates andterms to the original agreement, or accepting alower reinvestment rate. Without this “make-wholeprovision”, the investment agreement would not beeligible to be used for bonds rated higher than theprovider’s rating.Standard & Poor’s views the performance of theprovider under the make-whole provision as integralto preserving the bond rating. If it is assumedthat prevailing interest rates have fallen and thatthe termination option is not practical, the agreementwill continue using one of the remaining threeoptions. The collateralization option requires notonly sufficient levels and types of collateral, butalso appropriate legal opinions that protect the collateralin the case of an insolvency of the provider(see below). The remaining options of finding asubstitute provider or enhancement for the agreementmay require costs for the provider dependingon market conditions.Following either of these sets of guidelines, bondissues rated in the ‘AAA’ and ‘AA’ categories mayutilize investment agreements with eligibleproviders with ratings as low as ‘AA-/A-1+’. Issuersshould recognize that use of lower rated providersinvolves requirements that should be considered atthe bidding stage so that the potential providers areaware of the additional requirements that make theagreements acceptable for rated transactions. Notethat this criteria only applies to transactions ratedin the ‘AAA’ and ‘AA’ categories. On transactionsdependent on investment earnings, for bonds rated’AA-’ and below, Standard & Poor’s applies astraight weak-link approach, whereby the rating ofthe bonds cannot be any higher than that of thelowest rating of any dependent provider.In addition, transactions structured to have theinvestment agreement as the only security for thebonds, such as an escrow, cannot benefit from thiscriteria, as the bonds are solely dependent uponpayment from the investment agreement provider. Ifthere is no additional security for the bonds, therating of the bonds is capped at the rating of theinvestment agreement provider.General TermsThe second aspect reviewed is the structure of theagreement to ensure it works appropriately with themechanics of the financing. Standard & Poor’sreviews the general terms of the investment contractfor consistency with the legal documents and theassumptions under the cash flows. Standard & Poor’swill compare the interest rate under the investmentagreement, basis for calculating interest, the interestaccrual dates and payment dates under the contract.Additionally, the investment agreement’s maturitydate should match the maturity date of the applicablefund, or the cash flows should model Standard &Poor’s then-current minimum reinvestment assumptionsafter the investment agreement maturity date.To the extent that investment agreements areobtained subsequent to the initial rating, Standard &Poor’s will review all outstanding agreements eachtime the rating is reviewed to assure that the terms ofthe agreements are appropriate for the bond rating.54 Standard & Poor’s Public Finance Criteria 2007

Joint Support To Investment AgreementsWithdrawal/DepositsCertain bond financings present uncertainty giventhe possibility of prepayment of the collateral securingthe bonds. To address the risks of the frequencyand size of the prepayments, investment agreementproviders, particularly in housing bond transactions,are increasingly becoming more restrictive inthe amount of funds they will accept, the length oftime they will hold such amounts, and the use oflockout periods in an effort to increase the predictabilityof the investments held with theproviders. As a result, investment agreements oftenhave limitations with respect to deposit and durationof the investment. Standard & Poor’s willreview the contract to ensure that the investmentagreement and cash flows are consistent. To theextent the agreement places limits on the amount ofthe investment, for example, the cash flows shouldthen model these limits by reflecting amounts abovethe limits held at minimum reinvestment ratesrather than the investment agreement rate.Additionally, certain bond structures, such asescrows, may include unscheduled bond paymentevents that require the trustee to withdraw allfunds from the investment agreement prior to theexpiration date. If, for example, bond proceeds areheld invested during an escrow period, and thestructure calls for the investment agreement tofund a mandatory redemption of the bonds shouldthere be a failed remarketing, the trustee wouldhave to withdraw all of the funds with limitednotice to the provider. Standard & Poor’s firstreviews the agreement for any lockout provisionsthat could prevent the withdrawal of funds. Theinvestment agreement will also likely include awithdrawal notice provision which Standard &Poor’s reviews to verify the availability of funds topay bondholders when necessary and in accordancewith the legal documents. Remedies shouldbe in place for any inconsistencies between thebond documents and the investment agreement.Grace PeriodWhile the rating of the provider takes into accountthe likelihood of the provider to pay under the contract,the default section of the investment agreementmay incorporate a grace period that may notbe factored into the payment structure of thebonds. Investment agreement providers typicallybuild in a grace period to account for potentialadministrative delays. The provider is not deemedto be in default unless payment is not made whendue and after a specified grace period, such as onebusiness day after which the Trustee gives notice tothe provider. Note that investment agreementsinvolving guarantees may also have additionalstructural notice periods that can affect when fundsare received. The structure should allow for thesegrace periods by adjusting the investment agreementinterest payment dates to compensate andtaking into account interest accrual periods.CollateralFollowing a downgrade event, the provider may optto post collateral so as to maintain the rating on thebonds. Standard & Poor’s determines the amountof collateral posted on a case-by-case basis at thetime of posting and based on the type of collateralposted. In addition, the collateral must be pledgedto the trustee and Standard & Poor’s should receivea legal opinion stating that in the event of theprovider’s insolvency, the trustee will be able to terminatethe agreement and sell the collateral withoutregard to the insolvency of the provider. ■Joint Support To Investment AgreementsStandard & Poor’s Ratings Services criteria forjointly supported obligations, whereby eachobligor is fully responsible for the entire obligation,may also be applied to investment agreements.These agreements provide full or partial credit supportin public finance transactions, and are importantfactors in determining the bond rating,especially in housing. Investment agreements alsoprovide reinvestment of various funds of municipalissuers, such as bond proceeds.As with any jointly supported bond, the multipleproviders must each be fully and independently obligatedfor the entire amount, and all terms and conditionsof the obligation under the investmentagreement. Therefore, a default on the obligationunder the investment agreement would only occur ifwww.standardandpoors.com55

Cross Sector Criteriathe multiple providers involved defaulted. The foundationfor the criteria is that the risk that the multipleproviders will default is less than the risk that eitherwill. As a result, the credit quality of the investmentagreement may be higher than the rating on eitherprovider (see “Criteria Update: Joint Support CriteriaRefined,” RatingsDirect, Feb. 3, 2006). Standard &Poor’s will examine each provider’s agreement toensure legal comfort with the type of obligation provided.Payments under the agreements should bemade directly to the bond trustee.The application of the joint support criteria toinvestment agreements creates additional flexibility,particularly for ‘AAA’ rated transactions, byexpanding the pool of potential investment agreementproviders. Strong credit quality could bederived like other jointly supported transactions,such as those with both a primary obligor and a letter-of-credit(LOC) supporting the bonds. The onlydistinction is that the jointly supported obligation isan investment contract rather than the obligation tomake payment of bond debt service.The rating criteria for investment agreements inbond transactions are outlined in Standard &Poor’s current criteria (see “Public FinanceCriteria: Review of Investment Agreements forMunicipal Revenue Bond Financings”). To qualifyfor a bond rating at a certain level, the jointlyderived rating of the providers should meetStandard & Poor’s investment rating guidelines.Pursuant to the joint support criteria, Standard &Poor’s will apply the appropriate reference tablebased on the correlation between providers. To theextent the investment agreement is provided jointlyby two banks, for example, Standard & Poor’swould use the medium correlation reference tablebecause both providers are in the same industry(and assuming they are not in the same region). Ifone bank was rated ‘A-’ and the other rated ‘AA’,the rating on the jointly supported investmentagreement would be evaluated at ‘AAA’ therebyqualifying the investment agreement for use in a‘AAA’ rated transaction. The same approach couldbe applied to short-term ratings by converting theindicated long-term rating of the providers into thecorresponding short-term rating. It should be notedthat monoline bond insurers remain ineligible forjoint-support criteria, reflecting the significant correlationbetween the insurer and its portfolio ofinsured obligations.Rating DependencyUsing investment agreements in rated bond transactionsleads to the possibility of a change in the bondrating due to a change in the investment agreementprovider’s rating. Like any rating which is dependenton its parts being of at least equal credit quality,with jointly supported investment agreements, thebond rating becomes dependent on the jointlyderived rating of the providers, and the correlationtable used to derive the joint rating. Due to thenature of joint support, a change in the rating ofone provider, however, does not necessarily lead to achange in the rating of the bonds. Using the exampleof the rated obligors above, if the rating on the‘AA’ entity was lowered to ‘AA-’, the rating on thebonds could be affirmed because the jointly derivedrating of the providers would still be ‘AAA’. If therating on the ‘A-’ entity was then lowered to ‘BBB+’,however, the jointly derived rating of the providerswould be ‘AA+’ and the rating on the bonds may belowered, unless remedies are taken to preserve therating. Obviously, changes in other credit factorscould separately affect the rating.Downgrade TriggersJointly supported agreementsShould the bond issuer want to preserve the bondrating in case of any adverse change to the creditquality of one of the investment agreementproviders, Standard & Poor’s will evaluate thedowngrade triggers of the agreement(s) to confirmthey are at a rating level consistent with our currentcriteria and incorporate the jointly derived rating.Remedies may be in place to preserve the bond rating—forexample, the agreement could provide thata substitute provider with a rating sufficient tomaintain the rating on the bonds will be obtained.If similar remedies are not included, the rating onthe bonds will likely drop to reflect the credit qualityof the jointly supported investment agreement.Following a rating change of one provider, if thecredit quality of the jointly supported agreement isadversely affected, the agreement should allow upto 10 business days to effect a remedy. If a remedysufficient to preserve the bond rating is not completed,the bond rating will be lowered to the levelof the jointly derived rating of the providers.Non-jointly supported agreementsThe application of joint support criteria may alsobe used as a potential remedy to preserve the bondrating if a provider’s rating is lowered in all investmentagreements, whether or not they initially usejoint support. If a provider’s rating is loweredbelow the level required for the bond rating, theagreement can specify that the provider enter intoan agreement with another provider that will allowapplication of the joint support criteria in a mannerthat will maintain the then current rating on thebonds. The multiple providers must each be fullyand independently obligated for the entire amountand all terms and conditions of the obligationunder the investment agreement. ■56 Standard & Poor’s Public Finance Criteria 2007

DefeasanceDefeasanceStandard & Poor’s Ratings Services, on request,rates legally defeased bonds and certain economicallydefeased bonds. A legal defeasance occurswhen the security lien of an indenture is released,and the debt has been legally satisfied even thoughthe debt may not have been formally retired. In aneconomic defeasance, an issuer sets aside sufficientfunds to satisfy debt obligations “in substance,” butthe debt is not legally discharged. The following criteriaapply for both insured and uninsured bonds.Legal DefeasanceIn a legal defeasance, the trust indenture is replacedby an escrow deposit agreement, which governs theescrow of funds. The escrow has to be verified toensure its ability to make full and timely debt servicepayments. Defeased bonds are eligible for ‘AAA’ratings if the transaction meets Standard & Poor’scriteria that addresses the legal structuring andcredit quality of the escrow. Additional criteriamust be met if a Forward Purchase Contract isincluded (see “Public Finance Criteria: ForwardPurchase Contracts and ‘AAA’ Defeased Bonds”).Economic DefeasanceEconomically defeased bonds of municipal issuersand conduits may receive ‘AAA’ ratings; however,typically, the highest rating assignable to the economicallydefeased debt of entities subject to Chapter 7or Chapter 11 of the U.S. Bankruptcy Code or public-purposeissuers (such as private colleges and universities,hospitals, not-for-profit corporations, orother charitable institutions) is the existing rating onthe obligor’s long-term debt unless legal comfortregarding bankruptcy issues is provided.Legal Defeasance CriteriaStandard & Poor’s reviews the following documentationto analyze legally defeased transactions.Escrow deposit agreementStandard & Poor’s reviews the escrow agreementto determine whether it establishes an irrevocabletrust and has provisions addressing the followingcriteria:■ The escrow funds are invested in noncallable eligiblesecurities (see “Public Finance Criteria:Investment Guidelines”) that mature in amounts■■■■■■sufficient to make full and timely debt service payments.The escrow agreement should specify thatreinvestment and substitution of the escrowedsecurities also must be in eligible securities.All money and earnings are pledged to the paymentof the refunded bonds.Provisions intended to protect the integrity of theescrow are reviewed, such as limitations on theactive management of the escrow, whether excessearnings and residuals revert to the issuer onlyafter the final principal and interest payment hasbeen made to bondholders and that neither theissuer nor the obligor are responsible for fundingfinancial shortfalls in the escrow.If excess earnings or residuals are allowed to beremoved from the escrow prior to maturity orearlier call date(s), Standard & Poor’s will lookto the rating or bankruptcy remote status of theentities involved in substitution and reinvestmentprocedures. Excess or residual earnings shouldonly be removed from the escrow after a bondpayment date and upon receipt of a report froman independent third-party accountant that verifiesthat the remaining funds will be sufficient topay debt service in a timely manner.Substitution of escrowed securities may necessitateupdated cash flow verification reports. If thesubstitution is due to the maturity of theescrowed security, then substitution into othereligible escrow obligations will not require anupdated verification report. But if the substitutionis of a non-maturing escrowed security, thenthe substitution should be accompanied by anindependent third-party accountant’s report tothe trustee verifying the adequacy and accuracyof the new cash flows.If not held uninvested, interest earnings should bereinvested in eligible investments. However, wewill not rely on reinvestment income in calculatingthe sufficiency of the escrow for principal andinterest payments to bondholders.Only entities Standard & Poor’s considers bankruptcyremote, escrow agent, or trustee maydirect reinvestment and substitution.www.standardandpoors.com57

Cross Sector Criteria■ Payment of fees to the trustee, escrow agent,accountant or issuer may be made from theescrow only if they are provided for in the cashflow statement and the escrow deposit agreement.Defeasing variable rate debt presents a unique situationas the interest rate on the bonds in escrowcontinues to reset, and the bondholders’ put optionmay not be extinguished when the indenture is discharged.For additional criteria related to legallydefeased variable rate debt, see the “Defeasance”section of “Public Finance Criteria: LOC-BackedMunicipal Debt”.Finally, Standard & Poor’s should be notified ofany substantive changes in the structure of thetransaction including, among other things, enteringinto a forward purchase contract or changing thedefinition of eligible securities.Cash flow verificationA report provided by a third-party accounting firmthat verifies the accuracy, adequacy, and timelinessof the funds escrowed to pay bondholders isreviewed. The report should verify that the anticipatedreceipts from escrow securities would be sufficientto pay principal and interest when due.Legal opinionsStandard & Poor’s may look for legal comfort oncertain issues:■ For public-purpose and Bankruptcy Code issuers,a legal defeasance opinion that indicates that thelien of the prior indenture or resolution has beendischarged and released.■ If cash contributions, rather than bond proceeds,fund all or part of the escrow an opinion indicatingthat, in the event of an insolvency of the contributor,the escrow fund and any payments onthe defeased bonds would not be recoverable as apreference pursuant to Section 547(b) of theBankruptcy Code.■ A bankruptcy opinion if excess earnings or residualsare allowed to be removed from the escrowprior to maturity or earlier call date(s) and theentity may be involved in substitution and reinvestmentprocedures.Standard & Poor’s does not require legal defeasanceor preference opinions in connection with thedefeasance of bonds issued by entities deemedmunicipalities (states, counties, or cities) that areeligible to file a bankruptcy petition under Chapter9 of the Bankruptcy Code.Economic Defeasance CriteriaStandard & Poor’s reviews the following documentationto analyze economically defeased transactions:■ Escrow deposit agreement: The criteria are identicalto those listed above under legal defeasance.■ Cash flow verification: The criteria are identicalto those listed above under legal defeasance.■ Legal opinions: Issuers typically fall into one offour categories—-municipal, conduit, bankruptcycode, and public-purpose issuers. The legal opinionsnecessary to analyze an economicallydefeased issue are outlined below for each type ofissuer and allow Standard & Poor’s to assess thelikelihood that an issuer will file or would beinvoluntarily filed under the Bankruptcy Code.Municipal issuersFor those issuers whose status as a “municipality”under Chapter 9 of the Bankruptcy Code is uncertain,an opinion is requested to verify whether theissuer is a municipality eligible to file underChapter 9 of the Bankruptcy Code.ConduitsConduits typically are municipally sponsoredorganizations, such as housing, health care, or economicdevelopment authorities. Standard & Poor’shas determined that conduits have little incentive tofile for bankruptcy protection. In cases where alegal defeasance opinion cannot be provided, but arating of ‘AAA’ is desired, a bankruptcy opinion isrequested to address cases where a non-bankruptcyremotethird party deposits funds through a conduitto defease bonds.Bankruptcy Code issuers (Chapter 7 or 11)Standard & Poor’s will look for legal comfort thatin an insolvency of the depositor, the escrow fundsand any payments on the defeased bonds would notbe recoverable as a preference under Section 547(b)of the Bankruptcy Code; will not be subject toautomatic stay under Section 362(a) of theBankruptcy Code; and would not be consideredpart of the estate of the depositor under Section541 of the Bankruptcy Code in order for the defeasancerating to be higher than the existing rating onthe obligor’s long-term debt.Public-purpose issuersPublic-purpose issuers are entities that are not consideredmunicipalities and are not “monied, business,or commercial corporations” under Section 303(a) ofthe Bankruptcy Code. These include private collegesand universities, hospitals, not-for-profit corporations,or other charitable institutions. Although theseentities are not subject to involuntary filing under theBankruptcy Code, Standard & Poor’s believes thatthe possibility of a voluntary filing exists. Therefore,the highest rating that can be assigned to the economicallydefeased debt of these type of issuers is the58 Standard & Poor’s Public Finance Criteria 2007

Defeasanceexisting rating on the obligor’s long-term debt unlessStandard & Poor’s receives legal comfort on thebankruptcy concerns outlined above.If these opinions cannot be provided, the highestrating that can be achieved is the long-term ratingon the depositor.Standard & Poor’s will not rate economicallydefeased debt for corporations, partnerships, orother similar issuers higher than such entities’long-term rating. Although the entity has setaside sufficient funds to satisfy the obligation,the debt has not been legally discharged and,therefore, in the event of an insolvency of suchentity, the escrow funds may be considered partof the bankruptcy estate, and payments to thebondholders may be interrupted. If a special purposeentity (SPE) that meets Standard & Poor’sSPE criteria is used and the appropriate bankruptcyopinions are delivered, a higher ratingmay be achievable. ■www.standardandpoors.com59

Tax-Secured DebtIntroduction To Tax-Secured DebtGO bonds generally are regarded as the broadestsecurity among tax-secured debt instruments.GO bonds effectively create a link between publicand personal debt: a homeowner unable to pay hisproperty taxes will forfeit his house just as surely asif he could not pay his mortgage, and an unlimitedtaxGO pledge would enable a trustee to invokemandamus to force the issuer to raise the tax rateas much as necessary to pay off the bonds. GObonds have other strengths as well: the property taxtends to be a steady and predictable revenue sourcefor municipalities, and when a vote is required toissue them, bondholders have some indication oftaxpayers’ willingness to pay.There is a broad range of security pledges amongtax-secured bonds. For example, there are unlimited-andlimited-tax GOs. Moral obligation bondsfall short of a full-faith and credit obligation, offeringa best efforts pledge of the issuer (generally astate) to seek appropriations when needed. Leasesare another form of obligation, whereby timelypayment of principal and interest depends onannual appropriations by the issuer. Municipalnote issues are divided into two major categories,bond anticipation notes (BANs) and cash flownotes, requiring different rating approaches. BANsare issued for capital purposes and generallyrequire the issuer to access the capital markets tosell long-term bonds to retire them. Tax and revenueanticipation notes (TRANs) are short-termobligations of an issuer, due within one to threeyears of the date of issuance, and often used forannual cash flow borrowing.Special tax and special districts come in a widevariety of forms and powers. Obligations are generally“tax-secured,” but special tax and special districts’ability to raise taxes is often restricted, and isoften reliant on future tax-receipts growth. Specialtax debt includes security types such as sales, gas,or hotel taxes; while special districts are oftensecured by special assessments, tax increment, orother types of revenue pledges. In the followingpages, Standard & Poor’s examines in detail thesecurity features, rating approach, and documentationrequirements for these various types of taxsecureddebt. ■GO DebtWhen a state or municipal issuer sells a generalobligation (GO) bond, the issuer pledges itsfull faith and credit to repay the financial obligation.Unless certain tax revenue streams are specificallyrestricted, the GO issuer frequently pledges allof its tax-raising powers. Typically, local governmentssecure the obligation with their ability to levyan unlimited ad valorem property tax; state governments,which have different tax structures, usuallypledge unrestricted revenue streams.GO bonds remain essential financing instrumentsof tax-supported capital projects. Examining fourbasic analytical areas enables Standard & Poor’sRatings Services to assess the capacity and willingnessof municipal governments to repay tax-secureddebt. Those areas are:■■■■Economy,Financial performance and flexibility,Debt burden; andManagement.Economic BaseThe economic base is one of the most critical elementsin determining an issuer’s rating. It incorporateslocal and national economic factors andtrends. The foundation of an entity’s fiscal health isits economy. Financial growth prospects andvolatility of major revenue sources depend on theperformance of the local economy, as do the affordabilityand range of services delivered by a government.An issuer’s geography and proximity totransportation networks, cities, and markets play a60 Standard & Poor’s Public Finance Criteria 2007

GO Debtkey role in economic development. The infrastructureof an area, including the road network, utilitysystems, and transportation facilities, will also beimportant. These two areas provide backgroundabout how a specific economy has developed todate, but also provide information on futuregrowth prospects.Demographic characteristics factor heavily intoeconomic analysis. The population base is analyzedin terms of age, education, labor skills and competitiveness,and wealth and income levels, and howthese factors are changing over time. Demographicanalysis also considers the impact of annexationsand the effect of migration patterns. Wealth characteristicsare a highly critical element of a demographicreview. High wealth and incomecharacteristics are viewed very favorably and cancontribute to superior debt-repayment capabilities.Common ratios used to analyze economic factorsinclude per capita effective buying income, whichmeasures resident incomes net of personal incometax and non tax payments and median householdeffective buying income, which measures after taxincome on a household basis.An entity’s tax base is initially evaluated for size,structure, and diversity. Assessed-and market-valuationtrends are analyzed historically, as is buildingpermitactivity. The tax base composition isreviewed to identify proportionate contributionsfrom residential, commercial, and industrial taxrevenuesources. To determine the degree of concentration,the leading taxpayers are profiled andassessed for their direct and indirect effects on thelocal economy. If a tax base is concentrated, ineither taxpayer or employment sectors, there maybe a vulnerability to any changes in one or a fewtaxpayers’ assessments, especially when propertytaxes comprise a large portion of the revenue base.Significant changes in the tax base are analyzed todetermine whether the causes are structural orcyclical. Common ratios used by Standard & Poor’sto evaluate the tax base include total market valueand market value per capita.The composition, output, and diversity of theemployment base are prime considerations in evaluatingeconomic strength. The employment base providesthe primary growth engine of a communityand can be an attraction or a deterrent for continuedeconomic development and viability.Specifically, the factors Standard & Poor’s analyzesinclude, but are not limited to:■ The industry mix and employment by sector toidentify diversification trends or structuralchanges in the economy over time. Specifically,contributions from the manufacturing, services,trade, construction, government, health care,higher education and agriculture sectors and howthese have changed over time relative to nationaland state trends;■ Concentration in major employers or reliance onparticular industries;■ Employer commitment to the community—importance of local facilities and employees tothe overall strategy of local employers, business-developmentplans, age of plant, andindustry prospects;■ Unemployment patterns and labor force growth,to gauge the cyclically of the underlying base;■ The regional patterns of employment and growthto the extent that a municipality participates in aregional economy; and■ The level of retail sales as well as growth trendsover time, particularly when communities rely onsales tax revenues.Specific comparisons of the general factors outlinedabove are made with available economic data.Where appropriate, these data also are comparedwith metropolitan statistical area (MSA), state, andnational data. Historical trends and their likelydevelopment are much more valuable than datacomparisons for a specific point in time.Generally, entities with higher income levels anddiverse economic bases have superior debt-repaymentcapabilities, reflecting better protection fromeconomic changes or unexpected volatility than othercommunities. Nevertheless, a strong economy doesnot always ensure a strong ability to meet debt payments.It is extremely important for an issuer to beable to capitalize on its primary economic strengthsin terms of revenue collection, leading to anotherhighly critical factor in credit evaluation: the financialmanagement and performance of an entity.Financial IndicatorsFinancial analysis involves several areas:■ Accounting and reporting methods;■ Revenue and expenditure structure and patterns;■ Annual operating and budgetary performance;■ Financial leverage and equity position;■ Budget and financial planning; and■ Contingent financial obligations, such as off-balancesheet debt, pension liabilities and otherpost-employment benefits.An analysis of these factors will present a clearindication of the financial strengths and weaknessesof an issuer. Such analysis also will provide theframework for judging capacity to manage economic,political, and financial uncertainties.The first important variable in judging financial performanceis the method of accounting and financialreporting. Based on the guidelines of Generallywww.standardandpoors.com61

Tax-Secured DebtAccepted Accounting Principles (GAAP), Standard &Poor’s assesses an entity’s financial reports. Emphasisis placed on the government’s primarygovernment/major funds (general, debt-service, andspecial-revenue funds), which under GASB Statement34 are now called fund financial statements and itsgovernment-wide statements, which provide a broadoverview that provides an all-encompassing view ofthe government’s finances.Further, Governmental Accounting StandardsBoard (GASB) interpretations of accounting rulingsare considered in evaluating the organization offunds, accruals, and other financial reporting methods.GAAP reporting is considered a creditstrength, and the ability to meet the GovernmentFinance Officers Association’s (GFOA) Certificateof Conformance reporting requirements also isviewed favorably. Enhancing public disclosure is agovernment’s Comprehensive Annual FinancialReport (CAFR), which includes significant financialdata and various statistical data to supplement theaccounting statements.Issuers are expected to supply adequate and timelyfinancial reports. Financial reports prepared byan independent certified public accountant are preferred.Lack of an audited financial report preparedaccording to GAAP could have a negative impacton an issuer’s rating, since questions about reportingwill be raised. If state agencies or other internalgovernment units prepare financial reports,Standard & Poor’s is interested in any deviationfrom GAAP standards and the independence of theauditors preparing the reports.Operating-account analysis includes an examinationof operating trends, focusing on the structureof revenue and expenditure items, primarily withinthe primary/major fund category including generalfund and debt-service funds. If other funds are taxsupported or include revenues related to generalgovernment purposes, they also have relevance indeveloping a complete understanding of financialperformance.Diverse revenue sources are preferable, as theycan help to strengthen financial performance andenhance stability. The use of fees not only createsnew revenue streams, but also places the burden formunicipal services on the users of the services.Special taxes, such as sales or excise taxes, allow forfurther revenue diversification. Although a balancedcomposition of revenues gives an issuer the flexibilityto meet all of its financial obligations, it does notnecessarily protect against the impact of a generaleconomic decline. For example, if a government’stax collections depend on several major revenuesources, the direct and indirect effects of an economicdownturn can be broad enough to affect revenueperformance. Revenue sources are examined over athree-to five-year period, with particular focus onunusual patterns in revenue performance that couldlead to significantly different financial performancein the future.Similarly, expenditure composition and stabilityare analyzed in the context of revenue patterns.Large expenditure items are identified and examinedto determine if continued expenditure growthcould endanger existing services or require additionalbudget actions to maintain balance. To theextent that certain spending items are extraordinaryor nonrecurring, the effect on long-term financialperformance is discounted; conversely mandatedexpenses can limit flexibility and decision-making.Discretionary spending, such as pay-as-you-go capital,is evidence of operating flexibility.The effect of any transfers among other governmentaland capital funds is considered in the reviewof financial performance. When inter-fund transferssupport the general fund and/or debt-service fund,Standard & Poor’s reviews the policy guidelinesand historical transfer practices. Volatility in transfersthat represents a deviation from past policycould be viewed as a sign of fiscal stress in both thetransferring and receiving funds.The balance-sheet examination focuses on liquidity,fund-balance position, and the composition ofassets and liabilities. In Standard & Poor’s considerationof appropriate fund-balance levels, severalvariables are important:■ The makeup and liquidity of the fund balance,particularly as related to the volatility and patternsof the revenue stream;■ The predictability of government spending;■ The availability of unencumbered reserves orcontingency funds; and■ The ability of public officials to sustain a strongfinancial position.The fund-balance position is a measure of anissuer’s financial flexibility to meet essential servicesduring periods of financial strain. Standard & Poor’sconsiders an adequate fund balance and policiesdetermining fund-balance goals to be credit strengths.A common ratio used to evaluate fund balance is theunreserved fund balance expressed as a percent ofoperating expenditures. This provides a measure ofhow much of the fund balance is not committed tospending and is available for contingencies.With the implementation of GASB Statement 34,Standard & Poor’s also evaluates issuers’ Statementof Net Assets, which measures all assets and liabilities(similar to a private sector business) and thestatement of activities, which presents how netassets have changed over the prior year. Over timeincreases or decreases in net assets provide an indicatorof how a government’s financial position is62 Standard & Poor’s Public Finance Criteria 2007

GO Debtchanging. Increases in net assets may indicate animproved overall financial position while decreasesin net assets may reflect a changing manner inwhich a government may have used previouslyaccumulated funds.The analysis of financial performance also takesinto account the role of short-term financing and itsimplications. As available cash balances decrease,cash flow difficulties can become more prominent.Nevertheless, conservative financial strategies andmanagement practices can enable an issuer to minimizecash flow difficulties.In reviewing an issuer’s cash management andinvestment practice, Standard & Poor’s considersthe types of investments, security precautions, anduses of investment income.Debt Factors And Long-Term LiabilitiesThe analysis of debt focuses on the nature of thepledged security, the debt repayment structure,the current debt-service burden, and the futurecapital needs of an issuer. Manageable debt levelsare an important consideration, since accelerateddebt issuance can overburden a municipalitywhile low debt levels may indicate under-investmentin capital facilities.Investment in public infrastructure is believed toenhance the growth prospects of the private sector.Neglecting critical capital needs may impede economicgrowth and endanger future revenue generation.Although some capital projects arediscretionary and can be deferred in difficult economicperiods, the failure to maintain existing facilitiescan create a backlog of projects. Eventually,when the backlogged projects are funded, the costmay prove burdensome to future taxpayers.In difficult fiscal situations where municipalitiesface operating deficits, some entities choose long-termfinancing of accumulated deficits as a solution.Standard & Poor’s believes that the “bonding out” offinancial problems is not a permanent cure and maycomplicate the ultimate resolution of the fiscal strain.The specific security pledged is analyzed. A GOpledge takes various forms that provide differentdegrees of strength. Unlimited ad valorem propertytaxdebt, secured by a full faith and credit pledge,usually carries the strongest security. However, inall ad valorem pledges, during a period of fiscalstress, debt service competes with essential services.Limited ad valorem tax debt, or a limited-taxpledge, carries legal limits on tax rates that can belevied for debt service. Standard & Poor’s viewsthis type of security more as a means to limit debtissuance than as a strict cap on revenues availableto retire debt.In a limited-tax situation, the tax base’s growth,the economy’s health, and the entity’s fiscal balanceposition are often more significant credit factorsthan the limited source of payment. In fact, a limited-taxbond can be rated on par with unlimited-taxbonds if there is enough margin within the tax limitto raise the levy, or if other available balances ortax revenues are available for debt service. Anenterprise system’s revenues, such as water or seweruser charges, as well as a full faith and creditpledge, secure double-barreled bonds. Taxing poweris used only if the enterprise’s revenues are insufficient.Standard & Poor’s approach is to reviewboth security pledges.GO bonds are considered self-supporting whenthe enterprise can pay debt service and operatingexpenses from its own operating revenues. Such aself-supporting enterprise could use the full faithand credit support of a municipal government withoutdiminishing the credit quality of the government’sGO debt.The debt maturity schedule can become importantin certain circumstances. Prudent use of debtdictates that the debt’s term matches the usefuleconomic life of the financed assets. An averagematurity schedule for capital projects is one inwhich 25% of the debt rolls off in five years and50% is retired in 10 years. A faster maturity schedulemay be desired to avoid increased interestcosts; however, it can place undue strain on anoperating budget. Statutory provisions governingdebt retirement are also important considerationsin evaluating payout.Standard & Poor’s looks for realistic debt limitationsthat permit an issuer to meet ongoing financingneeds. A city near its debt limit has less flexibility tomeet future capital needs, but more importantly, maybe unable to borrow money in the event of an emergency.Restrictive debt limitations often necessitatethe creation of financing mechanisms that do notrequire GO bond authorization or voter approval.Standard & Poor’s examines the community’sfuture financing needs; a capital improvement planindicating both funding needs and anticipatedfunding sources is a useful planning tool for determiningfuture borrowing needs. Municipalitiesshould regularly review their critical capital needsand schedule capital improvements for assets’ life.The history of past bond referendums is one indicationof the community’s willingness to pay forsuch improvements.Standard & Poor’s also measures the debt burdenagainst a community’s ability to repay. Three indicatorsof this ability are:■ The tax base;■ The wealth and income of the community; and■ Total budget resources.Ratios used by Standard & Poor’s to measuredebt burden include:www.standardandpoors.com63

Tax-Secured Debt■ Debt to market value, which measures overalldebt to all taxable property within the government’sjurisdiction;■ Debt per capita, which measures overall debt bypopulation;■ Debt as a percentage of personal income (whichis available on the state level but not on the locallevel); and■ Debt as a percentage of operating expenditures.Each of the first three debt burden ratios are alsomeasured net of self-supporting obligations for thepurpose of ascertaining the true debt obligationsupported by no other sources.In general, a debt burden is considered highwhen debt-service payments represent 15%-20%of the combined operating and debt-service fundexpenditures. This benchmark will vary with thestructure of government and the level of servicesthat an entity provides.Pension LiabilitiesPension liabilities remain a significant credit factorfor state and local governments. Standard & Poor’sviews pension obligations as long-term liabilitiesthat should be managed in a way that will notadversely affect the bond issuer’s ability to makedebt service payments. Although various debtinstruments may have a lien position that is seniorto pension obligations, benefit payments carry withthem a political reality that adds to any legal protections.While debt levels are usually more predictabledue to long-term capital plans and thelargely fixed-rate nature of the obligations, unfundedpension liabilities tend to be more volatile.It is important to consistently monitor the keyvariables of the issuer’s retirement systems.Accordingly, Standard & Poor’s reviews pensiontrends related to funding progress. This analysisincludes changes in assets and liabilities, fundedratios, unfunded actuarial accrued liabilities(UAAL) and the relationship of the UAAL to payroll.Pension asset valuations can change, as canactuarial liabilities. The higher contribution requirementsthat result from unfunded liabilities couldmake any preexisting fiscal stress more acute, especiallyif the increase was dramatic. Therefore,Standard & Poor’s will evaluate the sponsor’s pensionfunding strategy, and the current and projectedcost implications on its financial profile. As part ofthis analysis, Standard & Poor’s will review thetrack record annual required contributions (ARC)and the percent of the ARC made. The historicaland forecast trends in pension funding are asimportant, if not more so, than the specific liabilitylevel at a single point in time.Other Post Employment Benefits LiabilitiesGASB Statement 45 will require the disclosure ofOther Post Employment Benefits (OPEB) in a mannersimilar to pensions starting in fiscal periodbeginning after December 15, 2006. Currently,OPEB expenditures are included in a government’sgeneral fund and detailed in an audit note, withfunding generally on a pay-go basis. Under the newstatement, the liabilities attributable to OPEB andthe annual required contribution for employerswould be actuarially determined and reported.GASB Statement 45 does not require funding of theliability. From a credit standpoint, OPEB liabilitiesand funding strategies will be evaluated in a similarway to pension obligations. This analysis willinclude a review of the historical and projected paygocosts for OPEB, the newly quantified un-fundedliabilities and current funded status, and the planfor managing ongoing annual required contributions.Also, the impact of projected annual OPEBcosts on the current and future budgets will beassessed. This review would also include the legaland practical flexibility a specific government has inmanaging these obligations from both the asset andliability perspectives.Management FactorsAn understanding of the organization of governmentis critical. The powers of a municipality establishthe entity’s ability to plan for changes in thepolitical, economic, and financial environment, andthe capacity to respond in a timely fashion. Theentity’s degree of autonomy is affected by homerulepowers, as well as legal and political relationshipsbetween state and local levels of government.The range and growth potential of services providedby the entity are also examined in relation tothe capacity to provide such services. The ability ofofficials to implement timely and sound financialdecisions in response to economic and fiscaldemands can depend on the tenure of governmentofficials and frequency of elections. The backgroundand experience of key members of theadministration are important considerations if theyaffect policy continuity and the ability to reformulateplans.Financial management is a major factor in theevaluation of state and local government creditworthiness.Past performance against originalplans, depth of managerial experience, and riskprofiles of key leaders all have an impact on thebottom line.Financial Management AssessmentStandard & Poor’s analyzes the impact of financialmanagement polices and practices through the use64 Standard & Poor’s Public Finance Criteria 2007

GO Debtthe Financial management Assessment (FMA). TheFMA attempts to provide a transparent assessmentof a government’s financial practices and to highlightaspects of management that are common tomost governments in a consistent manner. TheFMA is an analytic enhancement that improvesthe definition of our analysis of management practicesand policies, and expand our methods ofcommunicating analytic conclusions about policiesand procedures.A government’s ability to implement timely andsound financial and operational decisions inresponse to economic and fiscal demands is animportant component of credit quality. The FMAmakes certain aspects of our analysis of managementmore transparent, specifically those concernedwith policies and practices that are considered mostcritical to credit quality. FMAs are assigned only togeneral government tax-backed and annual appropriation-backedissues.The FMA encompasses seven areas most likely toaffect credit quality:■ Revenue and expenditure assumptions■ Budget amendments and updates■ Long-term financial planning■ Long-term capital planning■ Investment management policies■ Debt management policies■ Reserve and liquidity policiesThe overall FMA assessments are communicatedin our analyses using the following terminology:■ “Strong” indicates that practices are strong, wellembedded, and likely sustainable.■ “Good” indicates that practices are deemed currentlygood, but not comprehensive.■ “Standard” indicates that the finance departmentmaintains adequate policies in most, but not allkey areas.■ “Vulnerable” indicates that the government lackspolicies in many of the areas deemed most criticalto supporting credit qualityThe FMA focuses on a government’s policies andpractices. It is neither an evaluation of the competencyor aptitude of individual finance professionalsnor an evaluation of a finance department’s abilityto handle either ordinary occurrences or uniquechallenges. The purpose of the FMA is to highlightthe most transparent aspects of management thatare common to most governments in a consistentmanner. Even with this narrow definition, otherpossible practices could be considered, such asaccounting and disclosure practices, internal controls,and policies for knowledge retention and staffturnover. While each of these has the potential toaffect credit quality, factors considered in the FMAare those that Standard & Poor’s considers themost critical in determining credit quality.It is important to keep in mind that the FMA isone component of a rating; we will continue toevaluate all of the other factors—economic, financialcondition, debt and management. Given whatthe FMA measures, it is possible that an entity witha strong FMA may be better able to tolerate weaknessin the basic credit areas, or conversely, may bebetter able to take advantage of improving conditions.As a result, the practices that are captured bythe FMA could contribute to rating changes, orallow a community to better prevent a downgrade.State RatingsState credit ratingsStandard & Poor’s analysis of states includes all ofthe factors considered in any GO rating. State governmentshave sovereign powers and therefore possessunique administrative and financial flexibilitywhich translates to a higher credit profile for stateratings in many cases. Generally states have broadpowers to establish their own tax structures andexpenditure responsibilities. Tax structure, or theability of a state to benefit from the economic activitywithin its boundaries, is an important rating factor,as well as the degree of flexibility existing inthis structure, both legally and politically. Statesalso enjoy flexibility in setting and modifying taxrates, deductions, exemptions, and collection dates.These discretionary powers can immediately andfavorably influence a state’s fiscal condition.While states generally have broad service responsibilities,they also enjoy considerable discretion inestablishing or changing disbursement dates andfunding levels for state assistance. This affords ahigh level of control over budgets and cash flowwhich, given the absolute level of these disbursements,can positively impact fiscal standing. Thesesovereign characteristics can be limited, however.For some states, the voter initiative or referendumprocess is very active and its effects are importantfrom a credit standpoint. Where decisions aboutspecific tax/revenue levels and spending allocationsare placed in the hands of the electorate, states havereduced flexibility to respond to changing economicor financial situations.State/local relationshipsStates’ relationships with their localities continue toevolve and are part of the credit review process forboth levels of government. How services and programsare provided across governments and whatthe funding relationship has been over time areimportant considerations. Successful legal challengesto some states’ funding of primary and secondaryeducation have bolstered state aid towww.standardandpoors.com65

Tax-Secured Debtschools, and in turn placed significant pressure onstate budgets. Conversely shifting responsibilities tolocal government units can ease a state’s financialburden, but will pressure credit ratings of local governmentsunless accompanied by new local revenuesor mandate relief.Special GO SituationsIn addition to traditional general obligation ratings,Standard & Poor’s rates a number of GO securitiesthat carry many of the characteristics of general obligationanalysis but may also have their own nuances.For example, in certain parts of the country, library,park, fire, forest preserve, municipal utility, andwater and sewer districts issue bonds backed bysome form of general obligation taxing powers.Analysis for this type of debt follows the same basicprincipals of GO tax backed analysis including thefour factors (economy, debt, management andfinances) but also factors in the uniqueness of theindividual districts. These may include the limitedservice functions, and in some cases the limited revenueraising capabilities or specific millage limitations.Since service functions are often limited (suchas providing library services or fire services), budgetsare often smaller in size and capital intensive. Oftentimes the fixed portion of the budget dedicated todebt service is a much larger component than wouldbe typical for a larger, full service operating budgetof municipality.Many of these types of districts are often coterminouswith the municipality or county they liewithin. In some cases they lie within more than onemunicipal boundary. In those cases where they arecoterminous and share the same economic base, itdoesn’t necessarily mean the rating will be thesame. While the economic factors may be the same,management practices, financial position and debtprofiles may be very different and could result inhigher or lower ratings. In particular, financial positionwill be an important determinant in assigningthe rating.Certain districts also carry, in addition to theirfull faith pledge, the ability to levy rates and chargesfor specific services provided. In the case where usercharges are also used, Standard & Poor’s evaluatesthe GO factors while also looking at the revenuestream of the user charge and factors that into therating. In some instances, the history of using usercharges that translate into strong financial positionhas contributed to higher ratings. ■Debt Statement AnalysisDebt analysis is a critical component of the ratingprocess at Standard & Poor’s RatingsServices. Debt analysis focuses on the nature of thepledge offered on various securities, the debt repaymentstructure, current and forecasted debt serviceburden and the magnitude of an issuer’s capitalneeds. Debt position is measured in several ways,but analytic construction of the basic debt statementis critical to the evaluation. Differences oftenarise between the analytic approach to indebtednessand the statutory approach represented by issuers.There has also been much debate about the inclusionof pension liabilities and other post employmentliabilities on an issuer’s debt statement. In terms ofdebt statement analysis, pensions and OPEB will notbe included unless the municipality has issued debtto fund its liability. However, Standard & Poor’s willanalyze various measures of an entity’s pension systemand OPEB liability and in order to perform comparableanalysis will show debt ratios both with andwithout debt incurred for pensions and OPEB.Debt Statement AnalysisWhen Standard & Poor’s examines the debt burdenof a municipality it starts by looking at all directdebt, and any other analytic obligations of the entity.Debt types included in gross direct debt include:■ General obligation bonds;■ Any short term debt or commercial paper;■ Other tax secured obligations such as sales, gasor excise tax obligations;■ Authority, certificate or other capital lease obligationsthat are secured by lease rental or contractpayments subject to appropriation;■ Moral obligation secured debt;■ Tax increment and special assessment securedobligations;■ Pension obligation bonds; and■ Any enterprise or revenue—based debt.Operating leases, tobacco and GARVEE bonds(supported by federal revenues) will not be includedin the debt statement analysis.66 Standard & Poor’s Public Finance Criteria 2007

Debt Statement AnalysisWith this aggregation of direct debt, Standard &Poor’s measures the full burden of debt on the populationin relation to wealth. After this evaluation,deductions are made from the debt statement forself-support of certain types of debt. Once a netdirect debt figure is determined, various ratios areagain calculatedSelf-support is an analytic judgment and will notnecessarily match statutory calculation of self-support.The following are typically deducted:■ TANs, RANS, and TRANs;■ State aid reimbursements for well defined, longstandingprograms;■ Federally supported GARVEE revenues;■ Enterprise debt secured by revenues only;■ Moral obligation debt that has not required anycontribution to the debt service reserve fund fromthe morally obligated party; and■ Tax secured enterprise debt that is fully or partiallyself-supporting from the enterprise.Self-Supporting DebtAlthough a debt obligation may be exempt from alegal debt limitation, Standard & Poor’s does notnecessarily treat the obligation as self-supporting.Standard & Poor’s will assume revenue secureddebt for enterprise bonds (water, sewer, solid wasteand electric revenue bonds), GO backed revenuebonds that have passed the coverage test, and stateaid supported bonds are self-supporting.If tax-secured bonds are paid from an enterprisefund, Standard & Poor’s will give credit to partialself-support, and will factor that level of supportinto the overall debt burden. For example, if anissuer’s GO backed water and sewer debt wasbelow 1x, but managed to have 0.7x for the lastthree fiscal years, then Standard & Poor’s wouldgive self-support to 70% of the GO water andsewer debt. If the coverage tends to change fromyear to year; from 0.7x in fiscal 2003 to 0.5x in fiscal2004, and 0.6x in fiscal 2005, Standard &Poor’s will use the lowest percentage of the lastthree years.In this case, Standard & Poor’s would assumethat 50% of the GO backed revenue bonds isself-supporting. Partial self-support does notapply to revenue bonds because they would be incovenant default. Standard & Poor’s analyzes thesystem to make sure that system revenues areable to cover both revenue and GO backed revenuedebt. Coverage from the enterprise fundrevenues must provide at least 1x support for thelast three fiscal years to be considered fully selfsupportingand to be factored out of the directdebt of the municipality.Bonds that are supported by special assessments,sales tax, gas tax, or tax increment financing(TIF) revenues will not be consideredself-supporting, and will be included in the directdebt of the issuer. If these bonds have a dedicatedmillage to pay debt service, this will be taken intoaccount and explained in the debt section of theissuer’s credit commentary, but it will not be consideredself-supporting.Pensions And Other Postemployment BenefitsStandard & Poor’s will continue to analyze anissuer’s pension system(s) and the funding of itsactuarial accrued liabilities (AAL). For informationon pension and other postemployment benefits(OPEB) criteria please refer to the Public FinanceCriteria: GO bonds.In terms of the debt statement, if the issuer hassold pension obligation bonds then the bonds willbe included in the debt statement and debt ratioswill be calculated both with and without the pensionobligation bonds. The same holds true forOPEB obligation bonds. However, Standard &Poor’s will recognize in its analysis the comparisonbetween an employer that has issued POBs and as aresult has higher debt ratios but lower unfundedpension liabilities versus one that has not issuedPOBs and thus has lower debt ratios but higherunfunded pension liabilities. The analysis will takeinto account that the increased debt ratios are offsetby the entity’s improved funding ratio.Debt Statement PresentationFor Standard & Poor’s to achieve a thorough analysisof a community’s debt levels, it is imperativethat the issuer provides a comprehensive debt statement.Although debt statements will never be uniformdue to the unique circumstances of themunicipalities, there are certain essentials that makeup a good debt statement.From an analytic standpoint, a good debt presentationwill communicate the nature of the pledgedsecurity, the debt repayment structure, the currentdebt service burden and the future capital needs ofan issuer.The debt statement should include a listing ofobligations of both long-and short-term debt andmaturity dates should be provided. Furthermore,the nature of the security should be concisely, butaccurately defined. If the entity paying the debtservice is different from the security, that should bedefined as well. In terms of lease obligation, there isoften a conduit authority set up to issue the debtfor the obligor, therefore the debt statement shouldinclude this debt and indicate the appropriateauthority for debt issuance.www.standardandpoors.com67

Tax-Secured DebtTable 1 Sample: Computation of Direct andOverlapping Debt(Mil $)Gross direct debtGeneral obligation 252.9Capital leases 27Tax incremental financing 16.9Sales tax 10.4Total gross direct debt 307.2Self-supporting debtGeneral obligation water and sewer 25Net direct debt 282.2Overlapping debtGeneral obligation 300Other tax supported 150Combined overlapping debt 450Net direct and overlapping 732.2Standard & Poor’s will also ask the issuer toreport another important measure of the debt burdenon the issuer’s operations—the debt service carryingcharge. Pre-GASB 34, the debt service carryingcharge, which is measured as the combined generalfund and debt-service-fund debt service to operatingexpenditures (not including pension obligations), wasan important measure of the issuer’s management ofdebt repayment and financial flexibility. Post-GASB34, the debt service carrying charge is measured asthe combined primary governmental debt service tothe primary government expenditures. The debt servicecarrying charge measures what percent of theissuer’s expenditures are used for debt repayment,and is a useful indicator of financial flexibility.Another tool that issuers use to manage debt isderivatives, such as swaps. Interest-rate swaps areused in conjunction with bond issues to save interestcosts, increase financial flexibility, syntheticallyadvance refund bond issues, and access differentinvestor markets. Swaps also are used to lock infixed rates of return on debt service funds and otherfloating-rate assets without sacrificing liquidity.Table 2 Sample Long-Term Debt Statement($ 000)Sales taxrevenueGO bonds TIF bonds* bondsMaturing in FY: principle Interest Total principle Interest Total Total principle Interest Total2006 43,265 22,518 65,783 5,393 3,033 8,426 1,979 2,390 915 3,3052007 42,675 19,064 61,739 5,094 2,908 8,002 2,098 446 598 1,0442008 34,125 15,664 49,789 3,866 3,008 6,874 2,298 468 574 1,0422009 18,770 13,332 32,102 2,575 3,305 5,880 2,434 488 550 1,0382010–2014 9,445 11,926 21,371 2,558 503 525 1,0282014–2019 50,115 47,640 97,755 15,839 2,488 1,932 4,4202020–2024 54,540 31,112 85,652 16,012 2,363 1,140 3,5032025–2030 9,322 1,240 470 1,710Total 252,935 161,256 414,191 16,928 12,254 29,182 52,540 10,386 6,704 17,090Changes in Outstanding Long-Term ObligationsGO Bonds TIF Bonds Sales Tax Capital LeasesOutstanding/July 1, 2005 258,888 17,049 10,721 Year Ended June 30New issue 22,621 2006 15Principal retired (28,574) (751.000) (335.000) 2007 13Accretion 2008 12Other 2009–2024 26,960Outstanding/Total minimumJune 30, 2006 252,935 16,298 10,386 payments required 27,000*TIF—Tax increment financing.68 Standard & Poor’s Public Finance Criteria 2007

Debt Statement AnalysisHowever, swaps expose issuers to counterpartycredit risk, termination risk, basis risk, rolloverrisk, and for many housing bond issuers, amortizationrisk. Therefore, Standard & Poor’s will reviewswap transactions in conjunction with the issuer’soverall debt profile and will assign a DebtDerivative Profile score. For information on theDebt Derivative Profile Criteria please refer toCriteria: Debt Derivative Profile.In terms of capital appreciation bonds (CABS),Standard & Poor’s will use the accreting value thatis presented by the issuer in the audited financialstatements. Since this includes interest payments,Standard & Poor’s will gauge whether the valueartificially inflates the debt position by 10% ormore, and will explain in the debt section of thecredit commentary the sinking fund and pay out ofthe CABS.Table 3 Sample: Revenue Bonds and Other Debt($ 000)—Water and sewer——Solid waste—Maturing in FY: Principle Interest Principle Interest2006 1,090 2,237 8,403 1,8562007 1,121 2,181 5,208 1,1192008 1,152 2,124 1,204 1,0772009 1,210 1,065 1,151 1,0192010–2014 6,886 8,8712015–2019 6,275 7,0902020–2024 9,197 2,8682025–2030 5,298 592Less:Unamortized discount& deferred amount (1,226)Premium 479Total 31,482 27,028 15,966 5,071Changes during Water Solidthe fiscal year and sewer wasteOustanding asof July 1, 2005 33,532 24,967New issuePrinciple retired (2,050) (9,001)OtherOustanding asof June 30, 2006 31,482 15,966Overlapping DebtAnother important measure of debt that should beincluded in a debt statement is the overlapping debtissuance (or underlying debt for counties). A comprehensivedebt statement will include a separatesection on overlapping debt and the percentagesapplicable to the municipality. The rationale for thisis that the burden on the community is for all debtissued. Therefore, the community is responsible forthe debt of the school district to the same extent asthe city and the county. The taxpayers are obligatedto pay taxes to each entity, and this is one of themost important measures of how the current obligationaffects the community.Similar to the presentation of direct debt, theoverlapping debt section should also include allsecurities, not just the general obligation bonds. Acomprehensive overlapping debt section wouldinclude bonds secured by special assessments, gastax, and sales tax, among others.Future Debt/CIPStandard & Poor’s closely scrutinizes an issuer’sCIP to evaluate future debt statement changesAgain, Standard & Poor’s examines the tax-supportedobligations and revenue obligations andtheir potential impact on the issuer’s future operations,and the potential burden to the community.A typical CIP presents the expected projects for thenext five fiscal years, a list of the projects and theircost, and the funding source—whether fundedinternally, by an outside governmental agency, ordebt financed. As well, the CIP would communicatewhether the project was discretionary or non-discretionary.In addition, the issuer should also communicatethe remaining borrowing capacity, taxrate and levy capacity, or other revenue capacity ofthe obligor/issuer.Debt ExampleFor example, table 1 describes what Standard &Poor’s includes in the analysis of the gross debtposition for a city. Under gross direct debt,Standard & Poor’s included the $252.9 million generalobligation bonds and the $27 million leasedebt, since both are direct obligations of a city, andthe debt service payment is derived from the city’soperations. As well, the other tax-supported debtincludes $10.4 million sales tax revenue bonds and$16.9 million tax increment financing bonds and isalso added to the direct debt obligation of the city.Under the net direct debt, Standard & Poor’ssubtracted the city’s $25 million general obligationwater and sewer debt because system revenues werepaying the debt service. (See self-supporting debtsection). Therefore, the city’s net direct debt positiontotals $282.2 million.Table 2 shows the debt statement presented toStandard & Poor’s by the city. The debt statementincludes $252.9 million in general obligation debt,$10.4 million in sales tax revenue bonds, $16.9www.standardandpoors.com69

Tax-Secured Debtmillion in tax increment financing bonds and $27million in capital leases. Of the $253 million generalobligation debt, the city proved that the $25 millionGO water and sewer obligation wasself-supporting, having more than 1x coverage formore than three consecutive fiscal years, and thisportion of general obligation debt was not includedin table 1. The city’s total net direct debt was$282.2 million.Although not included in the debt statement, thecity has $31.5 million in water and sewer, and$15.97 million in solid waste debt outstanding. Thecoverage of water and sewer debt has been morethan 3x for the last three fiscal years, and the coverageof solid waste was 1.25x for the last three fiscalyears. Therefore, Standard & Poor’s is assuredthat operating revenues are not supplementing theenterprise funds, and the enterprise fund is not incovenant default. The city’s enterprise debt presentationis shown in Table 3. ■Special Tax BondsThe key feature of the special tax criteria, whichcenters on those bonds that are secured by alien against a non-property tax, is that the tax rateis generally fixed. Pledged tax revenues will rise andfall based only on the economic activity beingtaxed. In many cases, the use of special tax bondproceeds may also be unrelated to the economicactivity that is taxed.The four most prevalent taxes used to supportspecial tax bonds are:■ Sales tax■ Highway user tax (including gas tax)■ Hotel tax, and■ Income taxMany other variations are also included in specialtax revenues, from cigarette taxes to rental cartaxes. Pledged revenue streams will be evaluatedbased on their unique merits, but all special taxbonds share common characteristics. In general,bond credit quality will depend on:■ The size and depth of the economic base;■ The stability, diversity, and magnitude of thepledged special tax revenue stream;■ The level of debt service coverage—both coverageof annual debt service and coverage of futuremaximum annual debt service; and■ Bond covenants, such as funding a debt servicereserve; restrictions on additional parity debtissuance; or whether excess revenues after paymentof debt service flow back to the bond issueror are retained under a closed flow of fundsexclusively for early debt retirement.Standard & Poor’s is refining its special tax criteriaas it relates to sales tax, income tax, and gas taxrevenue bonds to place greater emphasis on fundamentaleconomic factors and less on legal featuresregarding additional debt issuance and reserve fundswhen, from a practical perspective, prospects aregood that debt service coverage will remain highregardless of the legal provisions in bond covenants.Enhanced recognition of fundamental economicactivity for sales tax revenue bonds is supported byretail sales data collected over past recessions,which has generally reaffirmed the stability of salestax revenues during adverse economic cycles, particularlyfor large economic bases. As such, higherrating levels can be sustained at lower coverage levelsfor certain municipalities.Likewise, the stability of fuel sales during recentand previous price spikes support the relativeinelasticity of fuel demand even during periods ofhigh fuel prices. Highway user tax ratings are alsobuoyed by the fact that a large portion of pledgedrevenues are typically derived from stable transportationrelated sources, such as motor vehicleregistration fees and motor vehicle license fees, andusually cover a large statewide population base.In particular, legal tests for additional sales taxparity debt will be weighed less heavily wheremunicipalities rely on excess sales tax revenues tofund general fund operations. In such cases, there isa disincentive to issue significant amounts of additionalsales tax borrowing, regardless of legal protections.For these issuers, heavy sales tax bondingcould have the effect of crowding out funding foressential ongoing municipal operations.Analytically, this unlikelihood allows us to placeless emphasis on the additional bonds test.The additional bonds test is also less significantfor municipal issuers with a long history of debtrestraint and little potential future financing needs.In contrast, additional bonds tests may retain theirtraditional importance when an authorized sales tax70 Standard & Poor’s Public Finance Criteria 2007

Special Tax Bondsis dedicated only to capital funding or when capitalneeds are large. Debt service reserves also take onless importance in cases where debt service coveragewill be maintained at very high levels, such as2x maximum annual debt service or higher. In thesecases, debt service reserves equal to half of maximumannual debt service, ones only funded whencoverage falls below a specified level, or in somecases not funded at all, may be sufficient.Special Tax Ratings Can Exceed A GO RatingA special tax bond rating can exceed that of amunicipality’s GO rating in certain circumstances—when an issuer’s base shows broad economic diversity,revenues show good stability in economicdownturns, debt service coverage levels are strong,and legal covenants provide strong protection orare analytically less relevant. Special tax ratingsmay rise above an issuer’s GO rating, since as apractical matter, the pledge of special tax revenuesmay place bondholders ahead of unsecured GObondholders. Chapter 9 of the U.S. BankruptcyCode specifically provides that a municipal bankruptcyfiling, “does not operate as a stay of applicationof pledged special revenues, which includesspecial excise taxes, to payment of indebtednesssecured by such revenues”. Although case law islimited by the small number of municipal bankruptcyfilings, it would appear sales tax bondholderswould have a strong priority interest in the event ofmunicipal distress, allowing sales and special taxratings to exceed a GO rating. However, heavysales tax bond issuance could potentially weighdown a GO rating. Special tax supported debt isincluded in Standard & Poor’s calculation of anissuer’s direct GO debt burden ratio, and couldresult, in unusual cases, in a downgrade of a GOrating when high debt service costs hamper the abilityto balance a general fund budget.Economic ConcernsThe health of the local economy is central to therating process. As it does when rating other typesof municipal issues, Standard & Poor’s initiallyevaluates the diversity and growth potential of aneconomy. A poorly performing or concentratedeconomy may limit the upside potential of a bondrating, despite high debt service coverage. The mainemphasis is on the breadth of the tax base, both bydiversity of retailer, and on the items taxed.Generally, levies on the widest range of items earnhigher ratings than those on limited categories ofgoods and services, (for example, a tax only onrestaurant sales may somewhat narrow the taxbase, as might a sales tax jurisdiction dependent ona limited number of auto retailers, while inclusionof retail grocery sales may provide greater tax stability).Standard & Poor’s reviews cyclical factors,such as tourism, that could cause fluctuations in taxreceipts. A large and diverse employment base willprovide some protection against swings in retailpurchases of area residents. A larger geographicjurisdiction also mean less likelihood that a residentwill visit a retailer outside an issuer’s taxing jurisdictionif a retailer closes down.Under certain conditions, the diversity of retailerscan be another rating factor, particularly for narrowretail bases. For instance, in a very small town,a large portion of revenues may come from oneshopping mall or an auto dealership that may facefuture out-of-town competition, or whose proprietormay fold. Standard & Poor’s may ask for a listof the top 10 retail outlets as a percentage of totalsales to help allay concerns of retail concentration,or provide retail sales by economic sectors. As anexample, a concentration in auto dealerships mayindicate especially cyclical retail sales.Confidentiality laws may preclude the release ofactual names of the largest retail generators. In suchcases, Standard & Poor’s can review retail figureswithout the release of the specific name of theretailers. Large population bases may be assumedto contain a diverse retail base, while smallermunicipalities may be deemed to carry some risk ofconcentration when precise retail concentration figuresare unavailable.One positive factor regarding sales taxes is thatrevenues continue to be remitted when a sales taxvendor declares bankruptcy, but remains in operation;conversely, however, tax revenue will come toa halt if the retail store closes or relocates outside ajurisdiction. In such cases, it is helpful that nearbyalternative shopping outlets are still in town.Sometimes, even major cities can suffer when alarge retail mall opens in a suburb, drawing offshoppers. For this reason, high retail sales per capitaare closely analyzed.Implications Of Growth TrendsGrowth trends may depend on the type of taxes.One of the strongest credit features of sales-tax revenuesis that they are inflation driven. Revenuesand debt service coverage will increase in inflationaryperiods, even when a local economy does notgrow in real terms. On the other hand, gas taxesare usually derived from a per gallon tax that doesnot grow with inflation. Nevertheless, gas taxesalso tend to remain relatively stable in recessionsand depend more on population growth. Incometax receipts also show general stability over time,especially for large economic bases, due to thebroad-based nature of the tax. Each type of specialtax will be examined on its own merits for possiblefuture growth and cyclicality.www.standardandpoors.com71

Tax-Secured DebtIn general, projections of sales tax or special taxrevenues tend to be imprecise and depend on anumber of assumptions about such variables asthe level of future construction. AlthoughStandard & Poor’s reviews future projections ofsales tax or other pledged revenue growth, it doesnot usually use them as a major factor for a rating.Recognizing the uncertainties in forecastingprecisely when new growth will occur, Standard &Poor’s typically bases its ratings primarily on historicalrevenues generated from an existing economicbase that will cover future maximumannual debt service.Although rating criteria focuses primarily on historicalrevenues and their ability to cover futuremaximum annual debt service, pledged tax growthrates are still examined. Standard & Poor’s will nottry to determine the reasonableness of an exact economicforecast, but note when situations wheregrowth will likely continue based on historicalgrowth trends and ongoing economic conditions.Debt service coverage wholly dependent on highfuture economic growth, particularly sustainedlong-term annual growth, suggests a greater riskprofile. However, some credit may be gained forrapidly growing areas, if near-term growth assumptionsappear reasonable.Standard & Poor’s usually asks for at least fiveyears of historical tax revenues or, if a sales or specialtax is newly imposed, five-year, pro forma taxdata based on historical retail sales from jurisdictionswith overlapping sales-tax levies. Pledged taxdata that are merely estimated based on sample surveyslack historical rigor.Debt Service Coverage And RatingsA common question asked of Standard & Poor’s is,what level of debt service coverage will result in adesired rating level? The answer is that there is nofixed level of coverage that will result in a givenrating because coverage levels are only one factor inthe rating process, which also includes an assessmentof likely additional debt issuance and amunicipality’s economic vitality, diversity, and cyclicality.Higher coverage levels may somewhat offsetconcerns within the other rating factors, but eachrating must stand on its own. Higher ratings generallyenjoy higher debt service coverage; however,rating level variations typically correlate moreclosely with population levels, as a proxy for economicdiversity.Higher coverage can offset a weaker economicbase, if coverage levels can be expected to be maintained.Accordingly, issuers may choose to structurein higher coverage and legal features to raise creditquality and offset a weaker economic base. Thedegree of coverage desired will depend on thedesired rating level and the historical and expectedfluctuation in sales taxes over an economic cycle.Variable rate debt, or deals involving swaps witha variable rate should address the potential forinterest rate fluctuations and the transaction shouldshow strength during a variety of stress scenarios. Afixed asset stream, such as a sales tax, is potentiallyvulnerable to variable interest rates, unless initialcoverage is sufficient at the time the bonds areissued. One good feature about variable rate salestax debt is that periods of high interest rates arealso often coincident with periods of high inflation,potentially allowing revenues to grow to meet theincreased debt service.Legal ProtectionsAdditional parity bonds tests protect against dilutionof future debt service coverage through theissuance of additional parity debt. The strongestadditional bonds tests specify that historical revenuesmust cover future maximum annual debtservice, plus an extra debt service coverage cushion.Special tax bonds, as well as other types of fixedtax debt, typically have no ‘rate covenant’ to raisetax rates in the case of a debt service shortfall. Assuch, there may be somewhat less restraint on issuingadditional parity bonds than other types of revenuebonds, unless excess tax revenues are neededfor other essential operations, as is often the casefor sales tax revenues that flow into a municipality’sgeneral fund.Typical additional sales and income tax paritybond coverage tests range from 1.2x historicalcoverage of debt service to 3x or more, with mosttests in the 1.25x-1.5x range. Hotel and gas taxadditional parity bonds tests, as well as those fortax revenues with more cyclical revenue streamstypically range higher. Some weaker additionalbonds tests use average annual debt service coverageinstead of maximum annual debt service,although this may be offset by a higher requiredcoverage multiple. Still weaker additional bondstests may use only projected revenues. Some additionalbonds tests allow future variable rateissuance. If so, the additional bonds test coveragemultiple ideally would be sufficient to protectagainst possible future swings in interest rates. Ifthe additional bonds test coverage multiple is low,the use of prevailing short-term interest rateswhen calculating future debt service for purposesof the additional bonds test would not be asfavorable as using some extra factor anticipatinga rise in rates. A good alternative might be to useinstead prevailing long-term rates, or prevailinglong-term rates plus an extra adjustment factor,allowing a coverage margin for a potential rise ininterest rates.72 Standard & Poor’s Public Finance Criteria 2007

Special Tax BondsAdditional bonds tests regarding subordinate liendebt would ideally be calculated using historicalsales tax revenue, divided by combined maximumannual debt service payments of both senior andjunior lien debt. Some junior lien tests use only netrevenues after prior payment of senior lien debt,and this can effectively dilute the additional bondstest to a lower coverage multiple, unless therequired junior lien coverage multiple is high.Analytically, Standard & Poor’s discounts thismethod of coverage calculation and employs a combinedcoverage ratio to evaluate junior lien debt.Rating distinctions between junior and senior lienare not automatic. Junior lien sales tax debt may berated on par with senior debt if the senior lien isclosed, or if no additional senior lien debt is otherwiseexpected. No distinction may also be made ifcombined current and expected future coverage levelsare so high that the importance of the lien positionbecomes minimal given the resulting low riskof insufficient coverage. On the other hand, if juniorlien debt service coverage is significantly lowerthan on senior lien debt, there could be a greaterrating distinction.A debt service reserve fund that is fully fundedfrom a portion of bond proceeds, or through asurety agreement with an investment-grade ratedentity, may add liquidity in times of stress but doesnot enhance fundamental credit quality.Most special tax bonds typically have an openflow of funds, whereby revenues not needed to paydebt service revert to the municipality. If excess revenuesare used to fund municipal operations, thiscan be a disincentive to issue additional debt, aspayment of increased prior debt service mightrestrict the monies available to fund municipaloperations. In such an example, a city might bemore likely to maintain high debt service coverageeven in the event of weak legal protections regardingadditional parity debt issuance. As such, anopen flow of funds may help support a higher salestax bond rating where the excess revenues areessential to fund municipal operations, even whenthe additional bonds test is not particularly strong.Sometimes bond legal provisions specify a closedflow of funds. In this case, excess tax revenues,after payment of debt service, can typically be usedonly for bond redemption. This provision can dramaticallyreduce average maturity and quickly raisefuture coverage, if at the same time no additionalparity bonds are allowed. As such, a much lowercoverage could be accepted for an equivalent ratingin the initial years, if the risk is mostly in the outyears, when effective coverage could grow to a dramaticallyhigher level with any sort of economic orinflationary growth and debt is continuouslyretired, or defeased early.Certain specialized tax revenue streams entailspecial considerations.Hotel Tax BondsHotel tax bonds are secured by lodging roomfees—either a percentage of room rentals, or afixed tax per room. In practice, few hotel taxbonds pledge purely hotel tax revenues: many alsoinclude sales taxes on restaurant sales or car rentalfees, with similar tourism based analytical concerns.Hotel tax bonds often fund capital facilitiesfor convention centers, which typically need regularrenewal or expansion.The approach to analyzing hotel tax revenuebonds, and food and beverage tax revenue bonds,follows the general special tax criteria. However,because the hotel tax base is narrower and morecyclical than broad revenues streams, such as generalsales taxes, higher coverage levels and bondholders’legal protections may be needed for equivalentrating levels. Specific considerations for hotel taxbonds include the issuer’s ability to generate hoteltaxes by attracting overnight visitors, the nature ofsuch visits (discretionary trips versus nondiscretionarytrips), historic hotel occupancy levels, andplanned expansion.Additional key areas of the hotel tax bond analysisinclude:■ The historic demand for hotel rooms within thetaxing jurisdiction;■ Occupancy rate trends;■ The number of room rentals; and■ Average room rates over a period of severalyears.A distinction also is made between the natureof travel to a given community. Although discretionarytravel—vacations and business trips—areaffected by economic cycles, vacations exhibitgreater sensitivity. A feasibility study is helpful intracking demand trends. These studies typicallyuse historical patterns to estimate future tends.Standard & Poor’s often finds analysis of historicalhotel tax trends more valuable than predictionsfor the future. A debt service reserve fullyfunded from bond proceeds to the maximumannual debt service takes on added importancefor a cyclical hotel/motel tax revenue bond issue,as well as one secured by restaurant and beveragetaxes. Hotel/motel tax revenue bonds or food andbeverage tax revenue bonds also typically have ahigher range of 1.5x-2x for their additional bondstest, unless the issuer’s hotel market is especiallybroad and diverse. One of the strengths that hoteltax and food and beverage tax revenue bondsshare with sales tax bonds is their response toinflation. Pledged tax receipts and debt servicewww.standardandpoors.com73

Tax-Secured Debtcoverage increase during inflationary periods evenif the source of the revenue stream exhibits noreal growth.Highway User Tax BondsHighway user tax bonds are issued primarily bystates to fund statewide highway and road construction,although local bonds are sometimessecured by state distributions of highway user taxrevenues to local municipalities. A state constitutionmay limit the spending of transportation relatedfees to transportation uses, which typically tend tobe very capital intensive. The broad statewide collectionof revenues for most of these bonds oftenaffords strong credit quality.Highway user revenues collected by states aretypically motor-fuel taxes, vehicle-registration fees,license fees, penalties and fines, and in some casesmotor vehicle ad valorem fees. Some states add federalgrant monies to the pledged revenue stream,which may make the revenue stream vulnerable tochanges in federal programs, especially since federalgrant programs must be periodically reauthorized.Higher debt service coverage may be needed to offsetsome of this increased vulnerability.An examination by Standard & Poor’s of pledgedfuel taxes during periods of rapid increases in theprice of gasoline has indicated that sales of fuel arerelatively insensitive to price in the short run,although they may vary somewhat over a long periodof years by causing a gradual shift to more orless fuel efficient vehicles as consumers trade invehicles. Another difference with sales tax revenuelies in the nature of fuel taxes. Unlike sales taxbonds, whose revenues increase with inflation, fueltax bonds are generally based on per gallon sales,and do not increase with inflation.The relative importance that a state governmentplaces on highway construction, and its commitmentto such programs, can be significant factors in therating process. States that have established highwayprograms by statute and the ability and willingnessof state administrations and legislatures to increasehighway user tax rates as a means to fully fund perceivedrequirements are important considerations.Generally, statewide revenue sources are consideredmore stable than revenues based on point ofsale within a small locality. Those states that distributehighway user tax revenues to localities on a percapita basis, instead of actual local sales, can serveto enhance a rating by providing stability. Otherstate revenue distribution formulas that are morecomplicated could serve to enhance or weaken apledge of state distributed revenues. If states havefrequently changed their distribution formulas in away that could reduce local revenues that arepledged to bonds, it may become a credit concern.Standard & Poor’s examines the revenue-distributionformula, historical changes to highway user taxallocations, and the frequency of tax rate increasesas a factor in determining revenue stability.Because highway user taxes are generally dedicatedfor the purpose of future infrastructure needs,there may be a greater presumption that a statewould issue significant amounts of future highwayuser tax debt, and the additional bonds test may insome cases take on greater significance than forsales tax debt where an issuer needs to use excesssales taxes for general operations.Income Tax BondsIncome tax bonds are primarily found in the stateof Indiana, although there are a few prominentexamples in other parts of the country. Statisticsshow that the gross personal income of a municipality’spopulace is generally very stable over time,most likely due to the broad based nature of thetax, and also goes up with inflation, as do salestaxes. Standard & Poor’s evaluates the size anddepth of a municipality’s economic base and its previousincome tax fluctuations. Local income taxestend to have a narrow range of tax rates, whilestate income taxes may be based on a more progressivetax rate schedule that could potentiallyfluctuate more in a downturn, although this may beoffset by a larger and more diverse state economy.A distribution of statewide income taxes to localitiesdetermined by population would usually beconsidered a more stable source of pledged revenuethan income taxes collected purely locally.However, both sources of income taxes may be consideredvery stable when the municipality covers abroad economy. ■74 Standard & Poor’s Public Finance Criteria 2007

Non Ad Valorem BondsNon Ad Valorem BondsNon ad valorem debt has become a popularalternative to GO bonds for many reasons.In addition to bypassing referendum requirements,many issuers believe that non ad valorembonds spread the burden of repayment more equitablyamong residents and non-residents, includingtourists and business travelers. This isattributable to the fact that many non ad valoremrevenues are user-based, including sales and otherspecial taxes, intergovernmental revenue sources,charges, and fees.Because some non ad valorem revenues, such assales taxes, are economically sensitive, pledging severalof them together may reduce the overall volatilityof the bond repayment revenue stream, and givethe issuer access to more favorable interest rates.However, a broad-based non ad valorem revenuepledge is not, by definition, stronger than an individualpledge. One must consider the issuer’s overalldebt profile, as discussed below.Many cities and counties use a secondary pledgeof non ad valorem revenues to enhance the creditworthinessof debt secured by a more narrow, andpossibly volatile revenue source that would potentiallyhave a weaker credit rating on a stand-alonebasis. This pledge takes the form of a direct paymentof non ad valorem revenues to fund debt service,or a deficiency make-up provision to fund debtservice or replenish a debt service reserve if the primaryrevenue source is insufficient.Standard & Poor’s Ratings Services generallyviews the covenant to budget and appropriate availablenon ad valorem revenues as being second onlyto a full-faith-and-credit pledge in terms of creditworthiness,and has rated most such debt one notchbelow an issuer’s GO bond rating if certain legalprovisions are present.The general creditworthiness of the issuer providesa basic underpinning for its non ad valorembond rating. Accordingly, if no published GO ratingexists, Standard & Poor’s assigns a shadow GObond rating that it will release to the general publiconly at the issuer’s request.Determining the creditworthiness of non ad valoremdebt for the purpose of assigning a ratingentails a blended approach of assessing the natureand strength of the pledged revenue stream andwhat other competing claims there may be on thenon ad valorem revenue stream. Below is a summaryof the major facets on which investorsshould focus.General CreditworthinessAs in a GO bond analysis, main areas of interestinclude the nature of the issuer’s economic base;financial controls and performance; investing policiesand performance; administrative factors, suchas taxing authority; and debt management, includingcapital planning procedures.Pledged revenuesDifferences exist in bond/legal documents providingfor non ad valorem debt. One common thread is:statement of the issuer’s “covenant to budget andappropriate legally available non ad valorem revenues.”Therefore, how “legally available non ad valoremrevenues” is defined is of critical importance.Legally available generally means that obligationspayable from one or more specific non ad valoremsources are net of amounts necessary to fund “essentialgovernment services.” Reviewing the mix of revenuesand their historical performance is animportant part of the analysis. It is also importantto verify that the specific revenues under the pledgeare authorized for the duration of the debt serviceobligations outstanding. The expiration of a majornon ad valorem tax source could be a significantcredit weakness. The funds subject to the non advalorem pledge should include at least the main governmentalfund of the issuers, which, in most cases,is the general fund. A general fund-only pledge isusually just as strong as one that makes no fund distinction,as most unrestricted non ad valorem revenuesare accounted for in the general fund.One advantage of the general fund-only pledge,from an issuer’s point of view, is that new sources ofrevenues can be placed in other funds for other uses,rather than automatically becoming subject to thelien on non ad valorem revenues. However, once arevenue is considered pledged, the issuer should notbe able to reroute it to other uses to the detriment ofbondholders. Depending on the timing of the receiptof pledged non ad valorem revenues and when debtservice is due during the issuer’s fiscal year, a debtservice reserve fund may be appropriate.Prior-lien obligationDebt secured by one of the revenue sources includedin the non ad valorem pledge is seldom noted inthe non ad valorem bond resolution. It is importantthat there be disclosure and analysis of all bondissues that may have a prior lien on any of thepledged non ad valorem revenue sources (such as awww.standardandpoors.com75

Tax-Secured Debtsales tax bond issue), as well as a comprehensiveassessment of all bonds or other obligations outstandingthat may have a direct or indirect pledgeof non ad valorem revenues. To find out debtamounts, provisions for additional bonds, andother information concerning prior lien or paritydebt, one may have to consult the relevant bondresolutions or other financing documents. Thisinformation can be very important in drawingmeaningful conclusions about whether non ad valoremrevenues will be sufficient to offset debt servicethrough the life of the bonds.If the issuer does not have any debt outstandingsecured by non ad valorem or other revenuesources, it may opt to issue some in the future. Itis therefore important to have a clear understandingof the issuer’s long-term capital spending plan.Anti-dilution testProvisions for anti-dilution are similar to additionalbonds test requirements common to revenue bondissues. Usually, the issuer is permitted to issue additionalnon ad valorem bonds only to the extent thatpledged revenues of a given fiscal year are greaterthan some multiple of debt service. An anti-dilutiontest based on historical rather than projected revenues,and maximum annual debt service rather thansome other measure, usually provides better protectionfor bondholders.Debt service coverageCoverage should be calculated based on availablenon ad valorem revenues after paying maximumfuture debt service on prior-lien bonds and shouldinclude other debt obligations secured by the nonad valorem pledge. Additional calculations shouldbe made to estimate coverage in the event that theissuer uses all of its prior-lien bonding authority(issues up to the maximum allowed by additionalbonds test under prior-lien resolutions). ■Lottery Revenue BondsStrong growth in lottery sales nationwide, reflectingthe overwhelming popularity of the games,and ample legislative support provide assurance asto the stability of lottery revenues as a source ofdebt service payments. Lottery receipts for ratedtransactions have shown strong growth and onlysmall dips during isolated downturns over the last10 years. To date, lottery revenues show little apparenteffect from the growth of casino gambling. Thestability of these receipts from a legally imposedstatewide monopoly can support strong ratings forproperly structured lottery revenue bonds.The ratings for lottery-secured bonds incorporatea review of historical operations and collections oflottery game receipts, as well as an evaluation ofthe legal covenants for the bonds. The level ofpledged revenue coverage of future maximum annualdebt service, and the legal covenants restrictingadditional debt issuance are very important creditconsiderations. Before assigning a rating to lotterybackedbonds, the stability and magnitude of thepledged revenue stream are closely evaluated.CompetitionThe growth in public gaming’s popularity has led toincreased competition for gaming dollars amongmany states. The extent to which other gaming thatis not used to secure the debt exists in the state, aswell as the availability of gaming in nearby states,can reduce pledged revenues. For these reasons,effective management of a diversity of gamingproducts is an important consideration. As a competitivestrategy, many state lotteries vary the compositionof gaming products, odds, and pay-offsevery year. State lotteries that offer a variety ofinstant and online gaming products, as well as thelarger prizes possible for small states from multistatepools, are better able to maintain interest,popularity, and participation among state lotteryplayers. The ultimate measure of the success ofthese management factors is the historical growthand stability of lottery revenues.The novelty associated with the introduction of anew game or a variety of new games can boost lotterysales. However, it would be considered a majorcredit strength if the revenues for any new or additionalgames also were pledged for the bonds. Thiswill ensure that the implementation of new gamesdoes not diminish the strength of the pledged revenuestream and, most important, dilute coverage.If this concern is not addressed, the addition of newand alternative games that are not pledged to debtservice will lead to a decline in pledged lottery revenuesand debt coverage.76 Standard & Poor’s Public Finance Criteria 2007

Lottery Revenue BondsLottery ManagementStandard & Poor’s Ratings Services appraisal ofmanagement focuses primarily on industry expertise,experience, and quality. Attention is placed onthe historical effectiveness in developing and promotinghands-on, innovative approaches to keepthe state’s lottery games competitive. A well-seasonedteam that is well informed of developingindustry innovations in marketing and vendingtechnology, foresees potential challenges, and canadapt to a rapidly changing environment, is a positiverating factor. Also important is the autonomyof the management body.Typically, management and control of a state lotteryis the responsibility of an administrative team appointedby the governor and confirmed by the state legislativebody. The team directs the adoption of rules,oversees the operation of the lottery, and is responsiblefor the honest and fair operation of the games.Financial OperationsTo assess a state lottery’s financial position,Standard & Poor’s analyzes trends in historical revenuegrowth with particular attention paid to cyclicalfluctuations, overall volatility, and length of history.Historical pledged revenues that provide higher coverageoffer some protection from cyclical factors.Based on the relative inexpensiveness of lotterygames as an entertainment item and the attractionof potential winnings, state lottery games haveremained popular and have been somewhat insulatedfrom recessionary cycles.Lottery revenue projections depend on a numberof underlying demographic and economic factors,including state population, state income, statewideemployment, and job growth trends. AlthoughStandard & Poor’s considers future projections oflottery revenue growth, it does not use projectionsas a major basis for determining a rating.Legal ProvisionsLottery-backed debt typically is secured by a pledgeof net revenues after collections, payment of prizemoney, and administrative expenses, as well as certainallocations to the state general fund. Variabilityin the distribution procedure can be mitigated bystatutorily controlling expenses and by establishingallocation formulas or caps.Lottery-secured debt typically has an open flowof funds, whereby net revenues not needed to payDocumentation Requirements■ Official statement■ Trust indenture■ State authorizing legislation■ Audited historical revenues for 10 years, if availabledebt service will revert to the state general revenuefund for other purposes so that the pledge of newor additional lottery revenues will not hamperfunding of other state programs.The lien position of pledged revenues is veryimportant. If there is no formal cap or dedicationof revenues, Standard & Poor’s will analyze thestate’s historical financial position and how revenueshortfalls, if any, were met in order to gauge thepotential that a state may be compelled in thefuture to redirect a greater share of lottery revenuesfor general fund purposes.The additional bonds test is important, as itensures a minimum level of debt service coverage offuture maximum annual debt service before additionaldebt can be incurred. Additional bonds testsshould be historical in nature, specifying that revenuesmust cover future maximum annual debtservice on historical and proposed debt by a fixedpercentage before new bonds can be issued. Allother things being equal, a higher additional bondstest and coverage level usually lead to a higher rating,unless the issuer’s lack of adequate revenue collectionhistory or revenue volatility becomes alimiting factor. If an additional bonds test allowsfor the issuance of variable rate debt or a bulletmaturity that will need refinancing, the additionalbonds test coverage multiple ideally would be sufficientto protect against possible future swings ininterest rates. If the additional bonds test coveragemultiple is low, the use of prevailing short-terminterest rates when calculating future debt servicefor purposes of the additional bonds test would notbe as favorable as using some extra factor anticipatinga rise in rates. A good alternative might be touse instead prevailing long-term rates, or prevailinglong-term rates plus an extra adjustment factor,allowing a coverage margin for a potential rise ininterest rates.Given the discretionary nature and quality of thepledged revenue stream, a debt service reserve fullyfunded from bond proceeds is a rating factor. ■www.standardandpoors.com77

Tax-Secured DebtSpecial-Purpose DistrictsTax Increment BondsTax increment financing, sometimes called taxallocation bonds, has been issued in a majorityof states, although California redevelopment agenciescontinue to account for the bulk of nationalvolume. Tax increment financing is secured by taxesgenerated from the increase in property value in adistrict after a redevelopment project has begun. Assuch, it does not raise the tax rate on district taxpayers,but merely reallocates tax revenues thatwould otherwise flow to pre-existing taxing entitiesin favor of a redevelopment agency that issues debt.Tax revenues produced from pre-existing propertybefore the tax increment district was formed continueto flow through to the underlying taxing entitiesas before; only the taxes attributable to theincrease in property values flow to the redevelopmentagency and are pledged to bondholders.Tax increment bonds benefit from several favorablestructural elements compared to other specialdistrict debt. Unlike special assessment and Mello-Roos bonds, no additional tax burden is created fortaxpayers, and tax collection rates are generally lessof a concern, unless project area tax payments areconcentrated in a few taxpayers. In addition, whileundeveloped land in a special assessment or Mello-Roos district can lead to high debt burdens, undevelopedland in a tax increment district is generallya favorable factor, since tax revenue will increase tothe extent new development occurs and taxableproperty values grow. In contrast, revenues do notincrease for special assessment or Mello-Roos debtwhen property values rise because those taxes arenot based on land value, although developmentmay lead to more favorable value to debt ratios.The main credit risk for tax increment districts isthat tax rates and the pace of private developmentin a project area lie outside the control of the redevelopmentagency issuing the debt. Actual tax ratesgenerating the tax are set by the underlying taxingentities—cities, counties, school, park districts, andothers—that set their tax rates without considerationof the needs of the redevelopment agency.Changes in state tax law, or assessment practices,can dramatically influence tax increment revenue.Tax increment district bond pitfallsA typical investment-grade tax increment districtalready generates sufficient revenues to cover futuremaximum annual debt service (MADS) at the timeof the sale of bonds, a feature sometimes called“coverage in the ground”. However, the experienceof southern California during the 1990s shows thatmany different factors can subsequently reduce taxincrement revenues. Some of the common pitfalls ofthese bonds include volatility in commercial realestate values during an economic downturn, particularlyfor warehouses and hotel properties, widespreadtax appeals that can overwhelm countyassessment offices, a residential real estate bust,construction risk on projected projects, state taxlaw changes, plant closures, concentration in a fewtaxpayers, purchase or foreclosure of land by taxexempt entities, and a high tax increment volatilityratio for recently formed project areas.Project area analysisStandard & Poor’s Ratings Services analysis focusesfirst on general economic factors that may affectthe economic growth of the project area, such as amunicipality’s population, employment, and incomelevel. Building permits may indicate overall cityconstruction trends. Nonetheless, the general characterof a city is not necessarily a barometer of theconditions within a localized project area. In thisrespect, a site visit may help give credence to rapidlyimproving economic conditions that are notreflected in assessed valuation numbers. One wayto get a description of a new project area is to readthe redevelopment agency’s plan, which outlinesprior economic conditions and project objectives.Taxpayer concentrationOne weakness of many project areas is their smallsize, leading to taxpayer concentration. Standard &Poor’s has no size limit on investment-grade ratedproject areas. Generally, smaller districts will haveweaker credit characteristics and, thus, lower ratings.A larger project area, generally one of over150 acres, is usually more diverse and more creditworthy.Standard & Poor’s analyzes taxpayer concentrationby comparing assessed valuation of the78 Standard & Poor’s Public Finance Criteria 2007

Special-Purpose DistrictsTax Increment Information RequirementsTo rate tax increment debt, the following standardized informationis usually required:A preliminary official statement, including:■ Number of project area acres and a description of the land uses within theproject area.■ Five year project area assessed valuation history, if available.■ Project area tax rates and underlying taxing entities.■ Base year assessed valuation.■ Debt service schedule.■ Ten largest taxpayers and each of their assessed values.■ Tax collection rates.■ Major pending assessment appeals.■ When sub-areas of a project area, if any, might expire before bond maturity.■ Cumulative project area tax limit, if any, and how much has been collectedunder it to date.■ Description of tax-sharing agreements with underlying taxing entities, if anyis senior to debt service. If they are, disclosure of any that could cause anincrease in prior payments in a future year.■ Additional bonds tests and other legal covenants.■ Bond Indenture.■ If there is a consultant’s report, a copy should be provided.top taxpayers to project area incremental value—not project area total value—because revenues riseor fall based on incremental valuation. It is notuncommon to see each of the top taxpayers representingmore than 100% of incremental projectarea valuation in newly formed project areas, eventhough top taxpayers may appear deceptivelydiverse when compared to total project areaassessed valuation.Generally, Standard & Poor’s requests theassessed valuations of the top 10 taxpayers. It istypical for 40% or more of the incremental taxbase to be held by the top five taxpayers, based onthe relatively small size of most project areas.Taxpayers may also not appear overly concentratedwhen considered individually, yet they may stillcomprise just one shopping mall or condominiumdevelopment. Market factors can swing the value ofsuch shops and homes together as a result of theircommon location and function, apart from fire ornatural hazard risks of adjacent buildings. Districtsconcentrated in a particular type of property, suchas aircraft or computer equipment capable of beingmoved to other locations, may also have other vulnerabilities,even if they are diverse by taxpayer. Ifpayment of debt service is essentially dependent onjust a few taxpayers making their tax payments, itmay be difficult to achieve an investment-grade ratingunless those taxpayers demonstrate creditworthiness,and the property is essential to its operations.Even in the case of a rated taxpayer, however,the property should be highly essential to the taxpayerto get the benefit of the credit rating assignedto the taxpayer. An example would be an importantgenerating plant of a rated investor owned utility.Assessment practices that may at first appear to“guarantee” tax collections have been shownthrough experience to not always be reliable. Afinancially strong company can still remit smallerthan-expectedtax payments by appealing its assessment(which can take three years or longer toresolve), not rebuilding after a fire, or delaying initialconstruction. Taxpayer bankruptcy proceedingscan also temporarily forestall legal foreclosure ortax assessment sales, since federal bankruptcy lawsupercedes local law.Historical assessed valuation growthStandard & Poor’s prefers to examine at least fouryears of project area assessed values, when available.One of the virtues of tax allocation bonds is the typicallyhigh growth rate of assessed valuation withinmost new project areas. However, a recent base yearmay cause deceptive percentage rises in incrementalassessed valuation because of the comparison to smallearly-year incremental values (see the tax volatilityratio chart). Total project area assessed valuation maybe a more meaningful indicator of growth trends. In afew states, fire, demolition, or conversion to taxexemptproperty may be used to decrease the frozenbase assessment—increasing incremental assessedvalue—without new construction.Future assessment growthAn important indicator of future assessmentgrowth is the acreage available for new development.A fully developed area, with no redevelopmentpotential, effectively limits the possibility ofassessed valuation growth. However, projectareas with large undeveloped land areas are notassured of attaining growth. Constructionstrikes, changes in market conditions, or higherinterest rates can suddenly cancel or delay eventhe most promising development.Construction risk, when present, is such a riskfactor that most investment grade-rated tax allocationbonds already demonstrate coverage of maximumannual debt service by historical tax revenues(Standard & Poor’s will consider next year’s taxlevy an “historical” revenue if it is based on thecurrent assessor’s assessment roll and the currenttax levy), although exceptions have been madewhen debt service could be covered with only limitedamount of future growth that seems especiallylikely. Historical coverage of debt service alone,however, does not necessarily guarantee an investment-graderating.www.standardandpoors.com79

Tax-Secured DebtManagementPolicy control of a redevelopment agency usuallylies in a city council, with an executive directorresponsible for implementation. The agency holdsbroad authority to acquire, develop, and administerproperty, as well as eminent domain powers. Oftena major portion of tax allocation bond proceeds isused to acquire and consolidate parcels of land.Examples Of Different Base To Total Project Area Assessed ValuationsDifferent volatility with same initial coverage and assessed valuationLow volatility High volatilityProject area A Project area BTotal assessed value $500 million $500 millionBase increment $100 million $400 millionIncremental assessed value $400 million $100 millionTax rate 1.00% 1.00%Pledged revenues $4 million $1 millionMaximum annual debt service $2 million $500,000Coverage 2.0x 2.0xIf project assessed value fell 10% Project assessed valuation $450 million $450 millionIncremental assessed value $350 million $50 millionPledged revenues $3.5 million $500,000Coverage 1.75x 1.00xBase assessed value to total value volatility ratio 0.2 0.8Tax Increment Bond Volatility RatioThe mathematical formula used to compute incremental tax revenues does not treat all project areas equally on a general decline inassessed values. Tax increment project areas containing a small amount of incremental valuation in relation to their total assessedvalue will show greater volatility revenues. This is often the case for recently formed project areas. Thus, two project areas, with thesame amount of total assessed value, can have unequal loss of tax increment revenues, even when losing the same amount of totalassessed value.Standard & Poor’s uses a revenue volatility ratio to highlight the speed at which revenues can fall in the event assessed valuesdecline. The ratio consists of the project area’s base assessment to total assessment. This ratio can serve as a proxy for the speedwith which tax increment revenues will rise or fall in the event of a fluctuation in assessed value. Standard & Poor’s expresses thevolatility ratio of base assessment to total assessment as a decimal fraction between 1.0 and 0.0. A higher number represents morevolatility. In other words, revenues will rise or fall more rapidly with a small change in project area assessed valuation when the ratiois high. The ratio is incorporated as part of Standard & Poor’s rating process.The ratio serves as a convenient flag for the most vulnerable districts in times of real estate decline. Most of the tax allocation bondsthat experienced troubles during California’s real estate downturn of the 1990s had high volatility ratios.On the other hand, a high volatility ratio can also cause a quick increase in revenues and coverage in the event of even modestassessed value increases.In the example, project areas A and B have the same assessed value and tax allocation coverage, but would respond very differentlyto a 10% decline in overall project area AV. Project area A has a low base-to-total assessed value volatility ratio of 0.2, while Projectarea B displays higher revenue volatility with a change in assessed valuation, with a volatility ratio of 0.8. Project area A, which isolder and has a smaller base valuation, suffers a much smaller decline in coverage, from 2.0x to 1.75x if total assessed valuationdeclined 10%. Project area B’s debt service coverage falls from 2.0x to 1.0x with the same percentage decline in assessed valuebecause it was more recently formed and has a high base valuation relative to total assessed valuation.The volatility ratio is specific to each project area, and is independent of the amount of debt issued by a project area.One alternative way to look at this volatility ratio is to examine its inverse. The inverse represents the percentage that total projectarea assessed valuation must fall to produce zero tax increment revenues. Thus, a high volatility ratio of 0.8 means total assessedvalue would have to fall 20% before there would be no more tax increment revenues.80 Standard & Poor’s Public Finance Criteria 2007

Special-Purpose DistrictsQuestions for management may encompass additionaldebt plans, unusual features of the redevelopmentplan, and the land use breakdown when theplan is completed.Legal considerationsStandard & Poor’s analysis of the legal structure ofa tax allocation bond focuses on the security pledge,flow of funds, debt service reserve fund, and provisionsgoverning the issuance of additional paritydebt. The flow of funds is usually simple. Tax incrementpays debt service, makes up debt servicereserve deficiencies, and then revenues are releasedfor any purpose. Lack of a fully funded reserve isviewed as a negative rating factor in view of the lowdebt service coverage of most tax increment bonds.Additional debt issuance is likely over the life ofa bond issue. Tests for additional bonds requiring1.25x coverage of maximum annual debt serviceby historical revenues, or revenues to be realized asa result of the most recent finalized assessmentrolls, are considered a typical provision. However,stricter additional bonds tests may enhance creditquality. Provisions allowing adjustments to revenuesbased on construction in progress or a consultant’sprojection can severely weaken theadditional bonds test. The coverage multiplerequired under the additional bonds test is examinedin relation to the number of taxpayers excesscash flow could cover in the event of delinquenciesamong major taxpayers, assuming a redevelopmentagency bonded out to the limit of its additionalbonds test. Thus, no one additional bonds test orcoverage level can guarantee a specific rating.More established diverse districts have issueddebt with less than a 1.25x additional bonds testwithout a negative impact on their credit rating astheir tax volatility ratio declined and their taxpayerconcentration diminished. Standard & Poor’sweighs a more permissive test against taxpayerdiversity, historical and projected growth trends inassessed valuation, the nature of such growth, andthe need and likelihood for additional debtissuance. On the other hand, higher debt servicecoverage and stronger additional bonds tests mayoffset weaknesses in district economic diversity.Aside from an issue’s legal structure, Standard &Poor’s evaluates tax increment authorization lawsand litigation. Standard & Poor’s examines all newstate authorizing legislation for potential problems.Litigation frequently accompanies tax allocationissues, especially in states newly authorizing suchfinancing, because public entities losing the tax revenueshave an incentive to sue. Taxpayers and overlappingunits often contest the constitutional validityof new tax allocation legislation; counties may wishto postpone the loss of revenues, and taxpayers maywant to delay eminent domain proceedings.Some tax increment bonds also have a pledge ofa city’s GO. Standard & Poor’s will rate such double-barreledsecurities based on the higher of theGO or tax increment rating, since both are pledgedto debt repayment.Financial operationsPrimarily, financial factors include an analysis offluctuating tax rates, delinquent collection rates (forthe project area, not the city), and historical debtservice coverage. No specified level of coverageleads to a particular rating, since taxpayer concentrationor legal factors may be much more important.When a particular weakness is identified, it isuseful to check coverage sensitivity to such vulnerabilities.For example, if an issuer experiences poorproperty tax collection, coverage levels and additionalbonds tests can be raised to compensate. Thelower of the additional bonds test coverage level, orcurrent revenue coverage of maximum annual debtservice, is used for analysis. Projected coveragebased on construction growth is not always reliable,but worth considering.Various mathematical considerations concerningthe ratio of base to total assessed valuation alsomay affect the volatility of the revenue stream inthe event assessed valuation declines (see chart onthe tax volatility ratio). In general, the smaller adistrict’s base valuation is compared to its total valuation,the lower the revenue volatility.Cumulative tax limitsProject areas in California are subject to a cumulativecap on tax increment that can be collectedfrom a project area over the life of the project area.Sometimes, higher-than-projected tax increment cancause the cap to be reached before final bond maturity.If this appears to be a significant possibility,Standard & Poor’s would prefer a covenant by theredevelopment agency to annually review the totalamount of tax revenues remaining and to escrowrevenues or not accept tax monies if it would causethe tax limit to expire before final bond maturity.Special Assessment BondsSpecial assessment bonds are secured by a specialtax, such as a street front-footage assessment,which is levied in relation to the benefit a propertyreceives from an improvement. As a consequence,the tax is not based on the actual value of a propertyand debt burdens, as a percent of the marketvalue of a parcel, can vary greatly from one parcelto another. Since each taxpayers’ tax payments areusually fixed and can not be raised to cover thewww.standardandpoors.com81

Tax-Secured Debtdelinquency of any other taxpayer, credit analysismust focus on the exposure to the weakest properties,even if overall average property value to debtratios are strong districtwide.In particular, special assessments on undevelopedland may create burdensome tax payments for thoseproperties. Undeveloped land typically carries propertyvalue-to-debt ratios of 3:1 or less, while developedproperties are generally closer to 20:1. Standard &Poor’s expects investment grade special assessmentbonds to be able to at least withstand two separatesensitivity analyses: (1) a multi-year tax delinquencyby the 2-5 largest special assessment taxpayers; and(2) a permanent delinquency by all special assessmenttaxpayers with under a 5:1 value-to-overlapping debtratio, absent special circumstances.Sources of money to cover potential delinquenciesmay come from reserve funds, an ability to raisetaxes to a limited degree, over-collateralization oftax payments, back-up support from a city’s generalfund (often found in Arizona), cross-collateralizationwith other special districts, a senior/subordinatebond structure, or other revenue sources.Special assessment bonds have proven very popularin growing areas such as California and Florida,where existing residents may be reluctant to pay forinfrastructure improvements in new housing developments.However, special assessment financing isused throughout many areas of the country.Examples of projects funded by special assessmentbonds include water and sewer lines, lightingimprovements, roadways, and sidewalks.Financing special assessment projectsThe special assessment process is often quite simple.In most cases, property owners in a limited area, ortheir local representatives, petition for the creationof a special assessment district. A project is specifiedthat will directly benefit property owners withinthe district and be paid for by fees or assessmentsbased on a measurement related to the benefit, suchas street frontage or square footage owned. Bondsare sold to finance the project(s), and security isprovided by the assessments.Most improvements provided by special assessmentbond financing are related to local infrastructure,although bonds have been sold to financeparking lots, landscaping, and public parks. Theseimprovements benefit district property owners byimproving the quality of their neighborhood andcontributing to greater property values.Usually, bonds are used only for the constructionof the project and not for maintenance. Often, themunicipality will absorb the maintenance cost, sincethe project generally is tied into a citywide system,such as water and sewer services.Standard & Poor’s believes that the lack of excesscash flow coverage typical for most special assessmentbonds may create risks, particularly for undevelopeddistricts. However, potentially speculativeelements can be mitigated through such factors as:■ An ability to raise assessment tax rates to alimited degree;■ The existence of excess cash flow from reserveearnings, refunding savings, or a senior subordinatecash flow structure;■ Strong taxpayer diversity, and a debt servicereserve that can cover simultaneous delinquenciesof at least the top two taxpayers;■ The ability to sell tax liens to cover delinquencies,although this is restricted under federal lawif a taxpayer declares bankruptcy;■ Particularly strong value-to-lien ratios;■ A lien on parity with or ahead of ad valoremtaxes;■ Legal protections within the bond structure;■ Economic incentives for timely payment of specialassessment obligations; and■ Low risk associated with the particular project.Major criteria considerationsDistrict makeup and economic base—A districtlargely undeveloped or concentrated in one type ofindustry is viewed negatively. A special assessmentdistrict tied to a stable and diversified economicbase is desirable. The effects of employment levels,wealth indicators, and regional trends on paymentof assessments are evaluated. A wholly residentialdistrict usually exhibits little taxpayer concentration,a very favorable situation if fully developed.Method of assessment collection. Special assessmentscollected at the same time and with the sameforeclosure methods of ad valorem taxes are preferred.Standard & Poor’s also may regard incentivesfor early payment and disincentives for latepayment as positive features. For example, penaltiesfor late payment and discounts for early paymentmay be worthwhile, depending on their effect oncash flows.Value-to-debt ratios. High property value-to-debtratios, preferably above 7:1 for investment-graderatings, increase the likelihood of making assessmentpayments on a timely basis. Also, the marketabilityof property in the district points to addedsecurity if properties must be sold as a result offoreclosure or bankruptcy. Value to lien ratios mustbe examined on a parcel-by-parcel basis for toptaxpayers, since tax levies cannot typically be raisedon the strong taxpayers to pay for the weak, renderingoverall district value to lien ratios problem-82 Standard & Poor’s Public Finance Criteria 2007

Special-Purpose Districtsatical in many cases. Standard & Poor’s prefersvalue to lien ratios using county or city assessedvaluation, although independent appraisal reportsmay be evaluated also if deemed reasonable.Lien position. A lien on parity with or aheadof ad valorem taxes is desirable. Preferably, thegeneral property tax bill should be combined on thesame statement as the special assessment tax bill tohelp collection rates.Treatment of property sales. Liens should remainin place upon transfer of property or be extinguishedby an immediate acceleration of all outstanding,current, and future special assessments onthe property.Foreclosure/bankruptcy provisions. Assessmentcollections should not be hindered by foreclosure,bankruptcy, or sales of tax certificates or taxdeeds. Action should be taken on a timely basis toensure that sufficient funds are available to makescheduled debt service payments. The marketabilityof property is also a concern here; propertyshould have sufficient value that bids will appearfor foreclosed property. Requirements allowingand requiring foreclosures to proceed on an acceleratedbasis compared to that for general propertytaxes is considered favorable.Clear right to issue. Public hearings and a deadlinefor discussion are necessary, within legalrequirements, so that there are no legal challengespossible once bonds are offered.Term and redemption of bonds. The debt serviceschedule is usually flat or declining over timeand should be within the useful life of the projectand improvements.Special Assessment and Mello-Roos Information RequirementsTo rate a Special Assessment or Mello-Roos bond the following information isusually required:A preliminary official statement, including:■ Size of district.■ General description of the district with estimated build out dates.■ Land use within the district broken out by percent of the tax from taxpayerswith less than a 5:1 value to lien ratio, less than 10:1, and greater than 20:1.■ Largest 10 district taxpayers with their assessed values and share of thepledged tax.■ Description of the formula used for generating the pledged tax.■ Debt service schedule.■ Tax collection rates.■ Overlapping tax rates and overlapping debt.■ Median home values in the district.■ Bond Indenture, Bond Resolution, or Fiscal Agent’s Agreement.■ Consultant’s or Appraiser’s report, if any.Debt service reserve. A reserve fund or othersecurity feature that provides for payment of debtservice is essential in the event that assessments arenot received on a timely basis. The amount of thedebt service reserve and the way that it is fundedare important, because funds to cover any revenueshortfall are expected to be available at all times.Cash flow runs. Sensitivity tests that demonstratethe bond structure’s strength in the event of delinquencyof the largest taxpayers are necessary inevaluating the ability of the bond structure to withstandunexpected events. Standard & Poor’s normallyexpects some excess cash, either in a debtservice reserve or through excess cash flow, beavailable to cover a delinquency by at least the toptwo to five taxpayers, unless the top taxpayer hasitself been rated by Standard & Poor’s.In some cases, Standard & Poor’s commercialmortgage group can evaluate the credit quality ofan individual development for assessment bondpurposes and the rating can be based on a singletaxpayer or retail development. Usually, however,Standard & Poor’s requests information determiningthe maximum number of taxpayer delinquenciesa district can handle before defaulting and comparesthis to the concentration of the top taxpayers.Where extremely high taxpayer diversity exists,such as in fully developed residential districts, thedebt service reserve alone may be able to cover thepermanent loss of the top five taxpayers for a numberof years, mitigating excess cash flow needs.California’s Mello-Roos DistrictsMello-Roos bonds, also known as CommunityFacilities District bonds, are specific to California.They are similar to special assessment bonds in thatthey levy a charge that is not based on propertyvalue, but dissimilar in that they usually have theability to raise the tax rate up to a maximum levelto cover taxpayer delinquencies. Most Mello-Roosdistricts levy a tax per dwelling unit or per acre,based on development status, but there is no realrestriction on the type of tax, other than it cannotbe based on property value.The different types of taxes allowed under theMello-Roos Act raise varying credit quality considerations,but certain key concerns are common toall Mello-Roos bonds. Probably the greatest creditrisks occur in the district’s initial phases, when thetaxpayer base is concentrated and debt-to-assessedvalue (loan-to-value) ratios are high because landmay be owned by a few developers and largelyundeveloped (see Undeveloped Special Districts). Asdevelopment occurs, credit quality should improveto the extent that ownership becomes more diverse,and loan-to-value ratios decrease. Upon a refunding,several years after a district’s creation, creditwww.standardandpoors.com83

Tax-Secured Debtquality could be vastly improved. Even relativelyundeveloped land could receive a favorable initialrating if the area is characterized by numerous taxpayers,good loan-to-value ratios, and flexibility tocover taxpayer defaults by raising tax rates.Generally, investment grade Mello-Roos districtswill show at least close to 1x cash flow coverage ofdebt service from parcels within the district thathave an assessed valuation to debt ratio of at least5:1, with no major taxpayer concentration amongthese higher value to lien taxpayers.Easy to implementMello-Roos financing is attractive for two reasons.First, unlike special assessment bonds, it allows thefinancing of general-purpose projects, such as policestations, which may be outside Mello-Roos districtboundaries. A second attraction is Mello-Roos districts’easy implementation in undeveloped areas.The Mello-Roos Act declares district landowners tobe the voters when 12 or fewer voters reside in aMello-Roos district, an interpretation that could besubject to future legal challenge if there are actualresidents present.Because districts may be formed in any size orshape, even from noncontiguous parcels, it is relativelyeasy to form and obtain ‘voter’ approval of a Mello-Roos district in undeveloped or industrial areas.Different governments, such as school districts orcities, may form separate overlapping Mello-Roos districtsas long as each governmental entity is authorizedto perform the different service being provided.Practically speaking, district boundaries can be drawnto guarantee that fewer than 12 voters reside in a districtor that residents support district formation.Any type of tax may be imposed in a Mello-Roosdistrict, as long as the tax burden can be evaluatedat the time of voter approval and is not leviedagainst property values. Taxes can be designed tomimic property taxes closely, even though by lawthey can’t be imposed solely on the value of a property.For example, a district could tax the numberof homes, street frontage, or number of acres. Evena per capita tax can be imposed, using taxes thatare fixed or fluctuate up to a cap. An acreage taxor an equivalent dwelling unit tax, are the mostpopular form of taxation. Taxes may kick in on differentdates, and maximum permitted tax ratesoften escalate 2% per year to accommodate anincreasing debt service schedule. Generally, undevelopedland (usually owned by developers) is nottaxed, or taxed very little, while future homeownerssupport actual debt service. As long as bonds areoutstanding, the tax cannot be repealed.The many possible Mello-Roos tax structures createdifferent risks depending on their structure.However, all districts have some features in common.The strongest districts have economic diversity,with numerous taxpayers and high value-to-loanratios, and levy a well-designed tax that covers abroad tax base. Such a district could receive afavorable credit rating if the existing tax base canproduce favorable coverage of future maximumannual debt service, and an additional bonds testlocks in the coverage.The best additional bonds tests use the maximumpermitted tax rate on the existing tax base to calculatea minimum coverage requirement on future maximumannual debt service. Weak additional bondstests may require only an appraiser’s report, subjectto possible error, estimating a certain minimum valueto-lienratio. Additional bonds tests based on buildingpermits granted, while stronger than a wholly projectedtest, are weaker than tests based solely on revenuesfrom owner occupied homes as determined by a certificateof occupancy or the county assessor, due tothe time lag between receiving a permit and actuallycompleting a structure.Concentration of district taxpayers is a particularrisk for small or start-up districts. If payment ofdebt service depends on payments from a few taxpayers,there are obvious vulnerabilities. Apartfrom the normal cash flow problems caused bydelinquency of a major taxpayer, a federal bankruptcylaw filing by a taxpayer can indefinitelyforestall local foreclosure action. Taxpayer concentrationis particularly important, because most districtswere originally formed by a few developersholding undeveloped land. The ability to raise taxrates may mitigate concentration risk if additionallevies could cover delinquencies by major taxpayers.Sometimes maximum tax rates are designed toincrease a certain percent every year to match anincreasing debt service schedule. If so, inflationassumptions should be carefully scrutinized in sucha case to ensure that homeowners would not besubject to possibly onerous taxes in later yearsMany types of taxes can be imposed and pledgedto debt service; therefore, Standard & Poor’s willexamine each Mello-Roos bond issue on a case-bycasebasis. Major rating considerations include:■ Surrounding economic characteristics;■ The nature of the development and the developer’strack record;■ Tax-to-property value relationships, with emphasison the percentage of the tax generated byparcels with value to lien ratios above 5:1;■ Restrictions on additional parity debt;■ Existence of overlapping districts;■ Project feasibility;■ Nature and diversity of items taxed and thetax structure;84 Standard & Poor’s Public Finance Criteria 2007

Special-Purpose Districts■ Cash flow timing and sensitivity to taxpayerdefaults;■ County assessment and collection practices; and■ The property value added by the funded project.Certain types of development are subject to morerisks than others. For example, multifamily housingprojects are more cyclical in their sales patternsthan single-family homes, and preleasing may mitigateoffice building construction risk.In general, the nature of development risk mayintroduce varying degrees of speculative characteristicsto undeveloped districts owned by just a fewdevelopers. However, credit quality may improverapidly as development occurs, and homes or commercialdevelopment are sold off. The ability toraise tax rates, while limited by reform legislation,still provides Mello-Roos districts with potentiallybetter credit quality characteristics than most specialassessment districts, with which they sharemany similarities. A number of formerly speculative“raw land” districts now have developed to thepoint where their credit quality is quite favorable.However, investors still need to do their homeworkto make sure that potential additional debt and fundamentaleconomic factors would still support ahigher rating as a district develops.Some Selected Common CharacteristicsOf Special Assessment And Mello-Roos Bonds‘A’District is fully or close to fully developed (80% or better), diverse taxpayer base;strong economic location; good maximum annual debt service coverage; debtservice reserve may be fully or partially funded, but must cover the loss of the topfive taxpayers for life of the bonds; high value to lien ratios of grater than 20-to-1;strong legal protections regarding additional debt issuance, and prompt propertyforeclosures.‘BBB’District is mostly developed (70% or better); some taxpayer concentration butexpected to be reduced as development continues; adequate economic basewith good prospects for continued economic growth; adequate maximum annualdebt service coverage of at least 1.0x; debt service reserve may be fully or partiallyfunded but must cover the loss of the top five taxpayers for seven to ten years;moderate overall value to lien ratios of at least 10-to-1; strong legal protectionsregarding additional debt issuance, and prompt property foreclosures.Non-Investment Grade — District is only partially developed; significant taxpayerconcentration with the top ten taxpayers accounting for more than 50% ofassessed value; developing economic base with uncertain prospects for economicgrowth in the future; failure of the debt service reserve to cover the loss of thetop five taxpayers for at least ten years; low overall value to lien ratios of atless than 10-to-1 and a significant amount of properties with value to lien ratiosof 5-to-1 or less; adequate legal protections regarding additional debt issuance,and prompt property foreclosures.Undeveloped Special DistrictsStandard & Poor’s has extended its criteria for specialdistricts, Mello-Roos (Community FacilityDistrict), and special assessment districts to includenoninvestment-grade debt and more clearly delineatethe types of development risk involved in largelyundeveloped special districts.Such distinctions are important, since the nature ofreal estate and construction risk can vary widelyamong undeveloped districts. Special districts withdebt rated below investment-grade display an evengreater degree of unique variety than more highlyrated debt. Nevertheless, certain commonly found situationswould compare in terms of creditworthiness(see chart, “Some Selected Common CharacteristicsOf Special Assessment And Mello-Roos Bonds”).Fundamentally, creditworthiness for special districtsdepends on prospects for strong real estate values,reasonable debt levels, and taxpayer diversity.Legal covenantsStrong structural legal protections regarding taxpayerforeclosure, debt service coverage, or debtservice reserves cannot, in and of themselves, raise arating into the investment-grade category unlessfavorable real estate conditions exist. Legalcovenants providing meaningful bondholder protectionmust lock in the economic benefits of a strongtax base against future issuer actions, such as additionaldebt dilution or poor tax collection procedures,but the tax base must exist first.Therefore, a Mello-Roos bond with a weak taxbase will not necessarily be able to improve itsbond rating with strong structural legal covenantprotections, since there is little to protect.Conversely, a Mello-Roos district with a strong taxbase may be prevented from obtaining a higherbond rating by weak structural protections.If development occurs, creditworthiness mayimprove dramatically in an undeveloped district.However, weak legal protections, written in at thetime of bond sale, may limit upside rating potentialeven if the tax base develops as planned. Investorsstill need to examine legal covenants closely in almostall situations, even before development occurs.In particular, a fully funded debt service reservemay buy an issuer some time during periods of heavyforeclosures, but cannot cover against ultimate losses.Other legal provisions of importance include:■ Maximum permitted tax rates;■ Additional bonds tests; and■ The timing of foreclosures and tax rate changes.There are also key legal differences betweenunlimited tax special districts, Mello-Roos debt,and special assessment debt, although undevelopeddistricts share similar real estate development risk.Special district and Mello-Roos bonds usually havewww.standardandpoors.com85

Tax-Secured Debtthe flexibility to raise tax rates to cover a taxpayerforeclosure loss. This is a key strength of specialdistrict and Mello-Roos debt over special assessmentbonds. Special assessment bonds usually havejust 1x coverage of annual debt service by yearlyspecial assessments and lack any ability to raise taxrates. In such cases, the bond may be only as strongas the ability to receive ultimate repayment fromthe weakest property taxed.Exceptions exist. Sometimes debt service reserveearnings can cover foreclosure losses of the top taxpayersif the top taxpayers are small, comparedwith the total tax base. Another exception occurs inFlorida, where the state allows the special assessmenttax rate to be raised in some cases, up to alimited amount. This feature makes these Floridaspecial assessment bonds resemble California’sMello-Roos bonds—a positive feature.Land appraisalsAppraisals of vacant land by private consultants maybe problematic. The difficulty is that they are basedonly on a value at a point in time, and built on a setof assumptions that developers will follow the expecteduse of the land. If plans do not materialize as anticipated,or new landowners change their expected useof the land, actual values for vacant land could changeappreciably. For this reason, private appraisals of rawland can often be considered unreliable. Standard &Poor’s looks at the reasonableness of appraisalassumptions and sometimes may discount appraisalconclusions. There are wide distinctions between differenttypes of development districts, and investorsmore than ever need to distinguish the strong creditsfrom the weak. In particular, investors may want todetermine if legal features could preclude a bond fromever moving into the investment-grade categories. Theaccompanying table, while it does not cover everycase, should provide helpful guidelines. Some positivefactors, such as debt service coverage, can offset othernegative factors, such as taxpayer concentration.District SizeStandard & Poor’s does not have a minimum sizelimit for an investment-grade rated special district;rather size affects a special district in that a smallsize may increase taxpayer concentration. A largedistrict concentrated in a few taxpayers may not beas creditworthy as a small district with little taxbase concentration in the top taxpayer. A specialdistrict consisting only of a 500-unit single-familyhousing development, for example, may achieve aninvestment-grade category rating, depending on theparticulars of local real estate conditions. ■State Credit Enhancement ProgramsState Enhancement ProgramsState credit enhancement programs generally fallinto four categories or program structures.Those categories are:■ Intercept/Withholding■ Standing or Annual Appropriation■ State Guarantee■ State Permanent FundThe type of program and the contractual relationshipbetween the state and the program participantdictates whether a program rating or outlookwill change due to a related state rating action. Notall programs fit neatly into the four categories mentionedabove. In these cases, whenever there is astate rating change, a program review will also takeplace to determine if there is a need to adjust theprogram rating or outlook.In general, credit enhancement programs aredesigned to give bondholders additional security forparticular general obligation and lease bonds.While the criteria differ depending on the program’sstructure and the specifics of a state’s statutes andconstitutional provisions, all programs typicallyinclude the following features:■ An independent paying agent, which acts asthe state’s notification agent in the event of apotential default;■ Sufficient coverage and liquidity of a revenuestream to be used for a debt service deficiencythat is independent of the issuer; and■ State oversight of program participants to ensurea well-managed program.Intercept/Withholding ProgramsIntercept or withholding programs operate on thestrength and availability of state aid, which can bediverted to a paying agent in the event a local governmentcannot make its full and timely debt servicepayment. Standard & Poor’s Ratings Servicesrates intercept or withholding programs that meet86 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programscertain requirements at a level one notch off of thestate’s GO rating—on par with the state’s appropriationrating—reflecting the appropriation nature ofthe intercept or withholding mechanism.Accordingly, if the state rating changes so will theprogram rating. Other programs do not meet theserequirements and are rated more than one notch offthe state’s rating. These program ratings will notchange due to a change in the state rating unlessand until they converge with the state’s rating.One category of intercept programs rated on parwith appropriation debt are programs structured toprovide full and timely payment of debt servicedirectly to a paying agent, regardless of theamount of undisbursed state aid due to the entityat the time of intercept. Programs that fall underthis category are:■ California Infrastructure Bank School AidIntercept Program■ Colorado State Aid Intercept Program■ Massachusetts Qualified Bond Act■ Mississippi State Aid Capital ImprovementBond Program■ Missouri Direct Deposit of State Aid Program■ New Jersey Qualified Bonds ProgramAlthough the specific structure of each programvaries, these programs are also characterized bystrong state oversight in addition to the other characteristicsmentioned above.Other intercept or withholding programs providefor payment of debt service only up to an amountequal to remaining undisbursed state aid. However,some of these programs are rated on par withappropriation debt because they require that participant’savailable state aid cover debt service by atleast 2x maximum annual debt service (MADS),reducing the risk that available state aid will beinsufficient to fully cover debt service. In order toachieve an appropriation-equivalent rating,Standard & Poor’s requires that the coverage multiplebe set equal to at least 2x MADS. Standard &Poor’s considers this level of coverage to mitigatethe risk of available state aid being insufficientwhen debt service is due. Programs that qualify forthis rating based on coverage requirements include:■ Georgia State Aid Intercept Program (resolutionenhanced—see program detail)■ Ohio State Aid Intercept Program■ Indiana State Aid Intercept Program (resolutionenhanced—see program detail)■ Kentucky State Aid Intercept Program■ Kentucky State Aid Intercept Program forCommonwealth UniversitiesThose intercept or withholding programs that donot provide for full and timely payment of debtservice or do not have the additional strengths discussedabove are not viewed by Standard & Poor’sas equivalent to state appropriations. Consequentlythese programs are rated lower than the state ratingand their ratings will not necessarily change due to achange in the state’s rating or outlook; however, inthe event a state rating is downgraded to a level at,or below, the program rating, the program ratingmay be lowered to a level at or below the revisedstate rating. Programs in this category include:■ Georgia State Aid Intercept Program■ Indiana State Aid Intercept Program■ New York State Aid Intercept Program■ Pennsylvania State Aid Intercept Program■ Virginia State Aid Intercept ProgramStanding Or Annual Appropriation ProgramsAppropriation programs are dependent on astate’s ability to use its cash reserves to make upany debt service deficiency for a participating localgovernment’s debt service payment. There is a distinctionmade between standing appropriationprograms which are rated on par with the state’sGO rating and annual appropriation programswhich are subject to appropriation risk and arenotched one notch below the state GO ratinglevel. Standing appropriation program ratings arenot subject to appropriation risk and reflect boththe state’s sovereignty and its constitutional obligationto fund education.For both standing and annual appropriation programs,the state’s credit quality is directly linked tothe program’s rating. Consequently, the programrating will move in tandem with its related staterating, keeping the relative rating differentialbetween the program and state rating constant. Theprogram’s rating outlook will always reflect thestate’s outlook.Standing appropriation programs:■ Minnesota State Standing Appropriation Program■ Minnesota County Credit Enhancement Program■ Texas Higher Education Bond Program■ West Virginia Municipal Bond CommissionProgramStates with Annual Appropriation Programs:■ New Jersey Fund for the Support of the FreePublic Schools Program■ South Carolina Education Finance ProgramState Guarantee ProgramsCurrently only four states have constitutionally-createdstate guarantees of eligible school general obligationbonds. In the event of a debt service shortfallof a participating school district, the state must useits general fund reserves or, in the case of Michiganand Oregon, issue general obligation bonds, if necessary,to make up any debt service deficiency inwww.standardandpoors.com87

Tax-Secured Debtorder that the bondholders receive full and timelypayments. In this instance, the state and programratings are the same. The program rating and outlookwill be adjusted as state rating and/or outlookchanges occur.State Guarantee Programs:■ Michigan State School Bond Loan Fund Program■ Oregon School Bond Guarantee Program■ Utah School Bond Guaranty Program■ Washington School Bond Guaranty ProgramState Permanent Fund ProgramsRatings on programs structured on the basis ofpermanent fund support do not have any directlink to the corresponding state’s rating. Thesefunds are constitutionally created, and the corpusof the fund is leveraged to provide a guaranty of aparticipating local government’s debt service. Theprogram rating is based on an analysis of the legalstructure of the fund, investment policies, liquidity,and operating guidelines. In the event of a ratingaction on the state, any changes in the creditquality of the program will be determined independentlyof the state rating.State Permanent Fund Programs:■ Nevada School District Bond Guarantee Program■ Texas Permanent School Fund Program■ Wyoming School District BondGuarantee ProgramState ProgramsTwo enhancement programs in California do not fitinto the four categories listed above including: theCalifornia Construction Loan Insurance Fund andthe California Motor Vehicle License Fees Program.The Construction Loan Insurance Program is managedby California’s Office of Statewide HealthPlanning & Development, and ultimately providesfor the issuance of state debt to pay debt service ifother funds available in the insurance fund are notsufficient to make debt service. The program israted on par with the state’s GO rating and willmove in tandem with the state rating. The MotorVehicle License Fee Program was created by statute,and guarantees an intercept of monthly license feerevenues collected by the state and transferred tocities and counties for various purposes. The securityprovided by these funds is independent of thecredit quality of the state, and any change in theprogram’s rating will be determined separatelyfrom the state rating.Program Description In Alphabetical Order:California Motor Vehicle License Fee Program (‘A’)Governing statute: This program was authorized in1990 under Assembly Bill 1375 and updated in2004 to hold the program harmless against reductionsin MVLF revenues in fiscal 2005 and beyond.This rating does not move in conjunction with thestate rating.Eligibility: The program is open to cities andcounties to guarantee payment of GO bonds orlease obligations through their allocation of motorvehicle license fees.Program provisions: Upon notification to thestate from a trustee that a required payment wasnot made from other sources, the California StateController is directed to make the payment fromthe community’s share of license fee revenues.Given the historical volatility in statewide licensefee revenues and the distribution formula’s directlink to populations, only cities or counties with apopulation of at least 2,500 are eligible to participatein the program. The local unit also mustdemonstrate that its allocation of license fee revenuesin each of the five preceding fiscal years willcover maximum future debt service at least 2.5x.The issuer must covenant not to similarly guaranteepayment on other obligations, unless the 2.5x coveragelevel can be achieved on the new total futuremaximum debt service.Final state legislation treats the loss of MVLF taxrevenue differently for cities and counties. Citieswill receive a partial replacement of lost revenuethrough state general fund appropriations in anamount that will grow based on what the priorMVLF tax would have produced. Counties willinstead receive a portion of their lost MVLF revenuesfrom a new local property tax allocation,and this new revenue source will grow only to thedegree that local property taxes grow.The cities’ MVLF debt service intercept is heldharmless under the legislature’s recent bill AB 2115,amending state code Chapter 610, section 6e. Thissection provides that MVLF property taxes willconstitute successor taxes for purposes of theMVLF intercept program.Counties’ MVLF debt service intercept is heldharmless under separate legislation, SB 1096,amending Chapter 211, government code Section25350.55, which requires a county auditor to interceptMVLF-related property tax payments in favorof debt service under the intercept program, insteadof intercepting MVLF revenues.Additional Standard & Poor’s requirements: Toqualify for the program rating, the financings mustaccount for the monthly distribution of license feerevenues, and the timing delay associated with thenotification requirement. To receive the programrating issues must be structured to provide formonthly lease or sinking fund payments, include afully funded debt service reserve, and have a payingagent, trustee, or similar representative acting in a88 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programsfiduciary capacity to promptly notify that state of alocality’s failure to make the required payment.California Health Facility ConstructionLoan Insurance Program (‘A+’)Governing statutes: The program began in 1969and is managed by the Office of Statewide HealthPlanning & Development. The rating moves in conjunctionwith the state rating.Eligibility requirements: The program is open tohealth care institutions participating in theCalifornia Health Facility Construction LoanInsurance Program.Program provisions: The bonds are guaranteedby the insurance fund but the ultimate backing forthe loans is the full faith and credit of the state.Thus, Standard & Poor’s assigns the state’s GO ratingto participants in the California Health FacilityConstruction Loan Insurance Program. The HealthFacility Construction Loan Insurance fund(HFCLIF) is funded by a one-time fee, not in excessof 3% of the principal and interest payable over thelife of the loan. These reserves, along with theHFCLIF, are the only financial resources availableto make up payment deficiencies in the portfolioprior to any state involvement. In the event of adefault, the state can continue to make regularlyscheduled debt service payments or issue debentureshaving a total face value of and bearing interest atthe rate of the respective bonds that they replace.Five days before an interest payment date, thetrustee must notify the office of any deficiencies.The office must make up any shortfall three daysbefore the payment date—first by drawing from thedebt service reserve fund, and then, from theConstruction Loan Insurance Fund. Since the inceptionof the program, there has been one default thatwas cured by payment from the Construction LoanInsurance Fund.California Infrastructure BankSchool Aid Intercept Program (‘A+’)Governing statutes: The program began in 2005,and is managed by the state’s California InfrastructureBank. The interception of state aid, if necessary,is authorized under state law AB 1554, asamended by AB 1303. The statutory provisionsintercept state general fund money distributed tolocal school districts under Proposition 98, as wellas various forms of state categorical aid.Proposition 98 is a voter initiative, passed in 1988,that amended the state constitution to require,among other provisions, that the percentage of stategeneral fund revenues devoted to K-14 schoolspending be no less than the prior year, unless overriddenby a two-thirds vote of the state legislature.Proposition 98 school aid constitutes a continuingappropriation, even in the event of a late statebudget. State statutory law prohibits school districtsparticipating in the program from filing for federalbankruptcy protection. This program rating movesin conjunction with the state.Eligibility requirements: Only school districtsthat have received emergency state loans to remainin operation participate in the program. The stateuses the intercept program to refinance loans madeto the failing districts. Schools receiving emergencyloans must consent to state oversight until the loansare repaid.Program provisions: Each bond issue under theprogram is separately secured under a separatelease and bond indenture. Each lease requires therespective school district to make lease paymentsequal to debt service, plus operating costs for itsleased asset, usually school buildings and land.When school districts participate in the program,they provide the state controller with a schedule offuture lease payments, and the state controllerintercepts state school aid in an amount equal todebt service and remits it directly to the bondtrustee, before providing the balance of state aid tothe individual school district.Proposition 98 state aid to school districts isapportioned under a statutory formula that sets arevenue limit per pupil for each district, and backfillsstate aid to the extent local property tax revenuedoes not achieve the revenue limit. Revenuelimit state aid is distributed in seven equal monthlyinstallments from July through January in the lastthree to five business days of each month. It isanticipated that each school district’s rental payments,under its individual lease, will be due thelast day of July, August, September, October,November, and December. The program ratingassumes debt service will be structured to be paidFebruary 15 and August 15, consistent with existingdebt issued under this program. Under the statestatutes, the state controller transfers pledged leaserental payments to the trustee prior to transferringother state aid funds to a participating district.Rental deficiencies from interceptable state aid, ifany, are rolled over into the next month. Schooldistricts are still required to make pledged leasepayments from their general fund if interceptablestate aid is not sufficient.Lease payments, and hence interceptable stateaid, may be abated under the respective school districtleases to the extent there is damage or destructionto the leased assets. To cover for this risk,participating school district leases will need to havepledged leased assets equal at least to the par valueof the bonds and require under their leases casualtyinsurance, excluding earthquake insurance, equal tothe replacement value of leased structures. Due towww.standardandpoors.com89

Tax-Secured Debtthe absence of earthquake insurance, leased assetswill need to pass Standard and Poor’s seismic riskscreening model. The leases will also need to containprovisions whereby the CaliforniaInfrastructure Bank is required to actively monitorinsurance in force and take action if it appears acasualty insurance policy is about to expire. Theleases will also need to require two years’ worth ofbusiness interruption insurance. Associated indenturesare expected to require a debt service reserveequal to the lesser of maximum annual debt service,10% of the par amount of bond issuance, or 125%of average annual debt service. The leases will alsorequire maintenance and operations expenses forthe leased assets to be paid by the participatingschool districts.Standard & Poor’s requires at least 2x coverageof annual lease payments by state aid in order tomaintain the program rating upon the initial rating.Colorado State Aid Intercept Program (‘AA-’)Governing statutes: House Bill 1214 created a stateaid withholding program to provide credit enhancementfor Colorado school district bonds. Based onthe provisions of this law, Section 22-41-110 ofColorado Revised Statutes, school districts mustapply to the state to use this program as bond security.This rating moves with that of the state.Eligibility requirements: Eligible financingsinclude GO bonds issued by a school district on, orafter, July 1, 1991, as well as electorate-approved,non-terminable leases and installment contracts. Toqualify bonds for the program, a school districtmust file an issuance resolution, a copy of the bondoffering document, and its agreement with an independentpaying agent. In 1997, the state clarifiedthat it will cover debt service payments even if itdetermines that a district is unlikely to repay theadvanced funds. Therefore there is no requirementthat existing state aid cover future maximum annualdebt service as long as it is expected that districtwill continue to participate in the withholding programand be eligible for future state equalization.Program provisions: If a paying agent has notreceived a debt service payment by the business daybefore the due date, the agent will notify the statetreasurer and the school district. After notification,the state treasurer will contact the school district todetermine whether payment will be made. If thedistrict cannot make the payment, the state treasurerwill forward the amount necessary in immediatelyavailable funds to the paying agent to be appliedonly to debt service, even if the state determines itis unlikely to be repaid in full by the district’s availablestate aid under Article 53 over the following12 months.The state treasurer’s policy stipulates that paymentwill be made by 1 p.m. on the due date toallow for timely payment to bondholders. Uponpayment by the state, the state treasurer will notifythe department of education, chief financial officerof the school district, and General Assembly. Thedepartment of education will initiate an audit todetermine the reason for nonpayment and, if necessary,develop control measures that will preventfuture nonpayment.Georgia State Aid Intercept Program(‘AA+’ or ‘A’ depending on legal protections)Governing statutes: Georgia’s voluntary state aidintercept program authorized by House Bill 792 in1991, allows the state to guarantee repayment of alocal school district’s GO bonds. Eligible financingsinclude any bonded indebtedness that the localschool district elects to have covered by the program.The AA+ rating moves with that of the state; the Aprogram will not likely move with the state’s rating.Eligibility requirements: To participate in thisprogram, a school district must, at the time of debtissuance, irrevocably authorize by resolution theState Board of Education to withhold aid paymentsfor debt service purposes when necessary.Program provisions: Under the program, the payingagent must notify the board if monies held inthe sinking fund are insufficient to make timelypayment of principal and interest no later than the15th day of the month before the scheduled debtservice payment date. Upon notification, the statetransfers to the paying agent the lesser of anamount sufficient to make the debt service payment,or the balance of any funds due the localschool district under any state education appropriationauthorized for the current fiscal year.Districts whose eligible principal and interestpayments are expected to exceed their averagemonthly state aid payment are advised by the stateagainst the selection of July 1 and Jan. 1 as the debtservice due dates.Additional Standard & Poor’s requirements:To receive a rating under the basic program,Standard & Poor’s requires minimum historicalstate aid coverage of at least 1x on maximumdebt service.Resolution based enhancements: Resolutionbased enhancements strengthen the structure of theprogram and make the program more similar tostate appropriation debt. Consequently, a schooldistrict may qualify for a rating on par with thestate’s appropriation debt if it includes certainstructural elements in its bond resolution. Anamendment to the Georgia constitution in 1996allows school districts to share in the 1% Special90 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement ProgramsPurpose Local Option Sales Tax (SPLOST) revenueused by most of the state’s counties. In recognitionof the additional security provided by voterapprovedSPLOST moneys and the state’s increasedcommitment to fund education, the addition ofstructural elements to an individual school district’sbond resolution can result in a program rating onpar with the state appropriation rating. To be eligibleto receive this higher program rating, a schooldistrict must incorporate one of two debt servicecoverage conditions in its bond resolution:For bonds that carry the additional security ofthe state aid intercept:■ Maintenance of at least 2x state aid coverage ofmaximum annual debt service; and■ An additional bonds test requiring at least 2xstate aid coverage of maximum annual debt servicefor all outstanding and subsequent bondsissued under the program.ORFor bonds issued under the state aid interceptprogram that carry the additional security ofthe SPLOST:■ Maintenance of at least 1.5x state aid coverage ofmaximum annual debt service;■ An additional bonds test requiring at least 1.5xstate aid coverage of maximum annual debt servicefor all outstanding and subsequent bondsissued under the program;■ At least 1x SPLOST coverage of annual debtservice at the time of issuance, and projected 1xcoverage for the life of the bonds; and■ An additional bonds test requiring at least 1xSPLOST coverage of debt service for all outstandingand subsequent bonds issued under theprogram with the additional SPLOST security.For all bonds issued under the state aid interceptprogram, the debt service schedule should conformto the intent of the program’s authorizing legislation.The debt service schedule should be establishedtaking into account the availability and timing ofstate aid payments and be in accordance with therecommendations of the state board of education.For SPLOST-supported bonds, Standard &Poor’s will review the methodology used in calculatingavailable SPLOST revenues. A five-year historicaland projected schedule is required forreview at the time of sale. An analysis of theschedule will be performed, taking into accountactual performance and any new occurrence thatcould affect future sales tax collections. In general,Standard & Poor’s would not expect to see salestax projections that exceed historical performancewithout identifiable reasons.Indiana State Aid Intercept Program(‘AA ‘ or ‘A’ depending on legal protections)Governing statutes: Based on Section 20.5.4.10 ofthe Indiana Code, the state treasurer is required towithhold state aid if a school corporation is unableto pay GO debt service requirements. The withholdingguarantee also applies to lease rental paymentsmade by a school corporation to meet aschool building corporation’s debt service. The‘AA-’ rating moves with the state’s rating; the ‘A’rating will not likely move with the state.Eligibility requirements: All school corporationsare eligible for the program rating, provided state aidlevels are equal to or greater than maximum annualdebt service requirements.Program provisions: If the school corporation isunable to meet its debt service obligation, the statetreasurer must make the payment from the corporation’sappropriated state aid for that calendar year.Payment is made directly to the paying agent on aschool corporation’s GO debt, and to the buildingcorporation when lease rental payments are insufficient.If the next state aid payment does not coverthe obligation, the balance is deducted from the followingallotment. As required by state statute,deducted aid is first taken from the state’s propertytax relief funds to a school corporation, secondfrom all other state aid funds except tuition support,and third from tuition support to the schoolcorporation. Strong state budget and tax levy oversightdecreases the likelihood that revenues will beinsufficient for debt service and enhances the qualityof the program. The state board of tax commissionersis statutorily required to review GO andlease rental property tax levies annually. If the proposedlevies are insufficient, the board will establisha levy to meet the school corporation’s obligations.Resolution based enhancements: Indiana schooldistrict bonds and school corporation leases issuedunder the state aid intercept program will beassigned a higher rating if the following elementsare added to the structure of a bond issue:■ State aid coverage of maximum annual debt serviceon outstanding and proposed program bondsmust be at least 2x.In addition, the school bond resolution mustinclude provisions requiring:■ Transfer of debt service payments to the payingagent at least five business days in advance of thedebt service due dates; and■ An independent paying agent or bond registrarwith immediate notification and claimant responsibilitiesto the state, in the event a debt servicedeposit is not made or is insufficient.www.standardandpoors.com91

Tax-Secured DebtAs is the case with Indiana’s basic program rating,the higher rating will carry a provisional (‘pr’)designation until the project construction certificateis received, since payments are contingent on successfulproject completion.Kentucky State Aid Intercept Program (‘A+’)Governing statute: State legislation revised in 1994(KRS 157-611, 157-615-157-620) expandedKentucky’s debt service withholding mechanism tocover all school district general obligation andlease-secured bonds. This rating moves in conjunctionwith the state’s rating.Eligibility requirements: Prior to the 1994 legislativechange, the Kentucky program was limited toschool debt issues with at least partial debt serviceparticipation by the Kentucky School FacilitiesConstruction Commission. The revised legislationnow covers all school district general obligationand lease-secured bonds if the district meets the followingcriteria: a) it must levy a minimum equivalenttax rate of 25 cents as defined by KRS157-615; and b) all new revenue generated by anytax increase required to meet the minimum equivalenttax rate must be placed in a restricted accountfor school building construction bonding and onJune 30 of each year the district shall transfer allavailable local revenues to a restricted account forschool building construction.Program provisions: The program is based on therequirement for the state to withhold appropriatedstate aid if a school district is unable to meet debtservice requirements. In connection with each programbond issue, it is the duty of the commission tosend to each board of education at least thirty daysbefore the due date of any payment a notice of theamount to become due and the date thereof and torequire acknowledgement thereof; and to receivefrom the board of education in the event of failure,satisfactory evidence that sufficient funds have beentransmitted to the commission or its agent, or willbe so transmitted for paying debt service and administrativecosts when due, as provided in the lease, tonotify and request that the department withholdfrom the board of education a sufficient portion ofany un-disbursed funds then held or set aside orallocated to it, and to request that the departmenttransfer the required amount thereof to the commissionfor the account of the board of education.Additional Standard & Poor’s requirements: Aschool district’s current annual state aid must covermaximum annual debt service by at least 2x.Kentucky State Aid Intercept Programfor Commonwealth Universities (‘A+’)Governing statute: State Legislation revised in 2004(KRS 160A.550-164A.630) establishes a debt servicewithholding mechanism to cover debt obligations ofthe commonwealth’s universities. This rating movesin conjunction with the commonwealth’s rating.Eligibility requirements: The legislation covers alldebt issued by the commonwealth’s state universities.The commonwealth’s Office of FinancialManagement, (a division of the Finance andAdministration Cabinet), reviews all debt issuanceby the commonwealth’s state universities, andreviews indentures to ensure inclusion of notificationguidelines and responsibilities of the Secretaryof the Finance and Administration Cabinet.Program provisions: Under KRS 164A.608, if auniversity is unable to pay the required principaland interest payments due or fails to transmit to thepaying agent bank or trustee the debt service or anypayment when due as required by the bond issuanceresolution, the paying agent bank or trustee shallnotify the secretary of the Finance andAdministration Cabinet in writing and request thatthe cabinet withhold or intercept from the governingboard a sufficient portion of any appropriated statefunds not yet disbursed to the institution to satisfythe required payment on the bonds. If the secretarydetermines that the institution is in risk of defaultingon the payment of the bonds, the secretary shallnotify the governing board and within five (5) daysremit payment to the paying agent bank or trusteesuch funds as are required from the appropriation tothe institution. Thereafter, the governing boardshall, to the extent that it is otherwise legally permitted,take action within sixty days (60 days) toadopt a resolution to generate additional revenues,such as increasing minimum rents, tolls, fees, andother charges, in order to positively adjust remittancesto the funds accounts.Additional program requirement: Provisions containedin the bond indenture must require the universityto make sufficient sinking fund paymentsthirty days prior to debt service due date. If insufficientmonies are available 30 days prior to the debtservice due date, the trustee must be directed totransfer funds from a debt service reserve (to befunded at maximum annual debt service) to thesinking fund to forestall a default on the bonds. Tendays prior to the debt service due date, the trusteemust notify, in writing, both the university and thecommonwealth’s Secretary of the Finance andAdministration Cabinet of such an event andrequest that amounts be remitted to the trustee pursuantto KRS section 164.608 to cure such deficiencyor to restore the amount transferred from thedebt service reserve.If, 10 days prior to the debt service due date,insufficient funds are available to make the debtservice payment, or if the debt service reserve hasbeen utilized to forestall a default, then such inci-92 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programsdences qualify as an event of default that triggersthe intercept, with the exercise of such and remittanceof such prior to the debt service due date,representing a cure of the event of default.In addition to the terms to be included in thebond indenture, Standard & Poor’s requires thatqualifying universities demonstrate a minimum of2x coverage of maximum annual debt service on alloutstanding debt (regardless of the indenture underwhich it is issued) from general fund appropriationsfrom the commonwealth for the current fiscal yearand the two most recent fiscal years. Furthermore,maintenance of the ‘A+’ rating will be dependent onmaintaining a minimum coverage of 2x.Massachusetts Qualified Bond Act (‘AA-’)Governing statute: Under the Qualified Bond Act(Massachusetts General Law, Chapter 44A), the statetreasurer pays debt service directly to the payingagent and withholds the amount of the payment fromthe borrower’s annual state aid appropriation. Thisrating moves in conjunction with the state’s rating.Eligibility requirements: Approval by the StateEmergency Finance Board, which oversees andmonitors the program, is required. The programcovers all pre-approved local debt issued by cities,towns and regional school districts.Program provisions: The entity’s treasurer certifiesto the state treasurer the maturity schedule,interest rate, and dates of payment on the bondswithin 10 days of issuance. If necessary, the statetreasurer pays debt service and after payment withholdsfrom the distributable aid payments or anyother amount payable to the municipality or schooldistrict (all state aid is subject to annual appropriation)a sum sufficient to cover debt service. Entitiesparticipating in this program are required to appropriateand to include in their tax levies amountsnecessary to pay qualified debt service. There is nocoverage requirement in the Massachusetts law;however, state aid has historically been substantiallyhigher than the amount of qualified debt service,resulting in multiple times coverage.Michigan State School Bond Loan Fund Program (‘AA’)Governing statutes: Section 16 of Article 9 ofMichigan’s constitution (adopted in 1963) createdthe Michigan School Bond Loan Fund Program toprovide districts access to funds to avoid a defaulton qualified debt. This rating moves in conjunctionwith the state’s rating.Eligibility requirements: For a bond to be eligiblefor the School Bond Loan Fund Program, it mustbe a voter-approved qualified bond. The proceedsmust be used for capital expenditure purposes, butnot for maintenance. To participate in the program,a school district must apply for qualification ofeach bond issuance. The district must complete thequalification application forms and substantiatethat the planned improvements are needed and thecosts are reasonable. In order to borrow from thebond loan fund, the district is required to levy minimumproperty tax millages for debt service and forgeneral operating expenses as the minimum localproperty tax effort.Program provisions: If a school district fails tomeet its debt service obligation for qualified debt,the state treasurer is notified and pays the requireddebt service. The loan from the bond loan fundbecomes an obligation of the district, with the loanrepayment scheduled as part of the district’s annualdebt service. Access to the loan fund is also availableas a property tax relief mechanism for qualifiedprincipal and interest payments. In effect,borrowing from the fund to limit property tax levyrequirements extends the debt retirement term. Ifthe balance in the state’s loan fund is insufficient tocover obligations, the state is required to makeloans from the general fund and issue general obligationbonds if necessary to raise sufficient funds.Since the fund is an obligation of the state, theguarantee program is rated on par with the state’sGO debt.Minnesota State StandingAppropriation Program (‘AAA’)Governing statutes: Authorized by MinnesotaStatutes, Section 126C.55, the Minnesota programwas designed to correct potential school districtdefault situations and is backed by a standingappropriation from Minnesota’s general fund. Thisrating moves in conjunction with that of the state.Eligibility requirements: All school districts areeligible to benefit from this enhancement. To applyfor participation in the School District CreditEnhancement Program, the school district files aschool board resolution with the commissioner ofeducation. Upon acceptance into the program, aparticipation certificate is issued to the applyingschool district.Program provisions: A participating district mustcovenant to notify the commissioner of the departmentof a potential default as soon as possible, butnot less than 15 business days before the debt servicedue date. A district must also covenant to depositwith a paying agent sufficient funds to make paymentson its bonds at least three business days beforethe debt service due date. The school district mustenter into a paying agent agreement that requires thepaying agent to inform the commissioner of educationif it becomes aware of a default, a potentialdefault or if there are insufficient funds on depositwith the paying agent three business days before thedebt service due date. Once a school district elects towww.standardandpoors.com93

Tax-Secured Debtenter this program and is accepted by the state, itcannot rescind its application as long as any debtobligation of that issue is outstanding. Upon notificationto the commissioner of education, the commissionerof finance will issue a warrant authorizing thecommissioner of education to pay the paying agentthe amounts necessary on or before the date paymentis due. The amounts needed for this purpose areappropriated to the Department of Education fromthe state general fund.Minnesota County Credit Enhancement Program (‘AAA’)Governing statutes: Authorized by MinnesotaStatutes, Section 373.45, the Minnesota programwas designed to provide a state guarantee of thepayment of principal and interest on a county’s GOor lease debt obligations issued after June 30, 2000for the purpose of funding the construction of jails,correctional facilities, law enforcement facilities,social services and human services facilities, or solidwaste facilities. This rating moves in tandem withthat of the state.Eligibility requirements: In order to qualify forparticipation in the County Credit EnhancementProgram, the bonds must be issued after June 30th,2000 and the county must apply to the PublicFacilities Authority prior to issuing the bonds. Thecounty must also enter into an agreement with theauthority obligating the county to be bound by theprovisions of Minnesota Statutes, Section 373.45Subd. 3.Program provisions: A participating county mustenter into an agreement with the Public FacilitiesAuthority obligating the county to:■ Deposit with the paying agent three days beforethe date on which the payment is due an amountsufficient to make that payment;■ Notify the authority, if the county will be unableto make all or a portion of the payment; and■ Include a provision in the bond resolution andcounty’s agreement with the paying agent for thedebt obligation that requires the paying agent toinform the commissioner of finance if it becomesaware of a potential default in the payment of principalor interest on that issue or if, on the day twobusiness days before the date a payment is due onthat issue, there are insufficient funds to make thepayment on deposit with the paying agent.The provisions of this agreement are binding toan issue as long as any debt obligation of the issueremains outstanding.After receipt of a notice of a potential default inpayment of principal or interest in debt obligationscovered by this agreement, and after consultationwith the county, the paying agent, and after verificationof the accuracy of the information provided,the authority shall notify the commissioner of thepotential default. The notice must include a finalfigure as to the amount due that the county will beunable to repay on the date due. Upon receipt ofthis notice from the authority, the commissionershall issue a warrant and authorize the authority topay to the paying agent for the debt obligation thespecified amount on or before the date due. Theamounts needed for the purposes of this subdivisionare annually appropriated to the authority from thegeneral fund.If Minnesota makes a guarantee payment on aparticipating county’s behalf, the county is obligatedto repay the state with interest and would berequired to levy a property tax if necessary, to makesuch repayments.Mississippi State Aid CapitalImprovement Bond Program (‘AA-’)Governing statute: The program was created underthe state’s Accountability and Adequate EducationProgram Act of 1997, which allows school districtsto authorize the state board of education to withholdan amount of the district’s MississippiAdequate Education Program (MAEP) funds andpledge these funds for debt service on capitalimprovement bonds. The authorization thatallowed districts to pledge MAEP funds for debtservice expired on June 30, 1998. This rating movesin conjunction with that of the state.Eligibility requirements: To qualify for the program,districts had to request that the stateDepartment of Education directly deposit theirMAEP funds with an independent paying agent andspecify this in the bond resolution. Upon stateapproval of this request, the state irrevocablyagreed to perform this function as long as programdebt is outstanding.Program provisions: State funds are depositeddirectly to a paying agent in advance of the debtservice due date and these monies are held in investmentsthat meet Standard & Poor’s criteria. Bondissues using this security were sized according to theamount of MAEP allocation each district received(up to $160 per pupil based on average daily attendance)and bond maturities could not exceed 20years. MAEP funds had to provide at least 1x debtservice coverage. The state, by statute will take allactions necessary to ensure that the amount of thedistrict’s MAEP funds pledged to repay state aidcapital improvement bonds will not be reduced aslong as the program bonds are outstanding.Missouri Direct Deposit of State Aid Program (‘AA+’)Governing statutes: In 1995, the MissouriLegislature adopted Senate Bill 301 that establisheda program to assist Missouri school districts with94 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programstheir financing needs. This rating moves in conjunctionwith that of the state.Eligibility requirements: Any school district is eligibleto apply to the state to use the program as anadditional bond security. Program guidelines specificallyexclude any type of obligation other than GObonds. Conditions for state approval include a stateaid coverage requirement plus the district enteringinto a binding direct deposit agreement with thestate to divert monthly state aid to a trustee-helddebt service fund. To enter the program, districtsmust meet coverage requirements of state aid ineach of the past three fiscal years covering maximumannual debt service by at least 1.5x and agreeto the state making direct deposit of its monthlystate aid payments to a state-selected direct deposittrustee. Once debt has been issued using this program,the district cannot pledge state aid as a primaryor parity security to any non-programobligation as long as any program debt is outstanding.Participating school districts waive all rightsand privileges to institute any action authorized byany act of Congress relating to bankruptcy.Program provisions: The Missouri program providesfor a first-dollar claim on monthly state aid,which will be directly deposited to a master bondtrustee. Program oversight and management is theresponsibility of the Missouri Health &Educational Facilities Authority (HEFA), as is theability to establish operating guidelines. HEFA alsopays certain issuance costs for participating schooldistricts. Under the program, a school district entersinto a direct deposit agreement with the state tofund a debt service payment account for either individualissues or participation in a HEFA-issuedpooled financing. Upon application approval, a districtcan use this security enhancement for new andrefunding issues.The state aid flowing to the direct deposit trusteeare the first dollars of the district’s monthly state aidpayment. The trustee, in turn, remits to each independentdistrict paying agent the required principaland interest at the required times. HEFA, theDepartment of Elementary and SecondaryEducation, the Office of Administration, and thetreasurer’s office coordinate activities to operate thedirect deposit mechanism. The direct deposit paymentswill be made in 10 level monthly increments,with payments starting the month of the bond issueclose. If any monthly payment is insufficient to meetthe 1/10th monthly increment requirement, the nextdirect deposit will make up the shortfall and includethat month’s required payment. Although the annualdebt service payments will be made out of the first10 months of a participating district’s state aid, thedirect deposit account has access to its entire annualstate aid appropriation, if needed.To eliminate the risks associated with late statebudget adoptions or mid-year state aid reductions,debt service payment dates cannot be in the endingor beginning months of the state’s fiscal year. Alldirect deposit funds and HEFA-held moneys will beinvested in securities that meet Standard & Poor’sinvestment criteria.Nevada School District BondGuarantee Program (‘AAA’)Governing statutes: The Nevada permanent schoolfund was established under Article 11, Section 3 ofthe Nevada Constitution, to hold the proceeds offederal lands granted to the state by the U.S.Congress for school purposes, estates that escheat tothe state, and fines collected under the state’s penallaws. The constitution specifies that proceeds of thefund may be pledged only for educational purposes.Interest earnings may be apportioned to the variouscounty districts for educational purposes. NevadaRevised Statutes’ chapter 387 enables local schooldistricts to apply for a guarantee of debt servicefrom the state’s permanent fund under the NevadaSchool District Bond Guarantee Program. This ratingis independent of that of the state.Eligibility requirements: The state treasurer willenter into a guarantee agreement with a school districtonly if the executive director of the departmentof taxation submits a written report to the stateboard of finance, indicating that the school districthas the ability to timely service of its debt obligations.Program provisions: Program debt is backed bythe constitutional pledge of the permanent fund’sassets. There is a statutory requirement that limitsthe program’s guarantee amount to 250% of thelesser of cost or fair market value of the fund’sassets. Additionally, the program limits the amountof bonds that may be guaranteed for any individualschool district to no more than $25 million outstandingat any one time. A state board of financepolicy limits permanent fund investments to U.S.Treasuries and agencies and specifies a minimumliquidity requirement. The minimum liquidityrequirement is defined as the cash flow necessary tosupport 10% of guaranteed bonded indebtednessand such securities must mature within one year.Finally, legal features structured into the guaranteeagreements provide for the early deposit of schooldistrict’s debt service payment with the state treasureror a designated paying agent, and immediate notificationto the state treasurer if such payment is notmade. The guarantee agreement requires that thedistrict transfer debt service amounts to the statetreasurer or a designated paying agent, not laterthan five business days prior to each scheduled paymentdate. If there is a shortfall, the treasurer paysthe deficiency to the paying agent from guaranteewww.standardandpoors.com95

Tax-Secured Debtfunds at least one day prior to the debt service duedate. If the guarantee is triggered, the state treasurerwill withhold subsequent payments of money thatwould normally be distributed to the district fromlocal school support taxes and the state distributiveaccount to replenish the permanent fund.New Jersey Additional State Aid Bonds Program (‘AA-’)Governing statute: The New Jersey Additional StateAid Bonds Program is authorized by New JerseyStatutes 18A: 64A-22.1. Additional state aid bondsrequire the state to appropriate funds to pay debt servicefor school district bonds and for county GO bondsissued on behalf of community college districts. Thisrating will move in conjunction with that of the state.Eligibility requirements: In order to participate inthe program, the board of chosen freeholders of acounty where a college is located must receive acertification from the state treasurer authorizingthem to issue bonds or notes in an amount not toexceed 50% of the total cost of the project and notmore than $265 million in principal. The board ofchosen freeholders may issue bonds or notes withinone year of receiving this certification from thestate treasurer.Program provisions: Within 10 days of issuingbonds secured by this program, the county treasureror the treasurer of any other legally empoweredissuer shall provide the state treasurer with a debtservice schedule and the name and address of thepaying agent. The state treasurer will appropriateand pay to the county, on or before the paymentdate, an amount equal to the payment due. Thecounty, or other legally empowered issuer, shall usethese funds solely for the timely payment of debtservice to the paying agent.New Jersey Fund for the Support of theFree Public Schools Program (‘AA ‘)Governing statute: The New Jersey Fund for theSupport of the Free Public Schools Program isauthorized by the Article VIII, Section 4 of the NewJersey Constitution. This rating will move in conjunctionwith that of the state.Eligibility requirements: Local school bondsissued by school districts, municipalities, and countiesare eligible for this program.Program provisions: The program pledges a portionof a fund’s assets for a school district’s debt serviceshould it be unable to meet principal and interestpayments. The bonds carry a specific contractualrelationship between the bondholder and the statefund. The treasurer acts as agent for the fund and, ifneeded, applies monies from the support fund topurchase maturing principal and interest due fromthe bondholder; these payments and purchases continueas long as the issuer remains unable to meet itsdebt service obligations.New Jersey Statutes 18A:56-19, as amended,requires two reserve accounts to be maintained inthe fund. The old school bond reserve account willbe funded in an amount equal to at least 1.5% ofaggregate school district debt issued by counties,municipalities, or school districts prior to July 1,2003. The new school bond reserve account will befunded in an amount equal to at least 1% of aggregateschool district debt issued on or after thatdate. In the event that the amounts in either the oldschool bond reserve account or the new schoolbond reserve account fall below the amountrequired to make payments on bonds, the amountsin both accounts are made available to make paymentsfor bonds secured under the reserves. On orbefore September 15th of each year, fund trusteesdetermine the aggregate amount of school purposebonds outstanding and are responsible for maintainingappropriate reserve levels based on the marketvalue of reserve investments. If at that time, thefunds on deposit fall below the required levels, theState Treasurer is required to appropriate anddeposit into the school reserve such amounts asmay be necessary to meet fund level requirements.To ensure sufficient liquidity, at least one-third ofthe obligations in the fund must be due within ayear. Fund assets are direct or guaranteed U.S. governmentobligations and are valued annually.New Jersey Qualified Bond Program (‘AA-’)Governing statute: New Jersey Statutes 18A:24-93authorize the state treasurer to intercept a portionof city, township, and other local municipality qualifiedstate aid to pay debt service on qualifiedbonds directly to the trustee. This rating moves inconjunction with that of the state.Eligibility requirements: To qualify for this program,the issuer municipality must receive stateapproval for the planned capital improvements andthe scheduled debt service.Program provisions: The statute authorizes thestate treasurer to intercept a portion of city, township,and other local municipality qualified state aidto pay debt service on qualified bonds directly tothe trustee. The state treasurer forwards withheldamounts to the paying agent for payment of debtservice on or before each principal and interest paymentdate. The balance of this state aid is thenremitted to the appropriate municipalities.Additional Standard & Poor’s requirements: Amunicipality’s state revenue must be at least equalto 1x maximum annual debt service.96 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement ProgramsNew York State Aid Intercept Program (‘A’)Governing statute: Section 99b of the state financelaw authorizes the aid withholding and specifies theprocedures that would be followed should the statebe required to make a debt service payment for aprogram participant. This rating will not typicallymove with that of the state.Eligibility requirements: All school districts areeligible for this program.Program provisions: Upon notification of a defaultby a school district, the state comptroller is requiredto deduct from the next state aid payment due to theschool district an amount sufficient to meet any deficiencyin debt service. If this aid payment does notcover the obligation, the balance would be deductedfrom the succeeding allotment. The funds would beforwarded directly to the paying agent, and thecomptroller would notify the school district of thepayment. A technical default can occur on New Yorkschool district GO bonds, as the state finance lawcontains no provisions to activate the mechanismbefore actual default. However, the minimum guaranteeprogram reflects the fact that a prompt cure ofany such default is assured.Additional Standard & Poor’s requirements: Aschool district’s annual state aid must cover maximumannual debt service by at least 1x.Ohio State Aid Intercept Program (‘AA’ or ‘AA-’ ratingdepending on required coverage levels)Governing statute: Pursuant to section 3317.18 ofthe Ohio Revised Code and section 3301-8-01 ofthe Ohio Administrative Code, the Ohio CreditEnhancement Program lets a school district enterinto an agreement that allows the state to withholdstate education funds due to the district underchapter 3317 of the revised code and apply thosefunds to the district’s debt service payments. Section3301-8-01 of the Ohio Administrative Code wasrevised in March 2004 to require 2.5x maximumannual debt service coverage levels. Prior to thattime, the required coverage under the program was1.25x. The ratings on bonds secured by the priorversion of the enhancement program will be evaluatedon a case-by-case basis, and issues that meetthe Standard & Poor’s requirement of 2x maximumannual debt service coverage will be upgraded to a‘AA’ rating. Those that do not meet this coveragelevel requirement will continue to be rated ‘AA-’For bonds issued after the program was amended inMarch 2004, the ‘AA’ rating applies. Both ratingsmove with the state’s rating.Eligibility requirements: To be eligible, a districtmust meet all program criteria including having theapproval of both the state department of educationand the office of budget and management to use thesecurity. Districts applying for inclusion in the programmust provide financial information to thedepartment of education and the office of budgetand management, including assessed value and taxpayerconcentration information, audits and budgets,and schedules of proposed and outstandingdebt. The program excludes noninvestment-graderated issuers and requires an extensive review of thecredit quality of unrated districts. The district musthave an underlying credit rating determination byStandard & Poor’s. Upon state approval, the contractbetween the state and local school district isirrevocable as long as any program debt is outstanding.At the time of state approval for programparticipation, projected state aid for the current fiscalyear must be at least 2.5x the maximum annualdebt service on the enhanced debt. In addition, oneach debt service date during the current or anysubsequent fiscal year, projected state aid remainingfor that year must cover the remaining debt servicefor the year by 1.25x.Program provisions: The district must certify tothe state department of education and the payingagent whether or not it can make its full debt servicepayment 15 days before each debt service duedate. Ten business days before the due date, the districtmust deposit with the paying agent an amountsufficient to make the debt service payment. If thedistrict has failed to make a sufficient deposit, thepaying agent will immediately contact the statedepartment of education. In the event a district isunable to make a sufficient debt service paymentand the payment will not be made by a creditenhancement facility, the department of educationwill pay the paying agent the lesser of the amountof the debt service due or the amount of state aiddue to the district for the remainder of the fiscalyear. This payment will be made at least one businessday prior to the debt service payment date.Oregon School Bond Guarantee Program (‘AA-’)Governing statute: The Oregon legislature passedthe school bond guaranty act in 1997 (OregonLaws 1997, chapter 614). This rating will move inconjunction with that of the state.Eligibility requirements: Participation in the programis voluntary and open to all common schooldistricts, union high school districts, education servicedistricts, and community college districts in the state.Program provisions: The amount of debt that canbe guaranteed by the state at any one time is limitedto 0.5% of true cash value of taxable property inthe state. The program is administered by theOregon State Treasury, which has establishedadministrative rules prescribing application proceduresand qualification guidelines. Upon determinationof a district’s eligibility, the state treasurer issuesa certificate of qualification valid for one year fromwww.standardandpoors.com97

Tax-Secured Debtthe date of issuance, which may be applied to any orall GO bonds, including GO refunding bonds,issued by the district during that period.Participating districts are required to submit to thestate department of education audited financial statementsand budget documents annually, as well asreport any material changes or events that mightaffect their eligibility for participation in the program.The business administrator of a participating districtis required to transfer to its paying agent moneyssufficient to cover each debt service payment atleast 15 days prior to the scheduled payment datefor guaranteed bonds. If unable to do so, the districtmust notify the paying agent and the statetreasurer. The paying agent must notify the statetreasurer if sufficient funds are not transferred tothe paying agent at least 10 days prior to the scheduleddebt service payment date. The state treasurerwill transfer sufficient funds to the paying agent tomake the debt service payment no later than thescheduled payment date if sufficient funds have notbeen transferred to the paying agent.A participating school district for which the statehas made a guarantee payment is obligated to repaythe state, with interest and, in certain instances, anadditional penalty. The state may obtain such reimbursementfrom moneys that otherwise would beused to support the district’s educational programs.The state is authorized to intercept any paymentsfrom its general fund, the state school fund, incomefrom the common school fund, and any other operatingmoneys provided by the state to the district. Ifthe state treasurer determines that interceptedfunds, interest, and penalty payments will be insufficientto provide timely reimbursement, the statemay require the district to meet its repayment obligationswith the help of the state attorney general’soffice. Legal remedies include compelling the districtto levy a property tax to pay debt service onits bonds and other obligations when due.In the event the state is required to make a debtservice payment on behalf of a participating district,if sufficient state funds are not on hand oravailable for such purpose, the state treasurer mayobtain a loan from the common school fund orother qualified state funds. The constitutionalamendment allows the state to issue property taxsupportedGO bonds to provide funding to satisfyits guarantee obligations under the program, includingthe repayment of borrowed moneys from thecommon school fund.Pennsylvania State Aid Intercept Program(‘A’ or ‘A+’ depending on legal protections)Governing statutes: Pennsylvania’s state aid interceptprogram is based on the withholding provisions ofAct 150, which amended section 633 of the PublicSchool code. Standard & Poor’s also assigns a programrating to lease bond obligations ofPennsylvania’s public school building authority basedon the provisions of Sections 785 and 790 of thePennsylvania Public School Code. This ‘A’ rating willnot typically move in conjunction with that of thestate; the A+ rating will move with the state’s rating.Eligibility requirements: The program automaticallyapplies to all school districts.Program provisions: Under these provisions, thesecretary of education automatically withholds stateaid from any school district that fails to meet debtservice or fails to pay lease rentals due a municipalauthority or nonprofit corporation. The withheldamount is the lesser of unpaid principal and interestor lease requirements, or the amount of state aidremaining for the fiscal year. These funds are transferreddirectly to the bond trustee, or the municipalauthority or nonprofit corporation. The secretary ofeducation requires a school district’s annual financialreport to include debt service payable duringthe fiscal year.Additional Standard & Poor’s requirements: Toreceive a program rating, Standard & Poor’srequires minimum historical state aid coverage of atleast 1x on maximum eligible debt service. To satisfythe debt service coverage requirement, the districtmust consider the timing and amount of debtservice payments and state aid receipts. Amendingthe bond resolution regarding the notification timingin the event of a potential default can helpenhance the program rating.Resolution based enhancements: A school districtmay receive a higher program rating if it includescertain structural elements in its bond resolution.Amendments to the Pennsylvania public schoolcode enacted in 1998 allow a school district to voluntarilystructure its bonds so that a failure tomake a required sinking fund deposit prior to thedebt service payment date triggers the intercept ofthe district’s receivable state education aid. Prior tothe amendment, this intercept was triggered onlywhen a school district failed to pay or provide forthe payment of debt service at the date of maturityor mandatory redemption, whether or not the districtestablished a sinking fund.The ability to leverage state aid receipts under theamended legislation into a higher program rating iscontingent on the school district’s inclusion ofstructural provisions in the bond legal documents.These provisions must specify notification and timingrequirements such that the state is notified of animpending shortfall, state aid is withheld, and thenecessary funds are transferred to the fiscal agentprior to the debt service payment date. As with thebasic enhancement program, the district mustdemonstrate at least 1x coverage of maximum98 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programsannual debt service by remaining state aid appropriationsto qualify for the higher program rating.Increased debt service coverage is not required toachieve the higher program rating, because the timingof district receipt of state aid is largely statutorilydefined.South Carolina Education Finance Program (‘AA’)Governing statute: The South Carolina program isbased on 59-71-155 of the 1976 South CarolinaCode. This rating will move in conjunction withthat of the state.Eligibility requirements: The program applies toschool district general obligation bonds and doesnot require a special application to use this programas security-it is effective for all school bonds issued.Program provisions: Under the program, countytreasurers are required to notify the state treasurer15 days in advance of a district’s debt service paymentdate if insufficient funds are available for fulland timely payment. The state treasurer monitorsthe situation until the third business day prior tothe payment date. If amounts are still insufficient atthat time, the state treasurer requires the countytreasurer to use state distributed school district revenueto make up the deficiency or the state couldadvance general fund moneys for that purpose. Themaximum amount of state general fund moneysavailable to be applied to a potential default isbased on the total appropriation under theEducation Finance Act for that year.South Dakota State Aid Intercept Program (‘A’)Governing statutes: The 1988 amendments to Title13 of South Dakota Codified Laws authorize leasepurchase agreements between the facilities authorityand school districts. If a school district is unable tomeet lease rental requirements to the facilitiesauthority, Chapter 19 of Title 13 of the state’sstatutes permits the secretary of education to withholdstate aid from the school district. This ratingwill not typically move with that of the state.Eligibility requirements: Local school districts areeligible for the program. Due to South Dakota’sGO debt limitations for school districts; major capitalprojects are funded by proceeds of bonds issuedby the South Dakota Health & EducationalFacilities Authority.The structure of a lease purchase agreementbetween the facilities authority and a school districtmust meet statutory requirements. The school districthas no option to cancel the agreement andmust annually levy a capital outlay millage, whichis limited to three mills. The capital outlay millageis the revenue source for lease rental payments. Themillage is continuously levied for the life of thelease, eliminating the risk of non-appropriation.The lease is a net lease, entitling the trust agent andthe facilities authority to full lease rental payments.Lease rentals are due to the trustee 45 days beforedebt service payments are due.Program provisions: Lease rental payments aredue to the trustee 45 days before debt service paymentsare due. If local revenues are insufficient tomeet the lease rental requirements, the trusteenotifies the facilities authority, as lessor. Theauthority requests the state Board of Education todirect the defaulting district’s state aid to thetrustee for payment of unpaid lease rentals. Stateaid is distributed three times per year (on or aboutAugust 15, January 15, and May 15th).Distribution is approximately 1/3, 1/3 and 1/3.The first distribution is an estimate because averagedaily attendance is not calculated untilOctober so adjustments are made to subsequentpayments. Lease payments are due 1/1 and 7/1.Debt service dates are 2/15 and 8/15.Additional Standard & Poor’s requirements: Stateaid must be at least equal to maximum annualdebt service.Texas Permanent School Fund Program (‘AAA’)Governing statutes: The Permanent Fund was createdby the state constitution to support publicschools, with income generated from state-ownedland and mineral interests. A voter-approvedamendment to the Texas Constitution allows theTexas Permanent School Fund to guarantee qualifiedschool district bonds. The 1983 amendment,Article VII, Section 5 of the constitution, extendsthe use of the endowment to ensure bondholdersof timely debt service payments. This rating isindependent of that of the state.Eligibility requirements: School districts apply tothe Commissioner of Education to qualify bondsfor the permanent fund guarantee. The commissionerreviews district economic conditions, academicaccreditation record, debt and capital needs andfinancial performance to determine potential futureliabilities against the fund. Standard & Poor’srequires evidence of the bond guarantee endorsementbefore assigning the enhanced Rating.Program provisions: The amount of debt that canbe guaranteed by the permanent fund is limited tothe lesser of: a) 250% of the lower of cost or currentfair value of the assets in the fund, excludingreal estate; or b) 250% of the lower of cost or fairvalue adjusted by a factor that excludes additionsto the fund since 1989. In the event of a default,the school district must notify the commissioner notlater than five days before the maturity date of theguaranteed debt. The commissioner will then paywww.standardandpoors.com99

Tax-Secured Debtdebt service to the paying agent and direct the stateto later withhold district state aid to repay thePermanent Fund.Standard & Poor’s rating reflects the fund’sstrong asset quality and the legal provisions limitingthe maximum amount of debt that may be guaranteedby the fund, which is twice the cost or marketvalue of the fund. Additionally, the state’s substantialoversight of the qualifying districts enhances theguarantee program.Texas Higher Education Bond Program (‘AA’)Governing statutes: In addition to the programs thatbenefit elementary and secondary education, anamendment to the state’s constitution enhances debtobligations of certain public institutions of highereducation. In accordance with Article VII, Section 17of the Texas Constitution and the 1985 Excellence inHigher Education Act, there is a continuing annualappropriation of $100 million to support higher education.This rating moves with that of the state.Eligibility requirements: Since 1985, the 26 stateuniversities that do not benefit from the PermanentUniversity Fund—those outside the University ofTexas system and the Texas A&M system, eachreceive a portion of the annual $100 million appropriation.To participate in the program, universitiesmust adhere to the Excellence in Higher EducationAct of 1985.Program provisions: The act allocates the annualappropriation among the universities according to aformula based on:Student enrollment capacity needs;■ Facilities condition;■ Institutional complexity;■ Existence of medical units; and■ Compliance with the Texas desegregation plan.A maximum of 50% of each qualified institution’sallocation may be pledged for debt service on bonds,while the remaining portion will be used directly forcapital improvement projects. According to Vernon’sCivil Statutes Article 4357, a university’s board ofStandard & Poor’s Rated State Credit Enhancement ProgramsState Debt Type Covered Rating Outlook EnhancementCalifornia Eligible city and county bonds A Stable Motor Vehicle license fee and leasesCalifornia Eligible health care bonds A+ Stable Construction Loan Insurance FundCaliforniaSchool districts that havereceived emergency state loans A+ Stable State aid withholding lawColorado Local school bonds AA- Stable State aid withholding lawGeorgia* Eligible local school bonds A Stable State aid withholding lawGeorgia* Eligible local school bonds AA+ Stable State aid withholding law with additionalcoverage of 1.5x state aid and 1x SPLOST or2x state aidIndiana* Local school bonds, leases A Stable State Withholding LawIndiana* Local school bonds, leases AA Stable State Withholding Law with enhancedcoverage provisionsKentucky Local school bonds, leases A+ Stable State aid withholding lawKentucky Commonwealth Universities A+ Stable State aid withholding lawMassachusetts All pre-approved local AA- Stable State direct deposit of state aid topaying agentMichigan Qualified local school bonds AA Neg Constitutional School Bond Loan Fund; stategeneral fund supportMinnesota Eligible local school bonds AAA Stable State standing appropriation lawMinnesota Eligible counties AAA State standing appropriation lawMississippi Eligible local school bonds AA- Stable State direct deposit of annual adequateeducation program funds to paying agentMissouri Eligible local school bonds AA+ Stable State direct deposit of state aid to payingagentNevada Eligible local school bonds AAA Stable Permanent School FundNew Jersey Local school bonds AA Stable Constitutional Fund for the Support of FreePublic Schools100 Standard & Poor’s Public Finance Criteria 2007

State Credit Enhancement Programstrustees or a university system’s board of regents mustfile a claim in the amount of the next debt service paymentwith the state comptroller. Filing of a claim willenable the bond trustees to receive a warrant for paymentdirectly from the state at least 15 days prior tothe principal and interest payment date. Bonds issuedunder Article 7, Section 17 of the state constitution arepayable solely from these constitutional appropriations.Each issue must also be in serial form, offeredfor competitive bidding, and be approved by the stateattorney general. Once approved, bonds are incontestable.The legislature may review the level of theappropriation and, with a two-thirds majority of bothhouses, reduce the amount of the constitutionalappropriation for the succeeding five years. However,the legislature may not reduce the appropriation so asto impair the payment of the obligations created bythe bonds or notes issued in accordance with Section17 of the constitution.Utah School Bond Guaranty Program (‘AAA’)Governing statutes: Utah voters approvedProposition 4 in 1996, a state constitutionalamendment providing a state general obligationguarantee on qualified local school district debt.The constitutional amendment allows for the implementationof the state’s school bond default avoidanceprogram under the Utah School BondGuaranty Act. This rating moves in conjunctionwith that of the state.Eligibility requirements: The state treasurer determinesthe eligibility of each school district for theprogram on consultation with the state superintendentof public instruction. Criteria for eligibilityinclude the ability of a school district to meet itsdebt service obligations without state support.Program provisions: Once a school district entersthe program, the state’s full faith and credit andunlimited taxing power are pledged to guaranteeStandard & Poor’s Rated State Credit Enhancement Programs (continued)State Debt Type Covered Rating Outlook EnhancementNew Jersey Additional state aid bonds AA- Stable State appropriations for school districts andcommunity collegesNew Jersey All pre-approved local AA- Stable State direct deposit of state aid to payingqualified municipal debtagentNew York Local school bonds A Stable State aid withholding lawOhio* Eligible local school bonds AA Stable State aid withholding law with 2xMADS coverageOhio* Eligible local school bonds AA- Stable State aid withholding lawOregon Qualified local school bonds AA- Stable State guaranteePennsylvania* Local school bonds A Stable State aid withholding lawPennsylvania* Local school bonds A+ Stable State aid withholding law with enhancedresolution provisionsSouth Carolina Local school bonds AA Stable State aid withholding and general fundmake-up provisionSouth Dakota Local school bonds A Stable State aid withholding lawTexas Approved local school bonds AAA Stable Constitutional Permanent School FundTexas Higher education bonds AA Stable Direct and continuing state appropriationsUtah Qualified local school bonds AAA Stable State guaranteeVirginia All local G.O. debt A Stable State aid withholding lawWashington Qualified local school bonds AA Stable State guaranteeWest Virginia All local G.O. debt AA- Stable Continuing state appropriations tocover deficienciesWyoming Eligible local school bonds AAA Stable Common School Account, PermanentLand Fund*See program detail.www.standardandpoors.com101

Tax-Secured Debttimely payment of principal and interest on the district’sbonds. Local school district debt guaranteed bythe state under the program will not count against theconstitutional limit on the state’s GO debt.In order to qualify for a program rating, eachschool district’s issuing bond resolution must providefor adequate and timely notice to the statetreasurer, by an independent third party, of impendingshortfalls in debt service. Once a state guaranteepayment is triggered, the state treasurer will interceptstate monies due the school district until thedrawn amount is reimbursed to the state.Guarantee payments must be repaid by the schooldistrict to the state with interest, and in some caseswith additional financial penalties. For additionalliquidity, the state treasurer can borrow moneyfrom the state’s Permanent School Fund to meet aguarantee payment, as well as use other resources.Virginia State Aid Intercept Program (‘A’)Governing statutes: Section 15.1225 of the Code ofVirginia authorizes the governor to immediatelyintercept state aid appropriated for municipalitiesto pay principal and interest on GO debt in theevent of default. This rating will not typically movewith that of the state.Eligibility requirements: The program automaticallyapplies to local governments.Program provisions: Bondholders must notify thegovernor of default by a local government. Thegovernor is authorized to withhold debt servicepayments up to amount of state aid appropriatedand payable. The funds would be forwarded directlyto the paying agent. A technical default canoccur since the notification can occur post defaultand the state law contains no provisions to forcethe mechanism before actual default.Because Virginia’s GO bond guarantee programis based on the governor’s authority to withhold aidpayments to local municipalities, the rating for theprogram reflects the state’s creditworthiness and thelegislative appropriations for local municipalities.Additional Standard & Poor’s requirements: Toreceive the guarantee program’s rating based on thewithholding provision, a municipality must demonstratethat state aid for each of the last five yearswas at least 1.25x future maximum annual GOdebt service. Each bond issue also must have a payingagent, trustee, or similar fiduciary representativeto promptly inform the state of a default.Washington School Bond Guaranty Program (‘AA’)Governing statutes: In November 1999,Washington voters passed by a vote of 60% to40% a constitutional amendment that allows thestate to provide a backup general obligation pledgeto local school district voter approved GO bonds.The program is authorized in chapter 39.98 of theRevised Code of Washington.The program provides pledges the full faith andcredit of the state of Washington to the payment ofvoter-approved school district GO bonds. Uponrequest and receipt of a certificate evidencing thestate guaranty from the Washington StateTreasurer’s Office, Standard & Poor’s ratesWashington state local school bond issues on parwith the state rating and the rating will move inconjunction with that of the state.Eligibility requirements: A school board electing touse the guarantee program must pass a resolutionauthorizing the district to apply to the state treasurer’soffice. This resolution can be included as part ofthe district’s bond election resolution or can be a separateresolution. Following a successful bond electionthe district must submit an eligibility request to thestate treasurer’s office. The state treasurer’s officereviews the request and determines eligibility.Program provisions: If during the term of thebonds, the county treasurer is unable to applyfunds sufficient to make debt service payments ondistrict bonds guaranteed under the program, thecounty treasurer notifies the state treasurer whowould immediately transfer sufficient funds tomake the required debt service payment. The statetreasurer’s office would recover from the districtany funds paid on the district’s behalf as well asany interest, recovery costs or penalties.West Virginia Municipal BondCommission Program (‘AA-’)Governing statutes: The program is authorized byChapter 13, Article 3 of the West Virginia Code.West Virginia’s Municipal Bond Commission is thesuccessor to the state’s Sinking Fund Commission.This rating will move in conjunction with that ofthe state.Eligibility requirements: The program covers alllocal GO debt.Program provisions: The bond commission servesas the bond trust agent, administering the GO debtsinking funds for the state’s school districts andmunicipalities and oversees debt service. All fundscollected to meet debt service on a municipality’sgeneral obligation bonds are turned over to thecommission for payment of debt service.In addition to this statutory provision, the commission’sadministrative guidelines include notifyingthe local government unit 35 days before a debtservice payment if funds on hand are insufficientfor debt service. If sufficient funds are not on hand15 days before the debt service payment, the entityis contacted again. Since 1921, the state legislaturehas made an annual blanket appropriation in thebudget authorizing the governor to meet any defi-102 Standard & Poor’s Public Finance Criteria 2007

Appropriation-Backed Obligationsciency in the state sinking fund because of a schooldistrict or governmental unit’s failure to meet itsdebt service obligations. The rating for WestVirginia’s program reflects the state’s strong debtservice oversight and the legislature’s replenishmentprovision for the bond commission’s sinking fund.Wyoming School District BondGuarantee Program (‘AAA’)Governing statutes: Local school district bonds areeligible to be guaranteed by the Wyoming SchoolDistrict Bond Guarantee Program under Chapter 13of the state’s Farm Loan Board rules and regulationsand Wyoming state statutes 9-4-701(j). This ratingwill move in conjunction with that of the state.Eligibility requirements: School districts applyingfor qualification under the program must first providethe Office of State Lands and Investments aletter from a nationally recognized rating agencyindicating that the bonds would be of at leastinvestment-grade quality. Applications for bondissues over $5 million must be accompanied by theprecise underlying rating before the guarantee canbe granted.Program provisions: No more than $300 millionin school bonds may be guaranteed by the pledgedguarantee fund, a very strong 3:1 leverage ratio.Bonds guaranteed under this program are backed by$100 million from the state’s Common SchoolAccount. The $100 million guarantee fund is a fungiblesubset of the Common School Account. TheCommon School Account is a state trust fundderived from mineral royalties on lands dedicatedfor school income and is, in turn, a non-fungiblesubset of the state Permanent Land Fund. Whileonly $100 million is pledged from the CommonSchool Account, and amounts over $100 million inthe Common School Account could be dedicated inthe future to other school programs, current implementationrules charge investment losses firstagainst the non-obligated part of the CommonSchool Account. This provides an even greater guaranteecushion, as the pledged fund would garner thelast non-obligated $100 million in the fund in theevent of investment losses.The Common School Account can be used onlyfor school purposes and currently contributesinvestment income for yearly distributions toschools. The state treasurer’s investment policy setsguidelines intended to maximize yield within theconstraints of maintaining book value. Outsidemoney managers can be hired to manage a portionof investments. Outside managers’ transactions arereported monthly and performance is judged quarterly.Each outside manager is expected to maintainan average portfolio credit quality of at least ‘AA’.Up to 5% of a portfolio may be invested in unratedsecurities, provided that these securities are judgedby the Board to be at least of investment-gradequality. No more than 5% of the portfolio may beinvested in obligations of any single issuer otherthan the U.S. government. Investment allocationsmay change over time, but have historically beenconservative. In addition, the guarantee programrules require that an amount at least equal to 10%of guaranteed bond principal be invested in U.S.government securities of three years’ maturity orless to ensure liquidity. Debt service payments arenot accelerated in the case of an underlying schooldistrict’s default, preserving the liquidity of theguarantee fund.Program rules provide adequate time for guaranteefunds to cover debt service payments when due, ifneeded. An independent paying agent is required tonotify the State Treasurer not less than five daysbefore a debt service payment date if it becomesaware of a potential default on a guaranteed debtobligation. Program rules also require a school districtto notify the state treasurer on its own 15 daysbefore a due date, if it projects that it will not be ableto pay debt service. If there is a debt service shortfall,the treasurer must pay the paying agent an amount tocover the shortfall at least one day before the debtservice due date. The state requires a defaultingschool district to repay the Common School Accountfor any draw, including lost interest on the fund. ■Appropriation-Backed ObligationsAppropriation-backed obligations come in variousforms; the most prevalent are lease revenuebonds, certificates of participation, and service contractbonds. Municipal appropriation-backed obligationsfrequently are used to avoid constitutionalor other legal restrictions on the use of GO debt.Appropriation-backed obligations may also be themost expedient and flexible financing method formany governments. For these obligations, timelypayment of principal and interest depends on annualwww.standardandpoors.com103

Tax-Secured Debtappropriations by the issuer. Because lease or servicecontract payments are not binding on future legislaturesor councils, appropriation-backed obligationsare generally not considered “debt” under issuers’technical and legal definitions. As a result of theappropriation risk those appropriation-backed obligationsthat meet Standard & Poor’s RatingsServices criteria are rated one notch off the GO ratings,as a reflection that appropriation-backed obligationsare not legally debt and do not bear thesame legal protections as GO bonds.However, analytically, these instruments are consideredobligations of the entity and are fullyreflected in the debt statement and ratios. As aresult, failure to make an appropriation will resultin a downgrade of both the appropriation-backedobligation and the general obligation of the entity,as a reflection of the willingness of an entity tomake good on its obligations.Standard & Poor’s does not consider the essentialityof a particular project in the evaluation of anappropriation-backed obligation. Instead, the willingnessto pay for that project is a part of theanalysis performed in the assessment of the generalcreditworthiness of the issuing government.Additionally, the necessity of a security interestbeing granted in the leased property is not required.A security interest is a common feature in whichthe governmental obligor grants the lessor, or thetrustee, as assignee of the lessor—title or a first lienon the leased property for the life of the bonds. Inthe event the government obligor chooses to exerciseits right of nonappropriation, the lessor, or itsassignee, has the right to take possession of theleased asset. For many projects, even if a securityinterest is granted, it is questionable as to whetherthe lessor or its assignee can effectively take possessionof the projects, as in the case of a prison, agovernment center, a school or any other facilitythat serves the basic functions of that government.Government Obligor’s General CreditworthinessThe government obligor’s general creditworthinessevaluation is based on traditional GO analysis, andincludes factors such as:■ Overall debt structure and burden;■ Economic and tax-base factors;■ Financial flexibility, performance, and position; and■ Administrative and management factors.If the government obligor were a utility district,university, hospital, or other not-for-profit entity,the relevant rating criteria used in assessing creditquality for those types of entities would be applied.Appropriation And Term FeaturesFor master leases or service contracts, wherenumerous operating departments may be involved,a centralized appropriations process helps to ensurethe timely payment of obligations.The following appropriation features are importantto the evaluation of the transaction’s structure:■ The useful life of the financed property or projectmatches or exceeds the term of the contract.■ The term of the contract matches the term of thebond issue or certificates of participation, avoidingexposure on renegotiation; if state law prohibitslong-term appropriation-backedobligations, term renewal should be automatic.■ The lease or contract payments represent installmentstoward an equity buildup in the financedproperty. At the end of the financing term, ownershipof the asset should transfer to the governmentobligor automatically or for a nominal fee.■ The government obligor agrees to request appropriationsfor lease or contract payments in itsannual budget.The government obligor unconditionally agreesto make rental or purchase option payments asagreed. Such payments should not be subject tocounterclaim or offset because of a disagreementover any aspect of the transaction. A clear statementthat “notwithstanding any other provisions tothe contrary, appropriation-backed obligationrental payments are triple-net not subject to counterclaimor offset” is preferable and should beincluded in the contract. However, language thatindicates that those payments are absolute andunconditional and can’t be reduced for any reasonis allowable A triple net appropriation-backed obligationis one that designates the government obligoras a tenant being solely responsible for all of thecosts relating to the asset being leased. The costscould include any upgrades, utilities, repairs, taxesor insurance requirements.For California lessees, while the lessee covenantsto appropriate lease payments, those payments aresubject to abatement in the event the leased propertyis not available for use. As such, Standard &Poor’s requires that, as it does with all abatementand non-date certain appropriation-backed obligations,both a review of the construction risk associatedwith the project and the presence of businessinterruption insurance.Underlying revenues in support ofappropriation-backed securitiesIn certain circumstances, a government may legallypledge specific tax revenues to meet its appropriation-backedobligation payment. If the pledged revenuesare not available for any purpose other thanthose consistent with the appropriation project,such as economic development or a convention center,the appropriation risk is significantly mitigated104 Standard & Poor’s Public Finance Criteria 2007

Appropriation-Backed Obligationsand the rating assignment will be determined by thecredit characteristics of the pledged revenue source,not the appropriation risk.Maintenance and insuranceThe government obligor should agree to maintainthe financed property in good repair and to insureit against loss or damage in an amount at leastequal to the purchase option value or replacementcost, whether or not repair and replacement aremandated by the agreement. If the payments aresubject to abatement in the event the property isdamaged, destroyed, or taken under a provision ofeminent domain, the government obligor mustmaintain business interruption insurance for at least24 months. Where applicable, special hazard insurancecoverage is required unless the financed facilitypasses Standard & Poor’s natural hazard test.Self-insurance for property damage risks is permitted.Adequate reserve levels must be maintainedand reviewed annually by an independent consultantor professional risk manager. Annual notificationto the trustee that reserve levels are adequatemust be made. Self-insurance is not an acceptablealternative to commercial coverage for earthquakerisk when the government obligor’s obligation islimited only to self-insurance reserves and does notextend to the municipality’s general resources.Debt-service reserve fundA debt service reserve equal to maximum semiannualdebt service or three months’ advanced (andunconditional) funding of debt service, or an equivalentcombination of reserves and advance funding,may be beneficial on leases and service contractsthat provide for abatement for lost use of propertyowing to damage or destruction, or to those instrumentswhere late budget passage risk exists. Inaddition, no debt service reserve is allowable if bothlease or service contract payments and debt servicepayments are not due until three months haveelapsed in the government’s fiscal year, once againallowing for the possibility of late budget adoption.Lessor features and bankruptcy riskMost appropriation-backed obligation transactionsrated by Standard & Poor’s are between a governmentalobligor and a non-profit public benefit corporation,as lessor, which has been establishedspecifically for the purposes of the lease transaction.These lessors, typically, are filers under Chapter 9 ofthe U.S. bankruptcy code and are considered bankruptcyremote. Alternative arrangements include:■ For lessors not judged to be bankruptcy remote,there must be a sale and absolute assignment bythe lessor of lease rental payments to the trustee,thereby ensuring timely payment to the bondholdersif the lessor becomes insolvent. Theassignment should be accompanied by a legalopinion stating that as a result of the assignment,bankruptcy of the lessor would not cause thelease and lease payments to be considered propertyof the lessor’s estate. The automatic stay provisionsof the bankruptcy code should not applyand therefore would not cause an interruption ofrental payments to the bond trustee.■ Insolvency-proofing the lessor is an alternativeapproach. The lessor should be set up as a singlepurposeentity (SPE) that is prohibited fromengaging in any business—other than owning therated project—and from incurring additionaldebt, unless it is rated at least as high as theStandard & Poor’s rated lease-secured debt.Furthermore, the SPE may not sell the projectexcept to another entity that meets these criteriaunless Standard & Poor’s rates the entity’s seniordebt at least as high as the lease obligation. Theseprovisions should appear in the lessor’s partnershipagreement or articles of incorporation and inthe trust indenture. Please refer to Standard &Poor’s criteria on SPEs for more detailConstruction riskConstruction risk is present in virtually all publicfinance transactions, but it typically introduces creditrisk only in those transactions where debt service paymentis contingent on project completion and/oracceptance. In those state’s where such a risk is present,Standard & Poor’s will perform a constructionanalysis for all issues where completion of the project,that is securing the lease payments, is required priorto the commencement of rental payments supportedby appropriated funds. For further clarification referto Public Finance Criteria: Assessing ConstructionRisk in Public Finance.Special considerations for vendor leasesVendor equipment and developer office leasesreceive further scrutiny in the rating processbecause the municipal lessee is not the party primarilyresponsible for the sale of securities. It is oftenthe vendors and/or developers that have a greaterinterest in the actual debt financing. Therefore,Standard & Poor’s closely assesses the followingareas in determining appropriation risk:■ Government support: Are the appropriate highlevelgovernmental officials supportive of thelease project, the lease provisions, and the saleof securities?■ Essentiality: Is the vendor equipment or developerlease essential? Making the case that essentiality ishigh for developer-owned office leases is also morewww.standardandpoors.com105

Tax-Secured Debt■■difficult because the government usually has noeventual equity interest in the facility. Ownershipof the building being leased normally resides withthe developer after the government makes all of itslease payments. Therefore, the incentive to makelease payments in later years is not enhanced bythe expectation of eventual ownership.Triple-net lease: Despite vendor involvement ordeveloper ownership, the lease must be triple-net,without the right of offset.Bankruptcy: An absolute assignment of rentalpayments from the private third-party lessor tothe trustee is required.Nontax-Supported LeasesHigher education leasesColleges and universities frequently use leases as ameans of financing capital improvements andequipment such as computers, telecommunicationsequipment, and research facilities. Historically,capital leases were the most used form of leasingfor institutions of higher education. From a ratingperspective, many of these capital leases are nodifferent than other bonded, long-term debt. Aninstitution wishes to finance an academic orresearch building over a long period of time, butmay be subject to state debt restrictions, whichprohibit the issuance of GO debt. For public universities,because of these debt limitations, capitalleases are often subject to annual renewal or reappropriationof debt service. However, public universitiesoften issue capital leases that are notsubject to appropriation. Typically, this instanceoccurs when a university wishes to involve outsidedevelopers, or affiliation foundations.Capital leases’ payment of debt service can besubject to annual appropriation, or it can be a continuingand unconditional obligation without theoption of termination. The rating assigned byStandard & Poor’s depends on the underlying security;if a lease for a public university is subject toannual appropriation of debt service, the ratinganalysis follows the criteria established for othermunicipal entities such as states and local governments.Therefore, in most instances, a lease supportedby legally available funds of a universitywill be rated one notch from the general obligationequivalent rating. There is one caveat, of course,which is that the lease rating is still a function ofthe underlying nature of the lease pledge and theobligor’s general credit quality. If the underlyingsecurity on an appropriation lease is not legallyavailable funds, or the broadest possible pledge,such as a general revenue pledge, then Standard &Poor’s might notch it further than leases for stateand local government entities.For instance, consider an appropriation lease fora parking system. If the revenues that actuallysecure the lease are only parking revenues, a fairlynarrow revenue stream, the rating would likely benotched lower than that on a general revenueappropriation lease. For a capital lease to be ratedon par with a general obligation equivalent rating,it should be continuing and unconditional, not subjectto annual renewal or appropriation, andsecured by the broadest possible pledge of revenues.Most capital leases for private colleges and universitiesreflect an unsecured general obligation. Mostprivate college bond ratings also reflect an unsecuredgeneral obligation pledge. Unlike health careinstitutions, which historically have placed a lien ongross revenues, private colleges and universities typicallydo not. Therefore, a capital lease, which is anunsecured corporate pledge, can be rated on parwith other unsecured debt of the institution.Health care leasesIn the not-for-profit health care sector leases are afairly common means of financing for majorequipment, such as radiology machines, telephonesystems, and computers. From time to time theyare used to lease additional space for physicians’offices, research facilities, or back-office functions.These leases are usually operating leasesalthough capital leases do occur from time totime. Capital leases are rare but are always incorporatedin the long-term debt structure of theorganization. If a capital lease for a health caresystem is subject to annual appropriation of debtservice, the rating analysis follows the criteriaestablished for other municipal entities, such asstates and local governments.Transportation leasesGenerally speaking, leases are not used as a financingvehicle in the transportation sector. In the veryrare instance when an airport issues lease bonds,where debt service is subject to appropriation risk,but not abatement risk, the rating analysis followsthe criteria established for other municipal entities,such as states and local governments. ■106 Standard & Poor’s Public Finance Criteria 2007

Federal LeasesFederal LeasesPrivate developers continue to show a stronginterest in using the capital markets to financeconstruction, or refinance existing mortgages byusing federal lease payments as security. However,credit quality on these transactions can vary widelydepending on the contractual, lease-term, and structuralprovisions of the lease. Standard & Poor’sRatings Services rates transactions that are backedby lease rental payments from several different U.S.agencies. Although all of these structures aresecured by lease rentals paid by the U.S. government,some transactions carry more risk. Reflectingthis risk differential, the rating distribution on theseissues ranges from ‘AAA’ to ‘BBB’, with the preponderanceoccurring at the ‘AA’ level.Most federal lease agreements are not structuredwith a public debt financing in mind. Each federallease has different features and needs to be evaluatedon a case-by-case basis. Most prominent inmany of the federal lease transactions is the riskassociated with the involvement of an unrateddeveloper as lessor. To mitigate the developer risk,Standard & Poor’s requires that the lessor be a single-purposecorporation or limited partnership(SPE) with restrictions on future indebtedness andits operations limited to the leased property. Pleaserefer to Standard & Poor’s criteria on SPEs formore detail. In addition, Standard & Poor’s willrequire a non-consolidation opinion between theSPE and its principals. However, significant developerrisk exists with the construction and operationof the facility. Four key areas that should be carefullyevaluated are:■ Appropriation risk;■ Structural risks;■ Cash flow risks; and■ Construction risk.As with municipal leases where the lease extendfor the full term of the bonds, the most importantfactor in determining credit quality is the government’sobligation to make lease payments subject tothe government’s access to the facility, as well as thelessor’s successful performance of all of its obligationsunder the lease. This is defined as the appropriationrisk. Certain government leases do notcarry the appropriation risk in that the government’sobligation is absolute and unconditional, subject tothe terms of the lease. If this is the case, an opinionwill be required from the agency’s general counsel’soffice stating that the lease rental payments are generalobligations of the U.S. government, backed byits full faith and credit. As long as the construction,structural and cash flow risks associated with thecontract have been full mitigated, such obligationswill carry a rating of AAA.There are two other types of appropriation riskthat federal leases carry. In some instances, the obligationto make lease payments is subject toCongress making an appropriation to the agencyfor a specific function, such as military housing.Under this scenario, the military department is obligatedto make the lease payment if Congress appropriatesany funds to the agency for housing militarypersonnel. The only way the military departmentwould not be obligated to pay is if Congress appropriatedthe funds for military housing and includedspecific language stating that the specific lease orclass of leases were not to be paid. The essentialityof the function to the government is important.The second type of appropriation risk is that ofthe congressional line item. This type of appropriationis more visible and would undergo a very stringentanalysis of essentiality. Risks associated withthe congressional line item appropriation involvenot only the funding of specific governmental programsbut also the importance of a single site to thedelivery of services provided by the program. Sincedemographics and cost structures change over time,it could have an impact on where and how the governmentwants to provide services.Structural RiskThe lease structure governs the environment underwhich the government’s lease payments are made.There are four basic elements that could have animpact on credit quality:■ The match of the lease-term to the term of thedebt obligation;■ Lessor obligations under the lease;■ Rent off-set rights by the government; and■ The government’s termination rights underthe lease.Historically, the term of a federal lease hasmatched the term of the debt obligation. However,this has recently become the exception rather thanthe norm due to increased federal budgetary pres-www.standardandpoors.com107

Tax-Secured Debtsure. A securitization can receive an investmentgraderating even if the term of the lease is not equalto the debt maturity. Some federal leases are structuredwith a limited term, but give the governmentthe option of renewing the lease one or more timesduring a fixed period. Developers have securitizedthe government’s lease payments over the entireperiod rather than for the current lease-term.However, there is a risk that the government willnot exercise its option to renew the lease if circumstanceschange, such as finding a lower-cost facility,or a program is not renewed. In these instances, theessentiality of the leased asset, and any factors presentthat may mitigate the renewal risk, will be thekey factors in determining whether the securitizationreceives an investment-grade rating. A real estateanalysis risk assessment may also be performed. (See“Mitigating the Renewal Risk” section)In general, rated municipal leases are triple netwith the government responsible for maintenance,taxes, and utilities. However, most federal leases donot carry this feature and the lessor can be responsiblefor one or all of these obligations. Federallease payments are structured in one of two ways,with each based on the amount of space leased—either the government pays a single rent paymentthat takes care of both debt service and operations,or lease payments are bifurcated into two separatestreams. These two rent streams are base rentalpayments, typically used to pay debt service, andoperations and maintenance rent.If the lessor defaults on his obligations under thelease, the government’s remedies can range fromrental offset to termination of the lease. The cashflow analysis plays an important part in evaluatingthis risk. However, if the government has the right oftermination, it could have severe rating implications.Strong cash flows, coupled with a sufficient cureperiod, could partially mitigate this risk, given thatthe lessor will have an incentive to operate and maintainthe facility properly. When the government’srights for lessor non-performance are limited to rentoffset, credit quality is also severely impaired if theoffset rights could affect base rental payments—theportion of the lease rental payment used for debtservice. If the offset rights only affect the operatingrent, there are two scenarios that could enable thetransaction to achieve an investment grade:■ The government has the right to offset operatingrents and perform the obligation itself; or■ The government has the right to offset operatingrents but cash flow coverage is deemed to be sufficientlystrong enough to mitigate risk.Some federal leases will contain clauses thatallow the government to vacate portions of theleased space and offset rent proportionately.Whether the government will exercise its right tovacate is speculative and, as such, would make anytransaction that contained the clause speculative.Another risk prominent in federal leases is that ofdamage and destruction. The government usuallywill have the right to abate rents during periods ofnonoccupancy. In some cases, although not all, thegovernment may have the right to terminate thelease. To achieve an investment grade rating, thelease must contain several features that minimizethe risks associated with damage and destruction:■ The lease must require that the governmentgives the lessor ample time to repair or replacethe facility;■ The government will continue to occupy and payrent on the useable portion of the facility; and■ The government will resume the entire contractedrent payments when restoration is complete.To mitigate the lessor’s liability and costs associatedwith damage and destruction, Standard &Poor’s requires the lessor to have rental interruptioninsurance for a period in excess of the time it wouldtake to rebuild the facility, as well as casualty insuranceat replacement value or not less than the paramount of the indebtedness outstanding. The insuranceprovider must carry a rating on its claims-payingability that is no less than one category belowthe rating on the transaction and, at minimum, isinvestment grade. In addition, Standard & Poor’srequires at a minimum a debt service reserve fundequivalent to at least two months’ base rent paymentfor the insurance claim process to finalize.Termination rights are provided for in most federalleases. Termination with respect to damage ordestruction and non-performance of lessor obligationsmay be mitigated by either insurance or otherrestrictions on the government or strong cash flows,respectively. Some leases contain a termination-forconvenienceclause that gives the government theright to end the lease and its obligations at any time.This risk can be mitigated by the determination thatthe essentiality of the project is strong or the governmenthas stated that it will pay off any outstandingindebtedness if it exercises its rights under the convenienceclause. This allows the developer to achievean investment-grade rating on the transaction.Cash Flow RiskThe cash-flow analysis evaluates the lessor’s abilityto fulfill all of its financial obligations under thelease and make timely payments to the bondholders.Given that each federal lease transaction has differentcharacteristics with respect to the lessor’s obligationsand the government’s remedies, Standard &Poor’s has not established a coverage test for its cashflow analysis. In determining cash-flow adequacy, it108 Standard & Poor’s Public Finance Criteria 2007

Federal Leasesis important to make sure that government leasepayments will match debt service due dates. Mostfederal leases are structured with monthly lease paymentsmade in arrears. Most federal leases are alsostructured with a base rent component and an operatingrent component. To achieve an investmentgrade rating, base lease payments will need to equalor exceed debt service requirements. If the lessor hasoperating or maintenance responsibilities,Standard & Poor’s evaluates the operating rentsunder very conservative expenditure estimates withreliance on historical costs for similar buildings inthe area. In addition, an operating reserve equivalentto a minimum of one month’s rent is required.Standard & Poor’s also evaluates the ability ofthe lessor to make the required capital repairs onthe facility during the life of the bonds. To do this,an independent engineer’s report is required. Ifannual cash flows are not sufficient to make therequired capital repairs in each year, Standard &Poor’s will require a capital reserve fund that caneither be funded upfront or from excess cash flowover the life of the bonds.Construction RiskConstruction risk occurs when the government’slease rental payment is dependent on the completionof the project to its specification. If constructionrisk is present, Standard & Poor’s requires aconstruction risk analysis be performed.Payment and performance bonds alone, given thehistorical lack of timeliness and sufficiency of suchpayouts, are insufficient to fully mitigate constructionrisk. For further clarification refer to PublicFinance Criteria: Assessing Construction Risk inPublic Finance.Public Private PartnershipsStandard & Poor’s has rated transactions wherethe bonds are secured by a pledge of the rent paymentsunder a lease between the maintenance andoperations (M&O) contractor and the developerand not between the federal government and thedeveloper. The credit risks associated with this typeof transaction include:■ The private nature of the projects being financed;■ The initial term of the lease not extending to thelife of the bonds; and■ The lack of a marketability of the project.To achieve rating separation from the private developerand an investment grade rating for this type ofstructure the following elements must be present:Strong legal structure■ The term of the lease has sufficient renewaloptions to extend to the life of the bonds;■ There must be an executed contract between thefederal government and the M&O contractor tomanage the facility which may or may not extendto the term of the lease;Mitigating The Renewal RiskThe following factors, if present, can mitigate lease renewal risk.Strong project essentialityThe project facility under consideration should be extremely essential to the operations of the issuing federal governmental agency.Significant renewal notificationThere should be a significant renewal notification period if the federal agency is not going to renew the lease.LocationThere should be certain characteristics of the leased facility that would be difficult to duplicate, thus enhancing the likelihood of leaserenewal. An example would be the location of the project facility. If there were limited availability of sites sufficient to meet the federalagency’s needs, thus making it unlikely that adequate space would be available to the agency for any future relocation, it wouldenhance the likelihood of renewal.Renewal rates are likely to be competitiveAn analysis of the cost of relocation should be performed to ensure that if the agency were to seek relocation at the renewal optiondate, and a similar relocation cost were to be required and amortized over a 20-year lease, the projected rental amount would beabove their present renewal rate.Other GSA optionsEven if the government agency desires not to renew the lease, the GSA has the option to renew and replace the agency with anotherfederal government tenant(s).www.standardandpoors.com109

Tax-Secured Debt■ The financed facilities should be owned by a singlepurpose,bankruptcy-remote entity. The facilitiesmay than be leased back to the private operator.■ The obligation to make debt service payment onbonds sold to finance these projects should be aspecial obligation of the issuing entity and payablesolely from the revenues of the trust estate;■ The contract with the federal government, alongwith the revenues associated with those contracts,should be assigned to the single-purpose, bankruptcy-remoteentity and, in turn, pledged to athird-party collateral agent as part of the collateralsecurity for the bonds;■ Confirmation that the contract revenues supportingthe transactions would not be property of thebankruptcy estate of the private operator or subjectto the automatic stay provisions were the privateoperator has to file for bankruptcy;■ Payments from the contract revenues should, inthe first instance, be used to pay debt service onthe bonds; second, to make any required propertytax or insurance premiums; third, to replenish allrequired reserve accounts and, last, to flow backto the operator for prison facility operations; and■ Confirmation that the operator can be terminatedand replaced in the event of a default by theoperator under any of the contracts with thefederal government.Moreover, the single-purpose, bankruptcy-remoteissuer should be owned by an independent not-forprofit-corporationhaving no affiliation with theprivate prison owner, preferably a not-for-profitthat has as a charter commitment to aid governmentin the providing of essential services.Strong project essentialityThe project facility should be of an essentialnature meeting the stated mission of the contractingfederal department.Strong lease revenue streamThe lease payments should originate from rentalreimbursement payments due the M&O contractorfrom the federal government under the M&O contract.The contracting federal department, as partof its consent to and acceptance of the lease, mustacknowledge that the rent under the lease, togetherwith other operating expenses are allowable reimbursableexpenses under the M&O contract.Rent paymentsRent payments should be paid directly to theTrustee by the contracting federal department thruthe Federal Assignment of Claims Act.Requirement to renewIf the M&O contract does not extend for the termof the lease, the M&O contractor must providethat as long as its M&O contract with the contractingfederal department remains in force and effect,the M&O contractor will exercise each of theextension options, which should match the extensionoptions of the lease.Operator substitutionIf the private operator fails to meet the requirementsof the M&O contract with the contractingfederal department, that contract may be terminated.The transaction should be able to rely on thegovernment department or a number of other privateoperators being available to assume the roleof operator. The M&O contractor should agreeunder the lease that any replacement operatorresponsible for the management of the facilityenters into a replacement lease for the propertywith the same terms and conditions as set forth inthe lease. As such, the payments from the contractingfederal department in support of the debt servicepayments on the bonds will continue regardlessof who the M&O contractor is.Strong monitoring of the facilityDetails surrounding the procedures and requirementsof the facilities will also be evaluated. Thecontracting government department should regularlymonitor the facilities and have measures in placethat will rapidly address any contract violations. ■110 Standard & Poor’s Public Finance Criteria 2007

Moral Obligation BondsMoral Obligation BondsMoral obligation debt differs from other debtobligations in that there is no legal requirementto make debt-service payments. A moral obligationpledge represents a promise by a governmentobligor to seek future appropriations for debt servicepayments, typically in order to make up deficitsin a reserve fund should it fall below its requiredlevel. Usually a government official will request anappropriation and the legislative body may grant it.In practice, moral obligation debt is customarilyissued by the following municipal entities:■ State governments wishing to enhance the creditworthinessof their agencies’ revenue indebtedness;■ State bond banks that lend bond money to localmunicipal subdivisions for infrastructure projects;and■ Local units for financing projects, ranging fromdowntown redevelopment, to job training, topublic housing.Standard & Poor’s Ratings Services criteria formoral obligation debt are strict, and all requirementsmust be met to achieve a rating based on theobligor. Moral obligation bonds are typically ratedone full category below an issuer’s GO bond rating.Rating MethodologyIn rating any moral obligation bonds, Standard &Poor’s expects a standard structure to be in place:■ A reserve fund, funded at maximum annual debtservice at the time of issue, either by proceeds orother available moneys;■ Language in the resolution (local) or statutes(state) that outlines the duty and process of monitoringthis fund and notifying an appropriateofficial in the event the money in the reserve fundfalls below the required level. Such notificationmust be made in a timely manner as to meet thebudgetary requirements of that government;■ A requirement that the appropriate budgetaryofficial request an appropriation to return thereserve fund to its maximum debt-servicerequired level whenever there is a draw on thatfund; and■ Language that provides the appropriate bodyof elected officials the option to make suchan appropriation.In assigning a rating, Standard & Poor’s not onlywill verify that this structure is in place, but willevaluate the essentiality of the financing’s purposeto the issuer. The legislative history will be evaluated—howimportant it is to ongoing operations, andhow motivated the issuer would be to live up to itsmoral obligation, even if it comes under politicalpressure to allocate scarce resources in other ways.The government must also:■ Represent that it fully intends to satisfy futuremoral obligation payments; and■ Provide evidence of legislation authorizing the projector program being financed, also detailing therequirements with respect to deficiency payments.Most bond issues supported by a moral obligationpledge are structured to be fixed rate instrumentswith a debt service reserve sized to maximumannual debt service. In some instances, bonds havebeen issued in a variable rate mode, which suggestssome unique credit concerns and issues. Since variablerate debt payments may fluctuate over timegiven changing interest rates, the appropriate sizingof the debt service reserve is an issue.In order for Standard & Poor’s to base the ratingof such debt on the moral obligation pledge ofthe government obligor, one solution is to set thedebt service reserve at the maximum allowableinterest rate or cap rate under the transaction.Such a solution would eliminate the concern thatin a rising interest rate environment the debt servicereserve would not be sufficient to cover a fullyear of debt service. Another method of resolvingthis issue is to increase the times that a request toreplenish a debt service reserve that has beendrawn upon is made. This would require the abilityof the government obligor’s appropriate budgetaryofficial to seek interim appropriations fromthe elected officials. Sufficient time must be presentfor those elected officials to meet and react tosuch a request. The timing of these events must bewritten into the appropriate documents supportingthe bonds.In general, moral obligation bonds are included inan issuer’s debt ratio if the underlying non-moralobligation security stream is not self-supporting onits own. Similar to appropriation-backed debt, amoral obligation bond default could result in adowngrade of a state or local government’s GO rat-www.standardandpoors.com111

Tax-Secured Debting. If a properly structured moral obligation defaulted,despite clear original legislative support, thestate’s willingness to pay on its other debt wouldneed to be examined.Under certain circumstances moral obligationdebt may warrant a rating above the traditional fullcategory, providing there are other security featurespresent. These additional security features includebut are not limited to the following:■ Additional excess assets;■ Strong historical track record of the underlyingassets;■ A large pool of assets providing cross collateralization;and■ Strong community support/essentiality for theassets.Weaker moral obligation bonds may fall furtherbelow the issuer’s GO rating, potentially even into thenon-investment-grade rating categories, usually as aresult of significant project risks, lack of clear governmentalstatement of intent, or structural concerns.Standard & Poor’s has noted two types of moralobligation bonds. In the first (and most common)case, moral obligation bonds are issued by governmentalor special purpose entities on behalf of governmentalunits or authorities. Taxes or fees thatare legislatively or administratively mandated supportthe repayment of such bonds. Less commonare instances where moral obligation bonds areissued to support loans made to private companies.Repayment of such “private purpose” moral obligationbonds is based on revenues generated by suchprivate companies. This latter type of moral obligationbond can raise rating concerns.It is conceivable that in the event of a bankruptcyby the company for whom the moral obligationissuer has essentially served as a conduit, any debtservice reserves pledged as security for the bondsmight be viewed as “property of the estate” of thatcompany, and not be immediately available to paydebt service on the bonds. To mitigate this risk,Standard & Poor’s will request comfort that alldebt service reserve funds or other credit supportfor the bonds will not be treated as “property ofthe estate” of the company and will not be stayedfrom being applied to debt service payments, ifotherwise needed. ■112 Standard & Poor’s Public Finance Criteria 2007

General Government UtilitiesWater And Sewer RatingsStandard & Poor’s Ratings Services rates watersewerrevenue debt issued by stand-aloneauthorities or special districts whose sole mission isproviding water-sewer services, and debt issued bylocal governments that provide these services,among others.In cases where a local government pledges additionalsecurity such as a full faith and credit GOpledge or a lien on sales taxes; the rating will reflectthe stronger of the two individual security pledges.An issuer’s GO bond rating and the rating based ona water-sewer revenue pledge will usually be closegiven a similar if not identical service area economy,and possibly even similar management and governance.The degree to which one rating is higherthan the other will depend on the specific characteristicsof the two credits.While the full faith and credit pledge may be perceivedto be the broadest possible pledge, issuers’GO ratings are often constrained by general fundoperating and political pressures that outweigh similarpressures on the enterprise side. To the extentthat the utility service area is substantially largerthan the taxing area covered by the GO pledge, theutility may also benefit from a deeper and morediverse economic base. Even when an issuer’s GOrating is lowered significantly, its utility rating mayremain stable if the unique aspects of the utilitywarrant it.Of course an issuer’s GO rating is just as likely tobe as high or higher than its utility rating. To theextent that a utility faces substantial capital pressures,resistance to normal rate increases, highleveraged positions, lower debt service coveragemargins, or higher customer concentration relativeto the tax base, it would be normal to see the GOrating higher than the utility rating.Areas reviewed to reach a rating determinationon water-sewer revenue bonds include:■ Economic considerations;■ Financial data/capital improvement plan;■ Rate criteria;■ Operational characteristics;■ Management; and■ Legal provisions.Economic ConsiderationsStandard & Poor’s regards the service area economyof a utility as a focal point in the evaluation ofcredit risk. The economic analysis is used to measurethe stability of a utility’s customer base, thepotential need for growth-related capital spending,and the affordability of rates. Income trends areexamined not only in absolute figures, but alsocompared with local, state, and national averages.Income indicators reflect a service area’s capacityto support current and future rates. Other measuresof wealth and economic vitality may includehousing values, property tax base growth trends,and retail sales activity. In addition to measuringwealth, these components help to demonstrate theprospects for growth.The job base of the utility service area can supporta higher rating if it is diverse and demonstrateslittle susceptibility to cyclical fluctuations in anysingle industry or sector. Standard & Poor’s evaluatesa list of the service area’s leading employersand assesses their level of commitment to the localeconomy via their past, present, and prospectivelevels of employment. Unstable employment patternscan shrink a system’s revenue stream and leadto increased rate sensitivity. Seasonal employmentusually brings more volatile treatment demands andrevenue patterns.Other essential statistics include population,housing starts, building permits, occupancy rates,and system connections. Trends in these variablesare examined to assess the potential for future customergrowth, and how this growth will affect therevenue base, the use of system capacity, and additionalcapital needs.Financial DataFinancial analysis focuses first on past performanceto determine the utility’s stability and consistency.Standard & Poor’s evaluates three or more years ofhistorical fiscal results and compares them withplanning and budgeting forecasts and policies. Thesepolicies are viewed as successful when managementachieves a stable fiscal performance through allphases of economic and weather-related cycles.www.standardandpoors.com113

General Government UtilitiesIndividual examination is given to audited financialresults, including debt factors, accounts receivable,liquidity, and net revenues available for debtservice. Debt factors are examined for overall debtlevels and historical and projected debt service coverage.Debt service coverage tests not only includedebt service on the utility’s own revenue bond debtplus any off-balance sheet debt obligations associatedwith unconditional contractual obligations,and any GO debt issued on behalf of the utilityand paid from utility revenues. Standard & Poor’sfocus is the adequacy of a cushion to ensure uninterruptedpayment.Credit judgment of debt service coverage levelsincorporates economic and operational factors. Adebt service coverage ratio shows the multiple ofnet revenues to debt service, with higher coveragegenerally indicating an affordable debt burden. As ameasure of debt capacity, the ratio is effective indifferentiating those systems that have a revenuestream that comfortably covers debt obligationsversus those systems that do not. Systems that havea very low coverage ratio may indeed be strugglingto meet rising operations and maintenance expenses,or be experiencing difficulty raising customerrates, or simply have a high level of indebtedness.Lower coverage is generally more acceptable in systemswith lower risk; generally those with a diversecustomer base, low revenue and expense volatility,and a well-maintained infrastructure.Another consideration in assessing debt servicecoverage ratios is the structure of a utility’s debt;while back-loaded debt may reduce the short-termdebt burden and make more debt seem affordablein the near-term, it increases overall debt servicecosts. In cases where a system is counting on customergrowth to occur in order to help pay forrising debt levels through either connection feerevenue or rates, this may be considered a negativecredit factor since future growth trends arenever assured.Revenues and net income levels are examined toensure that all costs, including annual renewals andreplacements, are recovered through adequate rates.This means that two coverage ratios will be determined,as they are applicable:■ Annual debt service coverage—simply, the ratioof revenues available for debt service to theactual principal, interest and other requirementscurrently due within that fiscal year.Standard & Poor’s uses net revenues, ratherthan gross revenues, to calculate the debt servicecoverage ratio.■ Fixed charge coverage—water and sewer systemshave different levels of financial and operationalrisk. More traditional systems may havetheir own water supply, treatment plants, etc.Increasingly common is some form of regionalservice from a wholesale provider or jointaction agency. Obligations to such regionalproviders are typically treated as operatingexpenses of the retail system and thus do notappear on the balance sheet as long-term debtof that retail system. In such cases, Standard &Poor’s calculates an adjusted debt service coverageratio that treats these off-balance sheet obligationsas debt-like, since they are stillrecurring, or “fixed,” long-term obligations.This allows for more logical comparison to utilitieswith on-balance sheet debt.Given the recent emphasis on recognition andfunding of long-term liabilities for both pension(GASB Statement 27) and other post-employmentbenefits (GASB Statement 45), effects on debt servicecoverage would be dependent upon how thefunding of the liability is handled. This ultimatelywill depend on the flow of funds as to whether ornot revenues available for debt service are affected.Standard & Poor’s scrutiny also covers the utility’sliquidity position. Accounts receivable to operatingincome is reviewed to gain an understandingof the collections environment. A cash flow historyand forecast may be required if receivables consistentlytotal more than 15% of operating revenues,assuming a monthly collections cycle. Anothermeasure of liquidity, days’ cash on hand comparesavailable liquidity with annual operating expensesand other system needs to determine sufficiency.The level of short-term debt, including variableratebonds, relative to total debt also is assessed todetermine sensitivity to changes in interest rates oran inability to remarket short-term paper.Derivatives may hedge this exposure, but they mayalso introduce additional risks. As far as long-termdebt, the debt to plant ratio is considered, as ameasure of a utility system’s leverage. This ratio,however, must be considered in the context of autility’s debt history and future capital needs. Whilea low debt to plant ratio is generally considered apositive credit factor, it would not be a strength incases where the low ratio is the result of underinvestmentin physical assets. Higher debt to plantratios, moreover, may not be considered a creditweakness if infrastructure is in good condition, andcapital needs are therefore minimal. Systems thatengage in asset-liability management programsintended to quantify optimal investment levels ininfrastructure are generally seen as being able tobetter manage debt levels. Management practices,such as a defined schedule of capital spending fromreserves and debt issues, are often as important asany particular ratio.114 Standard & Poor’s Public Finance Criteria 2007

Water And Sewer RatingsLastly, Standard & Poor’s studies the utility’s capitalimprovement plan to determine what affect itwill have on system operations, rates, and finances.The overall size of a plan is not necessarily the mostimportant fact in reviewing CIPs. It is whether theplan addresses the utility’s needs, and if it is manageableand affordable given budgetary realities.Large water and sewer systems are usually betterpositioned than smaller systems to implement large,long-term capital programs because they can spreadthe costs over a broader, more diverse customerbase. Their economies of scale, greater flexibility toincur rate increases, generally solid financial performanceand long-term financial and operationalplanning allow the implementation of such capitalimprovement programs (CIPs) without causing acrushing blow to ratepayers.A utility’s capital program will necessarily influencerates for service, and rates will influence theutility’s financial health, including debt service coverage,liquidity, cash flow, and its overall degree ofindebtedness. Long-term capital plans that havealready associated project costs with fundingsources allow for estimated impacts to rates, operatingcosts and overall financial condition to beincorporated into the analysis.Water And Sewer RatesIn analyzing the rates charged to customers,Standard & Poor’s focuses on a number of importantfactors: rates compared with neighboring communitiesand/or similar systems; rates in relation tothe service area’s economic wealth and income levels;and the rate-setting process.The competitiveness of rates compared withneighboring communities can be an importantaspect of users’ willingness to accept further rateadjustments. Also, high rates can impede economicdevelopment, particularly, if nearby areas withcomparable levels of service charge lower utilityfees. Standard & Poor’s also examines the affordabilityof rates in the context of local wealth andincome indicators.Standard & Poor’s closely examines the rate-settingprocess. The number of required approvals, theability to recover current and future costs, thelength of time necessary to implement adjustments,and the track record of the approving entity areimportant credit factors.Operational CharacteristicsMunicipal water and wastewater utility systemsface the challenge of meeting state and federal environmentalregulations, as established by the SafeDrinking Water Act and the Clean Water Act, andthe need to implement capital improvement programsdesigned to satisfy future needs. A system’sability to comply with these demands withoutdiminishing financial integrity, or rate affordabilityand competitiveness, is a critical rating factor.Standard & Poor’s analysis of operations takesinto account the following:■ Customer profile and usage trends;■ Compliance with environmental regulations; and■ The adequacy of system capacity.Customer profileCustomer data are disaggregated into residential,commercial, and industrial classes to better discernthe relative importance of one type of user to thesystem. Standard & Poor’s studies customer trendsto determine the sensitivity of the system to swingsin the economic cycles. In addition, a historicalusage trend when coupled with demographic trendsenables Standard & Poor’s to assess the potentialfuture capital needs of a utility. Standard & Poor’salso examines the customer base to identify majorcustomers and the percentage of revenues that theycontribute. Care is taken to assess any one customerresponsible for a large share of revenues to determinethat customer’s stability, commitment to theservice area, and contribution to the bottom line.Concerns regarding concentration can be somewhatmitigated if the system has long term arrangementswith large users that ensure revenue stability.RegulationsPrudent management must anticipate the potentialimpacts and financial burdens on their systems offuture state and federal environmental regulations.Failure to comply with permit requirements couldlead to a ban on additional water and/or sewer connections,thereby obstructing a community’s economicgrowth, and result in harsh fines. The creditquality of a municipal system reflects Standard &Poor’s assessment of management’s ability to implementnecessary capital improvement programs tosatisfy new and pending regulations while avoiding“rate shock.” One index of planning capability isthe status of plant and line maintenance; if a systemis properly maintained, it will reduce the need formajor repairs. Some measures are water-line lossratios, inflow-infiltration studies, and the presenceor absence of an ongoing maintenance program. Tothe extent that compliance issues exist, the dialogueand relationship with state and federal regulatorybodies will be examined.System capacityStandard & Poor’s studies a water and sewer systems’existing infrastructure. The utility’s operationalcapacity, in terms of the sizing of it’streatment plants and its collection and distributionsystems is analyzed to determine if additionalcapacity will be needed and if the utility has plannedwww.standardandpoors.com115

General Government Utilitiesfor necessary expansions. Standard & Poor’s analyzesthe following factors for water systems:■ The water system’s source and available supplyof dependable water;■ If that supply affected by water rights, aquiferdepletion and/or saltwater intrusion; and■ If there are and long term commitments forwholesale delivery.Standard & Poor’s will assesses the aforementionedfactors in the context of service-area growthand the cost of providing additional water to sustaingrowth.The available safe yield of water and the capacityof pumping systems and treatment plants are comparedwith the aggregate customer average andpeak daily demand. The amount of storage isassessed as an important component in meetingpeak demand and providing reliability. Again,Standard & Poor’s evaluates these figures in conjunctionwith an assessment of demographic anduse trends. Significant excess capacity may indicateoverbuilding and heavy carrying costs for the currentuser base. Alternatively, the need for capitalspending is apparent if a system experiences, or isforecast to experience, a shortfall in supply or treatmentand distribution capacity.Standard & Poor’s applies similar criteria to evaluatingwastewater systems: peak and average customerflows as compared with the collection andtreatment plant capacity. Additional questions areasked of managers of sewer facilities, such as themethod for disposing of sludge and other issuesrelated to effluent discharge.ManagementStandard & Poor’s assesses management’s ability toimplement measures on a timely basis to proactivelyshape a utility’s financial and operating condition,as opposed to reacting to external events.While this aspect of a credit evaluation is somewhatsubjective, standard yardsticks are available tomeasure management’s performance in setting andachieving stipulated objectives. To determine management’scontrol, Standard & Poor’s looks at thequality of planning techniques, such as demographicand rate studies, financial forecasts, and capitalimprovement programs. The extent to which thesedocuments are factored into current budgets andlong-term plans also is evaluated. To determine theeffectiveness of management’s actions, the plans areexamined against the actual results.In assessing management, Standard & Poor’s willanalyze the environment in which decisions affectingthe utility occur. Generally, higher rated entitieswill, over time, develop “best practices” that notonly serve as guiding rules of thumb (or actual codifiedpolicies) to ensure continuity, but also thatthere is logical rhyme and reason to those rules.While an absence of decision-making organizationalguidelines will not necessarily constrain the rating,reactive or inactive implementation of financial andoperating measures considered crucial to performancewill be viewed negatively.To assess the management environment,Standard & Poor’s will examine the following:■ Asset management and long-term capital planning—withmany utilities this is the most importantpiece to the puzzle. Larger systems may havemore sophisticated asset inventory systems thatsmaller utilities may not be able to afford.However, all well-managed systems should have abasic idea of the useful life of at least the keycomponents to their infrastructure, as well as thefinancial and operational costs associated withmaintenance of efforts, staying in compliancewith relevant regulatory bodies and potentialimplications from non-action. Incorporating thisknowledge into a long-term capital improvementplan helps a utility determine when rate increaseswill be necessary and plan for them in advance.■ Long-term financial planning—recurring costssuch as personnel and debt service (on-or off-balancesheet) are stable and predictable. Otherlarge expenses such as fuel, electricity and chemicalsmay vary greatly from year to year. Changesin operations, such as newly constructed pumpingfacilities or expanded treatment plants mayalso significantly affect the operating and maintenancebudget. Pro forma financial projectionsthree to five years into the future allowStandard & Poor’s to assess how such changeswill impact the utility. A crucial component tothis analysis will be not only whether or not sucha pro forma document exists, but also the underlyingrevenue and expense assumptions supportingthe document.■ Rate-setting practices-Standard & Poor’s pays particularattention to the utility administrators’capacity to implement rate increases and capitalimprovement programs independently. Autonomyin rate setting is viewed as a decidedly positive factor,given that it insulates the utility from exposureto political interference that might deter a timelyand adequate adjustment. If favorable action by apublic board, city council, or state public servicecommission is required, Standard & Poor’s weighsmanagement’s ability to work with these entities toattain approval of its requests. Management’srecord of raising rates consistently and promptly is116 Standard & Poor’s Public Finance Criteria 2007

Water And Sewer Ratings■■also reviewed. Holding rate levels constant for multipleyears does not benefit ratepayers if inflationaryincreases in operating costs and other expensepressures eventually compound to force a rateincrease of such magnitude that ratepayers haveextreme difficulty in budgeting for this expense.Such patterns of irregular rate increases increasethe risk that ratepayers will pressure ratemakers toresist needed changes, thus increasing credit risk tobondholders. This is not to say that minimizing anynegative economic development consequences ofrate increases, and pursuit of lower rates from furtherefficiencies should be ignored; they should begoals that are judged from a long-term perspectiverather than exclusive targets to be met in the currentyear regardless of long-term consequences.When managed from a long-term perspective,sound policies usually benefit both bondholdersand ratepayers, and the interests of these two constituenciesare more consistently aligned.Investment and liquidity policies—seasonal cashflow needs, capital requirements, risk managementand emergencies are among the many reasonsa utility will keep certain levels of cash onhand. Standard & Poor’s also gives credit toalternative liquidity in the form of designated—but ultimately lawfully available—cash in theform of rate stabilization, depreciation, or otherfunds. Utilities tend to have larger cash reservesthan general governments, in which case investmentincome is often material and significant.This includes not only unrestricted cash and designatedfunds, but also various different restrictedfunds such as debt service reserves and unusedbond proceeds. Standard & Poor’s will ask if theorganization has established policies pertaining toinvestments, such as investment objectives, maturities,portfolio diversification, etc. Furthermore,reporting and monitoring mechanisms and frequencywill also be examined.Debt management policies—while it is assumedthat investment grade utilities will not fundoperating and maintenance requirements withthe use of long-term debt, there are many waysto fund identified capital needs. Stronger decision-makingenvironments are those in whichpolicies exist that have correlation to betweenthe debt and the asset type, the asset’s useful life,and debt levels that are appropriate to the situation.For utilities in which the use of derivatives(such as an interest rate swap) is permitted,Standard & Poor’s will ask for a copy of the formalswap management plan as adopted.Legal ProvisionsAs defined in a bond indenture or resolution, thelegal provisions make clear the issuer’s responsibilitiesand the bondholder’s recourse in the event ofthe issuer’s noncompliance. The role of legal provisionsin Standard & Poor’s credit analyses ofmunicipal water and sewer utilities has evolvedover time as the bond market’s experience withwater-sewer revenue debt has increased and legalcovenants have become more varied. As thesetrends have evolved, legal covenants have becomemore liberal, often without a resulting downgradein the issuer’s credit rating.Variables such as service area stability, operationalcapacity, financial and operational stability, andtransparent and effective rate setting practices haveproven to be strong indicators of water-sewer creditquality, often more so than the particular legalcovenants constraining the utility. However, utilitiescannot strip bondholders of traditional protectionsand expect to preserve ratings unless they show thattheir ongoing cash flows, balance sheets, and operationalstrategies will support credit quality, in otherwords, ongoing operational results must consistentlyoutperform legal covenant requirements.Legal provisions are analyzed in conjunction withassessments of a utility’s customer base, rate competitiveness,operational flexibility, management,financial strength, and regulatory pressures. Whenthese assessments indicate that the utility’s expectedongoing performance will be well in excess of theminimal levels guaranteed by the legal covenants,the degree of strength granted by these protectionsbecomes much less relevant to the rating. In contrast,when future performance is expected to becloser to levels guaranteed by the covenants, thelegal protections themselves become important tothe assumptions of continued stability at that level.In such cases, legal covenants can play an importantrole in the rating.Standard & Poor’s considers each legal provisionseparately and examines the conditions underwhich different variations do or do not result in differentcredit ratings. It is important to rememberthat while weaker legal covenants may not have arating impact when performance is strong, if creditquality starts to deteriorate, it is likely that a lackof strong covenants will increase the potential anddegree of a downgrade.SecurityStandard & Poor’s does not distinguish between agross and a net revenue pledge. It is Standard &www.standardandpoors.com117

General Government UtilitiesPoor’s view that operation and maintenance expensesmust be paid in order for a system to be a viable,ongoing concern that will generate revenues for debtservice, whether pledged on a net or gross-lien basis.Standard & Poor’s will review the security pledge toensure that ongoing revenues are available for debtservice payments. If the pledge allows prior periodrevenues through the use of a rate stabilization fundthen it is better that those revenues provide the revenuecushion stated in the rate covenant and thatrevenues derived from the operation of the utilityalone provide at least one times annual debt servicecoverage. If an issuer intends to use tap fees, systemdevelopment fees, or connection fees as part of thepledged revenue stream it is important that the systemhas at least sufficient coverage from operatingrevenues alone. If operating revenues are insufficientit may be necessary to demonstrate that operatingrevenues are intended to cover annual debt servicewithin a few years.While the typical senior-lien pledge of an enterprise’snet revenues is considered to be the mostsecure, junior-lien debt need not always be ratedbelow senior obligations. In cases where the seniorlien has been legally closed and the creditworthinessof the issuer supports the higher rating, an argumentcan be made to rate both the senior lien andsubordinate lien at the same level. Also, if an issuerhas a proportionately smaller amount of senior liendebt versus subordinate lien debt and if the generalcreditworthiness of the issuer warrants it then thetwo liens can be rated on par.Finally, in some cases the general creditworthinessof the issuer is strong enough to allow the seniorand subordinate debt to be rated on par. Manyissuers have set internal policies to operate thewater and/or sewer systems at coverage levels wellabove the rate covenant to generate sufficient revenuesto fund a large portion of the capitalimprovement plan. When an issuer consistentlyoperates in excess of the legal rate covenants ofboth the senior and subordinate debt, this couldjustify the support of equivalent ratings.Rate covenantsThe rate covenant, actual coverage, and the abilityto raise rates are factors that provide credit strengthto water and sewer utility revenue bonds. Withmost utility financing, the rate covenant requiresmanagement to set rates for service that will generatenet revenues sufficient to provide a defined minimumlevel of debt service coverage—typically1.10x to 1.20x. While this range is the norm, ratecovenants as low as 1x are acceptable in situationswith limited operating risk. While a 1x (sufficiency)rate covenant would be acceptable, Standard &Poor’s expects to see higher levels of coverage inmost years. The covenanted level is the minimumlevel and is considered the exception rather than therule over the long term.Again, the definition of revenues providing thecoverage is as important as the covenanted level ofrequired coverage. Generally, recurring revenuesfrom operations should be sufficient to cover debtservice, and only such revenues should be defined as“net revenues”. Cash balances and nonoperating ornonrecurring revenues such as developer fees, systemdevelopment charges, and connection fees are sometimesincluded, but cause additional concerns. Often,these resources are available for use only once, anddepletion of those resources can put significant pressureon rates. Although “rolling coverage” is becomingincreasingly common, operating revenues shouldtypically cover operating costs and Standard &Poor’s will analyze coverage calculations both withand without non-operating revenues.Additional bonds testsThe additional bonds test ensures existing bondholdersthat a minimum level of coverage has beenmet upon the issuance of additional parity debt.Standard & Poor’s focuses on whether the issuer’sright to offer senior or parity bonds at a later timecould result in a dilution of coverage. A conservativeadditional bonds test requires that net revenuesfor a prior fiscal period (the previous fiscal year or12 consecutive months) equal at least 125% of themaximum annual debt service requirement, takinginto account the issuance of proposed bonds. A testthat measures historical earnings is stronger becauseit is less speculative than those based on revenueprojections. Often, projected tests rely on assumptionsthat may not be realized, such as future rateincreases or revenues generated by new facilities.Adjustments to historical net revenues to reflectnew customers or rate increases, which have beenimplemented prior to the proposed bond issuance,are common and acceptable. While a conservativeABT helps mitigate future bondholder risk,Standard & Poor’s also takes into account thescope of the capital program and related risks andimpact on a system’s financial profile.Flow of funds—transfers outThe flow of funds specifies the order and timing inwhich system revenues are used to meet the obligationscreated by the indenture. Of critical importanceto the rating is the lien position of debtservice payments in relation to other system obligationsoutside of ordinary operations and maintenancecosts. Also, Standard & Poor’s looks forestablished reserve funds, such as debt servicereserve and renewal and replacement accounts to befunded in turn, to provide additional cushion for118 Standard & Poor’s Public Finance Criteria 2007

Water And Sewer Ratingsdebt service payments and system maintenance.Frequency of payments to the debt service fundrange from monthly to semiannual transfers. Froma financial perspective, monthly deposits are preferred,since this approach allows a smooth buildupof the debt service fund and an early indication ofany shortfalls.The flow of funds also enumerates the issuer’sability to transfer surplus funds out of the system.A reliance on transfers from the utility to the generalfund adds to a system’s revenue requirementsthat can result in additional rate pressures for customers.While the ability to retain all surplus fundswithin a system is certainly a plus, transfers toanother fund are not necessarily a negative factor. Awell researched, flexible, consistent, and well communicatedtransfer policy is likely to offset the concernthat such transfers potentially can drain theutility’s cash position or constrain management’sability to fund capital improvements from earnings.In addition, the general government managers andpolicy makers will have less room for disagreementand debate if a transfer policy is well establishedand maintained.Whether a utility recognizes various overheadcosts through direct operational expenses orthrough transfers to other governmental funds hasno effect on the rating analysis. Standard & Poor’sreview includes a calculation where transfers andoff-balance sheet debt are considered along withdirect operation and maintenance expenses whencalculating debt service coverage. This additionalcoverage calculation provides further insight into asystem’s overall financial flexibility.Debt service reserve and other reserve fundsA fully funded debt service reserve can provide anadditional level of financial cushion for bondholders.When an unexpected budget shortfall occurs,the reserve fund gives the utility time to implementneeded adjustments before bondholders areadversely affected. The usual debt service reserverequirement is equal to the lesser of 125% ofaverage annual debt service, 10% of bond proceeds,or maximum annual debt service. For systemswith higher risk profiles, such as customerconcentration, cyclical economic bases, or consumptionand revenue volatility, a fully fundeddebt service reserve will likely make a difference inthe rating and may be essential for an investmentgrade rating. From a practical standpoint, however,the debt service reserve is really a liquiditysource and provides only limited additional securityto bondholders—-it essentially provides the utilitywith time to address whatever issues havepressured performance. It is also likely that if asystem needs to use the reserve, it is already intechnical default on the rate covenant.For utilities that consistently maintain high operatingreserves and sustain high debt service coveragelevels, the debt service reserve becomes less relevant.Policies that maintain coverage above covenantedlevels, fund a defined percentage of infrastructurerequirements internally, and maintain contingencyor capital reserves at defined levels, reduce the likelihoodof the utility ever falling into a position whereit would need to use the reserve. In such cases, nodebt service reserve may be needed to sustain a rating.Because unforeseen circumstances can occur,Number Of Participants Also A FactorWholesalers range in size from as small as three customers, to 50 or more. The precise rating approach will generally be determinedby, and may vary by, the size of the wholesaler’s customer base. Since a debt-issuing wholesale utility is reliant on the ability of itscustomer base to pay all operating costs plus debt service, the credit quality of a wholesale utility’s participants (whether they areconsidered members or customers) will affect the wholesale utility’s credit quality to varying degrees. If a wholesaler is made up of10 or fewer participants, and there are no contractual provisions that require non-defaulting members or customers to increase theirpayments to account for such delinquency, then Standard & Poor’s will employ a weak-link approach to the analysis. This is becausethe failure by a single participant to fulfill its payment obligations to the wholesaler would result in a project deficiency, therebyexposing bondholders to the credit quality of the project’s weakest participant.In cases where a wholesale utility has about 10-25 members, there may be certain additional factors that allow the wholesaleutility’s credit rating to move up or down from its customers’ or members’ credit quality. These factors include the project or system’soperating history; consistently high debt service coverage, which is uncommon for wholesalers; or the level of reserves typicallycarried by the wholesaler.Wholesale utilities with more than 25 members or customers, assuming there is not undue concentration among a very smallgroup of customers, can be expected to exhibit sufficient diversity to allow for a more system-oriented approach. Factors such asdebt service coverage, equity in the form of unrestricted cash and investments, and overall economic considerations will becomemore prominent in the credit analysis, similar to the analysis of municipal retail utility providers. Wholesalers of this type do notgenerally have limited step-up language in their governing agreements.www.standardandpoors.com119

General Government Utilitieshowever, utilities may choose to include a debt servicereserve simply for the sake of prudence. Someutilities have taken advantage of “springing” reservecovenants, whereby the utility is obligated to fund areserve from operations once coverage dips below aspecified level. Although such covenants may preventthe utility from spending revenues needed topay debt service in the immediate future, the featuresmay also pose additional risks for the utilityby increasing the amount of revenues required of theutility at the precise time when liquidity is deteriorating.Wholesale Systems’ Legal ProtectionsThe ability of a wholesale provider to pass onincreased costs to retail systems depends on acombination of legal, operational, and demographicfactors, just as retail providers face similarissues in passing costs on to their customers.Accordingly, Standard & Poor’s analysis forDocumentation RequirementsThe following materials should be submitted in conjunctionwith a rating request:Financial Documents■ Three years of audited financial reports■ Current year’s budget■ Bond resolution or trust indenture, including supplementalresolution or indenture, if appropriate■ Service contracts with wholesale customers■ Power purchase agreementsSystem Information■ Engineer’s report, feasibility study, or rate study if available■ Anticipated capital improvement program■ Largest customers by revenues and service■ Three to five years of operating statistics■ Customers by class■ Sales in revenues and service by class■ System capacity and average and peak system demands■ Five years of historic and projected rates, with locallytargeted comparisonsEconomic Information■ Population trends■ Income trends■ Composition of employment by sector■ Unemployment rates■ Largest employers in service area■ Tax base trends■ Building permit activitywholesale utilities is similar to that of retail systems.Because many wholesale-retail relationshipsare governed by long-term contracts, however,such agreements are important to the wholesaleranalysis. Standard & Poor’s will evaluate thewholesaler’s contracts with the retail utilities todetermine the flexibility of the wholesaler toadjust rates as well as the strength and ultimaterepayment obligation of the retailers. Creditstrengths exist in contracts where a step-up provisionensures that the financial impact resultingfrom a failure to pay by one party is spread outamong the remaining retail parties. In contractswhere no make-up provisions exist, the wholesalermay be more vulnerable to individual retailerweaknesses if contract provisions do not allow forsupplemental rate adjustments. While contractprovisions in some cases can result in rating differentiation,the economics of the customer base inaggregate, coupled with the system’s operatingperformance, remain the important rating factors.Drainage Revenue BondsThe criteria for assigning ratings to bonds securedby drainage fees are similar to the criteria forwater and sewer ratings. As is the case with waterand sewer ratings, Standard and Poor’s reviews theeconomic conditions of the service area, the financialand operating history of the enterprise fund,rate setting criteria, system management and thelegal provisions associated with the bonds.Generally, the ratings for bonds secured bydrainage fees are as strong, if not stronger, thanwater and sewer revenue bonds issued by the sameentity. Principal factors that typically differentiatethe credit quality of drainage revenue bonds fromwater and sewer revenue bonds include the lack ofrevenue volatility often experienced by water andsewer system revenue streams, very low rates orfees, a smaller overall capital improvement program,and greater expenditure control.The service area and customer base are usuallycoterminous with the area served by the utility’swater and/or sewer system. As drainage districtshave few operational responsibilities, drainage feesare typically set to generate modest coverage ofannual debt service and perhaps fund ongoing payas-you-gocapital programs. These fees are often aflat, periodic fee paid per equivalent residentialunit, or on a square-footage basis. As such, the revenuestream within a drainage fund is not subject tothe weather-related fluctuations most water andsewer funds experience, so maintaining high coveragelevels becomes less important. Since thedrainage fee is usually added to the water bill, nonpaymentof only the drainage fee is not practical,120 Standard & Poor’s Public Finance Criteria 2007

Electric Utility Ratingstherefore collection rates are as strong as that forthe water and sewer fund.Unlike water and sewer ratings, there is typicallya gross pledge of revenues securing drainagerevenue bonds. Net coverage is often close togross coverage as most drainage funds have littleoperations and maintenance expenses. Sincedrainage systems are usually established for thepurpose of addressing capital-specific items, mostdrainage fund expenditures are capital-related andcan be delayed by management should liquiditybecome a concern.The rate covenant and the ability to raise ratesare important factors, but less so given the overallstability typically experienced by drainage revenues.It is typical, however, to see a ratecovenant set to achieve debt service coverage of atleast 1.10x. The rates or fees charged are typicallyvery low in relation to the overall bill for waterand sewer usage. ■Electric Utility RatingsStandard & Poor’s Ratings Services criteria reflectthe challenges and risks of publicly owned utilitiesoperating in a deregulated wholesale environment,and approaching retail competition. Thecriteria also reflect the dynamics of the energyindustry and the credit implications for bondholdersand lenders, and emphasize the qualitative andquantitative factors that indicate an electric utility’scapacity to operate in a market in which it mustwork to retain, and gain customers.Credit ratings for public power issuers embodythe interplay between eight variables: management,operations, competitive position, markets, regulation,service area economy, finances and legal provisions.Standard & Poor’s also assigns businessprofiles to all rated electric utilities, which includesthe first five factors. These factors are incorporatedin credit ratings, and enhance an investor’s abilityto differentiate between utility systems by complementingthe credit ratings and outlooks.Similarly, business profiles enable utilities tomake comparative analyses and internal assessmentsto benchmark themselves against other utilitieswith which they may compete. Business profilesare ranked on a ten-point scale. A score of “1”reflects the strongest business profile.ManagementA competitive marketplace puts a premium on leadershipskills. Management’s decisions in all facets ofutility rate setting, operations and finances, are criticalto a public power system’s long-term viabilityand strength. Standard & Poor’s assessment ofmanagement includes an evaluation of the extent towhich a utility’s strategic plans are supported bylocal councils or boards of directors, and the extentto which the governing body’s actions are supportiveof credit quality. Management should demonstratean understanding of, and be supportive ofrate structures, customer service initiatives, andfinancial strategies that bolster credit quality. WhileStandard & Poor’s evaluation of management consistsof a qualitative assessment, our analysisemploys specific criteria for measuring the effectivenessof management. The following elements areexhibited by well-run utilities:■ Institutionalized planning processes that arerevised regularly to reflect changing conditions;■ Sound financial and operating policies that aresupported, implemented and achieved;■ A deep and experienced executive team;■ A solid grasp of industry issues that extendsbeyond the local utility;■ Extensive knowledge of customers andtheir needs;■ Extensive knowledge of competitors; and■ A proactive and farsighted managementapproach that has the support of an informedboard or council.Management should also demonstrate an understandingof the risks and rewards associated withentering into contracts with counterparties, andwith entering into new lines of business beyond thescope of its core mission. Additionally, managementwill be assessed on their ability to operate within agiven governance and oversight structure.OperationsStandard & Poor’s examines the full gamut of autility’s operations through a multi-pronged analysisthat explores the following:■ Power and fuel resource mix, capacity, supplyand demand;■ Operating efficiency and reliability; and■ Capital needs.www.standardandpoors.com121

General Government UtilitiesThe strength of a utility’s operational profile andcost competitiveness is rooted in its portfolio ofpower supply resources. Standard & Poor’s evaluationalso includes the analysis of the operating statisticsof a utility’s power transmission, distribution,and generating facilities. Efficiency measures,including frequency and duration of unplannedservice interruptions, plant heat rates, and availabilityand capacity factors, all are vital in determiningfacility efficiency and ultimately the competitivenature of an individual power plant, or the utility’soverall cost profile.Standard & Poor’s examines the diversity or concentrationof resources and assesses the fuels uponwhich a utility depends. This analysis exploresresource availability, reliability and cost.Standard & Poor’s does not have a bias towardowned or purchased resources, and the financialanalysis of a purchased power agreement willequate fixed capacity payments with debt serviceincurred when financing directly owned or jointlyowned generation assets in computing fixed chargecoverage. Rather, resource diversity, flexibility, andcost competitiveness are the key determinants ofoperational health.Issues associated with purchased resourcesinclude the level of demand charges, unique contractterms and duration of contracts, and the abilityto take advantage of market opportunities. Animportant component of the power supply evaluationis an assessment of a utility’s fuel mix, supplyarrangements, fuel costs, and any financial or otherhedging mechanisms designed to control fuel risk.Fuel contract terms, especially pricing conditions,duration, reopener options, and minimum takeprovisions will be examined. Standard & Poor’swill look for a balance in the length and nature ofthese supply contracts, and for each utility willdetermine the degree of risk associated with its fuelpurchasing practices.Standard & Poor’s will explore the degree ofsophistication and the checks and balances used inconjunction with any hedging program. Crucial tothe analysis of an issuer’s fuel mix and purchasedpower mix is an assessment of counterparty risk.This includes an analysis of wholesale contractswith regard to duration, termination provisions,price, and the extent to which they add a fixedcomponent to the financial profile. Coal, gas, andnuclear-fired generation at various times have fallenin and out of favor. As such, a diverse mix of fuelthat enables a utility to employ cost efficient generationis viewed as a strong operational component.Prepaid power purchase agreements typicallyoffer the buyer favorable inducements such as discounts,and can be funded with tax-exempt debtissued by municipal issuers. For debt-financed, prepaidpower contracts, the principal and interestpayments are treated similar to capacity paymentsof the more traditional purchased power agreements.Operational considerations include thesource and nature of the contracted power supply,which may be unit specific or from a more diversepool of generation assets; the amount of the commoditypurchased relative to the issuer’s total supplyneeds; contract duration; and creditworthinessof the power supplier. Contract terms are also scrutinized,and should provide bondholders with protectionin the event the counterparty fails toperform its contractual obligations.For prepaid natural gas transactions, the treatmentof the debt issued to fund the prepayment isslightly different than that of prepaid power contracts,since pay-as-you go gas supply purchaseagreements do not typically have a capacity componentimputed, as with purchase power agreements.The annual amount of the debt service onthe prepaid bonds is typically sized to approximatethe cost of gas that would arise had the gas beenpurchased under a long-term gas purchase agreement,so the impact on cash flow under either scenariois minimal, as long as the supplier continuesto perform.For prepaid gas transactions involving directlyissued debt or involving third party conduits suchas joint action agencies, debt service is calculated orimputed to measure the transactions impact on debtratios. However, the qualitative factors that mitigatepotential pitfalls usually associated with debtleverage, such as the risks of load loss, supplier performanceand remarketing, will be taken into consideration.Therefore, although evaluated on acase-by-case basis, debt-financed prepaid gas contracts,so long as their terms do not give rise to significantadditional operating risks, and if structuredso that counterparty risks and remarketing risks aremitigated, generally should have a neutral impacton credit quality when compared to a pay-as-yougo gas purchase agreementCosts of historical investments in generatingplants continue to represent a significant challengeto utilities and frequently are a significant elementunderlying above-market rates. Investment is measuredin terms of the amount of debt that has beenincurred and the associated costs of servicing debtin relation to kWh sold, kWh of demand, kW ofinstalled capacity, and the number of customersserved by the system. Again, fixed capacity paymentsmade under purchased power agreementswill be factored into the analysis, equating suchpayments with principal and interest on generationrelateddebt. In the event that a municipal electricutility is faced with a deregulated retail environment,the elimination of stranded costs is critical to122 Standard & Poor’s Public Finance Criteria 2007

Electric Utility Ratingsits viability. A utility whose fixed obligations causerates to be above market levels is unlikely to beable to fully recover these costs in a competitiveenvironment, which will have negative implicationsfor both the utility’s business profile and rating.Transmission access is vital to a utility system’soperations, and credit and business risk. In determiningstrength in this area, Standard & Poor’s will lookat the number of interconnections with which theutility in question has access, the cost profiles andsupply and reserve characteristics of these other interconnectedutilities, and the price paid for wheeling ofpower. Importantly, Standard & Poor’s will evaluatethe extent to which these interconnections and potentialpower diversity arrangements provide a utilitywith enhanced operating and competitive flexibility.The Federal Energy Regulatory Commission (FERC)is authorized to impose market rules regarding transmissionoperations, and the impact on a utility assuch rules evolve will also be evaluated.Operating efficiency and operational strength aremeasured with reference to the cost of producing aunit of energy. Historical and projected trends inaverage and marginal production costs on anabsolute and relative basis are reviewed. A utility’sgenerating costs relative to industry averages willindicate the economics of its power supply and thepotential for stranded costs.The efficiency of a utility’s services and operationsis evaluated according to ratio analysis,including production cost per kWh, debt per kWhand debt per customer. A utility’s efforts at managingits load curve—and therefore its costs—throughdemand side and resource management programswill be viewed positively to the extent that they areeconomically reasonable and practically achievable.Some utilities with below average load factors maybe less able to control the associated inefficienciesand costs, but they also may be less susceptible tocompetitive forces.Favorable operational characteristics include:■ Diverse supply sources;■ Favorable fuel supply arrangements coupled withcost containment strategies;■ Widespread transmission access that does notdepend completely on a single entity to wheelpower;■ Production costs that are competitive and reflectreasonable operating and maintenance costs; and■ Manageable environmental or regulatoryexposures.Some public power entities are active in, orplanning to provide new services, such astelecommunications services, chilled water, andsteam, in addition to their core businesses inorder to diversify their revenue streams.Standard & Poor’s will evaluate whether or notsuch additional ventures, which can increasefinancial risk, will be detrimental to the utility’score business. Important components of suchanalysis are the relative share of operating expendituresattributable to, and the amount increasedleverage associated with such enterprises.Competitive PositionCompetitiveness is important to the retention ofnative load and the preservation of the revenuestream pledged to debt repayment, for both systemsoperating in open access environments or in thosethat are currently protected. Competitive positioningremains important, even for utilities in statesthat have yet to advance deregulation due to heightenedawareness of retail choice among even captiveelectricity customers.Overall system average rates, as well as rates ofa customer class, are at the center of Standard &Poor’s review of a utility’s relative competitiveposition. The analysis is extended to include anassessment of the rates that a utility charges specificloads and rates levied on its largest customersrelative to potential alternative suppliers.Standard & Poor’s explores each utility’s ratedesign, use of contract rates, and rate affordability.Affordability is measured relative to income levelsand usage patterns. The commitment of policymakers to provide equitable rates that reflect thecosts of providing service without subsidies is crucialin the changing environment. The presence ofautomatic power or fuel cost adjustments, whichlimit or avoid the political influence over timelyrate adjustments geared to recapturing fluctuatingcommodity costs, is viewed favorably.A discussion of rates also includes the issue of autility’s rate-setting process, whether regulated by athird party or through self-determination.Strong competitive positioncharacteristics include:■ A rate design that equitably apportions costsbetween and among system customers;■ Unit rates by customer classification that displaya competitive advantage;■ Projections of rates that will continue to display acompetitive advantage, preserve the revenuestream associated with native load, fund capitalexpenditures for system maintenance and growthand help attract new load;■ Ability to establish rates free from state regulatorybodies; and■ Flexibility to adjust rates quickly and frequentlyto match potentially volatile cost structures.www.standardandpoors.com123

General Government UtilitiesService AreaAn analysis of a utility’s service area entails areview of its customer base and demographiccharacteristics.Standard & Poor’s examines each utility’s customerbase in terms of total number of customersand the number of customers by class. Revenues,kWh sales, margins and load factors are examinedfor each customer class and for the largest customers.The terms and time frames of any longtermcontracts negotiated with industrial andcommercial customers are also examined. Load factorsand unit costs charged to key industrial customersare particularly important because theydemonstrate the attractiveness of these customers toother suppliers or the opportunity for self-generation,and the potential for lost revenues. Large customers’supply options and cogenerationcapabilities are important to ascertain potential systemexposure. Also factored into the analysis of thecustomer base is an evaluation income levels todetermine the relative affordability of rates.The service areas of rural areas are sparsely populatedwith few customers per line mile, whichreduces the risk that a competing utility will cherrypick its most attractive customers. Yet, these serviceareas also limit the opportunities for revenuegrowth, and tend to increase capital investment andservice costs per unit of sales.Historically, Standard & Poor’s examined anelectric utility’s service area economy as a proxy forthe stability of the revenue stream pledged to repaythe utility’s debt. While economic analysis remainsa major focus, it can be tempered by the influenceof competitive factors.Favorable market characteristics include:■ Load factors for the system and leading customersthat do not make the system particularlyvulnerable to competitive factors;■ Stable or increasing population trends, in accordancewith other forecasts for the utility; and■ High wealth indicators relative to cost-of-livingindices and the level of electric rates.RegulationStandard & Poor’s assessment of regulationencompasses several regulatory factors. Theseinclude the impact of federal, state, or local regulatorswith regard to ratemaking, competition, transmission,and the environment. The impact of theregulatory framework will come into play amongseveral rating factors, particularly operational andfinancial factors.In terms of restructuring of electric markets,Standard & Poor’s believes that the movementtoward a more openly competitive environment ispossible over the long term, and would most likelyoccur on a state-by-state basis, as opposed to viafederal pre-emption. Standard & Poor’s recognizesthat many utilities will find that open markets willcreate opportunities, and also risks. Generally, however,public power utilities in regulatory environmentsthat do not require them to face directcompetitive threats from other power suppliers aresubject to less credit risk.FinancesA traditional analysis of a utility’s financial performanceincorporates a review of debt service coveragemargins and liquidity, but also examinesspecific utility results and decisions. For example,some utilities are emphasizing competitiveness overthe financial strength associated with excess coveragemargins and debt service reserves, in an attemptto ensure long-term system viability. Standard &Poor’s incorporates the effects of such policychanges and the potential diminution of financialcushions into its credit ratings. Standard & Poor’swill assess the costs of achieving competitivenessand the impact of competitiveness upon financialintegrity and system reliability. Reduced coverageand reserves may be appropriate for some utilitiesbut not for others, depending upon the degree towhich competitiveness can be enhanced and alsothe operational and competitive challenges thateach utility faces.Key financial ratios include debt service coverage,and fixed charge coverage; unrestricted cash as apercentage of total expenditures; and debt to equity,among others. While debt service coverage is a traditionalfinancial metric for municipal utilities, it iscommon for municipal electric systems to structuretheir operations using off-balance sheet debt forgeneration projects, and purchased power agreementsthat have debt-like characteristics. As such,fixed charge coverage, which imputes fixed paymentsassociated with power and transmission purchases,whether through debt service or capacitypayments tied to purchase contracts, is the morecritical coverage ratio in the financial analysis ofpublic power utilities. Transfers to other governments,while often expressly subordinate, are factoredinto the analysis as operating andmaintenance expenses that reduce available net revenues,since such transfers typically resemble propertytaxes, franchise fees, direct costreimbursements, dividend, or return-on-equity typepayments commonly paid by other enterprises suchas investor-owned utilities, and are assumed torecur annually.The balance sheet has become a key tool for controllingcosts and achieving competitiveness. Assetto-liabilitymanagement is particularly important124 Standard & Poor’s Public Finance Criteria 2007

Electric Utility Ratingsfor systems that have high debt due to their investmentsin high-cost generating assets and the extendeduse of capitalized interest to fund them. Popularoptions that are being pursued by public powerinclude the restructuring of debt, extending the usefullives of plants, writing off uneconomicresources, accelerating the amortization of high-costdebt, and increasing the use of variable rate debt,interest rate swaps and other debt derivatives. It isquite likely that still other financial tools will beintroduced in response to the pressure to bringdown rates.The use of each of these tools is evaluated relativeto its appropriateness to the specific situationof a given utility. Generally, these mechanisms canbe said to produce positive results to the extentthat they reduce the upward pressure on rates.Utilities that maintain adequate cash balances todeal with the opportunities and challenges posedby a restructuring industry maintain importantflexibility. For instance, ample funds will allowthem to pay off high-cost debt, thereby improvingtheir cost of capital and equity ratio. Some systemswith strong business fundamentals could reducetheir cash balances without impacting their creditratings. This is particularly true for distributionsystems that do not have the same pressures anddemands on liquidity as the more generationdependentsystems. The movement of the industryin this direction is evidenced by the revised bondresolutions and indentures that are designed to freeup reserves that have been maintained under traditionalfinancing documents.Standard & Poor’s monitors the use of syntheticfinancial instruments. These instruments presentbenefits, but also can increase risk, particularly asoperating margins and reserves are trimmed toachieve competitiveness. Because risks associatedwith financial derivatives are borne by ratepayersand are not shared with owners, as is the case withinvestor owned utilities, it is imperative that a veryhigh degree of oversight and control be employed.Legal Provisions Of Retail Electric SystemsStandard & Poor’s views an electric revenue bondtransaction’s legal provisions in conjunction withthe system’s overall financial profile. For electricutilities that are able to generate system surpluswell above minimum levels required by bondcovenants, legal provisions will be of less importancein the rating analysis. For electric utilities thatdemonstrate relatively weaker financial profiles, theanalysis of legal provisions remains a critical factor.As defined in a bond indenture or resolution, thelegal provisions make clear the issuer’s capabilities,responsibilities, and the bondholder’s recourse inthe event of the issuer’s noncompliance.For an electric utility with a strong financial profile,strong or weak legal covenants will not correlatewith a higher or lower rating. For a weakerelectric utility, liberal legal covenants will continueto be viewed as a weakness and could serve as thebasis for the assignment of a lower rating to systemswith modest credit quality.The most important legal provisions reviewed arethe security pledge, rate covenant, flow of funds,additional bonds test, and debt service reserve.Also, a growing number of issuers are incorporatingswaps or other derivatives into bond transactions,to supplement the traditional legal structure.Please refer to the Debt Derivative Profile sectionfor additional information.SecurityThe most common form of bond security for utilitybonds is system net revenue. Some issuers elect tosecure bonds on a gross revenue basis. However,Standard & Poor’s believes that pledged system revenuesshould always be sufficient to cover debtservice and operating expenses and, therefore, doesnot differentiate between net and gross revenuepledges. Similarly, off-balance sheet debt obligationsof retail utilities that are usually secured by systemoperating expenses are treated as senior lien debt.Typically, these payments are take-or-pay obligationswith wholesale agencies.Rate CovenantThe rate covenant establishes the minimum level ofdebt service coverage that a system must provideon a fiscal-year basis. Standard & Poor’s analyzesthe rate covenant in relation to the overall operationaland financial performance of the individualsystem. Generally, a mature system with stableoperational and financial performance will notneed as strong a covenant as a system that can besubject to volatile financial margins or anticipatesa large capital program.A rate covenant addresses all obligations—seniorand subordinate debt, as well as other system fundrequirements. Typically, rate covenants for retailsystems range from 1.10x-1.25x the annual principaland interest requirements of senior lien debt.This extra margin provides bondholders with financialprotection. Sufficiency-only rate covenants ofsenior lien debt are of less concern for issuer’s thatconsistently set and achieve internal coverage policieswell in excess of coverage levels required by therate covenants.For issuers that operate at less substantial margins,weak or sufficiency-only rate covenants willplay a greater role in determining the rating. Forthese issuers, a covenant that allows the issuer touse existing cash reserves, otherwise known aswww.standardandpoors.com125

General Government Utilities“carryover coverage”, or one-time revenue sourceswould likewise have negative rating consequences,especially if such funds are forecast to be necessaryfor coverage compliance.Flow Of FundsThe flow of funds specifies the order and timing inwhich system revenues are used to meet the obligationscreated by the indenture. Of critical importanceto the rating is the lien position of debtDocumentation RequirementsThe following materials should be submitted in conjunction with a rating request:Financial Documents■ Official statement■ Indenture/resolution (including supplemental resolution and indenture)■ Other legal documents■ Debt service schedule (with and without current financing)■ Five years of audited financial information■ Capital improvement plan■ Current year budget■ Pro forma projections■ Contracts for purchased power (including participation agreements)■ Contracts for fuel (if applicable)■ Contracts with leading customers■ Details on power and interest rate swaps.System Information■ Type of unit (base, intermediate, peaking), fuel type, availability, capacity,loadfactors and installation date for individual generation units■ Peak data (historical)■ Load factors for leading customers■ Leading customers as a % of revenue■ Revenue by customer class (residential, commercial, industrial, other), historical■ Customers by class (residential, commercial, industrial, other) historical■ % power purchased, % power generated, historical & projected■ % of purchased power under contract; % of purchased power brought onspot market■ Fuel mix, historical and projected (for generators)■ Rates historical, projected■ Fixed charges for off-balance-sheet obligations, historical and projected■ Debt service schedule for off-balance-sheet projects, andparticipation percentages.■ Transfers, historical and projected■ Rate stabilization funds (historical/projected) held at the issuer level■ Transfer policy and methodology if available■ Debt and hedge policies if available■ Policies related to entering into non-traditional ventures, if available■ Summary of power supply, transmission, and fuel purchase contracts, includingterm price, amounts, fixed and/or capacity payments, and other key facets.service payments in relation to other system obligationscreated by the indenture. The flow of fundsdefines the issuer’s ability to transfer surplus fundsout of the system. Such transfers can drain the utility’scash position or restrict capital improvementsotherwise financed from earnings. Transfer paymentsthat are limited to a reasonable amount andlimited to a specific formula, such as a percentageof revenues, partially offset this concern. However,Standard & Poor’s will calculate coverage bothwith and without transfers for comparative purposes.Frequency of payments to the debt service fundrange from monthly to semiannual deposits. From afinancial perspective, monthly deposits are preferred,since this approach allows a smooth buildupof the debt service fund and an early indication ofany shortfalls.Additional Bonds TestAs with the rate covenant, the additional bonds testis viewed in conjunction with the financial and debtprofile of the system. The purpose of the additionalbonds test is to protect existing bondholders fromdilution of their security position. Standard &Poor’s focuses on whether the issuer’s right to andlikelihood of issuing parity bonds at a later timewould result in a decline in coverage. Attributes ofa strong additional bonds test for parity debtinclude a test based on historical net revenues thatpreserve sound coverage of existing and proposedobligations. A test that measures historical earningsis preferred, since it is less speculative than thosebased on revenue projections. Often, projected testsrely on assumptions that might not be realized,such as future rate increases or revenues generatedby new facilities.Likewise, adjustments to historical net revenuesto reflect new customers, system acquisitions, rateincreases, or contracts for additional services canweaken an otherwise strong historical earnings test.ReservesStandard & Poor’s looks for established reservefunds, such as debt service reserve accounts maintainedat specific funding level, to provide additionalcushion for debt service payments and systemmaintenance within a given budget year. For issuerswith thinner margins, a fully funded debt servicereserve is important, since it provides an additionallayer of protection for bondholders.Typically, a debt service reserve requirement isequal to the lesser of 125% of average annual debtservice, 10% of bond proceeds, or maximum annualdebt service thresholds, which are derived fromIRS regulations. This restricted reserve is expectedto be funded from bond proceeds, or built up frompledged revenues, usually over no more than five126 Standard & Poor’s Public Finance Criteria 2007

Solid Waste System Financingsyears. The former approach adds more creditstrength. Substitution of cash-funded reserve by asurety bond and/or LOC obtained from a creditworthyentity also is acceptable. If the reserve fundis tapped to meet debt service payments, a reasonablereplenishment schedule should follow. Renewaland replacement accounts and rate stabilizationfund accounts are also common, and provide additionalfinancial cushion, but are not considered necessaryfrom a credit standpoint.Typically, a system with stable operations andstrong financial margins can carry diminished debtservice reserve provisions, including the use ofspringing covenants, without credit implications.Alternatively, absence of fully funded reserve forsystems that generate thinner margins, exhibit assetor customer base concentration, a shallow servicearea economy, or cash flow constraints, the mayresult in a lower rating. ■Solid Waste System FinancingsAreas reviewed to reach a ratingdetermination include:■ Economic considerations;■ Financial data/capital improvement plan;■ Rate criteria;■ Operational characteristics;■ Management assessment; and■ Legal provisions.Particular concerns related to solid waste managementwithin different states are included in theanalysis of these factors. Generally, areas that coulddiffer from state to state are environmental laws,the power to create franchises, the magnitude ofcompeting alternative disposal options, and lastly,the level of government responsible for the implementingof solid waste disposal plans. Those uniquefeatures applicable to credit quality of individualissuers will be reviewed on a case-by-case basis.Economic ConsiderationsThe economic assessment of the markets in whichthe issuer operates will be discussed in this section.The analysis will primarily consider waste flowavailable within the service area, and the ability ofthese flows to generate sufficient revenues to repaydebt, and also includes an analysis of historic andprojected waste flow trends. The characteristics(commercially generated versus residential generated)of the waste flow will also be considered. Inaddition, the service area economy and demographicswill be scrutinized. Another key element ofwaste flow availability and control relates to thearrangements and relationships with waste haulers.Consideration of the different types of arrangementsunder which haulers and the system operate,such as franchise agreements and contracts, amongothers, are factored into the rating analysis.The economic analysis will also examine the servicearea, and how it is defined including considerationof agreements and relationships withparticipating municipal governments for the regionalor countywide systems. An adversarial or litigioushistory with either haulers or with municipal governmentswill present greater market risk. Employment,population trends, and wealth and income indicesare reviewed to establish the underlying economicstrength of the service area and its capacity to repaythe financing. Service demand (garbage flow) typicallyreflects the service area’s economic activity. Fromthe economic base analysis, Standard & Poor’sRatings Services can assess the waste stream servicedemand. As a starting point, historical garbage disposalalternatives, tonnage, and costs are reviewed.Per capita disposal rates can be indicative of thevolatility of the waste flows and the effectiveness ofrecycling and reduction programs.A review of the area’s future disposal alternativesand reliability of facilities is performed.Competition from alternatives (versus control ofthe waste stream) is assessed to understand tonnageprojections. The capacity of all available facilitieson an annual and lifetime basis is thencompared with the forecasted service area demand.If surplus capacity exists, an analysis is performedof the additional costs and exposure inherent incarrying that excess. If the facilities are inadequateto handle current or projected service areademand, the evaluation includes the cost of financingadditional facilities.Rating CriteriaThe rating criteria includes a review of the system’scost structure with a primary focus on current andprojected tipping fees relative to alternative or competingfacilities. The proximity of competing facili-www.standardandpoors.com127

General Government Utilitiesties, as well as the capacity for those facilities toaccept outside waste will be examined. The assessmentwill also consider the total household costincluding collection and disposal. While the overallsystem or project cost profile is of primary importance,some consideration will be given to fee structuresince risk of waste diversion can be mitigatedthrough the method of cost recovery. However, theoverall system or project cost profile will stillremain as a critical factor.Operational CharacteristicsIn evaluating the operations of a solid waste systemor project, Standard & Poor’s focuses on the serviceprovider’s flexibility in handling changing industryrequirements while efficiently fulfilling its primarypurpose. As mentioned, waste disposal methodsmust address a number of environmental issues.A key consideration in the analysis is bondamortization versus the useful life of the facilities.The expected life of the landfill should at leastmatch the term of the debt, and the legal structuremust provide flexibility to respond to the variabilityin landfill life if waste flow levels change. A system,by its nature, has an advantage over projectfinancings in handling these risks. However, a projectalso can be structured to manage them effectively—forexample, a landfill disposal contractthat provides project back-up disposal capacity.However, contracts also have risk. Contracts generallyallow less control than system-owned capacityand can be subject to legal, regulatory, and performanceconcerns.System or project operations are evaluatedagainst demand for disposal over the term of thebonds. If components of a system or a facility aretemporarily or permanently out of service, the abilityto dispose of waste elsewhere is reviewed. Thecapacity to handle such a situation with a minimumof shock to operations or cost is viewed as a creditstrength. The greater the volume of waste that canbe disposed of at redundant facilities, the better theability of the issuer to generate revenues to repaydebt. This leeway allows time for the developmentof other alternatives that might guard against a suddenincrease in the price of disposal and reliance onan outside source for the service. Such reliance subjectsthe operations to the whims of another entityfor continuance and cost, and the lack of control isviewed as a weakness.Standard & Poor’s assesses the entire waste streamand disposal process to evaluate if changes have beenadequately addressed. For example, growth in theservice area. Afterwards, questions about the propersize of facilities or provisions and plans for expansionare evaluated. An inordinate reliance on onemethod of waste management raises questionsregarding the system’s flexibility to respond to wasteflow changes and facility problems.An assessment of the impact of the external pressuresbrought on by regulation and environmentalmandates, whether at the federal, state, or locallevel. The analysis will consider how complyingwith the regulatory environment will impact a systemor project’s ability to compete. The impact canbe felt through increased costs or changes withinthe business environment. The U.S. SupremeCourt’s decision in the Carbone v. Clarkstown,N.Y. case, which invalidated flow control, drasticallychanged the environment for the solid wasteindustry. This has prompted proposed legislationand other actions at all levels of government. Thissection specifically addresses the impact of anysuch initiatives.Financial Data/Capital Improvement PlanIn evaluating finances, the concern is the level ofcoverage and liquidity. As with Standard & Poor’sfocus on the legal structure, a review of differentoperating and nonoperating scenarios thatdemonstrate sufficient debt service coverage in allcases is required. Costs are viewed relative to thecapacity to pay. As the cost of disposal is generallyrising, the comparison of future costs with historicalcosts has less meaning, but the control andmanagement over future cost increases areweighed against the risks. Also, the effectivenessof the chosen disposal options is measuredagainst the cost of future alternatives. By operatinga solid waste system, a community generallyhas more cost control. It also assumes more riskin ownership and/or operation than if a privateenterprise provides disposal. Landfill closurecosts, for example, can be substantial and shouldbe amortized over the life of the landfill in orderto match revenue generation with costs.Costs are reviewed in terms of tip fees per tonand household costs. The former is a relevantmeasure for systems that rely, for their major cashflow component, on tipping fees paid by franchisedand private haulers. Clearly, the competitiveposition of the tipping fee impacts financialperformance. However, total household costs alsoprovide an important basis for evaluating thecosts of the system. Household costs shouldinclude not only disposal cost, but also the cost ofcollection and transportation to the disposal site;individuals are concerned with their total bill forgarbage service, not the various components.Household cost increases are reviewed for acceptabilityand affordability.Costs under different scenarios are reviewed andmeasured for variance. Large variances may raiseconcerns. How attendant increases and risks are128 Standard & Poor’s Public Finance Criteria 2007

Solid Waste System Financingsmitigated is factored into the analysis. For example,if the revenue stream depends heavily on a secondaryrevenue stream, such as energy revenues, therisk of lower energy sales and the impact on householdcost are evaluated. The steps that an issuertakes to mitigate as many of it’s revenue generationrisks, that ultimately lessen the financial impact onhousehold cost, the stronger the rating.Additionally, Standard & Poor’s will focus onwhether a system is in compliance with its EPADocumentation RequirementsThe following materials should be submitted in conjunction with a rating request.Financial Information■ Three years of audited financial reports (if available)■ Current year’s budgetLegal Information■ Bond resolution or trust indenture■ Enabling legislation■ Disposal and transportation contracts■ Solid waste management planSystem Information■ Engineer’s report or feasibility study, if available■ Anticipated capital improvement plan■ Three to five years of historical and projected rates, with locallytargeted comparisons■ Three to five years of operating statistics (if applicable)■ Customer or hauler trends■ Waste-flow tonnage■ Per capita generation■ Recycling ratesEconomic Information■ Population trends■ Income trends■ Composition of employment by sector■ Unemployment rates■ Largest employers in service area■ Tax base trends■ Building permit activity■ Sales tax trendsAdditional Requirements For Project Financings■ Construction, electric sales, service, and operating contracts■ Site lease■ Vendor performance guarantee■ Project operating statistics (if applicable)■ Throughput■ Energy generation/revenue■ Capacity factormandated post closure costs, such as is managementsetting aside sufficient funds to meet thisfuture liability fully, and if not what plan does managementhave to eventually meet this liability. Whencalculating annual debt service coverage the operatingexpense labeled provision for post closure costwill not be included in determining total operatingexpenses, thereby insuring that debt service coveragewill not be adversely affected by the decision toannual fund the post closure cost liability.Management AssessmentAn assessment of management’s ability to adaptand respond within the business environment andconsider strategies for ensuring waste flow and revenuestreams is undertaken. One of the most criticalaspect is to determine whether the managementteam is proactive or reactive. Standard & Poor’sfocuses on who ultimately makes the key decisions(an elected versus appointed governing body), suchas when and how much to increase rates, what theadditional debt plans will be, and what policies areto be adopted. More importantly what has been thehistory of making timely and effective decisions.An independent consulting engineer’s report, historicaloperating records and a meeting with managementprovide information to evaluatemanagement’s ability to construct and operate thefacilities. If a private operator is contracted to runthe system or facility, Standard & Poor’s focuses onwhat the incentives there are for that operator toprovide efficient operations. In all cases, an equitableagreement for both parties and terminationclauses for nonperformance are necessary.Long Range PlanningPolicies focusing on short-and medium-term issuesmay be implemented with some success, but theyare likely to prove insufficient without some focuson relating the system’s current status to its longtermneeds. True operational stability assumes thata system’s current and likely future needs have beenmeasured and are relatively known.The average increase in rates to be targetedover the next decade cannot be known withoutsome idea of the cost pressures a utility may face,and without an honest effort to estimate theseneeds, it will be extremely difficult to educate andinform ratepayers. Cost pressures to be estimatedinclude those for operations, replacement, regulatorycompliance, and accommodating additionalgrowth. The nature of these cost increases shouldbe considered, that is, whether they are ongoingor likely to be diminished over time, along withtheir magnitude.Many utility officials cite the impossibility of correctlyestimating future economic developmentwww.standardandpoors.com129

General Government Utilitiestrends, regulatory outcomes, and the long-term patternsof various cost pressures. As such, they claimthat trying to measure them actually represents apoor use of limited resources, especially for smallersystems that lack the staff or funds for consultantsto devote to such studies. While most of these driversare indeed highly uncertain, Standard & Poor’sviews a refusal to consider the potential burden ofpressures beyond the short-to medium-term as acredit risk. Accordingly, even small utilities thathave attempted to examine long-term risks and possibilitiesin limited ways consistent with theirresources and capabilities will likely find their rateprojections and capital plans more accepted byStandard & Poor’s.Legal ProvisionsLegal provisions are defined through the bondindenture and other documents, which outline thebasic structure of the financing. Whether the structureprovides for an integrated solid waste system, astand-alone project or a subsidized financing offacilities, the analysis focuses on what is the securityfor the bonds and the identification of the supportingrevenue stream.Standard & Poor’s Ratings Services reviews allcontracts concerning service, operation, construction,and energy sales for possible credit implications.The revenue stream pledged under thesedocuments can vary considerably. A mixture of specialtaxes, disposal fees, and a municipal entity’scredit can be pledged in addition to other revenues,such as those from the sale of by-products. Thenature and diversity of the revenue stream is animportant factor, given the transportability of solidwaste. A system or facility that receives all or mostof its revenues from tipping fees paid by privatehaulers is likely to be more vulnerable to competitionthan a system that can use alternative revenuestreams, such as household disposal feesA detailed analysis begins with identification ofthe source of revenues for debt service payments.The ultimate credit strength depends upon the primaryrevenue stream, such as revenues influencedby market events (i.e. tipping fees) or the generalfund pledge of the community. Through a serviceagreement, a municipality might covenant to makepayments from general fund by the use of annualappropriations. In these circumstances, Standard &Poor’s establishes a GO assessment that generally iscritical to the rating determination. A general fundpledge is assessed at less than the full faith andcredit pledge of the municipality; factors consideredare the presence or lack of, appropriations risk, thelevel of financial flexibility available to the generalfund, and the economics of the project.When a user fee is pledged to debt repayment,Standard & Poor’s focuses on the history of theuser fee and how it is collected and assessed. Caseswhere the user fee is formulated, but has yet to beimplemented, generally provide weaker credit support.If a method of billing and collection exists,and such a fee only needs to be levied, the creditgenerally is considered stronger.Under different operating scenarios, the legalstructure must provide a sufficient revenue streamto cover operating costs and debt service payments.The legal structure should provide a revenue streamthat can be maintained, despite additional maintenancecost, lower throughput, reduced energy outputor price, and outages caused by system failureor environmental requirements. For example, recoveredmaterial sales from a recycling program arelikely to vary, depending on product quality andmarket price. The ultimate or primary revenuestream must have the flexibility to make up for anydeclines in revenue flow from a more unpredictablesecondary stream. Here, reserve funds may berequired to provide a bridge from one budget yearto the next, depending on the flexibility of the primaryrevenue stream.One unique concern that must be addressed bysolid waste issuers is the transportability of solidwaste. Since there is usually no direct link betweenthe solid waste utility and the customer, the haulerscollecting the waste can choose the disposal site.The ability to direct waste to the project or system’sfacilities provides an important link between thewaste generator and the disposal system. Wasteflowcontrol can be provided by municipal ownershipof collection vehicles, some form ofcontractual arrangements, or through economicmeans. Waste flow control ordinances are not factoredinto the analysis and should not be relied onin light of the U.S. Supreme Court’s Carbone decision.Based on the competitive nature of the solidwaste industry, a system that cannot effectivelyretain the waste flow is generally not investmentgrade, unless alternative revenue sources are availableand pledged for debt repayment. ■130 Standard & Poor’s Public Finance Criteria 2007

TransportationAirport Revenue BondsIn recent years, growth and expansion of newentrants to the airline industry once dominated byestablished network carriers have demonstrated theimportance of providing aviation infrastructure,and the dynamic nature of the airline businessmodel. While airports have proven quite resilient,the sector is obviously directly exposed to developmentsin the airline and travel industries. Lookingforward, the airlines’ own financial profile isexpected to continue to be cyclical, with competition,alliances, bilateral agreements, rising laborand fuel costs, uncertainties and instability seen ascommon occurrences.With some interruptions, passenger traffic hasdemonstrated steady growth, mirroring economictrends while imposing significant capital requirementson airport operators. After the U.S. deregulationof the airline industry, discretionary travel, andbusiness demands stressing mobility and timelinessmake air travel and airports essential to, and abarometer of, the nation’s economy.Standard & Poor’s Ratings Services approach torating airport revenue bonds reflects the growingmaturity of the national and international airportnetwork with a focus on passenger demand—-bothlocal and connecting—that drives aeronautical andnonaeronautical revenue, as well as an airport’s rolein the overall aviation system. Standard & Poor’shistorically has treated U.S. general airport revenuebonds as a special type of utility debt, instead of aslease obligations of various carriers. The strongbusiness position of most airports, public sectorownership and essentially closed flow of funds,along with the existing regulatory environment thatrestricts the use of airport revenues to airport purposeshave allowed strong investment-grade ratings,relative to those of the airlines.Service Area Characteristics And Air Traffic DemandStandard & Poor’s analysis begins with understandingthe foundation of air passenger service and theunderpinnings of the regional economy that producesthe existing and future demand for aviationinfrastructure. The definition of a service or catchmentarea of each airport varies, depending onregional characteristics. An airport’s reach frequentlyextends beyond its city’s limits or entire metropolitanarea, adding diversity to its user base whilealso exposing the airport to competition. Factorsexamined by Standard & Poor’s include historicaland projected population growth, employmentexpansion and mix, as well as wealth and incomelevels are important in the economic evaluation.Historical airport utilization trends versus those ofthe nation are reviewed. An airport facility demonstratingstable passenger trends during a recession isgenerally stronger than one that grows spectacularlyin good times, but experiences greater trafficlosses during a downturn.The importance of local economic factors to arating depends, in part, on the nature of the airport’straffic. If most passengers are of the originationand destination (O&D) nature, the localeconomy dictates the level of service demand.Conversely, an airport used heavily for connectingtraffic depends less on service area economics.Substantial transfer traffic is usually vulnerabilitybecause the choice of connecting facility is notmade by the passenger, but dictated by the airlineand thus related more to a carrier’s viability androute decisions.However, each airport has mitigating factors thatcould, in some cases, effectively offset this concern.These include:■ The importance of the facility to the overall systemof U.S. airports;■ Favorable geographic situation, evidenced by a“natural” hub location and the absence of viabletransfer alternatives.■ The level of connecting traffic;■ A balanced and growing economy that may needadditional O&D airport capacity currently usedfor transfers;■ Airfield capacity and attractive facilities intowhich other carriers would expand service;■ Low debt burden and carrying costs;■ The financial strength of carriers accounting forthe greatest amount of connecting traffic, and theircommitment to the airport or city including theirlevel of infrastructure investment in the region;■ The role of the facility in the dominant carrier’sroute network; and■ Legal provisions that allow maximum flexibilityin charging rates to carriers on an as-needed basis.www.standardandpoors.com131

TransportationGiven the declining number of viable carriers andthe proliferation of hubs, it is unlikely in othercases that a departing hub carrier would bereplaced so easily. In general, Standard & Poor’shas viewed the debt of most transfer airports slightlybelow similarly secured debt of an O&D facility.However, hubs that have demonstrated sufficientstrength in the aforementioned conditions, havereceived ratings comparable to an O&D facility.Competitive facilities within or near a servicearea are a concern, especially if they offer betterservice. Passengers are often quite willing to travelfurther on the ground for less expensive fares, morefrequent air service, or larger aircraft. Increasingly,however, due to the increasing need for facilitiesand the slow pace that new or improved facilitiesare provided to meet demand, even those airportsin close proximity with one another can serve separateand distinct segments of the market.The carrier mix becomes increasingly importantas any single airline’s share grows. At an O&D facility,dependence on one or two carriers creates shorttermvulnerability, as a strike can cripple an airporttemporarily and have a significant impact on financialoperations. This problem can be partially mitigatedby legal provisions that provide ample reservefunds and coverage levels, midyear flexibility toraise rates, and the ability to recover deficienciesoccurring in the prior year. While one or two dominantcarriers may expose the airport to temporaryproblems, Standard & Poor’s believes that the criticalrating factor is still air traffic demand.If demand exists and the routes prove relativelyprofitable, other carriers have historically filled thevoid over time to replace an airline that hasreduced or cease operating out of an airport,diminishing the likelihood of prolonged loss of airportactivity. However, in certain economic climatesthat affect the airline industry as whole, theability of other carriers to take all or even a largeportion of a failed carrier’s traffic may be significantlylimited—especially if much of the activityrelated to connecting passengers or serviced routesconsidered marginally profitable by the remainingor new airlines.Use And Lease AgreementsThe intent of use agreements between an airportand its carriers is twofold:■ To ensure a revenue stream providing for operatingcosts and debt service payments; and■ To establish certain procedures for rate settingand revenue collections.Historically, long-term agreements also have indicatedan air carrier’s commitment to a particularmarket. There are two general categories, residualand compensatory, which differ primarily in termsof which party bears financial responsibility for revenueshortfalls, and, conversely, who benefits fromany surplus. Standard & Poor’s does not explicitlyfavor one methodology over another, but evaluateswhether the specific agreement terms are appropriatefor an airport’s operating conditions.Attitudes toward lease agreements havechanged considerably since deregulation. Threetrends are clear:■ For both carrier and airport, the desire to committo long-term agreements has decreased;■ The traditional distinction between residual andcompensatory rate-setting methodologies nolonger exists; and■ A desire by airport operators to have more controlover revenues, particularly nonairline revenues.The greater degree of competition under deregulationand the risk of airline (tenant) bankruptcyare largely responsible for the shorter terms commonin many of today’s use agreements. Air carriersmay not want to maintain service in an area generatingintense interline competition or low yield.Conversely, airport operators want to avoid beingsaddled with unused terminal space resulting fromtenant bankruptcy or routing changes.Many agreements have been structured to combinethe revenue protection offered by a residualapproach with some sharing of excess revenues, asin a compensatory agreement. This latter provisionallows for the build-up of discretionary reserves,which can be used to fund capital projects on apay-as-you-go basis. Airports with agreements thatgenerate annual debt service coverage, as opposedto rolling coverage, can provide more of a cushionabove minimum coverage levels and be viewed as acredit strength. Similarly, the presence of a sophisticatedconcession program that results in significantnonairline revenue supporting capital development—andoffsetting debt needs—will be viewedpositively. Airports with compensatory ratemakingmethodologies are generally demonstrate coveragelevels in excess of typical rate covenant requirementsof 1.25x debt service.However, the presence of one type of rate-settingmethodology does not necessarily result in a ratingdistinction. It is important to note that the presenceof use agreements does not produce any specificlevel of airline usage at an airport. An air carrier’sfinancial obligations under a use agreement are verysmall, compared with potential operating lossesincurred by serving an airport with poor demand.Federal law restricts the application of airport-generatedrevenues for airport purposes generally. Forinstance, airport revenues cannot subsidize otherpublic services unrelated to operating the airport,therefore, in many respects; even compensatory air-132 Standard & Poor’s Public Finance Criteria 2007

Airport Revenue Bondsports can be viewed as residual-like enterprises withno outflows of cash to governments or investors.In most instances an airline’s decision about whichairports to serve is based more on fare levels, loadfactors, and overall yields they expect in that marketrelative to other markets rather than airport charges.Collectively, airport costs typically constitute approximately7% of an airline’s total cost structure.The primary value of use agreements lies in establishingprocedures for operating the airport andmethods for charging rates and fees. Once thisframework is established, even if the use agreementsexpire, the same procedures of revenue collectionand management likely will be used to run the facilityand most airport operators retain the authority toimpose fees by local ordinance if necessary.While use agreements may provide an additionallevel of comfort if a particular airline ceases tooperate or alters its routing structure, the inherentdemand in the air traffic market remains the ultimatesecurity for the bondholder. A strong marketwill continue to attract carriers to serve thatdemand, while even the strictest use agreementwill not, in and of itself, ensure timely payment ofdebt service.Legal ProvisionsThe legal protections afforded bondholders by theindenture, resolution, or other supporting securitydocuments and the specific legal provisions pertainingto the business operations of the airport enterpriseare important components of the ratinganalysis and can bear a direct influence on the outcome.These provisions are evaluated in the contextof the credit strengths and weaknesses of the issuer.Legal provisions alone cannot prevent operatingand financial performance declines, interruptions ofdebt service payments, and the overall risk of creditdeterioration. It is the underlying credit quality ofan issuer that determines the degree of influencethat legal provisions will bear on a bond’s rating.For airport operators with a weak business andfinancial profile, more liberal legal provisions willoften result in assigning a lower rating than if theyhad been more stringent. For an issuer with astrong business and financial profile, the presenceof the very same more liberal legal provisions maynot have an influence on the rating at that point intime. If their credit quality starts to deteriorate,however, it is likely that more liberal legal provisionswill increase the potential for a downgrade.The rate covenant and how it is calculated isreviewed to see the degree to which cash flow fromoperations is needed to cover fixed charges. Mostsenior lien airport revenue bonds have a ratecovenant with a defined 1.25x minimum level of debtservice coverage. However, how that 1.25x minimumcoverage requirement is met can vary significantly.The strongest means of meeting this requirement isfrom operating cash flow with no addition to revenuesfrom other sources (such as a coverage accountas described below) or offsets to the debt servicerequirement from other revenue sources. Cash balances,other non-operating revenues (such as nonrecurringgrant revenues), and reserve funds aresometimes included in the definition of revenues orotherwise allowed in the use of calculating the ratecovenant, but these sources can be depleted and arenot reliable ongoing revenue streams.It is important that the definition of revenuesproviding coverage is limited to revenues fromoperations and that they are sufficient, 1x, to meetoperating and debt service requirements (“sufficiency”).Other sources of revenues, such as passengerfacility charges, are given greater credit in the calculationof debt service to the extent that they arepledged to bondholders.Many airport credits meet their rate covenantrequirement through the use of coverage accounts.While “rolling coverage” helps to keep user costslow, it is also important that the issuer limits theamount of reliance on coverage accounts anddemonstrates sufficiency. The actual or forecasteduse of these other sources to meet the debt servicerequirements could have negative ratings consequences.Other factors that weaken the ratecovenant are legal provisions that give the issuer theability to net debt service requirements. A frequentexample is the provision that allows for the nettingof passenger facility charges or grant revenues fromdebt service. This results in a more generous calculationof debt service coverage.Standard & Poor’s calculates debt service coverageand the issuer’s ability to meet the rate covenantfrom an indenture perspective and from an operatingcash flow perspective, which places greateremphasis on the ability to meet operating requirementsfrom operating cash flow alone. While generatingreal coverage of debt service obligations fromannual reoccurring cash flow provides for a strongerrate covenant, Standard & Poor’s does not make arating distinction based on the presence or absenceof this provision alone. More dominant operators oftransportation infrastructure with strong businesspositions and rate flexibility can have weaker ratecovenants that allow for coverage accounts with nocredit implications, all things being equal. Theopposite is true of weaker operators.The additional bonds test (ABT) usually is basedon the rate covenant multiple and the calculation ofthe ABT’s coverage requirements shares the inherentstrengths and weaknesses of the rate covenant.The ABT is perhaps viewed as the primary legalfactor in terms of affecting the rating as it outlineswww.standardandpoors.com133

Transportationthe parameters under which future debt holdersmay claim on revenues on an equal basis as existingbondholders. Most ABTs in the airport sector allowfor the use of projected revenues in meeting the typical1.25x existing and future debt service obligations.This use of projected revenues is inherentlyweaker than a requirement to demonstrate coveragefrom existing cash flow.Meeting the ABT requirement through the useof non-reoccurring cash flow items such as fundbalances, coverage accounts, reserves, etc. areviewed as a credit weakness. Sometimes, the issuermay have the standard legal provisions withrespect to the ABT and rate covenant, but operatesat a much higher level and has committed todoing so by adopting a board policy to maintainthe rate covenant and ABT at a higher multiplethan required under the indenture or bond resolution.In these cases, the issuer’s board policy mayhave a direct impact on the ratings outcome andcan help bolster otherwise weak or adequateindenture provisions.The flow of funds is always closely reviewed inrating airport revenue bonds, as it specifies theorder and timing in which system revenues are usedto meet the obligations created under the indentureor bond resolution. This establishes the relative lienposition of the debt service payments in relation toother issuer obligations. Standard & Poor’s alsolooks to see what reserve funds are established andthe required reserve funding levels. Finally, a criticalcomponent to the flow of funds is an evaluation ofthe disposition of surplus funds. With a few exceptions,U.S. airports are restricted by federal lawwith regard to how airport-generated revenues maybe applied, specifically prohibiting their use fornon-airport purposes. Thus, taking airport-generatedsurpluses to support the general fund of a city orto make distributions to shareholders is notallowed. This allows U.S. airports to be viewed ashaving essentially a closed flow of funds.The presence of reserve funds for debt service,operations and maintenance, or a capital improvementfund can be beneficial to an issuer. In particular,additional reserve funds that can be used tomeet debt service requirements can also be viewedas an additional source of liquidity. Most airportrevenue bonds have a debt service reserve fundthat is funded based on IRS regulations at bondclosing. Some bond resolutions or indentures giveflexibility as to the timing of the debt servicereserve fund, giving issuers the ability to issue debtand fund the reserve from net pledged revenuesover time—usually no more than five years.However, the extent to which this ability is exercisedcould result in an incrementally lower ratingdepending on the inherent liquidity of the issuerand its overall credit quality. Funding of the debtservice reserve requirement in an amount less thanthe IRS regulations could also have credit implications,especially for weaker credits or those thathave experienced erosion in liquidity.Other, more liberal debt service reserve requirementscall for a “springing reserve,” whereby netrevenues are required to fund a reserve over a periodof time if coverage drops below a predefined multiple.While this allows the issuer flexibility in fundingthe reserve requirement, it also is of limited valuegiven that at the precise time when liquidity is apotential problem or is deteriorating the issuer is alsounder pressure to fund a reserve fund. A fully fundeddebt service reserve fund provides the most financialcushion to bondholders. Anything less than thisrequirement could have rating implications dependingon the issuer’s business and financial profile.More recently, interest rate swap transactions arebeing entered into in conjunction with debtissuances in order to save on interest costs, increasefinancial flexibility, or to synthetically advancerefund bond issuers. For the most part, swapsentered into by transportation issuers have been tolock in fixed interest rates on variable-rate debtissuances. Evaluation of the swaps includes theassignment of a “debt derivative profile” score. Fortransportation revenue bonds, it is important thatthe indenture cover these new types of transactions.Specifically, most indentures have provisions thatallow swap interest payments to be made from thesame revenue source that pays debt service.In addition, termination payments are generallyjunior to the debt service obligations, which help toensure that an early termination will not negativelyaffect the ability to meet debt service requirements.Some airports have termination payments that areon parity with debt service or payable from operations.The risk of termination can be mitigated ifthe issuer has good liquidity and strong revenuegenerating capabilities.The goal of the legal provisions is to provide adequateprotection to bondholders while allowingmanagement sufficient flexibility to respond tochanging business conditions. Where the indentureor bond resolution varies from the standard securityand covenant provisions—either providing significantlatitude or restrictions on the issuer—theseprovisions will be evaluated in context of the inherentcredit quality of the issuer or can make a differencein the ratings outcome.FinancesThe analysis of airport financial operations varies,depending on its rate-setting approach. At a residualairport, the airlines collectively assume financialrisk by ensuring payment of all airport costs not134 Standard & Poor’s Public Finance Criteria 2007

Airport Revenue BondsDemand informationoffset by nonairline revenue sources. This obligationeffectively guarantees certain revenues, but isonly sufficient to satisfy rate covenant coveragerequirements. Therefore, unlike a compensatory airport,the total revenues collected in any given yeardo not represent an accurate measure of the airport’strue earnings capacity. In general, a residualairport will have lower, but more stable, debt servicecoverage than a compensatory airport, but thecoverage level is less meaningful in a residual setting.In addition, the ability of the airport to generatesignificant levels of nonairline revenues can, in aresidual agreement environment, reduce airlinecosts, or, under a compensatory agreement, creatediscretionary funds to finance facility improvements,thereby reducing overall debt requirements.Standard & Poor’s analysis of other financialconditions is similar regardless of rate-settingmethodology. Among important factors are historicaland projected revenue diversity, debt burden,and airline costs per enplanement. Analyzed on apro forma basis, this last measure is particularlyuseful because it incorporates future debt servicecosts and indicates the degree to which concessionscan offset airline costs. Truly discretionary sourcesAirport Information Requirements■ Relevant passenger and airline activity statistics by fiscal and calendar yearincluding origination/destination statistics; connecting passenger data, airlinemarket share data, flight schedules, average fare information, recent passengersurvey data.■ Service area economy and market studies.■ Passenger forecasts.Financial information■ Audited financial statements (five years).■ Current operating budget.■ Airline rates and charges analysis.■ Summary of relevant Passenger Facility Charge programs and authorizations.■ Five year detailed capital improvement program and funding sources.Other documentation■ Trust agreements, bond indentures and all supplemental indentures.■ Sample airline use and lease agreement.■ Financial feasibility reports detailing forecast revenues, expenses andcapital requirements with resultant cost estimates.of cash and overall cash position are also importantas well as access to other sources of liquidity.The presence of a fully funded debt servicereserve is also significant, since pledged revenuesmay be affected by factors beyond management’scontrol, such as construction delays, litigation, andweather. The need for other reserves varies with theproject’s nature and construction schedule.In addition, the role played by other sources offinancing for airport purposes must be noted. Whileit is uncommon, GO or excise tax supported debtpaid from airport revenues on a subordinate basisprovides a cushion to revenue bonds; GO debt paidfrom general tax sources is viewed as an equitycontribution to an airport and strengthens the overallfinancial position. For instances that involvesubordinated GO or excise tax supported debt paidfrom airport revenues, Standard & Poor’s includesthis debt when evaluating airport’s debt burden andall-in debt service coverage.An independent feasibility study is useful in estimatingfuture airport utilization and financialprospects. The consultant typically projects futureenplanements and aircraft operations and derives afinancial forecast loading in anticipated capitalrequirements. Standard & Poor’s evaluates the consultant’sassumptions and methodologies to arriveat its own estimates. While Standard & Poor’s maynot always agree with such reports, they usuallyplay an important role in the rating process.Other ConsiderationsDespite their relative importance, demand, legal,and financial factors are not the only elementsexamined in rating airport revenue bonds. The size,structure and purpose of the financing program andneed for additional debt financing are also important.Considerations such as the influence of localpolitics, management’s experience with large constructionprojects, and the presence of budget controlsplay significant roles.Airport revenue bonds are different from otherrevenue bonds because of the presence of a privateintermediary—-the airlines—-between the users ofthe service and the entity that pays debt service.However, strong airport demand, solid legal provisions,and prudent management of the airport’sfinancial operations can alleviate some of the problemsintroduced by airline intermediaries and theirvolatile industry. ■www.standardandpoors.com135

TransportationStand-Alone PassengerFacility Charge DebtLeveraging passenger facility charges (PFCs) hasproven to be an effective tool as airports lookto maximize their debt-issuing capacity or limit theeffect of capital improvements on the airline-supportedrate base. With proper structuring andstrong credit fundamentals, stand-alone PFCs orrevenue bonds where the only security is the pledgeof PFCs can receive solid investment-grade ratings.The PFC program is now an established and criticalsource of capital funding at U.S. airports. StandalonePFC bonds have some fundamental differencescompared with general airport revenue bonds.These include:■ The vulnerability of a fixed-rate revenue streamand debt service coverage to declines in enplanedpassengers attributable to a variety of reasons,including economic downturns, rising air fares,aviation fuel price increases, or natural disasters;■ Other events that could interrupt pledged revenueflow, such as an air carrier bankruptcy; and■ The ability of the Secretary of the U.S.Department of Transportation to terminate theairport’s power to levy the PFC.Airport management can reduce these risksthrough compliance with the FAA’s record of decisionand its “informal resolution process,” properoversight, strong management of PFC programs,and structural enhancements to the debt transactionthat provide ample coverage of debt service frompledged PFC revenues. Additionally, upon request,the FAA includes language in their record of decisionfor PFC stand-alone transactions, which indicatesthe FAA’s intent, in the case of a violation, toprovide a five-year cure period prior to termination.Most important is compliance with current andfuture provisions of the Aviation Safety andCapacity Expansion Act of 1990 and all implementingfederal regulations pertaining to PFCs.These provisions include those governing use andadministration of PFC revenues, as well as assurancesrequired to prevent termination by theDepartment of Transportation.Standard & Poor’s Ratings Services alsorequires management to agree to provide notificationif revenues from collections decline or are disrupted,or if it is notified by the FAA of apotential violation of federal regulations. Withcertain other legal assurances, the issuer can keepthe lien open and use PFC revenues on a pay-asyou-gobasis.With the stand-alone PFC pledge, Standard &Poor’s analysis will focus on the traditional creditfactors that support the airport’s general airportrevenue bond rating with a special emphasis onpassenger demand, debt service coverage, airportmanagement, the airport’s PFC program, legal andstructural provisions, and federal agreements—allof which are important in addressing the inherentrisks of the PFC program.Traffic AnalysisStandard & Poor’s examines the economic underpinningsof the airport’s service area. In most cases,a distinction is made between the added vulnerabilityfor connecting versus origin and destination(O&D) airports, with higher coverage requirementsfor airports without a strong and diversified O&Dbase. Careful consideration is given to traffic performancethrough national and local economiccycles, as well as susceptibility to fluctuationscaused by factors affecting the airline industry.Traffic variations will be reviewed in the context ofthese circumstances, as well as changes attributableto airline service decisions and growth in the numberof O&D passengers.Federal regulations allow connecting hubs to collecta disproportionate share of the PFC revenues.However, if connecting traffic declines, connectinghub airports stand to lose a greater amount of PFCrevenue than if a similar level of traffic declined atan airport with a greater proportion of O&D passengers.Most of this concern is reflected in the generalairport revenue bond rating, which considersthe concentration of connecting passengers and airlinemarket share.Other important traffic fundamentals are diversityin airlines and potential competition from otherfacilities. Low operating costs and favorable airlinerelations are credit strengths.Because pledged revenues are a direct function oftraffic levels and cannot be adjusted to meet debtservice obligations, passenger forecasts take on anew significance with PFC-backed bonds. While theairport already must have traffic levels that generaterevenues in excess of future PFC debt needs,136 Standard & Poor’s Public Finance Criteria 2007

Stand-Alone Passenger Facility Charge Debtprojections must be justified and consistent withhistorical trends.Faster-than-expected growth can result in the airportreaching its maximum PFC authorization levelbefore its bonds mature. This requires managementto create a debt structure that allows for earlyredemptions or escrow of excess annual collections.Simultaneously, Standard & Poor’s expects that airportmanagement would apply for further approvalto extend its authority to collect PFCs.Another factor in forecasting PFC revenues is thelevel of PFC-eligible passengers assumed by airportmanagement. Under federal statute, certain classesof passengers cannot be assessed a PFC, includingtravelers flying on tickets acquired with frequentflyer coupons, nonrevenue passengers, or those whohave already paid more PFCs than permitted. Inaddition, airport sponsors may exclude a class ofpassengers if they represent less than 1% ofenplaned passengers. Also, according to statute, theair carriers can keep $0.11 per PFC to compensatefor the administrative costs of collecting and remittingPFC revenues to the airport sponsor.Airport management should be able to demonstratethis mix, and forecast revenues should reflectonly eligible PFC passengers and net out airlines’collection fees.Debt Service CoverageDebt service coverage is an important determinantof credit quality since it reveals how much revenuecan decline before an airport cannot pay its debtservice. Standard & Poor’s considers PFC revenuemore vulnerable to airline shifts or financial difficultiesat airports with one airline dominating themarket and connecting enplanements. To mitigatethis concern coverage of PFC debt service by PFCrevenues should be higher than the standard coveragerequirement at O&D airports. For hubs concentratedin one or two airlines, stronger creditsdemonstrate annual coverage of PFC debt serviceby PFC revenues is between 1.50x-2.00x, whileO&D airports generally have between 1.35x-1.75xat a minimum. In practice, most airports prudentlymaintain stronger coverage levels from leveragingonly a portion of the PFC stream they receive.Because of the fixed-rate nature of PFCs annualdebt service is typically level over the life of thebonds. Standard & Poor’s analyzes lower coveragefor structures that include a subordinate lien on netairport revenues.Airport ManagementKey to the stand-alone PFC bond is airport management’sability to manage the PFC project andcollection process, and to quickly resolve any questionsregarding the proper use of PFCs. Standard &Poor’s reviews the airport sponsor’s PFC programto evaluate collection, monitoring, and administrativesystems, as well as the willingness and abilityto comply with the FAA’s record of decision, whichspecifies approved projects. Additionally, managementshould demonstrate air carrier compliancewith the PFC reporting and remittance proceduresoutlined in federal regulations. Airlines are requiredto remit all revenues to the airport monthly andwithin 30 days of the previous reporting period.Carriers are required to maintain financial managementof PFC revenues and submit quarterly reports.One of the proposed amendments to the PFC programin 2006 is requiring protected airlines reorganizingunder Chapter 11 to submit a monthlyPFC account statement and a quarterly report tothe FAA.The type of project to be financed and management’sexperience with capital projects are importantcredit factors. To the extent that projects areassociated with capacity enhancements, are clearlydistinct from other projects, and are manageableand achievable, the potential for misuse of PFCrevenues and possible termination is limited.Although in most instances, successful completionof a PFC project bears no relation to the revenuesrequired to service the debt, Standard & Poor’swill evaluate how well airport management hasmanaged PFC-eligible projects in the past, or howfrequently the airport has had to cure violationsthrough the informal resolution process. Projectdelays that result in scope changes or cost overrunsthat require additional PFC, lowering coverage,could be a rating concern.Legal ProvisionsThe legal provisions are important credit factors—specifically, indenture covenants to comply withcurrent and future provisions of the Aviation Safety& Capacity Expansion Act of 1990; all implementingfederal regulations governing use and administrationof PFC revenues; and all assurances requiredto prevent termination by the U.S. Department ofTransportation. Provisions outlined include thosegoverning use and administration of PFC revenues.Specific provisions of these covenants include:■ Obtaining FAA approval for all projects;■ Compliance with the National EnvironmentalPolicy Act of 1988 and the Airport Noise andCapacity Act of 1990;■ Not signing long-term leases with any air carrierfor PFC-funded facilities;■ Excluding PFCs from general airport revenues forpurposes of setting airline fees and charges;■ Terminating leases of facilities financed withPFC revenues if the facility is not fully utilizedwww.standardandpoors.com137

Transportationand not available to other carriers if requestedby management;■ Not including the depreciation or capital costs ofPFC-financed project in the airline rate base; and■ Maintaining records and submitting reports inaccordance with federal regulations.In addition, Standard & Poor’s looks to specificcovenants, including the provision of all reports toensure compliance, investment restrictions, a 1.05xsufficiency covenant requirement to prevent airportfrom over committing PFCs, and immediate notificationof any delays in the collection of PFCs, or uponcontact by the FAA regarding possible violations.Open Lien Versus Closed LienHow PFC revenues collected in excess of annual debtservice requirements are applied can affect the rating.The strongest structure is one in which the lien isclosed, and surplus PFCs are used to redeem debt.This reduces the average maturity, thus minimizingthe uncertainties associated with long-term events.The closed-lien model is not the only optionavailable to airports with strong fundamental creditcharacteristics. The uncertain nature of PFC revenuecollection and the restrictions under which theauthority to levy PFCs are granted by the FAA canpresent a structural problem; clearly, the airportsponsor would not want to be in a position whereby,because PFC revenues came in faster thanexpected and excesses were spent on eligible projects,the authorized amount was reached beforemeeting all the PFC debt service requirements.However, it is possible to keep the lien open anduse excess PFCs for other eligible projects, providedthat certain legal covenants are incorporated intothe indenture. Essentially, the airport shouldcovenant to review quarterly—or, at a minimum,annually—the amount of PFC revenues availableunder the authorization and not spend PFCs outsidethe bond indenture if it would cause theremaining amount authorized to be collected to fallbelow the remaining cumulative PFC debt serviceor amounts needed to redeem bonds. To guardagainst this the indenture will typically include a1.05x sufficiency covenant for the airport to adhereto. Funds restricted and held could be used to calldebt or establish an escrow to pay debt service asper the originally scheduled amortization after therevenue limit has been reached.If an airport demonstrates strong fundamentalcredit characteristics, structural provisions—such asearly redemption—could permit scheduled debtservice to extend beyond the date at which PFCsare authorized.If the lien is left open, the additional bonds testtypically mirrors the coverage outlined above andhistorical coverage of future debt service requirementsof 1.35x-1.75x for O&D airports and 1.50x-2x for connecting hubs is characteristic.Finally, Standard & Poor’s will accept a very limitedelement of projected PFC revenues eligible tomeet the additional bond test. Essentially, projectedPFC revenues can be adjusted to reflect changes inthe PFC amount or reasonable projections of PFCrevenues based on a consultant’s report. However,the additional bonds test multiple is typically met inevery year of the forecast, beginning with the subsequentyear, therefore limiting the projected elementto one year.FAA Record of DecisionCritical to the rating is the FAA’s record of decisionor final agency decision, signed by airport management,which is the official approval document andsets forth projects that can be funded with PFCs, aswell as the total dollar amount that can be collected.For PFC stand-alone transactions, upon request, theFAA includes language in the record that outlinesthe “informal resolution process” to be followed,before commencement of formal FAA revocationprocedures, for the purposes of resolving potentialcompliance federal regulations problems and/or suspectedmisuse of PFC revenues. Under the record,the airport and the FAA must agree to recognize theFAA as a third-party beneficiary under the Indentureof Trust, which permits the FAA to take actionsredirecting the flow of PFC revenues in the event ofsuspected violations. The informal resolutionprocess could extend up to 360 days before commencementof the formal revocation process, whichcould last an additional 270 to 360 days. Any violationthat has occurred since the inception of the PFCProgram has been resolved through the informal resolutionprocess. In most cases the violation was aproject not being implemented in a timely fashion.Corrective action taken by public agencies in theseinstances was either revising the project scheduleand adhering to it or deleting the project. Giventhese protracted notification periods and strongmanagement, termination is unlikely.Airline BankruptcyOne weakness associated with the collection of PFCrevenues is the fact that PFCs are collected and heldby airlines and remitted to airports on a monthlybasis. Accordingly, there are risks associated withinterruption in the process due to an airline bankruptcyor investment loss by the airline beforeremittance to the airport. To date this has notproved to be a credit concern. In general, exposureto this risk should be limited by proper collectionand administration procedures, reducing theamount potentially owed by the remitting carrier to30 to 60 days of PFC receivables, depending upon138 Standard & Poor’s Public Finance Criteria 2007

Airport Multi-Tenant Special Facilities Bondswhen the collection occurred. A fully funded debtservice reserve also provides security if delays ortiming issues with regard to debt service paymentare significant. Possessing a relatively diverse airlinecarrier mix also mitigates airline bankruptcy risk.Additionally, credit risk exposure to the airlineshave been limited by changes to law to make clearthat collected PFCs are indeed held by airlines anddue to the appropriate airport operators. Statutoryrequirements under current aviation authorizationlegislation (Public Law 108—176—Dec. 12, 2003;Vision 100—Century Of Aviation ReauthorizationAct) provide for airlines in bankruptcy to segregatePFC revenue into a separate corporate account(“PFC Account”), preventing the airline in bankruptcyfrom commingling future PFCs with corporaterevenues during bankruptcy proceedings; andnot pledging PFCs as collateral to any third party.FAA WithdrawalEven if properly structured, there is always the riskthat the FAA will withdraw PFC revenues, based onimproper use of the funds. If PFC revenues werewithdrawn, an analysis would be conducted to determinethe effect on the public agency’s general airportrevenue bond rating in cases where it is a doublebarrelstructure (see below). If a large amount ofdebt is supported by the PFC, a withdrawal of theright to levy the fee would lead to credit concerns.Any such action also would call into question thepublic entity’s management capabilities.Double BarrelFor many airport issuers, double-barrel bonds thathave a first lien on PFCs and an additional subordinatelien on net airport revenues will remain anattractive option when exploring the issuance oflong-term debt. The advantage of this structure isthat it eliminates the two major risks attributable tostand-alone PFC bonds; that is, lack of rate-settingability to cover revenue declines and terminationrisk. While there may or may not be a rating distinctionbetween double-barrel and stand-alonePFC bonds, based on legal provisions and protections,each approach is a viable option, and thefinal structure that management chooses willdepend on their individual circumstances.Standard & Poor’s would expect an airport tomanage its double-barrel PFC program similarlyto a stand-alone program and ensure continuedreceipt of PFCs. This structure would allowlower coverage requirements and managementflexibility with respect to PFC authorization andcollection. The double-barrel pledge may be anoption for issuers who otherwise exhibit solidcredit fundamentals, but may show some exposurebecause of airline concentration or higherlevels of connecting passengers.The limitation of double-barrel bonds is that theyoften require majority-in-interest support of the airlines,because, ultimately, airline rates and chargeswould have to be increased to cover PFC debt serviceif authorization were revoked.Airport operators may, pursuant to Vision 100,use PFCs for making payments for debt service onindebtedness incurred to finance a project at theairport that is not an eligible airport-related projectif the Secretary determines that such use is necessarydue to the financial need of the airport.Regardless of structure, Standard & Poor’s willevaluate airport coverage of all debt from all availablerevenues, including PFCs. Those facilities thatprovide higher margins will generally, other thingsbeing equal, have higher ratings. ■Airport Multi-TenantSpecial Facilities BondsIncreased involvement of airports in financing specialfacilities has led Standard & Poor’s RatingsServices to develop criteria for rating multi-tenantspecial-facility debt. The criteria apply to uniqueprojects and facilities and permit the analysis toscrutinize and give weight to the market demand,rather than defer entirely to the tenants’ credit profile.An emphasis on project essentiality and structuralfeatures that enhance bondholder protectionscould result in the transaction receiving a higherrating than that of the participating airlines, on acase-by-case basis. However, there are inherent limitsto the degree of credit elevation above that ofthe airlines’ rating. Given the credit characteristicsof the airlines, it is likely that many of these projectratings will be below investment-grade. In addition,single-tenant airport special facility bonds will notbe rated higher than the tenant’s corporate rating.Airport CharacteristicsAirports considered for these ratings must beamong the strongest and largest in the country. Awww.standardandpoors.com139

Transportationstrong preference will exist for facilities supportingorigin and destination (O&D) traffic, rather thanconnecting hubs. Only large hubs, as defined by theFAA, will generally be considered. Projects at largehubs should represent key additions to the air travelsystem, which would enhance the likelihood ofcontinued demand for these facilities.Airport management must be experienced andhave a clear understanding of its rights and privilegesunder these arrangements.An increasing enplanement and aircraft operationtrend will be considered a strong positive factor.Cargo growth will be examined closely for the providingcarrier, as well as the rate of growth, if acargo facility is being evaluated. Increased activitywill place a premium on the value of all airportrelatedprojects, and Standard & Poor’s views theseas possessing increased protection.Project EssentialityElements that reflect essentiality include projecttype, inherent demand, strong support of airportmanagement, and importance to the operation ofthe airport facility.Although many different types of projects havebeen financed through special facility bonds, projectsthat fit most easily, from a credit perspectivefall into the following categories:■ Terminal space;■ Fueling facilities; and■ Cargo facilities and aircraft hangers.Projects at airports that are designed to satisfydemand that significantly exceeds currently availablefacilities, and where there is limited ability toprovide adequate locations to meet this demand aretypically more creditworthy. Unmet demand overand above the completed project will ensure that anew tenant for the facility can be found, if needed.Standard & Poor’s considers projects that cannotbe located off the airport more essential than thosethat can. The most creditworthy projects are forterminal and fuel hydrant facilities. Inherentdemand for the project is the most important ratingfactor. Typical questions asked include: How manyair carriers want projects of this type? Are all existingfacilities fully utilized? In addition, a multi-tenantfacility with a diverse mix of tenants is superiorto a project serving fewer tenants.Airport involvement is critical to this approach.Airport management must be involved in the designof the facility, and the project should fit in the overallmaster plan. In addition, Standard & Poor’sevaluates the specific nature of the facility. Themore tailored it is for one airline’s needs, the moredifficult it may be to relet.Standard & Poor’s also considers the percentagerepresented by the new project of the total availablespace for this purpose. For example, a new cargofacility that is only 10% of all existing space will bedeemed weaker than one that represents 50%. Thisfact must be viewed in the context of the amount ofother space available for additional facilities of thistype and the potential for additional facilities andfuture competition for the project.Finally, the security backing these transactions isproject specific and, therefore, adequate insuranceprotection must be provided. This would include,but not necessarily be limited to, property insuranceat full replacement value; title insurance to eliminateconcerns over ownership; and business interruptioninsurance to mitigate concerns aboutmeeting debt service obligations due to temporaryinterruptions in operations.Legal FactorsAlthough legal arrangements will vary from projectto project, in a typical financing Standard & Poor’sreviews transaction documents and opinions toassess the bankruptcy-remoteness of the issuer/lessor,contractual terms governing the use of the facilityby the air carrier and legal protections availableto the airport in the event of an air carrier’s default.Among other factors, this review assesses the risksthat an air carrier in a reorganization bankruptcyproceeding may be able to remain in possession ofits portion of the facility while not paying rent orotherwise performing on its related tenant obligations,that the air carrier may be able to recover orstay the application of funds in the transaction, andthat the airport may be prevented from dispossessingthe defaulting air carrier and reletting its spaceon a timely basis.Recent air carrier bankruptcies have shown thatair carrier challenges to the characterization of leasingstructures, attempts to avoid pre-petition payments,and attempts to recover unapplied funds orreserves, may disrupt expected cash flows and delayor frustrate the exercise of remedies. Standard &Poor’s believes that the likelihood of an air carrierin bankruptcy taking these or similar actions andthe adverse affect of the actions on a project wouldbe greatest where the project’s credit risk is concentratedin a predominant or single tenant.In a multi-tenant special facility financing, creditrisk diversification may somewhat reduce the likelihoodof air carrier challenges that adversely affectthe financing. Even in the bankruptcy of the lowestrated key tenant, however, the air carrier is likely totake some of the previously discussed actions thatchallenge the weakest aspects of the structure. As aresult, Standard & Poor’s assessment of the legaland structural risks will be an important element ofthe rating analysis. Standard & Poor’s considers anumber of other factors in its rating analysis of140 Standard & Poor’s Public Finance Criteria 2007

Airport Multi-Tenant Special Facilities Bondsthese facilities, including other factors discussed inthis article. For a multi-tenant special facilityfinancing that has a higher level of legal and structuralrisks, however, Standard & Poor’s may not beable to elevate the rating above the corporate creditrating of the lowest rated key tenant.Most multi-tenant special facility financings havebeen based on a lease structure with a special-purposeentity as the lessor and issuer of the rated securitiesand the airline operators as lessees. Standard &Poor’s reviews the ownership, organizational structureand operating constraints of the lessor in light ofthe special-purpose entity criteria applicable to theentity to assess the risk that the bankruptcy of anyrelevant transaction participant may detrimentallyaffect the issuer’s full and timely payment of therated securities in accordance with their terms.Typically, in a multi-tenant special facility financing,the contractual terms governing the use of anair carrier’s portion of the facility are in a leaseagreement between the air carrier and the lessor.Although lease provisions vary depending on thetransaction, leases that are more supportive of higherratings typically include provisions to keep utilizationof the facility at a level sufficient to supportpayments on the rated securities. These provisionswould include, for example, minimum utilizationstandards that the tenant must attain or the airportwould have the right to relet the space, therebyensuring the continued optimal use of the facility.The airport, or landlord, would be allowed to reletspace within 90 days of any default and remove atenant from occupancy (“use-it-or-lose-it” provisions).Stronger provisions would provide for relettingwithin a shorter interval after a default. Theairport itself would have the right to use its bestefforts to relet the space of defaulted tenants. If athird party, such as a developer, is involved in thelease arrangements, the lease would preserve theairport’s right to relet the space to the exclusion ofthe third party and otherwise to protect against thepotential bankruptcy of this intermediary. The termof the lease would be at least as long as the term ofthe rated securities to prevent financially viable airlinesfrom walking away from their obligationswhile the securities are outstanding.Other transaction terms that are more supportiveof higher ratings would include debt maturities ofno more than 20 years, debt service reserves equalto maximum annual debt service, limiting or prohibitingadditional debt issuances at the same levelof priority, staggered lease and debt service paymentdates, and a charge-back to the tenants of allcosts associated with the project or sufficient debtservice coverage levels to cover operating costs.Air CarriersDiversity of the air carriers involved is a strength inthese financings. Ideally, this type of debt is issuedto provide space for a group of airlines, not for oneor two tenants. In addition, the relative creditstrength of the air carriers involved will be considered.The credit rating in a special facility transactionwill be highly correlated to the underlyingcorporate credit ratings of the tenant airlines.Unrated airlines with significant stakes in theproject must undergo some review by Standard &Poor’s to assess their creditworthiness. Carrierswith higher Standard & Poor’s ratings will beviewed most positively, as will those that are usingthe facility to support O&D traffic. An importantaspect to the rating is understanding the relativeimportance of the project within the air carrier’sexisting system and strategy.Financial FactorsStandard & Poor’s will evaluate projected cash flowsurrounding all facilities. Depending on the project,Standard & Poor’s may require sensitivity analysesthat assume various vacancy levels. Projects thatcan withstand lower use rates or occupancy levelswill receive higher ratings. These projections shouldproject lease revenues adjusted under conservativeassumptions, although inflationary increases can beassumed if allowed under the lease documents.Interest income should be estimated at low levels,and airline payments should be as independent aspossible from the activity levels experienced solelyat the special facility. Expenses should be estimatedusing reasonable inflationary increases. Coverageon a projected basis should be a minimum of 1.50xfor the strongest of projects, with higher coveragelevels given additional positive weight. ■www.standardandpoors.com141

TransportationPort Facilities Revenue BondsIn evaluating port revenue bonds for publiclyoperated maritime facilities, Standard & Poor’sRatings Services considers several key variables,such as competition and industry factors, includingregulation; financial performance; operations; management;and legal protections afforded bondholders.Ultimately, ports derive their financial strengthfrom their overall business position as provider ofmaritime infrastructure.Operationally, port cargo and container volumesgenerally move with broader economic variablesand trade trends, which have been quite strong,benefiting all ports generally and larger, load centeringports in particular. Most port operators donot face new competition due to the tremendouscapital investment and transportation infrastructurerequirements, and environmental and regulatoryrestrictions. Their competitive risk is the loss ofcargo or incremental growth to other markets.However, through sound planning, budgeting, andmarketing, a port can effectively mitigate somecompetitive risks.Ports are affected by external factors that remainlargely outside of management’s control. Beyond theeconomics of goods movement, political and competitiverisks, as well as the unpredictable characterof uninsurable natural hazards are all variables thatcan negatively impact a port’s competitive positionand financial outlook. Concentration in the tenantmix contributing to port revenues and the credit riskexposure to the financial condition of major tenantsis also an exogenous factor that can directly influenceport finances.To an important extent, these factors have preventedport bond ratings from attaining the ‘AAA’ ratingcategory, and make the ‘AA’ rating category difficultto achieve. The highest rated entities have diversedemand, a very strong competitive position, soundfinances and oversight, and strong legal covenantscombined with largely steadily growing volumetrends. Reliance on a very few products, tenants or afew trading partners, combined with historic volumetrends exhibiting variability usually prevents ratingsfrom rising above the ‘BBB’ rating category.Competition And Industry FactorsIn first evaluating a port’s credit strengths,Standard & Poor’s analyzes its competitive positionand those broader maritime industry and regulatoryfactors that will likely influence futurefinancial performance. Competition is examinedboth in the context of other ports (regionally orglobally) as well as other modes that provide competitionfor certain high value cargo imports orexports. The port’s relative position to competitorsis reviewed based on data pertaining to commodityvolumes, value, and the relative importance of eachcommodity type to total port revenues. The establishmentof dominant cargo centers has not eliminatedcompetition, and several smaller and largerports have survived by finding a specialty niche ina certain single commodity type or cargo-handlingmethods. Heavy dependence on a few products togenerate port revenues exposes a facility more tothe vagaries of supply and demand.Standard & Poor’s also reviews the terms of contractualagreements with shipping lines, port tenants,and shippers, or consignees. While tariffstructures and other port charges including dockageand wharfage may not be significantly different (orgoverned by maritime associations), the overall portrate structure is examined, again with an eyetoward overall competitive position. Feasibilityanalyses and/or market studies, particularly thoseprepared when the port operator is undertakingcapital improvements and incurring debt to providefacilities or related infrastructure, can be an importantsource of operational data, in addition to proforma projections they may provide. All ports areexposed to the broader industry trends affecting theshipping industry as well as regulatory and environmentalissues affecting operations.The globalization of trade and manufacturingcommensurate with the growth in the shipping andhandling of maritime cargo containers continues toprofoundly affect the way port operators conducttheir business. Transportation economics, just-intimeinventory, outsourcing, growth in consumerproducts and other factors have all fed the increasein containerization. This, along with the increasingsize of ocean-going vessels and the efforts of majorsteamship lines to develop a seamless intermodalmovement of goods through cooperation with railroadsand trucking firms, has worked to diminishthe influence of ports’ pricing of services as a determinantin the routing of cargo. Instead, the142 Standard & Poor’s Public Finance Criteria 2007

Port Facilities Revenue Bondsincreased focus on supply chain logistics and timeto-markethas accentuated the importance of portsto provide efficient movement of goods from vesselsto the dock to intermodal facilities to rail and trucklines. The capital investments required to improvethe flow of goods at the lowest cost is integral tothe success of ports.Shipping lines, with their substantial investmentin larger vessels, and the higher costs associatedwith deployment and idling of these ships, have asa main priority making as few ports of call as possible,with rapid cargo loading and unloading. Tothis end, increasingly, they are drawn to large, modernfacilities with state-of-the-art loading and storagecapabilities, and those with efficient rail andtruck links, capable of transporting rapidly growingcargo volumes to distant markets. As major shippinglines demand these services, port operators arechallenged to decide whether to provide such costlyfacilities or risk losing an important part of thislucrative trade.Generally, the larger ports, servicing a sizablelocal or regional market, have been the major beneficiariesof these trends. Their size better enablesthem, or their tenants, to finance costly docksideequipment and to provide extensive marshalingyards. The coalition of shipping lines and railroadshas produced a greater concentration of cargo handlingamong a handful of these larger ports.Regional load centers provide a single destination—to or from—which containers can be transportedoverland to major internal markets. Because of theimportance of their own primary markets, the largerports usually have served historically as the first,or last, ports of call. This has become an increasinglyimportant factor as shipping lines try toreduce the number of calls.Many smaller to mid-sized ports are often thebeneficiaries of growth in the overall trade, capturingcommodities or general categories of cargocrowded out of larger ports. However, many smallerports are dominated by a few larger tenants ortypes of cargo and remain relatively static, servinglocal or regional economies.Port activity is affected by political and economicpolicies, natural hazards and the exposure to cargointerruptions from terrorist-related incidents. Forsome external factors, the risks to port operationsare mitigated by diversity. Federal policies concerningforeign trade, currency, and agriculture canhave a significant impact on the amount of cargoflowing through a specific port. Those ports thathave developed a broad array of trading partners,commodities handled, and a stable relationshipwith major shipping lines should be well positionedto ride out any temporary, or cyclical, disruption inthe flow of one or two products.Since 2001, port security and the financing ofimprovements related to perimeter boundaries andmonitoring systems have become more important.Port operating expenses and personnel costs havegrown and federal funding sources have been generallyinadequate relative to the needs. The potentialfor additional security improvements represents apotential drain on port finances to the extent theyare not accompanied by additional revenue sourceseither levied by port operators or in the form offederal assistance.ManagementThe organizational structures of ports range fromindependent authorities to city departments andstate agencies. Organization is important because itidentifies the amount of managerial authorityentrusted to a port’s staff. Complete authority, orautonomy, permits senior management to makebusiness decisions based on port operations ratherthan political sensitivities. Every port management,even an autonomous one, is constantly challengedby the often conflicting goals of spurring economicdevelopment within its regions, while attempting toachieve self-support or profitability. The compositionof the boards of directors and executives canillustrate the amount of local support for the facilityand its importance to the local economy. Since aport’s board and executives normally face a numberof complex challenges, their method of selectionand their experience are ascertained.Financial OperationsIn assessing a port’s financial position, Standard &Poor’s typically analyzes five years of audited financialstatements, as well as revenue and expense projections.Year-to-year revenue and expendituretrends are examined. Issues of interest include thevolatility and relative growth rates of each.Following 2001, many ports experienced significantincreases in security costs, both voluntary and federallymandated. As funding was not provided toports for many security requirements, ports reducedexpenses in other areas. Costs of insurance andemployee benefits have also increased significantlyin recent years. Maintaining a sustainable coststructure in the face of rapidly increasing expenseshas proven a significant test for management atmost ports. In addition to current expenses,Standard & Poor’s also examines the extent towhich future employee pension and healthcare benefitliabilities are funded.Coverage of annual debt service is examined, onboth a historic and projected basis. Because portsface exposure to such short-term risks as economicfluctuations, competition, tenant credit risk, labor,operating and event risk and natural hazards,www.standardandpoors.com143

Transportationhealthy coverage of annual debt service by netpledged revenue is a very important rating consideration.Minimum historic or projected coveragelevels are carefully considered. A commitment byport management to maintain a certain minimumlevel of coverage can be an important creditstrength. Pro forma coverage of maximum annualdebt service (MADS) is frequently considered.Other leverage measures, such as debt to net revenue,may also be considered.Like coverage of annual debt service, liquidityalso provides ports with a cushion against shorttermvolatility in revenue. Unrestricted cash andinvestments are considered, often measured in days’cash relative to annual operating expenses, and as apercentage of outstanding debt. Restricted operatingreserves are also considered. As with debt servicecoverage, a commitment by port management tomaintain a certain minimum level of liquidity canbe an important credit strength. A port’s exposureto swaps and variable rate debt is also considered,typically measured with Standard & Poor’s DebtDerivative Profile score.Operator ports typically sign contracts with shippingcompanies and receive income based on cargothroughput. Landlord ports typically lease propertyto shipping companies and receive fixed leaseincome. Although both models provide tradeoffsbetween risk and operating flexibility, operatorports face more volume risk in the short term thando landlord ports. For both types of port,Standard & Poor’s considers customer and tenantconcentration, the length of contracts and leasesand any minimum annual guarantees.Capital BudgetAn important part of the analysis involves examinationof planned capital expenditures. The types offacilities required in the future, their costs, andplanned financing are all important. An independentfeasibility study by an experienced consultant ishelpful. Some ports may not be able to attract additionalbusiness without first building competitivefacilities. However, prior commitments from usersare more likely to ensure financial stability thanbuilding on speculation.The amount of future debt planned is an importantrating factor, since a heavy reliance on newdebt can weaken an issuer’s financial position.Although most rated ports have moderate debt burdens,the possibility of substantial future borrowingexists. The ability of a port to finance a significantportion of the capital budget with surplus earningsis a very positive rating factor. Regardless of howfacilities are financed, a port’s tariffs are examinedto determine whether facilities will be competitiveafter project completion.Legal ProvisionsMost port revenue bond issues are secured by apledge of net revenues. Standard & Poor’s does notgive added weight to a gross revenue pledge, sincea port that cannot pay debt service and operatingexpenses is not likely to remain an ongoing entity.In addition to net port revenues, some issuerspledge net airport revenues or excise taxes. To theextent that such diversions significantly enhancecoverage levels, they could raise the credit rating.Issuance of port GO debt, where lawful, also mayenhance the revenue bond rating by reducing theamount of revenue bonds needed. The use of propertytaxes to pay operation and maintenance, orcapital expenses, is a favorable development, sinceit frees an equivalent amount of port revenues tocover debt service.The lien position of pledged revenues can beimportant. Issues with a first lien on the pledgedsecurity can receive higher ratings than subordinatelien debt since they are not as exposed tocoverage dilution, but combined coverage levelsand the relative proportion of senior and subordinatelien debt can also be rating factors. Legalcovenants vary in strength and are appraisedwithin the context of each port. Rate covenantstypically are about 1.2x annual debt service. Thedebt service reserve requirements of issues generallycall for a reserve equal to maximum annualor average annual debt service, or 10% of bondproceeds. The strongest provision requires areserve equal to maximum annual debt service,and fully funded from bond proceeds. Most additionalbonds tests call for coverage of debt serviceon outstanding and proposed debt in the 1.2x-1.5x range. Tests that include only historical revenuesare stronger than those that permit theinclusion of future earnings. ■144 Standard & Poor’s Public Finance Criteria 2007

Toll Road And Bridge Revenue BondsToll Road And Bridge Revenue BondsThe heavy costs associated with construction andmaintenance of roadways and bridges normallyrequire large amounts of debt, even for publiclyowned toll roads. The sizable debt burden, combinedwith the presence of competition, the potentialfor fuel shortages, toll sensitivity, and shiftingdemographic and economic factors, make it difficultfor a revenue bond issue secured solely by tollsto receive a Standard & Poor’s Ratings Services ratingabove the ‘A’ category. However, several wellestablishedtoll facilities, particularly toll bridgeswith limited competition and U.S. state toll authoritieswith very stable demand, low rates and welldefinedcapital programs now maintain ratings inthe ‘AA’ category. For privately owned toll roadsthat benefit from very long-term concessions, butare highly leveraged, high investment-grade categoryratings are difficult to achieve given the highdebt levels relative to cash flow generation, combinedwith the ongoing pressures to distribute equityto shareholders.Traffic DemandToll road ratings focus on traffic demand as themost essential ingredient for a financially successfuloperation. For “green field” or “start-up projects”construction risk also demands significant analysis.Strong demand for a toll facility is vital to its successfuloperation and the ability of the facility togenerate toll revenues. Most U.S. toll roads havebeen, and will be developed in heavily traveled corridorswith a demonstrated need to relieve trafficcongestion and reduced travel time for motorists.However, in some cases, demand for improved servicehas not been strong enough or developed fastenough to generate revenues sufficient to cover theoperation and maintenance expenditures of thefacility, as well as debt service. This is particularlytrue for new toll roads, expansions or extensionsbuilt in anticipation of future development. In otherinstances, the healthy, vibrant economic base thathad supported the system deteriorated, resulting inflat or declining traffic flow.Typical questions to pose when evaluating theseprojects include:■ Is the project a new road or bridge to ease congestionon overcrowded existing roads, or is it designedto spur or in expectation of new development?■ What is the composition of vehicles between commercialand private vehicles as well as trip purpose?■ Will all access roads or connecting roads notunder direct control of the project team be inplace prior to the completion of the project?Ultimately, how do the timesavings provided bythe toll facility relate to the toll structure?Answers to these questions begin to identify thevarious strengths and weaknesses of a project andwhat information will be needed for Standard &Poor’s analysis. Toward this end, Standard &Poor’s expects a detailed feasibility study reviewingthe underlying economic underpinnings and project-specificissues that result in the projected trafficand revenue forecasts. The forecasts should clearlystate all assumptions used and extend through thedebt offerings repayment term. In some instances,Standard & Poor’s may request an independentevaluation of the traffic report (should the feasibilityreport be generated by the project sponsor) toverify and collaborate the reasonableness ofassumptions and methodologies applied.Evaluating the economic strength and diversity ofthe toll road’s region is integral to the ratingprocess. Standard & Poor’s will analyze the region’swealth, income, and employment indicators, as wellas a host of other factors. While a sound and growingeconomic base usually ensures a high level ofcommercial and business-related travel, the level ofdisposable personal income has a direct bearing onthe volume of discretionary and recreational trips.Commuter or short-haul traffic, indicated by suchmeasures as average trip length, largely depends onlocal economic conditions. However, those tollfacilities directly connected with other major thoroughfaresare shielded to an important degree fromlocal economic conditions.An examination of total traffic trends is not sufficient.The nature and composition of that travel, aswell as its vulnerability to business cycles, changesin fuel prices, and toll elasticity are also critical.While commercial traffic serves as a stabilizingforce, most successful toll roads or bridges have agood balance between commercial and private-vehicletrips. Commercial traffic is less sensitive to tollincreases than private-sector traffic since, for all butthe marginal carriers, additional costs can eventuallybe passed on to customers. Fuel prices have, onwww.standardandpoors.com145

Transportationan inflation-adjusted basis, remained very low and,historically, price increases have not had a dramaticeffect on travel or gasoline consumption trends.However, the long-term effects of significantly higheroil prices, on a real basis, on traffic and demandlevels are unknown.Within the private travel sector, a breakdown ofnondiscretionary (business) and discretionary(recreational) trips is useful. Business-related trips,while obviously sensitive to levels of economicactivity, tend to be less so than recreational travel.As a general rule, a diverse traffic mix cushions theimpact of a decline in any one segment.Demand is affected by demographic characteristicsand local economic performance. However, for startuptoll roads, Standard & Poor’s also assesses theoverall acceptance of tolls in the region as the economyin the area may be vibrant but the road usersmust also demonstrate a willingness to pay tolls.CompetitionSince most toll roads and bridges are designed torelieve existing traffic congestion or reduce commutingtime in a heavily traveled corridor, well-plannedprojects generally encounter little competition in theimmediate years following an opening. Nonetheless,subsequent development of toll-free thoroughfarescan attract traffic away from a toll facility.In assessing the potential for such competition,Standard & Poor’s examines the capital improvementprogram of the appropriate state or federaldepartment of transportation, as well as the plansof regional and local transportation commissionsand the private sector. Where a high degree ofcooperation exists among various levels of governmentaltransportation departments and private tolloperators and authorities, the likelihood that competingroadways will be developed is lessened. Alack of coordinated planning is behind almost allcases where toll-free roadways were constructed tothe detriment of a toll facility. In addition to standardissuer meetings, discussions or meetings withthe appropriate national, state and local transportationplanning boards are helpful.Where competitor facilities exist, especially freecompetitors, as is often the case with congestionrelief projects, the level of traffic diversion projectedfrom the existing roadways to the new road isan important indicator of project success. Projectswith conservative diversion factors tend to beviewed more favorably. If start-up traffic historyand diversion levels exist for other local facilities,whether free or tolled, it can further help to analyzethe forecast traffic.The key to a facility’s competitive analysis is thecost-benefit analysis that drivers make in the formof timesavings or increased access versus cost. If, inthe mind of the decision maker, the new road doesnot get one to work faster or allow deliveries fastenough to recover the cost of the toll, the project isnot likely to succeed. The use of electronic toll collection(ETC) systems has improved traffic flows,though it is not clear that such systems produceoverall annual savings relative to manual toll collectionsystems given the pace and scale of technologicalreinvestment of second, third and fourthgeneration systems. It is also uncertain what theimpact of such ETC systems on the overall elasticityof demand if users of the system do not easilynotice toll increases. Clearly, the introduction ofelectronic toll collection will allow for more efficientand potentially variable toll changes, ultimatelygiving operators more revenue-maximizingoptions. With the increased use of ETC systemsalso comes a thorough analysis of the toll roadoperator’s violation rates and its violation enforcementsystem process.ManagementIn addition to assessing management’s overall abilityto coordinate its activities with planning boardsand governmental bodies, Standard & Poor’s evaluatesmanagement in the context of quality of planninginvolved in the budget-making process foroperations, maintenance, and capital improvements.For existing systems with an operating history, successfulfinancial performance serves as a broadmeasure of management capabilities. The degree ofautonomy enjoyed by the directors of a toll facilityhas an important bearing on its capacity to manage.Of particular importance is the ability and willingnessof management to increase tolls as needed.When the level of a rate increase is limited byconcession agreement terms or governmentalapproval, a history of being able to increase tollrates when needed to the maximum level allowedis considered a positive. It is also considered astrength if ratemaking decisions are shieldedfrom normal political processes or influence.Failure to increase toll rates when neededbecause of intervening political influence is a frequentsituation with existing facilities thatStandard & Poor’s has evaluated.OperationsEvaluation of maintenance procedures is also somewhatdifficult. While it is fairly common practice fortoll road entities to hire independent engineeringfirms for periodic facility inspections and to determinethe need for repairs, the reports derived fromthese surveys often are general in nature and offerlimited insight to third parties. Moreover, membersof the engineering profession often have differingviews on what constitutes adequate maintenance.146 Standard & Poor’s Public Finance Criteria 2007

Toll Road And Bridge Revenue BondsNevertheless, several considerations can be usefulin determining the quality of maintenance.Operators that retain their own engineering staffs,capable of conducting frequent inspections, may bebetter equipped to plan and budget for repairs andperform preventive maintenance than those systemsthat rely entirely on outside engineering firms forless frequent inspections. The utilization rate of thefacility, that is, the number and type of vehicles traversingthe roadway for a given time period, providesa good indication of the relative need forresurfacing and repair. Clearly, a facility that allowsaccess to the heaviest of motor vehicles will suffergreater roadway deterioration and require a largermaintenance budget than a system with a comparablelevel of traffic limited to lighter-weight vehicles.Operating and capital reserve accounts are commonin toll road projects and cover risks associated withexcess usage. These reserves are typically funded atlevels recommended by engineering staffs or consultants.However, for established toll facilities the lackof these reserves might also be acceptable based onsome combination of their historically high unrestrictedcash balances, high debt service coveragelevels, and demonstrated toll rate flexibility.With start-up toll roads, projected annual operatingcosts (on a per mile or per kilometer basis) thatare similar to other existing toll roads with similaroperational and construction qualities can oftenprovide an initial level of comfort and the startingpoint for further analysis.Feasibility StudyFinally, in reviewing a capital improvement programor extension to an existing system,Standard & Poor’s considers the project’s feasibility.Feasibility, as determined by an independentengineering firm, can be an important tool in thecredit analysis. A well-documented feasibilitystudy includes:■ An overview of the existing facility.■ A market and demand analysis that examines thefollowing factors: demographic patterns; historicaland projected traffic patterns; traffic mix (bytype of vehicle and nature of trip); competingfacilities; historical and projected toll rates; and,where practicable, the sensitivity of motorists tovarious toll levels.■ A financial analysis examining revenues andoperating costs, as well as projecting the impactof planned improvements and competitive highways.The financial analysis should demonstratethe degree of financial stress that a new project,or roadway expansion, may place on existingoperations and income levels.A set of sensitivity runs or analyses are criticalfor all start-up facilities and for all existing facilitiesthat are undergoing a significant capacity addition.However, the sensitivity analysis will vary on acase-by-case basis depending on the degree of historicalinformation available and the aggressivenessof assumptions in the forecasts. Standard & Poor’sevaluates the reasonableness of the assumptionssupporting these forecasts. Assumptions regardingfuture traffic growth rates and operating costsshould be based on historical patterns, with forecaststhat greatly exceed historical levels likelyadding credit uncertainty.In evaluating the traffic and revenue forecasts,Standard & Poor’s ultimately looks to the coverageof annual debt service by net revenues taking intoaccount expenses, capital expenditures and otheroperating obligations in addition to revenues. Whentoll rate adjustments are linked to changes in inflationor when toll rate increases require the approvalof governmental authorities, coverage of debt serviceby net revenue is an extremely important creditfactor. In these circumstances, the ability to raisetoll rates in real terms may be limited.However, depending upon the managementobjectives of the operator (e.g. revenue maximizationversus cost-recovery) the specific level of coverageof annual debt service by net revenues maynot be as important when there is a strong anddemonstrated willingness to raise rates as needed.In fact, a toll facility with lower coverage ratiosand with considerable flexibility for increasing realtolls could be perceived as a stronger credit than asystem with higher coverage ratios and limitedcapacity for raising tolls.Legal ProvisionsWhile legal protections for bondholders vary considerably,almost all toll road authorities provide amargin of safety by pledging to levy tolls at levelsthat will produce net revenues (after payment ofOperations and Maintenance expenses) equal todebt service plus a coverage multiple. The mostcommon ratio used in a toll covenant is 1.25x.The value of a covenant with debt service coverageappreciably higher than 1.5x is questionable,depending on the sensitivity of motorists to highertolls and the practical ability to raise tolls whenneeded. The speed with which a toll rate increasecan be implemented is a critical rating factor. Ifrate adjustments require approval of elected officials,delays can ensue. On a few occasions,authorities have been in technical default becauseof such delays.As with all revenue bonds, additional bonds teststhat include only historical revenues are significantlystronger than any test allowing projected rev-www.standardandpoors.com147

Transportationenues. Specifically, tests with projected rather thanhistorical revenues serving as the basis for calculatingfuture debt service coverage significantly reducethe value of such a test, but are relatively common.In these cases the relative conservativeness of management—andtheir projections—will be a factor inhow a prospective test is viewed.A debt service reserve, fully funded at the equivalentof one year’s debt service requirement, can providesignificant liquidity to bondholders,particularly given a potential for delays in implementingrequired rate increases.Additionally in some cases, states have enhancedthe security for toll revenue bonds by pledgingstate-levied highway user tax receipts, or a straightGO backup.Financial Projections/Debt Structure/Sensitivity AnalysesOne traditional measure of financial strength fortoll revenue-backed facilities and project bonds isdebt service coverage. Typical coverage for manyexisting U.S. operating toll facility is in the 1.5x-2xrange for debt service from net revenues, as manyprovide for significant pay-as-you-go capital costsafter operations and debt service. Standard &Poor’s believes that investment grade start-up facilitiesshould reach or exceed these coverage levels tooffset many of the risks indicated above. Toll roadtransactions structured under a corporate modelwhere senior unsecured debt is offered should providesolid interest coverage ratios and should have along enough concession term to allow for re-financingand ultimate debt repayment.For start-up facilities, the amount of debt that aproject must support establishes the hurdle, in theform of debt service, for which the project mustexceed. The existence of equity or subordinateddebt positions or contributions from privateinvestors, local, state, or federal governments canserve to lower the bar, making the project moreaffordable, and hence more creditworthy. A debtservice schedule that is relatively level over timealso allows more flexibility than an upwardlyincreasing schedule that keeps the pressure on constantgrowth through traffic or rate increases.Sensitivity analyses are also typically requested tosimulate normal or historic changes in economicconditions, traffic declines, operating and capitalcost increases, and tariff adjustments to help gaugethe project’s ability to withstand change. Whereprojections are critical to future financial condition,Standard & Poor’s will typically also request low,no-growth and break-even sensitivity cases.Public Private Partnerships:Revenue/Debt and Equity ConsiderationsThe recent multi-billion dollar privatizations of theIndiana Toll Road and the Chicago Skyway representnot only an enormous change in US toll roadfinancing, but also in global toll road financings.These two financings mark a departure from thetypical 25-35 year project finance model and hasled to significantly different debt structures. Thebasic analytical considerations in evaluating thesetransactions remains the same with regard todemand, competition, management, and operationsand our analysis still follows a combination ofexisting toll road criteria and project finance criteria.However, the debt levels tend to be significantlyhigher and debt repayment tends to extend significantlybeyond the traditional 20-30 year period.Furthermore, the debt associated with thesetransactions tend to use defer pay structures andrely on refinancing. To date, these transactions haveoccurred with respect to existing toll facilities withdemonstrated strong cash flow generation, whichhas enabled them to support the higher debt levels.In addition, the longer amortization periods areaided by concession terms that are considerablylonger (75-99 years) than in the typical concessionfinancing. Debt levels would have to moderate significantlyin a privatization of a start-up facilityeven with a very long-term concession period.The challenge of long-term concession periods isin evaluating the traffic and revenue forecasts andfeasibility studies. Planning or macro-economicforecasts, which are key inputs into most trafficmodels, themselves, only stretch as far as 10-20years into the future. Additionally, demand modelsgenerally remain incapable of capturing structuraladjustments to travel markets—such as the longertermimpacts of changes to preferences, relativepricing, technology and so forth. To address thisconcern, Standard & Poor’s takes a conservativeapproach to longer-term traffic forecasts, reducinggrowth-rate expectations over time to reflectincreasing uncertainty and unforeseen events thatcould result in real declines. While the approach totoll rate setting under a private operator model willfocus more on revenue maximization, price elasticityis nonlinear. Mid-to far-term growth ratesexceeding 1% per year are unlikely to be consideredin our analysis and, depending on the assetscharacteristics, this could be capped at zero.Similarly, in evaluating projected tariff increases,revenue projections will be adjusted only for reasonableinflationary corrections. It is under thistraffic and revenue profile, that Standard & Poor’s148 Standard & Poor’s Public Finance Criteria 2007

Mass Transit Bonds Secured By Farebox Revenueslooks to see that all debt can be re-paid prior to theend of the concession term. While high growthrates may be achievable and the potential for strongrevenue generation over the long-term may exist,this becomes more speculative in the far-term andinconsistent with the certainty required for investment-graderatings.The revenue generation profiles of toll roadsmore naturally fit amortizing debt structures.However, current financing trends has seen debtstructures with a blend of multi-tranche debt withdifferent amortizing profiles including bullet maturitiesand other nonamortizing debt instruments.One key aspect of our analysis is to determinewhether or not the project cash flows can supportthe peak debt service levels that such instrumentscan introduce later in the concession term.To date, Standard & Poor’s has evaluated a limiteduniverse of such credits and our views are stillevolving. However, at present it is envisioned thatfor such very strong mature assets, is that peakaccreted debt would occur in the first 15-20 years ofthe concession (depending on the concession term);50% of the maximum accreted debt would berepaid within 30-40 years; and all of the debt wouldbe repaid by the 45th to 50th year of the concessionterm, leaving an ample refinancing tail should trafficand revenues not meet expectations. These areguidelines and each long-term highly leveraged tollroad concession would be evaluated on their ownmerits but the concept of limiting debt accretion andrequiring debt to be paid down well before the endof the concession term remain the same.Transactions with bullet maturities introduce refinancingrisk. An investment grade rating might bedifficult to achieve if more than 20% of total debtis due to be retired in any two consecutive years.Refinancing risk is manageable in long-dated concessionswith a sufficient refinancing tail of about10-30 years. Financial models, however, will beexamined to understand the assumptions beingmade about refinancing such as the interest rateemployed and stress tests will be used to evaluatethe sensitivities of the transactions to less favorableinterest rate assumptions. Investment grade structureswill typically have secured appropriate hedgingarrangements in this regard.With private ownership of toll facilities, equityconsiderations are introduced into the legal structure.As deferred pay structures are introduced, it alsomeans that early year coverage ratios are over inflated,giving a misleading indication of project performance.Furthermore, deferred pay structures can resultin leaving free cash flow available for equity distributionsprior to any substantial debt repayment.Standard & Poor’s views projects as having less riskwhere dividends are to be distributed only whenproject performance is in-line with or exceed expectations,and is likely to continue to do so.In this context, Standard & Poor’s analyzes theissuer’s proposed dividend distribution lock-upcovenants. These lock-ups are generally set at levelsjust below the financial model’s base case minimumdebt service coverage ratio for investment grade credits.The closer the permitted dividend distribution testis to the minimum coverage ratio, the better the subordinationrelationship between equity and debt.Dividend lock-up tests also focus on the number ofconsecutive years that must pass (following dividend)lock-up before dividend outflows recommence.Forward-looking tests provide for a stronger structure.Finally, the issuance of additional debt for shareholderdistributions require that the additionalbonds test for such purposes be set at a higherratio than for leveraging for other reasons, such ascapital expenditures. ■Mass Transit BondsSecured By Farebox RevenuesOperators of mass transit systems often look toleverage a variety of available revenues streamsto finance both long-term capital investments aswell as facilities less critical to the system. Whiletypically a recipient of federal, state and local moneysin the form of grants, taxes, toll revenues, andother proceeds, some operators look to revenuesderived from the farebox or operations of the systemas a pledge of security. While the farebox canbe a reliable and a relatively stable revenue source, itis obviously dependent on the viability and continuedoperations of the public transportation providerand is exposed to events or circumstances that candisrupt ridership or fare collection. The transitindustry’s history of deficit operations, laboractions, dependence on revenue transfers for capitalinvestment, as well as operating subsidies along witha general lack of fare raising flexibility are creditconcerns. Consequently, Standard & Poor’s RatingsServices rates few bonds backed solely by transitwww.standardandpoors.com149

Transportationrevenues and intergovernmental subsidies; salestaxes and other nontransit-related revenues actuallysecure most bonds issued for transit purposes.DemandEvaluation of demand for a start-up facility is difficultand centers largely on determining the plausibilityof traffic and engineering studies. Generally,Standard & Poor’s would have difficulty rating astart-up mass transit facility bond or other transitlikerail project in the investment-grade categories ifthe system had no operating history and was backedsolely by farebox revenues. Localities that have onlylimited public transportation service need a majormarketing effort to persuade commuters to foregodriving. Many people who vote positively for transitprojects have no intention of using them regularly;they are seen as a method of getting other people offthe highways. New transit systems rarely achievetheir projected ridership. Nevertheless, if a systemcan reduce travel time significantly at reasonable costin a safe environment, it will attract some motorists.Ridership can be enhanced by establishing linkagewith suburban transit systems; around thecountry “Park and Ride” programs, wheremotorists can park at the exterior terminuses of asystem and complete their commute by rail or bus,have been highly successful.For established systems, the historical demandand the relative competitiveness of alternative travelmodes are reviewed. Virtually every metropolitanarea with an established network also has a regionaltransportation commission responsible for coordinatingthe planning and development of all methodsof transit. Since members of the commission areappointed by governors or other elected officials,their past policies and practices provide a valuablemeasure of how public policy has been used toattract commuters to a transit system. With anestablished system, there is an evaluation of historicalridership patterns and departures from these patternsfollowing fare increases and during economicdownturns. These trends are a rough measure of thevalue of transit for users and their willingness to payincreasing amounts for the service.OperationsBecause mass transit systems are capital intensiveand generally have deficit operations, these systemsrely heavily on governmental support. This is compoundedby the fact that fare increases generallyevoke strong negative reactions from users, thereforerevenue flexibility is often limited. As a result,most transit systems rely on government subsidiesor the pledge of tax revenues in addition to fareboxrevenues. Standard & Poor’s reviews the history ofthese additional revenue sources and the stability ofthis revenue stream. In particular, Standard &Poor’s looks to the ability of management to closeany projected operating deficits through its abilityto raise revenues either through fare increases orincreased other revenues or through operationalcutbacks. The ability of management to containcosts and increase labor productivity is especiallycritical because wages and benefits account for wellover half of total operating costs in this labor-intensiveindustry.For older more established systems, operatingdeficits can also mean that maintenance programshave been neglected or there is significant deferredmaintenance. As a result, Standard & Poor’s examinesthe mean distance between failures in each yearso as to determine the overall state of repair for thesystem. Standard & Poor’s is especially attentive tomaintenance procedures, since no system canattract new ridership or retain existing users if theequipment is subject to frequent breakdowns.In examining capital improvements and extensions,the feasibility of the project, usually as determinedby an independent engineering firm, and thelogic of the assumptions supporting the conclusionsare studied. The project also is evaluated within thecontext of the regional transportation commission’soverall planning and the adequacy of pledged revenuesto cover debt service on the debt to be issued,as well as any parity debt that is outstanding.Legal ProvisionsGiven the weak financial condition of transit systems,legal provisions are important to an investment-graderating. Where the pledged security is agross lien on farebox revenues, Standard & Poor’slooks to both historical coverage of debt serviceobligations and covenants related to additionalindebtedness in order to provide bondholder protectionfrom revenue declines that could not be mitigatedby reducing operating expenses. In practice,most operators view farebox revenues as a supplementalsource to provide leverage and do not lookto maximize this type of debt. Rate covenants maynot provide credit strength to the extent most operatorsexhibit a general lack of revenue flexibility.Standard & Poor’s evaluates the practical aspectsof such a rate covenant against what is frequently ahighly charged political atmosphere and litigationthat delay or change proposed fare increases. Someissuers of transit revenue bonds try to compensatefor what is seen as a weakness in the rate covenantby supplying an exceptionally high multiple in theadditional bonds test. Those tests that include onlyhistorical revenues are significantly stronger thanany test allowing projected revenues. A fully fundeddebt service reserve helps provide liquidity in timesof cash flow stress. ■150 Standard & Poor’s Public Finance Criteria 2007

Parking Revenue BondsParking Revenue BondsStandard & Poor’s Ratings Services maintains ratingson several types of public parking facilities,including downtown urban parking systems, individualparking garages, and commuter rail parkingfacilities. Parking operations are also evaluated inthe broader context of other enterprises includingmunicipalities, hospitals and universities. The levelof demand for a public parking facility is the keyfactor in evaluating its credit strength. A wellfocused,cohesive public policy by local governmenttoward parking can go a long way in establishingstrong demand. Those communities with a soundmaster plan that coordinates public-parking projectswith those of private systems generally havemore financially successful operations.Governmental limitations on competing privateparking are considered a credit strength, and havebeen achieved in some cases by zoning ordinancesor by limits on construction permits for new privateparking facilities. Some municipalities fail to take acomprehensive planning approach to parking.Often, the result is a patchwork of competing facilitiesthat may not efficiently serve the dynamic needsof a flourishing central business district or provideadequate security to bondholders.Where the pledge of revenues from parking operationsis the primary security, Standard & Poor’s viewsa parking system consisting of several off-streetgarages or lots, supplemented by metered curbsideparking and often parking fine revenues, as strongerthan one comprising a single site or a few facilities. Anextensive network of metered parking can serve as asolid financial anchor for a system, because operatingand maintenance costs are relatively low, and meteredparking often produces the highest profit margin in asystem. However, local governments frequently viewnew parking projects as an economic developmenttool—one that might attract a large retailer or hotelierto the community, which leads to the construction ofsingle-site, startup parking facilities.Standard & Poor’s considers start-up parkingfacilities as highly speculative. Because of the speculativenature of a single-site, start-up parking venture,it is extremely difficult for it to attain aninvestment-grade rating on its own merits.Standard & Poor’s even views existing single-sitefacilities with a history of successful operationswith some caution. The closing of a major retaileror other redevelopment efforts can have a profoundimpact on revenues generated by a single garage, oreven a small parking system, because the servicearea of a garage or lot typically extends only a fewblocks. Nonetheless, if a single-site parking projectsucceeds and develops a history of consistent profitability,then the facility could serve as a linchpinfor securing financing of additional projects.There are no minimum coverage levels for a particularparking facility rating. Large, diverse,monopolistic systems are generally able to achievehigher ratings with lower coverage levels thanmore limited systems. All other things being equal,higher coverage of debt service by net revenuesleads to a higher rating. However, a parking system’ssize and diversity, and a system’s ability toraise its parking rates, may outweigh coverage considerations.Standard & Poor’s views negativelyany limitations on a parking system’s rate-settingflexibility and ability to respond to marketdemand. Similarly, a proven track record of periodicand regular rate adjustments is viewed positively,demonstrating both the ability and willingness tomodify prices to meet minimum covenant levels ormanagement-identified debt service coverage levels.DemandBecause demand for parking is the paramount ratingconsideration, Standard & Poor’s ratingapproach focuses heavily on the underlying economicgrowth and employment base of the locale.Historical population, employment, and wealthlevels are examined. Trends in new office andretail building activity, as well as diversity of newgrowth, may be indicative of future demand. Thecurrent status of urban renewal plans or trends inbusiness relocations that could adversely affectparking is also important. Projected office buildingconstruction is not accorded significant importancein the rating process because these estimatescan be highly unreliable, and projected growthmay never occur.While statistics on municipalities are readilyavailable, parking demand for the immediate servicearea of an individual garage is difficult toobtain. Standard & Poor’s rating policy emphasizesexisting parking demand, as opposed to projecteddemand. Existing parking systems can obtain ratingsin the ‘BBB’ category or better, depending onthe historical level of parking revenues and othersources of security that may be pledged. If a garageis being expanded, the historical occupancy rate, orthe number of customers on waiting lists formonthly parking, should be available. Standard &www.standardandpoors.com151

TransportationPoor’s considers reliance on local companies thatmay have leased or guaranteed revenues on a certainnumber of parking spaces. If a proposedexpansion, or a startup garage or system, relies onprojected demand, then Standard & Poor’s requiresa thorough demand study. Typically performed bya parking consultant, a demand study will examinecompetition for parking and attempt to forecastparking volumes and rate increases. Standard &Poor’s will examine the forecast’s assumptionsregarding the rate of “ramp-up” growth followingthe opening of the parking facility and its assumptionsregarding the rate at which the market willbear increases in parking rates. An operatingreserve fund to cover possible shortfalls in forecastedrevenue, in addition to any debt service reservefunds, may be viewed positively.CompetitionCompetition may severely restrict a parking facility’sability to raise rates. Standard & Poor’s studies thenumber and occupancy levels of competing facilities,their proximity and rates, and anticipated new facilities.Some cities’ systems have a significant competitiveedge over private parking because of thelower-cost, tax-exempt financing available to them.A municipality may retain great rate-setting flexibilityif it owns almost all of the downtown parking andthere is no available mass transit; such a competitiveposition is considered a significant credit strength.Highly rated systems will often have prepared marketstudies that document their competitive position,including relative price, space, and availability data.ManagementManagement is assessed primarily by the feasibilityof its expansion plans, the extent of annual maintenance,and its track record of rate adjustments.For municipal parking entities, the effectiveness ofoperational oversight can also be a rating consideration.Substantial bond-financed expansion beyondthe system’s existing parking spaces—especially forthe purposes of economic development—may beconsidered imprudent and speculative because ofthe uncertainty of attracting the level of demandneeded to meet higher debt service. The ability andwillingness of management and oversight bodies toapprove and raise rates is also very important, asdemonstrated by timely historical increases. In thisrespect, insulation from normal political processesis considered a strength, and weight is given tomanagement or governance structures that havethe unilateral ability to increase rates. Proper managementof and reinvestment in the facilities is alsovery important to Standard & Poor’s. If only oneor two garages support debt service, regular ongoingmaintenance is essential, especially in climateswith weather conditions that can reduce a structure’sestimated useful life. A structural failure fora small system could be disastrous. Standard &Poor’s will look to ongoing maintenance and reinvestmentin parking facilities.Insurance is helpful and sometimes essential forsmall systems, including, if appropriate, businessinterruption insurance, property and casualtyinsurance, and coverage for other applicable andinsurable risks. Standard & Poor’s has engagedconsultants to assess the risk of eight natural hazards,such as earthquakes, for each county in thenation. For California, seismic evaluations of eachzip code have been performed. If a single-sitegarage is located in an area with a greater than5% risk of 50% or more destruction before finalbond maturity, special natural hazard insurance orbuilding procedures are required for a rating of‘BBB’ or higher.Legal ProvisionsLegal provisions vary in importance with theunique characteristics of each bond issue. A commonquestion is whether a gross revenue pledge isviewed differently from a net revenue pledge. Ingeneral, parking enterprises are evaluated on a netrevenue basis, regardless of the pledge of revenue.This is because, in most circumstances, a parkingfacility’s rate structure—and therefore its competitiveposition and revenue-generating ability—reflects the full cost of operating the facility,including the capital and operating components.However, covenants to pay operations from anothersource (e.g., a city’s general fund) can provide someenhancement to the rating. A covenant to maintainrates at sufficient levels to allow at least 1.00x debtservice coverage by net revenue is considered a fundamentalelement in a viable, long-term parkingenterprise. Most rate covenants range from 1.25x-1.50x debt service requirements. Additional bondstests that include only historical revenues arenotably stronger than tests that allow considerationof projected revenue. A debt service reserve fullyfunded from bond proceeds provides liquidity andis an important rating consideration for issuers withlow debt service coverage. Such reserves are alsoimportant for issuers with potentially volatile revenuestreams, such as start-up projects, which requirea ramp-up period for new facilities to attain selfsupportingstatus. A flow of funds that ensuresfunding of operating and capital maintenanceaccounts before transfers to a city’s general fundis also viewed as important to the long-term viabilityof a parking enterprise. Covenants that prohibitthe elimination of more than a certainpercentage of total system spaces also provide ameasure of security. ■152 Standard & Poor’s Public Finance Criteria 2007

Health CareNot-For-Profit Health CareThe not-for-profit health care sector encompassesa variety of different types of health care entitiesseeking access to the capital markets. As a result,Standard & Poor’s Ratings Services rating criteriacovers a range of nonprofit health care providers inaddition to single-site hospitals and multi-hospitalsystems. While each provider has unique areas ofanalytical focus, the framework for all of them issimilar. Standard & Poor’s continues to emphasizequalitative and quantitative factors in determiningthe rating of a health care entity. However, intoday’s more competitive and continually evolvinghealth care environment, an examination of theprovider’s competitive position—including thenature of the market, market share, relationshipswith key market constituents, and cost structure—isessential to our evaluation.centers, and large medical centers draw patients frombroader regional bases, providing some insulationfrom local economic cycles. This information feedsinto Standard & Poor’s assessment of demand forthe institution’s services, its market position relativeto the needs of the population and to the competition,and the evaluation of the institution’s strategicplans. The reimbursement and planning environmentalso is an important service area characteristic, whichfrequently affects financial results. Some states haverate setting or planning regulations, such as certificatesof need and Medicaid managed care initiatives,in an attempt to control health care costs and expenditures.Therefore, an understanding of the uniquefeatures of a state’s reimbursement and health-planningenvironment is an important element in understandinga provider’s fiscal well being.Demand And Service Area CharacteristicsOverall measures of business volume remain animportant analytical tool, although the interpretationof volume data must be analyzed carefully. Inmarkets with high managed care penetration,analysis of volume trends must include a review ofpayment terms and overall profitability of businesslines. Although traditional inpatient and outpatientstatistics are analyzed, Standard & Poor’salso focuses on adjusted admissions and averagedaily census to gauge the revenue-producingcapacity of an organization, along with the reimbursementrate environment.To the extent that utilization is flat or declining,Standard & Poor’s is interested in a provider’s abilityto control resource consumption and preservecash flow. Population trends, unemployment rates,local wealth levels, the size of the region’s uninsuredpopulation, and major employers are analyzedto determine their effect on health careutilization and payor profile. Additionally, the populationprofile is important in determining the typeof services needed. Typically, an older population islikely to require more intense inpatient servicesthan a younger population, which may be mosteffectively treated on an outpatient basis.The types and levels of services provided areimportant analytical considerations affecting theinstitution’s competitive and financial position. Forexample, major teaching hospitals, regional referralInstitutional Characteristics And Competitive ProfileThe competitive environment—always an importantelement—has become even more so as thirdparty contracting has contributed to overallheightened competition for patients on an inpatientand outpatient basis. An in-depth understandingof the provider’s market share over timefor key services, centers of excellence, and competitiveposition in its primary and secondaryservice areas is a critically important area of focusfor Standard & Poor’s as an indicator of creditstrength. In addition, affiliations with otherproviders are a key issue, as consolidationremains a key factor in most markets. Standard &Poor’s must be fully aware of the market dynamicsof both the credit being rated as well as itscompetitors. Understanding current strategicalignments and payor relations for all marketproviders help Standard & Poor’s better predictan individual hospital’s future.Standard & Poor’s reviews the size of theprovider’s medical staff, the average age of the staff,and level of board certification and admission dispersionamong the top admitters. The ability toattract and retain new doctors is another usefulindicator. Additions and deletions to staff—traditionallyan area of focus—include an emphasis onrecruitment of primary-care physicians.Given the role of primary-care physicians to influencepatient flow and resource utilization, it is impor-www.standardandpoors.com153

Health Caretant for Standard & Poor’s to understand the relationsthat a provider has with primary-care physicians,as well as with the rest of the medical staff,including an understanding of practice patterns, andloyalty of the medical staff to the institution.Standard & Poor’s also factors the financial performanceof physician practices into ratings wherehospitals, systems, and managed care corporationsemploy and manage doctors. Whether these practicesare inside or outside the obligated group,Standard & Poor’s incorporates this business lineinto the rating through analysis of financial performance,strategic vision, and quality of management.The successful operation of physician hospitalorganizations or similar structures is viewed positivelyif it enhances physician loyalty and establishesappropriate financial incentives. The ability ofhospitals and physicians to negotiate third-partycontracts, as a single unit remains helpful in manymarkets although this has become less prominentover the past few years as exclusive managed carecontracts have been replaced by broader point ofservice networks. The role of information technologyand electronic medical records is becomingincreasingly important both as a means to improvequality of care, meet evolving standards of care,and pay-for-performance requirements, but also asa physician recruiting and retention tool. As relationshipswith physicians have evolved,Standard & Poor’s also recognizes that relationsbetween other providers and insurers have alsochanged. It is important to highlight these key relationshipsduring the rating process, particularlysince affiliation agreements and network formationare important to overall strategy.Management And Administrative FactorsOne of the best indicators of management’s abilityis the provider’s track record. However, given thecompetitive operating and reimbursement environment,the past may not always be the best predictorof future results. Therefore, Standard & Poor’sanalysis of management seeks to determine whetherthe management team exhibits the depth and experienceto provide leadership, deal effectively withthe medical staff, budget effectively, monitor andcontrol financial and personnel resources, define thehospital’s role, and develop and implement adynamic strategic plan, including an effective informationtechnology program, to enhance the overallhealth of the organization.Management’s ability to assess its institution’sstrengths and weaknesses and to develop soundstrategies to enhance the institution’s competitiveposition is crucial to continued success. In meetingswith Standard & Poor’s, management teams shouldbe prepared to discuss these topics in detail. Theprovider’s management, information technology,and capital budgeting systems should be appropriatefor the size, type, and complexity of the institution.Standard & Poor’s discusses with managementthe types and frequency of monitoring and reportingto the staff and to the board of trustees.The role of the board and its interaction with themanagement team continue to be areas of analyticalfocus, and a meeting with the member of the boardof trustees is desirable. The board’s size, composition,structure, and activity are noted, with particularconsideration given to its participation in settingstrategic and financial policies. In addition manynot-for-profit boards have adopted some or all ofthe rules articulated in the federal Sarbannes-Oxleylegislation. It is helpful to understand the Boardview of these rules and what, if any, have beenadopted by the Board.Another area of discussion is risk managementand the hospital’s malpractice coverage and history.The ability to get reasonably priced malpracticeinsurance is also examined, along with generalproperty and casualty insurance. Overall levels ofrisk retention as well as diversification of insurancerisk are examined to see if the provider is overreliant on their own balance sheet for first dollarcoverage up to the retention limits or if there is anover reliance on any one insurance company. To theextent an organization relies on a captive insurancecompany additional information is likely to berequested regarded the captive’s performance, fundinglevels at the captive as well as captive polices onreinsurance to make sure the captive itself has managedits risk appropriately.Financial FactorsFinancial position and performance are essentialelements of Standard & Poor’s analysis. However, ifa provider’s business fundamentals are not sound,currently sound financial performance and positionmay not be sufficient to offset longer-term businessStandard & Poor’s Rated Health Care ProvidersStandard & Poor’s rates a broad spectrum of health careproviders, including but not limited to:■ Single-site hospitals-including rehabilitation, children’s,cancer centers and psychiatric institutions;■ Multi-hospital systems;■ Academic medical centers;■ Physician groups and faculty practice plans;■ Continuing care retirement communities andnursinghomes; and■ Human Service Providers154 Standard & Poor’s Public Finance Criteria 2007

Not-For-Profit Health Careconcerns. For example, a very competitive servicearea, a weak local economy, a weak medical staffprofile or an over reliance on investment incomemight explain why a hospital is rated below whatits financial profile might otherwise indicate.Conversely, the absence of competition and a growingeconomy and population base sometimes cancompensate for lower cash levels or thinner margins.Standard & Poor’s financial analysis highlightsincome statement, balance sheet, cash flow statementtrends and future capital requirements. Onebad year does not necessarily mean an immediaterating downgrade, unless the experience was verysevere or is determined as being the beginning of along-term shift in financial performance. When confrontedby a weak year, Standard & Poor’s carefullyreviews management’s corrective action plan toaccess the likelihood it will return the organizationto financial health. The stronger and more detailedthe correction plan, especially if combined withclear implementation schedules, are generallyviewed more favorably than broad but undefinedcorrection programs. Trend analysis is critical to allrating decisions.Income-statement analysis focuses on revenuegrowth, payor mix and profitability by payor, andoperating and excess margins. Standard & Poor’slooks at local state regulations and funding issues,as well as the level of competition among the insurers.Standard & Poor’s will ask management aboutits managed care contracting strategy, current ratenegotiations and role of pay-for-performance contracts,if any, in the local marketplace. Programs tocontrol costs are also examined in detail, as is overallrevenue cycle performance including managementof bad debt.Standard & Poor’s is interested in measuring aninstitution’s financial flexibility, or its ability tomeet its debt-service requirements even understressful conditions. Also important is an organization’sability to have sufficient cash flow and debtcapacity to meet future capital needs. Low-costproviders with a favorable payor mix and marketdominance will have a clear advantage. Competitivepressures may constrain high-cost providers fromraising prices, although they may be suffering financially.Typically, Standard & Poor’s will ask howthe provider’s costs compare with those of otherproviders, and is interested in any initiatives undertakenor under way to control or reduce costs ofproviding services. Low costs and demonstratedefficiencies are key to strong margins, along withnegotiating clout with managed care payors. Keyincome statement indicators are operating andexcess margins, historical pro forma debt-servicecoverage, and debt burden. Increasingly overall baddebt and charity care levels are impacting marginsnegatively. In some cases community perceptionsthe sufficiency of the charity care that is being providedis an issue that can indirectly impact margins.Standard & Poor’s also uses ratios such as full-timeequivalent employees to adjusted admission, andsalary and benefit expenses to net patient revenueto help analyze trends over time for a single creditand improve comparability between credits in similarmarkets with similar services. Institutions withfavorable ratios have a greater degree of financialflexibility to meet the challenges of today’s environment.Quality metrics are also reviewed in availableand can provide some measure of flexibility iffavorable. Pension funding levels are also reviewed,as they are increasingly an important use of cashthat competes directly with an organization’s abilityto fund capital needs.Although operating and excess margins are bothimportant measures of profitability, Standard &Poor’s believes that operating margin is the bestmeasure of the ongoing ability to generate profitsfrom the business. Excess margins include investmentincome (including realized gains and excludingunrealized gains), as well as unrestricteddonations. However, weak operations combinedwith dependence on non-operating earnings canhighlight underlying weakness in most cases. Somevery well endowed institutions are exceptions tothis especially if their fund raising ability is strong.In addition to focusing on an organization’s abilityto produce profits, Standard & Poor’s examinescash flow statements to measure a credit’s cash-producingability. Our ratios borrow heavily from corporatefinance, and answer the question of whetheran institution is generating sufficient cash flow tofund its strategic objectives while maintaining sufficientcushion consistent with its rating. Key cashflow ratios include cash flow to total liabilities andEBIDA (earnings before interest, depreciation, andamortization expenses). Standard and Poor’s alsoexcludes from excess income unrealized gains orlosses from swap agreements.Standard & Poor’s analysis also focuses on thebalance sheet, particularly leverage and liquidity.Balance-sheet strength is key in today’s volatileoperating environment. An institution with significantliquidity or light leverage can more easily survivethe increasingly common scenarios of reducedreimbursement; poor managed care contracts, orvolatile investment performance. Standard & Poor’suses traditional liquidity ratios such as days’ cashon hand and cash to debt. Standard & Poor’s alsoexamines in detail a provider’s investment allocationand investment policies, especially if nonoperatingrevenue is a significant source of funds fordebt service. In addition, the liquidity of the investmentportfolio is also examined closely especially ifwww.standardandpoors.com155

Health Carethe provider is using its own balance sheet to supportpotential variable rate debt tenders.Standard & Poor’s uses capital structure and liquidityratios such as debt to capital, to help evaluatemore thoroughly debt repayment ability and debtcapacity across the rating spectrum. Future capitalneeds and projected sources of capital to fund thoseneeds, whether it is internal cash flow or externaldebt or a combination, remain an important elementof Standard & Poor’s analysis.In addition, an organizations’ overall mix offixed versus variable rate debt is analyzed, bothpre-and post-usage of swaps. Swaps are analyzedfor termination risk, and the potential for largepayments that may then be required. In generalmost health care credits entering into swaps havesufficient liquidity to handle unexpected terminationevents but this could be a problem if an organization’soverall rating profiles deteriorate.Particular attention is paid to whether or not theswaps contain rating triggers that could force termination.Standard & Poor’s has developed criteria(see related criteria) used in reviewing any organizationswith swap exposure and assigns a debt derivativeprofile score as part of the review process.Health Care SystemsStandard & Poor’s definition of a health care systemincludes vertically or horizontally integratedsystems that may have at least three hospitals withsufficient financial dispersion in a single region, aswell as traditional multi-hospital/multi-state systems.The definition also includes systems that havemultiple distinct business lines, even if geographicdispersion is more limited.Over the past decade the number of systems, particularlythose rated in the ‘AA’ category, has risen.System ratings generally are higher than ratings forsingle-site facilities because of the financial andnonfinancial synergies and the dispersion of riskthat generally accrues to systems. This is amplydemonstrated in Standard & Poor’s not-for-profitmedians published annually for systems and standalonefacilities.Standard & Poor’s approach to rating health caresystems is similar to that used for single-site facilities.In both cases, creditworthiness depends on certainqualitative, quantitative, and legal factors.However, a system’s credit standing can beenhanced by geographic, financial, and businessline dispersion. When rating systems, Standard &Poor’s evaluates the extent to which these creditenhancingqualities exist. Key rating considerationsalso include the system’s structure, management’sadministrative philosophy, and overall system levelfinancial track record—which naturally reflects anyeconomies of scale achieved through the consolidationof financial and management resources.The first step in the rating process is to evaluatethe system components that have covenanted torepay the debt issue. In the case of an obligatedgroup legal structure, Standard & Poor’s analyzes theobligated group and its relationship to the system asa whole. The entire financial profile of the system isanalyzed in addition to the obligated group’s profile.If the system employs a corporate-style unsecuredGO pledge, Standard & Poor’s focuses on the creditgroup, if applicable, as well as the entire system.Overall, Standard & Poor’s seeks to understand thesystem’s overall strategic plan, especially as it relatesto growth, operations and financial policy includingfuture capital and funding needs.Obligated GroupThe obligated group might not include all of the entitiesin the system. The initial obligated group oftenexcludes leased and managed facilities, ventures notrelated to health care, and for-profit corporations.Similarly, the group often excludes businesses thatmight diminish the group’s creditworthiness, such asmoney-losing physician businesses.Standard & Poor’s assesses any managementplans that would change the obligated group’sstrength. Potential acquisition, divestiture, anddiversification strategies are particularly important.Plans to divest an important revenue-producingentity or absorb a losing operation can affect theobligated group’s financial strength. Many systemsalso guarantee the debt of weaker institutions, as adiversification strategy or to buoy an affiliatedinstitution in distress. As a result, Standard &Poor’s examines the downside risk of guaranteesand in general fully factors those into the rating,although some credit is given in self-supporting situations.Standard & Poor’s also evaluates potentialtransfers of cash or other assets out of the obligatedgroup. Sheltering assets may be attractive forsome purposes, but often weakens the balancesheet from a credit perspective. Standard & Poor’sasks about any off-balance-sheet activity and willfactor in any contingent liabilities that existwhether they are on the balance sheet or not.Major operating leases for employed physicians,research or administrative space are generally factoredinto the analysis.Finally, Standard & Poor’s reviews the system’sactivity outside the obligated group. Health caresystems often have the opportunity to engage inhealth-related services and alternative deliverysystems, as well as speculative nonhealth-relatedprojects. Although these activities may take placein subsidiaries excluded from the obligated156 Standard & Poor’s Public Finance Criteria 2007

Not-For-Profit Health Caregroup, Standard & Poor’s evaluates the scope ofsuch ventures and assesses their impact on thesystem’s creditworthiness.System CompositionThe system’s individual components also are important.Answers to the following questions are criticalto system evaluation:■ In a system where members are geographicallydispersed, are they located in markets with favorableeconomies and are they competitively positionedwithin these markets?■ How integrated is the system from an operationsand finance perspective?■ What are the size, geographic location, and marketposition of the group’s major acute-care players?■ Is the system constrained by any regulatory, competitive,reimbursement, or economic environments?■ Are the scope and types of services variedthroughout the system?■ How effective is management at correcting problemsubsidiaries?■ Has management demonstrated a willingness todivest non-profitable subsidiaries?In addition, Standard & Poor’s evaluates eachentity’s percentage contribution to net revenues,assets, and profits, financial and admission trends,payor mix, and overall profitability. These factorsdemonstrate the degree of financial, geographic,and risk dispersion in the system. Positive ratingfactors associated with systems include managementexpertise, access to capital, economies ofscale, pricing flexibility, and the use of corporatepersonnel, centralized cash management, developmentof centralized information technology expertise,and insurance and pension trusts. In additionto these traditional strengths, the newly added systemsdemonstrate regional dominance through verticalintegration and the ability to adapt to localmanaged-care penetration. Also, in most cases, systemshave larger, more diverse revenue bases, makingthem less vulnerable to reimbursement andmarket pressures.Board and managementThe organizational structures of health care systemsvary considerably, based on board philosophy, aswell as more practical factors, such as the system’ssize, services, and geographic scope. These factorstranslate directly into the level of corporate controland the degree to which centralized services areavailable to subsidiaries.Regardless of a system’s organizational structure,management must be able to control the dynamicsassociated with a large corporation. Typically, ahealth care system has greater financial resourcesthan a single hospital and, consequently, greaterfinancial flexibility. Rating benefits derived from thisflexibility depend directly on the system’s ability tomanage these resources. If growth is being pursuedaggressively, what is the size of the overall capitalplan, how much debt is being used to finance newprojects versus internal cash flow, and are the plansprudent? Conversely, if the system is over bedded oroperating unprofitable ventures, is the flexibilitybeing used as a cushion to delay decisions? Is managementwilling to make hard decisions to divestunprofitable or non-strategic subsidiaries? Theseissues highlight management’s ability, as well as thefinancial planning capabilities of the system.Successful health care systems include regionalproviders offering a continuum of services, as well asthe more traditionally defined multi-hospital systems.The role of the board and its interaction with themanagement team continue to be areas of analyticalfocus, and a meeting with a member of the boardof trustees is desirable. The board’s size, composition,structure, and activity are noted, with particularconsideration given to its participation in settingstrategic and financial policies. In addition manynot-for-profit boards have adopted some or all ofthe rules articulated in the federal Sarbannes-Oxleylegislation. It is helpful to understand the Boardview of these rules and what, if any, have beenadopted by the Board.Major distinguishing factorsIn assessing the credit strength of various types ofsystems, Standard & Poor’s draws three major distinctions.First, distinctions can be drawn betweensystems formed by natural market synergies overtime and those formed more recently because ofmarket pressures. Whether they are regional ornational, the more mature systems formed over timegenerally are better positioned to take advantage ofthe incentives in the current health care market,while recently formed systems face the challenge ofinternal system integration, in addition to a multitudeof external pressures. While there still are benefitsto multi-state providers, including economic andregulatory diversification, national systems must createor participate in local mini-systems to competewith strong regional systems and alliances.Second, distinctions can be made between systemsthat have a salaried, hospital-based medicalgroup and those with a traditional medical staff. Asrevenues continue to be limited, systems that controlphysician resources will be best positioned tocontain expenses and maximize margins.For health systems that own their own managedcare plan, Standard & Poor’s evaluates the strategicand financial contribution of the plan. Criticalareas of analysis include:www.standardandpoors.com157

Health Care■■■■The plan’s position within the overall managedcare market, including products offered, pricecompetitiveness, market share, and compositionof the provider network;Impact of the plan on relationships with otherinsurance companies that the provider contractswith;Strategic purpose of owning the plan, such asincreasing market share, improving negotiatingleverage with existing market managed care players,better care management, or capturing a largerportion of premium dollars; andFinancial results, including the stand-alone performanceof the plan and its impact on financialresults of the rest of the health system.If the plan loses money, or is subsidized by thelarger system (these are often hidden subsidies)management will be expected to articulate a clearstrategic benefit for plan ownership, a detailed performanceimprovement plan, or a well-conceivedexit strategy.Finally, distinctions can be made between systems’managed care strategies. Many systems that haveowned managed care products through the pastdecade have extensive experience with underwriting,claims administration, physician integration, andresource control that can only be gained over time.As always, the presence of a single credit-enhancingfeature will not necessarily improve a rating. On theother hand, a system need not exhibit all the characteristicsdiscussed above to obtain a solid rating.Legal Criteria SummaryPart A: Structural provisionsSecurity■ Unsecured GO pledge.■ Revenue pledge, GO of the obligated group with or without a mortgage of the facility.■ A joint and several obligation of the obligated group.■ Negative lien covenant with senior lien debt limited.Permitted investments■ Investments rated by Standard & Poor’s in the investment-grade category.■ Obligations of, or obligations guaranteed as to principal and interest by the U.S. government or any agency or instrumentalitywhose obligations are backed by the full faith and credit of the U.S. government.■ FHA debentures.■ Obligations of government sponsored agencies that are not backed by the full faith and credit of the U.S. government (examplesinclude: FHLMC, FHL banks, FNMA, SLMA).■ Federal funds, unsecured certificates of deposit, time deposits, and bankers’ acceptances from any bank whose short-termobligations are rated by Standard & Poor’s and mature in less than 365 days.■ Deposits, not rated by Standard & Poor’s, but fully insured by the FDIC.■ Commercial paper rated by Standard & Poor’s in top two categories.■ Investments in money market funds rated by Standard & Poor’s in top two categories.■ Repurchase agreements with any transferor whose debt or commercial paper is rated by Standard & Poor’s.■ U.S. Treasury STRIPS, REFCORP STRIPS, and FICO STRIPS, or any stripped securities rated by Standard & Poor’s.Events of default■ Failure to pay principal, interest and premium when due.■ Failure to observe or perform any other covenant for 30 days (technical default).■ Default in the payment of any material indebtedness for borrowed monies.■ Obligor becomes bankrupt or insolvent.■ Cross-default provisions in legal documents.Remedies■ Acceleration by trustee permitted.■ Bondholders can force acceleration or waive certain events of default.158 Standard & Poor’s Public Finance Criteria 2007

Not-For-Profit Health CareLegal ReviewStandard & Poor’s evaluates the legal provisions of ahealth care bond issue based, in part, on the creditstrengths and weaknesses of the health care obligor.Legal provisions alone cannot prevent operating andfinancial performance declines, interruptions of debtservicepayments, events of default, and the risk ofoverall credit deterioration. Consequently, whileweak or liberal provisions can cause a lower ratingto be assigned, strong legal covenants generally willnot lead to a rating higher than that of the obligor.Credit quality determines the degree of influence thatlegal provisions bear on a bond’s rating.Legal covenants should provide protection tobondholders, while allowing hospital managementsufficient operating flexibility to respond to changingbusiness conditions. However, Standard &Poor’s will assess any future hospital action thataffects the hospital’s credit quality, even if suchaction is addressed in the legal documents, and willadjust the rating accordingly. In general not-forprofithealthcare providers will provide a gross revenuepledge with clear limits on senior debt. Inaddition, a rate covenant is expected along withreasonable transfer of assets tests including departuresfrom the obligated group.Unsecured health care pledgesA number of health care credits have chosen to issuebonds with an unsecured GO pledge, which is essentiallya promise to pay by a corporate parent withno underlying revenue pledge or mortgage from thehospitals or other operating units. There may be arevenue pledge from the parent itself. While theLegal Criteria Summary (continued)Part B: CovenantsRate covenant■ An event of technical default shall exist if, at any time, the net available falls below 100% of MADS on all long-term debt.■ The obligor shall employ an independent, nationally recognized consultant and immediately follow the consulting firm’srecommendations if the obligor’s net available falls below 110% of MADS on all long-term debt.Insurance■ The obligor must maintain adequate levels of coverage, including malpractice, business interruptions, and natural hazards withinsurance consultants reports discussing adequacy of insurance levels annually for any self-insurance programs.Notification■ The obligor agrees to notify:■ Bondholders and Standard & Poor’s immediately upon an event of default;■ Standard & Poor’s upon a change in the obligated group structure;■ Standard & Poor’s upon a change to legal structure;■ Standard & Poor’s upon the incurrence of additional debt;■ Standard & Poor’s upon entering into any SWAP transaction and■ Standard & Poor’s on any mode change.Part C: Legal TestsDisposition of assets■ Transfers of assets outside the obligated group must be limited.Mergers/consolidations divestitures/change in system composition■ Surviving organization assumes all concurrent obligations at time of merger or consolidation;■ No event of default immediately post transaction (including covenant defaults).Substitution■ Limitation on ability to substitute new security without bondholder approval.1. For a more complete listing of permitted investments see criteria for Qualified Investments for Municipal Transactions.2. In calculating debt service, Standard & Poor’s treats interim debt, balloon debt (which is expected to be refinanced) andvariable-rate debt as if it were long-term debt with level debt service payments at the current market rate. Standard & Poor’salso includes guarantees in its “worst-case” debt service calculation.3. The sum of excess income, depreciation expense, amortization expense, and interest expense.www.standardandpoors.com159

Health Carecorporate model has fallen into disfavor in recentyears, a number of the largest systems have thislegacy structure. While the corporate parent may ormay not have significant resources of its own, thebulk of the value-producing assets are not directlypledged to the debt. However, various internalarrangements allow the parent to collect moneyfrom constituent members to pay debt service.While this type of legal structure gained popularityin the mid-to-late 1990s for larger not-for-profithealth care providers, and is currently in disfavor, ithas been successfully time-tested in many otherparts of the U.S. corporate debt market.Standard & Poor’s ratings incorporate analysis ofthe legal documents; however, these security agreementsplay a secondary role in gauging and ratingan obligor’s ability and willingness to repay debt.Standard & Poor’s credit analysis always begins bylooking through obligated group structures to theposition of the organization as a whole regardlessof the specific pledge being provided. In some casesminor rating adjustments can be made for non-obligatedentities that are appropriately ‘ring-fenced’from the main obligated entity. This is discussed inmore detail within our senior living criteria.Standard & Poor’s expects that some credits willcontinue to use the unsecured GO structure or oneof its many variations, especially if its legal structureis already established in the market. The flexibilityof these documents must be matched by wisegovernance and sound management as fundamentalchanges in corporate assets can, and often do, havea profound impact on credit quality. Standard &Poor’s active and ongoing surveillance of thesecredits monitors the impact of additions, and moresignificantly, deletions of affiliates.Required covenantsIn general, Standard & Poor’s is comfortable analyzingthe concept of an unsecured GO pledge.However, to provide effective bond security, severalfeatures, outlined below, strengthen the obligor’scredit rating and legal and security arrangements.Credit rating: Credits issuing under an unsecuredGO pledge typically are rated ‘A+’ or better.Although Standard & Poor’s stated earlier that thisstructure by itself would not negatively affect a rating,lower-rated credits often do not have the creditcharacteristics necessary to prove to Standard &Poor’s that they can effectively manage under alooser legal structure.Senior debt: The unsecured GO debt typicallyremains the senior debt security for the entirehealth care system. To preserve the senior positionof this debt, Standard & Poor’s expects clearlydefined limits on senior liens outside this structure.As a benchmark, senior liens up to 25% of longtermdebt; unrestricted fund balance; or net property,plant, and equipment will be allowed in the documents.Access to cash: Senior corporate officersshould be able to quickly upstream cash and liquidinvestments without limit from constituent members.Rate covenant: The system as a whole, includingany contractual affiliates, should maintain arate covenant of at least 1x principal and interestcoverage of maximum annual debt service. Failureto meet this test should generate an independentconsultant’s report to the system’s governing bodyand senior management.Designated affiliate modelThe unsecured GO pledge also includes the conceptof designated or restricted affiliates. This model ismore like traditional legal structures, as it seeks tomarry the freedom of the unsecured GO pledge withsome of the characteristics of the more traditionalobligated group structure. Under this variation of theunsecured GO model, the parent, which remains theonly entity promising to pay, seeks to move the creditanalysis and the key legal covenants from the systemas a whole to a narrower subset of the system,namely restricted or designated affiliates. These affiliatesare bound to the parent either through ownershipor contract. In either case, however, the parenthas a clearly established mechanism to upstreamfunds for debt-service payments if necessary.A key difference between this structure and traditionalobligated groups is enforceability. As a result,although the designated affiliate model appears tobe structured like a more traditional joint and severalobligation, and within the system it essentiallyis a joint and several pledge, it actually cannot bedirectly enforced as such by bondholders. Rather,bondholders must rely on the parent’s obligation toenforce its internal documents. As a result,Standard & Poor’s legal analysis of the designatedaffiliate model will mirror that performed for pureunsecured GO pledges.One potentially troubling aspect of the designatedaffiliate model is the ability of the parent to designateand undesignated affiliates almost at will. Intheory, the parent could undesignate enough affiliatesso that the credit is fundamentally changed. Whilegenerally considered highly unlikely, this has thepotential to threaten management’s ability to repaydebt. In these cases, some simple additions to thepreviously stated requirements should be in place.Typically Standard & Poor’s sees at least 1xrate covenant calculated on the entire systemaudit, not just the credit group. In addition, theresults of contractually designated affiliatesshould be included within the rate covenantcalculation. If violated, this test will providethe board of directors and bondholders with avaluable independent assessment of managementand current operations. As always,160 Standard & Poor’s Public Finance Criteria 2007

Not-For-Profit Health CareStandard & Poor’s also expects that the unsecuredGO pledge remains the senior debt of thecredit group. The permitted lien test and its25% limit on lien debt that can run to the parentand designated or restricted affiliates asopposed to the system as whole, should remainin force at all times. Compliance should exist atall times, not just at the time of a new debttransaction. A common mistake is to treat thisas a transaction test instead of a default test. Ifapplied only at the time of a transaction, subsequentundesignations could leave the remainingmembers of the credit group in violation of thisprinciple. When properly structured, this testwill safeguard against the parent undesignatingaffiliates in such a way as to leave the systemwith too much senior lien debt. By making thisan on-going requirement, it precludes a violationof the test and, as a result, the rated unsecureddebt cannot fall to a junior lien positionwhen measured against the 25% allowed limit.Off-Balance Sheet DebtNonprofit health care organizations are increasinglyusing off-balance sheet debt to finance certainassets. How this usage is viewed from a credit perspectivevaries for a number of reasons. Some ofthe questions Standard & Poor’s asks to determinethe credit impact include:■ What are the assets being financed?■ Are they critical to the ongoing welfare and missionof the organization?■ What is the legal structure of the deal?■ Is there a moral or legal obligation involved?■ Are there true contingent liabilities being undertakenby the organization?The answers to these questions, combined withan obligor’s fundamental credit strength, are usedto gauge the potential rating impact of any offbalance-sheettransaction. In certain cases theimpact is significant; in others slight. In eithercase, Standard & Poor’s needs to be informed ofall off-balance-sheet transactions because theremay be financing risks that could have credit consequences.Issuers and obligors often perceive offbalance-sheetfinancing as a means to preservedebt capacity and enhance operating flexibility,with no impact on their senior debt rating—a freelunch, if you will. However, this is clearly notalways the case.Broadly speaking, off-balance sheet debt refers to ahost of different financing structures. These include:■ Sale/leaseback transactions;■ REIT financings;■ Various types of operating leases or guarantees;■ Contribution agreements between unrelated partiesto finance jointly owned assets; and■ Public/private joint ventures or partnerships,many with a real estate developer.The common element is that the repayment obligationdoes not appear as a liability on the ratedorganization’s balance sheet and, in some cases,may appear as an operating lease.Standard & Poor’s ascertains the risks of offbalancesheet transactions—regardless of thelegal structure—when a rated non-profit organizationis involved and the transaction is deemedimportant to the organization’s ongoing welfareor mission. Once the potential off-balance-sheetrisk is identified, Standard & Poor’s review of arated organization factors in the relevant risks,which include additional debt-service costs oroperating lease payments related to the financing.The potential of having to “step up” to a guaranteeis also assessed. The impact on a rated obligor’sdebt could range from minimal to high, inwhich case it is treated as the equivalent of anobligation on parity with the obligor’s own debt.This range reflects the legal structure as well asthe degree to which an organization, as a whole,is legally or equally as important, morally obligatedon the transaction. The importance of theasset being financed via the off-balance sheet tothe overall mission and strategy of the organizationis also central in determining the extent ofthe rating impact.The potential risks of off-balance-sheet financingsinclude:■ The potential dilutive effects on the rated obligor’sbondholder security;■ Risks associated with the ownership and controlof the asset being financed;■ Potential liability and poor public relations if theoff-balance sheet financing encounters financialproblems;■ Strained managerial resources resulting fromadministration of an off-balance-sheet projectand related financing program; and■ Potential jeopardy of the rated issuer’s taxexemptstatus.Fueling the rise in off-balance-sheet financing arethe following one or more goals:■ Preserve debt capacity by only financing the mostmission-critical assets or programs with the obligor’sstrongest security;■ Enhance financial flexibility by proceeding on aspeedier time table than that required for a moretraditional bond financing;■ Increase risk sharing through joint ownership orother collaborative relationships;www.standardandpoors.com161

Health Care■ Financing terms that can be more flexible and moresuitable to the specific asset being financed; and■ Legal covenant flexibility.In addition, some entities, especially in seniorliving, are attempting to fund non-recourse projectswith limited support from an obligated entity.While Standard & Poor’s always begins its analysisof the organization as a whole, there are limitedcircumstances where obligated group performancecan be ‘ring-fenced’ from the impact of nonrecoursedebt that in most cases is dilutive to theobligated group. In these cases Standard & Poor’swill review the strategic importance of the nonobligatedentity, the financial relationship betweenthe parties, the scope and depth of managementresources and legal issues. In some case the debt ofthe obligated group can be up to three notcheshigher than the consolidated rating of the organization.This is discussed in more detail in the seniorliving criteria. ■Senior LivingThe majority of rated credits in Standard & Poor’sRatings Services not-for-profit senior living sectorare either single-site continuing care retirementcommunities (CCRCs), or multi-facility organizationswhere CCRCs comprise the majority of theorganization. CCRCs typically offer independent living,assisted living, nursing care, and additional servicesto senior citizens pursuant to a long-termresident contract. These contracts may include paymentof an entrance, or advance fee as well as amonthly maintenance fee. CCRCs appeal to manyelderly people because of the variety of living andservice arrangements available, and the security ofconvenient access to nursing care and other supportservices if, and, as they become needed.The majority of Standard & Poor’s CCRC creditratings are in the ‘BBB’ or ‘A’ categories. Ratingstend to cluster in the lower end of the investmentgradespectrum because of industry-risk factors,including the competitive and fragmented nature ofthe business, the small size of many CCRCs, thediscretionary nature of the services provided, andthe significant demand for capital to update facilitiesin order to attract an increasingly sophisticatedand demanding resident population, resulting ingenerally high leverage and debt burden.Historically, the industry has generally been relianton investment income to offset operating losses andkeep annual price increases to a minimum. In thepast several years, however, the industry as a wholehas focused greater efforts on generating positiveincome from operations, since market volatility canlead to unstable earnings and coverage trends. Thisshift is one of the drivers behind the recent stabilizationof long term care credit ratings.Standard & Poor’s analysts evaluate a CCRC’screditworthiness based on the organizational structure(including whether it is a standalone facility ora multi-site organization), the strength of the organization’sgovernance and management, demonstrateddemand for existing and planned facilities,and the adequacy and predictability of key revenuesources. The mix of private versus governmentalrevenue sources is also relevant to the analysis, asMedicaid and Medicare reimbursement can beunpredictable. Additionally, because of the serviceorientednature of this business, the ability to keeprevenue increases in line with labor and other costsis key to Standard & Poor’s analysis. A strongemphasis is placed on adequate liquidity, to meetoperating and debt-service costs, as well as futurecapital needs and future service liabilities if theorganization offers life care contracts. In addition,the service offerings, location, and the conditionand attractiveness of the physical facilities are comparedwith those offered by other competitors inthe service area, as well as the merits of the proposedproject and financing. Financial performanceis evaluated, including the use of ratio analysis, todetermine the ability of the organization to meetoperating costs and existing and planned fixed-capitalcosts. The annual ratio report for CCRCsexplains our ratios in detail. Future capital plans, aswell as potential projects at affiliated organizations,are also considered.Organizational StructureSystem ratings generally are higher than ratings forsingle-site facilities because of the financial andnonfinancial synergies and the dispersion of riskthat generally accrues to systems. Standard &Poor’s approach to rating senior living systems issimilar to that used for single-site facilities. In bothcases, creditworthiness depends on certain qualitative,quantitative, and legal factors. However, a162 Standard & Poor’s Public Finance Criteria 2007

Senior Livingsystem’s credit standing can be enhanced by geographic,financial, and product line dispersion.When rating systems, Standard & Poor’s evaluatesthe extent to which these credit-enhancing qualitiesexist. Key rating considerations also include thesystem’s structure, management’s fiscal and administrativephilosophy, and overall system level financialtrack record—which naturally reflects anyeconomies achieved through the consolidation offinancial and management resources.ManagementStandard & Poor’s analysis of the organization andmanagement of a CCRC is extensive. While themanagement strength and expertise of board membersin the industry has grown significantly, thisarea was at one time a significant weakness. A sitevisit and tour of the facility and service area areusually required for all proposed financings.Standard & Poor’s representatives typically meetwith key members of the administration and board,and management company (if under independentmanagement contract). It is also desirable for representativesof the sponsoring organization to attendthis meeting to discern their role in, and commitmentto, the continuation of the enterprise.An organization’s track record is one strong indicatorof management’s ability and the board’s rolein oversight. However, similar to the acute care sector,senior living has been impacted by outside pressuressuch as economic forces, rising insurancecosts, reimbursement pressure and staffing challengesin skilled nursing, to name a few.Standard & Poor’s analysis of management seeks todetermine whether the management team exhibitsthe depth and experience to identify and react toupcoming challenges, to budget effectively, monitorand control financial and personnel resources, anddevelop and implement a dynamic strategic plan toenhance the overall health of the organization.Management’s ability to assess its institution’sstrengths and weaknesses and to develop soundstrategies to enhance the institution’s competitiveposition is crucial to continued success. In meetingswith Standard & Poor’s, management teams shouldbe prepared to discuss these topics in detail. Theprovider’s management, information, and capitalbudgeting systems should be appropriate for thesize, type, and complexity of the institution.Standard & Poor’s discusses with management thetypes and frequency of monitoring and reporting tothe staff and to the board of trustees. Credit considerationsinclude the organization’s:■ Mission;■ Governance structure and financial goals;■ Compliance procedures with regulatoryauthorities;■■■Accreditation;Financial planning and budget preparation; andRole of the Board in reviewing and providinginput into the issues noted above.Demand, Market Position And DemographicsDemand is a key indicator of the financial health ofa CCRC, and demand is driven by both competitivecharacteristics of a facility (the attractiveness of theproduct, the service offerings and amenities, as wellas pricing), and the demographics and economiccharacteristics of the service area. In this regard,Standard & Poor’s evaluates the appropriateness ofthe CCRC’s marketing program, product offeringsand pricing relative to service area characteristics.Management and/or its financial representativeswill be expected to prepare a competitive marketprofile of existing and proposed CCRCs and otherorganizations that could be viewed as competitorsin the service area, including stand-alone assistedliving, skilled nursing facilities, or other senior residentialcommunities. The analysis should includecensus by contract and/or unit type and shouldindicate the fees in effect for each major type ofcontract or service offered. Area population trends,per capita wealth and income levels, as well asmedian home prices are also part of the analysis.Additionally, the relation of a project’s entry fees toarea median home prices, as well as trends in thereal estate market, are explored.In addition to service area and competitive information,Standard & Poor’s reviews a range of operatingstatistics, including occupancy by level ofservice, unit turnover rates (due to move-outs anddeaths), and fill-up rates of any new units, as thesemeasures are also indicators of a facility’s demandand desirability.Contract TypesThere are a variety of important financial factorsthat Standard & Poor’s examines in addition to anorganization’s audited financial statements andratios. These factors can influence how financiallystrong the institution must be to offset certain risks.For example, three main contract types are used byCCRCs, either singularly or, more recently, in combination.However, certain contract types are riskierthan others. The first type is known as a Type A, orlife-care contracts. The distinguishing feature of thiscontract type is that the resident pays one monthlyfee regardless of the level of service received (i.e.,whether the patient is in independent or assisted livingor skilled nursing). Type A contracts pose thehighest level of risk, as the organization must managethe cost of resident care effectively with morelimited ability to recoup costs through higher fees.For all providers, entrance requirements and screen-www.standardandpoors.com163

Health Careing procedures (financial and health-oriented) areanalyzed, but this may be most critical to life-careorganizations, which are essentially offering longtermcare insurance to residents.The Type B, or modified, contract typically offersthe same range of service levels and amenities as alife-care contract, except that the contract typicallyprovides only a fixed number of skilled nursingdays at no charge, with any excess utilization subjectto a full or discounted per diem charge. Thetotal number of fixed days can vary depending onthe organizations specific contract details. When aresident moves permanently to a higher level ofcare, he/she pays higher rates for that service level.Typically, entrance fees and monthly maintenancefees are lower for CCRCs offering Type B contracts,reflecting the substantial reduction of thepotential health care liability.The third contract type is the Type C, or fee-forservicecontract. Facilities employing this contracttype charge different rates for each level of care,and may also offer more services and amenities ona fee-for-service basis. Residents are guaranteedaccess to nursing care, but pay full per diem rates.Other features now offered by CCRCs are refundableadvance or entrance fees; with these contracts,the refund amount is negotiated in advance, and usuallytied to length of occupancy and/or resale of theunit. At this time, a 90% refund model is becomingmore common; entry fees under this type of contractare typically significantly higher than non-refundableentry fees, but the organization has limited ability tosignificantly build reserves after initial fill-up as subsequentresident turnover only generates limited cashflow. Refund policies, while fulfilling a marketdemand, add an element of risk. Strong actuariallydetermined reserves help offset these risks. BecauseCCRC providers frequently offer refundable advancefees as an option, more scrutiny is devoted to howmonthly fees are determined and subsequentlyadjusted, as well as the conditions for the entry feerefund (primarily whether it is dependent on unitreoccupancy). Even the refundable contracts that aredependent on reoccupancy usually have languagethat sets a fixed time frame for resale before therefund must be returned, typically up to one year.However, this concern is somewhat mitigated if anorganization has a history of strong demand and typicallyrefills a unit in a much shorter time frame.Financial PerformanceOne of the basic factors that determine financialstability is an organization’s ability to match its revenuesto its cost structure. In the senior livingindustry, one basic factor influencing this is thecontract type, as noted above. Additionally, a historyof monthly and entry fee rate increases as well aspricing philosophy are central to the analysis.Additionally, Standard & Poor’s examines the organization’scontracts and pricing methodology vis-àvisits ability to recoup the cost of providingservices. On the cost side, Standard & Poor’s evaluatestrends, particularly with regard to more recentpressures such as liability and workers compensationinsurance, and nurse staffing and other laborcosts. Finally, Standard & Poor’s will review theCCRC’s overall financial performance and projections.Key financial indicators include operatingand excess margins, revenue and expense growthrates, coverage of pro forma maximum annual debtservice, debt burden, and days’ cash on hand. Thesources and reliability of nonoperating income—including contributions, and endowment earnings—are also evaluated.Balance Sheet And Capital ProgramCash reserves and overall leverage measures play akey role in evaluating a senior living organization’screditworthiness. A solid balance sheet can offsetthe risk of the health care liability of a life-carefacility, for example, or earnings volatility related tocost spikes or occupancy pressures. Key debt ratiosinclude debt service as a percentage of revenues, thedebt-to-capital ratio, debt-service coverage, and thecash-to-debt level. A review of investment policies,asset allocation and endowment spending policiesare also examined. To determine whether the cashflows of the CCRCs are sufficient to meet thefuture health needs of the resident population,Standard & Poor’s will also review the most recentactuary’s report, with related assumptions.As in all revenue-bond analysis, Standard &Poor’s focuses on the structure of a proposed debtissue from an economic and legal standpoint toensure that the proposed structure is feasible inlight of the obligor’s existing financial performance,commitments, and debt capacity. Project-relatedfinancings are generally supported by an independentfeasibility study prepared by a consultant withextensive experience in the CCRC industry. In additionto the project that is the subject of the bondissue being rated, Standard & Poor’s evaluates anorganization’s strategic and financial plans over athree-to-five year period, including annual capitalspending as well as any significant upcoming developmentprojects or future debt plans. Standard &Poor’s incorporates to some degree any expecteddebt or spending that is planned to occur within aone-to-two year time frame, but also seeks tounderstand the longer-term strategic direction andplanned financial goals of the organization.164 Standard & Poor’s Public Finance Criteria 2007

Senior LivingLegal CriteriaStandard & Poor’s legal criteria for CCRC financingsare similar to those for health care revenuebond financings. They include:■ A revenue pledge of the CCRC. A mortgage mayalso be offered.■ A fully funded debt service reserve fund at bondclosing.Residents’ and other creditors’ claims to entrancefees should be subordinate to debt-service payments.-Documentation Requirements for CCRCsFactoring Non-Recourse Debt In Senior LivingGrowth strategies in the senior living sector, includingdevelopment of new communities or expansionsand/or redevelopment of existing campuses, representboth an opportunity, and potential added creditstress for rated organizations. Opportunitiesinclude increased risk dispersion, the ability to capitalizeon demographic growth, leverage managementstrength, create revenue diversity and expenseeconomies of scale, and allocate overhead expensesover a larger revenue base. Campus redevelopmentprojects allow organizations to maintain marketabilitythrough offering bigger units, moreDocumentation Requirements for CCRCsThe following documentation is required to complete any credit analysis:■ Three to five years’ audited financial statements, with current and prior-yearunaudited interim statements;■ A sources and uses statement for the bond financing;■ A debt service amortization schedule;■ A description of the obligor, including members of the board of directors andmanagement team, and affiliated organizations;■ A description of the service area, including demographic and economic supportingdata;■ Utilization and payor mix data for major business segments for the past fiveyears and current year budget;■ Current-year financial budget with supporting assumptions;■ Resident contract types and refund policies in effect for CCRCs; and■ History of advance fees and maintenance fees for CCRCs and/or room rates fornursing home services.The following additional documents are needed to complete a public rating:■ A preliminary official statement;■ A three-year financial forecast with related assumptions for project financing;■ Legal documents;■ The latest actuary’s report;■ The past two years’ auditor’s management letter comments,with management’s response; and■ For new credits, a site visit, including a management meeting and tour.amenities, such as fitness centers, or a wider rangeof services including Alzheimer’s care. Additionally,there are a significant number of senior livingorganizations that were built thirty or more yearsago, which require major reconstruction in order tomeet expectations of today’s seniors. Typically, suchprojects are funded primarily with debt, so managementmust balance the potential long-term benefitof the projects with the near-term construction andfinancial risk and potential rating impact of theadditional debt.The capital-intensive structure of most developmentstypically requires the issuance of a relativelylarge amount of debt, potentially creating financialstress. Long-term debt increases the financial risk ofthe organization in the near-term by straining theincome statement with increased debt service, andincreasing leverage on the balance sheet.Standard & Poor’s looks at existing “in-groundcoverage” as one important measure of financialimpact—-whether the existing organization can paythe full amount of the new total maximum annualdebt service (as well as its existing debt service)without the benefit of new project revenues, in casethe project experiences significant delays in constructionor fill-up, prolonged start-up losses, or inrare cases, project failure. With projects that producenew units, the cash and revenue payoff is usuallyanticipated three-to-five years out, soStandard & Poor’s views this as a period of crucialrisk. Once the facility achieves stabilized occupancy(typically 90%), the organization has a significantincrease in liquidity from the entry fees receivedupon fill-up, and may use some of this cash to paydown a large portion of the project-related debt—inmany cases, this is a scheduled pay down that ispart of the original plan of finance.When developing or acquiring a new facility, anorganization can leverage the credit strength of therated entity by issuing new project debt as part ofthe existing obligated group. However, many seniorliving organizations do not believe that ‘start-uprisk’ of a new project should be borne by residentsof existing facilities. Additionally, as a practicalmatter, many credits are not strong enough to successfullyhandle the costs and risks of a majordevelopment project without negatively impactingtheir current rating. In order to protect residents ofexisting facilities, as well as protecting their creditstrength, some organizations segregate new projectsfrom the rated entity (typically an existing obligatedgroup), by issuing debt through non-obligated subsidiaries,or through non-recourse ventures. In addition,a number of senior living organizations areadopting a range of covenants and organizationalstructures aimed at protecting, or “ring-fencing”the rated entity.www.standardandpoors.com165

Health CareHowever, Standard & Poor’s seldom views thesenew entities as totally “off-credit” from the existingorganization. Instead, we perform an extensiveanalysis designed to determine whether the existingorganization can be separated, to some degree,from the consolidated credit, and if so by howmuch. The analysis hinges on how closely the nonobligatedentities are tied to the existing obligatedgroup, both legally and strategically. Non-obligatedcommunities that further the mission and strategicintent of the rated organization, that are locatednear existing obligated communities, and that havethe same or a similar name will likely be viewed asvery closely connected to the rated organization.We also seek to understand what the financial commitmentsare between the rated organization andaffiliated project, what support has historically beenprovided, if any, and whether the management teamof the rated organization has the ability and willingnessto let the non-obligated community fail in aworst-case scenario.Analytical Treatment Of Non-Recourse DebtIt is Standard & Poor’s long-standing practice tofactor “off-balance sheet” debt related to a ratedorganization into the assessment of that organization’sfinancial profile and creditworthiness, regardlessof the accounting treatment surrounding theobligation. This includes “non-recourse” debt issuedby non-obligated affiliates related to a rated entity.In the not-for profit health care and senior livingsectors, the historical approach was to base the ratingon a review of the consolidated entity (includingboth obligated and non-obligated entities, oftenunder a parent organization) rather than only theobligated group, in keeping with Standard & Poor’scriteria in other sectors. Under this approach, nonrecoursedebt and the risks associated with the nonobligatedventures (in this case, typically start-upCCRCs) were fully incorporated into the ratedorganization. The basis for this position was thatthe parent entity (which may or may not be part ofthe obligated group) may have the ability and incentiveto divert resources from the financially healthyobligated entity in support of troubled non-obligatedaffiliates. Efforts to segregate risk, as well as theorganization’s legal ability and a willingness todivest of troubled entities, were not typically considered.This criteria has evolved in recent years, however,to incorporate the efforts by not-for-profitproviders in this sector to segregate risk and toallow for some separation, in many cases, of therated entity from non-recourse project risk.In all cases, the rating of a financially healthyobligated group is still constrained by the creditworthinessof the consolidated organization. The centralcriteria issue is whether a rated entity can be sufficientlyinsulated (or “ring-fenced”) from the creditrisks of new communities such that an obligatedgroup can be rated higher than the consolidatedentity. Standard & Poor’s believes “ring-fencing” ispossible in some cases, and has adapted existing criteriasuch that it is appropriate for not-for-profitorganizations. Most importantly, there are bothlegal and strategic considerations, which focus onboth the organization’s ability and willingness toallow non-recourse debt to be supported only by itsspecifically pledged revenue, with no additional supportfrom the rated entity, if the non-obligated ventureis not able to meet its financial commitments.The legal criteria include the use of a set of structuralfeatures, covenants and collateral similar to thoseused in corporate sector (see “Ring-FencingCriteria” below). Qualitative criteria that analystswill examine range from basic operating issues suchas co-branding practices and location of the facilities,the strategic importance of the non-obligatedfacility or facilities, to the financial relationshipsamong the various parties and any history of supportfor, or divestiture of, non-obligated entities.If an obligated group is successfully “ringfenced”,the rated credit can have its rating up to afull rating category higher than the fully consolidatedanalysis would suggest. However, in many cases,a development project is linked to the strategicgoals of an organization and therefore the parent oreven an obligated group may extend limited supportfor start-up projects or offers some assistanceto a troubled facility before deciding to abandonthe venture. Therefore, assumptions regarding thelikelihood of any future support are factored in,even if the full amount of debt is not consolidated.The rating decision to ‘float’ a rating one, two orthree notches higher than the rating that an analysisof the consolidated entity would suggest, remains ajudgment of the rating committee, but this judgmentwill be based on four main factors:■ Strategic importance;■ Financial relationships among parties;■ Scope and management resources; and■ Legal issuesAs a starting point, Standard & Poor’s analyzesthe creditworthiness of the consolidated organization,assuming the full debt burden and operationalrisk of both obligated and non-obligated affiliates.The creditworthiness of the obligated group is alsoanalyzed on a standalone basis, without taking intoconsideration any risk of non-obligated entities.The ultimate rating is determined by analyzing thestrategic value and risk of non-obligated affiliates,as well as the financial relationships among theentities. In addition, the legal structure and securityfeatures of the obligated group are analyzed, todetermine whether Standard & Poor’s “ring-fenc-166 Standard & Poor’s Public Finance Criteria 2007

Senior Livinging” criteria may apply. In some cases, even if theobligated group is adequately “ring-fenced” fromcredit risk of non-obligated affiliates, other factorscontribute to a closer linkage than the legal structurealone may suggest.In general, the rating model looks like this:Strategic Importance: The Probability Of SupportThe single most important judgment thatStandard & Poor’s rating analysts will make iswhether the management team of the rated organizationwould let the non-obligated community failin a worst-case scenario. To understand this, it isimportant to understand the strategic importance ofnon-obligated facilities. Non-obligated communitiesthat further the mission and strategic intent of therated organization, that are located near existingobligated communities, and that have the same or asimilar name will likely be viewed as closely connectedto the rated organization. An organization islikely to provide at least some assistance to a troubledcommunity, or be hesitant to divest of a projectthat has strategic importance. Another relatedconcept is that the obligated entity may have a“moral obligation” to support a community, particularlyif it is co-branded and located in a contiguousor market with existing communities or sharesa common sponsor—often a religious entity. Thisconcept is based on the supposition that a ratedentity may, from a practical standpoint, be forcedto support a non-obligated facility, if not doing socould potentially cause damage to an organization’sreputation or standing within a community. Forexample, if a “John Doe House”, a (fictional)CCRC, adds a second campus in close geographicproximity and calls it “John Doe House South”,and the campuses are associated with each otherfrom a marketing perspective, the parent or evenJohn Doe House management would likely supporta troubled John Doe House South rather thanabandon it to bankruptcy or closure.Financial Relationships Among PartiesOther evidence of linkage or separation can bedetected from an analysis of the financial commitmentsamong the obligated and non-obligated entities,as well as the obligated group’s track record indealing with affiliated projects. Most obvious areasto examine include inter-company loans, cash transfersor other movement of funds or undertaking ofliabilities among obligated and non-obligated entities.Another important, but more subtle financialrelationship that exists between obligated and nonobligatedentities (or between a parent and its obligatedand non-obligated affiliates) is related tomanagement services. Management relationshipsand fees charged for management services should beclearly formulated and documented in the form of acontract. Waiving or subordinating management feesfor projects that are experiencing financial difficultyis one means of providing support for an entity thatfalls short of explicit cash transfers, loans or subsidies.Similarly, an undefined fee methodology (orcharging of higher or lower fees to communitiesbased on financial health) can be a way to assist anailing community. An organization’s track record inthis regard is germane to assessing the degree oflinkage or separation of an obligated group. A historyof divesting of under-performing organizations isalso helpful in this area.Scope And Management ResourcesOne of the most qualitative and least tangible areasof analysis is the question of the commitment ofmanagement resources toward non-obligated ventures,and the magnitude of the non-obligated projectsrelative to the obligated group. Even if theobligated group is legally “ring-fenced” and has nohistory of financial support for non-obligated projects,significant growth activities can pose creditrisk, by potentially stretching the resources of theobligated group’s management team or causingmanagement to lose focus on core operations.Related to this, the sheer scope of non-recoursedebt relative to the obligated group may be a creditconcern, for example if non-recourse debt is ordersof magnitude larger than the obligated group debtand financial resources.Ring-FencingConsolidated Entity RatingParent and All Subsidiaries(Obligated and Non-Obligated)Assumes Full LinkageDegrees of Linkage/Ring-FencingRating Continnum (Maximum 3 Notches)Obligated Group RatingOnly OG EntitiesAssumes Full Ring FencingMore LinkedMore Ring-Fencedwww.standardandpoors.com167

Health CareLegal Issues Related To Non-Recourse DebtStandard & Poor’s analysis hinges upon assessingboth the willingness to support non-obligated entities(demonstrated by the issues above), and theability of an organization to do so. AcrossStandard & Poor’s, the ability to rate an obligatedgroup or subsidiary higher than the consolidatedentity hinges first on whether the entity meets a rigorousset of legal criteria (see ‘Ring-Fencing’ sectionbelow). The security features are designed to limit aparent entity’s ability to drive the subsidiary (in thiscase, an obligated group) into bankruptcy, or totransfer assets or liabilities in support of non-obligatedaffiliates. If the legal criteria for “ring-fencing”are met, then the other factors affectinglinkage are then considered.In addition to security features and other legalissues, the regulatory environment in which aCCRC operates also plays a role in the analysis.States with strong regulatory oversight may limit orprohibit a CCRC from transferring funds outsidethe community to troubled affiliates. A strong regulatoryenvironment could have positive credit implicationsin this regard.‘Ring-Fencing’ In The Not-For-Profit Hospital SectorHistorically, the analysis of other health care credits(i.e. acute care hospitals and health care systems)has been based on fully consolidated results includingobligated and non-obligated parent companiesand subsidiaries. At times this has benefited entitiesespecially when closely aligned, for example whennon-obligated foundations with large endowmentsare factored into overall ratings. However, in theacute care sector, the most common non-obligatedsubsidiaries have been physician enterprises.Typically these entities dilute the performance ofthe obligated group. However, the physician enterpriseare generally essential to the on-going operationsof the organization as a whole, so no matterhow legally segregated they are, Standard & Poor’sconsiders them to be very closely linked to the ratedentity and therefore a consolidated approach isused. Other types of subsidiaries can range frompharmacy operations, to nursing homes to medicalequipment companies as well as to a broad range ofhorizontal expansion into control of other hospitals.While we expect to continue to review thesearrangements in light of the “ring-fencing” criteria,these types of subsidiaries usually support the overallmission of the organization, are direct subsidizedby the obligated group directly or indirectly, andthus would continue to be reviewed as a singleorganization for credit rating purposes.‘Ring-Fencing’ CriteriaIn general, the rating of a weaker parent constrainsthe rating of an otherwise financially healthy, whollyowned subsidiary. A weak parent has the ability andmay have the incentive to siphon assets out of itsfinancially healthy subsidiary and to burden it withliabilities during times of financial stress, althoughthis scenario is less likely within a not-for-profitcontext. The weak parent might also have an economicincentive to file the subsidiary into bankruptcyif the parent itself were forced into bankruptcy,regardless of the subsidiary’s stand-alone strength.Ring-fencing may allow for an exception to thisrule. In appropriate circumstances, a package ofenhancements, including legal and structuralinhibitors to a filing of the subsidiary by the parentand provision of so-called “nonpetition” languageby the parent, along with other considerations suchas regulatory insulation, may allow a subsidiary’srating to be elevated over the credit quality of theconsolidated entity (assuming the stand-alone ratingof the subsidiary merits the same). Typically,Standard & Poor’s will not rate even ring-fencedsubsidiaries more than three “notches” above thecredit quality of the consolidated entity.Additional Documentation Requirements For ’Ring-Fencing’■ Audited financial statements of obligated group andconsolidated audited financial statements of parentand all affiliates (three years)■ Obligated group trust indenture and other legal documents,including any that evidence limitations on transfers ofcash outside the obligated group■ List of board members of parent, obligated group facilities,and non-obligated facilities, including identification ofindependent directors■ Number and composition of board members requiredto transfer assets outside a community, make loans toaffiliates, or file bankruptcy.■ Reserve powers of the parent and/or obligated groupboard of directors, particularly with regard to nominationand replacement of directors■ Copy of management services agreement and informationon management fee methodology■ Any limited support agreements from parent or obligatedgroup to non-obligated affiliates, including plans toreplenish resources at the parent level if supportagreements are drawn upon;■ Legal opinions (non-consolidation)■ Information on the role of the state regulatoryagencies governing CCRCs.168 Standard & Poor’s Public Finance Criteria 2007

Physician Groups And Faculty Practice PlansStructural featuresStructural features are focused on addressing twomain concerns: (1) whether a healthy obligatedgroup’s assets may be subject to substantive consolidationin bankruptcy in the event of insolvency ofthe parent or non-obligated entities; and (2)whether the parent may have the ability to causethe subsidiary to file itself into bankruptcy.Moreover, the structure of a “ring-fenced” subsidiaryshould have mechanisms in place restrictingthe ability of the parent to siphon off assets or burdenthe subsidiary with liabilities. In structuredfinance, these concerns are partially addressedthrough the use of a special purpose entity (SPE)subsidiary. It is conceivable that some of these featurescan be applied to senior living 501©(3) organizations,including:■ The incorporation of each obligated group facilityinto a separate 501©(3), special purposeoperating entity (SPOE). A special purposeoperating entity is not a bankruptcy remoteentity, as that term is traditionally used in structuredfinance transactions, although it doesshare some characteristics);■ The creation of a duty of the board of directorsof the special purpose operating entitytowards the residents of the senior living facilityin question (this should be consistent withthe charitable purposes for which the 501©(3)was established);■ Provision of a non-consolidation opinionbetween the parent and the special purpose operatingentity, where appropriate;■ “Independent director” on each SPOE board,unrelated to or affiliated with the parent whosevote is required to file the facility into bankruptcyand to approve contracts, notes or other obligationswith the parent.CovenantsCovenants are often offered as a means to justifyratings separation, particularly protective covenants(designed to limit transfers of assets) and the nonpetitioncovenant (in which the parent undertakes notto file the subsidiary into bankruptcy). Standard &Poor’s view is that in and of themselves, covenantsdo not sufficiently insulate a subsidiary from its parent,but a tightly drafted covenant package isdesired, including but not limited to:■ Negative pledges.■ Nonpetition covenant.■ Restrictions on asset transfer and inter-companyadvances.CollateralIf debt issued by the senior living obligated groupdebt is fully secured by a pledge of all or substantiallyall of the assets of the obligated group facilities,such pledge should reduce the parent’sincentive to attempt to cause the obligated group tovoluntarily file itself into bankruptcy. Such a securitypledge could include:■ A gross revenue pledge and a general pledge ofassets, including mortgages;■ The parent’s pledge of any interest in the subsidiary;■ All pledges must be perfected; and■ In addition, all non-recourse debt must be similarlysecured.For a complete description of Standard & Poor’s‘ring-fencing’ criteria, please see, “Ring-Fencing ASubsidiary”, RatingsDirect, Oct. 19, 1999. ■Physician GroupsAnd Faculty Practice PlansHealth care industry changes, including reimbursementreforms at the state and nationallevels during the past 15 years, have helped developand expand more cost-effective outpatient treatments.At the same time, limitations on physicians’income and the emergence of large hospital-basedoutpatient departments have increased physiciangroup competition with hospitals by bringing businessinto physician-owned outpatient settings thattraditionally have been performed at hospitals.Ambulatory surgery and radiology procedures aretwo good examples that are often offered by wellorganized,well-capitalized multi-specialty grouppractices, and typically at a lower price than hospitals.These physician groups occasionally needaccess to capital to build facilities and purchaseequipment that will allow them to provide costeffectivehealth care services.www.standardandpoors.com169

Health CareRating CriteriaStandard & Poor’s Ratings Services applies the followingcriteria to the outstanding public financegroup practice ratings. In addition, portions of thecriteria are applicable to the analysis of physiciancomponents in integrated delivery systems.Rating considerations for not-for-profit physiciangroups include analysis in the following categories:■ Physicians■ Operations■ Finances■ Competition■ Leadership■ Institutional relationships■ Information systems; and■ Legal covenants.The most critical factors for ratings assessmentare the physicians, operations and finances. Theother aspects of the clinics discussed below contributeto strength in these key areas:PhysiciansThe most critical part of the rating process focuseson physicians, since they are the actual revenue producers.The composition, qualifications, quantity,and quality of the physician group play an importantpart in the analysis. In addition, physicianleadership’s philosophy and overall strategic vision,including managed care contracting and willingnessto forge alliances with alternative providers, is animportant rating factor. Although the analysis willbe slightly different for stand-alone group practicescompared with faculty practice plans, in general,Standard & Poor’s reviews the following factors:■ Number and specialty mix of physicians, includingadequacy of primary care physicians currentlyin the group, as well as recruitment plans andrelated funding;■ The nature of the local physician market (forexample, practice patterns, general availability ofphysicians, and the competitive position of thegroup in the market);■ General administrative factors including the credentialingprocess as well as the type of employmentcontract used—noncompete clause,compensation allocation consistent with managedcare incentives, salaries competitive with industrynorms by specialty and with local salaries;■ Top-10 revenue-producing physicians (includingpercent of total revenues generated, age, and tenurewith the group), the overall staff’s average age,board certification rates, as well as additions/deletionsto the staff in the past three years; andFor faculty practice plans, ages and tenure of thechairs of the top-five revenue-producing departments,vacancies in the major services (internalmedicine, surgery, obstetrics, family practice), andpercent of tenured faculty.OperationsThe history of the group practice, its structure, andits longevity are the starting points in Standard &Poor’s evaluation of the credit. The primary considerationis the likelihood that the group practice willremain viable for the life of the bonds.Consequently, Standard & Poor’s Public FinanceRatings group will rate debt issued only by not-forprofitgroup practices; the financial and operationalincentives of a proprietary group generally are notconsistent with the capital retention levels necessaryfor an investment-grade rating. Overall investmentgrade physician groups will demonstrate a competitivebusiness position, a sound balance sheet and atrack record of adequate cash flow and debt servicecoverage. Beyond understanding how and why thephysicians came to work together, Standard &Poor’s must assess the group’s ongoing strategy andits appeal to physicians in the future.Standard & Poor’s focuses primarily on multispecialtyclinics with 100 doctors or more. Amongthe operational aspects of the clinic Standard &Poor’s examines are:■ History of the group;■ Market position and breadth of patient draw;■ Nature of relationship with other medical facilities■ Economics of service area;■ Current physical assets and proposed futureneeds; and■ Debt structure including use of bond proceeds.CompetitionMulti-specialty group practices compete not onlywith other groups and solo practitioners, but oftenwith outpatient surgery centers, diagnostic centers,testing laboratories, and hospitals. A group’s abilityto attract and retain physicians and patients is paramountto the rating. As competition for patientsamong physicians and other providers intensifies,group practices must demonstrate their cost effectivenessand ability to attract patients and profitablemanaged care contracts. Multi-specialtygroups must demonstrate their ability to controlcosts and maintain profitable operations in thisenvironment.The key competitive factors reviewed include:■ Physician competitors for patients, includingother groups, solo practitioners, and hospitals;■ Nonphysician competitors seeking to providemedical services directly to patients, including170 Standard & Poor’s Public Finance Criteria 2007

Physician Groups And Faculty Practice Planshospitals, ambulatory care, surgery, and emergencycenters, other professionals and payors,such as HMOs and insurance companies; and■ Breadth and nature of managed care contractsand relationships.LeadershipStandard & Poor’s meets with physician and nonphysicianleadership during the rating process. It isimportant to understand the strategic goals of thephysicians and administration to ensure that theyare compatible. Standard & Poor’s looks for strongleadership from the board of trustees and prefersgovernance to be community oriented and not consistingsolely of physician group members.Management should be appropriately credentialed,with ample experience in the management ofphysician group practices. In areas with high managedcare penetration, a professional devoted tocontracting practices and monitoring adds strength.The review includes:■ Management tenure and qualifications;■ Review and discussion of strategic planning issues;■ Compensation, financial, and operating policies;■ Finances and operations of other subsidiary orsister corporations; and■ Influence of university management and policieson faculty practice plans.Institutional relationshipsGroup practices have many opportunities to cooperate,join, and contract with hospitals, universities,insurance companies, and other payors. In addition,partners ranging from hospitals to large for-profitspecialty companies are joint venturing with physiciansin a variety of projects from ambulatory centersto specialty hospitals. Standard & Poor’sexamines formal and informal relationships thatexist with other institutions.For stand-alone group practices Standard &Poor’s reviews:■ Operational relationship with primary admittinghospitals;■ Financial contracts and/or joint ventures to sharecosts, revenues, or overhead; and■ Managed care contracting practices.When evaluating faculty practice plans, issues surroundinguniversity and medical school finances aswell as the dean’s tax are explored. To the extent thatthe university hospital has forged alliances with othercommunity providers, the relationship between thefaculty group and local physicians will be discussed.Information systemsTo manage a health care enterprise efficiently andprofitably, integrated information systems are necessary.Standard & Poor’s will review the medicalgroup’s plans for development of an electronic medicalrecord either on its own or in conjunction withlocal partners such as nearby hospitals. In additionStandard & Poor’s will assess the group’s ability tomeet and monitor any required quality metrics aspart of its reimbursement agreements. Standard &Poor’s will also look for the group’s ability to generatecertain key reports from its information systemssuch as:■ Managed care members profile, benefit plan, utilization,and cost per member per month;■ Encounters per full time equivalent (FTE) physicianby new and existing patients;■ Hospital inpatient use rate and cost per patientper month versus regional averages;■ Revenue and expense by physician, payor, andservice;■ Analysis of clinical outliers and out-of-area utilization;and■ Physician profiling reports including any reportsneeded to meet pay for performance targets.FinancesStandard & Poor’s will review five years of auditsbased on the accrual method of accounting as astarting point in the financial analysis. Althoughaccrual-based accounting is preferred, Standard &Poor’s recognizes that it may not be available forsome faculty practice plans, based on their financialintegration with universities. Management letters,reimbursement issues, research commitment, fundraising, working capital needs, and future financingplans also are explored. The revenue and expensecomponents of the income statement are examinedto assess overhead levels and allocation, physiciancompensation, sources of revenue from outside payors,and sources of revenue from clinical departmentsand research. Questions concerning thebalance sheet include trends in accounts receivableand collection rates, adequacy of malpracticereserves, level of cash reserves and restricted fundsfor research and capital investment, strategic androutine capital needs, and other liabilities.Information requested includes:■ Five years of financial statements, most recentinterim statements, and if available, projections,including flow of funds to and from associateduniversity or medical school, if applicable;■ Utilization information—patient visits, newpatient growth, covered lives, and encounters perphysician;■ Payor mix as a percentage of revenues;■ Research grants, expenses, and subsidies;■ Joint-venture documents;www.standardandpoors.com171

Health Care■ Other liabilities, such as incurred but not reportedclaims, malpractice claims paid and pending,guarantees, leases, and other debt; and■ Endowment funds available at the university insupport of faculty practice operations or debt.Legal covenantsStandard & Poor’s requires legal and security provisionssimilar to those used in other health carefinancings. A GO or revenue pledge is customary,and a mortgage is not required, although a negativepledge on assets is needed if the GO pledge is used.A liquidity covenant is an important considerationand may be requested to help maintain balancesheet strength. Criteria for funding debt-servicereserve funds vary according to the rating categoryand are consistent with other health care financings.Although Standard & Poor’s prefers to havephysician salaries subordinate to the repayment ofbonds, this covenant alone is not sufficient toensure an investment-grade rating, since, withoutadequate physician compensation, the clinic is atrisk for turnover and subsequent loss of businessand revenue. ■Human Service ProvidersHuman service providers serve individualswho have development disabilities or aresuffering from mental illness, and who typicallyneed substantial support to function at their highestlevel. The human service providers supporttheir clients with distinct programs to meet distinctchallenges.CriteriaThe following rating approach is applicable toquasi-governmental providers and freestandingtraditional nonprofit community agencies. Aprovider’s organizational model, governmentalrelationship, and type of service provided, amongother factors, will be given greater or lesserweight, depending on each situation. Due to theconstrained reimbursement systems in which theproviders operate, and the generally weak reservesheld by these organizations, ratings tend to rangefrom high speculative-grade (‘BB’ level) to mediuminvestment-grade (‘A’ level).Major factors in Standard & Poor’s RatingsServices review include:■ Service essentiality;■ Provider assessment;■ Management quality;■ Financial analysis;■ Funding agency relationship;■ Fund raising history; and■ Pledged security and legal structure.EssentialityThe most important factor is essentiality, whichincorporates the likelihood that government,through funding agencies, will continue to fund certaincritical services. Because many human serviceproviders have break-even operations and limitedliquidity, Standard & Poor’s relies on strong serviceessentiality to boost credit quality.The courts have mandated community-basedtreatment for developmental disabilities and mentalhealth, making these services essential. On the otherhand, chemical dependency programs as well as daycare and training programs receive less supportfrom the judiciary, government, and the public.Therefore, Standard & Poor’s views these servicesas less essential as well. However, if a provider candemonstrate a history of funding support for lessessential services, this would be a positive factor inthe rating determination. A history of funding supportby leading state or local agencies through goodand bad times is also a critical factor.The providerStandard & Poor’s looks at two key items whenassessing the provider: An analysis of services providedand the provider’s market position.Services should be self-supporting from their fundingsources with a minimum of subsidization frominvestment income or contributions. A broad array ofservices offered to a variety of populations minimizesthe impact of funding reductions or market forces inone or two particular service lines. However, if takento the extreme, this strategy can expose the providerto additional risk if lines of business are new andunproven, or do not complement other service offerings.For example, if a provider takes on a highly specializedtreatment, such as services for severelyautistic children, without prior or related experience,this can expose the provider to additional risk.Standard & Poor’s also reviews geographic diversity,172 Standard & Poor’s Public Finance Criteria 2007

Human Service Providerswhich can diversify funding and market risk.However, there is additional risk if the provider’sservice area is too large to manage, or so small that itis vulnerable to competition.Standard & Poor’s analysis of market positionseeks to understand the provider’s importance in aservice area. A dominant market position, includinglargest number of clients served, most contractsreceived, or high barriers to entry in a specific serviceniche are favorable factors. Standard & Poor’s investigatesmarket penetration, contracts received andlost, as well as competitors’ strengths and weaknesses.Of particular concern are a number of for-profitproviders that are entering the market. In addition, itcan be difficult to assess the competition since measurableunits of output and cost are not standard andoften not measured within the industry.ManagementThe quality of management affects all factors inStandard & Poor’s credit evaluation. Management’shistory and track record, its ability to maintain aviable organization and strategically move it towardthe future are integral to Standard & Poor’s analysis.Evidence of an experienced management team,one not reliant on one or two people, is key.Standard & Poor’s assesses the sophistication ofmanagement practices by analyzing strategic plans,use of cost measures, and standard procedures.Standard & Poor’s will also investigate the strengthand oversight of the board of trustees. Where appropriate,accreditation by national bodies, such as theCommission on Accreditation of RehabilitationFacilities, can indicate compliance with professionalstandards. In addition, the level and degree of stateoversight is especially important given overall statemandates to provide these services.Financial analysisFinancial analysis, similar to that for revenuebonds, emphasizes a strong track record of financialviability that allows the organization to maketimely debt service payments. This includes an historicalanalysis of utilization and types of contracts,and how these contribute to profitability.Standard & Poor’s looks at referral patterns togauge whether major referral sources will continue.Standard & Poor’s also looks for evidence of aservice backlog, such as a waiting list. Sinceproviders have minimal price flexibility,Standard & Poor’s emphasizes cost control in itsanalysis and looks for treatment costs on a perclientbasis. Standard & Poor’s also asks providersto discuss examples of historical problems affectingfinances, management, funding and treatment, andhow they were remedied.Revenue and income trends are reviewed includingoperating and excess margins, debt service coverageand the overall debt burden of the organizationon a historical as well as pro forma basis ifnew debt is being issued. Liquidity and debt structureare also important to determine the provider’sflexibility and cushion against future events.Various liquidity measures, including unrestricteddays cash on hand as well cash to pro forma debtare two important metrics as well as various measuresof overall leverage. Most human serviceproviders are not highly profitable organizations,and margins are generally not as high as for comparablyrated health care providers. Some providersrely on gift income to balance operations.An established fundraising program, and a steadystream of bequests and fundraising can sometimesoffset weak operating performance if similar levelsare achieved on a recurring basis. However, overtime, most organizations rated by Standard andPoor’s are able to break-even based on programrevenues alone. The presence of an endowment canprovide a steady source of operating income forsome providers. In this case, Standard and Poor’swould ask about whether there is a standard spendingpolicy that can provide some operational stability,or whether the endowment is only used to coveroperating deficits that might occur.Funding agenciesAn integral component of the provider’s financialstrength is its relationship with the funding agencies,the major sources of revenues. Since providersoften rely on one-year renewable funding contracts,it may be difficult to assess revenue-stream quality.Standard & Poor’s generally speaks directly withthe major funding agency in order to understandseveral key points about the durability and strengthof major contracts. These points include:■ The nature of the contracts with the provider;■ How contracts are awarded and renewed;■ The history of cancellation and funding cutbacks;and■ The day-to-day working relationship with theprovider.Standard & Poor’s reviews the nature of the contractsand their award procedures to evaluate thecompetitiveness of the process. Standard & Poor’sfavors contract renewals based on performance, notprice, because the former supports financial andtreatment stability. If contracts are frequently canceled,Standard & Poor’s will be concerned aboutthe quality of the selection process as well as thequality of the agency’s revenue stream.Cancellations will be unlikely when there are strongcooperative relationships between the agencies andproviders. In addition, the use of various types ofintercepts from different funding programs canpotentially provide credit enhancement.www.standardandpoors.com173

Health CareLegal and security provisionsThe legal and security provisions are also similar tothose found in revenue bond financings. In general,the provider’s entire revenue stream will be pledgedand assigned to the payment of debt service. Otherlegal provisions should include the presence of adebt service reserve funded at maximum annualdebt service, appropriate security pledge, and assurancesthat providers have made provision for successorsto meet debt service payments. Providersalso must meet published Standard & Poor’s guidelineson permitted investment. ■174 Standard & Poor’s Public Finance Criteria 2007

Education And Non-Traditional Not-For-ProfitsHigher EducationCollege And University Credit RatingsThe evaluation of private colleges and universitiesfocuses on four core areas—demand, finances,management, and debt. Demand is particularly significantbecause student enrollment often drivesfinancial operations, especially at tuition-dependentcolleges and universities. Enrollment declines canresult in shortfalls in tuition revenues, directlyaffecting budget operations. Since most private universitiesrely heavily on tuition revenues, enrollmentand admissions trends are therefore critical. Thesetrends are perhaps even more significant than forpublic institutions, where state support can sometimescushion the impact of enrollment declines. Aschool that experiences weakened demand may beforced to cease operating, while a school that suffersfrom deteriorating finances can recover if demand isfavorable, and management is astute.When asked to evaluate the credit or debt ratingof a new private institution, Standard & Poor’sRatings Services will often make a site visit to theinstitution. At a minimum there should be a conferencecall with management for any newly ratedcredits. Seeing the institution provides an opportunityto see facilities from an outside perspective—anespecially important consideration for a productthat is discretionary and highly consumer driven.The process involves evaluating a full range ofinformation ranging from enrollment and demandinformation, to 5 years of audited financial results,budget information, and other information aboutthe institution.DemandStandard & Poor’s evaluates an institution’sdemand in the context of the school’s niche and thecurrent higher education environment.Demographic trends, the popularity of particulartypes of programs, and the existence of competinginstitutions also are incorporated into the ratingprocess. Standard & Poor’s measures demand interms of enrollments, applications, acceptances, studentquality, yield, and retention.EnrollmentStandard & Poor’s first examines enrollment sizeand trends. While size is not by itself a primary ratingfactor, it can indirectly affect the rating. Smallerinstitutions tend to have more limited programofferings, making them more vulnerable to shifts inprogram popularity. Furthermore, for smaller institutions,the loss of a few students can have a proportionatelygreater impact on revenues. A smallcollege that has little or no financial cushion andlimited budget flexibility can find itself particularlyvulnerable. However, many students prefer a smallcollege setting for the personal attention and levelof involvement it may provide, and there are,indeed many highly rated small colleges. Whatevera school’s size, enrollment trends are analyzed, andthe reasons for upward or downward cycles aredetermined. Specialized schools tend to be smallerthan more comprehensive institutions.To isolate particular trends, enrollment is brokendown into headcount and full-time equivalents,graduate and undergraduate students, and full andpart-time students. Often, enrollment in particularprograms is examined. Application, acceptance, andmatriculation information provides an ongoingmeasure of demand for an institution and revealsthe school’s admissions flexibility or ability to copewith changes in student demand. While all threefigures often fluctuate from year to year,Standard & Poor’s focuses on general trends andtheir consequences. Standard & Poor’s also evaluatesinformation about the number of transfer students,and selectivity information related totransfers. For some institutions, transfer studentscan supplement a weak retention rate.Enrollment in nontraditional programs—such asadult learners, noncredit or nondegree programs—tends to be more volatile than enrollment in traditionalfour-year college degree programs.Standard & Poor’s requests at least five years ofdemand information for new ratings.FlexibilityAn institution’s admissions and program flexibilityis an essential part of demand analysis. The moreflexible an institution, the better able it is to dealwith the vagaries of demographic declines, economicdownturns, increased competition, and changingprogram preferences. Standard & Poor’s assesses aninstitution’s flexibility in seven areas:Selectivity. Selectivity is measured by an institution’scompetitive position and the degree of difficultyin gaining admission to an institution.Standard & Poor’s evaluates the absolute number ofwww.standardandpoors.com175

Education And Non-Traditional Not-For-Profitsapplicants to an institution’s programs—for undergraduates,graduate, and professional students.Standard & Poor’s measures completed applicationsonly, and evaluates the acceptance rate. For themost competitive institutions, acceptance rates ofbelow 20% are increasingly common. Among theinvestment-grade rated universe, acceptance ratesvary from a low of 5% to as many as 95% of studentsbeing admitted from completed applications.Matriculation rates, measured by the percentage ofadmitted students who enroll, range from as low as15% to as high as 80%. Generally, the lower theDocumentation RequirementsBond documents■ Bond resolution or indenture.■ Lease or mortgage.■ Official statement.Demand information■ Five years of headcount enrollment information brokendown by undergraduates and graduates and reflectingfull- or part-time status.■ Five years of first-time freshman application information,including acceptances, matriculants, and student qualityindicators and average test scores.■ Top 10 competitor institutions and win/loss statistics,if available.■ Program offerings indicating additions and deletionsof programs over the past five years.■ Five years of student fee tuition and room andboard charges.■ Five years of faculty information broken down by fullandpart-time faculty, percentage tenured, and percentageholding doctorates.Financial information■ Five years of audited financial statements and currentyear budget summary.■ History of state appropriations and formula used todetermine appropriation, if applicable.■ History of annual giving, capital campaign, and funddrives, including participation rates and goal success.■ Endowment investments, investment reports,and spending policy.■ Capital improvement and future debt plans, andcomprehensive debt service schedule.Management■ Brief management biographies.■ Description of governing board or body and relationshipwith institution.■ Strategic plan.acceptance rate and the higher the matriculationrate, the more competitive the institution.Sometimes, more specialized schools such as engineering-baseduniversities, or art and music schoolsexhibit a high degree of self-selection. Acceptancerates may be slightly higher than for other comprehensiveinstitutions, but at the same time, matriculationrates may be higher as well. Standard & Poor’sconsiders whether a particular niche changes thedegree of selectivity for an institution.Geographic diversity. As a rule, the wider aninstitution’s student draw or geographic diversity,the less likely it is that a regional demographicdownturn will affect enrollment. Hence, a widegeographic draw is a rating strength. However, inattempting to widen its draw, an institution maylose ground on its matriculation rate, since applicantsfrom farther away are often less likely tomatriculate than those closer to the college.Sometimes institutions attempt to widen their geographicdraw, but they may do so at the expense oftheir historic demand base. States like California,Texas, and Florida (high growth states) create specialcircumstances in the assessment of demand.Rapid population growth and the vast populationin these states makes it difficult for an institution toexpand geographic diversity. Location in a highgrowth state is generally viewed as a positive creditfactor for private institutions as the potentialdemand for an institution grows naturally.Student quality. Strong student quality, as measuredby class rank or average high school GPA,standardized test scores (SATs and ACTs), andother factors, enhances a school’s ability to withstanda decline in demand. Schools with high-qualitystandards often can maintain enrollment bylowering admissions requirements. Since studentquality measures differ substantially from one collegeto another, care is taken to understand themethod used at the institution being rated. Whilestudent quality measures are one indicator of flexibility,Standard & Poor’s never views these scoresand ratios in isolation.Faculty. High levels of tenured faculty generallymean higher levels of fixed expenses for items suchas salary and benefits. In addition, fixed faculty levelsmay not allow a school to easily change programofferings to reflect current demand, thereforelimiting an institution’s flexibility. Applications, inturn, may drop off if program offerings do notmatch current preferences. A high tenure rate cancreate problems if the number of faculty needs tobe adjusted. Standard & Poor’s considers a tenureratio of over 70% to be somewhat constraining.Nonetheless, most highly rated institutions alsohave a high rate of tenure for full-time faculty.176 Standard & Poor’s Public Finance Criteria 2007

Higher EducationProgram offerings. Schools with highly specializedprograms can fall out of favor quickly. On theother hand, schools with specialized programs areoften successful because of a lack of significantcompetition, or a niche program. Conversely, comprehensiveinstitutions with a wide variety ofundergraduate offerings plus many strong graduateprograms generally experience less volatile enrollment,even if demand falls off in a particular area.Standard & Poor’s examines the popularity of variouscurriculum offerings and notes program closuresand openings.Competition. In analyzing competition, a keyquestion is, which colleges does this institution winor lose students from or to? Although exactwin/loss statistics can be hard to obtain, such informationgives Standard & Poor’s insight into theinstitution’s competitive position. Analysis of competitionenables Standard & Poor’s to determinewhether the school has its own niche, or whether itmust constantly change its programs to adjust toexternal competition. Obviously, first-choiceschools are less vulnerable than students’ second orthird selections.Retention and graduation. A trend of increasingattrition is a sign of rising student dissatisfactionand is often a precursor to declining demand. Thereasons for such a trend, and actions taken to correctit, are examined. The nation’s most selectiveinstitutions generally demonstrate freshmen reten-Selected College/University Financial (FASB) RatiosRevenue diversity (all numerators divided by total unrestricted operating revenues)Tuition dependence (%)Numerator = gross tuition and feesGifts and pledges (%)Numerator = annual fund gifts and pledgesEndowment income (%)Numerator = endowment spending policy incomeHealth care operations (%)Numerator = health care operating revenuesAuxiliary operations (%)Numerator = auxiliary system operating revenuesExpense and financial aid ratiosInstruction (%)Tuition discount (%)Financial aid burden (%)Bottom line resultsNet operating income (NOI) (%)Net income (IN) (%)Return on net assets (%)Balance sheet ratios Liquid ratiosCash and investment/operations (%)Unrestricted resources/operations (%)Expendable resources/operations (%)Debt ratiosUnrestricted resources to debt (%)Expendable resources to debt (%)MADS burden (%)Full-time equivalent measuresNet tuition per FTE (%)Revenue per FTE ($)Expenses per FTE ($)Pro forma debt per FTE ($)Unrestricted resources per FTE ($)Expendable resources per FTE ($)Instructional costs/total operating expensesTotal financial aid costs/gross tuition and feesTotal financial aid costs/total operating expensesChange in UNA/total unrestricted operating revenuesChange in UNA/total unrestricted revenuesChange in total nett assets/total net assets (BOY)Total cash and investments/total operating expensesUnrestricted resources/total operating expensesExpendable resources/total operating expensesUnrestricted resources/total debtExpendable resources/total debtMADS/total operating expensesTuition revenue less financial aid/FTE studentsTotal operating revenue/FTE studentsTotal operating expenses/FTE studentsTotal pro forma debt/FTE studentsUnrestricted resources/FTE studentsExpendable resources/FTE studentsUNA—Unrestricted net assets. MADS—Maximum annual debt service. Unrestricted resources—(UNA - (net PPE - long-term debt).Expendable resources—(UNA + TRNA - (net PPE - long-term debt). PPE—Property, plant and equipment.TRNA—Temporarily restricted net assets.www.standardandpoors.com177

Education And Non-Traditional Not-For-Profitstion rates of 90% or more. A retention rate of 65%or below, or conversely, an attrition rate of 35%from year-to-year can be cause for concern.Graduation rates nationwide are dropping overtime, and a failure of students to continue their educationalprogress represents a significant concern forinstitutions, both in terms of maintaining institutionaldemand and demonstrating favorable outcomes.Graduation rates tend to correlate withselectivity—the more selective an institution, thehigher the four-and five-year graduation rates.Institutions with a large number of engineering programstend to have slightly lower four-year graduationrates, but five-year graduation rates should becloser to the norm for its competitive peers.FinancesStandard & Poor’s analysis of a private university’sfinancial strength focuses on revenue and expenditurecomposition, financial operating performance,financial resources, balance sheet liquidity, anddebt burden. Standard & Poor’s evaluates at leastfive years of historical audited information, as wellas current year’s budgets to actuals, and any forecastsor multi-year financial plans that are beingused by management.Revenues. Standard & Poor’s evaluates historicaland projected trends in revenue composition. Adiversified revenue base is viewed positively, sincemultiple revenue sources tend to mitigate fluctuationsor shortfalls in an individual revenue stream.Larger institutions with graduate programs andresearch activities tend to have greater revenuediversity. Many smaller colleges and universitiesalso demonstrate less dependence on tuition andfees because of gift income and endowment levels,which provide annual operating income. However,at many private institutions, tuition and fee incomeusually accounts for at least 20% of total revenues.Standard & Poor’s considers financial aid to be adiscretionary expense item, and therefore we grossuptuition and fee revenues. Unlike the health caresector, where discounts are contractually determined,financial aid is not a contractual obligation.Research grants, endowment income, private gifts,public grants, and auxiliary income from dormitories,dining, and parking facilities can reducereliance on tuition.Standard & Poor’s assesses an institution’sability to raise revenues through tuition adjustments,intensified research activities, or auxiliaryoperations. Tuition rates are compared with competitors’charges to determine rate flexibility.Research grants are reviewed for diversity insource, purpose, and recipient. For most institutions,research revenues tend to be nearly equalto research expenses, although a thoroughaccounting of all costs may show otherwise—thatthe costs of research actually exceed revenues. Anew area of revenue for many colleges and universitiesis patent income and royalties, especiallyfrom the development of new drugs. Generallythis revenue is a small source for most universities,however, major discoveries can lead to hundredsof millions of dollars over the life of apatented drug. Generally, these revenues areviewed favorably and can provide additional revenueto an institution. Conversely, the revenuestend to be accruing to already highly rated, andusually revenue-diverse, institutions.An institution’s endowment spending policy alsois reviewed to determine income-raising capabilityand to ensure that the endowment corpus is beingpreserved. Many colleges and universities are experimentingwith new spending models and movingaway from an historical industry standard thatallows spending 5% of a three-year moving marketvalue average. Concerns that might cause an institutionto adjust its endowment spending modelinclude smoothing spending levels in volatile marketsand guaranteeing a minimum or maximumlevel of spending. Ultimately, institutions that adjusttheir endowment spending models are hoping toimprove the predictability of spending rates.Whatever the model, Standard and Poor’s examinesdeviation from prior spending practices, especiallywhen the rate of spending exceeds or is substantiallylower than comparable peers.Finally, Standard & Poor’s examines pastfundraising experiences, as well as planned fundraisingefforts, and proposed purpose of gifts. Alumniparticipation rates usually are highest for collegesand universities, which have produced mostly undergraduates.Alumni of graduate and professionalschools tend to donate at lower rates than alumniwith undergraduate degrees. Alumni participationrates tend to be highest at small to medium, liberalarts colleges, where rates of 40%-60% are notuncommon. Alumni participation rates are lower atpublic colleges and universities, but some flagshippublic universities, which have produced hundredsof thousands of alumni, have strong fundraisingrecords and development potential.Expenses. Standard & Poor’s evaluates expensesand assesses an institution’s ability to reduce costs ifrevenues decline. A high ratio of fixed to variablecosts limits this flexibility. Faculty commitments,financial aid budgets, utility costs, plant maintenanceneeds, health care costs, pension payments, and debtservice payments constrain financial flexibility.Standard & Poor’s looks at historical expendituretrends and will investigate large percentage increases.178 Standard & Poor’s Public Finance Criteria 2007

Higher EducationRisk managementStandard & Poor’s evaluates institutions for theirability to plan in the event that operations becomedisrupted for any reason. Many institutions arenow developing an office of risk management, orappointing chief risk officers, who oversee thedevelopment of contingency and emergency plansfor the institution. Standard & Poor’s asks aboutinsurance coverage in three areas: property andcasualty, business interruption, and liability.Operating resultsStandard & Poor’s analyzes a college’s incomestatement over the most recent five-year period,focusing on activity within unrestricted net assets.Generally, Standard & Poor’s expects at least modestoperating surpluses over the long run, signifyingthat revenues are sufficient to meet all operatingneeds, including depreciation and plant renewalexpense. However, a one-or two-year operatingdeficit is not considered a problem, if the schoolhas a large, liquid financial cushion. Standard &Poor’s notes whether the school includes depreciationas a budgeted expense. Often, year-end GAAPresults are negative, because depreciation was not abudgeted item for the year.Endowment and long-term investment poolsDepending on its size and restrictions, endowment(or a long-term investment pool) gives an institutionsignificant financial strength and liquidity.Growth trends in endowment are examined, andinvestment and spending policies are analyzed.Endowment levels are compared with an institution’sdebt level and budget, and a per studentendowment level is calculated and compared withthose of other colleges and universities. Generally,the larger the portion of unrestricted endowment,the better, but even a largely restricted endowmentcan provide significant strength, as it also producesspendable endowment income. Restricted endowmentfunds also may be somewhat fungible, freeingup other operating funds that can be used for otherpurposes. In addition, endowments restricted forscholarships or faculty chairs may lend programmaticstrengths and help a college attract studentsand faculty.Investment performance is compared to broaderbenchmarks such as the National Association ofCollege and University Business Officers(NACUBO) mean, which is published every yearbased on a national survey, and to particular benchmarksselected by the institutions themselves. Thesemeasures provide a yardstick—how well did theinstitution’s investments perform relative to itschoices. Standard & Poor’s generally asks for acopy of the investment report reviewed by theboard on a quarterly basis. This report typicallyprovides important information on asset classes,recent investment performance, and highlights anyanomalies related to investment performance.Liquidity of the endowment is a growing concern ascolleges and universities diversify their investmentportfolios in an effort to enhance return and reducevolatility. Standard & Poor’s asks how frequentlythe portfolio is valued; management should beaware of what portion of the invested assets arehighly liquid—could be valued on a daily basis asmarketable securities. If large portions of theendowment are “locked-up” in private equityarrangements, that would need to be disclosed duringthe rating process. Most schools spend a prespecifiedportion of their endowment on annualoperations. The most common spending policy hasbeen that 5% of a three-year market value averageof the endowment will be utilized for operations.Because of recent fluctuations in equity markets,however, more schools are adopting spending policycaps or collars—to spend no more or less than acertain percentage of the endowment. Standard &Poor’s considers an endowment spending rate above6% to be high, and above 8% to be excessive.LiquidityIn general, liquidity measures how long a schoolcould function without taking in additional revenue.Three different measures are used to assess bothoperating and debt liquidity: cash and investments,unrestricted resources, and expendable resources.Each of these figures is drawn from the balancesheet and then compared to operating expenses,total debt (long-term and short-term) outstanding,and pro forma debt. Because endowment is includedin the balance sheets of private colleges and universities,available liquidity can include sources derivedfrom all funds of the institution—endowment, operatingfunds, and internal plant funds. Standard &Poor’s does not exclude endowment from its assessmentof liquidity, unless the endowment is restrictedfor a specific purpose. Therefore the calculation ofavailable liquidity rests on the type of equity andgenerally includes only unrestricted or temporarilyrestricted net assets. However, unrestricted equityand temporarily restricted equity should be supportedby sufficient liquid assets such as cash and marketablesecurities. If unrestricted resources tooperating expenses exceed 100%, or a year of annualoperating expenses, the school exhibits good liquidity.Conversely, institutions with unrestrictedresources to operating expenses below 30% havemore limited cushion and operating constraints.Unrestricted resources at less than 25% of proforma debt are a concern.www.standardandpoors.com179

Education And Non-Traditional Not-For-ProfitsDebtA college or university’s total debt burden or totalamount of debt outstanding relative to its operatingbudget also is part of Standard & Poor’s financialanalysis. One way to measure a university’s debtburden is to compare maximum annual debt serviceto annual operating expenses. A ratio greater than10% generally indicates an excessive debt burden,and over 7% is considered to be moderately high.However, schools with particularly high levels ofendowment and liquidity, and good operating performance,often can support a greater debt load.Unrestricted resources are particularly importantwhen evaluating unenhanced short-term or demandfeature debt. Standard & Poor’s compares the variable-ratedebt burden in a “worst-case scenario”with unrestricted and expendable resources andwith operating expenses. There are no guidelines asto what the ideal debt structure should be for a collegeor university. In general, the higher the level ofendowment, the greater the amount of variable ratedebt issued by these institution. When a universityhas a very high level of floating-rate debt (above50%), Standard & Poor’s expects the institution tobudget for a higher cost of capital to cover anyunexpected rises in interest rates. Most interest rateswaps for highly rated colleges and universities areused to hedge interest rate exposure—to convertvariable rate payments to a fixed rate of interestand therefore ensure some predictability in futurepayments. Standard & Poor’s expects that issuerswho enter into swaps or other derivative instrumentsunderstand their use and can quantify therelative risks of these transactions and provide aswap management plan, whether the swap is usedto hedge interest rate risk on debt instruments or toenhance investment return.Management And GovernanceDecisions in admissions, finances, and debt strategycan be critical to an institution’s future andreveal a great deal about management’s philosophy.The choices made by different schools in verysimilar circumstances can mean the differencebetween ongoing viability and financial distress,or even closure. Standard & Poor’s analysis evaluatesmanagement’s:Ability to foresee and plan for potential challengeManagement’s ability to anticipate the impact ofevents such as changes in the general educationmarket, demographic trends, or deferred maintenanceneeds is assessed.Strategies and policiesWhether proactive or defensive, the policies adoptedby an institution must be evaluated in light ofhow realistic or attainable they are. WhileStandard & Poor’s does not try to determinewhether one strategy is better than another, it doesevaluate whether a strategy seems realistic. Forexample, a college budget that assumes an incomingclass of 500 freshmen when recent new enrollmentshave consistently been below 450 would notbe convincing.Track recordAn institution’s track record indicates how managementwill deal with new situations and problems.Standard & Poor’s examines the effectiveness of pastoperations and plans and evaluates management’sability to lead an institution through industry andenvironmental shifts.TenureSudden or frequent management turnover can be asign of stress or weakness. While less quantifiablein and of themselves, management decisions directlyaffect the variables involved in Standard & Poor’sdemand and financial analysis.Board composition and structureStandard & Poor’s evaluates boards and governanceby looking at a number of areas. Theseinclude board composition, committee structure,strategic planning, board financial contributions,and board elections. A board should be an independentbody that is able to replace a president orother senior leadership. A recent trend is a reductionin the number of board members. Certainly aboard needs to be large enough to have an appropriatecommittee structure: generally includingaudit, finance, academic affairs, and an executivecommittee. Most boards meet on a full basis fourtimes a year. Less frequent board activity could be aconcern unless there is an active executive committee.A board should be financially independentfrom the college and conflicts of interest shouldalways be disclosed.DebtLegal provisionsSecurity pledges. Standard & Poor’s debt ratingsrefer to a specific bond issue; they are not a generalstatement about the issuer. In contrast, an issuercredit rating is a current opinion of an obligor(such as a college or university) to meet its financialobligations. An issuer credit rating focuses on theObligor’s capacity and willingness to meet its financialcommitments as they come due. The opinion isnot specific to any particular financial obligations,as it does not take into account the specific natureor provisions of any particular obligations.The demand and financial analysis describedabove allows Standard & Poor’s to assign ratings to180 Standard & Poor’s Public Finance Criteria 2007

Higher Educationa general obligation pledge of a private university.Most private universities that sell debt issue unsecuredgeneral obligations, supported by a full faithand credit pledge. Sometimes particular issuingauthorities (since most private universities who issuetax-exempt debt must issue debt through a taxexemptconduit issuer) require a lien against certainrevenues of the institution and the maintenance oflegal covenants such as asset to liability ratios.However, these legal requirements would not raise aprivate college debt rating above its GO rating.Public universities, in contrast, may issue a varietyof debt types and very few have the ability to issuefull faith and credit debt. However, a school’s flexibilityto raise tuition and fees charged against all students,for example, allows Standard & Poor’s to rateunlimited student fee or tuition fee pledges for publiccolleges and universities on par with an institution’sGO rating. This policy is important in analyzingpublic institutions because many public schools arerestricted in their use of GO and state appropriationpledges. Other types of security pledges may beapplied to a university’s bonded debt, such as pledgesof revenues from a specific enterprise, including dormitoriesand parking systems, or a limited pledge oftuition or student fees (see section on privatized dormitoriesand enterprise financings for more informationon auxiliary revenue bonds).Standard & Poor’s views debt secured by enterprisefunds to be generally weaker than GO ortuition pledges. For example, a dormitory bond’srevenue source may be limited to room rentals,while a GO or tuition pledge implies a much broaderrevenue-raising capability. A bond secured bytuition or a school’s GO pledge is likely to experienceproblems only if the entire school experiencesdifficulty. An individual dormitory, on the otherhand, could close without necessarily affecting universityoperations. However, if the revenues pledgedare from a large dormitory system, and most studentslive on campus, dormitory revenues could perhapsbe as important to the college’s overall healthas tuition and student fees. The dormitory’s value tothe school largely determines the distance betweenthe dormitory rating and the school’s GO rating.CovenantsRate covenants and additional bonds tests also areexamined. However, with the exception of enterprisedebt, these provisions generally carry lessweight in university analysis than in other types ofbond issues for other municipal enterprises. Thisde-emphasis is because the payment of debt servicedepends less on the maintenance of specific ratesand charges than on demand for the institution’sservices and its financial health. Additional bondstests for virtually all GO pledges do not enhancebondholder protection because the requirements,which are usually based on assets and liabilities,impose no real constraint on the college. However,enterprise operations must set rates to provide sufficientcoverage; therefore, for enterprise-backeddebt, Standard & Poor’s prefers rate covenants andadditional bonds tests with substance. Ratecovenants usually require institutions or their governingboards to set rates and charges which wouldenable debt service coverage to meet greater thansufficient coverage. Minimum rate covenants of1.15x-1.2x are acceptable, if debt service coverageis historically good and stable. The strongest additionalbonds tests require historical revenues to beat least 1.25x future maximum annual debt service,including the proposed bonds. Many other additionalbonds tests in this sector are proposed, ratherthan historical, and allow certification of futurerevenues by a business officer of the college.Debt service reserve policies. Cash flow considerationsin colleges and universities usually are less ofa problem than in other municipal enterprises;therefore, reserve funds are not always necessary.While it is true that tuition revenue inflows are seasonal,the presence of unrestricted resources andendowment often compensates for the absence of areserve, or rainy day, fund. Nevertheless, bondssecured strictly by enterprise revenues generallyrequire a fully funded debt service reserve fund,even if the college has a large endowment.Other liabilities and debt-like instrumentsStandard & Poor’s also incorporates other liabilitiesin its analysis of financial resources. These caninclude short-term debt outstanding at year-end,unfunded pension liabilities and postretirement benefits,contingent liabilities, debt obligations of affiliatesand wholly owned subsidiaries, and operatingleases. Because our analysis focuses on retained equity,versus strictly cash and investments, all liabilitiesreduce the amount of equity. Therefore, all liabilitiesare indirectly captured in Standard & Poor’s calculationof unrestricted and expendable resources. Alarge unfunded liability relating to postretirementbenefits such as health care and pensions could be ofconcern if management has no plan for how to fundthese liabilities or benefits over time. Many collegesand universities are frequent users of commercialpaper and variable rate debt obligations. Often commercialpaper has been authorized, but not issued. Ifa commercial paper program is dormant, or the institutionhas never issued up to the authorized amountof the program, only the actual amount issued by thecollege will be incorporated in the financial ratiosbased on audited financial statements. However, ourrating takes into account the possibility that additionalmay be issued.www.standardandpoors.com181

Education And Non-Traditional Not-For-ProfitsRating Public Colleges And UniversitiesStandard & Poor’s rating approach for public universitiesis similar to that used for private institutionsin terms of demand, management, finances,and legal provisions. However, since fiscal 1996,financial accounting for private institutions has differedfrom the accounting standards that publicinstitutions follow. As a result, Standard & Poor’smaintains two different sets of financial ratios foruse in evaluating colleges and universities. In addition,since a major portion of a public university’sannual budget comes from state sources, analysis ofstate support is also a rating factor. State mandatesand policies also can greatly influence the demandand financial characteristics of a public university.State supportOn average, public colleges and universities derivemuch less than half of their unrestricted operatingbudgets from state appropriations and the amountprovided for operating support continues to declineover time. On the other hand, many states provideconsiderable capital support for construction andmaintenance of academic facilities along with generaloperating support. Standard & Poor’s evaluatesstate support by focusing on the following factors:■ The state’s GO rating, which provides a snapshotof a state’s economic, debt and financial conditionand offers a basis for evaluating the strengthof higher financial education support.■ The track record of appropriation support forhigher education within a given state. Particularattention is paid to how higher education fares intimes of financial stress at the state level.Standard & Poor’s is interested not only in howsuccessful individual institutions are in obtainingappropriations, but also in the strength of astate’s overall support for higher education.■ The history of allocations to the specific institutionbeing rated. In addition, Standard & Poor’scompares the institution’s historical percentageshare of total higher education appropriationwith that of other state institutions.■ Nominal amount of state support and changes inthe funding formula which might benefit highergrowth,stable, or slow-growth institutions; and■ The history of state appropriations per full-timeequivalent enrollment. Some of the highest levelsof support on an FTE basis, such as at theUniversity of California and University of NorthCarolina, are virtually double other flagship peers.While not the sole rating feature, a state’s generalcreditworthiness (often measured by a GO rating)may provide a helpful starting point for a publicuniversity rating. An analysis of an individual publicinstitution’s demand and finances, combinedwith similar information about the state’s otherpublic universities, allows Standard & Poor’s todevelop a range of possible ratings. The highest ratingsfor public colleges and universities are usuallyassigned to flagship institutions characterized byhigh funding levels, nationally recognized academicprograms, and unusually strong admissions orfinancial position. Other state schools generallyreceive lower ratings, depending on the strength ofstate support to specific institutions, financial andadmissions characteristics, and the security pledge.However, ratings tend to be higher than for privatecolleges and universities because of the presence ofstate support.While a state has unlimited taxing power, a stateuniversity may have less flexibility because a majorportion of its annual budget is at the discretion ofthe state legislature. Thus, without overwhelmingdemand or financial strength, a state university’screditworthiness usually does not exceed or evenequal that of its sponsor state. Public institutionshave broken through this barrier on the basis ofhighly selective demand, large endowment holdings,and/or comprehensive research programs, andbroad revenue diversity. Most public universitiesare not affected by a positive or negative change ina state’s financial condition, except that a fundingenvironment can become more favorable if a state’sfinancial condition improves. The degree of change,if any, in a rating will reflect institutional demandand financial characteristics, as well as the university’srole in the state system of higher education andits funding history.During periods of fiscal stress, many public universitiesare able to increase tuition and fees considerably,without any reductions in demonstrateddemand. Universities with significant insulatingcharacteristics could experience some fiscal strain, iftheir respective states make cuts to higher education,but it may not be demonstrated in the university’sfinancial results. Standard & Poor’s evaluateseach institution on a case by case basis, in the eventof state rating changes, to determine whether theoutlook has changed, or the financial circumstancesare unchanged, better, or weaker.State policiesIn addition to actual appropriations, underlyingstate mandates and policies also impact public universityfinances and must be considered in the ratingprocess. Mandated tuition caps, budgetaryreversions back to the state, required remission ofexcess or unspent dollars back to the state, and limitson bonding for specific projects can all affect aninstitution’s financial operations. These policiesmake analysis of a public university’s finances quite182 Standard & Poor’s Public Finance Criteria 2007

Higher EducationSelected Public College/University Financial Ratios (GASB)Income statement ratios Revenue diversity (all numerators divided by adjusted operating revenues)Net tuition dependenceNumerator = net tuitionStudent dependence (net tuition + auxiliary rev)Numerator = net tuition + auxiliary revenueState operating appropriationsNumerator = state operating appropriationsGrants and contractsNumerator = state, private, and federal grantsGiftsNumerator = giftsAuxiliary incomeNumerator = auxiliary incomeHealth care incomeNumerator = total health care incomeTotal adjusted operating expensesAudited operating expenses plus appropriate nonoperating expensesconsidered to be operating expenses, such as interest expenseTotal Adjusted Operating RevenuesAudited operating revenues plus appropriate nonoperating revenuesconsidered to be operating revenues such as state appropriations,investment income, and private giftsOperating results (all ratios computed relative to adjusted operating expensesChange in adjusted operating incomeChange in estimated operating income/adjusted operating expensesChange in unrestricted net assetsChange in UNA/adjusted operating expensesChange in total net assetsChange in total net assets/adjusted operating expensesBalance sheet ratios Liquidity and debt ratiosCash and investments/expensesCash and investments/pro forma debtCash and investments/outstanding debtUNA/expensesUNA/pro forma debtUNA/ outstanding debtAdjusted UNA/expensesAdjusted UNA/pro forma debtAdjusted UNA/outstanding debtAdjusted UNADebt burdenCurrent debt service burdenMADS burdenPro forma MADS burdenAverage age of plant (years)Full-time equivalent measuresNet tuition per FTE ($)State operating appropriations per FTE ($)Outstanding Debt per FTE ($)Pro forma debt per FTE ($)Net capital assets per FTEEndowment per FTEUniv. C&I/adjusted operating expensesUniv. C&I/pro forma debt principalUniv. C&I/outstanding debt principalUNA/adjusted operating expensesUNA/pro forma debt principalUNA/pro forma debt principalAdjusted UNA/adjusted operating expensesAdjusted UNA/pro forma debt principalAdjusted UNA/pro forma debt principalUNA, adjusted at analytical discretion to include: foundation quasiendowment or foundation UNA; debt service reserves; debt servicebalances; board-designated reserves or endowment; university-heldquasi endowment not included in UNACurrent debt service/adjusted operating expensesCurrent MADS/adjusted operating expensesProjected MADS/adjusted operating expensesAccumulated deprecation/annual depreciation expenseNet tuition/total full-time equivalent studentsTotal state operating appropriations/total full-time equivalent studentsOutstanding debt/total full-time equivalent studentsProforma debt/total full-time equivalent studentsNet capital assets/total full-time equivalent studentsEndowment (market value)/total full-time equivalent studentswww.standardandpoors.com183

Education And Non-Traditional Not-For-Profitsdifferent from that of a private institution. Forexample, while a large financial cushion allows auniversity more flexibility and independence fromthe state, some public institutions are limited as tothe amount of unrestricted reserves they can retain.Standard & Poor’s considers public colleges anduniversities with unrestricted resources below 5%of total annual operating expenses to be vulnerableto severe operating constraints. Capital campaignsto increase unrestricted resources or endowment arelooked upon favorably.MissionAlthough analysis of demand is similar for privateand public universities, ratings of public schools aresometimes skewed by the institutions’ role in providingeducation and the importance of state support.Standard & Poor’s generally regardsacceptance and matriculation rates as key factors indetermining an institution’s overall demand position.However, public institutions generally havemore liberal or open admissions requirements, andacceptance rates for public schools (ranging from30%-80%) are generally not as competitive asthose for comparably rated private institutions. Inaddition, while some premier public institutionshave very high student quality indicators, andacceptance rates may equal those of more selectiveprivate institutions, many public institutions exhibitlower quality measures because of open admissionspolicies. However, a public university may be a primaryprovider of higher education, or the state’sflagship institution and matriculation rates may bevery high. Thus, public universities are often highlyrated, despite having less admissions flexibility thantheir private counterparts.Legal provisionsSince public universities enjoy state funding support,they have less need to guard against revenuevolatility. Where the debt being rated is a GO, orequivalent, of a public institution, a debt servicereserve is not needed if a college has met tworatios for each of the past three years. First, unrestrictedresources divided by operating expensesand interest, should exceed 5%. Second, maximumannual debt service divided by unrestrictedresources should be less than 50%. In Standard &Poor’s view, meeting these two ratios demonstratesenough liquidity to mitigate the absence of a debtservice reserve.Rating Community College DebtAs the role of community colleges has expandedover the past decade, enrollment growth andimproved state support have resulted in increasedcreditworthiness for these institutions.Community colleges have developed along thesame lines as public four-year institutions. However,while public colleges and universities look much thesame from state to state, community colleges existin many different forms.In some states, community colleges fall under theresponsibility of large flagship universities. Otherstates have less centralized systems, whereby individualcommunity college districts have beenformed that resemble independent school districts.Other structures include a state board of educationthat oversees activities of community colleges, inmuch the same way as a state board of regents governsfour-year institutions. Finally, some states donot even have community colleges, but, rather, electto offer technical and vocational classes throughtheir four-year institutions.The wide array of structures has led to debtbeing issued under a variety of security pledges. It isthis variety of security pledges, rather than any realdifferences in debt-repayment ability, that hasresulted in the ratings on community college debtbeing spread across the spectrum, from potentiallya ‘AAA’ where debt is secured general obligationsor ad valorem tax revenues to the ‘BBB’ category.Most community colleges are supported by threemain revenue sources:■ Local ad valorem property taxes;■ State appropriations; and■ Tuition and fees.These income streams can be pledged individuallyor in combination to create numerous securitypledges. The most common pledges, in descendingorder from broadest and most creditworthy to narrowest,include:■ A GO pledge of all of the school or district’sresources, including ad valorem property taxes;■ A pledge of tuition or tuition and fees, excludingproperty tax support;■ A pledge of one or more unlimited student fees,excluding tuition and property tax support; and■ A pledge of auxiliary (dormitory, dining hall,parking) revenues.Depending on the underlying security, ratingsassigned to the debt of a single community college,or district, could vary from one issue of bonds toanother. Community college revenue bonds aretypically rated below GO bonds, depending on thebreadth of the pledged revenues. Issues secured bytuition and fees, and other enterprise revenuesmight be rated higher than revenue bonds securedsolely by enterprise revenues of the community college.All ratings still take into account the communitycollege’s financial performance and othercredit characteristics.184 Standard & Poor’s Public Finance Criteria 2007

Higher EducationThe revenue pledgeThe GO analysis also forms the starting point forthe analysis of a community college or district revenuebond. Because the bondholder no longer canrely directly on tax-raising capability and the usuallypredictable nature of property taxes for repaymentof bonds, an assessment of the demand.financial, management, and legal characteristicsbehind the pledged revenue stream becomes moreimportant.For this purpose, the analysis can be brokendown into four main areas:■ Demand or enrollment and admissions trends;■ Financial operations;■ Management; and■ Debt type and structure.The last three factors are assessed according tothe criteria that Standard & Poor’s has establishedfor public four-year colleges and universities.Demand is evaluated from a slightly different perspectivethan it is for traditional four-year publiccolleges and universities.Demand analysisUnlike most public colleges and universities, communitycolleges generally do not apply strict admissionscriteria. Instead, they employ open-enrollmentpolicies that guarantee full access to students whomeet minimum entrance requirements. Thus, themost telling demand statistics are not related toselectivity, but to enrollment trends.To measure enrollment trends, Standard & Poor’slooks at several factors, including:■ The absolute number of enrollees from year toyear;■ Total credit hours annually for five years;■ The breakdown between full-and part-time students;■ Reasons for any cyclical increases or declines inenrollment;■ The presence of other two-year educationaloptions in the immediate area;■ The breadth of the college’s course offeringsand any overlap with other local educationalinstitutions;■ The college’s role in local economic developmentefforts and reliance on agreements with privateindustry for retraining of workers;■ The strength of the underlying economy anddemographics as a generator of students; and■ The number and type of articulation agreementswith nearby colleges and universities.Typical demand characteristics of an investmentgraderevenue bond rating for a community collegewould be increasing enrollment trends, a balancedmix of full-and part-time students, and a managementteam that is actively seeking articulation, ortransfer, agreements with four-year institutionsand/or tie-ins with local private industry. Decliningenrollments can be an indicator of competition fromneighboring districts or colleges, negative underlyingdemographic trends, or poor management.Auxiliary Revenue Bonds And Privatized DormitoriesTraditional auxiliary revenue bondsStandard & Poor’s has been rating university auxiliaryrevenue bonds for decades. Traditionally, proceedsfrom these bonds financed parking, dining,residence and athletic, and research facilities. Inmost cases, auxiliary bond issuance is driven bypublic universities who often have limited GO ortuition-backed bonding capability. Auxiliary, orenterprise, revenue bonds are generally supportedby revenues from the related project being financedsuch as room and board charges, parking fees, indirectcost recoveries, and other limited student fees.The starting point for Standard & Poor’s assessmentof all auxiliary revenue bonds is the full faithand credit, or GO, rating for the university issuingthe bonds. This rating assesses the university’sdemand and financial strengths and weaknesses andprovides a measure of institutional long-term viabilityand potential demand for the auxiliary projectunder consideration. This approach also reflects theuniversity’s role as project manager responsible forproject maintenance, rate-setting, and control overpolicies governing facility use (for example, a policythat all freshmen must live on campus). Standard &Poor’s perceives this high level of university oversightand ownership to be equivalent to a pledge ofthe university’s moral obligation to repay auxiliarysystem debt.Because auxiliary revenue bonds are secured by anarrower revenue stream than the GO or tuitiondebt of the university, ratings on such debt are usuallynot as high as the university’s general obligationrating. In most cases, auxiliary revenue bondratings are placed one-to-three notches below theuniversity’s GO bond rating, but the ultimate ratingdepends on the size and strength of the particularfacility or system, financial performance, historicaland projected debt service coverage, and legal provisions.The GO bond rating typically acts as a ceilingfor these ratings and it is unlikely for auxiliarydebt that is not secured by unlimited student fees,or a very broad pledge of revenues, to be rated onpar with a university’s GO debt.After establishing the GO rating for the university,Standard & Poor’s analyzes the specific characteristicsof the auxiliary project including:■ Demand for the facility;■ Essentiality of the service being provided;www.standardandpoors.com185

Education And Non-Traditional Not-For-Profits■ History of financial operations including coverageof pro-forma maximum annual debt service;■ Scope of the pledged revenue stream; and■ Legal provisions, including rate covenants andadditional bonds tests.Analysis of these factors, in combination withinstitutional demand, long-term viability, and underlyingcreditworthiness, helps to determine the rating.Modified rating approach foron-campus privatized housingThe issuance of dormitory revenue bonds is not anew development in higher education finance.Many of the dormitory revenue bonds rated byStandard & Poor’s date back to the 1960s. Theiruse, like bonds used to finance parking, dining,and athletic facilities, was almost universally limitedto public universities because debt constraintsor other statutory limitations were not experiencedby private colleges and universities. Privatecolleges have not been prohibited from issuingdebt for any reasons other than the former cap ontax-exempt bonds. Private colleges and universitiesalways pledged their general obligation becausethey could do so.However, beginning in the 1990s the environmentbegan to change. Colleges experienced a surgein demand for modern, updated apartment stylehousing, and needed to respond more quickly tomarket demands. The concept of using developers’expertise and separately created 501©3 issuers tohelp issue the debt for these projects rose in popularity.The motivation for most institutions wasobvious. For public institutions, the ability to circumventtraditional financing guidelines can cutyears off a construction project and significantlyreduce construction costs.Private colleges and universities, meanwhile, facetheir own growing capital needs and are lookingfor ways to preserve their debt capacity and yetremain competitive. Colleges and universities pursuingthe option of privatized housing often want toknow two things: (1) whether using off-balancesheet debt for residential facilities will affect theirexisting credit profile and debt capacity; and (2) thedegree to which they need to support a project toensure a lower cost of capital for their students’housing. Standard & Poor’s criteria for off-balancesheet housing addresses these concerns and largelyrests on the “credit-risk” relationship model.The credit-risk relationship modelIf a college transfers credit strength to an affiliatedentity or project, then the corresponding risks ofthat enterprise will almost always transfer back tothe college. The greater the linkage between thesponsor institution and the project, the more likelythe debt financing will affect an institution’s creditprofile, whether the financing is “off-balance sheet”or not. However, a closer link to an institution’scredit strengths and the possibility of subsidizationof debt service will usually mean a higher standalonerating and a lower cost of capital. A newhousing project with very little link to a sponsoringinstitution will probably not benefit from the institution’screditworthiness. On the other hand, theinstitution can probably safely assume that theissuance of the related debt will not affect its ratingat or after the time of the transaction.Nonetheless, debt related to an entity’s business isalways of concern, especially when the primary customersare the institution’s students. Even a projectthat does not require immediate subsidization mayrequire management effort or time. Future accountingrules could also change, requiring debt that wasoff balance sheet to be consolidated in subsequentfinancial statements. A project related to an institutioncan also represent competition; if future housingoccupancy drops on campus, an importantquestion is whether students will occupy newerfacilities related to the campus, but not the university’sown housing facilities. Issuing additional debt,even if off-credit, could represent credit dilution forexisting bondholders of dormitory revenue bonds.Because of these issues, Standard & Poor’s uses twostandards in evaluating the “credit-risk” relationship:economic interest and control. Does the universityor school have an economic interest in theproject; and does it control who uses the facilitiesbeing financed, project budgets and rate setting, andwho manages the property (control).Comparing traditional dormrevenue bonds and privatized housingWhen rating on-campus privatized housing facilities,Standard & Poor’s first focuses on the differencesbetween these projects (often calledoff-balance sheet debt) and traditional universitydormitory revenue bonds. The chief distinctionbetween off-balance sheet debt and traditional auxiliarybonds is the absence of university oversightand ownership. Traditional dormitory revenuebonds are, in nearly every instance, sold directlyunder the university’s name, controlled by the university,and revenues and expenses of the projectand related debt are consolidated in the university’sfinancial statements. Because of the absence ofownership, Standard & Poor’s does not rely on itshistoric method of shading ratings on dormitoryrevenue bonds using the institution’s GO equivalentrating as a starting point.Instead, for project-based, privatized housing,Standard & Poor’s will use a university’s long-termrating as a proxy for long-term viability and poten-186 Standard & Poor’s Public Finance Criteria 2007

Higher Educationtial demand for housing. If demand for on-campushousing is weak or non-existent, and the university’slong-term rating is low investment grade, it isunlikely that any proposed financing will achievean investment grade rating without a very substantiallink to a sponsoring institution. Conversely, ifhousing demand is strong, and the proposed projectis being used to replace existing housing, the projectwould be viewed favorably. A substantial linkmight be a college guaranty of debt service or anunconditional lease vacancy agreement.The chief similarity between traditional dormitoryrevenue bonds and project dormitory bonds is thateven traditional dormitory revenue bonds are technicallynon-recourse obligations. Bondholders are oftenentitled only to pledge revenues derived from theproject or system of projects. So, for both, the revenuestreams are narrowly defined as being producedby a particular project or set of projects. Anothercorollary is that both are occupied by customers—students of the college or university. As such, it isprobably incumbent on the college to ensure that anyproject to which they are related provides studentswith decent, livable, and economical space. If studentsin the privatized facilities also receive financialaid from the institution for living expenses, theschool is indirectly paying for the facility. If the collegeis a residential college, it may not make financialsense to use financial aid for a project in which thecollege builds no ownership equity.Rating methodologyIn assessing this type of debt—without ownership(and usually without management) by the university—Standard& Poor’s examines many of the samecharacteristics that are evaluated for traditionalauxiliary bonds. Generally the following factors arenecessary to achieve an investment-grade rating.While the following section speaks largely to housing,any other enterprise financing could apply thecriteria for relevancy.Evidence of long-term institutional viabilityA school with a long-term GO rating of ‘BBB+’ orhigher and a strong residential mission is likely tohave the capacity to consider this new type offinancing option. Below this rating threshold,achieving an investment-grade project-based ratingmight be difficult, unless the school provides directfinancial support.Relationship between project owner and relatedinstitutionThe relationship between the two will be evaluatedbased on board composition, ground lease structure,management agreement, and the factors leadingto the decision to pursue the particularfinancing. A university that will ultimately ownhousing in the middle of its campus seems to have avested interest in making that project successful.However, the degree to which a university, particularlya public university that does not currentlyown a project, can legally, or is willing, to cover ashortfall in debt service for that project is untested.It may be easier for private universities to step upto a financially unsuccessful project, but only if it ison their campus and they already exercise somecontrol and oversight.Project demandStudent demand for a new housing facility might bedemonstrated by demand for existing on-campushousing. High occupancy rates, replacement housing,the presence of waiting lists, university leasing of offcampushousing accommodations, and recent enrollmentgrowth will all be viewed favorably. Standard &Poor’s will evaluate external feasibility studies thatshow sufficient demand for on-campus housing, butthese usually provide only partial comfort.Project locationMost projects rated in this way will be on or nearthe core college or university campus. If the proposedhousing is off-campus, the college does notthe land, and there is no significant financial ormanagerial link to the school, Standard & Poor’swould most likely use its affordable housing criteriato rate the project debt.Project managementThe highest rated projects will often by managed byan institution itself (which connotes a higher degreeof responsibility and oversight). At the behest of theuniversity, other projects will be handled by outsidemanagers, usually a for-profit company. The lengthof management contract is generally not as importantas other credit factors. A stronger institutionallink will include university rate setting, budget setting,and housing policies that are virtually indistinguishablefrom other university housing.Rate covenantRate covenants will typically cover debt service andoperating expenses. A typical rate covenant will setrates at a minimum level of 1.20x the next year’sdebt service and operating expenses. In Standard &Poor’s experience, many standalone privatizedhousing projects, that have been completed, haveexperienced either pricing pressure or higher thanexpected costs, such that it has been difficult tomeet the standard 1.2x rate covenant.Additional bonds testsAdditional bonds tests should protect bondholdersagainst the possibility of future debt weakening ordiluting the specific project’s revenue base.www.standardandpoors.com187

Education And Non-Traditional Not-For-ProfitsAccounting IssuesHistorical additional bonds tests are viewed morefavorably than projected tests. The absence of anadditional bonds test will be viewed negatively.Reserves and insuranceA full debt service reserve should either be fundedfrom bond proceeds or through an approved reserveCurrently public and private universities follow very different accounting standardsingeneral public universities follow standards proposed by the GovernmentalAccounting Standards Board (GASB) and private universities follow standardsset by FASB. These differences in accounting rules for similar institutions makecomparisons between private and public colleges and universities difficult andrequire the use of separate analytical ratios for the two groups. However, beginningin fiscal 2002, and for early adopters, fiscal 2001, public universities producedfinancial statements in accordance with Governmental Accounting StandardsBoard Statement No. 35 (GASB 35). While these financial statements resulted indifferent-looking statements for public colleges and universities than under fundaccounting, they are similar to the current format followed by private colleges anduniversities. Perhaps the most striking effect of the change is the appearance of alarge operating loss on a university’s statements, because any state operatingappropriations are considered to be a nonoperating revenue, or subsidy, item underthe new statements. Not unlike our approach to endowment spending, we add backin state appropriations as an operating revenue item. Public colleges and universitiesare also required to expense depreciation. Operations should be balancedincluding depreciation, as failure to account for depreciation expense will lead toreduced equity over time. Since Standard & Poor’s ratios for higher education institutionsmeasure liquidity largely based on equity, this accounting issue can ultimatereduce a college oruniversity’s unrestricted equity.Measuring Operating PerformanceRecent investment losses highlight an analytical problem in the credit analysisof higher education: the absence of a standard industry measure of operatingperformance for colleges and universities. Not only do accounting applicationsvary among private and public colleges, but private colleges and universities alsorecord their financial results in very different ways. Some colleges record allinvestment income and gains as operating revenue. When investment performanceis positive, their operating results appear favorable. On the other hand, for thosewho record only endowment spending as operating revenue, even a year with significantinvestment losses can appear uneventful. Investment losses of millions ormore simply tend to fall below the line. Performance appears to vary dramaticallyfrom year to year without endowment spending as a smoothing device. Thus, inorder to place institutions on an equal footing and eliminate dramatic ups anddowns in investment markets, Standard & Poor’s adjusts for differential accountingby moving all investment income and gains (or losses) below the line for thoseinstitutions who do not record some component of endowment spending as operatingrevenue. Standard & Poor’s then adds back actual endowment spending allocationto get a measure of operating performance. If an institution does not have anendowment spending policy (a rare occurrence), realized income in the form ofinterest and dividends are often a proxy for endowment spending. A major concernsurrounding this exercise is the necessary adjustment of audited financial information.When GAAP statements are difficult to reconcile, Standard & Poor’s higher educationanalysts often ask management for internal operating statements. In these cases,internal statements do not replace the need for audited statements, they merelyprovide a supplement.substitute. A portion of net cash flow should also beretained to build up maintenance and repairreserves. Projects should include a capital (per bed)reserve funded from cash flow, sufficient to handleannual maintenance. Housing maintenance is importantto keep the facility attractive during the life ofthe bond issue and provide for unanticipated majormaintenance. Standard & Poor’s evaluates businessinterruption insurance and the provision for coverage(generally 18-24 months) in the event of damageor destruction. The single site nature of many ofthese projects creates additional risk and full insuranceand reserves are crucial.CoverageMost projects rated by Standard & Poor’s provideadequate or better cash flow protection, with amultiplier of at least 1.2x coverage of maximumannual debt service in every year.Other considerationsProjections should include a reasonable allowancefor vacancies and expense growth. Historicallymany projections provided for these projects haveused a very high occupancy rate of 95%-97%.Standard & Poor’s looks for break-even occupancythat is much lower than this level; generally ifbreak-even occupancy is less than 75%, cash flowsare viewed more favorably.Because of the untested history of these projectsand the concurrent risks of an aging facility, ashorter debt maturity is viewed more favorablythan a longer maturity, even if coverage dropsslightly with the shorter maturity.Many investment-grade projects do not includeconstruction risk. However, construction risk willbe evaluated based on Standard & Poor’s criteria,and a project with construction risk can be ratedinvestment grade. There are mechanisms availableto mitigate construction risks so that a project canbe rated prior to actual completion. Sometimes theformation of a new “privatized housing system”can offset concerns about single site project or constructionrisk. Significant university involvement inthe construction process is also viewed favorably.Credit linksAs seen from the above section, the closer the linkbetween a project and its sponsoring institution,often the higher the rating. However, the closer therelationship, the more likely it is that the housingdebt will be considered a direct or indirect obligationof the institution. Good reasons to consideroff-balance sheet, or indirect debt, as institutionaldebt are:■ The institution receives a direct economic benefit;■ The institution manages the project as if it wereany other on-campus activity;188 Standard & Poor’s Public Finance Criteria 2007

Higher Education■■The project is highly essential for the institutionand loss of control could be harmful to the institution’soverall performance and reputation;The institution benefits from immediate or eventualownership of the project being financed.Ultimately, ratings encompass a variety of factors,of which debt is just one. The inclusion ofadditional indirect debt in an analysis of an institution’soverall credit picture does not necessarilymean that a rating will change. Most often the revenue-producingnature of projects will be taken intoAuxiliary Revenue Bond Rating FactorsHousingDiningParkingScope of Financial LegalPledge Demand Essentiality Operations Structure% of students Historical Commuter or Adequate Additionalhoused on occupancy residential coverage bonds testcampusschoolRevenues Evidence of Part-time or Rate flexibility Rate covenantderived waitlist full-timefrom standalonestudent bodyfacility or systemCompetition— Budgeted capital Closed or openon or off campus expenditures flow of fundsLocation of facilityDebt service reserveRenewal andreplacement reserve% of students Competition— Commuter or Adequate Additionalparticipating in on or off residential coverage bonds testmeal plan campus schoolRevenues derived Part-time or Rate flexibility Rate covenantfrom standalonefull-timefacility or systemstudent bodyBudgeted capital Closed or open flowexpendituresof fundsDebt service reserveRenewal andreplacement reserveNumber of spaces Historical Commuter or Adequate Additionalin system occupancy residential coverage bonds testschoolRevenues derived Defined users— Faculty and/or Part-time Rate convenantfrom standalone students visitors student or full-timefacility or systembodyEvidence of Budgeted capital Closed or open flowwaitlist expenditures of fundsCompetition—Debt service reserveon or off campusLocation ofRenewal andinstitution—replacement reserveurban or ruralLocation offacility(ies)relative to maincampus buildingwww.standardandpoors.com189

Education And Non-Traditional Not-For-Profitsaccount when considering institutional ratings. Selfsupportingprojects are generally viewed morefavorably than projects, which produce no additionalrevenues, all other factors being equal.Rating Stand-Alone Medical SchoolsFrom a rating perspective, since most U.S. medicalschools are affiliated with a university or hospitalor both, it is impossible to evaluate the medical collegewithout considering the associateduniversity/hospital operation. Partnerships and affiliationswith other health care entities is still animportant part of the rating analysis, but only oneof many factors.Most ratings associated with medical colleges arerefined by their relationship with a related universityand/or hospital. In the case of publicly supportedmedical colleges, the rating also incorporates anevaluation of state support. However, Standard &Poor’s does rate free-standing medical schools notaffiliated with a university or a hospital.The rating process begins with evaluation ofdemand and a financial analysis similar to that usedwhen assessing other higher education institutions.The analysis is tailored to incorporate special characteristicsof medical schools, such as limited classsize, high tuition levels, state reimbursement programs,research programs, affiliation agreements,and revenues from faculty practice plans.State-Supported Medical SchoolsState support adds another twist to the evaluation ofmedical schools. Standard & Poor’s rates a fewcombined hospital/medical school entities thatreceive significant state appropriations. While studentdemand, hospital utilization rates, and servicearea characteristics are important rating factors forschools of medicine that also run teaching hospitals,strength of state support can be a key credit factor.Independent Medical SchoolsFree-standing medical schools—those without hospitalfacilities, offer an opportunity to assess a medicalcollege unaffected by the credit characteristicsof affiliated institutions or hospital revenues. Thesecolleges depend more on student demand andtuition, than other medical schools, and must supportthemselves without the benefit of state moneyor a larger university or hospital. However, theymay benefit from affiliated income from partnershipswith adjacent or associated hospitals, and theamount of reimbursement for residents and facultycan be significant. In addition, because their facultypractice in associated clinics and hospitals, they arestill subject to health care industry risk. Because oftheir limited wherewithal and sometimes their weakfinancial performance, historical ratings on freestandingmedical schools generally have not beenrated higher than the ‘A’ category.Demand AnalysisDemand analysis of medical schools mirrors thatused in evaluating colleges and universities.Standard & Poor’s focuses on enrollment trends,application, acceptance and matriculation results,student quality, and competition from other programs.Medical schools often offer more than justmedical degrees, and some medical schools offerboth allopathic and osteopathic programs in medicine.Larger, more comprehensive programs providediversity, particularly since health science academicprograms are known for their cyclicality. However,historical demand for medical school admission hasfar exceeded the available supply. This relationshipholds, despite several years of a national decline inapplications to medical schools. In general, allopathicschools of medicine tend to be more competitivein admissions than osteopathic schools of medicine,however, there are more standalone osteopathicschools of medicine rated by Standard & Poor’sthan allopathic. More of the nation’s allopathicmedical schools are associated with large, researchuniversities. Osteopathic medicine schools, with afew exceptions tied to public, research universities,tend to be standalone institutions.Since there are so few medical school spaces, students’choices are limited, and matriculation ratesare often higher than for other unrelated professionalprograms such as law and business. The flexibilityafforded by such selective admissions isparticularly significant for medical schools that cannotrely on enrollment in other programs to offsetperiods of falling demand. While medical collegesremain vulnerable to industry changes and changingattitudes regarding the medical profession,Standard & Poor’s expects demand for medicaleducation to remain strong, and in fact, recenttrends indicate a positive movement upward inmedical school applications.Financial AnalysisStandard & Poor’s financial analysis of medical collegesalso parallels the approach used for otherhigher education institutions, centering on:■ Revenue and expense composition;■ Annual financial operating results;■ Liquidity and endowment; and■ Debt load.Standard & Poor’s uses the same financial ratiosand indicators used in the assessment of collegesand universities. The chief focus on the balancesheet is liquidity represented by various degrees ofrestrictions on equity. Many medical schools builttheir financial reserves more through decades of190 Standard & Poor’s Public Finance Criteria 2007

Private Elementary And Secondary Schoolsstrong operating performance, until the 1990s and2000s, when performance was more strained. Thus,most medical schools have a higher degree of unrestrictedequity than most colleges and universities.The chief focus of the income statement is operatingperformance and revenue diversity, as well as anunderlying Profit and Loss analysis of the variouscomponents of the income statement.While the analytical approach is similar, some ofthe financial characteristics of medical schools arevery different from other colleges and universities.For example, revenues from faculty practice plans,research grants, and state capitalization programscan result in much greater revenue diversity for smallmedical schools than for similarly-sized colleges anduniversities. Medical schools affiliated with hospitals,or those classified as state institutions, often derivean especially small portion of their revenues fromstudents and tuition. Tuition discounting is usuallynot a concern for medical schools.While these other revenue sources help to insulatemedical colleges from fluctuations in studentenrollment, they may be vulnerable to change themselves.For example, financially strapped state governmentscan reduce state support, forcingpotentially large increases in tuition rates.Faculty practice revenues, mirroring reimbursementpressures on other health care providers andinstitutions, are often strained, with costs exceedingrevenues. Payments for graduate medical educationor residency programs can also come under pressureif the affiliated hospitals, with which the medicalschools partner, face weak operating results. Whenpayments under affiliation agreements decrease,often it is reimbursement for graduate medical educationthat suffers the most. Most payments underaffiliated contracts are multi-year in nature, providingsome revenue stability, but renegotiations canprove difficult in a weak environment. Most standalonemedical schools are not heavily leveraged, butfew also have the large endowments seen at othercolleges and universities. ■Private ElementaryAnd Secondary SchoolsThe universe of rated private primary and secondaryschools, although still relatively small,encompasses a diverse group of educational institutionswhose operations and characteristicsresemble colleges and universities more closelythan traditional elementary and high schools. As aresult, in rating private primary and secondaryschools, Standard & Poor’s Ratings Servicesassesses operational indicators similar to thoseused in rating colleges and universities.A key element in the rating is demand, measuredby such factors as enrollment, the number of applicants,the percentage accepted, matriculation rate(percentage of students offered admission whoattend the school), and student quality. Institutionalcharacteristics, such as the curriculum offered andwhether a particular institution is a boarding orday school, also are important considerations.Financial factors, management, and legal provisionsgenerally, but not always, modify the rating. A highendowment can considerably offset weakerdemand. Most debt sold by private schools issecured by a GO pledge, so legal provisions bearless weight for debt ratings in this area.Independent schools, while facing many of thesame challenges as colleges and universities, operatein an environment vastly different from that of highereducation institutions. For example, independentprimary and secondary schools generally draw froma smaller, more regional market—particularly if theyonly offer day school programs—than do colleges,which may receive enrollment applications fromacross the country. In addition, independent schoolstypically are smaller than their public school counterparts,which receive local support and property taxrevenues. Given the high tuition levels, a significantnumber of students attending such schools are affluent,which further limits the potential applicant pool.Tuition is an important element in the financialprofile of independent schools, and in general, privateprimary and secondary schools have considerablyless revenue diversity than colleges anduniversities. However, with student charges alreadyrivaling those of colleges and universities, thepotential for additional increases may be limited.More and more tuition increases are being matchedby rising financial aid costs. Although most of theschools make significant amounts of financial aidavailable to help offset the high tuition cost,Standard & Poor’s believes that local economicfluctuations may be more likely to affect parents’decisions to send their children to private primarywww.standardandpoors.com191

Education And Non-Traditional Not-For-Profitsand secondary schools. Parents may be forced tochoose between a private primary/secondary educationor a private college education for their children.While many parents are motivated to financea private primary or secondary education, it stillrepresents a discretionary choice. Typically, independentschools are very small and their revenuebase is very concentrated. This concentration provideslimited flexibility, and the loss of just a fewstudents can have a big impact on a school’s financialperformance. Too, because of their small size,independent schools may find it difficult to achieveeconomies of scale.DemandIn analyzing demand factors, Standard & Poor’sfirst considers the school’s mission (day versusboarding school, level and number of gradesoffered, single-sex versus coeducational, parochialversus nonsectarian, and program type).Standard & Poor’s also reviews the size of the territoryfrom which students are drawn and the numberof schools in competition for this select pool ofapplicants. Boarding schools, with a wider geographicdraw, are potentially more creditworthythan day schools, which draw students only fromtheir local areas. However, the creditworthiness ofboarding schools is often affected by the additionalfinancial stress of having to maintain housing and alarger overall plant. A day school with local drawwould be able to achieve a high rating if, forinstance, it had a very large endowment and considerableunrestricted monies. This, in addition tosolid demand, would more than compensate for itsposition as a day school.Student demand factors are reviewed to determinea school’s popularity and selectivity.Standard & Poor’s examines enrollment and applicationtrends, acceptance rates, matriculation, andstudent quality, as measured by standardized testscores (secondary SAT scores of applicants and SATscores of graduates), and retention. IndependentDocumentation Requirements■ Five years of audited financial statements.■ Current year’s budget summary.■ Comprehensive debt service schedule.■ Major strategic, capital, operating, or academic plans.■ Official statement providing descriptive information.■ Most recent investment report.■ Bond resolution or indenture.■ Lease or mortgage (if applicable).■ Loan agreement (if applicable).schools generally display stable demand trends, i.e.the number of applications tends to be very stable,along with enrollment levels. Management shouldexplain changes or disruption in the number ofapplications or wide swings in enrollment. Thehighest rated independent schools often lose lessthan 5% of their students each year to attrition. Inaddition to these factors, Standard & Poor’s looksat colleges attended by students upon graduationfrom the independent school.Despite smaller enrollment levels and applicantpools, which often result in acceptance rates thatare generally weaker than comparable measures forcolleges and universities, most private primary andsecondary institutions have had a relatively strongrecord of growth.As a means of increasing enrollment, some independentschools use marketing efforts similar tothose employed by higher education institutions.Such strategies include broadening geographic drawby targeting specific areas, increasing student aid,and expanding programs. An example mightinclude an expansion from solely day programs to amix of day and five-day boarding.Admissions flexibility is a key factor in evaluatingan independent school. Strong student qualityenhances a school’s ability to withstand a reductionin its applicant pool, allowing it to accept less qualifiedstudents. Other measures of student qualityinclude the percentage of graduates attending college,analysis of the colleges attended, and graduates’success in college. Indicators for elementaryand middle schools tend to be less standardized,requiring case-by-case determination of appropriatecriteria, such as students’ performance on statewidetests compared with norms. For all schools,Standard & Poor’s assessment of competing institutionsalso is important. The attrition rate, or thepercentage of students who do not return each year,is helpful in measuring student and parent satisfactionwith the school and also provides insight intofinancial performance.Operational And Financial FactorsStandard & Poor’s review of operations andfinances starts with an examination of revenuesources and diversity of funding. The privateschools rated by Standard & Poor’s are evaluatedusing the same ratios and financial indicators usedto assess the creditworthiness of private collegesand universities. These ratios are developed forinstitutions that follow FASB standards of accountingand display. Important areas of inquiry are relativerestrictions on equity, total change in netassets, and change in unrestricted net assets fromoperations. Similar to many private colleges anduniversities, many independent institutions rely on192 Standard & Poor’s Public Finance Criteria 2007

Private Elementary And Secondary Schoolstuition as their main source of revenues, althoughendowment income and auxiliary revenues fromsources such as boarding fees, summer programs,and rental facilities provide significant support forsome schools. However, for more highly ratedschools, endowment income and private contributionsare increasingly important. Most independentschools run annual fundraising campaigns, andmajor comprehensive fundraising or capital campaigns.The largest of these campaigns is generallymuch smaller than the largest of capital campaignsfor colleges and universities, but the alumni basefor most independent schools is quite limited.Parental participation rates for many of the schoolsrated by Standard & Poor’s are quite high—as highas 90% or more. Alumni participation rates vary,but can be much higher than a comparable level ata private liberal arts college.Standard & Poor’s also examines expenses andfixed costs, such as tenured faculty, operation andmaintenance of plant facilities, and debt service. Ingeneral, primary and secondary schools do not havetenured faculties, giving these schools greater abilityto react to fiscal pressures than educational institutionsthat award tenure to faculty. On the otherhand, these schools are often so small that it maybe difficult to achieve economies of scale seen inlarger institutions. It is not uncommon for a schoolwith fewer than 400 students to receive an investmentgrade rating. However, it is likely that it is notstrong operating margins, but a good balance sheet,balanced operations, and good demand that drivean independent school rating.The debt service burden is assessed by looking atmaximum annual debt service as a percent of operatingexpenses. Because of their small size, andsmall operating budgets, independent schools debtservice burden is often a high percentage of operatingexpenses. A debt load above 10% could be significantand may be a rating factor, however, itdepends on whether the school has the existingoperational capacity to take on the debt. A troublingindicator is the need to raise the endowmentdraw to support the increased costs of debt service,particularly if the increase in endowment spendingresults in a rate well above 5%. Day schools withoutlarge auxiliary operations present a special case.For example, in the context of a small budget andlack of tenured employees, even a high maximumannual debt service could be considered manageableif operating performance is good and an endowmentprovides additional support. Many independentschools issue variable rate debt secured byletters of credit or other credit enhancement. MoreRelevant Admissions Statistics*■ Headcount enrollment and projections.■ Total full-time equivalent enrollment.■ Total number of boarding and/or day students.■ New student information—including applicants,acceptances, and matriculants for each class, ifavailable, and average SSAT scores or SAT scoresof graduating seniors.■ Top 10 competitor institutions and win/loss statistics.■ Attrition and/or retention rates.■ Colleges and universities attended by graduating seniors.■ Day and boarding tuition and fee charges.■ Average room and board charge.■ Number of part-time and full-time faculty.*Five-year historical data required.of these schools are using interest rate swaps tohedge the interest risk exposure on the transactions.Standard & Poor’s evaluates swaps to calculate aDebt Derivative Profile (DDP) score.Standard & Poor’s reviews a school’s annualoperating results to determine long-term financialstability and strength. Liquidity analysis principallycompares cash and investments, unrestrictedresources, and expendable resources with operatingexpenses and debt. Unrestricted resources exceeding100% of expenses indicate strong liquidity position.Schools with unrestricted resources to operatingexpenses below 50% have more limited cushion andoperating constraints. Often, again because of theirsmall operating budgets, most independent schoolshave higher relative resources to expenses and debtthan a comparably rated college or university.Finally, Standard & Poor’s reviews facility needs,capital plans, and deferred maintenance to determinetheir potential impact on future financialstrength. Strong operating results may be significantlyoffset by substantial deferred maintenance,which can cause future financial strain. Little or nodeferred maintenance would be an added financialstrength to a school. Some independent schools failto account for depreciation in their operating budgets,which subsequently results in a year-end declinein unrestricted net assets. Because Standard &Poor’s evaluates liquidity using net equity ratios,the drop in unrestricted net assets directly leads to adrop in liquidity. If a school does not budget fordepreciation, Standard & Poor’s will evaluate thequality of the physical plant for signs of neglect andwill ask about annual allocations to plant renewaland replacement.www.standardandpoors.com193

Education And Non-Traditional Not-For-ProfitsPrivate primary and secondary schools that showa combination of strong results when evaluatedagainst the criteria discussed above will be positionedto achieve investment-grade ratings.Standard & Poor’s is unlikely to assign ratings muchhigher than the ‘A’ category without significantendowment and financial strength. Furthermore,Standard & Poor’s expects that most institutionswith ratings at the higher end of the spectrum willcontinue to be very selective boarding schools witha diverse student draw. ■Charter SchoolsAcharter school is an independent public school,receiving public funds, that operates under acharter or contract for a specified period of time toeducate children according to the school’s owndesign, outside of the existing public educationbureaucracy. It may be a new school, a start-upschool, or an existing one that separates from anexisting school district. It is held accountable interms of its charter and continues to exist only if itfulfills those terms. The statutory framework underwhich charter schools operate varies significantly bystate and often requires the reauthorization of thecharter by the sponsoring entity after a specifiedperiod of time, typically three to five years. Afterrenewal, some charter authorizations may run aslong as 10-30 years. The first charter school openedin Minnesota in 1991.Charter schools pose unusual analytical challenges.Public school districts and charter schoolsdiffer in critical ways. Public school districts mustremain “going concerns”, regardless of managementperformance or economic environment.Financial stress does not cause a public school districtto go out of business, and may even generatepositive counter-measures due to state oversight andsupport. In addition, public schools do not need toget their charter renewed periodically to stay inbusiness. In contrast, charter schools may permanentlygo out of business. Most charter school closuresto date have occurred largely because of issuesrelating to financial mismanagement.Standard & Poor’s Ratings Services’ approach torating charter schools depends on factors affectingeach local school, as well as the state legal frameworkfor authorizing and funding charter schoolsfrom statewide revenue sources. Rating analysis willvary from state-to-state and continue to evolve,because each school and state charter structure isvery different.Standard & Poor’s rating methodology for bothschool districts and charter schools includes anoverview of the following:■■■■■■■Charter frameworkDemand for a schoolFinancesManagement and administrationDebt, capital planning, and expansion riskDemographicsLegal structure of the debtState Statutory FrameworkAn important ingredient of a creditworthy charterschool includes a clearly established state statutoryframework for establishing, maintaining, andfinancing charter schools.Charter authorityStandard & Poor’s examines who, under statute,has the authority to grant charters. Powers areusually vested with a state-appointed board, astate university, or most commonly, a local schooldistrict. When a local school district is grantingthe charter, Standard & Poor’s needs to feel comfortablethat the school district supports the charterschool, since the two may compete for thesame students. Local school districts may supportthe charter school for varying reasons, such asrelieving new building needs in growing districts,or providing a unique educational curriculum notcurrently provided. The number of charter schoolsand competing new entrants that are allowed bystatute or may be established in the future is animportant demand consideration. In some cases, alocal school district official may serve on a charterschool board, enhancing support and integrationof the charter school with the local school district.In some states, charters can be granted by a city,state, or a university that do not actually competedirectly with a local school district, thus eliminatingsome of the competitive aspects.State legal frameworkState charter statutes set the legal foundation—aswell as the payment mechanism—for charters in astate. A very important component of the statutes is194 Standard & Poor’s Public Finance Criteria 2007

Charter Schoolsan impartial legal framework for charter renewal orrevocation, including a right to appeal a charternon-renewal; such oversight contributes to moreuniform results. A clear renewal and appeal processshould diminish the political elements involved inestablishing or maintaining such schools, whileensuring adequate community input.Some states also provide start-up or other additionalcapital funding for charter schools, enhancingthe ability of a charter school to fund its debt.Charter termThe charter term is an important credit factor. Thestate statute will either limit the term or establishthe entity that is charged with granting the charterterm. Charter schools are often granted charters oflimited terms—typically up to five years—andtherefore are subject to periodic renewal evaluations.Some states do grant charter renewals forlonger periods, some as long as 20 years. Charterscan usually be revoked even prior to the end of thecharter term, usually for cause. While charters mayonly extend for five years, longer-term capitalfinancings are generally amortized over a 20-30year term. A good match between the charter termand bond amortization may contribute to a betterrating, although Standard & Poor’s does notrequire long charter authorization periods for aninvestment-grade rating. A school with good financialoperations and stable enrollment is likely toremain a going concern, and thus a shorter charterterm relative to debt maturity can be acceptable.Schools that have been through a charter renewalor similar review process at least once support theassumption of future successful renewals, and aremost likely to be rated investment grade.In general, Standard & Poor’s believes that theperiodic need to renew a charter does not necessarilypose a major risk to receiving an investmentgraderating. A successful charter school with highdemand for its product will have its charterrenewed, much as successful hospitals will havetheir operating licenses renewed if they meet a communityneed. Closures of charter schools generallyfollow from management or financial disorder, notfrom the arbitrary charter revocation or closuredecision of the authorizing body.The role of the charter school authorizerThe charter school authorizer plays an importantrole in determining credit quality. Nearly all of theinvestment-grade charter schools rated byStandard & Poor’s have been through a successfulcharter renewal process, although schools that havenot been through the renewal process may stillmerit an investment-grade rating. A long-term chartercould be a positive rating consideration. In addition,a school that has received interim charterapprovals as new grades are added or programschanged will be considered to have gone through aprocess similar to a charter renewal. In some cases,where the initial charter term is long, Standard &Poor’s has accepted a letter from the charter authorizeraffirming current school compliance with theterms of its charter.Standard & Poor’s focuses on the following questionswhen evaluating the authorizer as part of acredit review:■ What are the guidelines for charter renewal? Ifthis is a detailed and specific process, there is lessroom for arbitrary revocation.■ What is the history of charter revocation in thestate and for the specific authorizer? Have asponsor’s charter decisions been appealed? Whohandles the appeals?■ What is the level of oversight from a financialreporting and facilities planning standpoint? Isthere a formalized financial reporting and oversightprocess during the fiscal year that allows forcorrective action to be taken in advance of thecharter review time frame?■ Is there a role for the authorizer in providing liquidityor credit enhancement relating to short-orlong-term debt issuance? This could be a positivecredit factor.■ Is there an interim charter renewal period whengrades are added or triggered to some other event?■ What is the relationship between the sponsor andits charter(s) over time? What level of academic,planning, or administrative support is available?■ How many charters have been granted and/or areoverseen by the charter authorizer? How manyschools has the charter authorizer closed?The strongest sponsor/charter relationships willhave formalized coordination and reporting inplace, and good communication that allows quickresolution of any academic, policy, facilities orfinancial issues that arise. As part of the ratingprocess, Standard & Poor’s will typically meet withofficials from both the sponsoring entity and thecharter school.Charter School FinancingA key part of the analysis deals with the fundingmechanism for charter school operation, that is,whether a combination of state or local funds willbe predictable and adequate. Many states simplyfinance students in their charter schools at or nearthe same per-pupil funding level of traditional publicschools, while others leave the funding formulato negotiation with the sponsor. In some states,charter schools get less funding per pupil than publicschools and receive no public funds for capitalwww.standardandpoors.com195

Education And Non-Traditional Not-For-Profitsfacilities financing. Others provide special per-pupilfacilities funding. While each state’s formula fordistributing funds to its charter schools differs, thestrongest systems occur when the state standardper-pupil funding of public schools follows the studentsto the charter schools. Additionally, per-pupilfunding may flow-through a sponsoring district, orcome directly from the state.Standard & Poor’s will evaluate the fundingmechanism and payment requirements to determineif cash-flow difficulties of a sponsor, such as asponsoring school district, could create cash-flowdifficulties at the charter school. A stand-alonecharter school typically has less flexibility to withstandfunding reductions or timing delays than atraditional multi-facility and multi-grade publicschool district.The statutory authorization for issuing charterschool debt needs to be clear. If specific fundingunder statute for facilities is available, it is alsoevaluated and considered a credit strength. Somestates provide direct funding for facilities, whileothers provide statutory authorization for localschool districts to provide facilities funding.Other states provide no capital funding provisionsfor charters.Student DemandStudent demand for the charter school is one of thekey elements of a rating evaluation. State fundinggenerally follows pupil attendance for most charterschools. Charter schools need to demonstrate arecord of demand for their educational services, asmeasured by stable-to-increasing enrollment, inorder to retain funding.Standard & Poor’s does not have a minimumenrollment size threshold for any given rating category.However, a small school may sometimesbecome dependent on only one or two key administrators,or be less able to be withstand minor randomfluctuations in enrollment. There may also beeconomies of scale involved with some largerschools, although every example must be examinedon its own merits.Specifically we look at the following:■ A well-documented waiting list that is regularlyupdated and maintained. A positive trend is particularlyimportant if the charter school is issuingdebt to significantly expand its facilities. Thequality of waiting lists will vary dramaticallydepending on its requirements, such as, the age ofthe list, the level of detail required per applicant,parent volunteer time agreed to serve uponenrollment acceptance, and other requirements.■ An overview of competition in the area thataffects the long-term viability of the school. Thiswould include an analysis of other charterschools currently operating in the area andwhether competing new charters could beauthorized in the future or whether competingcharter schools have authorization in their chartersto expand enrollment. In addition, the localpublic school district is examined as a potentialcompetitor in terms of quality of school offeringsand its degree of overcrowding. Analysis ofother private school alternatives in the area isalso done. Forecast assumptions should be basedon reasonable well laid out assumptions asregards public and private competition andanticipated future competition.■ A charter school enrollment trend that is stableor growing is also preferable, with good retentionrates and manageable student turnover.Enrollment forecasts should be based on reasonable,well laid out assumptions.Unlike private independent schools rated byStandard & Poor’s, charter schools are required tomaintain open admissions policies. If demandexceeds supply, most charters use a lottery systemto fill available spaces.Unusual curricula present a challenge in the ratingprocess. Standard & Poor’s has to determinewhether a unique academic focus is relevant to thecommunity and will continue to attract students.Another challenge associated with charter schools isa frequent absence of recreational and student facilitiestypically found in large suburban high schoolsor private independent schools. Limited athleticfacilities and related programs can significantlyhamper recruitment efforts for older students, particularlythose in high school and junior high,although they may reduce charter school operatingcosts. Some charter schools have the ability tocharge a facilities fee to offset activities’ costs; otherscannot. Some charter schools may be able tocoordinate with their local public school districts toprovide recreation programs.Financial FactorsThe charter school’s own management of itsresources is a key determinant of its creditworthiness.Since most charter schools are likely to besmall, there will be fewer opportunities to realizeeconomies of scale; therefore, careful financial managementis critical. Of particular importance is theformula by which revenues are derived, often net amanagement fee to the sponsor. Revenues in some196 Standard & Poor’s Public Finance Criteria 2007

Charter Schoolsstates are not always determined on a per-pupilbasis. Other financial factors include:Operating historyInvestment-grade rated charter schools will likelyhave a stable financial operating history, preferablyfor at least three years.Fund balanceFund balance reserves are critical due to charterschool reliance on enrollment for funding.Enrollment can, and does, fluctuate, while fixedcosts may not. Standard & Poor’s examineswhether there is a formal fund balance policy basedon cash flow requirements, and if the school successfullyadheres to such policies.Financial flexibilityThe ability to reduce budgets, if necessary, also contributesto financial flexibility in the event of anunexpected downturn in enrollment, as do conservativebudgetary policies. Standard & Poor’s routinelyasks charter schools how they wouldmaintain a balanced operating budget if enrollmentdipped or state funding were delayed or reduced. Inthis respect, low class sizes provide some flexibilityto increase student-to-teacher ratios and cut costs.General financial policiesAdequate casualty insurance is advisable since charterschools often use a single site facility. Existenceof long-range financial and facilities planning, andformalized policies relating to fund balance andcash flow reserves are also positive managementand financial factors.Audits and financial reportingWhile Standard & Poor’s strongly prefers independentaudits, we have rated schools that are presentedas a component unit of a school district that is alsothe authorizer. Availability of independent audits—at the charter school level—may be a critical ratingfactor. Uniform financial reporting is important forfiscal accountability and also factors into charterrenewal decisions.Cash managementCash management policies and procedures areimportant. The frequency and timing of payments tocharter schools throughout the year varies by state,which may affect daily cash flow. Banking relationsmay also be reviewed when access to liquiditybecomes important due to modest cash reserves,since cash flow requirements can be uneven. Whilesome states have provisions to accelerate funding tocharter schools that can alleviate cash flow issues,other states have no such provisions.Renewal and replacement reservesExistence of a formal reserve for future renewal andcapital expenses that is funded within the operatingbudget each year is considered a positive credit factor.The establishment of such a reserve with fundingup-front or through required payments overtime may strengthen credit security.Endowment/fundraisingIs there an established endowment or fundraisingprogram? The existence of such a program maycontribute to financial flexibility. Conversely, isthere a dependence on fundraising to support programscrucial to attracting students to the school?Management And AdministrationManagement factors are a critical part of charterschool review and will be a pivotal factor in determiningif a school is investment grade. Standard &Poor’s considers the history of charter school establishment.Biographies of key staff members mayindicate the depth of the management team. Keystaff should have solid experience in financial managementin addition to the expected academic/educationalcredentials, or an experienced managementcompany or public school district staff should providesuch expertise. Charter school management isexpected to have, or obtain, construction managementexpertise, as needed. In situations where thesuccess of the charter school is closely tied to thecharisma and personality of a founder, successionplanning is necessary to ensure ongoing viability ofthe school.Private management contracts are not uncommon.This is generally credit-neutral as long as themanagement company is experienced and the termsof the management contract do not adversely affectbondholder repayment. There should be policies inplace to maintain operations in case a managementcompany resigns or is fired.Details about the budgeting process are importantfinancial management issues, and Standard &Poor’s checks to see if management has been generallyaccurate in its enrollment and cost projections.Information regarding teacher recruitment is alsoimportant, as well as teacher certification, salaryscale comparisons with the local school district andcompeting charter schools, how teachers arerecruited, certification requirements, comparativesalary scale, and turnover.Debt And Capital PlanningMany state statutes specifically authorize charterschools to issue debt. Public capital financing forcharter schools, however, is in its infancy comparedto other municipal rating sectors. Many states havewww.standardandpoors.com197

Education And Non-Traditional Not-For-ProfitsRelevant demand informationnot yet developed an active public debt market forcharter schools. Although charter school facilitiesfinancing varies substantially from state to state,many schools are left to their own resourcefulnessand the diligence of interested community membersto secure and finance adequate facilities. Many newschools initially finance space using short-term leases,then later purchase their leased facilities or relocateto new facilities purchased with long-term debtonce they have established a financial track record.If a substantial portion of classroom space will stillremain under short-term lease after a debt-financedexpansion, a contingency plan needs to be in placein case the leased space cannot be renewed.Charter School Information Requirements■ Description of school’s history and founding■ Total student enrollment (for last 5 years)■ Current year and future enrollment targets■ Number of students on waiting lists (for last 5 years), preferably broken outby grade-level■ Measures of educational outcomes (test scores, performance onstandardized tests)■ Number of faculty and staff■ Description of current facilities (if more than one location, indicate numberof students■ Number and description of close competitorsRelevant financial information■ Sponsor (names and addresses of key contacts)■ Charter School management biographies■ Current charter provisions (term and funding levels)■ Charter renewal history and description of charter renewal process■ Audited financial statements (or independent financial reports for last 3 years)■ Current year operating budget■ Description of funding mechanism and cash flow■ Description of any fundraising activities, public or private gifts or grants■ Revenue projections (including estimated enrollment, revenues, expenses, anddebt service coverage)Other documentation requirements■ Sources and uses and debt service schedule■ Description of bondholder security■ Offering statement/disclosure information■ Independent property appraisal (market value assessment of completed projectand land may be required)■ Independent site assessment (may be required)■ Lease agreement■ Trust indentureA key charter school debt ratio is the debt serviceburden relative to the operating budget. An annualdebt service burden of more than 20% of expenseswould be considered onerous in most cases. This isprobably one of the more critical measures, becausea high fixed cost for debt service can significantlylimit fiscal flexibility. Any charter school expectingto raise its debt levels needs to demonstrate an abilityto pay for the increased debt service, especiallyif the revenues are expected to come from enrollmentgrowth. The need to grow enrollment rapidlyto meet approaching debt service obligations is considereda weakness. The strongest charter schoolscan demonstrate ability to meet future debt servicewith existing enrollment levels or very limitedreliance on enrollment growth. An example of limitedreliance on future growth might be the additionof an extra grade level, which currently enrolledcharter school students may graduate into.Using a lease structure to repay debt rated at thelower end of the credit spectrum may not be considereda material credit weakness, although it is preferableto have a general obligation pledge of the charterschool in addition to a mortgage on a school building.Charter school lease structures must meetStandard & Poor’s lease criteria. Basic security featuressuch as appropriate debt service reserve funds,additional bonds tests, use of a trustee to hold bondfunds, and similar security features should be incorporatedinto the financing structure. Legalcovenants such as a rate covenant are not relevantto a charter school; charter schools do not chargetuition, but receive state revenues. A charter schoolusually can only increase net revenues by increasingenrollment or reducing expenses.Standard & Poor’s also considers what futurecapital requirements and other projects will be necessaryto keep schools viable and competitive:■ How will annual maintenance requirements behandled as part of the operating budget?■ If capital facilities are to be expanded, how willthe increased operating costs be handled?■ How thoroughly have expansion plans been considered?Charter schools are at a disadvantage comparedwith public schools, because their state operatingrevenues might also be needed for paying debtservice, in contrast, public schools enjoy a separateproperty tax levy for debt service. A formalcomprehensive business or capital plan can be acredit strength.Also of concern are the debt issuing provisionsof the entity providing the charter authorization.Is it actively involved and does it have an approvalrole on projects under consideration? Does the198 Standard & Poor’s Public Finance Criteria 2007

Charter Schoolsauthorizer have guidelines regarding facilities ordebt structure?Projected future debt service coverage margins areevaluated but may be of limited value compared toa demonstrated ability to manage budgets and generaterevenues. Projected budgets should adequatelyprovide for future debt service payments plus a marginfor unexpected financial fluctuations. Identifyingareas of the budget that could be cut would be anadvantage and may serve the purpose of providing ahedge against potential drops in enrollment.Standard & Poor’s prefers projections indicatinga coverage margin on new debt. However, theunique nature of charter schools, which receive thebulk of their revenues from government, asopposed to tuition receipts, makes the level of coverageof debt service less important, since the creditquality of the state providing the funding providesa certain level of revenue stability, assuming enrollmentstability. Revenues will be stable due to stablestate funding and stable enrollment, not fromtuition-setting power. Given this, flexibility that canbe found in the budget on the expenditure side ofthe budget to accommodate fixed debt service costswill demonstrate credit strength.Charter schools that finance facilities to accommodatesignificant additional student enrollment growthwill usually have greater difficulty achieving aninvestment-grade rating. Facilitiesconstruction/expansion risk is present if debt serviceis onerous and the ability to repay the increased debtis limited if the facility does not open on schedule, isover budget, or can not attract enough additionalstudents to pay for itself. Demonstrating demand foran expanded facility becomes increasingly difficult asthe anticipated percentage increase in enrollmentgrows. It may be even harder to demonstrate theability to attract enough new students to pay for theincreased debt if the school plans to open a newsatellite campus in a far away location.Even a move to new facilities in a nearby locationcan create the risk that not all students will followto the new location. In some cases, theattraction of a school may be the ability to walk toschool, or a desirable central drop-off location, afeature that may be lost in a move.Sometimes an additional bonds test can help mitigateconcerns about potentially aggressive expansionplans, although additional bonds tests don’t necessarilyprovide full protection, since subordinate debtcould also create financial hardship. A senior lien ondebt does not help if a school closes due to the difficultiesof repaying its other obligations.Socioeconomic FactorsTraditional economic indicators for general obligationpublic school districts, such as income,employment base, and unemployment rates, are lessof a credit issue for charter schools than for publicschools because charter schools are not directly taxsupported by the local economic base, but bystatewide school funding appropriations.Demographics of an area serviced by a charterschool are nonetheless analyzed, particularly populationgrowth. Historic and projected studentenrollments are an indicator of overall educationdemand. A rapidly growing area is generally morecapable of supporting education alternatives inorder to meet demand for facilities. However, acharter school can be successful in a slow or decliningenrollment environment if public school optionsare substandard, the charter school represents amore attractive alternative curriculum, and there isnot major political friction with a charter authorizerfrom the competition for a declining studentpool. Documentation of higher test scores than incompeting public schools can help demonstrate theappeal of a school. In some cases, the attraction ofa charter school over a public school may be simplythe amount of greater discipline being offered, ormaybe a less structured environment. Some publicschool districts view charter schools with specializedcurriculum options as almost another kind ofmagnet school within the overall public school system,and worthy of their support. ■www.standardandpoors.com199

Education And Non-Traditional Not-For-ProfitsNon-Traditional Not-For-ProfitsThe substantial number of rated not-for-profitcorporations generally falls into four broadareas that are separate from the traditional sectorsof health care and higher education. They are:■ Cultural institutions and attractions;■ Voluntary membership organizations;■ Endowed and charitable foundations andcorporations; and■ Research institutions.In many respects, the only similarity betweenthese four entities is their tax-exempt status. Yet,despite this diversity, Standard & Poor’s RatingsServices has developed a common rating methodologyto assess their creditworthiness. This methodologybuilds on our criteria for hospitals anduniversities, yet incorporates the unique characteristicsof each new nonprofit entity. In general,Standard & Poor’s public finance does not ratepolitical parties and churches.Rating MethodologyThe four main credit factors considered for eachorganization are:■ Demand for the organization’s productsand services;■ Management and governance;■ Financial performance and resources; and■ Debt and capital structure.While these factors are the same as those used forassessing many types of credits in public finance,the focus of the evaluation is quite different,depending on the type. For cultural institutions,demand is often the focal point. Most of the culturalinstitutions rated by Standard & Poor’s areadmissions-driven, and earned income is a functionof the number of people who attend or visit a facility.For membership organizations, the primaryfocus is the tie between the organization and itsmembers, and an analysis of the service or servicesprovided. Membership revenue may not be thelargest source of operating income for the organization,but the relative importance of the corporationto a particular industry is often a key factor.Analysis of endowed foundations focuses less ondemand and more on financial resources and balancesheet strengths, and the likelihood of growthor stability, or the possibility of reduction in thepool of assets. The driving factors behind the analysisof research organizations are the nature andlevel of the research, whether the costs of researchare fully reimbursed, and an entity’s ability to withstandfunding changes. Most of the research institutionsrated by Standard & Poor’s, in addition to asizable research base, also benefit from the presenceof long-term investments or endowment.DemandStandard & Poor’s assessment of demand requiresa thorough understanding of each entity, its mission,market, and niche. An important componentshaping the character of these organizations is anissuer’s tax-exempt status. Such status entitles nonprofitsto an exemption from taxes on related businessincome and to issue tax-exempt debt—twosignificant advantages not available to for-profitcounterparts. Conversely, not-for-profits often runbreakeven financial operations; but because theseorganizations retain earnings without shareholderdistribution, they tend to build reserves over time.Standard & Poor’s reviews an organization’scharter to assess its mission and changes in this roleover time. Depending on the primary activity of theorganization, we examine various measures ofindustry effectiveness and performance. For example,when assessing a museum, Standard & Poor’smight review net revenues per visitor, a commonindustry statistic. When assessing an endowed orcharitable foundation, assessment of fundraisingefficiency (what portion of dollars raised is spent onprograms and what portion on administrativecosts), is also important. This point is especiallytrue for organizations that engage in direct mailfund drives and which raise a substantial portion oftheir annual budgets from external donors.An assessment of competition or competitiveposition is also important. Unlike a municipality,which provides essential services and therefore islikely to survive despite fiscal stress, nonprofitsmust have a role unique enough to ensure ongoingviability. Closing a local service nonprofit organizationmight not cause significant long-term distressor dislocation to the local community or users. Butclosing an important federally sponsored researchinstitution that provides essential research for thefederal government might be more disruptive to thegovernment of the entities in this sector rated byStandard & Poor’s. However, very few of theseinstitutions go out of business. Some organizationshave voluntarily rescinded their exempt status and200 Standard & Poor’s Public Finance Criteria 2007

Non-Traditional Not-For-Profitsconverted to taxable, or proprietary corporations.Typically, any tax-exempt debt would be refundedat that point.Management and governanceManagement is an important credit factor, particularlyfor nonprofits wrestling with industry competitionand often limited financial flexibility.Standard & Poor’s assesses management and governanceby reviewing:■ The composition of the board of trustees, itsexpertise, its independence, its committee structure,and its role in setting financial guidelinesand goals;■ The quality of management information readilyavailable in the rating process;■ Operational policies, investment and debt policies,and strategic plans;■ The ability to anticipate and react to new developmentsin the marketplace; and■ Current tenure of existing administrative officersof the organization and their relevant experiencein the industry.While nonprofit corporations are not required tofully adopt the provisions of Sarbanes Oxley at thistime, in practice many of them voluntarily adoptmost of these as practices, with the exception ofcertification of financial statements. Most of theorganizations in this sector that achieve investmentgrade ratings also engage in multi-year financialplanning and can easily produce budget models thatforecast future operations.Since many exempt organizations rely on largeendowments, balance sheet management (bothasset and liability) also is important. Standard &Poor’s reviews investment policies, investment performancerelative to market benchmarks, currentasset allocation, and spending policies. As far asliabilities, Standard & Poor’s reviews debt policies,existing debt structure (including any off balancesheet or subsidiary liabilities), plans forreducing any postretirement liabilities, andemployment cost structure.What is a Nonprofit?A nonprofit organization is an entity organized so that no partof its income benefits a private shareholder or individual. Anonprofit corporation usually applies for a tax-exemptionunder Subchapter F of the Internal Revenue Code. The majorityof tax-exempt organizations rated by Standard & Poor’sderive their tax-exempt status from Section 501(c)(3) of theInternal Revenue Service Code.Financial performance and resourcesFinancial analysis begins with an historical overviewof the institution’s operations. The not-for-profitcorporations rated by Standard & Poor’s almostuniversally report their operations under FASBreporting guidelines. Financial analysis typicallyincorporates five years of historical performance,current year’s preliminary results, and the nextyear’s operating budget. If 5-year, or multi-year forecastsare available, these documents provide a goodindication of management’s assumptions aboutfuture business activities. Within the financial context,Standard & Poor’s examines:■ Growth in the operating budget andbudgeting practices;■ Revenue diversity and cyclicality and the opportunityfor future revenue growth;■ Expense flexibility, or the ability to make programmaticchanges without negatively affectingdemand; and■ Rate flexibility, particularly in those cases wherethere is significant industry competition;■ Financial performance on an aggregate basis,measured by the existence of operating surplusesor deficits;■ And financial resources, measured by cash andinvestments and unrestricted and expendableresources.Affiliated organizations are generally consolidatedin financial statements of the entity being rated,and Standard & Poor’s analysis incorporates theassets and operations of subsidiary corporations ofnot-for-profits. Projections beyond the currentbudget year also are reviewed, for they often revealnew program directions and can be a gauge ofmanagement’s realism. Important financial ratiosinvolve the assessment of debt burden and operatingcushion.For debt burden, Standard & Poor’s examinesmaximum annual debt service as a percentage ofexpenses and total debt relative to cash and investmentsand to total unrestricted resources. Unlessthere is an ability to adjust rates on an ongoingbasis, Standard & Poor’s expects current operatingsurpluses to cover total debt service, including principaland interest associated with new debt. Whilemany nonprofits operate on a breakeven basis,Standard & Poor’s believes that these organizationsshould have an operating cushion to shield themfrom inevitable economic cycles. Operating marginvaries by type of organization. Some membershiporganizations demonstrate a high level of profitability,while some charitable organizations only breakevenfrom year-to-year. The most important cushionratio compares unrestricted resources to expenseswww.standardandpoors.com201

Education And Non-Traditional Not-For-Profitsand provides a measure of an entity’s ability tofund operations if operating revenues decrease.Different organizations require different cushionlevels. For the most part, the level of working capitalrequired is a function of the organization’scash flow. An entity that receives a steady streamof income throughout the year can operate onthinner reserves than one that receives most of itsrevenue once or twice a year. An exempt organizationthat can quickly and easily reduce expendituresat midyear can operate with thinner reservesthan one that must commit funds well in advance.Most not-for-profit corporations rated byStandard & Poor’s have a good sense of their coststructure—what portion of their operating expensesare fixed and what portion, or components, arevariable. Some organizations indicate that a substantialportion of their salaries and benefits couldbe considered to be variable in nature, while facilitiescosts, insurance, and legal fees are not.Generally, institutions with unrestricted resources(measured in cash and liquid investments) below25% of their annual operating budget have a limitedfinancial cushion.In addition to operating revenues, many nonprofitsrely on annual voluntary contributions. A longhistory of successful fundraising managed by a professionalstaff can offset concerns about the cyclicalityof this revenue source. However, thesestrengths would not be enough to offset the risksassociated with an organization totally dependenton contributed revenues.Debt and capital structureIn addition to reviewing specific debt ratios asnoted above, Standard & Poor’s considers security,the project being financed, and future capital plansin its assessment of debt. Organizations that arecapital, or facilities-intensive, should have debt policiesin place. Debt policies should include the typesof allowable debt, directions about when derivativescan be used, and how an appropriate level ofdebt is determined. Other long-term liabilities, suchas postretirement obligations, may need to be consideredin addition to any long-term bonded indebtedness.The level of debt that is manageable is verymuch specific to the type of institution being rated.Cultural facilities, which are more place-intensive,tend to have higher debt burdens than other typesof nonprofit corporations.Security. Most not-for-profit corporations’ bondissues are secured by an unsecured corporate, GOpledge of the obligor institution. WhileStandard & Poor’s will consider a narrowerpledge, such as membership fees at a museum orindirect cost recoveries of a research laboratory, itis unlikely that such a structure will receive ashigh a rating as a GO pledge. As additional security,a fully funded debt service reserve is prudentunless the issuer has substantial liquidity. Mostissuers also include legal covenants, such as ratecovenants, asset-to-liability tests, and restrictionson the issuance of additional debt. The ratingimpact of such covenants depends on the nature ofthe entity and each covenant’s relative strength ordegree of restriction. Some covenants are so looselywritten that they do not provide any real protectionfor bondholders. Stronger legal covenantsgenerally do not result in a higher general obligationrating. Endowed foundations present a specialcase for bondholders. While they look for someindication that a pool of assets will not be spentdown, nonprofit corporations issuing tax-exemptdebt are subject to arbitrage restrictions, whichwould be a strong disincentive to pledging anykind of “reserves”. However, restrictive covenantsand policies remain a protection that bondholderswouldn’t otherwise have, and a gauge of willingnessto meet the needs of investors.Project. An analysis of the project to be financedincorporates several factors. Standard & Poor’s initiallywill examine the need for and scope of theproject, and how it fits into the organization’s overallactivities. Many of the nonprofit project financingsrated by Standard & Poor’s involve theconstruction of new headquarters buildings and theconsolidation of operations in one location, and areconsidered fairly essential. Standard & Poor’s alsoanalyzes the degree of self support assumed for theproject, compares debt maturity with project life,and evaluates other sources of funding. Undertakinga project that does not help meet an organization’smission, that takes it in new untested directions, orthat is likely to require considerable financialresources in the future even when an organizationhas debt capacity, could be considered a negativerating factor. Most of the project financings ratedinvestment grade are projects being undertaken byexisting exempt organizations. Start-up projects bynew organizations without a track record, or byentities without any financial resources, may find itdifficult to achieve investment-grade ratings.Capital improvement program. A review of thesize, sources of funding, and timing of future capitalplans provide important insight into an organization’sneeds and goals for expansion. Standard &Poor’s also is interested in determining whetherthese plans will significantly change an organization’sscope or mission. Some organizations, such asaquariums or other attendance-driven cultural institutions,must constantly plan for new attraction andupdates of their facilities. A failure to consider newexhibits or changing exhibits could be of concern.202 Standard & Poor’s Public Finance Criteria 2007

Non-Traditional Not-For-ProfitsCultural InstitutionsWhile the rated universe of cultural organizationslargely consists of museums, the rating approach issimilar for all types, including zoological parks,public radio and television stations, aquariums, andhistorical sites. Rated issuers are highly diverse,ranging from fine arts to natural history institutions.They also vary widely in their constituencies(adults, children, tourists, or local residents), admissionand membership levels, revenue sources, andfinancial flexibility.To assess demand for a cultural institution,Standard & Poor’s examines:■ The national and/or international prominence ofthe collection;■ Admissions and membership levels and trends;■ Competition from and location near other localmuseums, similar organizations, and touristattractions; and■ Fee structure and rate flexibility.Service area economic conditions also play animportant role, particularly when the institution hasa more limited, local draw. In addition, admissionand membership trends often are affected by theuse of blockbuster or special exhibits, a phenomenonsomewhat unique to museums. These supershows usually run for a limited time and, despitehuge crowds and swelling revenues, often aremoney-losing propositions. Nonetheless, blockbusterscan have a longer-term positive effect byattracting new members and repeat visitors.Because blockbusters dramatically inflate revenuesand expenditures in show years, it is often difficultto make accurate financial plans. As a cultural institutionassumes long-term debt, it is important that itDocumentation Requirements■ Official statement or other disclosure■ Bond resolution or trust indenture■ Lease or mortgage■ Five years audited financial statements and current year’sbudget summary■ Entity descriptive information■ Legal opinions**In addition to tax and validity opinions, Standard & Poor’smay require certain bankruptcy-related opinions, includingthe status of the issuer under section 303(a) of the BankruptcyCode-the inability of a creditor to file an involuntary petitionagainst the issuer-preference opinions, and, if applicable,nonconsolidation opinions. Most private universities issuetax-exempt debt through conduit issuers. Sometimes thisrequires additional documentation such as loan agreementsand information on the intent to perfect security interests.budget for these variations and maintain an adequatefinancial cushion to offset fluctuations. Infact, the highest-rated museums enjoy significantfinancial flexibility, with endowment and unrestrictedmonies well in excess of the annual operatingbudget, even though they do not always produceconsistently good operating margins.The visible civic role played by many culturalinstitutions often results in high levels of municipalgovernment and/or private donor support.Attendance-based cultural facilities with cyclicalrevenue streams, limited outside support from governmentalor private donors, and no endowment,would be unlikely to achieve investment-grade ratings.Start-up cultural organizations are not likelyto be rated investment grade, since they do nothave a record of attendance or membership, andmight not have an endowment. Museums thatundergo significant expansions must demonstratethat there is some predictability to their current revenuesource, such that projections seem attainable.In fact, most forecasts are far more positive for firstyear attendance after a major project completionthan what actually occurs.An important part of Standard & Poor’s analysisof a cultural institution is a review of the proposedproject, particularly its potential impact on attendanceor membership and the organization’s missionand focus. Exempt organizations often receivesubstantial governmental support, which might offsetthe risks associated with increased debtissuance. Therefore, the outlook for future governmentaland private support is a crucial part ofStandard & Poor’s analysis.Membership OrganizationsOne subset of not-for-profits that has garnered significantmarket interest is voluntary membershiporganizations. Such entities range from professionalmembership organizations to trade associations,religious organizations, and scientific societies. Therating analysis depends, in large part, on the primaryactivity of the organization and the benefitsderived from membership.As with other not-for-profits, Standard & Poor’sanalysis of a membership organization begins witha comprehensive evaluation of the operating historyof the institution and its current activities andmanagement. While actual membership growth isimportant as a proxy for demand, the main focusis on understanding an institution’s particularindustry and role within that industry. To that end,Standard & Poor’s examines offered services, membershiptrends, and measures of industry effectivenessand performance. Some organizations have arole so unique that they have no competition intheir particular industry. For example, thewww.standardandpoors.com203

Education And Non-Traditional Not-For-ProfitsAssociation of American Medical Colleges is theaccrediting body for the majority of the nation’smedical schools and the only sponsor of theMedical College Admissions Test (MCAT).Regardless of an organization’s competitive position,Standard & Poor’s expects to see a consistentor stable membership base. Wide fluctuations inmembership make planning and budgeting difficultand are viewed negatively. Standard & Poor’s ratesboth large and small membership organizationsand size is an important characteristic. Generally,the larger the organization, the more revenuediversity and greater level of financial resources itpossesses relative to operating expenses and debt.However, a small membership organization couldbe highly rated with a substantial endowment andgood operating performance.Other areas of inquiry for membership organizationsinclude:■ Historical membership data by type of memberfor at least ten years;■ Breadth of focus. Organizations with a narrowfocus are felt to be most vulnerable to periods ofeconomic stress;■ Degree of professionalism in the administrativestaff. For any investment-grade credit,Standard & Poor’s would expect to see an experienced,permanent staff with functions distinctfrom the governing body, or membership directorateof the organization;■ Benefits derived from membership. Exceptionallystrong credits provide services that are highlydesired and cannot be obtained elsewhere; and■ Competing membership organizations who providethe same type of services and may overlapwith members■ Percentage of members who count the organizationas their primary professional society.Financial performanceThe financial history of a membership organizationis analyzed for at least a five-year period.Standard & Poor’s evaluates historical financialperformance to determine how well the organizationperformed given its available revenues(income statement) and resources (balance sheet).Most of the membership organizations rated byStandard & Poor’s have limited capital needs andan operating cushion equal to six months of operatingexpenses, however, there are entities with aconsiderably higher cushion and those with amuch lower cushion who pursue a rating. Whilemany organizations have sufficient liquidity to payfor the project being considered, partially payingthe project costs with accumulated equity toreduce debt burden also reduces operating cushion.Unless debt burden is a concern, using equityfor long-term projects is unlikely to result in ahigher rating for the organization.Standard & Poor’s examines the major sourcesof revenues and patterns of expense growth. Asfor most rated organizations, revenue diversity isimportant and shields membership organizationsfrom potential cycles. A critical issue is budgetaryflexibility and the ability to cut expendituresmidyear without jeopardizing operations.Management should be able to quantify areas ofvariable costs that can be eliminated, or scaledback, in the event of financial stress. Ancillaryservices, provided at no cost to the membership,account for a major portion of operating expensesat many membership organizations, and are oftenthe first place that management will look to scaleback. However, organizations must recognize thatmajor cuts in public service activity could call intoquestion their tax-exempt status. Membership feehistory also is examined and compared with thatof any competing organizations. Rate flexibility isparticularly important, and it is preferable thatany rate-setting capacity be centralized within thefinancial management function rather than with avoluntary board.Endowed And Charitable FoundationsThe common characteristic of all tax-exemptendowed foundations is a pool of money used tosupport a specific cause, such as health care ormedical research, educational endeavors, or programsfor low-and moderate-income people.United States tax laws, in fact, require that certainphilanthropic organizations give away at least 5%of their assets every year. This required drawdownin resources is an important consideration, sincemost foundations will secure their bonds with anunsecured GO pledge, which in effect, encompassesthe corpus of their unrestricted endowment andrelated income. Many of the not-for-profits currentlyrated by Standard & Poor’s have no sourceof income other than investment earnings. The sizeand quality of a foundation’s endowment relativeto both debt and operating expenses is thus ofRelevant Statistics for Cultural Institutions■ Historical admissions and membership trends.■ Competitor institutions (local tourist attractions andother museums).■ Fee structure and history of rate increases.■ Revenue diversity.■ Net revenue per visitor.■ Average annual membership fees.204 Standard & Poor’s Public Finance Criteria 2007

Non-Traditional Not-For-Profitsparamount importance. Standard & Poor’srequests at least five years of historical financialdata and asks for portfolio and endowment datasuch as quarterly board reports.In evaluating endowment, Standard & Poor’slooks beyond size at a number of specific factors,including:■ Growth in endowment assets over time;■ Asset allocation policies and quality of the investmentpool, and a comparison to targeted investmentmix;■ Historical rates of return compared to broadermarket or customized benchmarks;■ Relative liquidity and availability of the portfolio;■ Endowment spending policies; and■ Restrictions on use of earnings and principal.Since the endowment is the basis for any ratingof an endowed organization, Standard & Poor’smay require legal covenants restricting the foundation’suse of its endowment. Generally, restrictionsmandate liquidity and asset coverage tests, andlimit additional debt issuance.While the above analysis focuses primarily onthe balance sheet, foundation mission, activities,and budgetary flexibility are also important. Todate, rated foundations tend to fall into one oftwo categories—independent or grantmaking andoperating. Although, one type is not necessarilymore creditworthy than the other, grantmakingentities may have more budgetary flexibility thanoperating foundations that actually run their owncharitable programs. Standard & Poor’s is particularlyinterested in the type of activity supportedby a foundation and the extent to which it cancurtail this support and control operating costs.Once started, Standard & Poor’s assumes thatcertain programs or foundation giving would bedifficult to stop, particularly if the foundation isthe sole sponsor.Research InstitutionsWhile nonprofit research institutions abound, thosemost capable of achieving investment-grade ratingsgenerally have a long history of working with agovernmental agency, or have a medium-to-highlevel of endowment. Despite their close ties to governmentsor sponsors, research organizations oftenface considerable credit risks, including contractnonrenewal and cyclical support for the type ofresearch being sponsored. Because of these risks,small institutions in a single competitive field, or ina field with a low funding priority, are more likelyto receive lower ratings.As with most areas of credit analysis, Standard &Poor’s reviews industry information to assess a nonprofitresearch organization. Specific governmentalcontracts are needed if the institution is operatingunder an especially large or long-term contract thatprovides the bulk of its operating income.Management meetings might include not only theinstitution’s management, but also large sponsors togauge ongoing support for the organization.Standard & Poor’s considers the following factorsto be particularly applicable when ratingresearch institutions:■ History of research programs and dollar amountof funding;■ Areas of research specialization and competition;■ Growth in the number of contracts and funding;■ Diversity of research—both classified and unclassified;■ Indirect cost recovery rates currently in place andtimetable for renegotiation■ Funding stability—options for contract renewal ifless than five years to termination dates; and■ Budgetary flexibility and the capacity to downsize.Other lines of inquiry go beyond the research programand include an evaluation of management,financial operations and resources, and debt burdenas previously discussed. Like membership organizations,Standard & Poor’s expects rated institutions toinclude permanent staff whose functions includefinancial management and day-to-day operations.Most research institutions rated by Standard &Poor’s are financially and operationally autonomous;however, any ties to a parent organization wouldinvolve an analysis of this relationship. Researchinstitutions receiving federal funds for research havean incentive to issue tax-exempt debt for facilities.These organizations can include the costs of facilitiescapital in their requests for reimbursement. Formany of them, being able to recoup the cost of capitalmakes debt a more favorable option than leasingresearch facilities.Bondholder security for debt issued by theseorganizations is typically a GO of the institution,but for many research organizations, direct andindirect costs of research are the primary sources ofRelevant Statistics for Research Institutions■ History of research programs and funding■ Areas of research specialization and competition■ Growth in the number of contracts, funding levels, andrate of indirect cost recoveries■ Diversity of research-both classified and unclassified■ Funding stability-options for contract renewal if less thanfive years to termination dates■ Budgetary flexibility and the capacity to downsizewww.standardandpoors.com205

Education And Non-Traditional Not-For-Profitsoperating revenue. While research funding hasbecome increasingly competitive, and there ispotential for continued changes in reimbursementmechanisms, research funding in general is provingto be a stable source of reimbursement andrevenue for research institutions. Rate covenantsgenerally carry little weight in legal provisions,since these organizations do not have the ability toadjust their rates to federal or other sponsors onan annual basis. However, additional bonds testscarry more weight, and historical additional bondstests add comfort that historical revenues have atleast been sufficient to pay for the current andproposed debt. ■206 Standard & Poor’s Public Finance Criteria 2007

Municipal Structured FinanceIntroduction To Structured FinanceStructured municipal financings are an integralpart of the municipal debt market. Structureddebt includes conventional transactions—such asbonds, notes, and commercial paper (CP)—securedby various types of credit and liquidity facilities,and secondary-market derivative products—such asprincipal and interest strips, custodial receipts, andtender option bonds.Standard & Poor’s Ratings Services rates primarymarket structured debt on the basis of third-partycredit or liquidity support without regard to theissuer’s underlying rating. To substitute the thirdpartycredit provider’s rating for that of the issuer,the credit provider must secure debt service payments,and/or, in the case of bonds with demandoptions, guarantee payment of tenders.In the secondary market, a municipal trust structureis used to issue receipts and act as a conduit forthe payment of principal, interest, and premiums, ifany, from the underlying obligation to the derivativereceipt holder. The rating of the derivative is determinedby the rating on the underlying bonds, whichmust have a current Standard & Poor’s rating.However, the rating on the derivative may also beenhanced by using credit and/or liquidity support.Standard & Poor’s assigns a long-term or noterating to fixed-rate municipal bonds and notes. Adual rating (for example, ‘AAA/A-1+’) is assignedto municipal variable-rate demand obligations(VRDOs) and generally benefit from credit and/orliquidity enhancment. The first component of thedual rating reflects the likelihood of payment ofprincipal and interest when due. The second componentaddresses the demand feature of the bondand the likelihood of payment of the purchase priceof tendered bonds. In the case of short-term variable-ratenotes, Standard & Poor’s note rating symbols(for example, ‘SP-1+/A-1+’) are used for thefirst component of the rating instead of long-termsymbols. For municipal commercial paper programs,Standard & Poor’s commercial paper symbolsare used (for example, ‘A-1+’).Documentation RequirementsThe primary documents needed to rate structured issuesare listed below. While the list is fairly standard, additionaldocuments may be requested in order to complete a rating.Primary market issues■ Rating request.■ Trust indenture.■ Letter of credit or SBPA as applicable.■ Authorizing resolution.■ Remarketing agreement.■ Paying/tender agent agreement.■ Depository agreement (commercial paper issues only).■ Preference opinion, if requested.■ Enforceability opinion(s), if requested.■ Offering memorandum.Secondary market issues■ Rating request.■ Custody/trust agreement.■ Offering memorandum, if requested.■ Cash flow verification, if requested.■ Offering memorandum for underlying security.■ Tender option agreement, if applicable.■ Broker-dealer agreement, if applicable.■ Auction agent agreement, if applicable.■ Market agent agreement, if applicable.■ Credit or liquidity support documents.■ Tax opinion.■ Enforceability opinion(s), if applicable.■ True sale opinion, if applicable.Outlooks are generally placed on VRDOs thathave credit provided by other than an LOC bank.The outlook will reflect the outlook of the obligoror bond insurer as applicable. Commercial paperratings, due to the tenor of the security do notreceive outlooks. ■www.standardandpoors.com207

Municipal Structured FinanceLOC-Backed Municipal DebtAbond transaction backed by a letter of credit(LOC) is typically issued by a municipal entity,which serves as a conduit. The bond proceeds areloaned to the underlying obligor, which is the entitythat bears the responsibility for repayment of thedebt. Banks provide LOCs, which cover full andtimely payment of principal and accrued interest inexchange for annual commitment and drawing fees.Standard & Poor’s Ratings Services has rated avariety of structures, including fixed-rate bonds andvariable-rate put bonds. Fixed-rate bonds onlycarry a long-term rating. Put bonds, which requireLOC coverage for purchase price, as well as forprincipal and interest, carry a dual rating. In itsanalysis, Standard & Poor’s seeks to ensure that thelikelihood of payment is equal to the likelihood ofthe bank’s honoring draws on its LOC. The bondholderis insulated from any bankruptcy, default, orlack of performance by the obligor.The rating that Standard & Poor’s assigns to aLOC-backed transaction is based on the LOCbank’s issuer credit rating. Standard & Poor’sapplies the weak-link theory if two or more LOCscombine to support a transaction. If each bank hasa several obligation, the transaction’s rating will bethat of the lowest-rated bank. Confirmation LOCdeals can earn ratings in accordance with the jointsupport criteria.Preference ConcernsStandard & Poor’s is concerned that the payment ofdebt could be recaptured from the bondholders asan avoidable preference in the event of a filing of abankruptcy petition by the issuer, the borrower, orany general partner or guarantor of the borrower. Atrustee in bankruptcy may set aside, or recapture,certain payments on account of antecedent debtmade within a certain period of time prior to thefiling of a bankruptcy petition. The appropriatepreference period within the U.S. is 90 days (or 365days in the case of any “insiders”).Payment structureThere are several ways to address possible preferenceproblems, beginning with the choice of paymentstructure. The three basic structures are:■ Direct pay;■ Prioritized direct pay; and■ Standby LOC.In a direct-pay structure, the primary source ofpayment to bondholders is funds drawn under theLOC. This is the only source Standard & Poor’sconsiders in its rating analysis. The LOC mustspecifically state that the bank will pay with itsown funds or reference International StandbyPractices version 1998.The prioritized direct-pay structure is similar todirect pay. Bondholders are paid with LOC fundsas the secondary source if the trustee does not holdsufficient preference-proof funds. Preference proofingentails providing the trustee with funds for theappropriate preference period before a paymentdate and certifying that no bankruptcy has occurredwith respect to the depositor within such period.In standby LOCs, the least common paymentstructure, bondholders are paid first with nonpreference-prooffunds. Since this structure could allowfor the disgorgement of bond payments following abankruptcy, the LOC is sized to cover the maximumamount of preference payments, in additionto its coverage of principal and accrued interest.Upon a bankruptcy filing, the LOC is drawn uponto establish an escrow fund for the preference risk.To protect bondholders from the consequences of abankruptcy following a final payment, the LOCexpiration date must extend beyond the duration ofthe appropriate preference period after such finalpayment. At the conclusion of such period, if thetrustee does not receive evidence indicating that nobankruptcy has occurred, the LOC shall be drawnupon to establish an escrow fund.Purchase priceVariable-rate demand bonds that use remarketingproceeds as the initial source for purchase pricepayments also raise preference concerns. Theremarketing proceeds that are used as a paymentsource to tendering bondholders must be restricted.These proceeds may not include funds from theissuer (if not a municipal entity), the underlyingobligor (if not a municipal entity), any general partner,or guarantor. The guarantors that raise thisconcern would be those of the bonds or the loanagreement, but not of the reimbursement agreement.If there are no guarantors of the bonds orloan agreement, then Standard & Poor’s mayrequest a written statement to this effect.Preference opinionsIn analyzing LOC-backed transactions, Standard &Poor’s considers whether the payment of debt maybe recaptured from the bondholders as an avoid-208 Standard & Poor’s Public Finance Criteria 2007

Introduction To Structured Financeable preference in the event of filing of a petitionunder the U.S. Bankruptcy Code with respect to theissuer, the borrower, any general partner of the borrower,or any guarantor. Under the U.S. BankruptcyCode, a trustee in bankruptcy may set aside, orrecapture, certain payments on account ofantecedent debt made within a certain period oftime before filing a bankruptcy petition. Preferenceopinions have indicated that any payments to bondholdersfrom particular sources of funds will not berecaptured as a preference in the event of bankruptcyof a related party.Standard & Poor’s no longer requests a preferenceopinion for transactions that limit paymentsources to the following:■ Initial bond proceeds;■ LOC draws;■ Remarketing proceeds (as appropriate);■ Funds held by the trustee for at least 90 days (orother appropriate preference period), duringwhich time there has been no bankruptcy filingby or against the issuer, borrower, general partners,or guarantors;■ Insurance proceeds paid directly to the bondtrustee; and■ Other money, including refunding proceeds,accompanied by a future preference opinion.Standard & Poor’s will continue to request preferenceopinions for the following:■ Deals in which LOCs have been provided forantecedent debt if there is a pledge of new collateralto the bank; and■ Transactions that may fall outside the jurisdictionof the U.S. Bankruptcy Code; and■ Standard & Poor’s reserves the right to require apreference opinion for any deal if circumstancesso warrant.Credit Cliff IssuesA Standard & Poor’s rating reflects the probabilityof full and timely payment to the bondholder untilfinal maturity, or such time as the bonds are paid infull. Credit cliff events—that is, events that lead toa termination or reduction of the amount or levelof credit support prior to such time—are, therefore,important factors in analyzing these structures.LOC expirationStructures allowing for the expiration of the outstandingLOC prior to bond maturity have a commonpotential credit cliff. Most bonds rated byStandard & Poor’s have 20-to 30-year maturities,while the LOCs supporting them rarely have initialterms beyond seven years. The bondholder faces thepossibility of having purchased a rated LOC-backedbond issue, but holding unrated and unsupportedbonds. To prevent such a scenario, an extension ofthe LOC or a substitute LOC must be executedprior to expiration of the existing LOC, or it is necessaryto take out the bondholders through amandatory redemption or a mandatory tender. Anyalternate LOC must meet the conditions for ratingmaintenance or lead to a mandatory tender.LOC substitutionA potential credit cliff arises from the provision ofa substitute LOC. To avoid such a scenario, anysubstitution of the LOC must be accompanied bywritten confirmation from Standard & Poor’s thatthe provision of the substitute credit facility willnot, in and of itself, result in a reduction or withdrawalof the then-current rating on the bonds (ratingmaintenance). Alternatively, a substitution maybe executed without certification of rating maintenanceif existing bondholders are taken out via amandatory tender or redemption on or prior to thedate of substitution. Note that either of these tworemedies is necessary prior to an assignment by thebank of the LOC, or prior to the granting of participationinterests to additional banks (unless it isclearly stated that the granting will not relieve theprovider of its obligation under the LOC).NonreinstatementAnother potential credit cliff arises from provisionsin the LOC that allow the bank to declare an eventof default under the reimbursement agreement ornonreinstatement of interest coverage under theLOC, following a draw for interest. Any notificationfrom the LOC provider to the trustee of these eventsshould lead to an immediate acceleration of thebonds, mandatory redemption, or mandatory purchase.In such a scenario, the LOC must have sufficientinterest coverage to cover all interest until itceases to accrue. Any waiver of events of defaultshould be contingent on written evidence of the LOCprovider’s reinstatement of principal and interest coveragein full and rescission of the notice of event ofdefault under the reimbursement agreement.ConversionConversion from one interest rate mode to anothercan also give rise to credit concerns if the LOCeither expires on conversion or has insufficientinterest coverage for the new mode. The provisionof a substitute LOC with sufficient interest coverageand rating maintenance, or a mandatoryredemption or mandatory tender upon conversion,can adequately address this concern.Affirmative retention optionTo mitigate the impact of credit cliff events, bondholdersmay be given the option to retain theirwww.standardandpoors.com209

Municipal Structured FinanceCriteria Outline for Bank-Supported Municipal DebtVII. MiscellaneousI. Preference-proofed monies (issuer and/or obligors not bankruptcy-remote)A. Available monies/eligible funds for payments not derived from credit and liquidity facilities.B. Remarketing proceeds prohibited from issuer and obligor(s).C. Preference opinion covering all payment events except defeasance not paid with available monies/eligible funds.II. Payment eventsA. Regularly scheduled principal & interest.1. All interest rate modes described in detail2. Adequate interest coverage provided by bank:a.) Maximum days in longest rate period covered, plusb.) Number of calendar days required to reinstate interest coverage after a draw on the bank facility, plusc.) Number of calendar days required to take out bondholders through mandatory tender, mandatory redemption,or acceleration following receipt of bank notice of interest nonreinstatementB. Mandatory tender1. Mandatory tenders described in detail2. Sources of paymentC. Optional tender (puts)1. Put options described in detail2. Sources of paymentD. Mandatory redemption1. Mandatory redemption events described in detail2. Sources of paymentE. Optional redemption (calls)1. Mandatory redemption events described in detail2. Sources of payment3. Premiums not covered by credit facility, if any:a.) On hand at time of call notice to bondholdersb.) Investment options adequate to support ratingF. Acceleration1. Events of default and remedies described2. Specify when interest ceases to accrue3. Sources of paymentG. Defeasance1. New preference opinion required at time of legal defeasance if issuer and obligor(s) are not bankruptcy-remote2. Standard & Poor’s rating maintenance required for variable-rate defeasance3. Acceptable defeasance securities:a.) Cashb.) U.S. government obligationsi.) U.S. Treasury obligationsii.) Agency obligations fully guaranteed by U.S.iii.) Obligations of certain agencies sponsored by U.S. governmentc.) Securities rated ‘AAA’ refunded with U.S. government obligationsIII.Required bondholder takeouts(mandatory tender, mandatory redemption, or acceleration)A. Interest nonreinstatement following credit facility drawB. Bank facility expirationC. Replacement of bank facility without rating maintenanceD. Receipt of bank notice of event of default and termination of bank facility210 Standard & Poor’s Public Finance Criteria 2007

Introduction To Structured FinanceCriteria Outline for Bank-Supported Municipal Debt (continued)IV. Bank facility drawing instructionsA. Credit facility draws must be consistent with bank document timingB. Liquidity facility draws1. Timing consistent with bank document2. Amount drawn is according to remarketing proceeds on deposit, if anyV. Bank document termination eventsA. Timed termination1. Termination countdown begins only after actual receipt of notice of bank notice by trustee or other party2. Bondholder takeout honored by bank must occur following receipt of bank termination noticeVI.Reimbursement provisionsA. Credit advancesB. Liquidity advancesVII. MiscellaneousA. Investment instructions for unused remarketing and bank facility proceeds must be adequate to support ratingB. Trustee or other specified drawing party may not resign or be removed until appointment of a successorC. Drawing party may not require indemnity to draw under bank facilityD. Custodian instructions to release bank bonds only after written notice of liquidity facility reinstatement from bankE. Notices to Standard & Poor’s1. Fixed rate conversion2. Redemptions3. Bank facility expiration, termination, extension, or substitution4. Changes to legal documents5. Defeasance6. Accelerationbonds. To affirm their intent to retain the bonds,bondholders should acknowledge in writing theirunderstanding of the rating consequences prior tothe event occurring.Timeliness of LOC draws.It is necessary to synchronize the trustee’s drawinstructions under the bond indenture with the paymentterms of the LOC to ensure that the LOC isdrawn upon in accordance with its terms to providefor full and timely payment of principal, interest,purchase price, and premium, if any.LOC SizingAn LOC must be for a specific amount with a definiteexpiration date. Other limitations reviewedwithin an LOC include its terms for draws, itsterms for reinstatement, and its turnaround timesfor the bank to honor an LOC draw. These termsare reviewed in conjunction with the structure ofthe bond documents to conclude that the LOCoffers full and timely coverage for the transaction.The factors used to calculate the required amountof LOC coverage are the following:■ Principal: the principal portion must equal thecurrent outstanding amount of bonds.■ Premium: the amount corresponding to thelargest premium applicable to a mandatoryredemption or tender.■ Interest: the interest portion shall be an amountequal to the maximum number of days of interestthat could accrue calculated at either the actualrate for fixed-rate bonds or the maximum ratefor floating-rate bonds.For purposes of calculating the interest coverageof the LOC, the appropriate length of the calendaryear, 360 or 365/6 days, must correspond with thebasis of calculation within the bond documents.The LOC provider should always agree to pay withimmediately available funds. It is critical that theLOC covers the maximum amount of interest thatcan accrue in the worst-case scenario.For direct-pay and prioritized direct-pay transactions,the following worst-case scenario wouldapply. In this instance, the trustee draws on theLOC for full coverage of the longest interest period.Following the draw, the LOC bank sends notice ofwww.standardandpoors.com211

Municipal Structured FinanceInterestpayment due12/1nonreinstatement of interest coverage at the latestpossible date under the terms of the LOC. Thetrustee then accelerates the issue, and interest ceasesto accrue at the latest date in accordance with theindenture. Standard & Poor’s calculation of interestcoverage also considers delays in notices or paymentscaused by nonbusiness days. The timeline isan example of Standard & Poor’s calculation ofminimum interest coverage for a direct-pay LOCtransaction. Assume the following structure:■ Interest is paid on the first business day of eachmonth, based on a 365-day year.■ LOC interest coverage automatically reinstateson the tenth business day following a draw,unless the trustee is notified of nonreinstatement.■ If the trustee is notified of nonreinstatement, itwill immediately accelerate the bonds.■ Interest ceases to accrue upon the date of declarationof acceleration.If the trustee is paying interest for the month ofDecember, interest will be due on the first businessday of January. If Jan. 1 is a Friday, then onMonday, Jan. 4, the trustee will draw on the LOCand pay 31 days of interest. The LOC bank cansend notice of nonreinstatement as much as 10business days later. Since Saturdays, Sundays, andholidays are nonbusiness days, notice of nonreinstatementcould come as late as Tuesday, Jan. 19.The trustee would accelerate the bonds, and interestwould cease to accrue that day. Therefore, 19 daysof interest would have accrued in January. In additionto the 31 days of interest from December, thetotal minimum interest coverage would be 50 days.Note that if interest does not cease to accrue uponthe date of the declaration of acceleration, additionalcoverage will be needed. Additional coveragemay also be needed if there is a longer accrual periodbetween the bond closing date and the firstInterest Accrual ScenarioInterestpaymentdue(not abusinessday)Fri.1/1Interestpaid fordecemberMon.1/431 days accrued 19 days accrued50 days total interest accrualMLK Jr.holidayMon.1/18Notice of nonreinstatementreceived(acceleration)Tues.1/19interest payment date on the bonds (for example ifthe bonds closed on Nov. 20 and the first interestpayment date was Jan. 4).In standby LOCs, where nonpreference-proofmoney is the first source of payment to the bondholder,the worst-case scenario also includes theconsequences of the borrower’s bankruptcy. Inaddition to coverage for accrued interest, the LOCmust also cover the maximum amount of interestthat can be disgorged from bondholders if it weredeemed a preferential transfer. Most transactions ofthis type have individual features. The factors toconsider in calculation of interest coverage are:■ Schedule of loan payments;■ Timing of notice of bankruptcy;■ Events of default;■ Grace periods;■ Acceleration schedule; and■ Applicable preference period.Note that the LOC’s stated expiration termsshould take into account the applicable preferenceperiod as well.Tender ProcessStandard & Poor’s applies a similar analysis to thepayment of purchase price as it does in assessing thelikelihood of full and timely payment of regularlyscheduled principal and interest. If remarketing proceedsare the first source of funds to be used for tendersand LOC funds are the second, the trusteeshould be instructed to draw on the LOC in anamount equal to the total purchase price due to tenderingbondholders, less the amount of the remarketingproceeds on deposit prior to the draw timedeadline established in the LOC. It is important thatthe trustee only consider proceeds actually ondeposit, as opposed to proceeds that are expected tobe received. If the trustee were to draw on the LOCon the basis of expected proceeds and any expectedremarketings were to fail, a shortfall in total fundsavailable to pay tendering bondholders would jeopardizethe timeliness of payment. In most instances,it would be too late to make a second draw on theLOC to make up the shortfall and still make timelypayment of purchase price. Alternatively, there canbe reliance on expected proceeds if the remarketingagent provides an unconditional commitment todeliver remarketing proceeds by the time necessaryto pay tendering bondholders regardless of whetheror not expected remarketings are successful.Since the tender process often involves severaldifferent parties (trustee, tender agent, remarketingagent), proper coordination of the flow of informationand funds among the various participants isnecessary to ensure full and timely payment of purchaseprice to bondholders. As a result, the analysis212 Standard & Poor’s Public Finance Criteria 2007

Introduction To Structured Financeinvolves an examination of details such as whoreceives the tender notices and who pays the purchaseprice to tendering bondholders.In some transactions, payment of purchase priceto bondholders is made by the tender agent ratherthan the trustee. If the LOC is written to the trusteeand the trustee is instructed by the indenture tomake draws on the LOC, the trustee must beinstructed do one of the following: (1) transfer themoney received from an LOC draw to the tenderagent, while allotting adequate time for the tenderagent to pay bondholders prior to the close of businesson the purchase date; or (2) direct the LOCbank to pay all proceeds of a tender draw directlyto the tender agent.Another acceptable option is to have the LOCbank authorize and the indenture instruct the tenderagent to make all tender draws directly, withoutinvolving the trustee. Remarketing proceeds mustalso be transferred from the remarketing agent tothe party paying purchase price in adequate timefor payment to be made to bondholders prior to theclose of business on the tender date. In the case ofmandatory tenders, undelivered bonds must bedeemed tendered.Purchase price reinstatementAny time all or a portion of tender price is paidfrom proceeds of a drawing on the LOC and theLOC coverage amount reduces upon honoring ofthe draw, the concept of purchase price reinstatementis an important factor. Bonds that are purchasedwith LOC money must not be released tothe new purchasers until the agent holding thesebonds has received written confirmation from theLOC bank that the LOC has been reinstated to itsfull amount of coverage for the bonds in question;otherwise, bondholders could be exposed to creditcliff risk by holding bonds that are not supportedby the LOC.Remarketing discountMost put bonds only allow the bonds to be remarketedat par. On some transactions, the remarketingcan be at a discounted price. To ensure full paymentto tendering bondholders, the discount mustbe limited to the amount of LOC coverage specificallyfor remarketing discounts.Expiration of the put optionThe short-term component of a dual rating on aput bond reflects the likelihood of full and timelypayment of purchase price upon a mandatory oroptional tender. As with principal and interest, thelikelihood of payment is equal to the likelihood ofthe bank’s honoring a draw for purchase price. Thebondholder is insulated from the performance ofthe issuer or the underlying obligor. Events ofdefault due to bankruptcy or technical default bythe issuer or underlying obligor should not lead tothe immediate expiration of the put option, whichwould be inconsistent with the short-term rating ofthe transaction.Optional RedemptionsCertain transactions are structured so that paymentof premium or principal associated with an optionalredemption is not covered by the LOC. For suchan event, the trustee shall not send out a notice ofredemption to the bondholders unless there are sufficientpreference-proof funds on deposit prior tothe giving of notice, or such notice will be conditionaland contain language to the effect that theredemption will be rescinded in the event there arenot sufficient preference-proof funds on hand priorto the scheduled redemption date.InvestmentsFunds held by the trustee, for which an investmentloss could lead to a lack of full and timely payment,must be restricted in their investment. This is mostcommon when the LOC is scheduled to fund earlierthan the payment date or when preference-prooffunds are being held as a payment source. Permittedinvestments may only be investments rated byStandard & Poor’s at least equal to the then-currentrating on the bonds. The investment must maturewithin 30 days or as needed for full and timely paymenton the bonds.DefeasanceIn a true legal defeasance, the bonds are deemedpaid, the trust estate is released, the trust indenture isdischarged, and, generally, the LOC is released. Thetrust indenture and LOC are replaced by an escrowof funds, which provide for the payment of any debtservice. Criteria for defeasance are designed toaddress both the credit quality of the escrow accountand the legal structure of the escrow. Except formunicipalities eligible to file for bankruptcy underChapter 9 of the Bankruptcy Code, defeasanceshould be accomplished with sufficient preferenceproof(as defined in the following sentence) funds topay for principal and interest until the bonds’ maturity,or earlier redemption. As in any other paymentstructure, preference-proof funds include:■ Funds provided under an LOC;■ Money accompanied by a preference opinion ofcounsel experienced in bankruptcy matters; or■ Funds “aged” for the proper preference period,depending on the details of the transaction.The preference-proof funds may be held in theform of either cash or direct obligations of the U.S.If U.S. government obligations are used, theyshould not be redeemable at the option of thewww.standardandpoors.com213

Municipal Structured Financeissuer, and they should mature at such times and insuch amounts as will be sufficient to cover the fulland timely payment of all principal, premium (ifany), and interest on the bonds.Certain additional criteria apply to effect a legaldefeasance in the variable-rate mode. Standard &Poor’s short-term rating addresses the likelihood offull and timely payment of purchase price. If, as inlegal defeasance, the indenture were to be discharged,the put feature would no longer be availableto the bondholders—a risk inconsistent withthe rating on the transaction. To maintain theintegrity of the rating and ensure full and timelypayment of debt service, as well as purchase price,Standard & Poor’s looks for the following:■ That defeasance be eliminated in all variable-ratemodes; or■ That the defeasance period in variable-rate modesbe limited by requiring a mandatory redemptionor purchase in whole to be scheduled no laterthan the first possible purchase date (whethermandatory or optional) or interest adjustmentdate; or■ That the trustee receive written evidence fromStandard & Poor’s that the defeasance would notresult in the reduction or withdrawal of the thencurrentratings.To ensure that sufficient money will be providedin the variable-rate mode for future payments tobondholders, defeasance deposits must be made atthe maximum rate allowable on the bonds due tothe interest reset feature of the bonds. The escrowagreement should address not only the interest resetfeature, but also the potential of bondholders’ tenderingtheir bonds during the defeasance period andthe resulting liquidity issues that arise. To accountfor possible tenders, escrow funds must either beheld in cash or in an investment that matures orwould be redeemable at par no later than the firstpossible purchase date (whether mandatory oroptional) or interest adjustment date.The residual interest or the difference betweenthe maximum floating rate provided for by theescrow fund and the actual variable rate of interestmay also raise concerns during the defeasanceperiod. If this excess flows back to the underlyingobligor and the obligor were to file for bankruptcyduring the defeasance period, a bankruptcycourt might apply the automatic stay provisionsand delay future payments out of the escrow fund.To address this scenario, Standard & Poor’s willlook for either that the residual interest flow backto the credit provider or a legal opinion statingthat the bankruptcy of the obligor would not, bythe application of the automatic stay provisions ofSection 362(a) of the U.S. Bankruptcy Code, delaythe use of money in the escrow fund to pay principaland interest on the bonds. Alternatively, if theunderlying obligor carries an investment-grade rating,Standard & Poor’s may be able to concludethat the likelihood of the obligor going bankruptduring the defeasance period is consistent with therating on the bonds, and the legal opinion wouldnot be needed.The trustee and any other participant integralto the tender process (sending or receivingnotices, transferring money, or paying bondholders)must remain in their position during a defeasancewhere bondholders have retained their rightto tender the bonds.Trustee’s RoleIn LOC-backed transactions, the trustee is obligatedto fulfill its fiduciary responsibilities. Standard &Poor’s relies on the trustee to follow the terms ofthe bond documents and to draw upon the LOC inaccordance with its terms. In standby LOC transactions,the trustee should remain in place beyond thepayment in full of the bonds (including maturity)until the applicable preference period has expired.IndemnityThe trustee may not require indemnity for drawsupon the LOC or for accelerations. If the trustee isallowed to require an indemnity prior to acceleratingthe maturity of the bonds, bondholders might beexposed to credit-cliff risk. An acceleration of atransaction’s maturity often occurs in response to anevent of default resulting from nonreinstatement ofLOC interest coverage. If the trustee in this instancewere allowed to wait for satisfactory indemnitybefore taking action required by the indenture, thebonds would remain outstanding without correspondingcredit support for interest coverage.Resignation or removal of the trusteeNo resignation or removal of the trustee should beeffective until the appointment of a successortrustee. Full and timely payment is compromisedany time a vacancy exists in the position of trustee.Terms of the transaction must provide for theappointment of a successor trustee prior to the resignationor removal of the trustee then in effect.Either the LOC must be transferable or a new LOCmust be issued to the successor trustee.In many deals, draws on the LOC are made, andpurchase price for optional and mandatory tendersis paid by the tender agent or some other party,rather than by the trustee. In these transactions, thesame concern with respect to a vacancy in thatposition would exist, and as a result, the provisionsused for the resignation/removal of the trusteewould also apply to the resignation/removal of theparty in question.214 Standard & Poor’s Public Finance Criteria 2007

Introduction To Structured FinanceLOC SubstitutionIn the event of an LOC substitution, Standard &Poor’s must again review the transaction in order tomaintain the rating. The review looks to concludethat the terms of the substitute LOC, along withthe terms of the bonds, support the transaction, asdid the then-current LOC.For U.S. transactions, Standard & Poor’s willalso inquire if any new or additional collateral isbeing granted to the new LOC bank. In two cases,courts held that under certain circumstances a paymentunder an LOC may be recaptured as a preferenceby a bankrupt account party (the debtor). Thetwo rulings concerned are In re Compton Corp.,No. 87-1135 Slip Op (5th Cir. Nov. 12, 1987) andIn re Air Conditioning Inc. of Stuart, 72 BR 657(S.D. Fla. 1987). In both cases:■ The LOC was issued to secure a preexisting obligationof the debtor;■ The debtor collateralized its obligation to reimbursethe bank for payments under the LOC;■ The debtor became subject to a bankruptcy proceedingwithin 90 days after its obligation toreimburse the bank for payments under the LOC;and■ After the bankruptcy, the bank was permitted topay a draw under the LOC.The courts held that:■ The pledge of collateral was a transfer by thedebtor of its property on account of anantecedent indebtedness;■ The pledge occurred within 90 days prior to thedebtor’s bankruptcy; and■ Although the pledge was made directly to thebank, it induced the bank to issue the LOC.Therefore, the pledge was for the benefit of theLOC’s beneficiary.As a result, the courts ruled that elements of apreference existed and, therefore, the debtor couldrecapture the LOC payment from the beneficiary tothe extent of the pledged collateral.These two cases affected Standard & Poor’s criteriaregarding the substitution of an LOC during thelife of a transaction and the provision of an LOCsubsequent to the issuance of the debt. If a substituteLOC is provided or an LOC is brought in subsequentto the closing of the transaction,Standard & Poor’s will rate the issue if there is anynew collateral offered to the bank issuing the newLOC, only if Standard & Poor’s has received a preferenceopinion of counsel that specifically addressesthe Air Conditioning and Compton cases.Standard & Poor’s concerns can be addressed byproviding a written statement that no new collateralis being offered to the bank issuing the new LOC.Confirmation LOC Rating CriteriaA confirmation transaction is structured to providefull credit enhancement of debt service with anLOC from a lower-rated or unrated financial institution(the facing LOC) and a confirmation in theform of a second LOC from a higher-rated institution.This second LOC (the confirmation LOC) alsoprovides full credit enhancement of debt service followingthe wrongful dishonor, default, or insolvencyof the fronting bank.In its analysis, Standard & Poor’s seeks toensure that the likelihood of payment is equal tothe likelihood of the confirming bank’s honoringdraws on its confirmation LOC. Bondholdersmust be insulated from any bankruptcy, default,or lack of performance not only by the underlyingobligor, but also by the facing LOC bank.Standard & Poor’s, therefore, seeks to ensure thatsufficient funds will be available from the confirmationLOC to make full and timely payment ofall amounts due to bondholders if the frontingbank wrongfully dishonors a draw request or if,upon the insolvency of the fronting bank, its facingLOC has been repudiated by a conservator orreceiver. As a result, the rating that Standard &Poor’s assigns to a confirmation transaction is atleast the confirming bank’s issuer credit rating. Ifapplicable, the transaction could be rated in accordancewith the joint support criteria.LOC repudiationThe concern of LOC repudiation developed as alegislative effect of FIRREA, the 1989 U.S. savingsand loan bailout legislation. FIRREA includes provisionsdescribing the FDIC’s rights and responsibilitieswhen acting as conservator or receiver ofan insolvent institution. Under the provisions ofFIRREA, if an LOC issuer becomes insolvent, theFDIC, as receiver of the insolvent institution, isable to repudiate the LOC if it is perceived to be aburdensome contract. Since an LOC can be repudiatedbefore it is drawn on, the confirmation LOCmust be available and be drawn on if the facingLOC is repudiated.Confirmation credit cliff issuesThe same credit cliff concerns regarding expiration,substitution, nonreinstatement, conversion, and purchaseprice reinstatement also exist and will be analyzedin the context of the confirming LOC structure.Confirmation LOC expirationA confirmation LOC can expire without priorredemption or tender of the bonds if there is priorwritten evidence from Standard & Poor’s of ratingmaintenance. This could occur if rating changesequalize the ratings of the fronting bank and theconfirmation bank. At that point, the confirmationwww.standardandpoors.com215

Municipal Structured FinanceLOC could be terminated without any change tothe rating of the bonds.Single-draw confirmationSome confirmation LOCs have no terms for reinstatement.They are available only for a singledraw. Upon any wrongful dishonor or repudiationof the facing LOC, the trustee must be instructed todraw for the full stated amount of the confirmationLOC and redeem or accelerate the bonds.Sources of paymentIn a LOC-backed transaction, the trustee isinstructed to make payment of principal, interest,premium, and purchase price in accordance withthe prioritized list of sources of payment. In additionto the facing LOC as a source of payment, thetrustee must also be specifically instructed to usethe confirmation LOC as a source of payment.Timeliness of LOC drawsIt is important to synchronize the trustee’s drawinstructions under the bond indenture with the paymentterms of the facing LOC and the confirmationLOC to ensure that each credit facility is drawn onto provide full and timely payment. In the case ofbonds supported by both a facing and a confirmationLOC, the trustee’s draw instructions mustleave sufficient time to draw on the confirmationLOC in order to provide full and timely paymentupon the wrongful dishonor or repudiation of thefacing LOC.Draw proceduresTerms of a confirmation LOC include the proceduresfor the trustee to properly conduct a draw.The terms must allow draws under any circumstanceof facing LOC repudiation or wrongful dishonor.In addition, the confirmation LOC shouldnot require the trustee to represent the drafts of thedishonored draw on the facing bank as a conditionof honoring a draw on the confirmation LOC. Thisenables the trustee to draw on the confirmationLOC following bank insolvency even if either thefacing LOC is repudiated before it is drawn on, orthe dishonored drafts are not properly returned tothe trustee.Preference concernsA key question about confirmation LOC structuresis whether or not, subsequent to a fronting bankinsolvency, the FDIC as receiver could recover paymentsmade to bondholders by the trustee that werederived from a draw on the facing LOC. This concernis based on the theory that the payments eitherwere not made in the ordinary course of business ofthe bank, were made in the preference of one creditorover another, or were made to prevent theapplication of the bank’s assets in the manner prescribedby the National Banking Act.In a January 1991 statement, the FDIC addressedthis concern by stating that, in its view, a courtwould hold that the FDIC, as receiver or conservator,could not recover payments made to bondholdersfrom the trustees draw under the facing LOC.Based upon this statement, Standard & Poor’s doesnot have additional preference concerns for U.S.confirmation LOC structures beyond those evidentwithin other fully credit-enhanced structures.If the fronting bank is a non-U.S. bank,Standard & Poor’s will research the possibility ofwhether payments from the fronting LOC bankcould be disgorged under the bankruptcy law ofthat country. If there is such a possibility, a solutioncould be that upon the fronting bank’s insolvency,the trustee will no longer draw on that LOC, butrather, will directly draw upon the confirmationLOC to avoid this preference concern.LOC-Backed Commercial PaperStandard & Poor’s also rates municipal commercialpaper (CP) programs secured by LOCs. With adirect-pay LOC, a depositary draws for the entireprincipal of and accrued interest on the CP notes atmaturity. The proceeds from the sale of new CPnotes are used to reimburse the bank for the drawon the LOC.In a CP program, the depositary usually acts asissuing and paying agent. The depositary issues,authenticates, and delivers new CP notes on theissuer’s instructions. It also pays the notes at maturityand ceases CP note issuance at the issuer’s andLOC bank’s requests. To ensure adequate LOC coverage,the depositary determines that the amount ofany new CP plus the amount of outstanding CPdoes not exceed the LOC commitment. Typically,the CP notes mature within 270 days and, in anyevent, no later than the 15th day prior to LOCexpiration. The bank is obligated to honor drawsto pay principal and interest on all CP notes untilthey mature, despite any early termination of itsagreement with the issuer.The depositary’s authority to issue CP can berevoked temporarily or permanently by the issueror the bank. In such a case, the depositor may notissue any new CP, and the LOC must continue tosupport all outstanding CP. If the bank gives acease issuance order, only the bank can rescind suchinstruction.In the event that the LOC provides for an earlytermination of the bank’s commitment, based on anevent of default under the reimbursement agreement,the bank immediately notifies the depositaryof the default and instructs the depositary to cease216 Standard & Poor’s Public Finance Criteria 2007

Municipal Applications For Joint Support Criteriaissuing CP notes. In addition, the depositary isinstructed to:■ Draw on the LOC for the entire amount of outstandingCP notes and hold draw proceeds untilsuch notes mature; or■ If the LOC will remain in effect by its terms untilthe last outstanding CP note matures, continue todraw on the LOC as CP notes mature until theentire program is retired.In the event that the former occurs, the depositarymust hold proceeds uninvested or invest theproceeds in qualified investments maturing whenneeded that are rated equal to or higher than therating assigned to the transaction. ■Municipal ApplicationsFor Joint Support CriteriaStandard & Poor’s Ratings Services uses its criteriafor rating jointly supported obligationswhen more than one entity is fully responsible forthe entire obligation. In this situation, a default onthe obligation would occur only if each entitydefaults. Common examples of joint supportinclude a primary obligor plus a guarantor or aprimary obligor and a letter-of-credit (LOC)provider. The risk that both entities will default isless than the risk that either one will. As a result,Table 1 Correspondence BetweenRatings And Probabilities Of DefaultRating Probability of Default (%)AAA 0.362AA+ 0.536AA 0.872AA- 1.13A+ 1.458A 1.782A- 2.479BBB+ 3.842BBB 5.876BBB- 10.637BB+ 13.179BB 18.258BB- 24.197B+ 30.565B 38.145B- 48.559CCC+ 65.517CCC 75.853CCC- 88.268the obligation may be rated higher than the ratingon the stronger obligor (supporter).SummaryThe criteria contain the following key elements:■ The rating for the jointly supported obligationwill be derived from one of three reference tables,one each for obligor pairs that have high, medium,and low default correlation (see tables 3, 4,and 5). The tables were generated with a sophisticatedcalculation of the joint default probability,including explicit default correlation assumptions.■ Obligations of very highly correlated entitiesremain ineligible for credit enhancement.■ Application of the criteria is extended to speculative-gradeentities. Previously, the criteria wereapplicable only to investment-grade obligors.■ The joint-support criteria will not be used to rateissues or issuers that receive less-formal support,such as the benefits enjoyed by many government-ownedenterprises. In other words, theseissues will continue to be rated no higher thanthe rating on the government or parent companyproviding support.Joint Probability Of Default CalculationJointPD = (PA*PB)*[DC PA*(1 PA)PB*(1 PB)]A constraint is added so that the joint PD is capped at thestronger obligor’s PD (the rating will never be lower than thaton the stronger obligor).Where: PA = the default probability of one obligorPB = the default probability of the other obligorDC = the default correlation of the two obligorswww.standardandpoors.com217

Municipal Structured FinanceJoint Probability Of Default CalculationThe joint probability of default (PD) is calculated asfollows:For the rating on each obligor, the corresponding10-year cumulative PD (displayed in Table 1) isused. After the joint PD is calculated, the number isconverted back into the closest corresponding ratingfor the 10-year time horizon. The underlyingPDs associated with each rating are consistent withthose used by Standard & Poor’s for rating CDOs.The following example is illustrative. If a Frenchbank rated ‘A+’ (PD of 1.458%) guarantees anobligation of an American manufacturing companyrated ‘BB+’ (PD of 13.179%), and the assumeddefault correlation is 15%, the jointly supportedrating would be ‘AA‘ (joint PD of 0.800%).Table 2 Default Correlation GuidelinesCorrelation Guidelines Default Correlation (%) CharacteristicsToo high No benefit (1) Affiliated companies, (2) government and its owned/supportedentities, (3) economically codependent entities, (4) both obligors inthe same country, and its sovereign government is rated speculativegrade.*High 25 Both obligors share two of the following: same industry, same region,speculative grade.*Medium 20 Both obligors share one of the following: same industry, same region,speculative grade.*Low 15 Obligors are in different industries and regions, and at least one isinvestment grade.**When rating a jointly supported foreign currency issue, the foreign currency ratings on the obligors and sovereign are relevant, but the resultis constrained by the transfer and convertibility limit.Table 3 High Correlation Reference TableAAA AA+ AA AA- A+ A A- BBB+ BBB BBB-AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AAA AAA AAA AAA AAA AAA AAA AAA AA+ AA+AA AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AAAA- AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AAA+ AAA AAA AAA AAA AAA AAA AA+ AA+ AA AA-A AAA AAA AAA AAA AAA AA+ AA+ AA AA AA-A- AAA AAA AAA AAA AA+ AA+ AA+ AA AA- A+BBB+ AAA AAA AA+ AA+ AA+ AA AA AA- A+ ABBB AAA AA+ AA+ AA+ AA AA AA- A+ A A-BBB- AAA AA+ AA AA AA- AA- A+ A A- BBB+BB+ AAA AA+ AA AA- AA- AA+ A A- A- BBB+BB AAA AA+ AA AA- AA+ AA+ A A- BBB+ BBBBB- AAA AA+ AA AA- AA+ A A- A- BBB+ BBBB+ AAA AA+ AA AA- AA+ A A- A- BBB+ BBBB AAA AA+ AA AA- AA+ A A- BBB+ BBB BBBB- AAA AA+ AA AA- AA+ A A- BBB+ BBB BBB-CCC+ AAA AA+ AA AA- AA+ A A- BBB+ BBB BBB-CCC AAA AA+ AA AA- AA+ A A- BBB+ BBB BBB-CCC- AAA AA+ AA AA- AA+ A A- BBB+ BBB BBB-D AAA AA+ AA AA- AA+ A A- BBB+ BBB BBB-218 Standard & Poor’s Public Finance Criteria 2007

Municipal Applications For Joint Support CriteriaDefault correlations of 25%, 20%, or 15% areexplicitly assumed based on the obligors’ characteristics,as shown in Table 2.Three different reference tables (tables 3, 4, and5) for different degrees of correlation are employed.To facilitate implementation, relatively simpleguidelines are used to determine which table isappropriate. The main factors are whether theobligors are in the same industry, in the sameregion, or speculative grade. The relevance of theseintuitive criteria is supported by Standard & Poor’sdefault correlation research. Most eligible jointlysupported issues are expected to fall in the mediumor low correlation categories.In the U.S., a region will generally be defined as astate. Outside the U.S., a region will generally bedefined as a country. However, we will also makecase-specific analytical conclusions about correlationwhen appropriate. To date, joint-support criteriahave typically been applied to transactionsinvolving a bank and either a U.S. corporate or aU.S. public finance entity. When assessing geographiccorrelation, a large bank, with a globallydiverse business profile, will not be treated as inany particular U.S. state. In other words, a majorbank with its home office in New York would notbe considered in the same region as a New YorkState municipality. Conversely, smaller banks withsignificant geographic concentrations in one tothree states may be considered to be in the sameregion as entities from any of those states.Entities To Which The Criteria Are ApplicableThe main application of the joint-support criteria todate has been for LOC-backed issues. Banks providingthe LOCs range from local U.S. commercialbanks to large multinational institutions based in anumber of countries. Virtually all transactions towhich the criteria are applied include at least onefinancial institution obligor.Under the criteria, Standard & Poor’s excludesvery highly correlated entities—such as affiliatedcompanies—from any joint-support benefit.Obligations insured by the monoline bond insurerswill remain ineligible for joint-support creditenhancement (above the rating on the insurer),reflecting the significant correlation between theinsurer and its portfolio of insured obligations. Thejoint-support approach remains inappropriate forU.S. public finance double-barreled bonds, whichare backed by economically codependent paymentTable 3 High Correlation Reference Table (continued)BB+ BB BB- B+ B B- CCC+ CCC CCC- DAAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+AA AA AA AA AA AA AA AA AA AA AAAA- AA- AA- AA- AA- AA- AA- AA- AA- AA- AA-A+ AA- A+ A+ A+ A+ A+ A+ A+ A+ A+A A+ A+ A A A A A A A AA- A A A- A- A- A- A- A- A- A-BBB+ A- A- A- BBB+ BBB+ BBB+ BBB+ BBB+ BBB+ BBB+BBB A- BBB+ BBB+ BBB+ BBB BBB BBB BBB BBB BBBBBB- BBB+ BBB BBB BBB BBB BBB- BBB- BBB- BBB- BBB-BB+ BBB+ BBB BBB BBB BBB- BBB- BBB- BB+ BB+ BB+BB BBB BBB BBB- BBB- BBB- BB+ BB BB BB BBBB- BBB BBB- BBB- BB+ BB+ BB BB BB- BB- BB-B+ BBB BBB- BB+ BB+ BB BB BB- B+ B+ B+B BBB- BBB- BB+ BB BB BB- B+ B+ B BB- BBB- BB+ BB BB BB- B+ B B B- B-CCC+ BB+ BB BB BB- B+ B B- B- CCC+ CCC+CCC BB+ BB BB- B+ B+ B B- CCC+ CCC+ CCC-CCC- BB+ BB BB- B+ C B- CCC+ CCC+ CCC CCC-D BB+ BB BB- B+ B B- CCC+ CCC CCC- Dwww.standardandpoors.com219

Municipal Structured Financesources (e.g., a general obligation pledge and revenuefrom water and sewer charges).Short-term and dual ratingsJointly supported short-term obligations are eligiblefor credit enhancement. This is accomplished byconverting the indicated long-term rating into thecorresponding short-term rating. A substantialnumber of LOC-backed issues have a short-termput or demand feature. Every seven days, the interestrate is reset and investors may demand repayment.Standard & Poor’s assigns a dual rating (e.g.,‘AA/A-1+’) to these instruments.U.S. public finance obligorsTechnically, both the LOC provider and theprimary obligor are obligated to meet both thescheduled long-term payments and the putoption. However, Standard & Poor’s has concludedthat U.S. public finance obligors, even thosewith high investment-grade ratings, do not havethe capacity to meet the sudden put. Accordingly,we recognize joint support for the long-term componentbut not for the short-term rating. Theshort-term rating on the LOC provider is assignedto the short-term portion of the obligation.Third obligorWhen there are three obligors, each fully responsiblefor the obligation (such as a primary obligor,an LOC provider, and a confirming LOCprovider), the joint-support criteria will be appliedto the best two out of three. We will use the jointsupportcriteria reference table (high, medium, orlow correlation) for the two obligors that producethe highest rating, which will often be the twomost highly rated obligors. Here is an example:The primary obligor is a health care entity rated‘BBB-’, an LOC is provided by a bank rated‘BBB+’, and a confirming LOC is provided by abank rated ‘AA-’. The primary obligor and LOCprovider are both in the U.S. state of Georgia; theconfirming LOC provider is in Germany. Wewould use the medium correlation table for thetwo banks (same industry, different regions, andboth investment grade), resulting in a rating of‘AA+’. If the health care obligor is upgraded anotch to ‘BBB’, a ‘AAA’ rating could be achievedby combining the primary obligor with the confirmingLOC provider in the low correlation referencetable (different region and industry).Table 4 Medium Correlation Reference TableAAA AA+ AA AA- A+ A A- BBB+ BBB BBB-AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AAA AAA AAA AAA AAA AAA AAA AAA AAA AA+AA AAA AAA AAA AAA AAA AAA AAA AAA AA+ AA+AA- AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AAA+ AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AA AA-A- AAA AAA AAA AA+ AA+ AA+ AA+ AA AA- A+BBB+ AAA AAA AA+ AA+ AA+ AA AA AA- A+ ABBB AAA AA+ AA+ AA AA AA- AA- A+ A A-BBB- AAA AA+ AA AA AA- AA- A+ A A- BBB+BB+ AAA AA+ AA AA- AA- A+ A A- A- BBB+BB AAA AA+ AA AA- A+ A+ A A- BBB+ BBBBB- AAA AA+ AA AA- A+ A A A- BBB+ BBBB+ AAA AA+ AA AA- A+ A A- A- BBB+ BBBB AAA AA+ AA AA- A+ A A- BBB+ BBB BBBB- AAA AA+ AA AA- A+ A A- BBB+ BBB BBBCCC+ AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-CCC AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-CCC- AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-D AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-220 Standard & Poor’s Public Finance Criteria 2007

Municipal Applications For Joint Support CriteriaTable 4 Medium Correlation Reference Table (continued)BB+ BB BB- B+ B B- CCC+ CCC CCC- DAAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+AA AA AA AA AA AA AA AA AA AA AAAA- AA AA- AA- AA- AA- AA- AA- AA- AA- DA+ AA- AA- A+ A+ A+ A+ A+ A+ A+ A+A AA- A+ A+ A A A A A A AA- A+ A A A- A- A- A- A- A- A-BBB+ A A- A- A- BBB+ BBB+ BBB+ BBB+ BBB+ BBB+BBB A- A- BBB+ BBB+ BBB+ BBB BBB BBB BBB BBBBBB- BBB+ BBB+ BBB BBB BBB BBB BBB- BBB- BBB- BBB-BB+ BBB+ BBB BBB BBB BBB- BBB- BBB- BB+ BB+ BB+BB BBB BBB BBB BBB BBB- BB+ BB+ BB BB BBBB- BBB BBB BBB- BBB BB+ BB BB BB- BB- BB-B+ BBB BBB- BBB- BB+ BB BB BB- BB- B+ B+B BBB- BBB- BB+ BB BB BB- B+ B+ B BB- BBB- BB+ BB BB BB- B+ B B B- B-CCC+ BBB- BB+ BB BB- B+ B B- B- CCC+ CCC+CCC BB+ BB BB- BB- B+ B B- CCC+ CCC+ CCCCCC- BB+ BB BB- B+ B B- CCC+ CCC+ CCC CCC-D BB+ BB BB- B+ B B- CCC+ CCC CCC- DTable 5 Low Correlation Reference TableAAA AA+ AA AA- A+ A A- BBB+ BBB BBB-AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AA+AA- AAA AAA AAA AAA AAA AAA AAA AAA AAA AA+A+ AAA AAA AAA AAA AAA AAA AAA AAA AA+ AAA AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AAA- AAA AAA AAA AAA AAA AAA AAA AA+ AA+ AABBB+ AAA AAA AAA AAA AAA AA+ AA+ AA+ AA A+BBB AAA AAA AAA AA+ AA+ AA+ AA AA- AA- ABBB- AAA AAA AA+ AA+ AA AA AA A+ A A-BB+ AAA AAA AA+ AA+ AA AA AA- A+ A A-BB AAA AA+ AA+ AA AA AA- A+ A A- BBB+BB- AAA AA+ AA AA AA- AA- A+ A- A- BBB+B+ AAA AA+ AA AA- AA- A+ A A- BBB+ BBBB AAA AA+ AA AA- A+ A A A- BBB+ BBBB- AAA AA+ AA AA- A+ A A- BBB+ BBB+ BBBCCC+ AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-CCC AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-CCC- AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-D AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-www.standardandpoors.com221

Municipal Structured FinanceTable 5 Low Correlation Reference Table (continued)BB+ BB BB- B+ B B- CCC+ CCC CCC- DAAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA+ AAA AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+ AA+AA AAA AA+ AA AA AA AA AA AA AA AAAA- AAA AA AA AA- AA- AA- AA- AA- AA- AA-A+ AAA AA AA- AA- A+ A+ A+ A+ A+ A+A AAA AA- AA- A+ A A A A A AA- AAA A+ A+ A A A- A- A- A- A-BBB+ AAA A A- A- A- BBB+ BBB+ BBB+ BBB+ BBB+BBB AAA A- A- BBB+ BBB+ BBB+ BBB BBB BBB BBBBBB- AAA BBB+ BBB+ BBB BBB BBB BBB- BBB- BBB- BBB-BB+ AAA BBB+ BBB BBB BBB BBB- BBB- BB+ BB+ BB+BB AAA BBB BBB BBB BBB- BBB- BB+ BB BB BBBB- AAA BBB BBB- BBB- BB+ BB+ BB BB BB- BB-B+ AAA BBB BBB- BB+ BB+ BB BB- BB- B+ B+B AAA BBB- BB+ BB+ BB BB- B+ B+ B BB- AAA BBB- BB+ BB BB- BB- B B B- B-CCC+ AAA BB+ BB BB- B+ B B- B- CCC+ CCC+CCC AAA BB BB BB- B+ B B- CCC+ CCC+ CCCCCC- AAA BB BB- B+ B B- CCC+ CCC+ CCC CCC-D AAA BB BB- B+ B B- CCC+ CCC CCC- DLegal And Structural ConsiderationsThe joint-support criteria are only applicable whenthe obligation is legal, valid, and enforceableagainst both (or all three) obligors. Any preferencepayment or clawback risk must be addressed in thestructure of the transaction.Analysts will exercise judgment to determinewhether the joint-support criteria should beapplied if the obligation is unusual or unpredictable.Note the eligibility of investment agreementsto be jointly supported by more than oneprovider (see “Public Finance Criteria: JointSupport To Investment Agreements”).ImplementationTo ensure transparency of Standard & Poor’s publicratings, the joint-support approach will only beapplied when both obligors have a public long-termand, if relevant, short-term rating unless the jointsupportcriteria affect only one element of a complextransaction. In addition, where one of thesupporters is a U.S. public finance obligor, the bondissue will also receive a Standard & Poor’sUnderlying Rating (SPUR) reflecting the unenhancedlong-term rating of the issue.If the rating on a supporting obligor is placed onCreditWatch, Standard & Poor’s will either placethe rating on the jointly supported issue onCreditWatch or state publicly that the latter ratingwill be unaffected by the obligor’s rating review. ■222 Standard & Poor’s Public Finance Criteria 2007

Forward Purchase Contracts And ‘AAA’ Defeased BondsForward PurchaseContracts And ‘AAA’ Defeased BondsStandard & Poor’s Ratings Services reviews forwardpurchase contracts (FPCs) in conjunction withnewly refunded bonds and outstanding ‘AAA’ ratedrefunded bonds. The FPC analysis involves a reviewof legal structure and the sufficiency and credit qualityof the assets placed in escrow. As with traditionalrefunded bonds, in order to provide a rating on anescrow that is accompanied by a FPC, Standard &Poor’s relies on counsel, escrow agents, accountants,and other experts and advisors for accuracy and completenessof the information provided.FPCs involve the sale by the issuer of its residualearnings from an escrow to a third party, theFPC provider, who receives an economic benefitbased on the nature of the residual interest purchased.The issuer receives a purchase price fromthe FPC provider that generally is equal to thepresent value of the future reinvestment income.The residual rights sold to the FPC provider (theseller) may include:■ The issuer’s right to receive excess reinvestmentincome, if any, after the payment of debt serviceon the bonds;■ The issuer’s right to direct the reinvestment ofmaturing proceeds of the initial escrowed securities;and■ The issuer’s right to substitute the reinvestedsecurities held by the escrow agent in the escrowfund.Many outstanding escrow agreements are silentwith respect to an issuer entering into an FPC subsequentto the escrow’s closing date and frequently,FPCs are executed afterwards. Because FPCs arenot considered eligible investments for ratedescrows, Standard & Poor’s believes that theescrow agreement should be amended to providefor the subsequent execution of the FPC. We wouldalso expect counsel to consider whether bondholderapproval should be obtained before the escrowagent enters into a FPC.FPC Rating CriteriaTo obtain a ‘AAA’ rating on an escrow that has aFPC, Standard & Poor’s first looks for compliancewith our defeasance criteria (see “Public FinanceCriteria: Defeasance”). Additionally, since the FPCprovider is purchasing the residual interest in theescrow account, Standard & Poor’s determineswhether such interest would cause the escrowedfunds to be affected by a potential insolvency of theFPC provider.FPC analysisStandard & Poor’s examines whether the FPC or theescrow agreement include the following provisions:■ The decision to purchase the newly deliveredsecurities from the FPC provider should be at theescrow agent’s option and, in general, at thedirection of the issuer.■ The FPC provider should have no right to substituteany of the initial escrow securities prior totheir maturity. After the maturity of the initialsecurities, to the extent that the FPC providerdelivers to the escrow agent new securities pursuantto the FPC, the FPC provider may retainthe right to deliver substitute securities withlonger maturities providing those newly deliveredsecurities mature on or before the next bond paymentdate. Because the initial escrow securitiesmatured in accordance with the terms of theescrow (and the original verification report), thedelivery of the new securities does not require anew verification report as the original escrowstructure presumed no investment earnings afterthe initial escrowed securities matured.■ The FPC or the escrow agreement should providefor independent accounting firm verification of thesufficiency of the escrow funds prior to any withdrawalof monies from the escrow. This shouldnot be confused with substituting securities providedpursuant to the FPC, which does not require anew verification report. The documents shouldmake provisions for, or reserve for, the cost ofthese additional verification reports, if applicable.■ The escrow agent should not be permitted toaccept any newly delivered securities from anotherFPC provider unless the FPC has been transferredto that provider and evaluated byStandard & Poor’s as evidenced by written confirmationof the rating of the escrow.■ The FPC provider or any subsequent FPCprovider, if applicable, has no lien or claimwww.standardandpoors.com223

Municipal Structured Financeagainst the escrow fund and waives any rights itmay have to enforce the obligations of the issuerto the FPC provider from any amounts or securitieson deposit with the escrow agent. Any damagesdue to the FPC provider or any transfereemay be paid from amounts on deposit in theescrow fund only after all bondholders have beenpaid in full.■ Amendments to the escrow agreement or the FPCshould be subject to Standard & Poor’s confirmationthat such actions will not adversely affect thethen current rating on the bonds.■ If the FPC provider transfers the FPC, confirmationshould be requested from Standard & Poor’sthat such transfer would not adversely affect thethen current rating on the bonds.■ The FPC provider may not deliver “partial interests”in securities—securities jointly owned bythe seller and the escrow agent. The new securitiesshould be held by the escrow agent under theescrow and mature on or before the date that theescrow agent needs funds to make debt servicepayments on the bonds. Standard & Poor’s doesnot assume that the market value of the newsecurities, if liquidated prior to their maturity,will be sufficient to pay debt service.■ The escrow agreement should provide that if theparties enter into a FPC subsequent to the datethat Standard & Poor’s rated the escrowed bonds,the escrow agent receives written evidence fromStandard & Poor’s that the FPC will not adverselyaffect the then current rating on the bonds.Legal opinionsTo ensure that the escrow funds will be availableto pay debt service on the defeased obligations,Standard & Poor’s requires that in addition to theopinions required in the defeasance criteria, thefollowing opinions be delivered in connection witha FPC:1. An opinion of counsel to the effect that, if theFPC provider becomes insolvent, the escrow funds(including the newly delivered securities) and paymentson the bonds would not be recoverable as apreference by the debtor in possession, trustee,receiver, or other conservator or liquidator of theFPC provider.2. An opinion of counsel to the effect that, in aninsolvency of the FPC provider, the escrow funds(including the newly delivered securities) and anypayments made from it would not be subject to theautomatic stay or any stay imposed by a conservator,receiver, or liquidator of the seller (and, ifapplicable, that the agreement satisfies the requirementsof Section 13 (e) of the Federal DepositInsurance Act).3. An opinion of counsel to the effect that, in theevent of the insolvency of the FPC provider, theescrow funds, including the newly delivered securities,and all proceeds thereon would not be consideredpart of the FPC provider’s assets available forliquidation by any trustee, conservator, receiver orliquidator to the FPC provider’s creditors.For example:■ FPC providers that are subject to the BankruptcyCode: the opinions should address items 1-3 andinclude references to Sections 362(a), 541, and547 of the Bankruptcy Code.■ FPC providers that are FDIC insured: the opinionshould address items 1-3 as reflected in the provisionsof FIRREA and the Federal DepositInsurance Act (FDIA).■ FPC providers that are not FDIC insured or subjectto the Bankruptcy Code: the opinion shouldaddress items 1-3 as reflected by the relevantstate and foreign, if applicable, regulatory provisions.4. If the FPC is entered into subsequent to thecreation of the escrow:■ Confirmatory opinion stating that the opinionsset forth in legal defeasance opinion and the taxopinions rendered at the closing of the escrowagreement are not affected by the execution,delivery, and performance of the FPC; and■ An opinion to the effect that the execution, delivery,and performance of the FPC is legal, valid,binding, and enforceable and does not require theconsent of the bondholders. ■224 Standard & Poor’s Public Finance Criteria 2007

Secondary Market Derivative ProductsSecondary Market Derivative ProductsStandard & Poor’s Ratings Services rates secondarymarketderivative products, such as tax-exemptsynthetic floating rate receipts (synthetic floaters),including the tender option and residual interesttranches, principal and interest strips and auctionfloater/inverse floater trust receipts—all based onunderlying deposits of municipal obligations.The most frequently rated secondary marketderivative products are synthetic floaters createdby depositing fixed-rate municipal obligations intoa trust structure. Synthetic floaters with a tenderoption, which are similar to primary market variablerate demand obligations (VRDOs), are typicallysecured by a liquidity facility that providescoverage for unremarketed tendered receipts.Residual interest receipts are created as part of thesame synthetic floater structure, and do not have atender option.The interest paid to residual interest holders generallyequals the interest collected on the underlyingobligation, minus the interest rate payable to thesynthetic floater holders with the tender option andfees. In a strip structure, some or all of the interestpayments associated with a bond are stripped fromthe principal payments, and both are resold at adiscount from their face value to separate purchasers.An auction floater/inverse floater receiptstructure allows two classes of variable-rate receiptsto be created from a single deposit of underlyingfixed-rate bonds. One class of receipt bears intereston an auction basis, and the other captures theresidual interest from the underlying bonds.All secondary-market derivative securities areexamined according to the following three analyticalcategories:■ Custodial or trust analysis;■ Legal analysis; and■ Structural analysis.Custodial Or Trust AnalysisThe custodial or trust analysis concentrates on theproper transfer of the underlying assets to the custodianor trustee and their issuance as receipts. Thisanalysis is identical for all types of secondary-marketderivatives. The custodian or trustee should beclearly instructed to:■ Receive the underlying securities from the depositorfree and clear of any lien or encumbrance andensure that the deposit is irrevocable;■■■■Establish and maintain a separately designatedaccount for each issue;Ensure that the underlying bonds that aredeposited into the custody or trust account arenot commingled with any of its other assets;Ensure that no current or subsequent fees aretaken from payments due to holders,Transfer payments in a timely fashion to holders.Legal AnalysisThe legal analysis concentrates on bankruptcy andtaxability issues and is also identical for all secondary-marketderivatives. The following legal opinionsare requested and examined:■ True sale opinion, if requested; and■ Tax opinion stating that there is no tax at thetrust structure (entity) level for federal, state,and, in some cases, local purposes.In additional to relevant opinions, the structuremust also meet additional legal criteria regardingthe structure. (See “Legal Criteria For U.S.Structured Finance Transactions”).Structural AnalysisThe structural analysis is tailored to each specificderivative product and concentrates on the followingstructural features:■ The flow of funds from the underlying bonds tothe receipt holders;■ The various payment events associated with thestructure;■ Designated sources of payment for each paymentevent; and■ Compatibility of the trust and liquidity facilitytermination events with the rating to be assignedto the receipts.Tender Option Synthetic/Residual Interest Synthetic FloatersSynthetic floaters are variable-rate trust receipts evidencingdirect ownership interests in a deposit ofunderlying obligations. Such obligations generallyhave a fixed interest rate but can also bear interestat a variable rate. Obligations deposited into a synthetictrust can come from various municipal sectorsand come in a variety of forms, such as bonds,notes and leases, among others. After the deposit ofthe obligation into the trust structure, two classeswww.standardandpoors.com225

Municipal Structured Financeof receipts are created—a synthetic floater receiptwith a tender option and a residual interest receipt.The synthetic floaters with a tender option are supportedby a liquidity facility to cover the purchaseprice of unremarketed tendered receipts. Syntheticfloaters with a tender option are assigned a dual ratingconsisting of long-term and short-term components,such as ‘AAA/A-1+’. The long-term rating isbased on the rating of the underlying obligation andaddresses the underlying obligation’s ability to payfull and timely principal and interest. The short-termrating is based on the short-term rating of the liquidityfacility provider and addresses the likelihood ofpayment of the purchase price of tendered receipts.Residual interest synthetic floaters can beassigned a long-term rating only that reflects therating of the underlying bond. Residual interestfloater holders may experience high variability inexpected returns as a result of non-credit risks.Synthetic floaters’ ratings only address the likelihoodof the floater holder receiving par plus anyaccrued interest based on regularly scheduledprincipal and interest payments from the underlyingobligation which, in some instances, may beenhanced by a municipal bond insurance policy,or receive joint support based on the applicationof joint support criteria. Synthetic floaters’ ratings,as is the case with all of Standard & Poor’smunicipal ratings, do not address the likelihoodthat the interest payable on the receipts or theunderlying bonds may be deemed or declaredincludable in the gross income of synthetic floaterholders by the relevant authorities at any time.The ratings also do not address the likelihood ofany payments to synthetic floater holders inexcess of principal and interest, such as premiumon redemption payments from the underlyingobligations or gain share payments.Structural analysisSynthetic floaters may be structured with a numberof different interest-rate modes similar tothose found in VRDOs, such as weekly or monthly.Synthetic floaters with tender options are subjectto optional tender upon requisite notice. Inaddition, the receipts are subject to mandatorytender when certain events occur, which include,but are not limited to, a change in the interestratemode, expiration or termination of the liquidityfacility. Standard & Poor’s applies its bankliquidity facility criteria when reviewing liquiditydocuments (See Public Finance Criteria: “BankLiquidity Facilities”).The trustee collects the semi-annual fixed interestpayments from the underlying obligations and payscertain fees related to the trust. The trustee thenpays the tender option synthetic floater holder thevariable interest rate and distributes any remaininginterest after payment of additional fees, if any, tothe residual synthetic floater holder.Standard & Poor’s will apply its LOC criteriawhen requested to rate synthetic floater structuresthat have an LOC wrap on the underlying obligation.If requested, Standard & Poor’s will reviewa structure to determine whether joint supportcriteria can be applied. The joint support criteriacan be applied to both the long-term rating, aswell as to the short-term rating.(See “PublicFinance Criteria: Municipal Applications ForJoint Support Criteria”).Two different tender option structures have beenused: the put and the swap. In the put structure, thevariable interest rate is set by the remarketing agentand capped at the underlying obligation’s interestrate (minus trust fees, if applicable). In the swapstructure, a net payment is made by the depositorto a swap counterparty, as long as the syntheticfloater rate is less than the bond interest rate. If thevariable tender option rate exceeds the underlyingbond rate, the swap counterparty pays the differenceto the depositor.Standard & Poor’s examines the documents inboth structures to ensure that the interest rate settingmechanism is clearly defined and that thetrustee’s duties with respect to the depositor andholders of synthetic floaters with a tender optionare carefully outlined.Multiple assetsStandard & Poor’s will review synthetic floaterstructures that have multiple obligations depositedinto a trust either at the trust’s creation or subsequentto the trust’s creation. The rating on thereceipts can be based either on an evaluation ofthe underlying asset pool using the municipalCDO Evaluator, or by using a weak-link approachusing the ratings of each of the assets dependingon the size of the pool. If a trust structure is createdto permit multiple obligations to be deposited,Standard & Poor’s analyzes the maximum ratedefinition to ensure receipt holders are not affectedby the multiple obligations’ different maturitiesand rates of interest. The maximum rate definitioncan state the maximum rate of the receipts will beadjusted such that the receipt holders will receivethe weighted average of the obligations taking intoaccount the multiple maturities. A more conservativeapproach can state the maximum rate of thereceipts will be capped at the lowest bond rate ofthe multiple obligations.Reinvestment risk (odd-lots)In some instances, the authorized denomination ofthe underlying obligation is different than theauthorized denomination of the synthetic floaters.226 Standard & Poor’s Public Finance Criteria 2007

Secondary Market Derivative ProductsSuch a mismatch can result in the underlying obligationsnot accruing sufficient interest due to theoccurrence of a prepayment. The entire amount ofthe prepayment of the underlying obligations cannotbe passed through to the floater holdersbecause the principal denomination may be lessthan that of the synthetic floaters. Thus, the structurecould potentially have receipts outstandingwithout an underlying interest generating obligation.Even if such prepayments are held investeduntil the authorized denomination amount is met,there is a risk that the investments will not generateenough interest to pay the requisite interest amountdue to the floater holders. The documents canaddress this risk either by having the authorizeddenomination of the receipts consistent with theunderlying obligation, or make an adjustment forsuch an occurrence in the maximum rate definition.Liquidity facility analysisAlthough synthetic floaters with a tender option arevery similar to other municipal VRDOs rated byStandard & Poor’s, additional liquidity risks areassociated with these structures because holders canlose the right to tender their receipts without noticeupon certain events. If a tender option terminationevent (TOTE) occurs, synthetic floater holders losetheir tender option rights and instead receive theirpro rata share of underlying bonds or proceeds ofthe sale of the bonds, provided that the proceedsare sufficient to pay the synthetic floater holderspar plus accrued interest and, if rated, the residualinterest holder at par. If sale proceeds are insufficient,then the synthetic floater holders and theresidual interest holders receive their pro rata shareof the underlying bonds as a distribution from thetrust. If Standard & Poor’s has rated the residualinterest receipt, the distribution to residual holdersupon termination cannot be subordinate to the paymentreceived by the holder of the synthetic floaterwith a tender option. In other words, the tenderoption floater holder and the residual interestfloater holder must each receive a pro rata share ofthe underlying obligation or the sale proceeds.Termination of the tender option without noticeis acceptable for the following events:1. The issuer of the underlying obligation failsto pay principal or interest when due and suchfailure is not cured during any designated cureperiod (if applicable); if the bond rating is basedon credit enhancement, payment default is limitedto the credit enhancement provider. If the underlyingobligation’s rating is based on the applicationof joint support criteria, then the TOTE cannotoccur until both entities providing support fail topay principal and interest when due and such failureis not cured during any designated cure period(if applicable).2. The issuer of the underlying obligation files forbankruptcy; if the obligation’s rating is based oncredit enhancement, bankruptcy is limited only tothat of the credit enhancement provider. If theunderlying obligation’s rating is based on the applicationof joint support criteria, bankruptcy has toapply to both entities providing support.3. The Standard & Poor’s underlying obligation’srating falls below investment grade (below ‘BBB-’).4. The underlying obligation is deemed taxable.The occurrence of other credit-related events arereviewed for approval by Standard & Poor’s on acase-by-case basis. The analysis of “other creditrelatedevents” must be deemed by Standard &Poor’s to be remote or factored into the long-termcomponent of the dual rating.Synthetic floater structures may include some orall of the events detailed above. Standard & Poor’sbelieves that the likelihood of the occurrence of thefirst two events is already factored into the longtermcomponent of the dual rating. If the transactionis structured to include event 3, Standard &Poor’s will rate the receipts only if they are derivedfrom underlying obligations that at the time of thetrust rating, have an enhanced, unenhanced, orjointly supported rating of ‘A+’ or higher.Standard & Poor’s permits liquidity facilities generallyto terminate without notice if the events triggeringsuch terminations are consistent withstandby bond purchase agreement criteria. Theseliquidity facility termination events typically are thesame as those that terminate the tender optionsunder the trust documents. If the rating on theunderlying bond depends on credit enhancement,such as bond insurance or an LOC, the events thatresult in termination of the tender option and theliquidity facility without notice must relate only tothe credit enhancement provider, not to the issueror obligor of the underlying bond. Further, if therating on the underlying obligation is based on theapplication of joint support criteria, then the eventsthat result in termination of the tender option andthe liquidity facility without notice should relate toboth entities supporting the obligation.The purchase price of tendered securities is paidfrom remarketing proceeds, and from draws by thetender agent on the liquidity facility. As withVRDOs, the liquidity facility for the tender optionsynthetic floaters must provide coverage for the fullprincipal amount of the securities, as well as themaximum interest rate on the tender option syntheticfloaters for the maximum number of daysthat can accrue during any interest payment period.The tender agent for the receipts must have clearinstructions in the trust documents to draw uponwww.standardandpoors.com227

Municipal Structured Financethe liquidity facility in accordance with its terms inthe event that remarketing proceeds are insufficientto pay the purchase price of tendered receipts. Theliquidity facility provider should agree to use itsown funds to purchase unremarketed tenderedbonds and also agree to fund tenders in immediatelyavailable funds. The conditions’ precedent andevents of default that are permitted to automaticallyterminate the liquidity provider’s obligation topurchase tendered receipts are reviewed carefully.As with primary market transactions, a liquidityrating based on an liquidity facility can never behigher than the equivalent long-term bond rating ofthe bond issue, since the bank’s obligation to fundthe purchase price for tendered receipts is conditionedon the underlying obligor or insurer’s abilityto meet its obligations (See chart, “Correlation OfUnenhanced CP Ratings With Long-TermRatings”). The liquidity rating of the syntheticfloater with a tender option will be based on thelower of the short-term rating assigned to the bankor the short-term rating correlating to the long-termrating of the underlying bond issue due to the linkagebetween the liquidity facility and its potentialtermination under the terms of the trust documents.Therefore, the likelihood of the liquidity facilityprovider terminating its obligation to purchase tenderedreceipts is correlated to the long-term ratingof the bond issue.Municipal StripsStrips are zero coupon receipts that represent portionsof individual interest and principal paymentsfrom a deposit of underlying bonds. To rate amunicipal strip issue, there must be an outstandingStandard & Poor’s rating on the municipal bondthat is stripped, since the strip rating reflects therating assigned to the underlying bonds. Anychange to the rating of the underlying bonds willresult in an identical change to the rating assignedto the strips.As part of the custodial analysis, Standard &Poor’s requires that the documents provide that allprincipal and interest payments flow directly to thecustodian so that the custodian may forward thebond payments to strip-holders.Auction Floaters/Inverse FloatersAuction floater and inverse floater trust receipts arevariable-rate secondary-market instruments structuredto divide the interest generated from a deposit ofunderlying municipal bonds. Although the receiptsare variable rate, they do not have optional tenderrights, and thus are not eligible for short-term ratings.The receipts are created when a depositor purchasesall or a part of a fixed-rate bond issue and,after depositing the bonds with a trustee, issues twoclasses of variable-rate receipts based on the underlyingbonds. Interest on the auction floater receiptsis set periodically according to an auction biddingprocess. Inverse floater receipt holders receive theresidual interest generated by the underlying bondsafter the auction floater interest is paid and anyapplicable fees are deducted.The receipts represent the proportionate directownership of the future principal, interest, andredemption premiums, if any, generated by theunderlying bonds. The rating on the receiptsaddresses the likelihood that auction rate receiptholders will receive the underlying principal andinterest payments when due. However, the ratingdoes not address the likelihood that an auction willbe successful or that an auction rate receipt holderwill be able to resell a receipt in any auction.Structural analysisTo qualify as a ratable auction floater/inversefloater structure, the documents for a particularissue must clearly define the auction interest andresidual interest rate setting mechanisms so theinterest earned plus any applicable fees do notexceed the interest generated by the underlyingbonds. There is an inverse relationship between therate on the auction receipt and the rate on theinverse floater. The inverse floater holder receivesCorrelation Of CP Ratings WithLong-Term Corporate Credit Ratings*AAAAA+AAA+AA-BBB+BBBAA-BBB-*Dotted lines indicate combinations that are highly unusual.A-1+A-1A-2A-3228 Standard & Poor’s Public Finance Criteria 2007

Secondary Market Derivative Productsthe difference between the interest generated by thebonds and the auction rate and any applicable fees.Moreover, inverse floater holders bear the riskof receiving no interest if the auction rate and thefees claim the entire interest paid by the bonds forthe auction period. The highest maximum auctionrate should be clearly set forth in the custody ortrust agreement.While auction floaters are purchased as a hedgeagainst rising short-term interest rates, inversefloaters are purchased as a hedge against decreasinginterest rates. In the event that interest rates turnagainst them, holders of either class of receipts maypurchase the other class of receipts in the openmarket and link them together to receive the underlyingbond interest rate, less applicable programfees. Auction floater/inverse floater programs mayalso give the inverse floater holders the right to purchaseauction floater receipts at par through amandatory tender. The purchase price for tenderedauction receipts is deposited with the custodian atthe time that notice is given or paid in immediatelyavailable funds on the tender date. If an inversefloater holder fails to pay the purchase price on thetender date, the mandatory tender is canceled thusa dual rating is not warranted. ■www.standardandpoors.com229

HousingIntroduction ToTax-Exempt Housing BondsRatings on tax-exempt housing bonds rely on thefollowing factors:■ Credit quality of mortgage collateral, includingcredit quality of mortgage insurers and guarantors,property insurers, and rent subsidyproviders;■ Credit quality of other income streams, such asfederal, state and local funding sources.■ Adequacy of reserve levels needed to provide asafety net for interruptions in debt service attributableto delinquency, default, and foreclosure;■■■■Credit quality of investments of all funds held forthe benefit of bondholders;Sufficiency of cash flow to make bond paymentsunder expected, as well as stress, scenarios;Ability of legal provisions to protect the flow offunds to bondholders under all circumstances;andThe ability of an issuer, obligor and trustee toadministrate its programs effectively. ■Single-Family Whole Loan ProgramsStandard & Poor’s Ratings Services rates singlefamilymortgage revenue bonds backed by wholeloans or loans securitized by the GovernmentNational Mortgage Association (Ginnie Mae), theFederal National Mortgage Association (FannieMae), and the Federal Home Loan Mortgage Corp.(Freddie Mac). Please refer to, “Public FinanceCriteria: Single-Family Mortgage-Backed SecuritiesPrograms,” for criteria specific to these MBS programs.Standard & Poor’s approach to rating wholeloan MRBs focuses on six areas of analyses: qualityof mortgage loans, insurance, cash flow analyses,reserves and investments, legal provisions, and programmanagement.Quality Of Mortgage LoansThe primary factors used to assess asset qualityinclude property type, type of loan, loan-to-value(LTV) ratio, portfolio size, and economic conditionswithin the lending area. These factors indicate aportfolio’s vulnerability to delinquencies, defaults,and possible deterioration in market values. In addition,due to anti-predatory lending legislation nowin place in many states, Standard & Poor’s will lookfor possible risk exposure in the loan portfoliobased on the specific issuer’s potential liability.Property typeHistorically, MRB issuers have restricted their portfoliosto single-family, owner-occupied detacheddwelling units. The targeting of money for othertypes of homes such as two-to-four unit homes, coops,and condominiums may occur to address thespecific housing needs. Standard & Poor’s ratinganalysis factors in the increased risks associatedwith these product types.Types of loansThe standard high quality, least risky loan portfolioconsists of 30-year level-pay, fixed-rate, first-lien,fully amortizing mortgages on single-family residentialproperties. Standard & Poor’s considers rehabilitationloans, construction loans, second-orthird-lien mortgages, bought-down mortgages, andtiered-payment mortgages to be significantly riskier.More recent product lines such as interest-onlyloans, 40-year mortgages, second loans and piggybackloans also have a higher risk profile.LTV ratioLTV ratios are an important determinant of thelikelihood of default. Higher LTV loans will havea higher assumed foreclosure frequency (FF)—acritical determinant of loss coverage. Programs230 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan Programsthat reduce the amount of equity a borrower hasin the property will have an impact in the assessmentof overall losses.Portfolio sizeEach portfolio must have sufficient size and geographicaldispersion to perform in a statisticallypredictable manner. Therefore, Standard & Poor’sloss coverage model assigns higher risk factors topools fewer than 300 loans and pools of loans withlimited dispersion.Economy of the lending areaThe economy of a particular area provides indicationsof the potential severity of mortgage defaultsthat could occur over the term of the bonds.Standard & Poor’s assesses the lending area to estimatethe level of delinquencies, foreclosures, andexpected prepayments to determine whether thevalue of the mortgaged properties is likely to bemaintained over the life of the bonds.Anti-predatory lending legislationStandard & Poor’s must review the potential forfinancial liability due to anti-predatory lending legislationon all single-family whole loan programs.Many states have adopted legislation with assigneeliability that can result in fines levied against loanpurchasers should predatory lending practices beidentified. In some instances, housing finance agencieshave been specifically excluded from theselaws. If that is the case, the HFA should provide anofficer’s certificate to that effect. If not, issuers mustbe able to provide appropriate representations andwarranties to cover this risk and, in some instances,additional credit enhancement may be needed. Theneed for credit enhancement may be waived if theissuer has a long-term rating equal to the rating onthe bonds, although the risk must still be quantifiedand taken into account in the issuer’s credit rating.Insurance And Insurance AlternativesStandard & Poor’s analyzes the level of primarymortgage insurance (PMI), mortgage pool insurance,cash advance coverage, standard hazardinsurance, special hazard insurance, title insurance,and any other loss coverage credit enhancementsprovided. Standard & Poor’s also may look foradditional insurance coverage, such as flood and/orearthquake insurance, depending on the geographiclocation of the mortgaged properties. In recentyears, many HFAs have sought alternatives to traditionalmortgage pool insurance, as escalating premiumsand deteriorating insurance company ratingshave become prevalent.Calculation of loss coverageLoss coverage must be sufficient to provide creditand liquidity protection under Standard & Poor’s“worst-case” scenarios. In determining total losscoverage needed, Standard & Poor’s looks for coverageof credit losses and liquidity shortfalls.The credit coverage offsets any shortfalls occurringsubsequent to the foreclosure sale and afterreceipt of PMI. Liquidity coverage is an estimate ofshortfalls due to mortgage cash flow delinquenciesprior to foreclosure and receipt of insurance recoveriesor credit enhancement payoff.As a starting point, Standard & Poor’s approachto loss coverage assumptions begins with an evaluationof the portfolio’s origination area. The categoriesare large state, small state/large county, andsmall county/city. Large states are those with populationsabove six million. The small state/largecounty category includes states with populationsbelow six million, and counties that have populationsabove one million. Areas in the smallcounty/city category have a population of less thanone million. Geographic and socioeconomic issuesalso affect the evaluation.Standard & Poor’s loss coverage tables identifythe FF, FC, and MVD assumptions for each ratingcategory and area classification. Modification ofthese assumptions may occur, depending on aspectsparticular to a pool of mortgage loans. The categorydistinctions are reflected primarily in the FF. Thehigher the portfolio concentration, the higher therisk of severe housing price declines in the event ofa substantial economic slowdown or housing marketdisruption. Therefore, the small county/city categoryalso reflects higher MVD assumptions thanthe other two categories.Two important assumptions are critical to determinethe level of loss coverage: The percentage ofloans in the portfolio that will go into foreclosureover the life of the bond issue, or the foreclosurefrequency (FF); and the expected average loss foreach foreclosed loan, or the loss severity (LS). Thecalculation of loss coverage is simply the multiplicationof the assumed FF of a portfolio by theassumed LS. There are many factors that influenceStandard & Poor’s FF and LS assumptions. Theseinclude the bond rating, portfolio dispersion, currenteconomy, type and level of PMI, market valuedecline (MVD), dwelling type, mortgage type, servicingcapability of the participants, foreclosure costs(FC), and LTV ratios. The historical delinquencyand foreclosure performance of an existing portfolioalso will factor into the FF and LS assumptions.Standard & Poor’s considers the following factorswhen calculating loss coverage:www.standardandpoors.com231

HousingPrimary or loan-specific insuranceThis can take one of three forms: conventional PMIprovided by rated mortgage insurers; guaranteesfrom the Federal Housing Administration (FHA) orthe Veteran’s Administration (VA); or USDA RuralDevelopment (RD) insurance. PMI pays claims as apercentage of loan amount. PMI coverage down to72% LTV on all loans greater than 80% LTV ismost common.When evaluating private mortgage insurers forloss coverage, Standard & Poor’s compares thefinancial strength ratings (FSR) of the insurers tothe current or prospective rating on the bonds.Insurers whose FSR ratings are at least as high asthe rating for the bonds are assumed to pay on allof their respective claims. Hence, the recoveryamounts are stipulated under the policy. It is possiblefor insurance providers with FSR ratings belowthe rating on the bonds to receive partial credit.Standard single-family FHA insurance covers100% of the mortgage principal, all but twomonths of accrued unpaid interest, and two-thirdsof foreclosure costs. VA loans originated on or afterMarch 1, 1988 are guaranteed as follows: homeand condominium loans of $45,000 or less areguaranteed at 50% of the loan amount; loans of$45,001 to $56,250 are guaranteed at a maximumpayment of $22,500; and loans of $56,251 to$144,000 are guaranteed at 40% of the loanamount, with a maximum guarantee of $36,000.Legislation passed in 2004 further increased guaranteesof a loan amount up to $417,000, with amaximum of 25% up to $104,250. There are nolimits on loan size so that if the loan amountexceeds the guaranteed limit, the value of the guaranteeis reduced on a percentage basis. VA loansoriginated prior to March 1, 1988 have a highercoverage in terms of the percent of the mortgage,but have lower limits of coverage in dollars.Manufactured home loans are covered at 40% ofthe loan, with a maximum guarantee of $20,000.Rural Development will pay its claim based onan appraisal after foreclosure has occurred ratherthan on the sale of the property, as in other insuranceprograms. RD will pay the lesser of any lossup to 90% of the mortgage, or an amount up to35% of the mortgage plus any additional loss equalto 85% of the remaining 65% of the mortgage.Adjustments must be made to the calculation toaccount for additional shortfalls in the RD insurance.These include additional coverage for the differencebetween the actual sales price and theappraised value, along with the cost of holding theproperty between foreclosure and sale.Loss severity. There is a level of primary insuranceat which the loss severity calculation can reachzero. However, when determining loss severity inconjunction with a deep primary insurance proposal,some loss always must be assumed on a foreclosedmortgage. This is because Standard & Poor’sassumes that worst-case situations will occur onsome of the mortgages in the pool. That is, a 100%market value decline and foreclosure costs higherthan 22% could result on a mortgaged property,and deep primary mortgage insurance would notcover the full loss.Foreclosure costs. Two components make upStandard & Poor’s assumption for FC (22% of theoutstanding loan): lost interest costs (9%) and hardcosts (13%). Lost interest costs arise as a result ofthe assumed loss of accrued interest for a period ofat least 12 months and are therefore equal to themortgage rate times the loan balance. The hard costcomponent includes brokerage fees (5%), legal fees(3%), taxes (3%), and other costs (2%).Agency credit. The credit portion of the loss coveragemay not be necessary for a given bond issue ifthe following conditions are met: (1) the issuer is anHFA that has an Issuer Credit Rating (ICR) or hasbeen designated “top-tier” (see state agency section);and (2) Standard & Poor’s calculation oftotal loss coverage is less than 2%. These amountsmust then be factored into the agency’s capital adequacy.In addition, when calculating the necessaryloss coverage for issues in which Standard & Poor’shas given the agency portfolio oversight and administrationcredit (but not necessarily an ICR or toptierstatus), Standard & Poor’s may find itappropriate to assume foreclosure costs lower than22%, provided that reduced foreclosure costs canbe adequately represented by the HFA over a significantperiod of time. This occurs because many ofthe variable costs associated with a foreclosurealready are included in the agency’s fixed administrationbudget, and well-managed agencies can controland reduce these costs substantially.Liquidity loss coverage. Liquidity coverage is necessarybecause of the loss of mortgage loan paymentsduring the delinquency period prior toforeclosure. Loss mitigation procedures and otherfactors can extend the length of time between delinquenciesto foreclosure to six to 24 months. Forthis reason, Standard & Poor’s assumes that liquidityshortfalls will occur for a period of approximately18 months. The liquidity coverage necessary isequal to FF divided by three years multiplied by themonthly mortgage constant times 18 months. Themonthly constant represents the level monthly principaland interest payment divided by the originalmortgage balance. The resultant liquidity coverageshould be covered by liquid reserves, for example,pledged funds in an investment agreement or aLOC, in each case from a provider with a creditrating at least as high as that assigned to the bonds.232 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan ProgramsThis will ensure the immediate availability of fundsupon a mortgage default. As this coverage providesliquidity, it can be funded from bond proceeds.Loan to value. Evidence indicates that theamount of mortgagor equity invested has a directimpact on the foreclosure rates. As LTV increases,the FF and MVD increase as shown in the table,“Loss Coverage Criteria”.Small pool size. Standard & Poor’s applies asmall pool size factor to the credit loss coveragepercentage on pools of less than 300.Dwelling type. For mortgage revenue bonds thatpermit three-and four-family residences where theincome from the rental units is taken into accountin determining program eligibility, or include cooperativeapartments, condominiums, or other type ofhomes, Standard & Poor’s makes adjustments toMVD and FF. The reasoning behind the MVDadjustment is that the market for such properties isnarrower than for single-family or two-family residences.The higher FF assumption is based on theMVD of such residences and the risks associatedwith rental property vacancies.Mortgage type. Standard & Poor’s increases FFfor interest only mortgages, 40-year mortgages andpiggyback loans, all of which reduce the amount ofequity a buyer has in the property, either at thetime of purchase or during the term of the loan.Standard & Poor’s assumes that other loan productsthat are not as common such as graduatedpayment mortgages (GPMs), graduated equitymortgages (GEMs), or mortgages with buy-downswill also experience a higher FF.Foreclosure frequency cap. Standard & Poor’s recognizesthat it may be excessively conservative toassume a FF level above 75% at the ‘AAA’ ratinglevel and 60% at the ‘AA’ rating level for loans thatare not delinquent or are newly originated.Therefore the FF is capped at these levels. This isgenerally only applicable to local whole loan issuers,which are very rare. In these cases the limited geographicdispersion would push FF beyond the caps,but experience from existing local programs indicatesthat they have never exceeded the capped FF.Minimum loss coverage. Even with very deepPMI, any loan portfolio will sustain additional losses.Generally, a minimum loss coverage of 2% isappropriate for investment grade ratings.Methods of providing loss coverageIssuers use several methods for coveringportfolio losses:Pool insurancePool insurance was once a widely used vehicle forproviding loss coverage. As the cost of insurancebecame prohibitive, HFAs developed many viablealternatives. Pool insurance is still available in somestates. To be acceptable, the pool insuranceprovider should have an FSR rating as high as therating on the bonds. Pool insurance covers losseson foreclosures in excess of primary mortgageinsurance. However, not all pool insurance policieswill cover losses on FHA-or RD-insured andVA-guaranteed loans. The policy must specificallyaddress coverage of such losses. Through advanceclaims provisions, pool insurance may provide liquidityprotection through periods of mortgagedelinquencies. Such payments will continue if theservicer and trustee diligently pursue foreclosure onthe mortgage. However, because of the relativelylow use of pool insurance policies in recent yearsand a scarcity of cash advance riders, issuers useliquid reserve funds more frequently to address theliquidity needs of particular loan pools.Self-insurance funds. Some HFAs that have foundthat the cost of pool insurance exceeds the amountof claims paid have used the self-insurance fund(SIF) alternative. For most agencies, Standard &Poor’s allows partial funding of the SIF under thebond resolution, with the remainder in set asidesand available fund balances (a leveraged SIF).Similar to pool insurance, the SIF would be drawndown to cover losses due to foreclosures and foradvance claims payments. Provided that a housingagency is eligible to establish and use the SIF, thefollowing minimum standards may apply, as consideredon a case-by-case basis:■ PMI covering at least the top quarter of everymortgage loan should be provided by a conventionalprimary insurer with a Standard & Poor’sFSR rating as high as the rating on the bonds.Alternatively, the SIF could be established tocover the reduced pool coverage requirements forFHA-insured, RD-insured, or VA-guaranteedloans.■ If leveraged, the SIF should be at a level of at least20% of the anticipated total loss coverage exposureavailable from excess assets in the bond program.A net worth maintenance reserve or agency generalfund set aside in an amount equal to 25% ofthe anticipated loss coverage amount is necessary,in addition to the amount held under the indenture.This reserve can be escrowed with the trusteeor an independent third party and pledged tobondholders, or it can be segregated in the agency’sgeneral fund balance and designated for replenishmentof the SIF requirement, as necessary. Themethodology used and maintenance level should beoutlined in a board letter or officer certificate andpresented to Standard & Poor’s at the time of rating.The SIF reserve should be funded under theindenture at bond closing or as a condition tomortgage origination.www.standardandpoors.com233

HousingStandard & Poor’s will review the agency’sintended investment of these monies, including thequality and liquidity of proposed investments,which should be invested in investments rated ashigh as the desired rating on the bonds. All SIFinvestment earnings and all premiums charged andreceived from a portfolio must first be applied torestoring the SIF to its initial requirement beforebeing released to the agency or used to redeembonds. All SIFs should be maintained at the originalloss coverage amount, drawn down only forlosses incurred, but not reduced based on theamortization or prepayment of the mortgage portfolio.Lastly, in addition to the net worth maintenancereserve overlaying the SIF, Standard &Poor’s will look at an agency’s fund balance toensure that the remaining 55% of the loss coverageexposure is available.The SIF reserve ratio is higher than that of a privatemortgage insurer because of the increased riskinherent in statewide portfolios, compared withnationally dispersed pools. Geographic concentrationincreases the possibility that the SIF might haveto make larger claims settlement payments duringlocal economic downturns without earning any offsettingpremiums in unaffected regions. The level ofreserves, including SIF reserve and net worth maintenanceamong others, reflects Standard & Poor’sanalytical assessment that the SIF might remain solventand meet all drawdowns, even in the event ofsignificant economic stress.Risk share agreements. Several pool insuranceproviders have entered into risk share or sharedloss agreements with HFAs. Traditionally, thesearrangements provide the housing agency withmore flexible loan underwriting requirements andlower premiums in exchange for the housing agencytaking on some of the real estate risks of the portfolio.Usually, the housing agency is responsible fortaking on the second or middle layer of risk.Because this risk is significant, Standard & Poor’sreviews all risk share agreements in detail prior tothe sale of the bonds and issuer’s acceptance ofsuch arrangements. Collateral or fund balances similarto those used for the self-insurance fund alternativemay need to be pledged to achieve thedesired ratings.Economic stress cash flows. Another method thatcan be used to address loss coverage involves thecapitalization of assumed worst-case scenario lossesinto the structure of the issue. This scenario incorporatesStandard & Poor’s criteria for directly simulatingthe effects of economic stress on a givenmortgage portfolio. This simulation, or “economicstress scenario,” is based on the same criteria usedto compute loss coverage and is incorporated intoall cash flow runs required in the rating process.The objective of the scenario is to demonstrate thata bond issue can undergo the worst-case assumptionsused to determine loss coverage and still meettimely debt service.The economic stress simulation occurs over thefirst three years after the first month of mortgageorigination wherein mortgages equal to one-third ofthe assumed foreclosures continue for one year, atthe end of the year, the nonpaying mortgages areforeclosed. All accrued interest is recouped and allprincipal recovered, less an amount equal to theloss severity. This scenario is repeated in each of thethree years, and all amounts are based on the initialportfolio balance.The losses incurred can be discounted at themortgage rate and deducted from total assets atloan origination, or deducted from the cash flowsas they occur. If the latter approach is used, cashflows reflecting the economic stress scenario mustbe sufficient to pay two bond payments during thefirst 12-month stress period without the benefit ofrecoveries from foreclosed loans. An additionalmethod is the establishment of a reserve amountthat, when invested at a particular rate, is sufficientto cover any losses created under the economicstress scenario. Cash flows should demonstrate theability to meet debt service and expenses under allorigination and prepayment scenarios loss coverage.Furthermore, it is important that the economicstress scenario not result in a reduction in the bondissue’s asset-to-liability parity ratio after origination.Such reductions in asset coverage indicate thatassets other than those earmarked for loss coveragesubstitution are utilized.LOCs. LOCs have been used by several HFAs tosatisfy loss coverage. The LOC must be issued by afinancial institution whose long-term unsecureddebt rating is at least as high as the desired ratingon the bonds. The LOC should provide credit andliquidity coverage and should provide for reinstatement,if the delinquency is cured by the mortgagor.General obligation pledge. Rated HFAs maypledge their general obligation to all payment obligationsunder a bond issue or restrict the pledge tospecific funds, such as reserve funds. Loss coveragemay be met in this way as long as the HFA’s ratingis as high as the rating on the bonds and the exposureto potential losses does not adversely affect theHFA’s ICR rating. In some instances, an HFA’s ratingmay be a full rating category below the bondrating and still qualify. Unless the HFA has anacceptable liquidity rating, only credit losses maybe covered in this way.Subordinate bonds. Several HFAs have used subordinatebonds to meet loss coverage. The size of thesubordinate issue must equal the amount of loss coverageneeded to secure the senior bonds’ mortgage234 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan Programsportfolio. For a senior/subordinated structure,Standard & Poor’s must determine if there is a bonafide distinction between the security of the seniorand subordinated liens. In the absence of a clear-cutdetermination, Standard & Poor’s will issue the samerating on each the senior and subordinated bonds.Standard & Poor’s addresses seven key componentsto substantiate a clear senior and junior positionwith respect to bondholders’ liens: security pledge tobondholders, additional bond provisions, redemptionprovisions, flow of funds, default/cross-default,bondholder rights and approvals, and miscellaneousitems.Overcollateralization. Overcollateralization canbe used to cover loan losses in bond structures thathave only senior lien bonds. In such instances, additionalcollateral, such as cash and/or loans, is providedin the amount of the loss coverage necessary.If the overcollateralization is in the form of additionalmortgages, Standard & Poor’s will discountthe loss coverage on the loan pool to reflect potentiallosses on those loans as well. These cash flowsmay require the deposit of additional collateral.Liquidity coverage may not be covered by overcollateralizationunless it can be demonstrated that theexcess collateral is liquid.Additional insuranceCondominium insurance. Single-family issues thatpermit a significant percentage of condominiums(10% or greater) should provide the following coverage:Multiperil coverage, including fire, andextended coverage on a replacement cost basis;public liability for personal injury and propertydamage resulting from accidents occurring in publicor common areas. Such insurance must contain a“sever ability of interest” endorsement that precludesthe insurer from denying the claim of a condominiumunit owner because of negligent acts ofthe condominium owners’ association or other unitowners; coverage against boiler explosion and otherTable 1 Rapid Prepayment Stress Run For ‘AAA’ Rated Issues—Years until full redemption of bonds —State HFALocal HFA or stateInterest rate (%) parity program HFA non-parity program6.50 or lower 5.0 4.06.51 to 7.00 4.5 3.57.01 to 7.50 4.0 3.07.51 to 8.00 3.5 2.58.01 to 8.50 3.0 2.08.51 to 9.00 2.5 2.09.01 and higher 2.0 2.0machinery accidents; blanket flood insurance forcondominiums located within federally designatedflood areas; and a fidelity bond on the condominiumowners’ association for condominium developmentsof more than 30 units.High-rise condominiums. For portfolios includinghigh-rise condominiums (buildings of five or morestories), the issuer must obtain a special hazard insurancepolicy. This policy insures the greater of 1% ofthe portfolio or the sum of the aggregate portfolioexposure in the top-two, high-rise condominiums.Special hazard insurance. Standard & Poor’slooks for insurance in an amount equal to twice thelargest loan in all single-family portfolios where apool insurance policy is used and special hazardrisks are excluded as claims payable under the policy.In establishing the two times policy, Standard &Poor’s assumes that the two largest single-familystructures will be destroyed regardless of portfoliosize. The high-rise condominium criteria apply thisconcept to the two largest property risks.Title insurance. Representations that title insurancepolicy are in place at loan closing for all mortgagesmust be in the financing documents.Flood and earthquake insurance. Representationsthat these types of insurance are in place on eachmortgage loan are necessary if the property is in afederally designated flood or earthquake zone.Cash Flow AnalysisThe first objective of cash flow analysis is to assessthe relative strength of the various revenue sourcesgenerated by the program’s assets to cover scheduleddebt service. The second is to ensure that programassets are enough to cover the outstandingbonds. The third objective is to evaluate theresiliency of the issue to withstand various originationand prepayment scenarios.Cash flow projectionsCash flow projections should include, at a minimum:■ Full origination of loans/0% PSA prepaymentexperience. This minimum prepayment level maybe increased to as high as 30% PSA if an issuercan provide historical evidence of prepaymentson loans in a seasoned indenture;■ Full origination of loans/100% PSA prepaymentexperience;■ Full origination of loans/three-year average life ofthe mortgage loans (typically 500%-750% PSA)prepayment experience;■ Non-origination of all loans assuming a fullredemption of bonds on the date specified in thebond documents in the event full origination doesnot occur.www.standardandpoors.com235

HousingAAADepending on the structure of each transaction,other cash flow scenarios may be needed. Such runsmay include, but are not limited to:Rapid prepayment scenario. All ‘AAA’ ratedissues should include this stress run. Cash flowsshould be prepared at a prepayment speed sufficientto retire all bonds within two years after origination;however, depending on the mortgage loaninterest rate, the issuer, and whether or not thebonds are part of a parity program, this scenariomay be run at slower prepayment speeds that retireTable 2 Loss Coverage Criteria (%)Large StateLTV 100 97 95 90 80FF 42 38 35 17 12FC 22 22 22 22 22MVD 37 37 37 37 37AALTV 100 97 95 90 80FF 32 29 27 13 9FC 22 22 22 22 22MVD 34 34 34 34 34ALTV 100 97 95 90 80FF 26 23 21 11 7FC 22 22 22 22 22MVD 29 29 29 29 29BBBLTV 100 97 95 90 80FF 19 18 16 8 5FC 22 22 22 22 22MVD 25 25 25 25 25AAASmall State/Large CountyLTV 100 97 95 90 80FF 61 58 53 26 18FC 22 22 22 22 22MVD 37 37 37 37 37AALTV 100 97 95 90 80FF 47 44 40 20 13FC 22 22 22 22 22MVD 34 34 34 34 34all bonds within a greater number of years afterorigination, as shown below:Depending on an issuer’s prepayment history,Standard & Poor’s may request a faster prepaymentscenario for ‘AA’ category indentures. This scenariowould include an initial prepayment rate of 1000%PSA for the first three years following loan origination,and then the three-year average life prepaymentspeed thereafter.PAC stress scenario. If the bond structureincludes a planned amortization class (PAC) bond,this stress run may be needed if the net interest rateon the PAC bond, factoring in any premium, isamong the lowest of all bonds in the structure.Cash flows should be run at the PSA prepaymentpercentage that the PAC bond is structured at,which is the level at which all prepayments first gotoward calling the PAC bond (typically around100% PSA), until the PAC bond is called in full,and then at 0% prepayments until bond maturity.Super-sinker stress scenario. If the bond structureincludes a super-sinker bond, typically seen in olderseries of bonds within a parity indenture, this stressrun should be included in consolidated cash flowsfor each series of bonds having a super-sinker bond.Cash flows should be run at the three-year averagelife of the loans prepayment rate until the supersinkerpriority term bond is called in full, and thenat 0% prepayments until bond maturity.Liquidity stress scenario. If serial bonds are presentin the structure when either a PAC or supersinkerbond is present and are not called on a prorata basis with the PAC/super-sinker, a run shouldbe submitted whereby the prepayments (run at thesame speed as the PAC/super-sinker run above) shutoff at the point of greatest decline in prepaymentmoneys received and remain at 0% until bondmaturity.CAB-remainder stress scenario. The cash flowsfor structures that include a CAB (capital appreciationbond) that is call-protected should include aCAB-remainder projection where cash flows are runat the three-year average life prepayment rate untilall current interest and other non-call-protectedbonds are called in full, and then at 0% prepaymentsuntil bond maturity.Multiple mortgage rate stress scenario. The cashflows for issues that include more than one mortgagerate may need to be run reflecting differentprepayment speeds for each mortgage rate. Pleaserefer to Chart 3 & 4 at the end of this article forthe information needed to perform this run.Forty-year mortgage scenario. Loans with longerloan terms usually generate less revenue on a semiannualbasis than 30-year loans. If 30-year and 40-year loans are in the same indenture, Standard &Poor’s may request an additional cash flow with the236 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan ProgramsA30-year loans prepaying at the appropriate rapidspeed in accordance with the rating, assuming thereare no prepayments on the 40-year loans. Thiswould indicate whether the indenture could maintaindebt service payments with the support of 40-year loans alone.Third-party verificationStandard & Poor’s may request that final cash flowanalysis be verified by an independent third party,Table 2 Loss Coverage Criteria (%) (continued)Small State/Large CountyLTV 100 97 95 90 80FF 38 35 32 16 11FC 22 22 22 22 22MVD 29 29 29 29 29BBBLTV 100 97 95 90 80FF 19 18 16 8 5FC 22 22 22 22 22MVD 25 25 25 25 25AAASmall County/CityLTV 100 97 95 90 80FF 75 75 67 22 22FC 22 22 22 22 22MVD 53 53 53 53 53AALTV 100 97 95 90 80FF 60 60 53 27 18FC 22 22 22 22 22MVD 47 47 47 47 47ALTV 100 97 95 90 80FF 50 47 43 21 14FC 22 22 22 22 22MVD 39 39 39 39 39BBBLTV 100 97 95 90 80FF 37 35 32 16 11FC 22 22 22 22 22MVD 34 34 34 34 34LTV—Loan to value. FF—Foreclosure frequency. FC—Foreclosure costs.MVD—Market value decline.such as a nationally recognized accounting firm,bond firm, or other expert in the field. This wouldoccur if the cash flow provider did not have a trackrecord of providing cash flows for a particular typeof transaction. Once a history of accurate cashflows has been established, third-party verificationwill not be requested.Variable rate bondsStandard & Poor’s assumes that many interest rateswaps and caps, or short-term assets are imperfecthedges for variable rate mortgage revenue bondsprincipally due to basis, amortization, androllover risk. Other risks, such as termination, taxevent and counterparty risk can also become risksin these structures, but are less common. For thesereasons, cash flow projections for mortgage revenuebonds should also incorporate appropriaterisks of variable rate debt, interest rate swaps, andinterest rate caps.All risks identified under swap and cap contractsby Standard & Poor’s should be incorporated intothe cash flow modeling projections as expenses or“additional” interest due on bonds. Reserve fundingor interest rate spread should be shown tocover any shortfalls produced as a result of themodeling. Alternatively, Standard & Poor’s canassess shortfalls to an agency’s capital adequacycalculation if the bonds benefit from a GO pledge.Variable rate bonds should be modeled as followsin cash flow projections. “Net” variable ratebond interest should be modeled at the lesser ofthe high stress interest rates forecast byStandard & Poor’s interest rate model, or themaximum interest rate as stated under the bonddocuments. Standard & Poor’s defines the netvariable rate bonds for mortgage revenue bonds asthose bonds with no synthetic hedge (swaps orcaps) or natural hedge (short term or variable rateassets) as well as the amount of “hedged” bondssubject to tax risk, amortization risk, and rolloverrisk. Hedged debt should include an additionalrun using the low stress interest rates fromStandard & Poor’s for the highest prepayment scenariothat applies to an indenture. This run wouldillustrate how well the cash flows perform whenthe swap counterparty makes the smallest paymentson swaps that are based on standard interestrate indices. Lower interest rates would resultin lower payments from swap counterparties, andhigh loan prepayments would accompany lowinterest rates. Standard & Poor’s may request lowinterest rate assumptions on different prepaymentruns for unique bond structures and to monitorthe strength of an indenture over time. For additionalinformation, please refer to “Public FinanceCriteria: Municipal Swaps.”www.standardandpoors.com237

HousingTable 3 Examples Of Loss Coverage Calculations At The ‘A’ Rating LevelLarge State Small State/Large County Small County/CityForeclosure frequency (%) 21 32 43Foreclosure costs (%) 22 22 22Market value decline (%) 29 29 39Assumptions:1) 30-year fixed rate, level pay $95,000 Mortgage2) Monthly constant=0.8046%, represents constant monthly payment of principal and interest divided by the original mortgage balance3) Private mortgage insurance down to 72 % (Coverage = 24.21%) case (1)4) 95% loan to value for private mortgage insured properties. 100% loan to value (95,000) for VA-guaranteed properties, 97% loan to value forFHA-insured propertiesMarket value ($) $100,000 $100,000 $100,000Mortgage ($) $95,000 $95,000 $95,000Depression market value ($) 71,000 71,000 61,000Market loss ($) 24,000 24,000 34,000Foreclosure costs ($) 20,900 20,900 20,900Total loss ($) 44,900 44,900 54,900Insurance ClaimCase (1) Private mortgage insurance down to 72%Mortgage $95,000 $95,000 $95,000Foreclosure costs 20,900 20,900 20,900Total claim 115,900 115,900 115,900Recovery 28,059 28,059 28,059Total loss (market value decline + foreclosure costs) ($) 44,900 44,900 54,900Recovery ($) 28,059 28,059 28,059Net loss ($) 16,841 16,841 26,841Loss severity (%) 17.73 17.73 28.25Credit loss coverage (foreclosure frequency x 1.2 x loss serverity (%) 3.72 5.67 12.15Liquidity coverage (foreclosure frequency x 1.2/three yearsx monthly constant x 18 months (%) 1.01 1.54 2.08Guaranty ClaimCase (2) VA guaranty, loan origination prior to 1998Mortgage ($) 95,000 95,000 95,000Foreclosure costs ($) 20,900 20,900 20,900Total claim ($) 115,000 115,000 115,000Recovery (60% to maximum of $27,500) ($) 27,500 27,500 27,500Total loss (market loss + foreclosure costs) ($) 48,450 48,450 57,950Recovery ($) 27,500 27,500 27,500Net loss ($) 20,950 20,950 30,450Loss severity (%) 22.05 22.05 32.05Credit loss Coverage (foreclosure frequency x 1.2 x loss severity (%) 5.56 8.47 16.54Liquidity coverage (foreclosure frequency x 1.2/three yearsx monthly constant x 18 months (%) 1.22 1.85 2.49238 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan ProgramsTable 3 Examples Of Loss Coverage Calculations At The ‘A’ Rating Level (continued)Gauranty Claim Large State Small State/Large County Small County/CityCase (3) VA guaranty, loan origination after 1988Mortgage ($) 95,000 95,000 95,000Foreclosure costs ($) 20,900 20,900 20,900Total claim ($) 115,900 115,900 115,900Recovery (40%, up to $36,000) ($) 36,000 36,000 36,000Total loss (market loss + foreclosure costs) ($) 44,900 44,900 54,900Recovery ($) 36,000 36,000 36,000Net loss ($) 8,900 8,900 18,900Loss severity (%) 9.37 9.37 19.89Credit loss Coverage (foreclosure frequency x1.2 x loss severity (%) 1.97 3.00 8.55Liquidity coverage (foreclosure frequency x1.2/three years x monthly constant x 18 months (%) 1.01 1.54 2.08Insurance ClaimCase (4) FHA Insurance Loss severity will always equal the followingMortgage rate/12 months x two months = 9%/12x2= (%) 1.50Forclosure cost less 12 months accrued interest x 1/2=13%x1/3= (%) 4.33Credit loss coverage (foreclosure frequency x 1.1 xadjusted loss severity (%) 1.35 2.05 2.76Liquidity coverage (foreclosure frequency x 1.1/three years xmonthly constant x 18 months (%) 1.12 1.70 2.28AssumptionsCase (5) RD Insurance30-year, 9% fixed rate, $100,000. Cost Factor = 10.19% of appraised value.Appraised value = depression market value + (depression market value x 10%). 100% loan to valueMarket value ($) 100,000 100,000 100,000Mortgage ($) 100,000 100,000 100,000Depression market value ($) 71,000 71,000 61,000Appraised value ($) 78,100 78,100 67,100Cost factor ($) 7,958 7,958 6,837Foreclosure cost ($) 22,000 22,000 22,000Total loss ($) 51,858 51,858 61,737RD recovery35% of mortgage 35,000 35,000 35,00085% of total loss less 35% of mort. amt. ($) 14,330 14,330 22,727Total RD recovery ($) 49,330 49,330 57,727Standard & Poor’s adjustable recoveryHolding period costs ($) 8,450 8,450 7,050Appraised value less depression market value ($) 7,100 7,100 6,100Total adjusted recovery ($) 33,780 33,780 44,577Net loss ($) 18,079 18,079 17,160Loss severity (%) 18.08 18.08 17.16Foreclosure frequency (%) 25.20 38.40 51.60Loss coverage (%) 4.56 6.94 8.85www.standardandpoors.com239

HousingCash flow assumptionsIn submitting cash flows to Standard & Poor’s, thefollowing assumptions should be made:Lag assumption. A 30-day lag (in addition tonormal arrearage) in receipt of mortgage paymentson newly originated and existing loans should bereflected in the cash flows for structures rated ‘AA’or below. Standard & Poor’s may require a laggreater than 30 days depending on historical delinquencylevels; this will be considered on a case-bycasebasis. Structures rated ‘AAA’ should reflect a60-day lag. Standard & Poor’s defines a lag as adelay in payment that is in addition to the normalarrearage (the time period encompassed from thedate of mortgage origination until the first scheduledmortgage payment date.) For example, if amortgage is originated on September 1, the firstscheduled mortgage payment would be due onOctober 1. Thus, cash flows incorporating a 30-daylag would not reflect receipt of this payment by thebond trustee until November 1.Worst-case draw schedule. Origination of themortgage portfolio should be reflected under theleast desirable placement schedule from an incomegeneratingperspective (i.e., last day draw if the mortgagerate less the servicing fee exceeds the acquisitionfund rate; first month draw if vice versa).FeesAll fees, including trustee, servicers, rebate analyst,and any other parties paid under the financing documents,should be shown in the cash flows inTable 4 Prepayment Speeds (% PSA)Mortgage loansrate (%) AAA AA A BBB11.00 900 866 853 84410.50 890 856 843 83410.00 870 836 823 81409.50 840 806 793 78409.00 800 766 753 74408.50 750 716 703 69408.00 650 616 603 59407.50 500 466 453 44407.00 350 316 303 29406.50 270 236 223 21406.00 230 196 183 17405.50 210 176 163 15405.00 195 161 148 13904.50 185 151 138 12904.00 175 141 128 119amounts consistent with the financing documents.All fees should be capped, stated as a percentage ofthe mortgages or bonds outstanding, and, preferably,subordinate to debt service. Minimum trusteefees should be no less than three basis points, withan additional one basis point provided for therebate analyst fee. Any fixed fees should be ratablyreduced in the event of a prepayment under themortgage loan, or stress runs may be needed.Investment earningsIn the absence of an investment agreement,Standard & Poor’s current reinvestment rateassumptions should be used.Debt-repayment scheduleCash flow runs should demonstrate that there aresufficient assets and revenues to pay debt serviceand expenses under a zero prepayment scenario. Insome instances, Standard & Poor’s will accept cashflows modeled with some level of prepayments.Prepayment penaltiesNo prepayment penalties should be assumed incash flows, as payment of these penalties may notbe enforceable under state law.RebateAll rebate fees and payments to the federal governmentfor rebate should be demonstrated.SurplusesAll projections should assume the availability ofsome surpluses (defined as revenues in excess ofdebt service plus expenses) for prior redemption ofoutstanding bonds. A minimum carry forward balanceeach period of at least $10,000 should bemaintained. If it is the practice of the agency torelease excess monies from the indenture at a certainasset/liability parity position or some otherpoint in the issue, cash flows should accuratelyreflect this release. Funds provided for loss coverageshould not be counted as an asset.RecyclingIndentures that provide for the recycling of mortgageprepayments and surpluses may require additionalcash flow runs. Documents should specifythat new (recycled) mortgage loans are to be madeonly at the same rate and existing term as theoriginal (prepaid) loan and such prepayment proceedsare to be held no longer than six monthsbefore being used to redeem bonds. Recycling canbe done with terms other than the same mortgagerate, term of the loan, or with different holdingperiods of prepayment proceeds as long as the specificterms as outlined in the trust indenture andmortgage documents are properly modeled in thecash flows.240 Standard & Poor’s Public Finance Criteria 2007

Single-Family Whole Loan ProgramsRecycling runs include, but are not necessarilylimited to:■ Full origination based on worst-case draw/threeyearaverage life prepayment experience/hold prepaymentproceeds for longest time stated indocuments/recycle all loans on worst-case delivery/then0% prepayments on recycled loans.■ Full origination based on worst-casedraw/three-year average life prepayment experience/holdprepayment proceeds for longest timestated in documents/then non-delivery of allprepayment proceeds.(Note: Recycling runs should include recycling ofsurpluses if required under the program.)Second mortgage loansStandard & Poor’s has developed specific criteriafor second mortgage loans, which are done primarilyfor down payment assistance. Please refer to thecriteria, “Single-Family Second Mortgage Loans.”Legal Provisions, Reserves And InvestmentsIn analyzing the strengths of an MRB issue’s legalstructure, Standard & Poor’s primarily, but not exclusively,focuses on seven sets of legal provisions:■ The debt service schedule, including the redemptionprovisions;■ The level of reserve fund requirements;■ The flow of funds;■ The permitted investments;■ The provisions for additional bonds;■ Trustee and servicer responsibilities; and■ Event of default and taxability provisions.Redemptions, reserves, flow of fundsDebt service should be structured assuming thatmortgage revenues will be received in their regularlyscheduled amount with no prepayments.Redemption provisions must clearly state howbonds will be called in the case of all partialredemptions. Unless sufficient stress runs are providedduring the rating process, all redemptions shouldbe done on a pro rata or strip-call basis unless adetailed cash flow certificate using the original cashflow assumptions demonstrates that future debtservice and payment of fees are not impaired underall cash flow scenarios. In evaluating an issue’s flowof funds, two concerns should be addressed: therelease of funds and the use of surpluses.With some exceptions, the flow of funds shouldbe closed for all local issuer transactions, with allsurpluses being used to call bonds. State agenciesmay use an open flow of funds if structured properly,and a cash flow certificate (requiring the samescenarios as were originally provided at the time ofinitial issuance) is provided each time funds arereleased. In both cases, the 2% liquid reserve shouldbe replenished through the flow of funds prior toany release of funds. In addition, legal provisionsshould give first priority to the payment of debtservice, then to payment of insurance premiums,with all other expenses subordinated and capped.Liquid reservesA liquid reserve of at least 2% of outstanding mortgagesshould be funded at closing and alwaysshould equal or exceed 2% of outstanding mortgagesduring the bond term. This reserve can beused to the extent that there are deficiencies in thecash flow stream needed to pay debt servicebetween the time that the loan is delinquent and theinsurance is received.Investments and additional bondsUsually, MRB issuers restrict their investments torisk-free or minimal risk investments, or to investmentagreements with banks whose unsecured debtis rated as high as the rating on the bonds. On acase-by-case basis, other investments may be considered,depending on the desired rating and theoverall strength of the program. Please see “PublicFinance Criteria: Investment Guidelines” for a fulldiscussion of acceptable investments for HFA programs.Housing agencies issuing bonds under openindentures should notify Standard & Poor’s in atimely manner of any intention to issue additionalparity bonds. The agencies also should provideStandard & Poor’s with the necessary informationto assess any potential rating impact on the bondsstill outstanding.Trustee and servicer responsibilitiesThe trustee and the servicer play an important rolein the success of a bond issue. Legally, they areobligated to perform a variety of duties under thefinancing documents. In some instances,Standard & Poor’s will review the trustee and servicercapabilities to carry out these responsibilities.Event of default and taxability provisionsThe only event of default that should trigger anacceleration of bonds on rated issues is the failure topay principal or interest on the bonds. Covenantdefaults should provide for remedies other thanacceleration unless bondholder approval to accelerateis obtained from a majority of bondholders.Standard & Poor’s ratings on single-and multifamilytransactions do not address the likelihood of taxability.Redemptions for a determination of taxabilityare not permitted unless the trustee has enoughmonies on hand to redeem the bonds in full.www.standardandpoors.com241

HousingProgram ManagementStandard & Poor’s focuses on the responsibilitiesand capacity of the issuer, trustee and mortgage servicerin MRB transactions. All responsibilitiesshould be clearly identified in the financing documents.Standard & Poor’s will conduct administrativeand managerial reviews upfront and ongoing toaddress the capacity of issuers and servicers. Theability to execute routine administrative functionsand make more complicated business decisions isespecially important in MRB issues. HFAs are reliedon heavily for this function.Trustee responsibilitiesThe ultimate responsibility for the successful managementof an issue is the bond trustee. To ensurethat the trustee function is performed adequately,the following guidelines should be established in thebond documents:■ The trustee may not resign until a successortrustee is appointed;■ The trustee should hold dedicated assets in fundsand accounts designated for a particular transaction,in trust, for the benefit of the bondholders.These funds should not be commingled with anyother funds in the trust or commercial department;■ The trustee has primary responsibility for receivingpayments from servicers, relevant guarantors,and other third parties, and remitting thesereceipts to the bondholders in accordance withthe terms of the indenture;Multiple Mortgage Rate Prepayment RunsGenerally, for nonparity, stand-alone bond financings where mortgages are originatedat two or more different rates, cash flows should be run reflecting the prepaymentspreads expected according to the rating level and mortgage interest rate.Prepayments will occur for both voluntary and nonvoluntary reasons. Voluntaryreasons include sale of the home due to a job change or desire to be in a largerhome, as well as refinancing the mortgage at a lower rate of interest. Involuntaryreasons include default and foreclosure of the mortgage loan.At any given rating level, as the rate on the mortgage loan increases, the rate ofprepayment also increases. This reflects the fact that the voluntary prepaymentsare expected to rise. Holding the interest rate constant, prepayments will alsoincrease as the rating level increases. This reflects the higher level of delinquenciesand defaults associated with the higher rating level.The table outlines the expected prepayment rate quoted in PSA for each ratinglevel and mortgage rate combination. When the mortgage rate used in a bondfinancing falls between two numbers on the chart, the rate for the high rate loanshould be rounded up and the rate on the low rate loan should be rounded down.So, if an issuer plans to offer mortgages at both 6.35% and 7.25% and it is seekingan ‘AA’ rating, the issuer would use a prepayment speed of 466% PSA for the 7.25%mortgage loans and 196% for the 6.35% mortgage loans.■ The trustee receives periodic reports with respect toreceived mortgage payments and future projectionsand performs the bond administration function;■ The trustee assumes the responsibilities of themaster servicer for the mortgage loans upon theservicer’s removal or resignation;■ The trustee covenants in the indenture to provideStandard & Poor’s, on an annual basis or as reasonablyrequested, any information necessary tomaintain the assigned rating on the bonds unlessthe housing agency has agreed to provide theinformation. This includes information on theperiodic delinquency, foreclosure, and prepaymentexperience, as well as the issue’s financialstatus; and■ The trustee covenants in the indenture toapply for the cash advance (if applicable) ifthe servicer has failed to do so when appropriate,and to assume servicing if the servicer isunable to perform.Administration of mortgage assetsTo assess management capability in the administrationof mortgage assets, Standard & Poor’s generallyexamines the participating entity’s volume andexperience in the origination or servicing of mortgages.This capability is strengthened if all of thelender/servicers comply with Fannie Mae/FreddieMac and/or FHA/VA standards.In MRB issues with a large number of participatinglender/servicers, program administration is anespecially important rating concern. Although thetrustee is ultimately responsible for the operation ofthe program, for most local issuer transactions, amaster servicer, acceptable to Standard & Poor’s, isneeded. The master servicer monitors and evaluatesthe performance of each lender during the originationperiod. Following the underwriting of a mortgage,the master servicer monitors and evaluates theperformance of each servicer, and recommendsreplacement of servicers, if appropriate. Most HFAsperform this function for their issues.Administrator responsibilitiesOn a monthly basis, the administrator shouldreview each servicer’s escrow records to reconcileescrow balances, and should monitor delinquenciesand foreclosures. The administrator also shouldensure that all claims are filed in a timely and accuratemanner under the various insurance policies,including the advance claims endorsement.Finally, the administrator should collect informationfrom the servicers and submit reports to thetrustee pertaining to the mortgage loans, as well asto monies remitted to the trustee by the servicers.242 Standard & Poor’s Public Finance Criteria 2007

Single-Family Second Mortgage LoansMortgage servicer responsibilitiesIn the typical MRB structure, mortgage servicersare required only to remit mortgage revenues to theextent that they are collected. If a mortgagor’s paymentremains delinquent, the servicer is required toundertake further steps to collect. The servicer alsomust apply for advance claims payments under theappropriate insurance policy or proceed towardforeclosure if applicable.Standard & Poor’s reviews the track record ofeach servicer as it pertains to originations, delinquencies,foreclosures, insurance claims processing,and claims denials upon the rating of a new resolution.Generally major servicers have sound proceduresto track loans and process claims. Servicerswith negative track records in one or more of theseareas may be requested not to participate in theprogram, although this is uncommon.FDIC regulations concerning the payment ofinsurance benefits limit the $100,000 FDIC benefiton a mortgage servicing account to $100,000 perinvestor, rather than $100,000 per account. Thishas an impact on all single-family, whole-loandeals. If an investor has an interest in one or moreservicing accounts or has another account at theservicing institution, then all of these accountswould be aggregated in calculating the insurancebenefit for that investor. Standard & Poor’s cannotbe assured that immediate remittance to the trusteeof amounts in excess of $100,000 will still leave theservicing account whole in the event of a servicerfailure. This concern needs to be addressed by theissuer on all single-family, whole-loan financings.Cash flow administrationOperation of an MRB issue’s cash flow depends onadequate cash flow administration. This functionincludes executing investment transactions andinvestment agreements, managing cash to maximizeinterest income, and identifying prepayments andappropriate bonds to be called from prepayments.This function should be carried out by the agencyor capable third party overseen by the issuer. ■Single-Family Second Mortgage LoansBonds secured by second mortgage loans originatedto low-and moderate-income persons areeligible to receive ratings as high as ‘AAA’, dependingon the credit supports and levels of over-collateralizationused to back the bonds. Rated secondmortgage bonds typically would be used for downpayment assistance and closing costs as opposed tocash out mortgages for consumer purposes. Bondsbacked by second mortgages need higher loan losscoverage than first mortgages because of the higherprobability of foreclosure and the lack of recoverableassets in the event of foreclosure. For example,loan loss coverage for second mortgage bonds ratedat the ‘A’ rating level would start at 25% and couldclimb beyond 48%, depending on characteristics ofthe loans and other factors.Standard & Poor’s Ratings Services will apply thesame standards when determining loan loss coveragefor second mortgages whether rating programssupported by only second mortgages or programswith first and second mortgage collateral. The evaluationis derived from Standard & Poor’s firstmortgage criteria and includes:■ Credit characteristics of the mortgage loan pool;■■■Reserve funding;Bond and legal structure; andCash flow sufficiency.Credit CharacteristicsThe higher credit coverage for second loan bondsresults from key elements that increase the risk of foreclosureof second mortgages, including the following:The subordinate nature ofthe second mortgage pledgeSecond mortgage lenders have a subordinate lien onthe assets pledged for repayment of the first andsecond mortgages. Default on the second mortgagedoes not affect payment of the first mortgage,whereas default or foreclosure on the first mortgageresults in the same on the second mortgage. In theevent of foreclosure, the order of priority requiresthat any proceeds generated from a sale go first tothe first mortgage lender. This could leave the holderof the second mortgage with no funds for recovery,resulting in a loss severity of 100%.Furthermore, payment interruption on the firstmortgage must be remedied before payment can gotoward the second mortgage.www.standardandpoors.com243

HousingCombined loan to value (CLTV)ratios in excess of 100%Second mortgages add debt associated with a residence,frequently bringing the CLTV above 100%.The financial pressure resulting from the additionalleverage leads to mortgage delinquency and foreclosuremore frequently.A lack of underlying collateral or mortgage insuranceBonds supported by first mortgages have numerousassets behind them. The value of the residenceitself, mortgage insurance or guarantees, mortgagebackedsecurities, and first priority in the event ofdefault and foreclosure provide security to bondholders.Second mortgages generally have only thevalue of the physical residence for support, but ifthat value does not surpass the amount outstandingon the first mortgage, the second mortgage is essentiallyan unsecured loan.Rating MethodologyStandard & Poor’s rating criteria for second mortgageloan bonds focuses on the credit characteristicsof the total mortgage loan program. Since loss severityfor second loans is assumed at 100%, Standard &Poor’s criteria for first mortgage loans is used todetermine foreclosure frequency rates, given suchfactors as the property type and loan (fixed,adjustable rate, among others), geographic dispersionof the loan pool, and the CLTV. In addition,Standard & Poor’s analyzes historical delinquencyand foreclosure rates, management oversight capabilities,and underwriting and servicing standards.Standard & Poor’s will not necessarily distinguishbetween state and local programs, as many local programsmay be similar to statewide programs.The strongest second mortgage programs will beissued in large and heavily populated areas that willhave greater geographic and economic diversification,will benefit from experienced loan and programoversight, use approved HFAs as servicers orservicers evaluated by Standard & Poor’s, and haveCLTV around 100%. As CLTV increases or any ofthe other elements deviates from the above, thetransaction exposes bondholders to increasing risk,resulting in higher loss coverage. For example, a115% CLTV pool in a small state could have a losscoverage level of 45% for an ‘A’ rating and 56%for a ‘AA’ rating. A 103% CLTV pool in a largestate could have loss coverage of 27% for an ‘A’rating and 33% for ‘AA’.OriginationThe standard high quality, least risky first mortgageportfolio consists of 30-year level-pay, fixed-rate,first-lien, fully amortizing mortgages on single-family,owner-occupied detached residential properties.Standard & Poor’s considers rehabilitation loans,construction loans, second-or third-lien mortgages,bought-down mortgages, and tiered-payment mortgagesto be significantly riskier than 30-year levelpayloans.As with first mortgage programs, the portfolio’sorigination area is crucial to determining loss coverage.Origination areas may be categorized as largestate, small state/large county, and smallcounty/city. Many of the issuers of second mortgageloans are local or regional entities. For them toachieve an origination designation above smallcounty/city, they must provide evidence of the numberof and likely dispersion of those loans.ServicingStandard & Poor’s will evaluate servicer responsibilitiesand capacity as reflected in provisions inbond and loan documents. The strength of servicersmay be assessed through several channels, includingdesignation through Standard & Poor’s ServicerEvaluation. Standard & Poor’s will consider anorganization’s background, internal controls, lossmitigation techniques, staffing, systems, key administrativefunctions, financial profile, and compliancewith applicable laws, regulations and industry standards.Optimally servicing of the first and secondloans is done concurrently, with one payment fromthe borrower covering both mortgages.Standard & Poor’s will not look for higher loanloss protection on programs that have separatelyserviced first and second mortgages in contrast tothose where the servicing and billing combine thefirst and second mortgage as long as both servicersare acceptable.Management and oversight of programSupporting the previous item is the issuer’s abilityto properly administer and manage a second mortgageprogram. In assessing the organizationalcapacity, Standard & Poor’s will review an issuer’sexperience with single-family mortgage programsand familiarity with second mortgages. State HFAstypically have more expertise with whole loan programs,of which second mortgage structures are onetype, so Standard & Poor’s may give more weightto a state agency than to a local issuer. State HFAsoften have their own servicing departments andexperience working through lenders and directlywith borrowers. The added oversight, technology,and experience that some state HFAs possess can bea factor in establishing loss coverage.Reserve CriteriaReserve funding for second mortgage loan bonds isused to cover potential loan losses and liquidityneeds. Standard & Poor’s assumes no foreclosureproceeds are available for the second lien holder.244 Standard & Poor’s Public Finance Criteria 2007

Single-Family Mortgage-Backed Securities ProgramsTherefore, loss severity for second loans is 100%,resulting in foreclosure frequency percentages,which are rating specific, as the determinant forreserve funding. Foreclosure frequency levels willbe adjusted from rating-specific levels based on theloan type, dwelling type, loan to value ratio, borrowerquality, servicing method, or other potentialstrengths or weaknesses of the mortgage pool.Once loss coverage is established as indicatedabove, cash flows must show that the transactioncan withstand such losses through bond maturity.Reserves can be funded in various forms, such asthrough over-collateralization, capital reservefunds, pool insurance policies, or evaporation ofassets as demonstrated in cash flow scenarios.Further explanation of these methods is found inthe single-family whole loan criteria.Legal ProvisionsStandard & Poor’s will focus primarily on the followinglegal provisions:Flow of fundsIn evaluating an issue’s flow of funds, two concernsshould be addressed: The release of funds and theuse of surpluses. With some exceptions, the flow offunds should be closed for all local issuer transactions,with all surpluses being used to call bonds.State agencies may use an open flow of funds ifstructured properly, and a cash flow certificate(requiring the same scenarios as were originallyprovided at the time of initial issuance) is providedeach time funds are released. In both cases, a 2%liquid reserve should be replenished through theflow of funds prior to any release of funds. In addition,legal provisions should give first priority tothe payment of debt service, then to payment ofinsurance premiums, with all other expenses subordinatedand capped.Second lienThe pledge of the second mortgage and revenuesfrom the loan to bondholders should be clearly statedand described in the bond documents. The purposeof the second mortgage is to establish anenforceable right to cash flows and any otherpledged property, in the event of a default.Standard & Poor’s will review second mortgagedocuments to ensure the creation of the second lien.Cash FlowCash flows should meet the same standards as firstloans. Please refer to the criteria on single-familywhole loans for cash flow guidelines. ■Single-Family Mortgage-BackedSecurities ProgramsIssuers use Ginnie Mae, Fannie Mae, and FreddieMac single-family mortgage-backed securities(MBS) in housing bond structures to securitizepools of single-family mortgages. These transactionsare eligible for a ‘AAA’ rating, based on theguarantee on the MBS by Fannie Mae, Ginnie Mae,and Freddie Mac, which have direct or implied supportof the U.S. government.The loans in the MBS pools carry insurance fromprivate mortgage insurers or the Federal HousingAdministration (FHA), USDA Rural Development(RD), or Veteran’s Administration (VA) governmentguarantee programs. While Freddie Mac andFannie Mae securitize all four types of loans, theGinnie Mae program limits the mortgages it securesto FHA, RD, and VA. However, much of the ratingcriteria for each MBS program are the same. Often,bond issues incorporate the use of at least two andsometimes all of these securitization programs.For new money issues, it is typical for bondproceeds to be deposited with the trustee in anacquisition fund. Then, various lenders originatesingle-family mortgages according to programorigination guidelines established in the financingdocuments. These mortgages are “warehoused”by a master lender. When the master lender hassufficient mortgages, Ginnie Mae, Fannie Mae,or Freddie Mac MBS are issued by the lender.The trustee gives the lender the correspondingamount of bond proceeds from the acquisitionfund in exchange for the MBS. Accrued interestmay be paid to the lender in one of two ways.The trustee can return the accrued interest to thelender on the first date after the security’s issuedate that the trustee receives a principal andinterest payment on the security. Alternatively,the accrued interest may be paid from the acquisitionfund or other trust fund monies on thedate that the security is acquired. The trusteemay hold the MBS in physical possession or inbook-entry form. Ginnie Mae securities typicallyare held in book-entry form.www.standardandpoors.com245

HousingThe trustee may purchase an MBS with monies inthe acquisition fund only after verifying the following:■ After acquisition, the sum of the outstanding balanceof the securities plus all fund balances(excluding the rebate and expense funds) equalsor exceeds the amount of bonds outstanding;■ The security bears interest at the pass-throughrate specified in the bond documents and maturesby the date specified; and■ The trustee will have a first perfected securityinterest in the security after purchase.Such verification guarantees that sufficient revenueswill be available to meet future debt serviceand expenses and that asset coverage will be maintained.The process of converting single-familywhole loans into MBS continues throughout theacquisition period. Any monies remaining in theacquisition fund at the end of the period are used toredeem bonds, unless the issuer seeks an extensionwith prior written notification to Standard &Poor’s Ratings Services.Cash FlowsAll mortgage payments shown in the cash flowsshould reflect the pass-through rate of the respectiveMBS, which is the mortgage loan rate net ofservicing and guarantee fees. In addition, fees to bepaid for trustee and rebate analyst services, issuerfees or any other fees as outlined in the trust indenturemust be reflected. Cash flows should show thatassets under the program are at least equal to liabilitiesuntil bond maturity or earlier redemption.Revenues must be sufficient to meet all scheduleddebt service payments on a timely basis.Cash flow runs must assume full delivery of theMBS on the least desirable origination date permittedunder the bond documents. This origination dateis determined by comparing the MBS pass-throughrate to the investment rate to be received on theTable 1 Rapid Prepayment Stress Run For ‘AAA’ Rated Issues—Years until full redemption of bonds —State HFALocal HFA or stateInterest rate (%) parity program HFA non-parity program6.50 or lower 5.0 4.06.51 to 7.00 4.5 3.57.01 to 7.50 4.0 3.07.51 to 8.00 3.5 2.58.01 to 8.50 3.0 2.08.51 to 9.00 2.5 2.09.01 and higher 2.0 2.0acquisition fund. If the pass-through rate exceeds theacquisition fund rate, last-day origination isassumed. If the acquisition fund rate exceeds thepass-through rate, first-day origination is assumed.The cash flow scenarios that should be providedare full origination of mortgage loans with 0% prepayment,rapid prepayment, and non-origination ofall mortgages. The non-origination run shouldassume a full redemption of bonds on the date specifiedin the bond documents in the event originationof mortgages does not occur. A rapid prepaymentrun is necessary for all ‘AAA’ rated single-familybond issues, including MBS transactions. The rapidprepayment scenario should be prepared at a prepaymentspeed sufficient to redeem all bonds withintwo years after origination; however, depending onthe mortgage loan interest rate, the issuer, andwhether or not the bonds are part of a parity program,this scenario may be run at slower prepaymentspeeds that redeem all bonds within a longerperiod of time after origination, as shown:Depending on the structure of each transaction,other cash flow scenarios may be needed. For adescription of some of the more common amongthese as well as additional detail with regard tocash flows, please refer to the criteria, “Single-Family Whole Loan Programs.” The cash flow discussionin this article includes information ontreatment of variable rate debt and swaps.The assumptions for all cash flows run shouldinclude appropriate mortgage payment lags reflectingthe actual expected receipt date of MBS payments.The Ginnie Mae I program guarantees payments onthe 15th day of the month; Ginnie Mae II on the20th; Freddie Mac on the 15th, and Fannie Mae onthe 25th. The form and source of coverage for creditshortfalls should be outlined in the indenture. Theseshortfalls may be funded in a variety of ways, includinguse of a bond premium, buying the MBS at a discountor an issuer contribution. Any monetarycontributions must be made with funds consideredpreference-proof pursuant to Sections 362(a), 547,and 550 of the Bankruptcy Code.Legal DocumentsThe criteria for MBS program documents closelycoincide with the criteria for single-family wholeloan issues with key analytical focus on all trusteeresponsibilities, additional bonds, eligible investments,redemptions, events of default, contributionsfor credit shortfalls, and flow of funds. Proper notificationshould be given to Standard & Poor’s forvarious events including, but not limited to, extensionof the acquisition period, any change to thebond or mortgage documents, or any change in thetrustee or investment agreement provider.246 Standard & Poor’s Public Finance Criteria 2007

Property Improvement LoansCertain other criteria are specific to the MBS programs.For example, all MBS should be registered inthe name of the trustee, held in its possession, andassigned as a first perfected security lien, free andclear of third-party claims. Selling the MBS securitiesat a loss should be with majority bondholderapproval, and this provision cannot be changedwithout majority bondholder approval. Lastly,lenders and servicers should be approved by GinnieMae, Fannie Mae, or Freddie Mac, as applicable. ■Property Improvement LoansProperty improvement loan (PIL) revenue bondsare tax-exempt debt instruments issued tofinance certain eligible improvements to owneroccupiedproperties. Standard & Poor’s RatingsServices rates bond programs secured primarily bysingle-family property improvement loans insuredunder the FHA Title I program, uninsured or guaranteedfor full and timely payment by ‘AAA’ ratedeligible MBS.The FHA Title I Property Improvement LoanProgram, formerly known as the FHA Title I HomeImprovement Loan Program, was established by theNational Housing Act of 1934 (as amended) and isone of HUD’s oldest programs. The act empowersthe FHA to enter into a contract of insurance withfinancial institutions that it determines to be eligiblefor such insurance.Rating criteria for PIL revenue bond programsare similar to the criteria used for single-familyMRBs. In both types of financings, issuers use bondproceeds to acquire eligible loans and the revenuesgenerated from the resulting pool of loans are usedto pay bond debt service. However, the types ofloans comprising the pool, and the type of insuranceprotection provided are markedly different.FHA Title I Loan CharacteristicsA borrower may obtain a FHA Title I loan tofinance alterations, repairs, and improvements onreal property, or to finance existing structures thatsubstantially protect or improve the property,including manufactured homes, single-family andmultifamily homes, nonresidential structures, andthe preservation of historic homes. For single-familyproperty improvement loans, HUD sets the maximumloan amount under the program at $25,000,and the maximum loan maturity at 20 years, 32days, and maximum interest rate based on marketconditions. All loans should be fully amortizing andlevel pay. There is no equity requirement for loansover $15,000 as long as the property beingimproved is owner occupied and the structure onthe property has been completed for at least sixmonths before the date of the Title I loan application.The borrower must have equity in the propertyat least equal to the loan amount when the loanexceeds $15,000 and the property is non-owneroccupied. Loans in excess of $7,500 are to besecured by a recorded lien on the improved property.FHA regulations do not require that this lien bea first lien on the property.FHA Title I Insurance CoverageInsurance provided by the FHA is the principalsource of credit enhancement for a Title I security.In the Title I program, the financial institution originatingthe loans obtains a contract of insurancewith the FHA. This insurance takes the form of areserve fund established and maintained by theFHA for the financial institution. The amount creditedto each institution initially is equal to 10% ofthe aggregate amount of all loans newly originatedor purchased by the financial institution. A Title Iborrower is considered in default under the regulationsif he or she has failed to make any paymentdue under the note and the failure has continuedfor at least 30 days.Prior to acceleration of the loan, the lender mustmeet with the borrower to affect a cure or enter intoa modification or repayment plan. Once these stepshave been taken, the lender must provide writtennotification to the borrower that unless a cure ormodification agreement is entered into, accelerationwill occur 30 days from the notice date. Failure todocument the above actions adequately may result ina claim denial. A claim must be filed no later thannine months after the date of default. Claims will bepaid by the FHA from the lender’s reserve fund. Theamount of the reimbursement will equal: The sum of90% of the net unpaid principal balance of the loan;90% of the uncollected interest due to the date ofdefault; and 90% of the interest computed at 7% peryear on the outstanding principal balance from thedate of default to date of claim submission plus 15www.standardandpoors.com247

Housingdays; as well as uncollected court costs, certain attorneyfees, and recording costs.However, the total amount of claims reimbursedto the institution is limited to the amount maintainedfor each financial institution in the FHAreserve fund. The amount of FHA Title I insurancecoverage will decline by the amount of claims paidor rejected by the FHA and the amount of insuranceallocable to a loan that has been sold or transferredwithout recourse. Adjustments to a lender’s insurancecoverage reserve account cannot occur with thefirst five years of contract. After the end of the fiveyear(60 month) period, and on each October 1afterward, the amount of insurance coverage in thelender’s reserve account is adjusted by deducting10% of the amount of the insurance coverage containedin the reserve account as of that date. Theadjustment cannot reduce the amount of insurancecoverage in the account to less than $50,000.Should claims exceed the amount available in theinstitution’s reserve, there is no further recourse tothe FHA. Under this circumstance, the lending institution’sonly recourse for repayment would be tocommence foreclosure proceedings if a securityinstrument is in place. However, as the vast majorityof Title I notes typically are second, third, orfourth liens on the property, foreclosure does notguarantee that the institution will recoup its losses.Only if there are monies remaining after all priorliens have been fully satisfied can the holder of theTitle I note seek payment. In areas where propertiesare declining in value, the chances of recovery areespecially slim.Nonrecourse vs. Recourse FHA Title I ProgramsStandard & Poor’s rates nonrecourse and recourseFHA Title I programs. In the nonrecourse program,all loans financed are insured under a single contractwith the FHA. The insured in this case is thebond issuer, which may be a state or local HFA,and must be an FHA-approved lending institution.Claims are expected to be paid first from the insurancereserve maintained for the agency by the FHA.The second payment source is typically loan lossreserves held under the indenture. Most issues benefitfrom a closed flow of funds, which trap excesscash flow to build up reserves to compensate forthe limitations on FHA reserve balances. Becausethere is no recourse to the originating lender torepurchase a defaulted mortgage loan as in therecourse program, reserves held under the indentureare necessary to maintain the rating.In the recourse program, loans may be insuredunder single or multiple contracts of insurance. Ineither case, one or more lending institutions originateinsured loans, which then are sold to theissuer, who, in turn, pledges them to the bondtrustee. The loans remain insured under the lenders’contracts, so that should a default occur, the loanwould be repurchased by the appropriate originatinglender. The trustee has recourse to the fullamount of loans purchased from a given participatinglender, regardless of the amount remaining inthe lender’s insurance reserve.In cases where all lenders participating in the programhave long-term unsecured debt ratings orissuer credit ratings as high as the desired rating onthe bonds, Standard & Poor’s gives full credit to therepurchase obligation without an in-depth analysisof the institution’s underlying FHA reserve or loanloss reserves held under the indenture. The rating ofthe provider of the repurchase agreement would bemonitored as part of Standard & Poor’s rating surveillanceefforts. A rating downgrade of the providerwould prompt a review of the rating on the bondissue and possible downgrading unless loan lossreserves held under the indenture are sufficient tomaintain the rating. In programs where participatinglenders are not rated or whose ratings fall below therating on the bonds, Standard & Poor’s will determinean appropriate level of loan loss reserve fundingnecessary to maintain the rating.Loan Loss Coverage AnalysisLoan loss coverage for both types of Title I propertyimprovement loan programs is usually necessaryfor an investment-grade rating. In nonrecourse programs,coverage must address FHA reserve’s limitedbalance, the potential for claims denial, and the factthat the reserve may not be dedicated to the pool ofloans financed under the trust estate. Underrecourse programs, coverage may still be necessarybased on the ratings of the lenders and the timingand amount of the repurchase obligation.Standard & Poor’s assumes that loss severity forTitle I property improvement loans will be 100% atall rating levels and for most issuers. There are tworeasons for this loss assumption:■ Title I property improvement loan balances aregenerally small in relation to the first mortgage;and■ Many Title I properties have a high combinedLTV.When these two elements exist, Standard &Poor’s investment-grade loss severity assumptionsshow that there is always some loss to the first lienholder. Consequently, there are no liquidation proceedsavailable for the second lien holder.For ratings of ‘A’ to ‘AA’ on Title I bond programs,Standard & Poor’s traditionally looks for15%—24% of original loan balance to be availableas a reserve against loan losses. These percentagesare based on a number of factors, includingStandard & Poor’s foreclosure frequency estimates248 Standard & Poor’s Public Finance Criteria 2007

Property Improvement Loansunder a stress scenario for similar loans and FHAdefault statistics. Standard & Poor’s StructuredFinance group conducted a study indicating thatTitle I delinquencies and foreclosures may warrantreserve levels for ratings of ‘A’ to ‘AAA’ closer to26.5%-45%. These reserves apply generally to conduitprograms. The nature of programs administeredby state and local HFAs lends itself to lessonerous reserve levels.However, Standard & Poor’s will look for thehigher reserve levels if an individual program’s lossesand foreclosures support the study. The FHAreserve can be counted when meeting this guidelineunder certain circumstances: the lender’s entireFHA reserve must be dedicated to the loans madeunder the trust estate; the lender states the intentionto file a claim on default as opposed to proceedingagainst the loan security; and other reserves mustbe available to supplement the 10% not covered byFHA. Reserve requirements may be met with cashwith over-collateralization or contributions, LOCs,or over-collateralization. If over-collateralization isin the form of mortgages, Standard & Poor’s willassume that 15%—24% (or if warranted, 26.5%-45%) of the mortgage assets will be unavailable,based on default.A minimum liquidity reserve of 2% of loans alsoshould be maintained so that bond debt service canbe paid during the months between default andclaims payment.FHA Title I Program AdministrationThe quality of underwriting and servicing underthe FHA Title I program is integral to credit quality.Standard & Poor’s will review the lenders’underwriting, quality control, collections, and servicingand claims denial rate to assess the health ofthe portfolio and the probability of successful andtimely claims payment. Standard & Poor’s generallylooks for underwriting procedures that are consistentwith FHA regulations. Failure to complywith FHA regulations can result in loans beingrejected for insurance; therefore, compliance proceduresare reviewed carefully. Servicing and collectionprocedures are subject to the same guidelinesas other single-family programs. Loan paymentsshould be held in fully insured accounts and immediatelytransferred to the trustee should theyexceed the insured amount. Systems should be inplace to monitor loan payments on a monthlybasis, and exception reports should be generatedmonthly to pinpoint delinquent loans. Once a loanis delinquent, procedures should be in place thatare consistent with FHA regulations. Claimsshould be filed at the earliest possible date permittedunder the program. Since claims cannot be filedafter the loan has been in default for nine months,the system should have a built-in trigger toannounce this final deadline. Selected loan files willbe reviewed for completeness of documentationand evidence of loan compliance. This is especiallyimportant, since only on default will HUD reviewa loan file for compliance. The historical claimsdenial rate should be low. To the extent that thedenial rates are excessive, less credit will be givento the FHA reserve.A master servicer, such as a state HFA or stronglocal HFA, is considered a necessity in a nonrecourseor recourse program with unrated or noninvestment-gradelenders. Standard & Poor’s expectsthe HFA to monitor the performance of the lendersand have procedures in place to remove lenders forpoor performance. Prior to the rating, and ongoing,Standard & Poor’s will meet with the lender ormaster servicer to review its procedures, the statusof reserves, and portfolio quality.PIL Revenue Bond Cash FlowsThe cash flow simulations for PIL revenue bondissues are the same as those for single-family issues.All loans are assumed to have a 15-to 20-year term,unless documents clearly restrict the percentage ofshorter-term loans to the amounts reflected in thecash flows. If loan payment deferments, as definedin the regulations, are to be allowed, the maximumamount of such deferments should be reflected inthe cash flows. If a portion of the loans to be originatedwill have a lower mortgage rate than the restof the portfolio, the source of the subsidy, and howit will be used to buy up the rate, must be reflectedclearly in cash flows and documents. If no subsidyexists, cash flows should be run assuming that onlythe lower interest-rate loans are originated.Finally, if any program assets are to be used toprovide lenders participating in a recourse FHATitle I program with a repurchase credit, theseassets should not be reflected in the cash flows. Arepurchase credit is a feature of certain older Title Iprograms that allows a lender to repurchase a givenamount of defaulted loans for less than the outstandingbalance of the loan. A reserve usually isestablished to provide sufficient liquid funds tocompensate for the credit. Standard & Poor’sassumes that the full amount of repurchase creditsavailable will be used, thus fully drawing down thereserve. Therefore, inclusion of the reserve in thecash flows would overstate revenues and assets inthe worst-case scenario. ■www.standardandpoors.com249

HousingFHA Insured Multifamily MortgagesThe security for Federal Housing Administration(FHA)-insured multifamily mortgage-backedissues consists of several components, primarily theinsured mortgage note, investments, and reserves.Standard & Poor’s Ratings Services assumes that amortgage default may occur at any time during theterm of the bonds. Since the FHA’s regulations andpractices do not provide for immediate claims payments,reserves need to be available to pay thebonds until the claim is paid in full.The FHA has given Standard & Poor’s assurancesthat HUD, of which the agency is a part, providespriority processing for insurance claimsinvolving projects financed with rated bonds. TheFHA permits processing to go forward when workoutsare being pursued, a concept often referred toas “dual processing,” which is necessary to ensurereserve sufficiency in the event that the workout isunsuccessful. Moreover, the agency has indicatedthat it will act to process claims expeditiously sothat final payment is received within a reasonabletime frame, assuming that the trustee acts expeditiouslyduring the assignment process. Standard &Poor’s sets its reserve fund guidelines based on theserepresentations and an assessment of the potentialfor delay based on actual defaults. These factors, aswell as demonstrated coverage of other inherentprogram shortfalls defined below, enableStandard & Poor’s to assign ratings as high as‘AAA’ to these issues.Standard & Poor’s criteria for FHA-insured mortgagesincludes multifamily, hospital and nursing homeprograms, as well as the HFA risk sharing program.Supports And ShortfallsStandard & Poor’s looks for coverage of the potentialshortfalls cited below at bond closing to protectbondholders in case of a mortgage default and aloss of interest earnings. Credit enhancement mechanismsinclude cash, third-party supports, and otherstructuring mechanisms.Liquidity ReservesReserves provide the liquidity needed to offsetpotential interruptions in debt service in the eventthat a mortgagor defaults. Bond proceeds can fundthese reserves, since interest paid on mortgageinsurance benefits should be sufficient to replenishthe reserves.Debt service reserve fundsStandard & Poor’s has concluded that, in cash payoutprograms, a debt service reserve fund equal toeight months’ maximum bond debt service shouldbe sufficient, based on the following:■ Mortgage insurance is paid in two installments.■ In a worst-case scenario where the default occursprior to final endorsement, the first portion of70% of mortgage insurance is paid within sixmonths of the date the notices of default andintention and election to assign are sent. HUDpays this amount following the recording of theassignment of the mortgage loan to the FHA.Bonds should be redeemed with this insurancepayment on the earliest practicable date.■ Standard & Poor’s assumes that the claim’sremaining 30% may not be received until the sixmonths after the first payment. This is becausethe trustee is required to obtain information anddocumentation from hazard insurers, the mortgagor,the servicer, and other third parties, andreliance on these third parties can cause delays.A debt service reserve fund (DSRF) equal tomaximum annual bond debt service is needed indebenture pay issues where the insurance claimis paid in one installment. Debentures areassumed to be received within one year of thenotice of default.Bond proceeds typically fund the debt servicereserve fund, although other methods, such as lettersof credit (LOCs) issued by banks rated as highas the bonds, or cash, are sometimes used. Theinvestment of DSRFs in investment agreements forthe life of the issue eliminates market risk. Whenthe reserve is funded with bond proceeds, if thereserve is called on, the expended portion is nolonger earning expected investment income.Depending on when the drawdown occurs,Standard & Poor’s has found that a shortfall maybe created. The shortfall may be offset by theinterest component of the FHA insurance proceeds.A sufficiently high debenture interest rate,relative to the owner’s mortgage coupon, can mitigatethe lost earnings on the debt service reservefund. Any shortfall that arises needs to be coveredat the time of the rating.250 Standard & Poor’s Public Finance Criteria 2007

FHA Insured Multifamily MortgagesMortgage reserve fundAn amount equal to two months of principal andinterest on the mortgage covers liquidity shortfallsimmediately following a mortgage default.Standard & Poor’s assumes that, although a mortgagor’spayment is due on the first day of themonth, the payment is not received until the lastday of that month. In addition, trustees are reluctantto file an insurance claim at this time, becauseFHA regulations allow an additional 30-day graceperiod for the mortgagor to make payments due onthe mortgage note.Demonstration of a 30-day lag in the cash flows,plus a reserve equal to one month’s principal andinterest on the mortgage note, can cover the twomonths’ liquidity requirement. Showing receipt ofone less mortgage payment between the full fundingof the mortgage note and the next bond paymentdate proves the cash flow lag. If the cash flowsdemonstrate sufficient revenues to pay debt service,no further credit support is necessary to fund thelag. However, if a shortfall exists, additional coverageneeds to be in place at bond closing. The secondmonth may be funded from bond proceeds,cash, LOC, or other acceptable credit support.In absence of a lag, the mortgage reserve fundshould contain two months’ principal and intereston the note. Bond proceeds can fund one of themonths, while the second should come from cash,LOC, or other acceptable credit support. Thefinancing documents should clearly provide for useand replenishment of this reserve, because FHAinsurance proceeds exclude the payment of onemonth’s interest on the mortgage note.Credit ShortfallsUnlike liquidity reserves, credit shortfalls cannot berecouped. Therefore, funding for credit shortfallsshould come from acceptable sources other thanbond proceeds. Additionally, combined trust assetsalways should exceed bonds outstanding by thetotal amount of credit shortfalls.The 1% assignment feeA program shortfall can occur on FHA-insured mortgagesin which the FHA pays out 99% of the outstandingmortgage balance. In such cases, at bondclosing, the mortgagor or other third party contributesthe “1% assignment fee”—that is, the remaining 1%portion of the mortgage to cover this shortfall.Nonasset bondsA structural shortfall occurs when the initialamount of bonds outstanding exceeds the outstandingmortgage amount and other trust estate fundsor investments eligible for inclusion as assets. Thissituation results in nonasset bonds without sufficientcollateral support.Negative arbitrageResulting from interest-rate spreads, negative arbitrageis a common problem in new construction orsubstantial rehabilitation transactions. This occurswhen escrowed monies earn interest at a rate lowerthan the mortgage and bond accrual rates. Mostoften, this results in a shortfall until the constructionfund has been drawn down in full and commencementof amortization on the mortgage notehas begun. To quantify the amount of the shortfall,Standard & Poor’s assumes that 90% of the fundsare drawn down one month prior to commencementof amortization. The remaining 10% aredrawn down 18 months later.Upon commencement of amortization, the cashflows should reflect a reduced mortgage paymentuntil the 10% draw. The principal componentremains the same as if the full mortgage amountwere originated. The difference comes in that theborrower only owes interest on the 90% drawnfrom the construction fund. This draw scenarioallows for the eventuality where commencement ofamortization occurs prior to final endorsement ofthe mortgage note by FHA. To prevent a greatershortfall, it is prudent to have the construction fundinvestment agreement expiring no sooner than 18months after commencement of amortization.Another situation where negative arbitrageoccurs is while the trustee holds funds for redemptionduring the required redemption notice period.During this time, shortfalls could occur if the fundscannot be invested at the bond accrual rate.Standard & Poor’s will use the minimum noticeperiod in the bond documents to calculate reinvestmentrisk coverage. This shortfall should be providedat bond closing and maintained for the life ofthe issue.Cash and LOCs associated with mortgage loansAccording to HUD regulations, cash or LOCs heldby the mortgagee may be deducted from the insuranceclaim. These items have the potential tobecome security for the bonds. Depending on duration,purpose, and amount, they may be subject tothe same requirements as the bond-related creditenhancements discussed above. In addition, documentsmust clearly condition release of these itemsonly with appropriate FHA approvals.Structural ConsiderationsIn FHA transactions, there are several structuralconsiderations that can have a substantial impacton the credit quality of the transaction. Thesewww.standardandpoors.com251

Housinginclude: trustee and servicer responsibilities andcompensation; legal provisions such as actions to betaken in the event of a mortgage loan default;redemption provisions and procedures governingmortgage loan advances; commencement of amortizationand final endorsement, to name a few.Project construction periodBond proceeds are deposited in the constructionfund on behalf of the issuer. Throughout the constructionperiod, the trustee authorizes mortgageloan advances to the mortgagor in accordance withthe building loan agreement. The trustee should disperseonly properly endorsed mortgage insuranceadvances. By restricting disbursements to amountsinsured by the FHA, the trustee is assured of havingsufficient high-quality assets to redeem all outstandingbonds, if necessary.During the construction period, the mortgagorowes interest at the construction loan rate on theportion of the mortgage loan principal that actuallyhas been advanced. Failure to make a monthlyinterest payment on the due date constitutes adefault under the mortgage note.Note amortization versus final endorsementStandard & Poor’s regards the commencement ofmortgage note amortization as the critical event inFHA-insured programs. Starting on this date, themortgagor’s obligation under the mortgage noteincludes repayment of principal, as well as intereston the mortgage loan.The bond indenture should state explicitly thedate that note amortization will commence, as setforth in the FHA firm commitment. The amortizationschedule should reflect the principal amount ofthe mortgage note as initially endorsed by the FHAunless modified by the agency at final endorsement.Standard & Poor’s evaluation of the adequacy ofmortgage revenues to meet bond debt service paymentsalso is predicated on these assumptions.Failure to begin amortization on the specified dateconstitutes a default under the mortgage. The bondindenture should instruct the trustee to initiate theassignment process if the mortgagor does not curesuch a default within the 30-day grace period.If an issuer permits extension of the commencementof note amortization, the following provisionsare necessary to simulate note amortization:■ The extension period is limited to a set period oftime. In no event may note amortization be extendedbeyond the date three months prior to expirationof the construction fund investment agreement,unless the investment agreement is extended or minimumreinvestment rates are assumed followinginvestment agreement expiration.■ The trustee receives cash flows provided by anindependent third party. Such cash flows shoulddemonstrate that sufficient revenues will be availableto (a) pay bond debt service for the term ofthe bonds as originally scheduled in the projectedcash flows; (b) pay all fees and expenses of thetrustee and mortgage servicer; and © pay allother fees and expenses incurred by the trusteeduring the extension period.■ If project revenues prove insufficient to satisfythe above cash flow projections, the trusteeshould receive cash or an unsecured LOC in theamount of the projected shortfall. The LOCshould come from an institution whose unsecuredlong-term debt is compatible with the ratingassigned to the bonds. Unqualified counsel opinionsare required for each kind of shortfall coverage:(a) if a revenue shortfall is covered by a cashcontribution or LOC, the trustee must receive anopinion of counsel stating that the contributionwould not be considered a preference under theprovisions of Section 547(b) of the BankruptcyCode; (b) in addition, the trustee should receivean opinion of counsel stating that the contributionwould not be subject to the automatic stayprovisions of Section 362(a) of the BankruptcyCode; and all opinions of counsel should be renderedby an attorney in the field of bankruptcywho is acceptable to the trustee.■ The trustee should conclude that extending thecommencement date of note amortization wouldnot adversely affect the bondholders or jeopardizethe FHA contract for mortgage insurance.Such extension also should not adversely affectthe tax-exempt status of the bonds. The indentureshould expressly state that extension of thedate for commencement of amortization is notpermitted if this is the case.The assignment processThe mortgagor is considered to be in monetarydefault if a scheduled mortgage note payment isnot received on the due date. Thirty days after thedue date, the trustee is entitled to institute theassignment process. If a mortgage note defaultoccurs prior to projected completion, the trusteefiles a claim for mortgage insurance benefits basedon the FHA’s initial endorsement of the mortgagenote. The FHA may process the claim in either oftwo ways:■ The FHA may require the trustee to turn overthe remaining construction fund balance. In thiscase, the FHA’s payment of benefits is based on252 Standard & Poor’s Public Finance Criteria 2007

FHA Insured Multifamily Mortgagesthe full principal amount of the mortgage noteas initially endorsed.■ The FHA may instruct the trustee to retain theremaining balance in the construction fund. Inthis case, payment of benefits is based on mortgageloan advances made prior to the date of thedefault. The trustee should convert all LOCs tocash as soon as possible after the mortgagor’sdefault. The remaining balance in the constructionfund should not be used for bond redemptionsuntil the trustee has received instructionsfrom the FHA about the disposition of thesefunds. To ensure that the FHA issues instructionsin a timely manner and to minimize reinvestmentrisk, Standard & Poor’s suggests that the indenturemake certain requirements of the trustee.The trustee should notify the FHA that, uponexpiration of the construction fund investmentagreement, the construction fund balance wouldbe applied to the redemption of bonds. However,the FHA can request that the trustee deliver theundrawn balance of the construction fund if thetrustee is notified not less than 30 days prior tothat date.The following procedures in the indenture willinstruct the trustee if a monetary default occurs andis not cured by the mortgagor within the 30-daygrace period:■ Once entitled to file a claim for mortgage insurancebenefits, the trustee immediately notifies theHUD area office in writing that an event ofdefault has occurred. Simultaneously, the trusteenotifies the HUD central office that it intends tofile a claim and will assign the mortgage to theFHA. At the same time, the trustee notifies theFHA that the assignment relates to a projectfinanced with rated bonds and is entitled to priorityprocessing. A schedule of bond paymentsand funds available to (including a statement ofall reserve fund balances) make such payments isincluded in the notice. In addition, the trusteerequests payment of the insurance benefits incash, if applicable. Standard & Poor’s receives acopy of each notice.■ The trustee immediately requests forms andinstructions relating to the assignment of themortgage. The trustee submits legal documentationwithin five days of receipt of the forms andinstructions to HUD’s Office of General Counselfor review. HUD requires the submission of acopy of the bond trust indenture or bond resolutionand a bond trustee statement of all reservefund balances accompany the claim. The trusteecommences completion of fiscal documentationin consultation with HUD’s Office of Finance &Accounting. The trustee should submit this fiscaldocumentation and any additional legal documentationfor review as soon as practically possible,no later than 30 days after recording theassignment of the mortgage loan.■ Within 30 days thereafter, or any shorter periodrequired by the FHA, the trustee files its applicationfor insurance benefits and assigns the mortgageloan to the FHA on the recordation date setby FHA.■ Within 30 days of recording the assignment ofthe loan to the FHA, the trustee submits completeand accurate legal and fiscal documents tothe FHA.■ The trustee may not foreclose on the mortgage.The trustee should pursue the assignment processin accordance with the above timetable, even ifthe indenture contains a mortgage note cure provisionthat allows an additional time for themortgagor to bring the mortgage loan current. Inaddition, any workout procedures should notconflict with the assignment process.The FHA requires mortgagees on projects subjectto HUD Mortgagee Letter 87-9 dated Feb. 20,1987 to request a three-month extension (the initialperiod) of the time to file an insurance claim if themortgage default occurs during the prepaymentlockout or penalty period. This is intended to allowthe mortgagee to effect a workout in lieu of assignment.Standard & Poor’s expects the trustee to proceedwith the assignment process simultaneouslywith any workout so that in the event a workout isdeclared infeasible, the mortgage is assigned toFHA in a timely manner. In this case, the documentsshould indicate that the trustee would follow,in addition to the steps above, the procedure outlinedbelow:■ On becoming entitled to file a claim, the trusteenotifies the HUD area office of the default.Simultaneously, the trustee files a request with theHUD central office for a three-month extension tofile a notice of intention and election to assign theloan (with a copy to Standard & Poor’s).■ The notice of default, as well as any communicationsto the HUD central office, includes aschedule of bond debt service payments indicatingfunds available to (including a statementof all reserve fund balances) make the paymentsand requests priority processing. Inaddition, the trustee immediately requestsforms and instructions relating to the assignmentof the mortgage.www.standardandpoors.com253

Housing■ The trustee submits documentation as describedin the procedure outlined above.■ If 30 days prior to any interest payment date onthe bonds the trustee determines that sufficientmoney will not be available to make the payment,it notifies HUD and requests immediatepayment of mortgage insurance benefits in cash.■ If at any time during the extension period thetrustee determines that a workout is infeasible, itimmediately requests HUD to make such a determinationand submits notification of intentionand election to assign the mortgage to the HUDcentral office.■ In no event does the trustee consent to any workoutagreement or any adjustment or revision ofthe mortgage insurance contract without priorwritten confirmation of the rating fromStandard & Poor’s.■ The trustee does not request an extension of theinitial period unless the trustee receives writtenconfirmation of the rating from Standard &Poor’s. If the conditions for further extension arenot met, the trustee immediately submits notificationof intention and election to assign the mortgageto the HUD central office. If the above stepsare followed, the trustee should be in a positionto record the assignment of the note.The financing documents should be clear thatfull processing be pursued in all workout situations.Another example of a workout is pursuantto Section 207.258(b) of the HUD Regulations,under which mortgagees have the option ofaccepting a partial claim payment in lieu ofassignment. Under this program, the FHA recaststhe mortgage into two loans: a first mortgage loaninsured by the FHA, and a second uninsuredmortgage loan held by the FHA. The FHA areaoffice determines the amount of the first mortgageloan, based on the debt service that the project’sestimated net operating income can support. Thesecond mortgage, negotiated between the projectowner and the FHA, is the difference between theoutstanding balance of the original mortgage loanand the recast first mortgage loan. HUD regulationsallow that pursuing the partial claim optionwill not prejudice the mortgagee’s right to file forfull insurance benefits and allow extension of thetime to file for full insurance.Procedures for processing of claims for projectssubject to the 87-9 letter should be followed, withone exception. Extensions to file a claim notexceeding three months (or such shorter periodrequired by the FHA) should be requested only onthe trustee’s decision to pursue a partial claim paymentor other workout option. FHA regulationsallow for a mortgage note cure to take place upuntil the date of assignment. To ensure that bondcash flow is not jeopardized, the indenture shouldcontain language providing for full payment of alldelinquent accounts and lost investment earnings,and verifying the ongoing financial feasibility of thebond issue.Following commencement of the assignmentprocess, the trustee should draw on the reserves onthe next bond debt service payment date in anamount sufficient, together with mortgage revenuesreceived prior to the default, to pay debt servicedue on that date. Funds covering the 1% assignmentfee should be used to redeem bonds no laterthan on assignment. Documents should clearly statethat a mortgage default should in no event trigger adefault on the bonds.Standard & Poor’s assumes that, within 12months of the default, the trustee will receive: mortgageinsurance benefits equal to 99% of the principalbalance of the mortgage note as of the date ofdefault, and accrued interest on the mortgage principalfrom the date of default to the date of paymentat the applicable FHA debenture rate. Asdescribed above, the FHA may pay mortgage insuranceproceeds in two installments.Immediately after receiving payment from theFHA, the trustee uses the mortgage insurance proceedsto redeem bonds. The trustee must carry outthe redemption at the earliest practicable dateallowed by the “Notice of Redemption” section ofthe indenture. Once in receipt of full mortgageinsurance benefits, the trustee uses these funds plusthose remaining in the DSRF to redeem bonds.Trustee and servicerTo help ensure that FHA procedures are pursueddiligently, the indenture and servicing agreementshould require the trustee and the servicer to beFHA-approved mortgagees. Such status should bemaintained throughout the life of the issue. In addition,the indenture should state that the trustee cannotresign without the appointment of a qualifiedsuccessor trustee, and that the trustee will assumeservicing responsibilities temporarily if the serviceris removed, resigns, or is unable to perform hisduties as servicer. Standard & Poor’s should benotified in the event that a successor trustee or serviceris appointed. The trustee or issuer should useits best efforts to put a successor servicer in place assoon as possible.Standard & Poor’s recommends that the servicerand the trustee be unaffiliated so that there is noproblem in allocating responsibility.The servicing agreement should state that the servicerwould forward the mortgage revenues to thetrustee immediately, but no later than three business254 Standard & Poor’s Public Finance Criteria 2007

FHA Insured Multifamily Mortgagesdays after receipt. The servicer should invest allmonies held by it in accounts fully insured by theFDIC. Amounts in excess of the insurable amountshould be remitted immediately to the trustee.Under no circumstances should the servicer holdany receipt longer than three business days. Thislimits the exposure of lost interest income on themortgage revenues.Because of the increased responsibilities ofFHA-insured mortgagees, Standard & Poor’s looksfor evidence from the trustee or HFA concerningthe following:■ Experience and track record with FHA-insuredmortgage loans;■ Methodology in tracking the progress of theassignment process; and■ Consultation at the time of default with legalcounsel expert in the field of FHA-insured mortgageloans.Issuer and trustee familiarity with FHA regulationsand procedures and understanding of theindenture provisions relating to the trustee’s actionsin the event of a mortgage loan default are criticalto protecting bondholders’ interest in a mortgagedefault scenario.Standard & Poor’s has developed a questionnairefor reviewing the qualifications of trustees and HFAsparticipating in FHA-insured transactions. The questionnaireaddresses specific areas of concern thathave arisen in actual mortgage default cases.Fees and compensationOngoing ordinary fees and compensation (typicallythose of the trustee and servicer) are to be capped inthe indenture and subordinated to bond debt service.Gross monthly mortgage payments and investmentearnings on bond funds can support ongoing fees.Sufficient coverage of documented fees should beshown in the cash flows. All fees should be a percentageof outstanding mortgages or bonds, and theadequacy of all fees should be verified. Some issuersprefer to set fees at fixed dollar amounts. In thiscase, documents should provide that fees are ratablyreduced proportionate to a reduction in the principalamount of the mortgage note due to prepayments orother unscheduled reductions. In addition, extraordinarytrustee fees should be covered at all times, particularlyprior to releasing funds from the program,except for redemptions. They also should be coveredbefore reduction and release of all credit supports,except for negative arbitrage. Such fees should besufficient to cover for legal and administrative feesand expenses incurred during default proceedings.The documents should provide for the trustee’saccess to these fees in a mortgage default scenarioand cash flows should show the availability of suchfees in the carry forward balance.Redemption provisionsStandard & Poor’s will review redemption provisionsin the mortgage note and trust indenture forconsistency and to ensure that the mortgage noteand bond payment schedules remain in balance.Mandatory redemptions are needed to address cashinflows due to mortgage prepayments and insuranceproceeds. Standard & Poor’s looks forredemptions resulting from:■ Monies remaining in the construction fund, onfinal endorsement, to the extent that the mortgagenote is less than the initially endorsedmortgage;■ Proceeds received from casualty or hazard insuranceor a condemnation award not used by themortgagor to repay or restore the mortgagedproperty;■ FHA insurance proceeds received after filing aclaim on a mortgage note default, includingaccrued interest paid on the claim, and the principalamount of debentures on their maturity;■ Monies in any mandatory sinking fund;■ Monies available from the ratable reduction ofthe debt service reserve fund when applicable.If optional redemptions are permitted in themortgage note, the trust indenture should include acorresponding redemption. If redemptions areincluded for excess monies remaining in the revenuefund on each bond payment date, Standard &Poor’s will look to see that bond cash flows reflectthe redemption. The trust indenture should includecoverage of all shortfalls, including any mortgagepayment lags provided in the bond cash flows. Suchredemption should also provide that at least a$10,000 carry-forward amount ($5,000 for issuesof less than $1 million) remain in the revenue fundsubsequent to release of excess funds.In almost all cases, a proportional reduction indebt service (strip call) is necessary when thebond structure provides for more than one termbond, current interest serials, capital appreciationserials, or mandatory sinking fund term bonds.In all cases, the indenture should provide for aspecified redemption notice period. All redemptionsfrom prepayments and mortgage insuranceproceeds should be at the earliest date practicable.A possible exception is for optional prepayments,if provisions are made for coverage ofaccrued interest to the date of redemption. In anyevent, sufficient accrued interest to the date ofredemption should always be included in theredemption payment.www.standardandpoors.com255

HousingCash Flow AnalysisStandard & Poor’s analysis of cash flow projectionsfor FHA-insured financings addresses two issues:cash flow sufficiency and consistency of documentedrepresentations with those made in the cash flowprojections. The cash flow runs demonstrate thatthe mortgage revenues and interest earnings generatedby the transaction are sufficient to meet scheduleddebt service payments on the bonds and fees.Cash flow analysis should include information onthe expected revenue stream and the anticipatedbond structure. This information comes from severalstatements and schedules, as follows:Assumptions statementThe assumptions statement should include the datesfor the initial FHA endorsement, commencement ofmortgage note amortization, and the first principaland interest payments on the bonds. It also shouldinclude relevant interest rates for the bonds (includingthe true interest cost), investments, the mortgagenote, and the applicable FHA debenture ratefor the property. The amount of one month’s principaland interest on the mortgage note and whetherthe cash flows are lagged.The last piece of information on the assumptionsstatement should be a table of sources and uses offunds as of the closing date. All sources of funds,including bond proceeds, accrued interest, premiums,and cash contributions, should be itemized.This table also should outline the amounts depositedto the construction fund, the debt service reservefund, the mortgage reserve fund, and the revenuefund at bond closing.Cash flow schedulesAfter reviewing all of the input assumptions,Standard & Poor’s analyzes the “base case” cashflow run, which assumes the mortgages and bondsreach scheduled maturity without any prepayments.The bond debt service schedule should clearlydefine maximum annual debt service, consisting ofthe total of the highest two consecutive semiannualperiods, so that Standard & Poor’s can computedebt service reserve fund sufficiency.A mortgage amortization schedule should be included,which demonstrates the monthly payment schedulefrom commencement of amortization to maturity.The revenue schedule is a compilation of informationpreviously generated in other schedules.Total revenues add up mortgage revenues, constructionfund earnings, investment earnings on allfunds, and other contributions.The cash flow summary and the asset-to-liabilityparity schedule also consist of information generatedin prior schedules. The cash flow summary istotal revenues minus total fees and expenses minusdebt service payments for each semiannual period.If documents provide for fees set at a fixed dollaramount, which are not proportionately reduced forprepayments, Standard & Poor’s will request astress run. The run must demonstrate that if a prepaymentof 90% of the mortgage note occurred,debt service on the bonds and the full set dollaramount of the fees are paid in full from remainingrevenues. In evaluating the cash flow simulations,Standard & Poor’s ensures full coverage of debtservice and fees. If a positive balance exists at theend of each period, then there is sufficient cashflow coverage. Some issues provide for release ofexcess monies at the end of each payment period.In such an open flow of funds, these monies mustbe shown in the cash flow summary as leaving theissue or not carried forward and counted as revenuesin the subsequent period. Extraordinarytrustee fees must be provided for as described earlier.In addition, a carry forward balance of $5,000-$10,000 should be provided.The asset-to-liability parity schedule divides totalassets (the outstanding mortgage balance, reservefunds, plus all excess fund balances) by total liabilities(the dollar value of all outstanding bonds).Unless the 1% assignment fee is covered separately,the issue always should be at 101% or greater parity,if 100% of the outstanding mortgage balance isused in this calculation. If 99% of the mortgagebalance is used, 100% or greater parity is acceptable.Assets used to cover other shortfalls, such asthe one-month’s interest not covered by the FHA ina default situation and extraordinary trustee’s fees,should not be included as assets.Cash flow simulationsIn new construction or substantial rehabilitationtransactions, cash flow simulations should simulatea worst-case draw scenario, in other words, theleast favorable time for drawing on the constructionfund to originate the mortgage. The interestrate earned on the construction fund is comparedwith the mortgage rate during construction. If theconstruction fund rate is less than the mortgage rateduring this period, cash flows should show themortgage being funded at the latest possible date.This is referred to as a slow draw. The drawdowndate under a slow draw is one month before thecommencement of note amortization. A slow-drawscenario allows Standard & Poor’s to verify that,should construction delays occur, the trustee hassufficient monies to pay regularly scheduled bondpayments and to redeem all bonds in the event of anonorigination of the mortgage note.If the relationship between the rates werereversed, with the construction fund rate beinggreater than the mortgage rate during construction,256 Standard & Poor’s Public Finance Criteria 2007

FHA Insured Multifamily MortgagesHFA Risk Sharinga fast-draw scenario would be requested. In a fastdraw, the mortgage would be funded in its entiretyat bond closing. According to this formula, the cashflows will show the least amount of interest earningsor revenues that could be expected before themortgage note is finally endorsed.Debenture Pay ProgramsStandard & Poor’s criteria for debenture pay programsdiffer from the cash program in three ways.First, unlike cash pay programs, debentures aredelivered at one time instead of in two installments.Debentures cannot be expected to be receivedbefore 14 months after default. Therefore, reservesshould be sufficient to cover this time period.Second, in addition to the base case run,Standard & Poor’s reviews a full set of cash flowruns depicting a mortgage note default at specifieddates. The default projections requested are a functionof the bond structure. Ideally, for any structure,Standard & Poor’s would like to receive oneset of cash flows that demonstrate the defaultoccurring at the worst possible time in the life ofthe bonds. If this is not possible, the following conditionsshould be met. If the issue consists of oneterm bond with anticipatory sinking funds, twodefault scenarios should be submitted. One assumesa default at the commencement of note amortization,and the other a default 19 years prior to finalmaturity of the bonds. The second scenario providesfor the bonds to be paid off without the benefitof the maturing debentures. If the issue consistsof multiple-term bonds, serials, or one-term bondwith mandatory sinking funds, cash flow projectionsshould assume a mortgage note default onevery bond payment date.Finally, the FHA pays interest on its debenturesonly on January 1 and July 1 of each year.Therefore, in a debenture payout issue, the bondThe HUD risk-sharing program enables state and local housing finance agencies(HFAs) to act on behalf of the FHA in issuing mortgage insurance commitments onmultifamily housing loans. Agencies share risk with the FHA in return for delegated,as well as customized, underwriting. Although the risk-sharing program requiresreimbursement from participating agencies, the program is a full insurance program,mandating full payment by the FHA before reimbursement.HUD designed the risk-sharing program to enhance timeliness of claims paymentby eliminating the FHA’s traditional claims-paying delays and simplifying theprocess. Paperwork requirements have been reduced, and financial audits are carriedout after the initial claim has been paid. The risk-sharing program allows forclaims to be paid in an amount equal to 100% of the mortgage note, with interestpaid at the mortgage note rate. The FHA mandates that this payment be used toretire bonds within 30 days of receipt. The full accounting process and determinationof the final claim payment, which determines the amounts the agency and theFHA ultimately will pay, take place after bondholders have been paid in full.payment dates should be scheduled to correspondwith the FHA’s payment dates. In addition, cashflows should assume receipt of debentures 14months after the first mortgage payment was duewith interest at the debenture rate paid through theJanuary or July prior to the date the debentures areissued. Subsequent to the first payment, six monthsof debenture interest can be shown on January 1and July 1 of each year.In some circumstances, HUD may indicate inwriting that claims will be paid in cash, as opposedto debentures, or a combination of cash and debentures.As long as the legal structure of the transactionsupports a cash payout, Standard & Poor’s willassume the same. If the possibility exists that paymentcould still be made in debentures for any reason,reserves should be sufficient to cover adebenture payment scenario, and cash flows shouldreflect sufficiency for both payout options.Debenture lockIssuers of tax-exempt debt who financedFHA-insured hospitals and housing projects in ahigh interest-rate environment have used the debenturelock mechanism. Because of tax restrictions,issuers were prohibited from issuing bonds to covercosts of issuance for the refunding bonds, resultingin nonasset bonds.Coverage of non-asset bonds was ensured as aresult of a written agreement entered into prior tobond closing, under which the FHA agrees to payclaims in 20-year noncallable debentures. In somesituations, the debenture lock is only in effect fordefaults occurring prior to the date parity isattained, after which time, claim payment reverts tocash pay. In a default situation, the debenture’sinterest rate, which was set when yields were high,should be high enough to cover the significantlylower interest rate on the bonds.HFA Risk Sharing ProgramThe HFA Risk Sharing Program differs from fullinsurance programs in several key areas that affectthe amount and timing of claims payment, as wellas the claims process. The rating criteria differs inthe following key areas:ReservesBased on FHA regulations and factoring in delaysand permitted extensions, Standard & Poor’s hasconcluded that 180 days’ coverage provided by adebt service reserve fund (DSRF) will be sufficientfor strong issuers to provide an appropriate cushionfor ‘AAA’ rated debt. In addition, cash flows shouldbe run with a 30-day lag in receipt of mortgagepayments. The lag provides the liquidity needed tocover for late payments without triggering a tap onreserve funds. In a default situation, the lag alsowww.standardandpoors.com257

Housingprovides an additional 30 days’ coverage during theFHA’s grace period. Although the loan is in defaultonce the payment is missed, the FHA requires a 30-day grace period before a claim can be filed. Thesereserve levels assume that the agencies file a claimat the latest date permissible under the HUD regulations(unless an extension is granted), which is 75days after default.Additional reserves that may be called for wouldbe for reinvestment of insurance proceeds duringthe call notice period under the bond documents.Also, for bond issues where the DSRF is fundedwith bond proceeds, if the reserve is called on, theexpended portion is no longer earning expectedinvestment income. Depending on when the drawdownoccurs, Standard & Poor’s has found that ashortfall may be created. The shortfall may be offsetby the interest component of the FHA insuranceproceeds. However, since the interest component isbased on the mortgage rate under the risk-shareprogram and not the FHA debenture rate,Standard & Poor’s has found this shortfall morecommon than under the regular FHA insuranceprograms. Sufficient funds need to be available topay bondholders in full assuming that the entirereserve fund is hit. The shortfall can be covered byfunding at bond closing or by review of a full set ofcash flow runs depicting a mortgage note default atspecified dates. Two base cases should be run. Bothcases should default the issue immediately afterfinal endorsement. However, the first case shouldshow receipt of the HUD payment two weeks afterthe default. The second should show HUD’s paymentsix months after the default. The weaker basecase should be expanded by simulating a default onthe first of each month for a one-year period.Additional default runs may be requested for theworst possible time in the life of the bonds, usuallyindicated by low or declining parity. Such defaultsimulations should show the ability to redeem allbonds in full, assuming bond redemption 30 daysafter receipt of benefits.Under the program, HUD permits extensions ofup to 180 days from default upon request.Additional extensions are possible in situationswhere the HFA certifies that a bond refunding ormortgage refinancing is in the works, as well as achange in ownership that will result in a mortgagecure. The simplified claims payment proceduresclearly allow agencies more flexibility in pursuingthese options while keeping bonds current.However, Standard & Poor’s cannot anticipate thata six-month reserve will always be sufficient inthese cases. Therefore, agencies desiring more flexibilityin filing claims should include conditions tofiling extensions in the bond documents. Suggestedconditions should include:■ Determination of the latest date for filing theclaim;■ Verification that reserves or additional depositsare sufficient to pay bonds, assuming that paymentfrom the FHA is received 180 days after thedate of default plus the number of days in theextension period; and■ Receipt of the FHA approval in writing.Assignment processThe assignment process is as follows:■ Notice of default status on multifamily projectsmust be filed within 10 calendar days after dateof default;■ Above form must be submitted monthly untilapplication for initial claim has been filed orHUD waives requirement;■ Application for initial claim payment and paymentinformation form must be submitted within75 calendar days of the date of default;■ Standard & Poor’s should be copied on all formssubmitted to and received from HUD;■ Before accepting partial payment of claim, majoritybondholder approval should be received andnotice sent to Standard & Poor’s;■ Provision for claim payment to be used to redeembonds within 30 calendar days of receipt, withwire transfer of excess funds to HUD 30 daysthereafter; and■ The HFA debenture must be issued within 30days of initial claim payment, or such other dateas approved by HUD.Cash flowsStandard no default cash funds should be providedconsistent with the fully insured FHA program. Inaddition, a default scenario should be provideddemonstrating that bonds can be redeemed in fullshould a mortgage loan default occur on the firstpayment date, assuming a six-month period toreceive insurance proceeds, investing funds forredemption during the notice period, and redeemingbonds on the date set forth in the bond documents. ■258 Standard & Poor’s Public Finance Criteria 2007

Ginnie Mae, Fannie Mae, And Freddie Mac Multifamily SecuritiesGinnie Mae, Fannie Mae, AndFreddie Mac Multifamily SecuritiesStandard & Poor’s Ratings Services rates multifamilyhousing transactions supported by mortgagesguaranteed by Ginnie Mae and GovernmentSponsored Enterprises (GSEs), such as Fannie Maeand Freddie Mac. In these structures, Ginnie Mae,Fannie Mae, or Freddie Mac issue and deliver tothe trustee an MBS in exchange for the mortgageloan. Over the past few years, however, Fannie Maeand Freddie Mac have typically provided their supportin the form of standby and direct-pay creditfacilities rather than MBS. Ginnie Mae continues toissue MBS in the form of permanent loan certificates(PLCs) or construction loan certificates(CLCs) that convert to PLCs for substantial rehabilitationor new construction projects. Mortgage paymentson the MBS, or payments from the creditfacilities, are the principal source of credit protectionfor the bonds and pay debt service and all programexpenses.MBS ProgramsGinnie Mae, Fannie Mae, and Freddie Mac areobligated to make payments under the certificate orcredit facility to the trustee, regardless of whetherpayments are actually made on the underlyingmortgage loans or bonds. Ginnie Mae and FannieMae guarantee the timely remittance of principaland interest on the MBS and credit facilities.Freddie Mac only guarantees timely payment ofinterest and ultimate payment of principal on MBS,with the exception of the Freddie Mac Gold program.Generally, Freddie Mac guarantees that principalon the participation certificate will be receivedwithin approximately one year of the scheduled duedates. This one-year lag in principal must beaddressed by funding a reserve in the issue or laggingall bond maturities by one year. Other alternativesmay be discussed on a case-by-case basis.From a rating perspective, Freddie Mac andFannie Mae programs are very similar in manyrespects to the Ginnie Mae programs outlinedbelow, and the criteria should be used when structuringFreddie Mac and Fannie Mae transactions.With regard to payment receipt dates, Freddie MacMBS are assumed to be received on the 20th of themonth (the 16th if book entry form) and FannieMae securities on the 25th of the month. In GinnieMae programs, payments are assumed to bereceived on the 20th of the month, although GinnieMae pays on the 15th. Standard & Poor’s assumesan additional five-day lag in the cash flows forGinnie Mae MBS, because MBS payments are notmade directly by Ginnie Mae. This is not the casefor Fannie Mae and Freddie Mac, whose paymentsare made directly. There is an additional 30-daypayment receipt delay at the onset of all FreddieMac programs, which must be addressed. Fundingfor these credit shortfalls should be clearly indicatedin the indenture and in the cash flows. (Note:Standard & Poor’s defines a lag as a delay in paymentthat is in addition to the normal arrearage—the time period encompassed from the date oforigination until the first scheduled payment.)Direct-Pay FacilitiesFannie Mae and Freddie Mac provide credit andliquidity support for fixed and floating-rate bonds.Fannie Mae and Freddie Mac cover for preferenceand stay provisions provided under the U.S.Bankruptcy code for funds paid by non-ratedsources. These floating-rate transactions usuallyhave a seven-day variable rate, where bondholdershave the option to tender bonds upon seven days’notice. The GSEs are obligated to make paymentsunder their respective facilities to the trustee in theevent that the mortgage payment has not beenreceived by a certain date. Additionally, the GSEsare obligated to cover the purchase price of tenderedbonds in the event of a failed remarketing.With this bond structure, Fannie Mae or FreddieMac pay the bond debt service directly as if it werethe mortgage loan, much like a direct-pay LOC.Although not an LOC, this facility is similar to abond LOC transaction. In this instance, the trusteedraws monthly on the facility and uses the funds topay debt service on the bonds. Cash flows areunnecessary because payments are received by thetrustee prior to debt service payment dates.Fannie Mae has modified its direct-pay facility toinclude a bifurcation of credit and liquidity expirationdates so that the liquidity support providedunder the enhancement expires 10 years after theeffective date of the agreement.This change introduces the possibility for a tenderoption to occur without the necessary liquiditysupport in place to pay the purchase price of bonds.www.standardandpoors.com259

HousingTo avoid this structural risk, liquidity events suchas mandatory or optional tenders should be scheduledto precede the termination of the liquidity portionof the direct-pay instrument.Fannie Mae and Freddie Mac direct-pay structuresmay include a mandatory tender upon substitutionof an alternate credit facility without ratingmaintenance. This substitution could be problematicin the fixed-rate mode if the liquidity support hasexpired. To resolve this issue, the documents can:■ Limit substitution to the variable-rate modes;■ Provide that the credit facility portion or a liquidityfacility portion will be available to back thetender;■ Indicate that credit facility expiration leads to aredemption; or■ Indicate that substitution can only occur ifremarketing proceeds equal to the full purchaseprice of the bonds are to be on hand for the substitutionto occur, otherwise the credit facilitywill remain in effect or there will be a redemptionof the bonds if the credit facility is scheduledto expire.These suggestions resolve Standard & Poor’s liquidityconcerns that could negatively affect bondholders.Standard & Poor’s will continue toevaluate the direct-pay structure and legal documentsto ensure the necessary provisions are inplace to address this issue.Standby Credit FacilitiesFannie Mae and Freddie Mac provide another typeof credit enhancement on bond issues in the form ofa standby credit facility. In this structure, the GSE isobligated to make payments to the trustee in theamount of the mortgage payment once the paymentis a specified number of days delinquent. Since theGSE agreement does not cover investment earnings,all revenues must be invested in investments rated ashigh as the bonds. In addition, payment of trusteefees must be provided for in a no-default and postdefaultsituation. Similar to the cash flows requiredfor MBS as described below, standby credit facilitytransactions should include cash flows run with alag to take into account the timing of the GSE’s paymentto the trustee, as well as the regular paymentlag on the underlying project mortgage.Ginnie Mae ProgramsUnder the FHA (223)(f) Ginnie Mae coinsuranceprogram, used for rehabilitation and repair of existingmultifamily dwellings, the owner completes thenecessary repairs permitting the issuance of theMBS and obtains a mortgage loan on the projectfrom the lender. At this time, bond proceeds, heldin an acquisition fund by the trustee, are used toacquire the MBS. The Ginnie Mae security securingthe mortgage is assigned to the trustee.The Section 221 (d)(3) and (d)(4) programs (constructionand substantial rehabilitation) and Section232 program (nursing homes) are similar to the 223(f) program, where all bond proceeds are escroweduntil the permanent Ginnie Mae-backed security isacquired. In most 221 and 232 issues, there is aconstruction period in which disbursements aremade, and funds are released periodically from theescrowed program or project fund. (Some 221issues use an outside source for construction, eliminatingthe construction draws.) As the borrowerconstructs the project, disbursement draws arerequested from the FHA. Because the rating isbased solely on Ginnie Mae, no credit is given tothe FHA-insured advance (draw) until it is securitizedby Ginnie Mae. This process of converting theFHA-insured draw into a Ginnie Mae security,called a construction loan certificate (CLC), is performedby the co-insured lender, and takes about20 business days.The CLC bears an interest rate equal to the lowerof the temporary or permanent rate established bythe FHA under the mortgage note. As constructiondraws are made, they are converted into CLCsbearing the same interest rate and maturity. TheCLCs represent full collateralization by GinnieMae, which guarantee timely payment of intereston the 15th of the month and stated principal atmaturity. At the project’s completion and the mortgage’sfinal endorsement, all CLCs are exchangedfor a permanent loan certificate (PLC), which is thelong-term Ginnie Mae-backed security.The mortgagor makes its payments to the lenderon the first of each month. The lender, in turn, passesthese payments through to the bond trustee bythe 15th of that month (in the case of Ginnie Maeprograms), representing payments on the MBS. (Themortgage rate is higher than the rate on the MBS.This differential covers the lender’s servicing fee andthe Ginnie Mae guarantee fee.) If the mortgage paymentsare not paid by the owner, or are insufficientto pay the trustee the principal and interest due onthe MBS, the lender is required to pay the trusteethe amount due from its own monies. If the trusteefails to receive payment from the lender by the closeof business on the 15th, or the 17th if the MBS isheld in book entry, the indenture should require thetrustee to seek immediate payment from GinnieMae. Since Ginnie Mae guarantees timely payment,there is no need for a debt service reserve funds(DSRF) to cover liquidity risk.If the mortgagor prepays all or a portion of itsmortgage, this amount will be prepaid to the lenderand then passed on to the trustee as a prepaymenton the Ginnie Mae security. The prepayment260 Standard & Poor’s Public Finance Criteria 2007

Ginnie Mae, Fannie Mae, And Freddie Mac Multifamily Securitiesincludes principal; premium, if any; and interestaccrued through the last day of the month in whichthe prepayment is made.Ginnie Mae has the option of curtailing orreamortizing the mortgage, although the latter ismore common. For this reason, documents shouldinstruct the trustee to notify Standard & Poor’s of aprepayment so that the rating impact, if any, maybe determined. The financing agreement shouldinstruct the lender to notify the trustee as early aspossible in the month in which prepayment is to bereceived by the trustee. The lender’s notificationenables the trustee to send notice of redemption sothat bonds can be redeemed at the earliest possibledate to avoid any undue reinvestment exposure.The trustee should redeem the bonds in the shortestnotice period provided under the indenture. Thisreduces the amount of time that the trustee has tohold prepayment monies that are not earningenough interest to cover the accruing bonds. Thecash flows should demonstrate sufficient asset coverageduring this time frame.Concerning optional prepayments, the prepaymentpenalty on the mortgage should be seasoned91 days to avoid recapture as a preferential payment.Ginnie Mae may not cover the premium portionto be paid on the bonds in the event that itwould be obligated to pass through the prepayment.This seasoning problem can be eliminatedthrough an issue-specific letter from Ginnie Maestating that it will guarantee the premium portionof the payment on the mortgage. Notice of redemptionon all prepayments should not be made untilthe premium is seasoned.Additionally, prepayment terms on the bondsneed to match the prepayment terms on the mortgage.This avoids the mortgagor making a prepaymentthat cannot be used immediately to callbonds. Redemptions resulting from prepaymentsshould provide that the resulting decrease in debtservice on the bonds is proportional, as nearly as ispracticable, to the decrease in the payments on theGinnie Mae securities during such period. Thismethod ensures that even if a curtailment occursinstead of a ratable reduction of future mortgagepayments, debt service will still be met, as it will bestructured around the prepaid mortgage terms. Thetrust indenture must state that the Ginnie Mae MBSis to be held by the trustee or in the trustee’s nameby the Federal Reserve and that the trustee has afirst perfected security interest in the MBS.MBS Cash FlowsWorst-case assumptions are used when structuringthe cash flows for this program. For constructionfinancing programs, worst case should indicate theleast favorable time from a revenue-generatingstandpoint for drawing on the acquisition fund toacquire the MBS. For example, if the acquisitionfund investment agreement earns less than theMBS, the acquisition scenario should assume deliveryon the latest possible date provided under theindenture. For each day that the MBS is notacquired, more negative arbitrage is created. Themaximum amount of this shortfall should be coveredin one of the following ways:■ Providing an unsecured LOC or cash;■ Selling the bonds at a premium; or■ Using another ratable credit enhancement.The method employed should be defined clearlyin the acquisition section of the indenture and thefinancing agreement.The submitted cash flow simulations should berun using appropriate lags and are expected to havesufficient excess assets to cover for reinvestmentrisk. All fees should be capped and paid from revenuesor interest income, and expensed in the cashflows. If fees are expressed as a fixed dollar amountand not as a percentage reduced over time,Standard & Poor’s will request a 90% immediateprepayment run. This is to ensure that the fixedfees could be paid in the event of a large prepayment.Alternatively, the fees specified in the legaldocuments can be ratably reduced with any prepayments.Expenses for MBS include Ginnie Mae,Fannie Mae, or Freddie Mac fees and lender fees.For a trustee to perform its duties adequately,Standard & Poor’s assumes a minimum fee of threebasis points. A portion of the trustee fees may bepaid outside of the trust estate, however, to theextent the trustee agrees in the bond documents tocontinue to perform regardless of compensation. Ifapplicable, a rebate calculation fee should beincluded at a level consistent with industry standards.Reinvestment exposure is determined by calculatingthe reinvestment shortfall, if any, for theredemption notice period on a full prepayment ofthe mortgage portfolio. This calculation assumesthat the mortgage prepays and is reinvested at thefloat contract rate or Standard & Poor’s reinvestmentassumption, and that the bonds are earning attheir stated interest rate.Commencement of amortization of the mortgageshould be a stated date in the documents and reflectedin the cash flows. Monies may be released onlyafter acquisition of the MBS, debt service and feesare paid, reinvestment is covered, and revenues tomeet the next debt service payment are captured.This release should be demonstrated through anopen flow of funds in the indenture. There should bea minimum carry forward balance in each period ofat least $10,000. A cash flow release test may benecessary on certain issues to ensure that the releaseswill not negatively affect future payment on thewww.standardandpoors.com261

Housingbonds. As a condition of bond closing, cash flowsshould be verified by an independent third party. Thethird party can be a nationally recognized accountingfirm; an expert in the field; or, in some cases, a qualifiedofficer of the state housing agency if applicable.On issues with multiple securities collateralizingseveral multifamily dwellings, the least desirablecash flow scenario should be provided. For example,if the underlying mortgages have varying rates,the mortgage with the lowest rate should be able tosupport the bonds, assuming that all the othermortgages prepay immediately. Lastly, it is crucialthat cash flow projections are consistent with representationsmade in the financing documents.A nondelivery run should be provided. If the securityis not delivered by the last possible acquisitiondate, cash flows must show sufficient funds toredeem the bonds in whole. The redemption fromnonorigination is usually on the date that is 30 daysafter the final acquisition date. To allow flexibilityin the acquisition of the MBS, extensions may beprovided for in the indenture. To ensure that anextension can be completed properly, Standard &Poor’s should receive 30 days’ written notification ofthe anticipated extension. Along with this extensionnotice, updated cash flows should be supplied alongwith supplemental documents, including the investmentagreement. The documents should indicate theextended call date 30 days after the new deliverydate in the event that a nondelivery is to take place.The same criteria for note amortization extensionsin FHA programs apply to all the MBS programs.To avoid the final payment being passed throughto the trustee after maturity of the bonds, themortgage should mature at least one month priorto the final bond maturity. Lastly, if a premium ispaid on the bonds to fund any shortfalls createdthrough the acquisition period, and if any partieshave a residual interest in that premium, the properlegal opinions may be necessary. For cash contributionsand LOCs, Standard & Poor’s may requestlegal opinions. ■Unenhanced AffordableHousing Project DebtStandard & Poor’s Ratings Services defines unenhancedaffordable housing projects (AHPs) as public-purposereal estate supported by below-marketrents. While many AHP transactions are structuredwith credit enhancements, unenhanced AHPs arestructured and rated based on the strength of the realestate to support debt service on the bonds. AHPtransactions may receive a variety of public supportand may have varying rent and residency restrictions.These include Federal subsidies, such as Section 8 andSection 236, as well as military housing allowances inprivatized military housing transactions.Many public purpose properties are economicallyviable even without Federal subsidies through theLow-income Housing Tax Credit Program, taxexemptbonds, exemption from real estate taxesand creative financing techniques. The unenhancedaffordable housing project debt criteria, does notapply to projects that will only be partially publicpurpose, or can convert to market rate during thelife of the bond issue. Transactions with these latterattributes are typically rated by Standard & Poor’sCommercial Real Estate Group. The analysis ofbonds backed by real estate focuses on real estatequality, legal structure, bond structure and reserves,and construction and lease up risk.Real Estate QualityStandard & Poor’s assesses the quality of the realestate to judge its ability to attract targeted tenancy,compete with nearby properties, maintain structuralsoundness and remain financially feasible. Theanalysis is based on:■ A site review;■ Measures of financial feasibility;■ Depth and strength of subsidies, if any;■ Market Analysis■ Property management;■ Ownership;■ Insurance, and environmental concerns.Site reviewThe site review focuses on the attractiveness andcondition of the property, and its comparabilityand competitiveness within the market. Based on asite visit, Standard & Poor’s assigns a rankingfrom “1” to “5”, with “1” indicating new highendmarket rate housing quality, and “5” indicatinghousing in bad physical condition, withphysical obsolescence. A ranking of at least “3” istypically necessary for investment grade ratings.The review consists of the following:262 Standard & Poor’s Public Finance Criteria 2007

Unenhanced Affordable Housing Project Debt■ Exterior—includes the exterior of the building,parking lots, landscaping, and sidewalks;■ Interior—includes lobbies, reception areas, hallways,apartments, health and recreational facilities,laundry facilities, and on-site management office;■ Deferred maintenance—overall assessment ofexterior and interior of the project. Examples ofdeferred maintenance would be potholes in pavementand sidewalks, peeling paint, leaking roofs,structural problems, and outmoded facilities;■ Location—includes an analysis of the neighborhood,the project’s compatibility with the neighborhood,and accessibility to essential services,such as hospitals, schools, post office, playgrounds,churches, public transportation, roads,and highways;■ Economy—includes an analysis of employmentsectors, economic diversity, population changes,income levels, and unemployment rates;■ Market and demand—includes comparabilitywith nearby properties, analysis of local vacancyrates, rent trends, occupancy rates, and absorptionrates;■ Tenancy—the quality and nature of the tenantbase is a critical part of analyzing real estatequality. Income levels and elderly or family tenancyare two critical aspects of assessing the tenantbase; and■ Environmental and hazard—includes analysis ofthe impact of potential environmental and hazardconcerns, such as earthquake and flood risk,nearby hazardous substance sites, and presence ofradon, PCBs, and asbestos.Third party reportsStandard & Poor’s will review independent third-partyreports as part of the rating process. These reportsshould be provided before the site visit, if available.Property condition reportsStandard & Poor’s reviews property conditionreports for all transactions. These reports are necessaryto determine that the project has an economiclife that exceeds the term of the bonds and to determinethe level of deferred maintenance that must befunded at bond closing to correct major propertycondition defects. Property condition report criteriacan be found on RatingsDirect under Criteria-Structured Finance, and at www.standardandpoors.com(look under Structured Finance Criteria,CMBS Property Evaluation Criteria).Environmental reportsEnvironmental reports help determine if there areenvironmental issues relating to the subject properties.These reports must be completed within six months ofthe closing of the transaction, and comply with theStructured Finance Environmental Report Criteria.These criteria can be found on RatingsDirect underCriteria-Structured Finance, and at www.standardandpoors.com(look under Structured Finance Criteria,Environmental Criteria).Appraisals/market studiesThe appraisal for an AHP transaction should be acomplete self-contained appraisal prepared by anindependent appraiser who is MAI certified and beprepared in accordance with the Uniform Standardsof Professional Appraisal Practice (USPAP) of theAppraisal Standards Board (ASB). The appraisalshould be commissioned by the owner of real estatein a refinancing transaction or by the purchaser inthe event of an acquisition financing. The appraisalshould state that the purpose of the appraisal is forthe purpose of valuing the property for use in conjunctionwith the proposed financing.The market study may be prepared by a MAIappraiser in conjunction with an appraisal of theproperty. The purpose of the market study is toprovide sufficient information for Standard &Poor’s to determine if the project will continue togenerate sufficient net cash flow to service thebonds being rated by maintaining projected occupancyand projected rents. The market studyshould, specifically, seek to provide specific informationfor the market for which the property isintended to serve, such as, low or moderate incomefamilies or elderly persons. The market studyshould address this issue by examining existing andanticipated demand for the specific housing marketand existing and potential supply of housing unitsto meet this demand.Financial feasibilityAnalysis of the financial feasibility of a projectinvolves an examination of historical and pro formafinancial statements to determine the adequacy of revenuesand cash flow to cover payment of debt service,funding of reserves, and operating and maintenanceexpenses. Standard & Poor’s considers debt servicecoverage (DSC) to be the most valuable financial yardstickin evaluating AHPs. Adequate DSC is needed toinsulate the property from such problems as risingexpenses, static rent levels, and high vacancies.Standard & Poor’s defines DSC ratio as annual netoperating income divided by the maximum annualprincipal and interest payments. In reviewing DSC,Standard & Poor’s will look for a scenario in whichno increases in rents or expenses are assumed, as wellas other stress cases that will be determined on a caseby-casebasis. Each income and expense item is verifiedwith three years of audited financial statementsand through the operating history of the project.www.standardandpoors.com263

HousingStandard & Poor’s reviews each item and mayadjust them to account for inconsistency with comparableproperties, to reflect the project’s trackrecord, to address aberrations in costs, or to providea more stressful cash flow test when needed.Standard & Poor’s will always assume propertymanagement fees in reviewing for appropriate DSClevels. Market management fees will be assumed forowner-managed properties. Standard & Poor’sallows for underwriting expenses with a fair andreasonable property management fee above the line(that is, before debt service), and the trust indentureshould provide for the payment of market rate andreasonable third-party management fees (which isusually 4%-5%, depending on the market), in theflow of funds before debt service.Although property managers may initially agreeto subordinate some or all of its management feesto debt service payments in the trust indenture flowof funds, there is no assurance that future propertymanagement firms will abide by these agreements,and likely assess a market rate fee. As such, allmanagement fees should be calculated above theline. Standard & Poor’s will always assume a propertyreserve for replacements in calculating net cashflow and will typically rely upon the independentProperty Condition Report to provide guidance onthe adequacy of reserves.Reserve for replacements will be assumed to bethe higher of, the levels outlined in the propertycondition report, or the following minimum levels:■ $250 per unit per year for properties that are lessthan 10 years old;■ $250 to $275 per unit per year for propertiesthat are 10 to 15 years old; or■ $325 to $350 per unit per year for propertiesthat are 15 to 20 years old or older.Standard & Poor’s views the loan to value (LTV)ratio as a secondary risk indicator. The highestacceptable LTV ratios will be for properties owned bystate and local HFAs or Public Housing Authorities(PHAs) with experience in affordable housing, or forFederally subsidized properties. Lower ratios may beapplicable where the public purpose nature of theownership is less established, as with a start-up nonprofitor a for-profit entity, or where liquidation ofthe property is a factor in the rating.Depth and strength of subsidiesRental and interest rate subsidies have a directimpact on project affordability, tenant characteristics,demand, and quality of real estate, amongother things. The presence of such subsidiesrequires an analysis of the depth, duration andmechanics of the subsidies as well as terminationrisk. The two major subsidy programs, Section 8and 236 are discussed in Public Finance Criteria:Federally Subsidized Housing Programs.Pledges from local municipal entities that subsidizeproject income and that are used in calculatingDSC (such as tax increment funds) must come fromrated entities in order for the transaction to be consideredfor ‘BBB-’ or higher ratings.Market analysisStandard & Poor’s analysis of multifamily propertiesalso takes into consideration economic anddemographic information concerning the market inwhich a property is located. Standard & Poor’splaces particular emphasis on information availablefrom a number of sources, including the marketstudy or appraisal commissioned for the financing.The market study or appraisal includes demographicand economic information in the area of the subjectmarket, along with vacancy and rent trends.Standard & Poor’s also utilizes independent marketinformation, for market information such as vacancyrates and rent trends. These independent reportsalso provide Standard & Poor’s with informationon competitive projects in the subject area, allowingfor a comparison of the property’s performance tothe actual sub market. In addition, Standard &Poor’s obtains independent economic informationto supplement the market study/appraisal.Standard & Poor’s also analyzes income andexpenses utilizing independent third party information.These reports provide information onincome and expense trends by metropolitan areaand multi-family apartment type. This marketinformation assists Standard & Poor’s in theanalysis of the financial feasibility of the projectand the underwriting.Property managementEfficient and effective management is necessary toensure the financial feasibility of the property. At thetime of the site visit, Standard & Poor’s interviewsthe property manager to review experience andtrack record, all aspects of day-to-day project operations,and overall operating strategy, including:■ Handling of day-to-day maintenance and preventivemaintenance program;■ Tenant rent collections and procedures to handledelinquencies and evictions;■ Turnover time for vacant units;■ Marketing plan and maintenance of waiting lists;■ Leasing abilities and lease renewal strategies;■ Accounting procedures to determine cash managementability;■ Regularity of property inspections;264 Standard & Poor’s Public Finance Criteria 2007

Unenhanced Affordable Housing Project Debt■ Management reporting and control procedures todetermine ability to recognize and correct potentialproblems quickly;■ Past performance reviews for subject property, aswell as for other properties under management;■ Annual operations and long-range capitalimprovement plan;■ Budgeting process and rent increase strategy;■ Communications with owner and tenants;■ Maintenance of social services appropriate fortenant population; and■ Ability to analyze changing market conditionsand diagnose problems and implement solutionsas needed.Ongoing financial and management reviews by aqualified asset manager are a critical aspect of thecontinuing financial viability of property-specificbond transactions. The nature of the oversightvaries, depending on the relationship between theowner, issuer, and property manager, as well as theorganizational structure and experience of each ofthe parties involved.Some local HFAs or PHAs are well equipped tomanage the properties they own without additionaloversight. Where the owner is relatively inexperienced,an experienced state or local HFA or PHAscould provide an acceptable level of oversight.Local HFAs or PHAs that own properties managedby a professional management company shouldhave systems in place for ongoing reviews.The following minimum oversight responsibilitiesreflect an effective level of extra protection forAHPs. Oversight responsibilities should be clearlyoutlined in a written plan that is part of the legaldocumentation:■ Regular basement-to-roof site visits, no less thanannually, including unit-by-unit inspections;■ Annual in-depth reviews of management procedures;■ Monthly budget checks, occupancy reports, anddelinquency checks;■ Review of audited financial statements;■ Control over release of excess funds;■ Ongoing monitoring of reserve funds andrequired sign-offs for use of funds; and■ Review of preventive maintenance program andadequacy of capital expenditures plan.OwnershipThe nature of the project’s ownership is an importantelement in rating AHPs for several reasons.First, since the rating approach gives credit to thepublic-purpose nature of the financing, it is importantto establish the public-purpose nature of theownership. What is the owner’s commitment tomaintaining the project at affordable rent levels?Generally, PHAs, HFAs, and nonprofits most easilyfit the description of public purpose. For-profitownership is less likely to make the same type ofrepresentations regarding the future of the project.However, for-profit ownership could be acceptablefrom a rating standpoint if the public purpose wasfirmly established through legal documentation,such as a regulatory agreement. In addition to public-purposededication by the owner, Standard &Poor’s looks for asset management and debt compliancecapacity. Multifamily ownership and experienceand financial strength are the two easiest waysto demonstrate affordable housing ownershipcapacity. With regard to real estate ownershipstructures, fee ownership and leasehold positionsare both acceptable; however, transactions withground leases must meet Standard & Poor’s realestate ground lease criteria.The second rating concern in reviewing the ownershipof the project (as well as the issuer of thebonds) relates to the potential for bankruptcy.Where the owner and the issuer are unrated, orrated lower than the bonds, Standard & Poor’s analyzesthe legal structure of the ownership, as well asthe structure of the bond issue, to evaluate thepotential for bankruptcy. Three entities that typicallymeet Standard & Poor’s standards for bankruptcyremoteness are municipalities, certain nonprofitor eleemosynary institutions, and special-purposecorporations.The potential for voluntary and involuntarybankruptcy will be assessed through an analysis ofthe legal organization of the ownership, the essentialityof its services, its need to access capital marketsand the purpose of its business, as well as legalopinions and the legal structure of the bond transaction.Insurance, and environmental concernsSince the collateral in a mortgage-backed debttransaction is tangible, it is subject to physicalimpairment or loss. Standard & Poor’s will reviewall potential hazard, special hazard, casualty, andenvironmental risks to the property through its siteinspection, and through structural engineering, specialhazard, and environmental reports, as describedpreviously. All potential exposures should be coveredthrough reserves or insurance policies. Typicalinsurance policies on rated transactions include fireand casualty, boiler and machinery, business interruption,earthquake, flood, liability, condemnation,and environmental insurance.A title update also should be provided as part ofthe rating package, as well as the certificate of titleor the title policy. Exclusions are reviewed carefullyto determine the impact, if any, on the rated debt.www.standardandpoors.com265

HousingQualified insurers For investment grade ratings,the rating of the insurance providers typically havea rating by Standard & Poor’s of not less than‘BBB-’. All insurance requirements are to be maintainedfor the life of the financing and the trustindenture should incorporate language outlininginsurance guidelines.In addition, the trustee should be named as themortgagee on all insurance policies relating to themortgaged property and the policies must have acancellation endorsement that the policy cannot becanceled or materially altered without giving 30days notice to the trustee.Property casualty coverage The property insurancecoverage provided must be at least equivalentto the “Special Cause of Loss” form, including coveragefor steam pressure explosion, flood and earthquakelosses, with valuation of the mortgageproperty based on replacement cost. The replacementcost option must include the additional costsassociated with “civil or ordinance of law” requirements.The amount of coverage provided might notbe less than the actual amount required to replacethe mortgage property in the event of a maximumpossible loss. It is the Borrower’s responsibility toprovide evidence of the maximum possible loss thatmay result from catastrophic perils insured against.The insurance may not be subject to restrictions orlimitations in coverage of any kind, which resultfrom the mortgage property being insured togetherwith mortgaged property not securitized. All insurancepolicies must include an agreed amountendorsement and co-insurance must be waived. Allexclusions not standard and customary to theindustry are subject to Standard & Poor’s review.Business interruption insurance This insurancemust provide loss of income protection resultingfrom direct physical loss to the mortgaged propertyand indirect loss which may significantly jeopardizerevenue, with limits of liability sufficient to sustainexpected income in respect of the mortgage propertyhad the loss not occurred In no event should therental loss provision be in an amount less than theannual rental income of the project. Co-insurancepenalties must be waived or completely avoided.Liability coverage The Borrower should maintaincommercial general liability and umbrella coverageand limits of liability that are customary to multifamilyreal estate and which adequately protects theinterest of the borrower and trustee, on behalf ofthe holders of the rated securities.Workers compensation and statutory coveragesThe Borrower must carry worker’s compensationinsurance as required by law, along with adequatelimits of employer’s liability, if applicable. In addition,all other insurance coverages that the borroweris or may be required to carry by law should beprovided.Boiler and machinery Comprehensive boiler andmachinery coverage is required on all mechanicalequipment that would cause a disruption in revenueif rendered nonoperational. The coverage providedshould cover direct losses and consequential lossesthat could materially jeopardize revenue.Legal StructureThe legal structure of the bond transaction is subjectto the Standard & Poor’s U.S. CMBS Legal andStructured Finance Criteria located on www.standardandpoors.com.Some highlights pertaining to real estate transactionsare:■ Security must include a mortgage, with first-lienposition in favor of the trustee and a net revenuepledge;■ Open flow of funds from the indenture will beevaluated on a case-by-case basis. Transactionswith strong properties and very strong ownersmay be rated investment grade with a open flowof funds with no release test or a release test thathas a lower debt service coverage level than thepro forma debt service coverage. Transactionswith weaker properties and/or weaker ownershipstructures should open flow tests at the proforma debt service coverage levels in order to beconsidered for investment grade ratings. Paymentof subordinate debt also is subject to open flowrequirements; Standard & Poor’s should receivenotice of the following events; extension ofacquisition period, partial mortgage prepayment,defeasance or discharge of the indenture, newinvestment agreement provider, impending sale ofcollateral or transfer of control of the single purposeentity, appointment of successor trustee, andsupplements or amendments to the bond &mortgage documents;■ Subordinate debt is acceptable, only if it is a nonforeclosablecash flow mortgage, which prohibitsany remedial action; and■ Investments should not adversely affect the ratingon the bonds.Ground leasesTransactions with ground leases must meetStandard & Poor’s real estate ground lease criteria.Under a ground lease, the lessor continues to ownthe land on which the improvements are locatedand leases it to a tenant, which is the borrower orowner. Standard & Poor’s will review the groundlease to assess whether adequate lender protectionsexist. In addition, the landlord should grant the266 Standard & Poor’s Public Finance Criteria 2007

Unenhanced Affordable Housing Project DebtProject Evaluationstrustee a right to cure the borrower’s default underthe ground lease. This gives the trustee the abilityto prevent a termination of the ground lease. Thereal estate ground lease criteria, can be found in theStandard & Poor’s U.S. CMBS Legal andStructured Finance Criteria located on www.standardandpoors.com.Bond Structure And ReservesBond structures typically incorporate fully amortizingdebt In addition, this debt can have bond maturitiesof up to 30 years, as long as the engineeringreport and site review indicate the structural soundnessof the property for the bond term, and appropriatereserves are set aside for ongoing preventivemaintenance and capital improvements.Generally, Standard & Poor’s will look for a debtservice reserve fund (DSRF) equal to maximumannual debt service on the bonds, which may befunded with bond proceeds. Exceptions would bewhere an acceptable servicer agrees to make servicingadvances in the event of temporary debt serviceshortfalls. Extremely high DSC may also providesufficient liquidity to obviate the need for a separatereserve. Monies for the debt service reservefund should be invested in investment grade securities(‘BBB-’ or higher), and be available to pay debtservice in the event of a shortfall.The cash flows should incorporate a 30-day lagon mortgage payments. Adequate reserves shouldbe initially set up and maintained in accordancewith the ongoing preventive maintenance andreplacement schedule indicated by management andconfirmed with a structural engineering report.Additional reserves may be necessary to bring theproperty up to environmental standards. MortgageStandard & Poor’s evaluates the property and the management and assigns aproject ranking from “poor” to “excellent. This ranking is a major determinant inthe final rating. Standard & Poor’s project evaluations are based on information inthe rating process, as well as the on-site property and management review.The guidelines for project evaluations focus on the following factors:■ The evaluation assigned to the project owner.■ Capacity, experience, and track record of on-site manager■ Historical vacancy.■ Market conditions in the project area, including a review of the overallcompetitiveness of project in the real estate market, including existing andcompeting projects planned for completion in the next few years.■ Overall project design and condition.■ Adequacy and condition of amenities.■ Local, regional, and state economy.reserves may be provided in the form of cashreserve funds or servicing advances.Subordinate debtSubordinate debt is frequently needed to make theprojects financially feasible. Standard & Poor’s mayexclude subordinate debt in its calculation of LTV.For example, if the debt is public purpose in nature,comes from governmental or municipal entities, andis a cash flow mortgage that is nonforeclosable.Standard & Poor’s will need to review the termsof the subordinate debt to ensure that it does notimpair the financial feasibility of the project.Standard & Poor’s will look for intercreditor agreementsbetween the trustee on behalf of the holdersof the rated securities and the subordinate lender toensure that the rights of the holders of the ratedsecurities to receive timely payments of principaland interest are not impaired.Construction And Lease-Up RiskMultifamily housing construction projects containsome degree of construction risk; that is, the possibilitythat the project will not be completed on timeor in accordance with specifications, thus causing adelay in debt service payments. For constructiontransactions, the level of construction risk the projectentails will be evaluated, and will be determinedto be low, moderate or high. If the level of constructionrisk is moderate to high, further analysiswill be undertaken, and could include the use of anoutside construction consultant. (See Public FinanceCriteria: Assessing Construction Risk)The more significant credit risk in new housingconstruction transactions is lease-up risk. New projectsmay fail to achieve projected income levelsbecause they cannot rent up properties to projectedoccupancy levels for market reasons such as excesssupply due to new construction, reduced demanddue to recession or the relative attractiveness of single-familyhome purchases compared to renting.Failure to achieve projected rents can occur for thesame reasons. While multifamily rehabilitationtransactions have the advantage of prior occupancyand established rental rates, loss of tenants duringrehabilitation can cause delays in achieving targetedoccupancy after completion of construction.History shows however, that in the affordable housingsector additional resources, such as soft secondloans from municipalities, developer, syndicator andnot-for-profit equity in tax credit transactions, andHFA funds, can help projects over these difficulties.In addition, capitalized interest and liquidityreserves can help tide a project over until lease upand stabilization are reached. Lease up risk must beadequately addressed for affordable housing transactionsto be rated investment grade or higher.www.standardandpoors.com267

HousingMobile Home ParksStandard & Poor’s Ratings Services views mobilehome parks (MHPs) as a subset of bond ratings onunenhanced affordable housing (AHPs). However,there are unique issues with regard to MHPs thatdeserve special attention.Transaction structuresRating bond-financed MHPs is substantially differentfrom rating bond-financed unenhanced multifamilyprojects in that, in virtually all MHPs ratedby Standard & Poor’s, the collateral for the bondholdersis land only and not real estate improvements.Typically, the tenants in mobile home parksown their mobile homes and lease the land onwhich the mobile homes sit from the park owner.The tenants typically obtain a loan to buy themobile home, and the mobile home is pledged tothe lender that provides the acquisition loan.Therefore, the collateral for bondholders in ratedMHP transactions is land and a pledge of theground rent from the tenants for the mobile homepark spaces. The bondholders do not have any collateralinterest in the mobile homes themselves.Standard & Poor’s analysis of MHP bond transactions,therefore, depends to a great extent on theasset quality of the MHP over the long term and itsability to generate a strong revenue stream.Asset qualityOne factor unique to MHPs that will be given carefulattention is the size of individual mobile homespaces. Mobile home spaces should be of adequatesize to accommodate larger mobile home units (i.e.,at least 24 feet in width). The trend has been andwill continue to be the placement of larger units (atSite Visit and DocumentationIn conducting its review of an affordable housing project, Standard & Poor’s relies on a site visit to each property, a completeapplication including owner, property management, and oversight provider questionnaires, a review of legal documents includingany loan guarantees, subsidy contracts, real estate and bond documents, investment contracts, loan information and review ofspecific third-party reports prepared by independent third-party professionals. The site visit will include:■ Internal and external inspection of the project, including several apartments, amenities, basement, roofs, maintenance areas,elevators and stairwells, storage spaces, garbage collections and recycling facilities, security systems, recreational facilitiesand grounds.■ Interviews with the prospective owner, property manager, construction planners and supervisors, and■ A tour of the surrounding neighborhood with visits to comparable properties.The following reports should be prepared by qualified, independent third-party professionals and should be no older than six months:■ Structural engineering report prepared by a licensed engineer or architect in accordance with Standard & Poor’s guidelines.■ Environmental report in accordance with Standard & Poor’s guidelines, and■ A complete self-contained appraisal performed in accordance with USPAP guidelines by a MAI certified appraiser.This report should include a market and demand study prepared in accordance with Standard & Poor’s guidelines.Standard & Poor’s will review the following financial, legal, and loan documentation:■ Trust indenture■ Investment agreements■ Loan agreements■ Mortgage and mortgage note■ Assignment of leases and rents■ Relevant insurance policies■ Ground lease if applicable■ Management contract■ Construction contract if applicable■ Legal opinions■ Subsidy contracts, if applicable■ Standard & Poor’s owner profile and questionnaire■ Standard & Poor’s property management profile and questionnaire, and■ Any other relevant transaction document.268 Standard & Poor’s Public Finance Criteria 2007

Unenhanced Affordable Housing Project Debtleast 24-foot doublewide units) on mobile homespaces. The ability of the park to accommodate thistrend will contribute to its ability to attract andretain tenants, maximize occupancy, and, hence,support debt service on the bonds. While manyolder MHPs may currently have a large number ofolder, singlewide units (i.e., 12 feet in width), if thespaces themselves are large enough to accommodatelarger units, this will partially offset the existence ofa substantial number of singlewide units.However, if existing MHP spaces are too small(i.e., less than approximately 34 feet in width) toaccommodate doublewide units, this means that thesinglewide units located on such spaces cannot bereplaced, and this may eventually threaten the parkowner’s ability to market those spaces to new tenants.New, smaller mobile home units (12 to 16 feetin width) may be more difficult or even impossibleto acquire in today’s market given the trendtowards larger units. If the park contains a substantialnumber of smaller mobile home spaces that canonly accommodate singlewide units of 16 feet orless, we will request a market study to demonstratethat the demand for such small spaces still existsand will continue to exist in the future. If the marketstudy determines that the MHP is functionallyobsolete due to the number of smaller spaces, theMHP may not be eligible to receive an investmentgraderating from Standard & Poor’s.Bond structureMobile Home Park transactions rated ‘BBB-’ orhigher may have bond maturities of up to 35 years,longer than the 30 years typical for other ratedAHP transactions. Since the collateral securing thebonds in MHP transactions consists almost entirelyof land, the question of useful life of real estate isnot an issue. While MHPs usually include someimprovements, such as clubhouses, swimmingpools, and other common areas, most of the valueof the project is derived directly from the land.However, the property condition report for thetransaction, should demonstrate that the effectiveuseful life of the improvements in the park isgreater than the term of the bonds.Cash flows and reservesStandard & Poor’s will assume a vacancy rate forMHP spaces at the higher of 2% of gross rentalincome, the park’s historical vacancy rate, or theactual MHP vacancy rate in the market. We willtypically rely upon the structural engineering reportto provide guidance on what the appropriatereserve for replacement should be. If, however, allor a portion of the capital improvements outlinedin the structural engineering report are to be prefundedwith money deposited in the replacementreserve fund at closing, Standard & Poor’s willapply any such deposit as a credit towards therequired on going replacement reserves.Ownership, property management, and oversightThe nature of the project’s ownership is an importantelement in rating MHPs. Standard & Poor’swill rank owners based on their experience, commitment,asset management capabilities, and financialstrength. In particular, we will look at whether theowners have experience in handling the uniqueaspects of MHPs. Transactions with owners withoutprevious experience in owning MHPs will usuallynot qualify for ‘BBB-’ or higher ratings. Standard &Poor’s will also look for property managers withexperience managing MHPs. At the time of the sitevisit, we will interview the property manager toreview experience and track record with MHPs, allaspects of day-to-day operations, and overall operatingstrategy. Specifically with regard to MHPs, wewill look at turnover time for vacant spaces and theprocedures in place for handling sales and replacementsof mobile homes in the park.Ongoing financial and management reviews by aqualified asset manager or oversight agent are alsonecessary. In most cases, an outside private oversightagent with experience in bond compliance forrated MHPs is retained to provide ongoing financialand management reviews. ■www.standardandpoors.com269

HousingAffordable MultifamilyHousing Pooled Financings■Pooling of affordable multifamily housing assetsgives issuers the benefits of economies of scaleand diversification, which can increase credit qualitywhen compared to single-asset transactions.Pooling is an efficient way for housing financeagencies (HFAs), banks, mutual funds, low-incomehousing tax credit (LIHTC) investors/sponsors andconduit issuers to get higher ratings for affordablemultifamily transactions than would be possible forsingle-asset transactions.Affordable multifamily pool transactions dependon the collective performance of multiple propertieslocated in a variety of markets and controlled byseparate borrowers. The ratings of pool transactionsare predicated on the notion that it is highlyunlikely that all of the properties will experiencedeclines in cash flow and value simultaneously, butthat, over the life of the transaction, some loans canbe expected to default, with resulting losses to thecollateral pool. Standard & Poor’s Ratings Servicesdetermination of credit enhancement levels for pooltransactions is designed to estimate the frequency ofdefault with respect to the underlying assets and theseverity of the loss that is expected to be incurred inconjunction with each default, given the characteristicsof the loans in the pool.For each rating level, Standard & Poor’s uses aninternal model, to determine the minimum loss coveragenecessary by rating category. Potential lossesin a pool are typically covered in two ways. One isthrough over-collateralization, whereby the poolhas sufficient assets over liabilities to cover potentiallosses. The other is through subordination,whereby the higher rated debt is supported by debtissued at the lower rated levels all the way down tononinvestment-grade. Examples of other types ofcoverage, include, a general obligation pledge forHFA pools, or credit enhancement for other pools.For the purposes of this article the three terms, losscoverage, over-collateralization and subordinationare used interchangeably in describing the losses apool has to cover at different rating levels.Pools of affordable multifamily housing debtobligations are typically issued following one ofthree basic structures:■ Bonds issued by municipal issuers such as HFAssecured by affordable multifamily mortgagesunder closed or open resolutions,■ Taxable debt obligations secured by pools ofaffordable multifamily mortgages issued by nontaxexempt issuers using a REMIC (Real EstateMortgage Investment Conduit) structure, andTax-exempt pass through debt obligations securedby pools of affordable housing tax exempt bondsissued by non-tax exempt issuers using someother form of pass through legal structure.Qualifying For Affordable Multifamily PoolTreatment In Rating Debt ObligationsIn order to obtain large pool treatment for a pooledtransaction, the pool must contain at least 20 debtobligations with 10 separate obligors. These transactionstypically, do not have one obligor representingmore than 10% of the cutoff principal balanceof the mortgages or bonds in the pool. For applicationof pool concentration rules, Standard & Poor’sdefines obligor as the ultimate borrower on thedebt obligation and not the tax-exempt issuer (inthe event that the issuer is a municipal tax-exemptconduit issuer issuing the debt obligation on behalfof a third party borrower.) As illustration, considerthe situation where a not-for-profit or public housingauthority or tax credit limited partnership is thelegal owner of a project and the borrower under aloan agreement or financing agreement.The issuer of the tax-exempt bonds is a taxexemptmunicipal entity issuing the bonds as a conduitissuer and has no legal binding obligation to useits own credit to pay debt service on the bonds. Inthis situation, Standard & Poor’s considers the legalowner of the project to be the borrower for concentrationrules and not the issuer. In certain tax-exemptbond transactions, a municipal entity is the legalowner of the multifamily property, as well as theissuer of the bonds, and leases the property on along-term lease to a not-for-profit entity in order toqualify the property for real estate tax exemption. Inthese situations, Standard & Poor’s would still considerthe not-for-profit to be the borrower for applicationof pool concentration eligibility.Individual Property ReviewsStandard & Poor’s will review the operating historyof properties in the pool. This review will consist ofan analysis of three years of audited financial statements,which will be used to derive net cash flow,and to assign an appropriate valuation to the properties.Property income will be reviewed for historicaltrends, and Standard & Poor’s will assume avacancy rate that is the greater of the actual vacancy270 Standard & Poor’s Public Finance Criteria 2007

Affordable Multifamily Housing Pooled Financingsrate at the property or the prevailing vacancy rate inthe market. The assumed vacancy rate will alwaysbe a minimum of 5% but in the case of elderlyhousing a lower minimum vacancy rate may beused, if appropriate. Standard & Poor’s will payparticular attention to rent restrictions on propertyunits to determine if the rents in the propertyincome reflect any legal rent restrictions on theproperty. Standard & Poor’s will compare assumedproperty expenses to historical property expensetrends, expenses from comparable properties inStandard & Poor’s rated property database andindependent third party information.Expense underwriting without real estate propertytaxes is acceptable in the event that the propertycan document statutory or specific property taxexemption. Capital expenditures are incorporatedin multifamily underwriting by estimating futurecapital expenditures and providing for an annualreserve for replacement which funds the capitalexpenditures over time. The capital expenditureprojections should be consistent with the thirdparty reports provided to Standard & Poor’s andwith our analysis of the property upon physicalinspection. Standard & Poor’s will include thisannual reserve for replacement in the computationof net cash flow of each property. The annualreserve for replacement will be the higher ofStandard & Poor’s minimum reserves for replacementsor the actual number recommended by theproperty condition survey. (See “Public FinanceCriteria: Unenhanced Affordable Housing ProjectDebt” for Standard & Poor’s minimum reserves forreplacements.) Standard & Poor’s typically seesmultifamily expense ratios in the 35% to 50%range although the ratio may be higher with projectswith restricted rents.Standard & Poor’s typically will do site visits toprojects comprising a minimum of 50% of the poolprincipal loan/bond balance. Based on a site visit,Standard & Poor’s assigns a ranking from “1” to“5”, with “1” indicating new high-end market ratehousing quality, and “5” indicating housing in badphysical condition, with physical obsolescence. Aranking of at least “3” is typically necessary forinvestment grade ratings. A weighted average rankingof property quality for the pool will be determinedand used to adjust pool subordination levels,if necessary.Standard & Poor’s will derive a value for eachproperty in the pool using an appropriate capitalizationrate, based on per property type. The analyticalteam will review appraisals for each propertyin the pool but does not use appraisal values forloss coverage computation purposes. Typically a9.25% cap rate will be used for older multifamilyprojects but higher or lower cap rates may be usedin certain instances. For instance, cap rates in the8.25%-8.75% range may be used for newer lowincomehousing projects due to the rent restrictionson the properties, the newness of the properties andthe additional oversight provided by various partiessuch as the low-income housing tax credit investor.Overall Review Of Quality AndDiversification Of Pool AssetsOnce the reviews for individual assets in the poolare complete, Standard & Poor’s will compile andreview statistics on the overall pool with regard toowner diversification, geographic diversification,affordable housing program termination risk, loanseasoning and mortgage payment delinquencies.Owner and geographic diversificationPools with a greater than 10% exposure to oneowner will not qualify for large pool treatment.Pools of such properties will be analyzed as smallpools and the rating on senior debt obligations willusually receive lower ratings than more diversifiedpools, (see “Public Finance Criteria: UnenhancedAffordable Housing Project Debt”). Typically,Standard & Poor’s measures geographic risk at thestate level. However, concentration risk within astate, or even a large county or city, does not precludeinvestment grade ratings on pools. All HFApools are concentrated in one city, county or stateand can obtain investment grade ratings. The morenarrow the geographic concentration, the higher therisk, however. Standard & Poor’s looks for mitigatingfactors, such as the depth of rent restrictions,historical performance, asset management, andpotential for ongoing financial support.Affordable housing program termination riskMany affordable housing projects have programtermination risk which may affect the ability of theprojects to pay debt service on a timely basis.Termination risk affects such programs as Section 8projects with Housing Assistance Program (HAP)contracts (either long-term or annually renewablecontracts) and LIHTC transactions (where mostpartnership agreements require a sale of the propertyafter the 15th year compliance period).While the Federal government has been extendingSection 8 contracts, it is difficult to say that projectsin a pool will have the HAP contracts extendedover the term of the bonds. It is possible that projectswith elderly tenancy, for instance, or withstrong ownership and oversight may stand a greaterchance to achieve contract extensions over the longterm.For projects where the HAP contract expiresprior to bond maturity and the Section 8 sponsorindicates that the project should be underwritten asa continuing Section 8 subsidized project,Standard & Poor’s will make an assessmentwww.standardandpoors.com271

Housingwhether the project has a good chance to beextended and, if so, will analyze using rents whichare the lesser of rents affordable to tenants making60% of HUD median income or local HUD FairMarket Rents (assuming tenant pays 30% ofincome for rent). Standard & Poor’s will also usehigher cap rates and lower default thresholds thanunsubsidized affordable multifamily in determiningloss coverage.Standard & Poor’s may also be able to make theassumption that a certain portion of the expiringSection 8 projects can make a successful transitionto unsubsidized status. These may include propertiesthat, already have a significant portion ofunsubsidized units fully rented which demonstratetheir ability to attract unsubsidized tenants; or,properties that compare favorably to other affordablemultifamily projects in the area in location,amenities, unit size, curb appeal and physical condition(properties that rank 3 or better byStandard & Poor’s) and have strong ownership.These transactions will be analyzed using the unenhancedaffordable housing project debt criteriaassuming a successful transition. In order to determinethat a successful transition can be made,Standard & Poor’s would need to visit each site andstress the pro formas with a two-year transitionperiod from subsidized to unsubsidized statusassuming that unsubsidized rents would be at a significantdiscount to market. Section 8 transitiontransactions that are included in pools will needsufficient reserves to cover the transition period.Standard & Poor’s will determine recovery rates forSection 8 properties not assumed to transition tounsubsidized status, on a case-by-case basis.The low income housing tax credit program,allows corporations and individuals to receive adollar for dollar credit against federal income taxliability for 10 years, and requires the projects tocomply with the program rent restrictions throughthe 15 year compliance period. For LIHTC properties,Standard & Poor’s will review the overall poolto determine if there is a concentration of programtermination risk in any given year. Pools with a significantnumber of loans with maturities greaterthan 15 years may suffer unique stress if all, or anumber, of properties are required to be sold inyear 15. Sales of properties frequently result in adrop off in net operating income. Pools with significantproperties that are sold in the same periodmay see such a drop in average NOI (net operatingincome) affecting debt coverage levels.Subordination levels for such pools may need to beadjusted to reflect the fact that, in reality, the assetshave balloon maturities tied to a sale of the propertyrather than are fully-amortizing.Mortgage loan seasoning and mortgagepayment delinquency historyStandard & Poor’s will review pool statistics formortgage seasoning (the period since the originationof the mortgage) and the payment history of the borrowers.Mortgages with shorter seasoning periodsmay have the underlying property NOI’s haircut duringthe individual property review process. Poolswith significant delinquency histories may receivelower ratings, or need higher collateralization levelfor similar pools with better delinquency history.Determination Of Loss CoverageStandard & Poor’s will value the assets in the pooland determine loss coverage levels by rating category,by computing a DSC and LTV for each property.Based largely on the LTV or DSC, Standard &Poor’s will determine the aggregate credit risk associatedwith the loan portfolio and the resultingdefault rates that must be survived to obtain agiven rating level. Default rates are then adjustedfor recovery assumptions and a lost interest amountis added to account for anticipated failure to receiveinterest until recovery is complete. Loss coveragecan be provided through over-collateralization (typicallyused by HFA pools) or subordination of subordinatedebt tranches. Standard & Poor’s mayadjust computed loss coverage levels due to poolsize, property type, lack of significant geographicand owner diversification, lack of pool mortgageseasoning, and significant affordable housing programtermination risk.Under higher rating scenarios, higher defaultrates are assumed, as compared to default ratesunder lower rated scenarios. In addition, in termsof recovery of principal and years of lost interest,Standard & Poor’s applies higher stresses at thehigher rating categories, and less at the lower ratings.The severity of the loss incurred in connectionwith each default depends on analytical assumptionsabout expected default experience and thespecific characteristics of the loan in question. Theanalytic assumptions relate to the decline in themarket value of the underlying real estate and tothe number of months between default and receiptof liquidation proceeds. Here again assumptionsvary by property type and rating category. Forinstance, at the higher rating categories,Standard & Poor’s assumes that it will take the servicerlonger to resolve a default on the underlyingproperty, than in the lower rated categories.The number of months between the borrower’sdefault and the servicer’s receipt of liquidation proceedsis used in combination with the loan couponto estimate the amount of lost interest associatedwith a default. The other loan characteristic that has272 Standard & Poor’s Public Finance Criteria 2007

Affordable Multifamily Housing Pooled Financingsan influence on loss severity is the extent of amortization.In the case of interest only loans, it makes nodifference whatever defaults occur shortly after theloans are securitized or when the loans mature: ineither case there will have been no amortization ofprincipal to help to absorb the loan losses. In thecase of amortizing loans, the later the default occursin the life of the loan, the less severe the loss isassumed to be as a result of the amortization.This criterion applies except for one notableexception. For LIHTC pools, the analysis focusesmuch more on years of lost interest and less ondefaults and recoveries. This is as a result of theimpressive history of the program since it’s inceptionin 1986, whereby defaults are very uncommon.A foreclosure on these properties would trigger aloss or recapture of the tax credit benefits. The historyhas shown that there are a percentage of propertiesthat don’t cash flow sufficiently to cover debtservice, and are supplemented by either reserves orsome other forms of capital infusions until theproperties can once again cover debt service fromoperations. As a result, the analysis emulates thisphenomenon and assumes a certain percentage ofthe properties in these pools will need capital infusions,and that the infusions depending on the ratinglevel will potentially be for a significant periodof time. As in the regular pool scenarios, the higherthe rating level the more stressful the assumptions,and therefore higher level of reserves will be necessaryat higher rating levels, than at lower levels.It should be noted that the basic variables onwhich the model operates for all property types, arestabilized net cash flow and market values for eachof the underlying properties as estimated byStandard & Poor’s and as based on the criteria outlinedabove. Although these estimates are derivedfrom information provided by the issuer or thesponsor, the Standard & Poor’s adjustments in connectionwith its analysis may cause the estimatesthemselves to look different from the numbersreported by third parties.Standard & Poor’s will review the pool legal documentation,both on the individual bond/mortgagelevel and on the trust/partnership/REMIC level. SeeStandard & Poor’s U.S. CMBS Legal andStructured Finance Criteria located on www.standardandpoors.com.Individual mortgages and bondindentures will be reviewed to ensure that the loandocuments properly reflect the cash flow assumptionsof the pool.Cash Flow AnalysisOnce Standard & Poor’s determines the credit supportnecessary at different rating levels, then ananalysis is needed for the rating of the actual pooldebt obligations assuming certain prepaymentassumptions. Where the pool structure is a passthrough entity (REMIC, partnership or trust), theinterest rate of the debt obligations is based off theweighted average coupon of the trust, and thestructure uses a “fast pay-slow pay” payment structure,the rating of the debt obligations is relativelysimple: the debt obligations get the rating based onthe subordination levels from Standard & Poor’sinternal model as adjusted.The analysis is more complicated for pools withloans which have various different coupon rates ormaturities, with pools with variable rate debt obligationswhose rate is pegged off an index differentthan that of the certificates/bonds secured by thepool (such is in common in HFA pools) or poolsthat use a “pro rata pay” structure. In these cases,Standard & Poor’s will review cash flow projectionsto ensure that, the debt obligations can bepaid on a timely basis under various scenarios; and,that there is no overall degradation in pool creditquality in the event that better performing loansprepay and the resulting principal payments areallocated to all pool classes, on a pro rata basis. Inthese cases, additional cash flow runs may be necessaryand stress cash flow models may be requested.The requested cash flow runs can vary dependingon the composition and characteristics of the pool,and are also applicable for State Housing FinanceAgency multifamily parity resolutions.Cash flow coverage scenariosAt the minimum, the following base case and stresscash flow runs must be prepared:Base case:■ All loans pay at stated interest rate and loanswith balloon maturities pay at balloon maturitydate with a 30-day lag in cash flows.Stress cases:■ Selective low LTV loans prepay-all loans belowthe average pool LTV with coupons above theaverage pool coupon prepay at the end of the ofthe loan prepayment lockout period.■ Selective high DSC loans prepay-all loans abovethe pool average DSC with coupons above theaverage pool coupon prepay at the end of theloan prepayment lockout period.■ All LIHTC prepay scenario-all LIHTC transactionsprepay loans in the 15th year after beingplaced in service.■ Massive prepayment scenario-all loans prepay atthe end of the individual loan lockout periods.■ High coupon prepay scenario-all mortgage loanswith coupons above the pool average loancoupon prepay at the end of the loan prepaymentlockout periods.www.standardandpoors.com273

HousingFor pools with construction loans:■ Cash flows should be run in accordance with the“Cash Flow Considerations” and “CapitalizedInterest” sections of the Standard & Poor’sPublic Finance construction criteria. (See “PublicFinance Criteria: Assessing Construction Risk”).Credit migration scenariosFor pools with pro rata pay structures, additional cashflow runs may be requested assuming that the highestDSC/lowest LTV loans prepay at the earliest possibleprepayment date after any lockout period ends.Standard & Poor’s will then review the loss coveragelevels of the remaining loans to determine the impacton credit quality of the remaining debt obligations.Rating Pools With Variable Rate Assets Or LiabilitiesStandard & Poor’s will review assets in pools withvariable rate debt and determine an appropriatefixed rate at which to underwrite the pool loans fordebt service coverage purposes. Standard & Poor’swill determine this appropriate fixed rate by reviewingdata from our floating rate interest rate models.In pools where the variable rate on the assets is notpassed through to the debt holders, the rate whichStandard & Poor’s will use for individual loananalysis may be less than the highest interest rateover the pool life as derived from our interest ratevector model. In that case, in order for pool debt toreceive high investment grade ratings fromStandard & Poor’s, the pool may have to providereserves for periods when interest rates are projectedto be above Standard & Poor’s assumed rate.Standard & Poor’s will review pools with variablerate assets and variable rate liabilities to ensurethat there is no basis point risk between the twodebt instruments. Rated certificates/bonds for poolswith fixed rate assets and floating rate liabilitieswill have to have appropriate debt service coveragelevels at both the expected floating rate liability rateand at the maximum rate. If no maximum rate onthe liabilities is provided in the documents, thenStandard & Poor’s will use its interest rate vectormodels to determine an appropriate maximum rate.In addition, Standard & Poor’s will need to reviewstress cash flow runs assuming the various prepaymentscenarios listed above.Issuers of pool debt obligations with variable ratedemand obligations (VRDOs) that have associatedput features may have to obtain liquidity facilitiesor other comparable credit support to addressremarketing risk.Servicing And Liquidity IssuesStandard & Poor’s looks for experienced multifamilyservicers in rating pooled transactions. The experiencecan be evaluated in several different ways.Servicers other than those with Standard & Poor’sServicer Evaluations are certainly acceptable. Otherservicers who would be acceptable are HFAs thathave a proven track record in servicing multifamilyloan pools (as would other types of entities thathave proven track records in multifamily loan servicing).Standard & Poor’s acknowledges that servicingpools of bonds will not necessarily require thesame skill set as a commercial loan servicer due tothe fact that bond trustees usually handle the cashflow requirements of a bond issue. Determiningwhether the obligations’ servicer is qualified willrequire an analysis of reporting requirements, cashflow management in some transactions, specialservicing in default or workout situations andworking with trustees and issuers in bond transactions.In order for a pool to receive a rating,Standard & Poor’s must be assured that the servicermeets Standard & Poor’s guidelines and can effectivelyservice the pool.Standard & Poor’s always looks for liquidity ininvestment grade rated bond transactions and pooltransactions are no different. Liquidity is there toensure that there is timely payment of principal andinterest in the event of a temporary impairment ofcash flow. Liquidity in affordable housing pooledtransactions can be provided by debt service reservefunds on the individual bond level or by having arated entity agree to provide servicing advances.The required rating level on the entity providing theservicing advances will depend on the rating d ofthe pool debt obligations.State And Local AffordableMultifamily Housing Pool Open ResolutionsHousing finance agencies have been issuing bondsbacked by pools of affordable multifamily projectloans since the late 1960s. HFAs have historicallysupported their multifamily bond issues and similarto LIHTC projects, have avoided default situationsby utilizing their resources, including capital infusions.Standard & Poor’s rates some pool financingson the strength of the multifamily mortgage collateralalone; some are combined single family and multifamilypools. Some multifamily-pooled resolutionsare rated based on the general obligation pledge of arated HFA and not on the quality of the underlyingloans. Most of the HFA multifamily pool resolutionsare single tranche but some have multiple tranches.In the single tranche multifamily pools, loss coveragefor the rated bonds is typically provided byexcess mortgages or cash reserves. In resolutionswith subordinate tranches, credit support for thehigher rated tranches is provided by lower ratedtranches. Some HFAs pledge their general obligation274 Standard & Poor’s Public Finance Criteria 2007

Affordable Multifamily Housing Pooled FinancingsInformation Requirementson subordinate multifamily pool tranches, in whichcase the rating on that tranche would be the creditrating of the rated HFA.Standard & Poor’s uses the same methodologyfor analyzing credit support levels for HFA affordablemultifamily housing pools as for conduitpools. Because many HFAs have a long track recordof excellent underwriting and asset managementcapabilities, Standard & Poor’s will rely to a certainextent on the issuer’s representations regarding calculationsof DSC and LTV, property quality andcondition, and strength of ownership and management.Standard & Poor’s will also give managementcredit to HFA’s with strong asset managementdepartments that can identify financial and managementproblems early, seek rent increases and subsidyextensions, and work out troubled loans.Construction Risk InAffordable Multifamily Housing PoolsHousing Finance Agency poolsMany HFAs have parity bond indentures or guaranteefunds that finance new construction ofaffordable multifamily housing projects. HFAs haveincurred minimal credit losses on these transactions,either during the construction/lease up phase orAs part of the rating process, Standard & Poor’s will perform a detailed review ofthe individual properties in the pool, based on the following information:■ Project name and address■ Project owner/sponsor■ Type of affordable housing project: e.g. LIHTC, project-based Section 8,tenant-based Section 8, 80/20, Section 236, Section 202, 501c3, military housing,student housing, assisted living, etc.,■ Number of units■ Age of property■ Original principal balance of loan/bond■ Current principal balance of loan/bond at cutoff date■ Interest rate on loan/bond■ Amortization period of loan/bond■ Maturity date of loan/bond and balloon payment, if any■ Prepayment terms for the bonds, if any■ Amount and investment of debt service reserve funds, if applicable■ Seasoning of loan/bonds■ Loan history of loan/bonds■ Three years of net operating income of property■ Trust indenture/loan agreement, mortgage, note, if applicable■ Third party reports: appraisal, property condition reports, andenvironmental studyduring the permanent phase thereafter. HFA’s typicallyservice their own mortgage loans on projectsunder construction or hire outside mortgage loanservicers to do the servicing. The agencies or outsideservicers frequently review construction drawsand make site visits to monitor constructionprogress. Procedures may vary from HFA to HFAbut frequently the HFAs have engineers on staff toreview construction progress on projects. It is veryrare that a multifamily project financed by an HFAdoes not get completed.HFA’s typically have a good history in financingprojects that achieve stabilization at targeted debtservice coverage levels. Most projects financedtoday by HFAs are usually LIHTC multifamilyprojects, which though they are typically nonrecoursefinancings have the advantage of havingdeep pocket limited partners who have tax incentivesto keep multifamily projects out of default, atleast during the life of the LIHTCs. In the eventthat projects do have financial problems or go intodefault, HFAs have resources to mitigate thesedefaults, such as parity indenture fund balances andfunds to make subordinate mortgage loans orgrants. Due to the long history of excellent performanceon projects with construction/lease uprisk and their systems in place, Standard & Poor’shas become very comfortable with the HFAs takingconstruction risk on affordable multifamily housingprojects and will rate parity bond indentures thatdo not have credit enhancements on projects underconstruction.If an HFA can demonstrate a positive experiencewith construction risk, as well as underwriting,oversight and construction procedures as outlinedabove, Standard & Poor’s will assume low constructionrisk and look to bond cash flows to modelconstruction risk. Bond cash flows should be run asin accordance with Standard & Poor’s constructioncriteria (see “Public Finance Criteria: AssessingConstruction Risk”). HFA parity indenture cashflows must demonstrate that bond debt service canbe paid assuming construction delays. If bond cashflows do not demonstrate sufficient resources tosupport the bonds during the delay period, the HFAmust identify other sources of financial support.Conduit poolsMore and more conduit programs have arisen tofund construction and permanent financing of multifamilypools. These typically take the form of,taxable debt obligations secured by pools of affordablemultifamily mortgages issued by non-taxexempt issuers using a REMIC (Real EstateMortgage Investment Conduit); or tax-exempt passthrough debt obligations secured by pools ofaffordable housing tax exempt bonds issued bywww.standardandpoors.com275

Housingnon-tax exempt issuers using some other form ofpass through legal structure.Construction risk in conduit pools is more variablethan for HFAs due to varying degrees of experienceand track record of sponsors, as well as the numberof markets involved (transactions are multi-state asopposed to state-specific). However, if managementis strong and has a local presence in all project locations,conduits can be strong sponsors of multifamilyhousing. This is especially true for LIHTC pools,where the investor has a vested interest in ensuringthe health of the properties in order to maintain thetax credits. Standard & Poor’s will assess constructionrisk to determine whether it is low, medium orhigh, and has employed a conservative approach toassessing this risk. Standard & Poor’s may engage anindependent construction consultant to assist indetermining the risk of construction loans in thepool. (See “Public Finance Criteria: AssessingConstruction Risk”). To date, conduit issuers haveobtained credit enhancement to cover constructionrisk, for investment grade transactions. Projects thathave rated letters of credit providing credit supportfor loans until stabilization will be given full value inthe pool, as long as the rating of the credit supportprovider, is as high as the rating on the bonds. It isunlikely that a pool heavily weighted with constructionloans will achieve an investment grade rating.Loans for projects that have completed constructionbut have not yet stabilized with the projectreaching 90% occupancy and underwritten NOIfor a minimum of six months will be assigned standardrecovery values, but Standard & Poor’s willhaircut project NOI resulting in a reduction of theproject’s collateral value in the pool. Recoverycredit for projects during stabilization will only begiven in those circumstances where the sponsorscan demonstrate to Standard & Poor’ that theyhave a long history of successfully overseeing multifamilylease up of new construction projects andhave the staff and systems in place to do so.Experience in FHA, Fannie Mae or Freddie Macnew construction programs will be consideredstrong indicators of ability to oversee conventionalmultifamily construction and lease up, but will notbe the ultimate determinant. ■Military Housing PrivatizationsMilitary housing projects are built on or nearmilitary bases and are structured so that militarypersonnel have preference in renting the units.The rent is paid by the military tenants and is set atthe service members’ basic allowance for housing(BAH), an allowance legislated by Congress as partof military service members’ compensation. Theseprivatized military housing projects may have varioustypes of Department of Defense (DoD) subsidies,such as donated or leased land at nominalcost, donated housing units, cash equity investmentsin the joint ventures that own the housing,subsidized utilities or infrastructure, and belowmarket-ratesubordinate debt. The DoD has the legislativeauthority to and may make available loanguarantees for these projects in the event of mortgagedefaults due to base closures, base realignments,or Armed Forces deployments.Bonds financing housing projects under the MHPIare eligible to achieve high investment-grade ratingsfor three reasons: Rental income from the projectcomes from a military housing allowance system,which, although subject to annual appropriations, hasa long history of congressional support with no fundingdelays. Monies are typically transferred directlyfrom the DoD to the trustee to pay bondholders.Military housing privatizations are project-specific andare tied to specific bases, but the BAH as a componentof service members’ pay is not appropriated for individualbases. Rather, military pay is a federal expenseincurred on behalf of the members of the military.Second, the MHPI is a strong program consistingof quality housing with strong demand at most militarybases with DoD contributions that enhanceproject feasibility while offering below marketrents. Third, the program authorizes the use ofappropriate protections, as needed, for lendersagainst base closure, realignment, or deployment.The analysis of bonds secured by military housingprojects will focus on four key areas:■ A review of the essentiality of the military base asan indicator of future demand for military housingon base and related military base closure,realignment and deployment issues, and relatedloan guarantees;■ The military housing aspects, including housingallowance payment history and mechanisms,DoD subsidies, ground leases, and any otheroperating agreements with the DoD related tothe housing;276 Standard & Poor’s Public Finance Criteria 2007

Military Housing Privatizations■■A real estate analysis including real estate quality,location, market demand, construction issues, netcash flow and real estate program administration;andBond structure, reserves, and investments.Military Essentiality AnalysisPrivatized military housing transactions must befinancially feasible in the event of a military-relatedevent such as base closure, base realignment, orlong-term military deployment. Military bases arenational assets, and most will not be closed becauseof their necessity for national defense. However, theDoD is under pressure to find savings in the defensebudget to finance military modernization. Therefore,savings through base closures that eliminate redundantDoD operations are periodically considered.In the event that there are further rounds of baseclosures, some bases are more likely to close thanothers, and although there may be political considerationsin the decisions over which bases to close,the potential for some types of bases to be selectedfor closure is able to be analyzed based on currentand future projections of military force structure,base capabilities, geographic location and theresults of rankings from previous BRAC rounds.The results of the latest BRAC round in 2005 are agood indicator of the military’s view of essentiality.Standard & Poor’s designates military bases ashighly essential, moderately essential, and essential.If the base is not deemed to be moderately or highlyessential, and is located in an area where the economicimpact of such a closing on a local economywould be very negative, then the military housingtransactions may need to have some form of DoDdebt guarantee in order to be investment-grade.Exceptions to this case might be where the baseis in a large metropolitan area of at least one millionpopulation and the combined military, military-dependent,and DoD civilian employeepopulation in the area from all military-relatedactivities is less than 5% of the total populationand the base housing is of good quality (e.g. location,design, physical condition, among others).The DoD may desire to have any military-relateddebt guarantees drop off in the event of a base closureand the project successfully transition to civilianhousing. In this case, Standard & Poor’s willreview the transaction to ensure that the projectmeets an appropriate DSC test for an adequate timeperiod before the guarantee can drop off.Despite the existence of the DoD base closureguarantees, Standard & Poor’s will evaluate theproject to determine its feasibility as civilian housingin the event of a base closure or realignment.Consequently, Standard & Poor’s will review a feasibilitystudy of the military housing project as militaryand civilian affordable housing. The developershould complete a transition plan and stress testsaddressing the project transitioning to civilianaffordable housing. The transition plan must cover:■ Property management;■ Marketing to civilians;■ Transition to local taxation;■ Utility conversion;■ Provisions for local government services, includingpolice and fire coverage;■ Access to schools and transportation; and■ Permanent base access.The mechanics of base closure guaranteesFor investment grade ratings, mortgage loan debtservice guarantees from the DoD should embodythe following concepts:■ The guarantee should cover base closure orrealignment and a temporary deployment fromthe base of a significant portion of military personnelassigned to the base;■ The guarantee should be specific relating to identificationand calculation of triggers driven by thenumber of personnel affected by a military-relatedevent; and■ The guarantee should be a full faith and creditobligation of the U.S.With regard to the mechanics of payments undersuch a guarantee, the guarantee should meetStandard & Poor’s criteria for payment guarantees.(See “Legal Criteria for U.S. Structured FinanceTransactions-Guarantee Criteria”)Real Estate Analysis/Construction RiskReal estate analysisStandard & Poor’s Ratings Services rating criteria forbond issues that are secured by privatized militaryhousing projects constructed or rehabilitated underthe MHPI is a combination of rating approaches forsubsidized and unenhanced affordable housing transactionsand federally appropriated debt. The realestate analysis includes a site visit as discussed below,a review of the ownership entity, and a review ofthird party environmental and physical needsreports. A full description of the real estate analysisis described in the “Public Finance Criteria:Unenhanced Affordable Housing Project Debt”.Construction riskConstruction risk is inherent in military housing privatizationtransactions due to the program consistingof renovation and new construction of militaryhousing. Construction risk is typically mitigated inthese transactions, by the fact that the owner takestitle to occupied units of military housing upon closing.In addition, the owner represents that they willwww.standardandpoors.com277

Housingkeep a certain number of units on-line during theinitial development period. Military tenants are typicallymoved out of old housing upon completion ofnew housing. Construction delays can be handled bydelaying the movement of tenants out of the olderhousing. In the event units are not on line during theinitial development period, Standard & Poor’s mayuse an independent consulting engineer to determinethe level of construction risk and potential mitigants.There are a number of other factors, whichare important in the construction analysis of militaryhousing privatization transactions. (Please see“Public Finance Criteria: Assessing ConstructionRisk In Public Finance”).Lease-up riskStandard & Poor’s considers lease up risk low infamily military housing transactions. The fact thatunits are on line throughout the development periodis a major mitigant to lease up risk. Often thetenants that are moved to the newly constructed orrenovated units are tenants relocating from otherunits on base. There is strong demand from militarypersonnel to live on base due to base amenities,support networks, schools and high security. As aresult, there are frequently long waiting lists forhousing on base. In addition, the rents for the unitson base are usually below what service-memberswould pay in the general market and the newlyconstructed housing stock is typically more attractivethan off base housing.Analyzing The Project As Military HousingIn evaluating the rental income stream comingfrom the military housing allowances, Standard &Poor’s will use the current BAH in effect for thatparticular military housing area (MHA) and thepay grade mix of the units as established by theDoD request for proposal (RFP) for the militaryhousing project. Standard & Poor’s will review theBAH history in the MHA to ensure the revenueprojections at the project are justified by the BAHhistory. If the pay grade mix of the units maychange or if there are provisions for lower-rankingpay grades occupying units reserved for higher paygrades, Standard & Poor’s will review stress cashflows to determine what reserves are needed fordifferentials in pay grade mix from the pro formarental income assumptions.There also will be a review of the pay grade mixof the units in comparison to the mix of paygrades in units stationed at the base and to thepay grades of families on the housing waiting list.In some instances, the DoD requires that, in theevent of a shortage of eligible military families,housing units must be held vacant for other categoriesof DoD employees. In these instances,Standard & Poor’s may opt to use a higher vacancyrate in analyzing the project or look for additionalleasing reserves. In addition, Standard &Poor’s will look for reserves to cover delays in anymortgage payments made by the DoD under theDoD guarantee. For instance, if the DoD guaranteehas a 120-day lag between the mortgage paymentdefault date and payment date, thenStandard & Poor’s will look for a 120-day additionaldebt service reserve. In the event that rentalpayments by tenants are tied directly to the BAHpayments, which are structured as a component ofmilitary pay to be made in arrears, thenStandard & Poor’s will look for an additional 30-day rental reserve in addition to the normal 30-day lag. Mortgage reserves may be provided in theform of cash reserve funds or servicing advances.Adequate replacement reserves should be initiallyset up and maintained in accordance with the ongoingpreventative maintenance and replacementschedule as outlined in the contract between theowner and DoD and confirmed with a structuralengineering report. Standard & Poor’s will analyzereplacement reserves in accordance with industrystandards to determine their sufficiency and if controlsover disbursement are adequate. Additionalreserves may be necessary to bring the property upto environmental standards.ReservesGenerally, Standard & Poor’s will look for debtservice reserve funds (DSRFs) equal to six monthsmaximum debt service on the bonds, which may befunded with bond proceeds. Exceptions would bewhere the base is not deemed to be moderate tohighly essential, and a transition to non-militarypersonnel is assumed. In these instances, a DSRFequal to maximum annual debt service on thebonds will be necessary. Monies for the debt servicereserve fund should be invested in investment gradesecurities (‘BBB-’ or higher), and be available to paydebt service in the event of a shortfall.Military housing project ground leasesStandard & Poor’s experience is that most militaryhousing transactions in which the housing is locatedon base will be structured such that the DoDwill use a ground lease in order to retain control ofthe land. Standard & Poor’s can assign investmentgrade ratings to transactions using ground leasestructures as long as the ground leases meetStandard & Poor’s ground lease criteria as delineatedin the criteria for CMBS transactions.Asset managementStandard & Poor’s will review the oversight role andcapacity of issuers, outside third-party asset managers,and DoD in each transaction to assess the278 Standard & Poor’s Public Finance Criteria 2007

Military Housing Privatizationsimpact on the rated securities. In certain situationswhere the ownership structure of a military housingproject is weak, Standard & Poor’s may be unableto rate these securities without the DoD or an effectiveoutside third-party asset manager playing a role.Base accessFor transactions that are not deemed to be moderatelyto highly essential, access to base housing willbe another factor in evaluating a privatized militaryhousing transaction to determine its feasibility as acivilian housing project. Projects on the perimetersof bases that can be physically segregated from thebase are stronger transactions than projects locatedin the interior of military bases. For projects locatedin the interior of bases, Standard & Poor’s willreview the plans for access to the base housing bycivilians in the event that higher defense conditionsrestrict access to the base to military personnel andother DoD personnel. Transactions where baseaccess is more limited may need the DoD guaranteesof debt service, higher reserves, or much highervacancy factors. In addition, transactions where thebase commander can restrict access to the projectby the owner or property manager in cases ofnational emergency will be carefully evaluated.Documentation RequirementsDocumentation that Standard & Poor’s will need to review before assigninga rating includes, but is not limited to, the following:■ Trust indenture.■ Loan or financing agreements.■ Mortgage or deed of trust.■ Ground lease, loan guaranty from DoD and other government documents.■ Investment agreements.■ DoD request of proposals.■ Base information■ Developer’s plan of finance, construction and management.■ List if participants in project.■ Offering statement.■ Construction agreements.■ Construction completion guarantees.Project cash flow projections:■ Beginning state cash flow projections assuming beginning state of units.■ Cash flow projections for each year of the development period.■ Ending state (stabilized) cash flow projections assuming completion oftargeted end state number of units.■ BRAC cash flow projections assuming the base is closed and transition to civilianhousing at the end of the period designated by DoD to complete the BRACprocess.Military Site Visits And DocumentationIn order to evaluate the debt obligations for a rating,Standard & Poor’s will make a site visit to theproject securing the debt obligations at the beginningof the rating process. Due to the complexity ofthese transactions, there are a number of issues thatStandard & Poor’s would like to address during thesite visit, including, but not limited to the essentialityof the military base that the housing serves.Before the site visit, Standard & Poor’s willreview the project request for proposals and a summaryof the base vital statistics, as well as the marketstudy so that selection of housing comparablesfor the visit can be made.Site visits should include:■ A tour of the military housing project.Standard & Poor’s will visit each military neighborhoodand rank each neighborhood and dointerior site visits of a representative sample ofunits and will take photos of each neighborhoodand a tour of off-base civilian housing comparableproperties.■ A presentation addressing civilian housing marketoff base (preferably by the author of the marketstudy) and how BAH rates and housing onbase compare to civilian housing and rents offbase.■ A command presentation of activities of the base(preferably by uniformed members of the U.S.Armed Forces) addressing base essentiality andcontrasting the base in question with other basesof similar type. A tour of the military facilities isan important part of the analysis of essentiality.■ A presentation on each military housing neighborhood,location, pay grades housed there, dateof construction and/or rehabilitation and its currentoccupancy rate.■ A presentation regarding environmental conditionsof the housing to be privatized and howenvironmental issues are being addressed.■ A presentation by developer and general contractoron their companies and previous experiencewith building large residential communities ingeneral and military housing projects in particular.■ A presentation by developer on development planfor the project including site plans, housing elevations,construction plan and phasing plans.■ A presentation by developer/investment banker onmitigation of construction risk for bondholders.■ A presentation by developer on how propertymanagement is to be handled.www.standardandpoors.com279

Housing■A presentation by developer/owner on how propertyasset management including debt complianceis to be handled.Unaccompanied Housing Privatization CriteriaThe MHPI, which allows for the privatization offamily housing, also allows for the privatization ofhousing for unaccompanied personnel. The unaccompaniedhousing program poses unique risksthat distinguish it from the family housing program.Most importantly, is the risk of deployment.Deployment would terminate the lease for a certainclass of (lower-ranked) personnel, causing cash flowto cease.In family housing, this risk is mitigated by thecontinuation of BAH payments following deploymentas long as the family of the deployed servicemember continues to occupy the home, which istypically the case. Second, construction risk ispotentially different than family housing, as thesetransactions may not involve the conveyance ofexisting units and the generation of cash flow fromexisting units, during the initial development period.As a result, Standard & Poor’s may use an outsideconsultant to review the construction of thesedevelopments, and determine if the mitigants topotential construction and lease up delays are sufficientin the structure of the transactions.Finally, in the event of a base closure, the alternateuse of the real estate is not clear as the existingand proposed units appear like student housing somay not be marketable to the general public, regardlessof the strength of the local housing market anddepth of demand, in the event of a base closure.Key Credit Considerations And Major Risks■ Standard & Poor’s will analyze military essentialityusing the same methodology as for the familyhousing program.■ Deployment history for each base will be analyzedto determine the potential impact of futuredeployment on the occupancy.■ Construction risk can potentially be differentthan family housing, as units may not be on lineduring the initial development period. In thesecases it is important to determine the level of riskEvaluating The Basic Allowance For HousingOn Jan. 1, 1998, the Department of Defense (DOD) initiated a new housing allowance system for all members of the Armed Forces.The new system, entitled the Basic Allowance for Housing (BAH), replaced the previous system that combined the Basic Allowancefor Quarters, plus Variable Housing Allowance. Implementation of the new system provides for much fairer housing allowances forservice members stationed in high cost areas but can result in lower overall housing allowances in areas with lower housing costs.The BAH is a single, price-based system that establishes housing allowances based on local housing costs by paygrade and familystatus. Growth in the DOD overall housing allowance budget is tied to the growth in a weighted average of national housing costs.The BAH allowance is computed by outside contractors who will perform surveys of housing costs in areas where military personnelare stationed. The consultants base their studies on one-two bedroom apartments, two-three bedroom townhouses, and three-fourbedroom detached houses within zip codes near bases where 80% of off-base service members live, and which have a mean familyincome of within a certain band. The BAH system incorporates a “save pay” provision that ensures that no service member will incur areduction in housing allowances until they move to a new station and are paid according to the BAH rate at that new location.The BAH is paid monthly in cash to service members with families only if they do not live in military housing. Any Armed Forcesmembers who live in military provided housing generally forfeit their housing allowance on a monthly basis and do not receive thehousing allowance in cash. Service members have the right to have their BAH sent directly to a third party via DOD direct depositor allotment.The housing allowance is considered a major component of the compensation of members of the Armed Forces. The CurrentStructure of U.S. Armed Forces military pay originated centuries ago when countries and individuals temporarily raised armies to wagewar. When raising an army, the sponsor had to provide not just pay, but food and shelter for the soldiers. This food and shelter graduallyevolved into a system of non-taxable food and housing allowances. These allowances were provided in cash to the Armed Forcesmember if the government did not supply food and shelter. The allowance was withheld from the Armed Forces member’s payif the government did not provide food and shelter.The legal authority to pay housing allowances to service members is subject to annual appropriation by Congress just as is militarybase pay. The legislative history for paying Armed Forces members on a timely basis is excellent. The rationale for paying ArmedForces members pay and allowances on a timely basis is strengthened by the fact that all enlisted members or the Armed Forcesand many officers serve under enlistment contracts that can be terminated early only subject to special congressional legislation ordisciplinary action. In addition, now that the military is an all-volunteer force, the DOD must structure adequate pay and allowancesto be attractive for recruiting and the retention of existing Armed Forces members.While the payment of housing allowances is subject to annual congressional appropriation, the essential function of nationaldefense, the long legislative history of paying military personnel pay and allowances on a timely basis, and the need to attract andretain Armed Forces members makes the housing allowance a strong ratable income stream.280 Standard & Poor’s Public Finance Criteria 2007

Federally Subsidized Housing Programs■posed by the proposed construction. This analysismay include Standard & Poor’s using a consultingengineer to determine these risk andpotential mitigants.The demand analysis should include how manyunaccompanied permanent party personnel areassigned to the base and/or are eligible for theprivatized housing, a description of the housingfor unaccompanied personnel currently available,and occupancy statistics. In addition, the marketstudy should include information on the housing■■■alternatives for these personnel available in themarketplace.Local housing market and alternate use for thereal estate (layout, amenities, and location).The revenue and BAH structure will be analyzedto determine future rental stream.The bond and legal structure for these transactionsis expected to be similar to family housing,including the level of reserves, and legal documentationsuch as the ground leases, operatingagreements, and trust indentures. ■Federally Subsidized Housing ProgramsStandard & Poor’s Ratings Services rates singleassetand pooled financings of properties supportedby federal subsidies, such as HUD Sections 8and 236. Ratings range from low to high investmentgrade, with lower ratings assigned to singleassettransactions and higher ratings assigned tostate housing finance agency (HFA) pools.Most federally subsidized properties are includedin HFA loan pools, often in conjunction withunsubsidized, credit-enhanced and even single-familyloans. HFAs have a strong record of managingthese asset pools, closely monitoring loan performanceand proactively taking steps to ensure financialstability. Single-asset financings are typicallydone through local authorities, municipalities andnot-for-profits. Strong properties with strong ownersand managers assisted by project-based federalsubsidies can achieve investment-grade ratings, evenwhen the contract is not coterminous with bonds.The rating criteria for federally subsidized projectfinancings is similar to unenhanced affordable multifamilyhousing criteria with refinements as indicatedbelow. Standard & Poor’s analysis focuses onreal estate quality, legal structure, bond structureand reserves. Real estate quality includes a sitereview, measures of financial feasibility, marketanalysis, property management, ownership, insurancecoverage and environmental concerns.Analysis of the federal subsidy is an importantaspect of analyzing real estate quality, and focuseson two key factors:■ Depth of the subsidy and how it affects the relativeaffordability of the project. The deeper thesubsidy, the greater the affordability, whichargues for lower debt service coverage levels thanneeded to support unsubsidized properties; and■ Subsidy mechanics, including the federal appropriationsprocess, contract provisions, such astermination events and regulations affecting keyfinancial aspects, such as rent increases.For a full discussion, refer to the criteria,“Unenhanced Affordable Housing Project Debt”.Project-Based Section 8There are key differences that affect ratings onbonds supported by historical Section 8 contractsand the contracts HUD is entering into today,specifically appropriation risk, contract term andthe rent increase mechanism. In the original program,Section 8 funding was typically set-aside atthe outset of the contract for its entire term, significantlyreducing appropriation risk. The term of thecontract was often equal to bond maturity and terminationrisk was restricted to poor owner performance.Rents were originally increasedaccording to an annual adjustment factor. In lateryears, HUD instituted rent ceilings, which had theimpact of severely restricting, and even freezing,rent increases.More recent financings are for developmentswith contracts that have expired and been extendedunder the Multifamily Assisted Housing Reformand Affordability Act of 1997 (MAHRA). Thesecontracts are subject to annual appropriation andtend to be for shorter terms, intensifying terminationrisk. While appropriations need to be madefor this type of contract each year, appropriationrisk is not a limiting factor to low to mid-invest-www.standardandpoors.com281

Housingment grade ratings due to the essentiality of federallysubsidized housing. Termination risk is moreof an issue that needs to be analyzed on a case-bycasebasis. Standard & Poor’s has seen contractterms as short as one year and as long as twentyyears. Generally, Standard & Poor’s looks morefavorably on longer-term contracts, but whetherthe term is one year or 20 years, termination riskcan be offset if the project meets the standards setforth under MAHRA for contract extension, aslong as the owner is legally obligated to apply forcontract extensions.The expectation that contracts will be extended isstrengthened by language in MAHRA that theHUD Secretary shall extend at the owner’s requestsubject to appropriation under such terms and conditionsthat the Secretary deems appropriate. Thelegislation permits the HUD Secretary the option ofnot renewing due to poor financial or operationalperformance of the project owner on the subjectdevelopment, as well as other HUD subsidized projects.Therefore, Standard & Poor’s will evaluatewhether the owner and property will meetStandard & Poor’s, as well as HUD’s standards ofperformance throughout the life of the transaction.In addition, the HUD REAC score at the time ofthe rating, and on an ongoing basis, is an indicationof HUD’s assessment of the owner. A deteriorationof the REAC score below 75 could be an early signalof the failure of the owner to operate the propertyat a level needed to maintain the contract.Other factors that add to the overall credit qualityof the transaction help to make the case for theessentiality of the project, as well as its ability towithstand contract termination, include if:■ The project caters to HUD’s targeted tenancy,especially, the elderly;■ The project could potentially operate withoutsubsidy; and■ A potential sale of the property upon contractextension could generate sufficient funds to retirethe bonds.Section 8 ConversionsIn situations where the owner has a viable plan forconverting a Section 8 subsidized property tounsubsidized status over the life of the transaction,Standard & Poor’s will consider ratings up to lowinvestment-grade for bonds meeting conversion criteria,as follows:■ The feasibility of the transition from subsidizedto unsubsidized status at the targeted rent levelsshould be substantiated in an independent thirdpartyreport;■ Projects should be owned and operated by anexperienced affordable housing organization witha proven track record or have oversight of a stateor local HFA or PHA;■ The owners should present Standard & Poor’swith a written transition plan, which is, in effect,a plan of actions to be taken in conjunction withthe expiration of the Section 8 contract. The planshould incorporate the methodology that theowners will use to ensure the successful conversionof the property within the shortest possibletime frame.■ Cash flow scenarios should be run showing paymentof bonds in the event that the Section 8contract is extended and in the event that theproject converts to AHP status.Scenario 1 assumes successful relocation of existingtenants and releasing of units during a transitionperiod assumed to begin upon expiration ofthe HAP contract. The length of the transition isassumed to be the greater of two years or fourtimes the absorption rate for similar properties inthe market. During the transition period, the projectneeds to meet at a minimum only the debt servicecoverage for HAP contracts. At the end of thetransition period, the project must meet the AHPdebt service coverage levels. Reserves should not berelied on in meeting the coverage levels.Scenario 2 anticipates great difficulty in relocatingthe existing tenants and re-renting the units. TheSection 8 tenants are only assumed to vacate theunits at the historical turnover rate for the property.Under both scenarios, a vacancy rate of at least5% should be assumed, as well as a 30-day periodto turn around a unit for occupancy once it hasbeen vacated. Once the Section 8 contract hasexpired, project income will consist of the tenants’portion of the rent (30% of income) based on thehistorical rent roll of the property.Ratings on Section 8 conversions will includeonly properties where most attributes fall withinthe “excellent” category. Standard AHP debt servicecoverage levels will apply, most likely at thehigher end of each category.Section 236 Interest Rate Reduction TransactionsFor the Section 236 interest reduction payment program(IRP), financing activity tends to be for singleassetstructures involving the bifurcation of themortgage loan and the creation of debt supportedsolely from IRPs. Unlike prior Section 236 financings,which relied upon total project revenues tomeet operating costs and debt service payments,these transactions rely only on the Section 236 payments.The tenant portion of a project’s income isnot pledged to the IRP bondholders.Because of the structure of these financings andthe track record of the program, real estate risk is282 Standard & Poor’s Public Finance Criteria 2007

Federally Subsidized Housing Programsvirtually nonexistent, but still a factor. Even thoughthe IRP revenue stream is not subject to appropriationrisk, expected ratings are at the ‘A’ rating leveldue to the risks of HUD’s contract termination orsubsidy reduction. The termination events involveelements of real estate risk that are generally notconsistent with higher rating levels. Higher ratingsmay be possible only with very strong participants,if certain other risks can be fully covered, or forpooled financings.Primary credit considerations include:■ Sufficient legal or other protections to mitigateany potential termination or reduction of the IRPby HUD;■ Proper regulatory oversight to ensure the project’scontinued eligibility for IRP;■ An experienced, capable oversight agency ableand willing to provide this oversight;■ Appropriately sized reserves to cover any fundingdelays; and■ Debt service coverage to provide reserve replenishment,if necessary.IRP AssistanceIRP assistance, by statute, is paid to mortgagees onbehalf of mortgagors to maintain the viability of alow-income housing resource. These payments arenot, and may not be paid directly to project owners.HUD wants to be sure that assistance goes toprojects that provide habitable low-income housingfor qualified tenants, so they require an “acceptable”public agency to provide regulatory oversightfor the project. The amount the project receives isnot tied to occupancy; the requirement is only thatthe units are in habitable condition and rented toqualified tenants. The key is the oversight, whichensures the project’s eligibility to receive the IRP.The assistance is calculated based on basic andmarket rents. The amounts are set forth in theamortization schedule in the original Section 236mortgage and are fixed for the life of the mortgage.The total amount to be received is the “budgetauthority,” and the amount scheduled to bereceived in any particular federal fiscal year is the“contract authority.” Section 236 budget authorityis not subject to annual appropriation. Bonds supportedby the IRP should have maturity no laterthan the maturity of the IRP subsidy.Assistance is paid in arrears after the filing ofform HUD-3111 “Mortgagee’s Certification andApplication for Interest Reduction Payments.” Theexpectation is that the mortgagee would legallypledge the IRP to the bond trustee for payment tobondholders. The bond trustee would be instructedto file this form in a timely fashion under the bonddocuments, with payment coming directly to thetrustee. If payment goes to the mortgagee, properprotections would need to be in place to ensuretimely and full remittance to the trustee. If therequest is received by the 20th of a month, paymentis wired usually by the first of the following month(and ordinarily not later than the fifth). No precisehistory exists about late payment from HUD, butsince HUD Central and not the regional offices paythe subsidy, there are not the delays sometimes seenin the payment of Section 8 subsidies.Debt service coverage and reservesIn order to cover for any potential delays in paymentby HUD, a debt service reserve fund (DSRF) sized atthree months of IRP payments is recommended forinvestment grade. Debt service coverage can be lowerthan would be needed under a project-based financing.This is due to the fact that the Section 236bondholder is not subject to the risks of project revenuesand expenses. Since the IRP revenues will beaccessed each month, excess coverage is necessaryonly as a cushion and to be available to replenish theDSRF if needed. A coverage level of at least 1.05xfor ratings at the investment-grade level is recommended.This coverage also provides a needed cushionin the event the number of units available forrental decreases, in which case HUD would reduceproportionately the IRP. Higher debt service coveragewould be needed above the ‘A’ category.OversightThe lender (mortgagee) on these financings can beany entity if a public agency agrees to be the oversightentity (i.e., party to the IRP agreement) toassure compliance. If no public agency is involved,the mortgagee must be HUD-approved and theproject must be FHA-insured, with HUD providingthe oversight. Public agency responsibilities accordingto the HUD notice are:■ Monthly requests for the IRP;■ The processing of periodic rent increases;■ Physical inspections of the property to ensurehabitability; and■ Monitoring to assure owner compliance with theterms of the IRP agreement and HUD rules governingthe project.In many cases, Standard & Poor’s expects thatthe public agency will be an HFA. Most, if notall, HFAs have extensive experience with Section236 mortgage loans and the administrative andasset management requirements listed above arewell within most HFAs’ core competencies. It isexpected that having HFAs as signatories on IRPagreements will be considered acceptable oversight,especially if the HFA has significant experiencewith subsidized multifamily housing. AnHFA should be prepared to detail its track recordwww.standardandpoors.com283

Housingwith the Section 236 program, its asset managementprocedures, and to discuss its understandingof its responsibilities under the IRPagreement. Section 236 bond issues without anHFA as the public agency will be examined on acase-by-case basis.Termination eventsIn the IRP agreement, HUD has the ability to terminateor reduce the IRP payments for the followingevents, and Standard & Poor’s will look for the followingremedies:■ The Section 236 mortgage is extinguished. Inmost instances, this will only occur with provisionsfor the full payment or redemption of theIRP bonds. In case of a foreclosure on the mortgageloan, the IRP should continue uninterruptedto the lender.■ The project ceases to be owned by an eligibleowner. Eligible ownership entities are outlined inthe HUD notice. To avoid this risk, the lendershould covenant not to allow transfer of ownershipto a non-eligible owner. In addition, the currentowner should covenant to always remaineligible under HUD requirements.■ The lender is no longer mortgagee of record andthe HUD secretary has not approved the lender’ssuccessor as mortgagee of record. The lendershould covenant to always remain mortgagee ofrecord through expiration of the IRP or receiveprior written HUD approval of a successor.■ The public agency does not meet its obligation tomonitor the operation and condition of the projector does not certify, in a manner acceptable to theHUD secretary, that it is satisfying this requirement.The public agency must meet the requirementsof HUD as detailed in the “Oversight”section. Standard & Poor’s will need to gain theBond/Mortgage DocumentationInformation requirements will include at least the following:■ A Trust indenture. which must require that a default on revenue bonds cannotcause default on Section 236 bonds;■ A loan agreement;■ Cash flows;■ An IRP agreement;■ A use agreement;■ The original Section 236 mortgage with amortization amounts; and■ The new Section 236 mortgage.Other documentation may be requested on an as-needed basis.necessary comfort that the HFA (or other oversightentity) is capable of performing this monitoringand certification on an ongoing basis.■ The borrower or the lender defaults under anyprovision of the IRP agreement. Standard &Poor’s will rely on the oversight of the publicagency to mitigate the risks that any ongoing violationunder the IRP agreement could cause a terminationof the subsidy. Most of the provisionsof the IRP agreement entail normal operatingprocedures for Section 236 properties, and HFAshave excellent track records regarding continuationof the subsidy.■ An action of foreclosure is instituted by the lender,except in the event the lender gives to the secretaryadvance written notice of its intention to institutesuch foreclosure, and submits to the secretary inadvance a plan, acceptable to the secretary, providingfor continued eligibility of the development forreceiving the benefits of Section 236.Foreclosure should be handled through covenantsin the bond documents that necessitate followingHUD’s requirements. The senior lender must agreein a document such as an inter-creditor agreementor subordination agreement that the senior lenderwill obtain the approval of HUD before initiating aforeclosure action.The HUD secretary shall have the discretion todecrease the amount of the monthly IRP payment ifthe number of units in the project available forrental also decreases. Any such decrease in the IRPpayment shall be, to the extent possible, in proportionto the decrease in the available units.Reduction in units could be through a voluntarydecrease by the owner, units rendered uninhabitable,or the casualty/condemnation of the units. Theowner must covenant to maintain all units for rentalthrough expiration of the IRP. HFA oversight limitsthe possibility of units becoming uninhabitable.For casualty/condemnation events, propertyinsurance that fully covers all bonds including theIRP bonds with a provider rated at least investmentgrade should be in place at closing. If the borrowerdecides to rebuild, insurance proceeds will be used(with public agency oversight) to reconstruct, andthe IRP subsidy should continue uninterrupted.Standard & Poor’s will look to covenants in thedocuments to assess the potential success ofrebuilding on time and within cost.If the borrower decides not to rebuild, IRP bondswill be redeemed either in full or pro rata in accordancewith the reduction in the IRP. In order toensure that there will be no shortfalls, businessinterruption insurance covering at least nine monthsof rental payments with a provider rated at least at284 Standard & Poor’s Public Finance Criteria 2007

Public Housing Authority Debtinvestment grade should be in place. This amount,coupled with the DSRF, should be sufficient tocover debt service during any potential delays inclaims payment by the property insurer. In allinstances where insurance proceeds can potentiallybe paid to IRP bondholders, Standard & Poor’s willlook for assurances that bondholders either areparty to a mortgage on the property or have an“insurable interest” giving them rights to thoseinsurance proceeds.Property conditionStandard & Poor’s will look for public agency representationsthat the upfront and ongoing physicalneeds of the property will be met fully as a result ofthe financing. As part of the condition assessment,Standard & Poor’s will look for evidence from thepublic agency of sufficient demand to make theproject viable going forward.Standard & Poor’s may also request third-partyreports (engineering and environmental) to supportthe current and future condition of the project, aswell as a market study and appraisal to gaugedemand and financial viability. Any property insurancepolicies or business interruption insurancepolicies will be reviewed to ensure proper coverage,eligible uses, and the sufficiency of the provider’srating level.Site visits will be part of the ratings process asdetermined on a case-by-case basis. Where the qualityof the property or the capacity of the oversightagency is in question, a site visit is warranted togain necessary information. ■Public Housing Authority DebtPublic housing authorities (PHAs) can use futureannually appropriated modernization funding tosecure long-term debt due to legislative changes putinto effect in 1998 that permit PHAs to borrow thefunds sufficient to accelerate the modernization andrepair of the aging and deteriorated housing stockin their portfolio.The U.S. Department of Housing and UrbanDevelopment (HUD) administers the Capital FundFinancing Program (CFFP).The greatest risk to bondholders investing inPHA debt secured by capital funds is that thismoney would not be appropriated by the federalgovernment in amounts sufficient to pay debt service.This risk cannot be eliminated by the federalgovernment except through direct support of debtservice through some form of full-faith-and-creditpledge, which has not been part of CFFP transactionsto date. However, this risk can be offset, asdiscussed below, through reserves and debt servicecoverage that anticipate funding cuts.Standard & Poor’s Ratings Services rates PHAdebt backed solely by the annually appropriatedHUD Capital Fund program in the investment gradecategory based on the following critical factors:■ Strong and extensive history of the federal government’ssupport for public housing programs;■ Significant ongoing need for affordable rentalhousing for the lowest income segment of therental population;■ Predictable mechanisms for allocating CapitalFunds to individual housing authorities;■ Potential for strong support by HUD; and■ Bond structures that provide adequate reserves,additional bonds tests, and segregation of CapitalFunds needed to support bond debt service.The main factors that affect where the rating willfall are:■ The level of debt service coverage on the bonds,evidenced both by appropriation trend stresses,revenue projections and the coverage provided bythe additional bonds test. All investment gradestructures should include at least a six monthdebt service reserve fund based on maximumannual debt service;■ PHA’s track record of HUD funding and creationof mechanisms to enhance predictability of fundinglevels;■ Evaluation of PHA’s past performance in its modernizationactivity, including its obligation andexpenditure history;■ Evaluation of the PHA’s capital improvementplan, including ongoing Capital Fund leveragingas well as management’s ability to undertake thescope of work;■ Strength of legal structure, including how thefinancing insulates bondholders from recaptureor withholding of the Capital Funds (to theextent that the law permits) for any reasons,www.standardandpoors.com285

Housing■including HUD sanctions due to performance,prior liens which may be placed on the funding,or flow of funds problems at the PHA level; and,Availability of a diversified stream of revenues,especially important at higher rating levels.Essentiality, Longevity, And PredictabilityIn evaluating the history of public housing, threeelements are clear contributors to the creditworthinessof capital funding:■ The essentiality of housing for low and very lowincomepeople;■ The long track record of funding for public housingby the federal government; and,■ Increasing predictability of funding levels forindividual public housing authorities.EssentialityThe need for the public housing program is at theheart of gauging the federal government’s continuingcommitment to the program. A review of thedemand for public housing, the general dearth ofaffordable rental housing, and the likely continuationof the undersupply indicates a high degree oflikelihood that public housing will continue to bethe centerpiece of the nation’s supply of housing forthose in greatest need. The federal government is nolonger in the business of developing deeply subsidizedpublicly and privately owned housing and hasmoved toward a paradigm of mixed-finance,mixed-income housing that can sustain affordabilityby renting to higher-income tenants. The number ofexisting deeply subsidized federally assisted unitscontinues to decrease due to the federal government’sreduction in subsidy to fund new conventionalpublic housing and the conversion ofprivately owned subsidized housing properties tomarket rate status upon expiration of subsidy contracts.Major production programs, such as theLow Income Housing Tax Credit program,although affordable, are targeted at higher-incometenants. Some segments of public housing tenancy,such as the elderly, who make up 32% of publichousing tenants, are expected to increase significantlyin coming years.Predictability Of PHA Funding LevelsAs part of analyzing appropriation risk,Standard & Poor’s carefully considered the methodologyfor allocation of Capital Funds to the individualhousing authority. Further changes in theCapital Fund allocations effected under the QualityHousing and Work Responsibility Act of 1998(QHWRA) greatly enhance the predictability andstability of allocations to the individual PHAs by:■ Establishing a formula for the Capital Fundarrived at through negotiating rulemaking, whichhelps to ensure consistency of methodology overthe years;■ Increasing predictability of the formula throughclarification of factors that can affect funding;and■ Allowing for a replacement housing factor, underwhich PHAs may receive funds over a period oftime for units that have been demolished.Although there are many factors that couldchange a PHA’s funding level, such as ongoing andbacklogged needs, impact of unit reduction, andperformance reward factors, projecting increases inPHA funding would not be consistent with investmentgrade ratings. What is consistent with investmentgrade ratings is the development of a worstcase funding level.Another significant factor that can affect PHAfunding levels are sanctions that HUD is withinits right to employ based upon PHA performance,discussed later under “The Importance ofHUD Approvals”.For each PHA transaction, Standard & Poor’sdevelops assumptions for funding levels based uponthe PHA’s actual Capital Fund allocation over time.HUD approvals clearly state that sanctions in relationto performance issues could not affect the level offunding below what is needed to make annual debtservice payments while bonds are still outstanding.Assessing The PHA Managerial CapacityAs part of the rating process, Standard & Poor’sreviews managerial capacity of the PHA as well aselements of the organization’s structure and overallmission that can affect the credit quality of theCFFP bonds. Standard & Poor’s reviews the PHA’sredevelopment plan including scope of work, financialplan, and strategy to ensure completion ofwork in a timely fashion. In addition, Standard &Poor’s assesses the PHAs capacity to complete theredevelopment plan, based on its past constructionand modernization performance, existence of institutionalizedmodernization procedures with checksand balances, and any changes in the proceduresdesigned to address any needs for additionalresources based on the scope of the work planned.Communication with HUD and timely submissionof one-and five-year plans are critical, as is thePHAs history of timely obligating and expendingannually allocated modernization funds. Finally,Standard & Poor’s looks at program and financialoversight practices of the PHA, the board’s backgroundand role in overseeing the PHA and theproject, and the experience, depth and capacity of286 Standard & Poor’s Public Finance Criteria 2007

Public Housing Authority Debtthe PHA’s senior staff members, including the modernizationand construction team.Debt Service CoverageAlthough there is a long and positive track recordoverall for public housing authority funding, thereis the potential for reductions in program funding,especially on a year-to-year basis. There are twolevels of appropriation risk that must be considered.The first level is that the federal governmentwill reduce the amount of capital funding to PHAsas a whole. The second level is that the individualPHA will suffer reduced funding as a result ofissues directly associated with PHA performance orthe method of allocating funds to the PHA. The keyingredient to offsetting these risks is to provide foradequate debt service coverage in the transaction totake into account these potential decreases. In thisinstance, debt service coverage means the amountof annual Capital Funds available to cover annualdebt service on the bonds. In determining theappropriate stresses for rated debt, Standard &Poor’s considers the following factors:■ Historical federal funding levels, taking intoaccount largest decreases in funding;■ Method of allocating PHA share, accounting forkey aspects of the formula funding such as theimpact of unit reduction; and,■ PHA risk and performance issues as well as trackrecord in funding receipt.To help analyze the potential effect of appropriationrisk, Standard & Poor’s tests coverage levels,assuming an annual reduction of appropriationsconsistent with the current trends to determine ifbonds can sustain at least one times coverage overthe term of the financing.In addition, coverage levels assume that CapitalFunds go directly to the bond trustee and that HUDhas provided legal covenants that funding will notbe withheld due to poor PHA performance (see“The Importance of HUD Approvals” below). Inanalyzing the appropriate coverage level for individualtransactions, Standard & Poor’s analyzes theactual coverage in conjunction with the level of capitalneeds and likely leveraging. The higher the coveragelevels, the greater stress the revenue streamcan withstand without jeopardizing debt service.The Importance Of HUD ApprovalsHUD is the administrator of PHA funding. For thatreason alone, HUD approvals play a very importantrole in PHA transactions and may account for ratingdifferences depending on HUD approvals eachPHA is able to secure. In all investment grade transactions,Standard & Poor’s expects that the PHAwill secure HUD approval of the development planand the bond transaction upfront HUD does havethe right to apply sanctions for poor PHA performancethat could affect funding levels. Therefore,reducing the risk of sanctions or other actions thatcould interrupt funds flow is a critical componentof investment grade transactions. In these transactions,HUD has included in its approval documentsclear statements that it will not sanction PHA fundsbelow the amount needed to pay debt service,albeit, subject to appropriations and to the extentpermitted by law. Although this has been viewedpositively, there are still provisions in the housinglaw that direct HUD to sanction poor performingPHAs. If a PHA does not obligate its allocation in atimely manner, then HUD’s withholding of fundsmay jeopardize the PHA’s ability to pay bond debtservice on schedule.In addition, the proportional reduction of fundsto account for the period of time that the PHA isout of compliance serves to erode the debt servicecoverage in the transaction for the year in question,and may also impact their ability to pay debt service.In contrast, the recapture of funds that have notbeen timely expended is not a threat to debt service.This is because recapture occurs four years afterfunds are allocated to the PHA. Because debt servicepayments are segregated in each allocation year, thedebt service for the recaptured year would havealready been paid. Therefore, it is the penalty associatedwith an obligation violation (withholding) thatis more of a rating concern than the penalty associatedwith expenditure violations (recapture).In order to analyze the likelihood of Capital Fundallocations being withheld by HUD, Standard &Poor’s requests detailed information in relation toCapital Fund obligation histories from PHAsrequesting a rating on a bond issue. At a minimum,this information includes data, presented throughHUD close out certificate reports and reports fromthe HUD LOCCS system, from at least the prior tenfiscal years that demonstrates when the PHA “fullyobligated” its modernization funding. While not asimportant in relation to debt service payments,expenditure histories also provide useful informationto help determine the PHA’s management competencyin adhering to HUD deadlines.By reviewing this information, Standard & Poor’sis better able to assess the potential for sanctionsthat would have a negative impact on a PHA’s abilityto pay bond debt service. If a PHA has violatedthese deadlines in the recent past, adjustments tothe transaction’s structure may be needed (either inthe form of higher debt service coverage or largerdebt service reserve funds or both) to mitigate creditconcerns, or a lower credit rating may be in orderfor the transaction.www.standardandpoors.com287

HousingFederal Funding HistoryTo minimize the effect of this legal directive,HUD agrees in its approval documents to permitPHAs to use unobligated funds from allocationyears to make debt service payments, and said paymentsare a permitted use to cure the obligationsviolations. While this does provide some comfortthat some funds are available to pay debt service ina withholding scenario, there is no way of knowinghow much money will be available for debt service;if the unobligated funds are sufficient to make thedebt service payment that would be missed due toallocations withholding. Therefore, the PHAs pastmodernization funds obligation performancebecomes paramount in determining the likelihoodthat funds will be with held due to a HUD sanctionagainst the PHA.While overall commitment of the federal government to the public housing programis important, examination of modernization funding is the main focus in understandingCapital Fund transactions. Because development funding for public housing did notinclude ongoing reserves for improvements, by 1968 Congress needed to addressthe severe deterioration in the housing stock through a modernization funding program.That early program has grown from initial appropriation to fund specific modernizationneeds of $35 million in 1977 to the Capital Fund program of today, which was fundedat about $2.4 billion in 2006. Since 1977, Congress has appropriated almost $60 billionfor public housing modernization. Because of the severe modernization needs ofpublic housing, the long history of funding, and the importance of the program tothe federal government, it is reasonable to assume that some funding will continuefor many years. However, recent history shows a declining trend of Congressionalappropriations for modernization funding over the last five fiscal years. Therefore,prudent leveraging and reserve sufficiency are very critical components of allinvestment grade PHA Capital Fund transactions.The Role Of ReservesReserves are necessary to ensure that no bond paymentsare missed due to government shutdowns,resulting late appropriations, and/or temporary severereductions in appropriations. All investment gradetransactions should include a debt service reservefund (DSRF) sized at least six months debt servicebased on maximum annual debt service on the bonds.The reserve fund can be funded from bond proceeds,should be funded upfront, and, if invaded, should bereplenished in the flow of flows before any CapitalFunds can be released to the PHA, and replenishedprior to the next interest payment date.The DSRF also serves to protect against anyadministrative delays in the receipts of Capital Fundsby PHAs. Typically, the funds appropriated byCongress for Capital Fund become available in theOctober/November of the year following the beginningof the federal fiscal year (Oct. 1). The carefultiming of debt service payment dates, coupled withthe DSRF, can provide a significant cushion to bondholdersand insulate them against the risk of latebudgets or other delays impacting debt service.Also viewed favorably are representations fromHUD that protect debt service against any delayscaused by the process whereby PHAs requisitionand receive approval for their allocation of CapitalFund. This occurs as part of the PHA’s annual plansubmission to HUD, which could be subject todelays either at HUD or the PHA.Key Legal FeaturesInvestment grade transactions include certainlegal provisions. To achieve an investment-graderating, issuers and their advisors should considerincorporating the following features in theirtransaction documents:■ The PHA grants the indenture trustee or collateralagent on behalf of the bondholders a perfectedsecurity interest in the Capital Fund programmoneys to be received by the PHA;■ Debt service payments are legally separate fromall other Capital Funds received from HUD. Debtservice payments and any replenishment ofreserve funds are clearly delineated and have apriority of payment only to bondholders, if possiblebefore any remaining funds are released tothe PHA;■ Capital Fund monies flow directly from HUD tothe indenture trustee or collateral agent to paydebt service without passing through the PHA;■ Capital Fund monies to be used for debt serviceare held under the indenture or deed of trust andare not be commingled with any other funds ofthe PHA;■ The pledge to bondholders includes not onlyCapital Fund monies but also the PHA’s contractrights pursuant to which the Capital Fundmonies are paid as well as the PHA’s rights underany successor program;■ An “additional bonds” test demonstrating thatthe lesser of (i) the prior fiscal year’s allocation ofCapital Fund; or (ii) the average Capital Fundreceipts for the prior three years, will providecoverage of maximum annual debt service(including the proposed bonds) at a coveragelevel determined by Standard & Poor’s at thetime of the rating for any additional bonds to beissued that will be on parity with the existingdebt; and,■ HUD stipulates in its approval documentationthat (1) use of Capital Funds for debt servicepayments is a permissible use of funds, (2) nosubsequent change in the permitted use ofCapital Fund monies will affect HUD’s obligation288 Standard & Poor’s Public Finance Criteria 2007

Public Housing Authority Debtto pay the Capital Fund monies, (3) amountspledged to the payment of debt service shall notbe available for any other purpose, and (4)amounts payable to the indenture trustee or collateralagent are not subject to recapture for anyreason whatsoever.Standard & Poor’s also reviews the legalcovenants made by the PHA and indenture trusteeor collateral agent to ensure compliance with theletter and spirit of the Capital Fund program. Forexample, the PHA should notify the indenturetrustee or collateral agent immediately upon beingnotified by HUD of the availability of the annualCapital Fund allocation. The indenture trustee orcollateral agent should then, in turn, proceed torequisition the Capital Funds immediately fromHUD and hold these funds in appropriately ratedinvestments until paid to bondholders.Standard & Poor’s requests legal comfort as tothe perfection and priority of the security interestgranted by the PHA in (or as to the nature ofabsolute assignment by the PHA) of all collateralheld by the indenture trustee or collateral agent, thestatus under the U.S. Bankruptcy Code of the PHA,and the effectiveness of the grant by HUD of all representations,warranties, covenants, approvals, permits,and waivers necessary to effect the transaction.Pooled TransactionsStandard & Poor’s rates pooled transactions, whichallow multiple PHAs access to the capital marketsthrough one financing. Two elements of these transactionsare noteworthy from a credit perspective—first, what pledge is being made by PHA poolparticipants, and secondly, the level of oversightrequired to ensure that a financing consisting ofmultiple authorities remains a strong credit.The pooled transactions completed to date havehad multiple authorities participate, but the obligationto pay debt service on the bonds is proportional—thatis, each authority is legally obligated topay only its proportional share of bond debt service.In Capital Fund transactions, the benefit ofpooling lies more with the PHA’s ability to gainaccess to the capital markets (due to sharedissuance costs) rather than bondholder security.Therefore, in a pooled transaction each authority’sdebt service is structured individually withoutreliance on another authority’s funds to meet therequired coverage level. In addition, each authoritymust have all the other components in place individually(approvals, reserves, among others) for theentire pooled financing to receive a rating. The ratinglevel for which the pool transaction is eligible isbased on the creditworthiness of the weakest PHAparticipating in the pool.The need to monitor the proportional feature ofthese transactions make it necessary to have oversightperformed by a competent entity to preservethe credit quality of the bonds. The oversight entityassists in monitoring both the programmatic andfinancing aspects of the transaction over the life ofthe bonds. Programmatic oversight involves monitoringthe manner in which a PHA expends bondproceeds to ensure it will not result in a reductionof future capital fund receipts. Financing oversightinvolves ensuring that all bond covenants are metand that the information required by PHAs in thesefinancings is provided to HUD, Standard & Poor’sand other entities as required in a timely mannerAcceptable oversight entities are familiar withaffordable housing involving government regulation.As part of the rating process, Standard &Poor’s evaluates the oversight entity’s past trackrecord with the capital markets and housingfinance, as well as its association with public housing.The entity’s competency should extend to thegeographic area covered by the pool’s participants.State HFAs, for example, typically have longinvolvement with affordable housing and successfultrack records, and are natural candidates for thisrole, although other entities perform oversight onrated transactions. With a strong and competentoversight entity in place, the credit quality ofpooled transactions can be as strong as singleauthority transactions.Federal Funding HistoryWhile overall commitment of the federal governmentto the public housing program is important,examination of modernization funding is the mainfocus in understanding Capital Fund transactions.Because development funding for public housingdid not include ongoing reserves for improvements,by 1968 Congress needed to address the severedeterioration in the housing stock through a modernizationfunding program. That early programhas grown from initial appropriation to fund specificmodernization needs of $35 million in 1977 tothe Capital Fund program of today, which wasfunded at about $2.4 billion in 2006. Since 1977,Congress has appropriated almost $60 billion forpublic housing modernization. Because of the severemodernization needs of public housing, the longhistory of funding, and the importance of the programto the federal government, it is reasonable toassume that some funding will continue for manyyears. However, recent history shows a decliningtrend of Congressional appropriations for modernizationfunding over the last five fiscal years.Therefore, prudent leveraging and reserve sufficiencyare very critical components of all investmentgrade PHA Capital Fund transactions. ■www.standardandpoors.com289

HousingHousing Finance AgenciesHousing finance agencies (HFAs) have built up aconsiderable level of expertise in real estatefinance, development, and portfolio management.Because of their prudent and conservative approachand many successful years of bond issuance, manyHFAs have built up significant net assets in their owngeneral funds or under various bond resolutions.Standard & Poor’s Ratings Services has givenvarying levels of credit support to an HFA’s bondprograms, particularly if an agency has a proventrack record in management and substantial financialresources outside of an indenture. To determineif an HFA is eligible for this flexibility, Standard &Poor’s considers:■ Agency’s managerial expertise■ Issuer’s financial strength■ Purpose of investment or credit support, and■ Portfolio performance and cash flow strength ofthe bond program.Rated HFAs may pledge their GO to financingsto cover all or a portion of security for bonds.External evaluators, such as U.S. government agencies,credit enhancers, and government-sponsoredenterprises, also look to issuer credit ratings as away to assess the overall capacity and credit qualityof an agency.HFA ICR CriteriaStandard & Poor’s analytical approach to assessingan issuer credit rating (ICR) for an HFA takes market,as well as agency-specific, risks into account,particularly when evaluating how an agency generatesrevenues and what factors could adverselyaffect its ability to service its GO debt. In assigningHFA ICRs, Standard & Poor’s assesses the stabilityand level of agency capital available to absorb loanlosses and other charges related to its debt structure,as well as the quality and liquidity of itsassets. ICRs entail an in-depth assessment of financialstrength, management, and the agency’s relationshipwith state or local government. Economicfactors endemic to the state or locality in which theagency operates also are considered in light of theagency’s financial position and the loan portfolio.Agency assets consist primarily of mortgage loansfor single-family homeownership and multifamilyrental housing for low-and moderate-income individualsand families. The relatively low tax-exemptinterest rates and access to federal, state, and localhousing assistance programs provide the necessarysubsidy to create high-quality, below-market-rateloans. In addition, HFAs are answerable to statelegislatures and other governmental entities. Thepublic nature of HFAs makes the autonomy of theirmanagement and security of general net assets animportant credit consideration.Standard & Poor’s evaluates the capacity andwillingness of HFAs to repay GO debt by examiningfive basic analytical areas:■ Earnings quality, financial strength, and capitaladequacy,■ Asset quality,■ Debt levels and types,■ Management and legislative mandate, and■ Economy.Earnings quality, financial strength,and capital adequacyIn order to gauge earnings quality and stability,Standard & Poor’s reviews financial performancefor the most recent five years, with emphasis placedon any notable fluctuations. A premium is placedon consistency of performance. However, one badyear is not necessarily a negative factor, unless itsignifies the beginning of a permanent shift.Standard & Poor’s uses income statement analysisto evaluate revenue sources, cost controls, andprofitability in tandem with a balance sheet analysisof liquidity, capitalization, and asset quality as discussedbelow. Both approaches require evaluationof an agency’s cash accumulation levels, types ofinvestments, interfund borrowing, historical use ofdebt, loan loss reserves, REO, net charge-offs, equity,and quality of unrestricted net assets.The principal areas of analysis are leverage, profitability,asset quality and liquidity. While all thesefactors are important, Standard & Poor’s tends toplace the highest emphasis on equity, since it gives anindication of the resources available to sustain operationsin difficult circumstances or fund programs thatfurther the mission of expanding housing affordability.HFAs tend to be well-capitalized entities that havebeen able to build equity in various environments.Profitability indicates how efficiently an agencyoperates. Agencies that are able to grow large loanportfolios typically have higher profitability than290 Standard & Poor’s Public Finance Criteria 2007

Housing Finance AgenciesKey financial RatiosThe following are some of the ratios Standard & Poor’s uses in analyzing the financialperformance and earnings quality of state HFAs. While many other ratios may beincorporated on a case-by-case basis, these ratios provide a benchmark forcomparison among other state HFAs.Profitability ratiosReturn on average assets is the most comprehensive measure of an agency’sperformance. However, when evaluating return on assets, it is necessary toexamine both the amount and quality of the reported earnings.Net interest income margin measures the most important source of qualityearnings-net interest income. The ratio is affected by the volume and type ofearning assets, as well as the cost of funds. Key to continued profitability isan agency’s ability to manage its net interest margin.Leverage ratiosAdjusted unrestricted assets to total debt, adjusted unrestricted assets to totalGO debt, total equity to total assets and total equity and reserves to total loansmeasure an agency’s capital base available to promote investor confidence andabsorb operating deficiencies.GO debt to total debt (GO debt exposure ratio) measures the extent to which anagency has leveraged its GO pledge. It is a good indicator of the potential dispersionof an agency’s unrestricted assets to support GO debt.Liquidity ratiosTotal loans to total assets and total investments to total assets measure anagency’s ability to access funds for short-term demands.Asset quality ratiosNonperforming assets to total loans, net charge-offs to nonperforming assets,loan-loss reserves to loans, and loan-loss reserves to nonperforming assets measurethe diversity and quality of an agency’s portfolio of earning assets. Net charge-offsare an indication of the actual loss experience of the mortgage portfolio, whileloan-loss reserves should be adequate to absorb those losses.Top-Tier Housing Agency CriteriaA predecessor to the ICR, the top-tier designation is Standard & Poor’s recognitionof an HFA’s history of superior portfolio management and underwriting, depth offinancial resources, and prudent investment policies. Standard & Poor’s expectstop-tier agencies to meet the financial thresholds and have the highest level ofperformance in the categories described below. Standard & Poor’s maintainstop-tier designations on a smaller number of agencies than on which it has ICRs.Elements for the top-tier designation are similar to those for ICRs and include:■ Bond issuance■ Sufficient unrestricted net assets■ Internal controls and financial management■ Portfolio quality■ Administrative abilities■ Investment policy, and■ Government support.■ The consistency of bond issuance reflects the agency’s ability to resolvedifficult situations amidst changes in the economy, governor and legislature.■ Analysis of the other components is similar to that of an ICR.those whose portfolios are stable or declining. Theability of an HFA to issue debt at a low enoughrate to support affordable loans at a higher rate,“earning spread”, is a key element to profitabilityand speaks to an agency’s financial acumen andaccess to capital markets.Standard & Poor’s will adjust leverage and profitabilitymeasures for GASB 31, the accounting rulethat requires governmental entities to reflect theirassets and income for changes in the value ofinvestments. HFAs have considerable investmentsthat they will hold until the term of the bond issue.GASB 31 requires these investments to be reflectedat market value and for that change in value to bereflected as a loss or gain in income. Because agencieswill not liquidate investments prior to theirmaturity at face value, GASB 31 is not relevant toHFAs and introduces unnecessary volatility in netincome and net assets.Besides the asset quality elements describedbelow, Standard & Poor’s assesses an HFA’s loanportfolio through ratios. The main ratios measurean agency’s loans that are at least 60 days or moredelinquent or in foreclosure against an agency’sassets and reserves. An agency with a comparablyhigh percent of NPAs to assets will not be penalizedas much if it has a high level of reserves to coverlosses on those loans.The final set of ratios measure an agency’s liquidityto cover short-term financial needs. The mainratio of loans to assets tends to be among the moststable of all HFA ratios. While desirable, high liquidityis often at odds with an agency’s mission ofproviding access to loans and reduces profitability.As a result, liquidity ratios receive the lowestweight in terms of significance.The financial analysis described above is viewedwithin the risk profile of an agency. One tool thatStandard & Poor’s incorporates to determine anagency’s risk profile is capital adequacy analysis.This process involves adjusting an agency’s equityfor any risks and shortfalls it may have to cover inscenarios that include default or catastrophe, suchas an earthquake. Standard & Poor’s will evaluatean HFA’s loans, contractual obligations and restrictionson equity to determine what assets would beavailable for the agency to honor its commitmentsor maintain the ratings on various bonds.Standard & Poor’s uses three principal ratios tomeasure an HFA’s capital adequacy:■ Adjusted unrestricted assets to total debt outstanding(leverage ratio),■ Adjusted unrestricted assets to total GO debtoutstanding (GO leverage ratio), and■ GO debt exposure (GO debt to totaldebt outstanding).www.standardandpoors.com291

HousingStandard & Poor’s adjusts an agency’s unrestrictedassets based on the level of reserves needed to supportGO debt and surpluses available from securedbond resolutions that are available for transfer to theagency’s general fund. The “adjusted” unrestrictedassets position is then divided by total debt and GOdebt (rating dependent) in order to gauge the level ofassets available to all bondholders.HFAs with an investment-grade ICR are expectedto maintain a minimum leverage ratio of 4%,with available liquid assets equal to 2% of totalloans outstanding.GO debt exposure is a good measure of the potentialdispersion of an agency’s unrestricted assets inthe event a call to the agency is required for debtservice on GO debt. The ratio is derived by dividingGO debt (rating dependent) by total agency debtoutstanding. Exposure is classified as low (0%-20%), moderate (21%-50%) and high (above 50%).Standard & Poor’s is concerned with an increasingGO debt exposure ratio in conjunction with deteriorationin unrestricted assets, as measured by theleverage ratios and the GO debt leverage ratio.Asset qualityIn light of the fact that HFAs cannot levy taxes orraise user fees, the assessment of asset quality, intandem with earnings quality, is of paramountimportance in determining an appropriate ICR.This is important even for HFAs that have no GOdebt outstanding. Many HFAs have built up considerableequity in their general funds and bond programsand have significant control of these assets.In order to determine the likelihood of asset accumulationover time and the likelihood of availability,Standard & Poor’s evaluates the quality of theagency’s mortgage collateral, focusing on portfoliosize, dwelling type, loan types, payment characteristics,mortgage insurance and guarantees, loanunderwriting criteria, and location. The agency’sloan portfolio performance is measured againstcomparable agency and Mortgage BankersAssociation (MBA) delinquency statistics to determinerelative performance, and historical losses aremeasured to determine the effect on net assets.Standard & Poor’s also evaluates the quality ofthe agency’s investment portfolio. In manyinstances, investments make up a significant portionof an agency’s asset base. In general,Standard & Poor’s analysis focuses on the investmentof net assets, restricted and unrestricted, aswell as bond funds. The amount of funds beinginvested, who manages the money, how dailyinvestment decisions are made, and the guidelinesthat are in place are reviewed. The agency’sinvestments should meet Standard & Poor’s standardpermitted investment guidelines. Principalprotection and liquidity should be the primarygoals of an HFA’s investment policy.Standard & Poor’s must feel comfortable that amunicipal issuer, such as an HFA, has specific guidelinesand systems in place to manage its exposure toderivative products and interest rate volatility.If an HFA invests in intergovernmental pools,these investments can further the goal of principalprotection and liquidity by using the same guidelinesoutlined for HFA bond and general funds.Debt levelsSince HFAs are generally highly leveraged entities, anagency’s GO debt philosophy—as it relates to theother ICR rating factors—is a crucial determinant ofcredit quality. If an HFA serves as a conduit andissues limited or special obligation bonds backedonly by mortgages, risk associated with debt repaymentis unlikely to pose risk to the HFA’s unrestrictedassets. In cases when an agency pledges its generalobligation as ultimate credit support, risk to theagency is potentially increased. This will be particularlytrue if the HFA is issuing GO bonds to financenon-earning assets. Standard & Poor’s refers to thisrisk as GO debt exposure. This exposure may bequantified through the GO debt exposure ratio asdiscussed above. Another factor is the agency’s exposureto interest rate and other risks through theissuance of variable rate debt and hedging instruments.Standard & Poor’s Debt Derivative Profile(DDP) evaluates an issuer’s risks related to debt-associatedderivatives. A discussion of the methodology isincluded in the Municipal Swap Criteria.Management and legislative mandateStandard & Poor’s assesses the operating performanceof HFAs, focusing on organization, philosophy,strategies, and administrative procedures.Standard & Poor’s assesses the continuity of managementand the agency’s ability to resolve difficultsituations during its operating history. The agency’sadministrative capabilities, such as portfolio oversight,loan-servicing capability, planning procedures,and sophistication of technology, are keyfactors in evaluating management.Next, financial management is consideredthrough historical financial performance, as well asthe experience and qualifications of financial personneland overall management. Although someaspects of financial management, such as cash flowgeneration, may be contracted out, effective managementincludes active review and oversight of allfinancial operations.In evaluating an HFA’s legislative mandate,Standard & Poor’s needs to be assured that thelong-term viability of the agency has the full supportof public officials. Security of agency net assetsand continued management autonomy are essential.292 Standard & Poor’s Public Finance Criteria 2007

Housing Finance AgenciesIn many instances, much of the initial funding forthe agencies may have been provided by the state orlocality, and key members of the agencies may beappointed by elected officials.The key to this analysis is to identify detractorsof the authority, if there are any, and find bipartisansupport for the authority’s programs. This canbe demonstrated by a history of legislativeapprovals of annual budgets, special programs,additional funding, housing legislation, and soforth. Also, the autonomy of the management team,should be unaffected by gubernatorial and legislativeelections. The agency also should anticipate thehousing needs of the legislatures’ constituents andcontinue to develop programs to address them.EconomyAnalysis of the state or local economic baseincludes evaluating the impact of changes indemand for housing, the impact of changing regulatoryand legislative environment for low-and moderate-incomehousing, and the dependence onspecific industries and how that may affect theagency’s mortgage portfolio.Housing in larger states with more diverseeconomies is less affected by economic trends thanhousing in smaller geographic regions. Therefore,the critical factors will vary based upon the regionin which the HFA operates. ■www.standardandpoors.com293

Other CriteriaBond InsuranceThe dramatic growth and acceptance of the useof bond insurance has been one of the mostinfluential developments of the past 35 years forcapital markets. From its modest beginnings in1971, when Ambac Assurance Corp. wrote its firstpolicy in the U.S. municipal bond market, the useof financial guaranty insurance has become notonly a significant mainstay of government infrastructurefinance in the U.S. but also a major forcein asset-backed, structured finance, and projectfinance transactions around the world. Accordingto the financial guaranty industry’s trade organization,the Association of Financial GuarantyInsurers, insurance in force (principal and interest)at the end of 2005 totaled nearly $2.9 trillion. In2005, bond insurers wrote coverage on more than$540 billion in par value of obligations.The success of bond insurance as a productreflects the fact that it provides a tool that issuersuse to lower their financing costs and to broadenthe investor base for their securities. Additional factorsthat have supported this success include theattractiveness of bond insurance to retail investorswho are risk-averse, the higher proportion of morecomplex transactions, periodic flights to quality,and greater numbers of issues eligible for insurance.Insurance penetration in the various marketsserved varies, based largely on the length of time thebond insurers have been active in the particularmarket, the extent to which a robust capital markethas developed in a segment or region, and the existenceof viable competitors or alternate issuancestructures that do not require bond insurance. Theinsurers’ highest penetration is in the U.S. municipalmarket, where more than 50% of the new issuancehas been insured in recent years. Penetration islower in the U.S. structured finance market, reflectingthe availability of alternate issuance structuresthat do not require insurance. Outside the U.S., penetrationis less developed, reflecting a combinationof less-developed capital markets, significant competition,and the fact that insurers have been active inthese markets for shorter periods of time.A bond insurance policy represents a financialguaranty company’s unconditional and irrevocablepledge to pay principal and interest in a timely fashionshould the issuer of the debt be unable to do so.The Standard & Poor’s Ratings Services financialstrength rating is a current opinion of the financialsecurity characteristics of an insurance organizationwith respect to its ability to pay under its insurancepolicies and contracts in accordance with theirterms. In addition to their financial strength ratings,the monoline companies also carry a companionfinancial enhancement rating. This rating providesinvestors with a specific opinion regarding an insurancecompany’s willingness to pay financial guarantyclaims on a timely basis.By regulation, since 1986, an insurer wanting toconduct bond insurance business in the U.S. had tobe operated as a monoline company—that is, a separatelystructured and capitalized entity operatingsolely as an insurer of third-party debt. The mostprevalent business model for a primary insurer, interms of numbers of active companies and evenmore so in terms of debt insured, is to be ‘AAA’rated. All the major monoline insurers have ‘AAA’ratings and are engaged in the guaranty of publicfinance debt—the older, more established segmentof the business that dates back to 1971—as well astaxable structured financings, which is a segment ofthe business that began in 1986. All the major‘AAA’ rated monoline primaries also insure transactionsoutside the U.S., either directly or throughsupported affiliates. There are two niche primaryinsurers, one ‘AA’ rated and one rated ‘A’, that participatein several of the same sectors as do the‘AAA’ primaries but seek out certain niches, eitherbased on lower credit quality or limited ‘AAA’monoline involvement, where they can competeeffectively. Many non-U.S.-based multiline insurers(insurers that participate in several product lines)still participate in the financial guaranty businessoutside the U.S. and as reinsurers of the U.S.-basedmonoline insurers.Rating MethodologyStandard & Poor’s rating methodology for monolinebond insurers addresses many of the same factorsinvolved in any insurance company’s financialstrength rating. However, the criteria developed forbond insurers have been tailored to the uniqueaspects of the financial guaranty business and differin important respects.One critical difference compared with other insuranceproducts is the expectation that only minimal294 Standard & Poor’s Public Finance Criteria 2007

Bond Insurancenet losses will occur in a normal operating environment.This expectation is based on the credit qualityof the insured portfolios, which overwhelminglyconsist of issues that are investment grade or nearinvestment-grade quality on an uninsured basis. Inother words, it is presumed that insurers only takeon liabilities judged to have minimal loss potential,except under extreme economic conditions.To date, losses incurred by monoline financialguaranty businesses rated by Standard & Poor’shave, in fact, been minimal. Based on this experience,there is little basis for establishing largereserves that normally are found with more traditionalinsurance lines, except where individualtransactions have necessitated “case-basis” reserves.Since the typical reserve analysis is not applicable,Standard & Poor’s uses a different approach—thecapital adequacy model—to determine the adequacyof capital reserves. This model tests the ability of thebond insurer to handle claims that would be expectedto occur in a hypothetical worst-case scenario.This scenario is structured to incorporate a level ofeconomic stress far more severe than might beexpected to occur in the normal cyclical functioningof the world’s economy.Another difference is that the criteria havebeen established with rating durability in mind.Table 1 Reinsurance Credit For Business Ceded ToA Monoline Reinsurer—Monoline reinsurer rating—(%) AAA AA A BBBCeding Company RatingAAA 100 70 50 N/AAA 100 75 70 50A 100 80 75 70N/A—Not applicable.Table 2 Reinsurance Credit For Business Ceded ToA Multiline Reinsurer—Multiline reinsurer rating—(%) AAA AA A BBBCeding Company RatingAAA 95 65 45 N/AAA 95 70 65 45A 95 75 70 65N/A—Not applicable.Investors expect that bond insurers’ ratings will bestable and not subject to frequent adjustmentbased on the normal ebbs and flows of credit qualityover the traditional economic cycle. While thecriteria have been crafted to encourage sound businesspractices that should result in stable ratings, itis not so limiting that ratings would never change.Poor execution of the business plan, underwritingpractices, or risk management, or decidedlyadverse credit quality changes to the underlyinginsured bonds, could result in a change to theinsurer’s rating.The following sections highlight rating criteria forrated insurers operating in the monoline format.Criteria for lower rated insurers is the same as for‘AAA’ rated insurers in many respects, differing primarilywith regard to underwriting, where the insurercan insure a higher proportion of speculative-gradetransactions; capital adequacy, where the insurer isnot required to be as strongly capitalized relative torisk assumed as would be an ‘AAA’ rated insurer; andcredit for reinsurance, where the credit given for aparticular reinsurer is somewhat higher and the ratingeligibility requirement is less restrictive.Monoline InsurersIn assessing the financial strength of each monolinebond insurer, Standard & Poor’s focuses on the followingareas detailed below.OwnershipStandard & Poor’s is comfortable with mature insurershaving significant public ownership as long as theinsurers practice long-range capital planning, includinga proactive capital sourcing philosophy that proposesto access capital well before it might be needed.Debt owed to third parties can also be appropriatefor mature insurers, as long as it is limited to a modest15%-20% of the holding company’s capital structureand its maturity structure is consistent with thecapital-generating ability of the business.Standard & Poor’s believes that the ideal ownershipprofile of a newer, less-established insurershould consist of large institutional investors ofhigh credit quality with a firm commitment to theindustry. The ideal capital structure for a holdingcompany is 100% equity. How-ever, minimal holdingcompany leverage is not a concern as long aseach debtholder also holds equity and all debtholdershold the same mix of debt and equity, as ownershipcreates a commonality of interest amonginvestors. The presence of high net worth individualsor public ownership of stock would not beviewed negatively, provided that such ownership isvery limited. Until the insurer has reached a level ofmaturity characterized by several years of successfuloperations, Standard & Poor’s does not considerwww.standardandpoors.com295

Other Criteriathe insurer to be seasoned enough to become significantlyreliant on the sometimes extremely ficklepublic markets for access to capital.Our minimum capital level for start-up bondinsurers is the greater of $300 million (paid-in andcontingent capital), of which two-thirds must bepaid-in, and that amount necessary for the insurerto demonstrate capital adequacy under Standard &Poor’s capital adequacy model. At this capitalizationlevel, Standard & Poor’s believes that a companyshould be able to operate successfully, attractingtop-level reinsurers, achieving over time a largediversified insured portfolio, hiring and retaininghighly qualified personnel, and meeting certainunforeseeable single-risk losses.Any capital commitments are risk-weighted andmust meet specific rating requirements to be creditedtoward the minimum capital target (see“Reinsurance” and “Bank lines and LOCs, capitalsupport from third parties, and parental support”sections below for more information). For example,in the context of an ‘AAA’ financial strength rating,a commitment from an ‘AAA’ owner will be given100% credit, a commitment from an ‘AA’ ownerwill be given 70% credit, and a commitment froman ‘A’ owner will be given only 50% credit. If theowner has a lower rating or no rating, no creditwill be given toward the minimum goal.ManagementSenior management is evaluated in terms of experiencein the bond insurance industry, related creditanalysis, and capital markets. Management’s abilityto establish strong operating and monitoring controls,including expense and risk management andsurveillance, is a key factor. Managerial depth andan awareness of the relationships between risks andpremium structure are also evaluated.Underwriting and risk managementA key assumption in Standard & Poor’s ratingmethodology is that the insured portfolio will meetcredit quality composition standards. For ‘AAA’rated insurers, this means the portfolio will consistoverwhelmingly of municipal and structuredfinance issues with an investment-grade (rated‘BBB-’ and above) risk of default. For ‘AA’ ratedinsurers, the portfolio can contain up to 15% ‘BB’rated issues, and ‘A’ rated insurers can have ‘BB’rated issues up to 40% of the municipal segmentand up to 25% of the structured segment of theportfolio. To validate this assumption and to assigncredit estimates for transactions in the overall portfoliothat help determine capital charges (a measureof portfolio risk), Standard & Poor’s performs aseparate credit assessment of each issue sold on aninsured basis. In addition, Standard & Poor’s meetsregularly with senior underwriting management toreview and discuss underwriting criteria.To minimize the effect of any negative sector trendsor local economic deterioration, Standard & Poor’sexpects the insured portfolio to be diversified withregard to the sector type and geographic location ofthe issuer. Standard & Poor’s also monitors single-riskconcentrations to prevent excessive exposure to anyone credit.In addition to reviewing the credit quality ofissues at the time of insurance, Standard & Poor’salso periodically monitors the bond insurer’s portfolioto look for any significant credit deteriorationthat might give rise to a need for additional capital.This is accomplished by a review of the insurer’ssurveillance activities, as well as Standard & Poor’sown independent examination of the outstandingportfolio. Standard & Poor’s monitors any creditslisted on CreditWatch on an ongoing basis to assessany vulnerability to claims payment.Capital adequacyAmong all the key rating areas examined, capitaladequacy forms the foundation for the capacity topay claims if needed. This area is examined moreextensively later in this article in the section titled“Standard & Poor’s Capital Adequacy Model.”This section defines the role of capital adequacy inour analysis and provides a detailed description ofour capital adequacy model, including its keyinputs and outputs, the factors that most influencethe results, and the key metrics based on the outputof the model. The model, which is a powerful toolfor evaluating capital adequacy but not the soledeterminant of the rating, is periodically reviewedand updated as circumstances warrant.ReinsuranceStandard & Poor’s capital adequacy model recognizesthat reinsurance (or reinsurance-like lines orLOCs, committed capital facilities, and parent-companysupport—collectively “soft capital”) can providevaluable risk-sharing and capital augmentationbenefits. The benefits are risk adjusted to reflect thecredit quality of the third-party provider, andcapped by individual provider and in the aggregateto avoid undue reliance on third parties. Moreover,benefits are granted only where a provider has beenjudged to possess the willingness to perform underthe related contacts in a full and timely manner. Ourcriteria relating to credit for soft capital incorporatean up-to-date evaluation of the reinsurance industry’sdynamics and performance and rely on the latestanalytic tools and techniques for assessing risk.Traditional reinsurance. The credit given for traditionalreinsurance is a function of several factors,the most important of which are the reinsurer’s rat-296 Standard & Poor’s Public Finance Criteria 2007

Bond Insuranceing; the durability of that rating; the ceding company’s(beneficiary’s) rating, which defines the level ofcertainty of performance desired; and the fact thatthe pool of active reinsurers is quite concentratedand highly correlated.Monoline reinsurers—those that only write financialguarantee business—are desirable counterpartiesreflecting their commitment to the business andthe fact that their ratings have proven to be highlydurable. By definition, a monoline reinsurer isdeemed to possess the willingness to pay claims infull and on time because its failure to do so wouldseverely inhibit its ability to attract new business.(See table 1 for a listing of reinsurance credit givenfor monoline reinsurance.)On the other hand, multiline reinsurers—thosethat write reinsurance over many product lines—are in aggregate somewhat less desirable giventhat their ratings have been comparatively lessdurable and they have a checkered history of participationin the financial guarantee sector. Forthese reasons, the credit for reinsurance from multilinereinsurers is five percentage points lowerthan the credit given to comparably rated monolinereinsurers. (See table 2 for a listing of reinsurancecredit given for multiline reinsurance).In addition, multiline reinsurers have, on occasion,demonstrated a propensity to handle financialguarantee claims using the time-honored traditionalreinsurance practice of investigating first, thennegotiating, and finally paying the negotiated claim.This practice fails to meet the needs of the financialguarantee market, which relies on timely payments.Therefore, for multiline reinsurance to receive thecredit listed in table 2, two conditions must be met:(1) the reinsurer must get a Standard & Poor’sfinancial enhancement rating, which signals that ithas met our standards regarding willingness to payclaims in a timely manner, and (2) the financialguarantee product line for the reinsurer must bedeemed to be a material part of the reinsurer’s business,which dictates that a failure to make timelypayment of a financial guarantee claim would resultin immediate financial strength and financialenhancement rating downgrades. The combinationof these two requirements gives us comfort that themultiline reinsurer’s willingness and incentive tomake timely claims payments is on a par with themonoline reinsurers.Bank lines and LOCs, capital support from thirdparties, and parental support. Banks are significantproviders of soft capital facilities that cover lossesup to a certain specified amount in the event thatan insurer’s losses exceed a threshold amount(“attachment point”). Attachment points are set tocorrespond to a severe loss scenario. Although thereis no history of bond insurers drawing on thesefacilities, banks are viewed as presenting the samecertainty of performance as qualifying insurancesoft capital providers. Banks achieve this status byvirtue of their long and favorable history of performancein honoring LOCs and by the fact that afailure to perform could trigger credit events underother bank products. Because banks exhibit twonegative characteristics in common with multilinereinsurers—that their ratings are less durable thanthose of monoline bond insurers and that somebanks have shown a propensity to change businessstrategy from time to time, resulting in decisions tocease offering these products—credit for bank linesand LOCs will be the same as given for qualifyingmultiline reinsurers (see table 2). Multiline reinsurersproviding similar products will receive the samecredit as outlined for multiline reinsurers providingtraditional reinsurance.Credit given for loss coverage facilities is dependenton the full amount of the facility being availableto the ceding company. For example, if a facilitywas structured to cover the next $500 million inlosses once $1 billion in losses had been incurred(the attachment point) it would be of less value ifour capital adequacy model projected total losses of$1.3 billion. In this example, only $300 million ofthe facility would be drawn. Accordingly, the fullamount of the facility will be considered for appropriatereinsurance credit only if the full amount oflosses covered plus retained losses up to the attachmentpoint are no more than 80% of total projectedlosses. Projected losses above the 80% level that arestill eligible for coverage by the facility would begiven credit at 50% of the otherwise applicableamount. No credit will be given for losses in excessof total projected losses that are eligible for coverageby a facility.Parent companies have a greater incentive tofund their capital commitments to the monolineinsurer because they have a significant investmentthat would be at risk should the commitment notbe funded. Therefore, credit for parent companycommitments will be the same as is given monolinereinsurers.Committed capital facilities. Committed capitalfacilities bring together the capital markets andreinsurance markets by creating a funded pool ofcapital that is available to the “beneficiary” in theevent of significant losses. These facilities eliminatethe risk that a soft capital provider will be unableor unwilling to perform through the mechanism ofestablishing a pool of funds that is available asneeded. By investing in extremely high-qualityassets and limiting when draws can occur, thesefacilities can provide essentially unquestionedaccess to funds without credit quality or marketvalue risk.www.standardandpoors.com297

Other CriteriaCommitted capital facilities will receive 100%credit, provided that asset credit quality and marketvalue risks have been eliminated to an ‘AAA’certainty. Credit will be reduced to reflect the existenceof asset credit quality risk, market value risk,or counterparty risk. Committed capital will becounted against an insurer’s overall soft capitallimits and will be limited as a percent of an insurer’scapital structure.Acknowledging the risk of a failed or dysfunctionalauction, Standard & Poor’s believes issuingauction-rate securities to fund a committed capitalfacility is most appropriate for those bond insurersthat are not part of a larger group, where there area greater number of potential sources of adversenews that could cause an auction to fail to properlyfunction. Specifically, bond insurers owned by alarge, diversified group or by a small pool ofinvestors are limited to auction-rate funded facilitiesequal to 10% of adjusted statutory capital (statutorycapital plus committed capital facilities). All publiclyheld monolines can have auction-rate fundedfacilities equal to 20% of adjusted statutory capital.Although these facilities offer many advantagesover other forms of soft capital, particularly withregard to the durability of the access to funds andthe absence of reliance on a third party to performunder a contract, they are not necessarily as permanent,nor do they provide as much flexibility, aspaid-in capital. Therefore, these facilities will beincluded in overall soft capital limits, and fees paidby the insurer are treated as interest expense whenanalyzing the consolidated enterprise. Once drawn,these facilities are viewed as debt at the consolidatedholding company level.Amounts issued in excess of the allowable limitswill not be treated as either debt or equity at theholding company level and will not be included ascapital in the capital adequacy model. Over time,the insurer will get more credit for the facility asallowable amounts expand, reflecting the growth inthe capital base and soft capital usage limits.Committed capital facilities are also constrainedby a test that limits total hybrid equity plus committedcapital facilities to no more than 20% of theinsurance holding company capitalization plus committedcapital facilities.Collateralized trust funds as a meansof enhancing credit given for reinsurance.Standard & Poor’s will give 100% credit againstceded capital charges for reinsurance backed by collateralas long as the following structure is in placeand under the following constraints:■ The structure is available only to reinsurers rated inthe ‘BBB’ category or higher.■ The collateral must be posted in a third-partytrust account for the benefit of the ceding company.Legal opinions must support the fact that thetrust is completely independent of the reinsurerand cannot be changed, impaired, or recapturedin the event of financial stress at the reinsurer.Legal opinions must also support a ceding companyto at all times have unimpeded access to thefunds in the event of nonpayment by the reinsurerfor any reason.■ Acceptable collateral is limited to cash, U.S. governmentsecurities, and ‘AAAm’ rated moneymarket funds. Other collateral will be consideredon a case-by-case basis.■ Collateral should be marked to market daily,and at all times should be valued (adjustedvalue) using Standard & Poor’s structuredfinance market value criteria. If the adjustedvalue falls below the amount required to achieve100% credit, the reinsurer must post additionalcollateral no later than three days from the datethe collateral fell below required levels.Shortfalls must be reported to Standard & Poor’sand the ceding company immediately, along withremedial steps to be taken.■ Standard & Poor’s should receive a quarterlyreport listing all securities held in the trustaccount. The report should include the type ofsecurity, maturity, Standard & Poor’s collateralfactor, and net adjusted value. The independentthird-party trustee for the trust should preparethis report.To compensate for the fact that the book of businessceded to the reinsurer is not identical to the cedingcompany’s book of business, raising the possibilitythat the ceded book of business might performless favorably than the ceding company’s book, theamount of collateral posted, after market valueadjustments, must be at least 125% of the totalceded capital charges. Where the reinsurer’s book ofbusiness does not exhibit satisfactory sector and geographicdiversity and single-risk management, thisadjustment can be increased. This adjustment is notapplied when collateral is being posted to increasethe credit given for facilities where a specified dollaramount of losses is being covered in excess of anattachment point.Reliance on soft capital providers. Standard &Poor’s monitors the reliance that a bond insurerplaces on reinsurance and other capital substitutes,such as owners’, third-party, or prefunded capitalcommitments to provide additional capital.Reliance on soft capital is thought to be excessivewhen these alternate forms of capital provide morethan 33% of an insurer’s total depression-periodclaims-paying resources. For this test, collateralized298 Standard & Poor’s Public Finance Criteria 2007

Bond Insurancereinsurance as described above is not counted assoft capital.Concentrations of soft capital providers aremonitored as well, using guidelines designed tolimit the effect of a nonperforming soft capitalprovider. An insurer’s reliance on a single providerof soft capital is measured using an alternativemargin of safety test, which assumes the default ofone soft capital provider. Reliance on a single softcapital provider is excessive if, under the alternativemargin of safety test, the default of thatprovider would cause a bond insurer’s margin ofsafety to drop five basis points or more below theminimum margin of safety required at the insurer’scurrent rating level. For purposes of this test, exposuresto soft capital providers under committedcapital facilities are included in soft capital but notassumed to default, and collateralized reinsuranceis excluded from soft capital.Financial performanceThe quality, level, and predictability of underwritingand investment income are important factors inthe analytical process. The insurer’s pricing policyshould demonstrate that premium levels provide asufficient return in relation to the capital requiredto support that issue. The predictability of underwritingincome is based, in part, on market conditionsand the composition of premium income (thatis, new issue, secondary market, unit investmenttrust, or mutual fund). The profitability of a startupcompany initially could be restricted because ofstatutory accounting conventions.Standard & Poor’s evaluation of investmentactivities focuses on the performance and risk characteristicsof the portfolio, including a discussion ofits composition, credit quality, and concentrationby issuer, industry, and geography. Another considerationis the relationship between the maturity ofthe investment portfolio and the average maturityof the insured bonds. Finally, liquidity resources areevaluated and measured against potential needs forfunds to pay claims (see “Liquidity uses andresources” section).The insurance operating company’s financialstatements produced under conservative statutoryaccounting principles are the primary source ofinformation for analyzing its financial strength andperformance. Consolidated holding companyresults, reported under GAAP accounting, also containuseful information—particularly for assessingmanagement’s conservatism, as evidenced in howthe company exercises judgment in the applicationof accounting practices and the company’s access tocapital based on its comparative returns on equityand use of debt leverage.DiversificationDiversification within the bond insurance industrycan take two forms: (1) diversification of the financialguaranty business plan and (2) holding companydiversification into noninsurance businesses.With respect to a company’s financial guarantybusiness plan, significant challenges face thoseorganizations that would seek to enter the business.Many start-up proposals have not successfullypassed the ratings process because of the difficultyof developing a credible business plan.The keys to success—and for achieving high ratings—includea well-diversified business plan andunderwriting strategy that today must at least targetboth structured finance and public finance inthe public and private markets with proper sector,market, and geographic diversity. We feel a diverseunderwriting strategy would enable a bond insurerto deploy capital to those markets that offer thebest growth prospects and returns on capital asthe capital markets change. Because of the emphasisplaced on a diverse financial guaranty businessplan, bringing a significant amount of capital tothe rating process is necessary, but not sufficientfor a start-up to attain a high rating. Solely relyingon investors’ desire for greater guarantor diversityis not an appropriate foundation to prove the economicviability of a company. It should be notedthat the sheer number of existing monolinesalready in the market has changed the businessdynamics for those firms that wish to follow. InStandard & Poor’s opinion, it will be more difficultfor start-up firms to earn an ‘AAA’ financialstrength rating if they only wish to do business ina single business segment. The need to convincinglydemonstrate the viability of the proposed businessplan will carry greater weight in our analysisgoing forward.In years past, bond insurance holding companiessought to diversify to enhance growth prospectsand seek higher profitability. For some companies,diversification efforts centered on financial services,such as money management, municipal investmentcontracts, and swaps. From a benefits perspective,alternative products’ contribution to consolidatedincome could relieve pressure on management toforge ahead in financial guaranty sectors that nolonger present attractive risk/reward dynamics.While these alternative products can contribute toconsolidated income, they can also present risk tothe bond insurer.For those activities that involve new productsand skills that are not consistent with traditionalbond insurance risks and skills, risk-managementpractices and staff capabilities receive addedwww.standardandpoors.com299

Other Criteriaemphasis in Standard & Poor’s analysis of aninsurer’s financial strength rating. Our analyticalapproach to diversification is to analyze each ofthe new activities and develop a capital charge, ifneeded, which is assessed to the bond insurancecompany. The charge will reflect the risk that theinsurer, as the “deep pocket” in the organization,might have to support the entity in a worst-casescenario. In addition, capital charges will incorporateany specific risk the insurer has taken on byexplicitly supporting diversification activity.Liquidity uses and resourcesStandard & Poor’s liquidity analysis for bond insurersexamines the ratio of current liquidity resourcesto the insurers’ largest possible claims or other paymentsdue in a given year. The aggregation ofclaims is in no way meant to suggest that thosepayments are expected, but rather is theoreticalanalysis. This exercise differs in concept fromStandard & Poor’s capital adequacy model thatmeasures a theoretical widespread depression levelof future worst-case losses against future claims-Bond Insurance Capital Adequacy Model—Growth Years——Depression Years—1 2 3 4 5 6 7NewBusinessActivityAssumed new business activity mirrors company’s business plan in year 1, followed by aggressive growth in years 2 and 3.The depression begins in year 4 and continues for 4 years. During these years, no new business is written but premiums continueto be collected for existing annual premium business.PremiumsWrittenPlanGreater of planor growth assumptionsNo new business written; collect installment premiums on existing businessNetIncomePremiumsEarnedNet Income = Premiums earned – operating expenses –losses + investment income + gains/(losses) on asset sales – taxesPremium earning pattern based on scheduled maturity of issues;no refundings or early calls assumed beyond year 1OperatingExpensesPlanGrowth consistentwith premium growthDecline to 93%of year 3 levelDecline to 89%of year 3 levelDecline to 70%of year 3 levelDecline to 48%of year 3 levelLosses(Net ofReinsuranceand SoftCapital)DiscreetlossesDiscrete losses plus debtservice reserve lossesDiscrete losses plus debt service reservelosses plus assumed defaultsReinsurance credit determined by ratings of reinsurance provider.Soft capital credit determined by rating of provider or structure.Discrete losses plusassumed defaultsInvestmentIncomeExisting investment yields based on embedded rates;new investment yields based on assumed ratesInvestment income discounted for assumeddefaults in investment portfolioAssetSalesNone assumedSale prices reflect discount for reduced liquidityand high interest-rate environmentSale prices reflect discount forreduced liquidityPolicyholder’sSurplusContingencyReservePolicyholder’s surplus = prior year’s ending surplus + net income +/–changes in contingency reserve + benefit of teax and loss bonds – dividendsAnnual additions based on regulatory requirements;reserve may be released if loss ratios exceed a specific amount in any yearAsset CarryingValueNo adjustmentCarrying value adjusted to reflect market valuedeclines due to defaultDividends toHoldingCompanyDividends paid to cover dividends to holding companystockholders plus debt service requirementsDividends paid to cover holding companydebt service requirements300 Standard & Poor’s Public Finance Criteria 2007

Bond Insurancepaying resources. The liquidity analysis reflects theassumption that occasional large losses could occurin a nondepressed economic environment.Uses. In addition to predictable and routine usesof cash, such as salaries and rents, which are capturedin the financial statement’s net cash flow fromoperations calculation, bond insurers face the possibilityof unanticipated cash outflows that representStructured Finance Capital Charge FormulaThe revised formula for structured finance capital charges is:(‘AAA’ - ’BBB–’ Credit Gap)4X1-‘AAA’ – ‘BBB—’ Credit Gap— This value is to be used regardless of the actualprotection in the transaction. The additional protection that may be presentin the transaction above ‘BBB—’ is taken into account in the second half ofthe formula.Investment-Grade Loss Coverage Provided— This value is equal to the amount offirst-loss protection in the form of collateral, other enhancements such as spreadaccounts or cash, or credit-adjusted reinsurance in excess of the ‘BBB—’ levelof protection.(Investment-Grade Loss Coverage Provided/‘AAA’ – ‘BBB—’ Credit Gap) 0.7 — Thefraction computes the portion of the ‘AAA’ – ‘BBB—’ Credit Gap that is coveredwith first-loss protection. This value taken to the 0.7 power defines the amount ofpotential investment-grade-level losses that have been covered by the first-lossprotection. The capital charge is equal to [one minus the percent of investmentgradelosses covered by first-loss protection] times the investment-gradecapital charge.Example 1—Typical One-Class Transaction—Entire Security InsuredAssumptions:‘BBB—’ loss coverage level 7.33%‘AAA’ loss coverage level 20.00%Actual loss coverage provided 11.00%(‘AAA’ - ’BBB–’ Credit Gap)4X1-0.7Investment-Grade Loss Coverage Provided‘AAA’ - ‘BBB–’ Credit Gap0.7Investment-Grade Loss Coverage Provided‘AAA’ - ‘BBB–’ Credit GapExample 2—Typical Multiclass Transaction—Junior Class InsuredAssumptions:‘BBB—’ loss coverage level 7.33%‘AAA’ loss coverage level 20.00%Actual loss coverage provided 11.00% – 13.00%■ The capital charge for the ‘A’ class is equal to the difference in the capitalcharge based on the two loss coverage levels that define the range ofthe class.■ The capital charge for loss coverage of 11.00 is 1.84 as computed in Example 1.■ The capital charge for loss coverage of 13.00 is 1.36 as computed in thesame fashion.■ The capital charge for the class is the difference in the two capital chargesor 0.48% of the assets in the collateral pool or about 24% of the par value ofthe class.potential demands on liquidity. For purposes of thisanalysis, we assume cash payments are required toaddress a default or other cash need in each of theinsurance sectors and cash sensitive noninsurancebusinesses in which the bond insurer operates. Thelist of possible cash requirements is as follows:■ The default of a municipal obligor and associatednet payments (largest such exposure in agiven year);■ Largest net bullet maturity default (potentiallyincludes investor-owned utilities, internationalbonds, or “guaranteed” maturity bonds);■ Largest debt services reserve draw;■ For the asset-backed sector, 90 days of paymentsassociated with the default of the insurer’slargest servicer;■ Largest noninsurance business obligation, ifapplicable, such as largest unscheduled draw on amunicipal investment contract;■ Holding company debt and dividend-servicingneeds; and■ Other cash requirements as deemed appropriate.The sum of all theoretical potential cash paymentsin each operating sector is then aggregatedand compared with cash resources.Resources. We assume that in a nondepressionsituation, insurers would choose, with respect toconverting financial assets to cash, to use thereverse repurchase (repo) market rather than dealingwith the tax, earnings, reinvestment issues, andtransaction costs associated with a forced sale ofbonds. Essentially a collateralized loan, the repomarket is a very large and liquid market that usuallyprovides attractive financing rates. Since repomarket participants (money market investors) arequite conservative in terms of eligible collateral,municipal bonds and other less-liquid financialassets like small business administration debt are,regardless of rating, not an acceptable source ofsecurity. They are nonetheless noted as a secondarycash resource. If a bond insurer, however, canestablish a municipal repo line with a counterparty,Standard & Poor’s might give some amount ofcredit for investments in municipal securities. Weinclude corporate and asset-backed debt as aresource; in view of less-than-universal acceptanceby all market participants and conservative marginrequirements, however, we haircut this asset classat 50%. Treasury, FNMA, and FHLMC bonds arealso conservatively haircut at 10%.Bank lines are another source of cash, albeitsometimes clouded by restrictions, or “outs,” suchas material adverse change language. Some linesalso allow the bank to cancel a facility in the eventof a rating change. For purposes of this analysis wetake into consideration the fact that the scenario wewww.standardandpoors.com301

Other Criteriahave presented might not necessarily jeopardizeexisting ratings. Cash resources include:■ Cash and short-term investments,■ Treasury and government agency fixedincome securities,■ Corporate and ABS/MBS bonds,■ Bank lines of credit, and■ Other securities as deemed appropriate.Historically we have observed, and continue toexpect, that discounted cash resources exceed thesum of theoretical claims and other payments inany given year. Conservative investment practicescommon to the industry that emphasize highlyrated fixed-income assets play a major role in theindustry’s sound liquidity profile. Likewise, thenature of the payment risk as defined in the policy,limiting claim obligations on defaulted insured debtto principal and interest as it comes due, also supportsthe bond insurers’ strong liquidity positions.Barring exceptional circumstances, the ratio of cashresources to possible uses of cash should be greaterthan 100%.Start-Up InsurersBond insurers need financial strength ratings fromone or more rating agencies as a prerequisite tocommencing operations. This unique requirementreflects the fact that the product that a bond insureroffers is in effect its financial strength, andinvestors will not purchase insured bonds withoutone or more independent evaluations of the insurer’screditworthiness. Standard & Poor’s is comfortablerating start-up bond insurers without thebenefit of a track record based on our rigorous initialreview of the insurer’s business plan, the qualificationsof its senior management, the commitmentand oversight of the owners, and the underwritingand risk-management guidelines, withsemiannual follow-ups to review progress. Thesereviews are complemented by our deal-by-dealreviews of all new business written that serve as anongoing check on underwriting philosophy andpractice. Finally, our minimum capital requirementsprovide a significant capital cushion duringthe early years of the insurer’s life while it is developinga diversified book of business and is moresusceptible to errors in underwriting and/or businessplan execution.The rating process for a new insurer is initiatedby a request for rating. Once both parties acceptTable 3 Representative Capital ChargesFor Asset-Backed SecuritiesCapital chargeAsset type as collateral(% of par value)Super-’AAA’ tranches of CDOs 0.1Trade receivables 1.0-1.5Prime auto loans 0.5-3.0Subprime auto loans 2.0-6.0Residential mortgages 1.0-6.0Subprime home equity loans 2.5-6.0High-yield bonds 4.0-8.0Table 4 Loss Tolerance+ TaxesStatutory net income– Refunded earned premiums+ Lowest five-year refundedearned premiums– Capital gains+ Capital losses– Miscellaneous earnings+ Miscellaneous losses= Core single-risk earningsXTwo= Single-risk loss toleranceTable 5 Maximum Principal Exposure To A Single IssuerCategory Unseasoned monoline Seasoned monoline multiple of(worst-case loss, % of par) % of surplus* loss tolerence (x)1 (25) 100 4.002 (37.5) 67 2.673 (50) 50 2.004 (60) 42 1.675 (75) 33 1.336 (100) 25 1.00*Assumes 12.5% return on surplus.302 Standard & Poor’s Public Finance Criteria 2007

Bond Insurancethe terms of the engagement, several meetings areheld where key topics are discussed in detail. Accessto the new insurer’s key executives is critical to thesuccessful completion of this phase of the process.Once all the necessary information has beenreceived and evaluated, a rating committee willdetermine the rating of the new insurer. The newinsurer has the right to refuse a rating it finds unacceptable.The process will usually take severalmonths from start to finish, although it hasstretched out to more than a year in extreme cases.Below is a description of the informationrequired from a prospective insurer:■ Assessment of market potential: Discussionsinclude what market(s) the new insurer is addressing,why that market needs additional capacity,and how the market dynamics would changeupon the new insurer’s entry into the market.■ Business plan—text and numbers: Text shouldinclude a discussion of how the company plansto compete and what its market share goals are,along with a list of key sources of business. Fiveyears of income, balance sheet, and cash flowstatements should be provided for both the insurancecompany and the holding company. Keybusiness statistics—par insured, par outstanding,principal and interest insured and outstanding,and premiums written—should be provided bycountry and by market sector (such as GO orhospital) on both a gross and net basis. Averagepremium rates by sector should also be provided.■ Underwriting guidelines: Detailed underwritingguidelines to be applied in assessing issues andissuers are to be submitted.■ Ownership: A list of owners and the name,address, and telephone number of a contact personat each owner must be provided. For otherthan Standard & Poor’s rated entities, a shortsummary of each owner’s business activities mustbe provided.■ Management: Resumes for each of the key managersmust be provided.■ Regulatory climate and applicable regulations:The country and state, if applicable, of domicile,along with licensing status in other jurisdictions,must be identified. Key regulations that affect theinsurance company and the insurancecompany/holding company relationship are to besubmitted for review.■ Risk management/controls: Significant risk-management/controlphilosophies and guidelines—including geographic dispersion, sector concentration,foreign currency exposure, and (if a reinsurer)■■■ceding company concentration—should be discussed.Single-risk guidelines should be included.Reinsurance: A discussion of the planned use ofreinsurance and the type(s) of coverage soughtshould be provided. A list of reinsurers where relationshipsalready exist and a representative list ofreinsurers that the new insurer expects to establishrelationships with should also be provided.Investment strategy: Investment strategy is discussedin terms of average credit quality, ratingdistribution, issuer/industry limitations, maturitydistribution, and duration matching. Thename(s) of investment managers to be engagedshould be provided.Capital adequacy model: At the appropriate time,a detailed list of assumptions will be provided tothe new insurer. The insurer will need to create acapital adequacy model and share with us theresults, based on our assumptions. At the sametime, the new insurer will be asked to fill out aworksheet, providing us with data to run ourown model.Monoline ReinsurersIn the mid-to-late 1980s, the dramatic volumegrowth of insured issues created a need forincreased reinsurance capacity at a time when multilinereinsurers were reluctant to make more capacityavailable and, in some cases, actually reducedavailable capacity. This shortage led to the creationof two monoline reinsurers dedicated solely to thefinancial guarantee industry. With the growth in theindustry and the primary insurers’ desire to diversifytheir reinsurance relationships, two additionalstart-up reinsurers joined the industry in the midto-late1990s, garnering a significant share of reinsurancepremiums ceded by the primary insurers.The nature of the relationship between the primaryinsurers and reinsurers began to change in thelate 1990s. The reinsurers’ role evolved from beingincremental capital providers to risk-managementtools for the primaries. In the process, the reinsurers’fundamental business weakened as they facedweaker growth, profitability, and market-shareprospects, and were challenged through their underwritingand risk-management functions to overcomethe adverse selection inherent in the reinsurancepractices of the primaries.As a result, in March 2002, Standard & Poor’srevised its rating outlook on the four companies thatthen comprised the monoline reinsurance industry tonegative, reflecting deterioration in their businesspositions relative to the primary companies fromwhich they assumed business. This business wasviewed as being less diversified, less profitable, and ofwww.standardandpoors.com303

Other CriteriaTable 6 U.S. Municipal And Corporate Rating Sensitive Capital Charges (%)* And Single-Risk Categories—Underlying rating Category—Single-riskSector CCC B BB BBB A AA AAA category§General ObligationStates 30 21 15 4 2 2 1 1Cities and counties 100 70 50 13 7 5 4 1Schools–elementary and secondary 40 28 20 5 3 2 2 1Special district 120 84 60 16 8 6 5 1Community college district 100 70 50 13 7 5 5 1Tax-Supported DebtSales, gas, excise, gas, and vehicle registrationLocal 150 105 75 20 11 8 6 2Statewide 80 56 40 10 6 4 3 1Guaranteed entitlements 100 70 50 13 7 5 5 1Special assessments, Mello Roos, tax increment financings 250 175 125 33 18 13 10 4Hotel/motel 250 175 125 33 18 13 10 4Personal incomeLess than 1.0 million population 150 105 75 20 11 8 6 2More than 1.0 million population 80 56 40 10 6 4 3 1Cigarette, liquor 250 175 125 33 18 13 10 4Health CareHospitals 350 245 175 46 25 18 14 6Hospital systems(three or more hospitals with geographic dispersion) 300 210 150 39 21 15 12 5Hospital equipment loan program 350 245 175 46 25 18 14 6Health maintenance organization 350 245 175 46 25 18 14 6Clinic practices closely affiliated with hospital 350 245 175 46 25 18 14 6Nursing home 350 245 175 46 25 18 14 6Nursing home system(three or more homes with geographic dispersion) 300 210 150 39 21 15 12 5Life-care center 350 245 175 46 25 18 14 6Life-care center system(three or more centers with geographic dispersion) 300 210 150 39 21 15 12 5Human service providers 200 140 100 26 14 10 8 3UtilitiesPublic power agency with special project risk (1) 400 280 200 52 28 20 16 6Public power agency with high dependence on nuclear (2) 300 210 150 39 21 15 12 5Public power agency with no specialproject risk and little nuclear dependence (3) 150 105 75 20 11 8 6 2Water, sewer, electric, and gas systems (revenue-secured) 120 84 60 16 8 6 5 1304 Standard & Poor’s Public Finance Criteria 2007

Bond InsuranceTable 6 U.S. Municipal And Corporate Rating Sensitive Capital Charges (%)* And Single-Risk Categories (continued)—Underlying rating Category—Single-riskSector CCC B BB BBB A AA AAA category§Solid waste disposal to energy or landfill project(single site) 250 175 125 33 18 13 10 4Solid waste system with landfill and/or waste-to-energy facility 200 140 100 26 14 10 8 3Solid waste transfer stations, trucks(no landfill/waste-to-energy facility) 150 105 75 20 11 8 6 2Special RevenuePrivate colleges and universities and independent schoolsGeneral obligation 250 175 125 33 18 13 10 4Auxiliary enterprises 350 245 175 46 25 18 14 6Public colleges and universities andcommunity college revenue bondsGeneral obligation—unlimited-fee pledge 90 63 45 12 6 5 4 1General obligation—limited-fee pledge 100 70 50 13 7 5 5 1Auxiliary enterprises and related foundations 150 105 75 20 11 8 6 2Guaranteed student loans 100 70 50 13 7 5 5 1Not-for-profit and 501(c)3s 350 245 175 46 25 18 14 6Charter schools 350 245 175 46 25 18 14 6Airports 120 84 60 16 8 6 5 1Limited tax-backed 100 70 50 13 7 5 5 1Passenger facility charge 200 140 100 26 14 10 8 3Special facility (with rate flexibility) 160 112 80 21 11 8 7 2Ports 180 126 90 23 13 9 7 2Limited tax-backed 140 98 70 18 10 7 6 1Special facility (with rate flexibility) 300 210 150 39 21 15 12 5Parking 250 175 125 33 18 13 10 4Toll roadsFive-year operating history 200 140 100 26 14 10 8 3Less than five-year operating history 300 210 150 39 21 15 12 5BridgesFive-year operating history 250 175 125 33 18 13 10 4Less than five-year operating history 350 245 175 46 25 18 14 6Federal grant-secured obligations 160 112 80 21 11 8 7 2Federal grant-secured obligationswith additional credit support 120 84 60 16 8 6 5 1Housing BondsHFA ICRs 150 105 75 20 11 8 6 2PHA 200 140 100 26 14 10 8 3www.standardandpoors.com305

Other CriteriaTable 6 U.S. Municipal And Corporate Rating Sensitive Capital Charges (%)* And Single-Risk Categories (continued)—Underlying rating Category—Single-riskSector CCC B BB BBB A AA AAA category§State agency single-family** 100 70 50 13 7 5 5 1Local agency single-family** 200 140 100 26 14 10 8 3FHA-insured multifamily** 6 4 3 0.8 0.4 0.3 0.2 1Stand-alone affordable housing/Section 8/student housing 350 245 175 46 25 18 14 6Mobile home parks/single-borrower pools 300 210 150 39 21 15 12 5Military housing/multiborrower pools 250 175 125 33 18 13 10 4Investor-Owned UtilitiesElectric distribution system 120 84 60 16 8 6 5 1Water, electric, and gas 120 84 60 16 8 6 5 1Gas distribution 150 105 75 20 11 8 6 2Telephones 150 105 75 20 11 8 6 2Natural gas pipeline 450 315 225 59 32 23 18 6Corporates and Financial InstitutionsLife and property/casualty insurance operating companies 40 33 28 7 4 3 2 5Life and property/casualty insurance holding companies 80 67 55 15 7 6 4 6Bank operating companies 40 33 28 7 4 3 2 5Bank holding companies 80 67 55 15 7 6 4 6Industrial companies 60 50 42 11 5 4 3 6Subordinated debt 80 67 55 15 7 6 4 6*Expressed as a percent of average annual debt service. Moral obligations: a constant adjustment factor of 200% will be used. Lease obligations: a constantadjustment factor of 200% will be used. General fund or non-ad valorem pledges: a constant adjustment factor of 150% will be used. Junior-lien bonds: a constantadjustment factor of 120% will be used. §See Table 5. **Top tranche, secondary market transactions only. Primary and mezzanine structures are assessed on anindividual basis. Expressed as a percent of par. For maturities of one year or less, the capital charge is reduced by 75%; for maturities of between one year and threeyears, the capital charge is reduced by 50%; for maturities between three years and five years the capital charge is reduced by 25%. (1) Public power agencies withspecial project risk, including, but not limited to, troubled nuclear operations and capital additions that fundamentally alter a utility’s debt profile and/or represent theadoption of new, unproven technologies. (2) Public power agencies that are highly dependent on nuclear generation to serve their customers’ needs. (3) All other publicpower agencies, including those that do not face special project risk and do not have a substantial dependence on nuclear resources to serve their customers.a higher risk profile relative to that written by the primaries.Subsequently, the following events transpired:■ One reinsurer’s rating was affirmed, attributableto a well-managed reinsurance strategy and capitalinfusion, including an investment by one ofthe primary bond insurers;■ One rating was affirmed but continued to have anegative outlook for a period of time until thecompany proved successful in its efforts to deemphasizereinsurance and place greater emphasison direct underwriting;■ One rating was lowered when the reinsurer’soperations ultimately merged into the operationsof an ‘AA’ rated affiliate direct writer of financialguaranties; and■ The final reinsurer, generally agreeing with ourassessment of the situation, chose to have its ratingwithdrawn and exited the business, placingits book of business into runoff.The analysis of a monoline reinsurer follows thesame basic methodology as for a primary insurer.However, with one striking exception, following thecompletion of our evaluation of the reinsurers in2002, our expectation is that, barring an unusual situation,the highest financial strength rating a denovo monoline reinsurer can receive will be ‘AA’.One fundamental difference from the methodologyused to evaluate a primary insurer is that the totalinitial capital required of a start-up reinsurer is $200million, compared with $300 million for a start-upprimary insurer. Otherwise, the differences in emphasisand criteria are only minor, reflecting differentmodes of operation and industry fundamentals.With respect to the rating exception cited for startupmonoline reinsurers, strategic planning that goesbeyond simply offering reinsurance capacity but306 Standard & Poor’s Public Finance Criteria 2007

Bond Insuranceinvolves a formal business “relationship” with a primaryinsurer could lead to a rating higher than ‘AA’.An example of this approach would be a primarycompany investing directly in the reinsurer. In thisscenario, it is our opinion that the ceding primarycompany would not adversely select against a companywhere it had an equity investment. The reinsurermight be limited to serving as a captive reinsurerto the investing primary insurer or could be able tooffer reinsurance capacity to other primary insurers.Another example would involve a monoline reinsurerthat is established as a captive reinsurer withno investment by a primary bond insurer. It couldreceive an ‘AAA’ rating if both companies have acommon parental ownership, the business it is cededis of investment-grade quality, and it meets all ofStandard & Poor’s ‘AAA’ criteria. In this scenario, itis our opinion that the ceding primary companywould not adversely select against an affiliate companydue to parental oversight and what, in someinstances, could be significant dependence on thereinsurer to support the rating of the primary insurer.Standard & Poor’s Capital Adequacy ModelOverviewFor ‘AAA’ rated financial guarantors, who by definitionhave extremely strong financial security characteristics,the capital adequacy model demonstrates thatthe bond insurer will remain solvent through, and following,an extremely stressful claims-paying environment.Assumptions remain the same for ‘AA’ and ‘A’rated bond insurers, although capital adequacy resultswill obviously differ. Using the same worst-caseassumptions, ‘AA’ bond insurers are expected to bemarginally or borderline solvent through, and at theconclusion of, the stressful claims-paying environment.Bond insurers rated ‘A’ are not expected to remain solventthrough the worst-case scenario; rather, theymust have capital resources of about 80% of theexpected claims.The Standard & Poor’s capital adequacy modelhas been in use for 20 years and has seen numerousmodifications and changes in assumptions over theyears. As risks or business conditions evolve, themodel is brought up to date. Changes can rangefrom higher or lower capital charges to reflectchanges in the risk of a sector, to changes associatedwith how much credit a bond insurer willreceive in connection with the business that it cedesto a multiline reinsurer. Driving any change is theunderlying intention of capturing a “worst-case”situation for that particular issue.Our capital adequacy model is a seven-year proforma balance sheet and profit and loss statementprojection using worst-case assumptions for all revenue,expense, asset, and liability categories. Revenue,for example, is adjusted to reflect the decline in premiumsdue to the runoff of the insured book of businessand an assumed cessation of new business activityat the start of a severe claims-paying period.Revenue is also adjusted by a decline in investmentincome, reflecting assumed defaults within the investmentportfolio as well as the sale of investments tooffset investment liquidations made to pay claims.For expenses, the most notable adjustment is made toclaims. Whereas claims typically equate to a fractionof premiums earned in a normal year, worst-caseassumptions cause claims in the pro forma exercise togenerate substantial income statement net losses.Reinsurance will moderate the claims, although reinsuranceobligations are discounted to reflect creditquality and willingness to pay issues. Operatingexpenses are assumed to decline at the start of theperiod of stress under the assumption that a halt tonew business activity would correspondingly reduceexpenses in the sales and marketing functions. Thebalance sheet is adjusted to reflect income statementactivity. Policyholder surplus will reflect not onlyincome statement results but gains to surplus duringthe stress period associated with some soft capitalfacilities such a contingent preferred stock trusts.Capital adequacy model usesThe capital adequacy model, along with its variouscomponents, has a multitude of uses. First and foremost,the model is a key rating determinant.Without an acceptable result or a reasonable planto cure a shortfall, ratings are in jeopardy.Nevertheless, it is extremely important to underscorethe point that the capital adequacy model isnot the sole rating determinant. In fact, most bondinsurer rating changes, CreditWatch placements, ornegative outlooks have occurred for reasons otherthan an unacceptable modeling result. These reasonsinclude management missteps, poor executionof strategy, and deterioration in economic viability.Each financial guaranty insurance company is intimatelyfamiliar with the details of the Standard &Poor’s capital adequacy model and has created, andmakes active use of, its own version of the model, asmodeling details and criteria are completely transparent.In conjunction with their strategic plans, theyuse the model for capital planning purposes. It ismost common for a bond insurer’s business to targetand manage to an intended capital model result. Themodel is a tool for the insurers in determining theneed for additional capital or dividend capacity.The capital adequacy model is also a sensitivityanalysis tool. In rapidly developing credit risk situations,such as Hurricane Katrina, the model allowsus to make modifications to the variable in question,such as exposure in a given sector under stress, andtest capital adequacy results against various incrementalchanges for that sector.www.standardandpoors.com307

Other CriteriaCapital charges, which are assigned to all insuredtransactions, are theoretic worst-case loss estimatesfor a transaction in the context of a diversified portfolioof risks. Capital charges are the key variable inthe model and are used to determine losses in thecapital modeling exercise. Capital charges have anumber of valuable uses. When individual capitalcharges are aggregated to calculate a weighted averagesector capital charge for a company, that numberis one measure of “risk” for an insured portfolio.Capital charge trends for a specific company can beinsightful and indicative of changes to risk or businessstrategies. Weighted average capital charges canalso be used to compare companies with one anotherfor insight into relative insured portfolio risk. Somefinancial guarantors also use capital charges for capitalallocation purposes in the process of determiningif a contemplated wrap of a transaction meets thatcompany’s economic hurdle rate.Start-up bond insurers and the modelThe model is also used in the analysis of start-upbond insurers. The pro forma projections extendfor nine years, as opposed to seven for a maturecompany. The first five years for a start-up bondinsurer are business growth years, and the finalTable 7 International Rating Sensitive Capital Charges (%)*And Single-Risk Categories—Underlying rating category—Single-riskCountry and Sector BB BBB A AA categoryAustraliaStates 15 4 2 2 1BelgiumRegions 20 5 3 2 1Municipalities and provinces 50 13 7 5 1CanadaProvinces 15 4 2 2 1Municipalities 50 13 7 5 1FranceDepartments/regions 20 5 3 2 1Municipalities 50 13 7 5 1Urban communities 50 13 7 5 1Mixed transportation systems 85 22 12 9 2Teaching and regional hospitals 100 26 14 10 3All other hospitals 125 33 18 13 4Municipal banks 125 33 18 13 4New towns 125 33 18 13 4ItalyMunicipalities and provinces 30 8 4 3 1Regions 40 10 6 4 1four are the depression period. The additional twoyears of growth act to put greater stress on capitalfor the start-up company because the pro formabook of business is larger.The model plays a central, albeit less important,role in the ultimate rating conclusion for a startupcompany. For an established company, its existingbook of business is a given, and projectedbusiness is likely to evolve based on the company’shistory and history of writing and achieving businessplan results. For a start-up company there isno existing book of business, and it is not unusualfor the insured portfolio to develop outside of initialprojections, making modeling results less reliableand usable. For a start-up company, the overcapitalizationrequirements during its formativeyears of operation offset the less-precise modelingoutput. Most important to the rating of a start-upbond insurer is to have a credible managementteam with a history of market knowledge and conservativeunderwriting, along with a business planthat demonstrates a strong likelihood of successunder the circumstances.Details of the modelNot unlike the business planning process for anymajor company, the Standard & Poor’s capitaladequacy model makes assumptions and setsexpectations for all aspects of a bond insurer’sexisting and future business. Income, balancesheet, and cash flow statements are producedusing statutory accounting principles. The majordifference is that we are modeling for a worstcaseclaims environment, whereas a financialguarantor’s business plan is projecting anexpected case.Business activityFor purposes of adding stress to the analysis, theclaims-paying period does not start with the existinginsured portfolio. Instead, a period of growthtakes place, thereby increasing the size of theinsured portfolio to be stressed. During thegrowth years, new business is assumed to expandat an aggressive pace: the greater of the insurer’sbusiness plan or 15% growth in written par formunicipal business and 25% for structuredfinance. The mix of business is consistent with thebond insurer’s business plan, assuming that mix isrealistic. Once the depression starts, no new businessis assumed to be written.Insured portfolio compositionThere are two components of the insured portfoliothat are stressed beginning in year four—the firstyear of claims-paying stress. The first is the existingportfolio, which amortizes according to scheduleand expectations over the first three business growth308 Standard & Poor’s Public Finance Criteria 2007

Bond Insuranceyears of the modeling exercise. The second elementis the new insured portfolio that is created in connectionwith the new business written over the firstthree years of business growth. Unless significantchanges in business mix are anticipated, such as amoratorium on business being placed on a certainsector, the mix of new business will generally mirrorthe mix of the existing portfolio.Theoretical lossesLoss estimation and the capital charges generatingthose losses are the most critical elements of thecapital model. This is not surprising given the criticalimportance of the underwriting function,which not only approves an individual issue as eligiblefor insurance but also provides direction tothe development of the risk portfolio in terms ofsector and geographic dispersion.For the insured municipal portfolio, each insurer’sweighted average capital charge percentage for municipal-backedissues is applied to the average annualdebt service of its portfolio to determine the theoreticallosses over the four years of the depression. TheTable 7 International Rating Sensitive Capital Charges (%)*And Single-Risk Categories (continued)—Underlying rating category—Single-riskCountry and Sector BB BBB A AA categoryJapanPrefectures 15 4 2 2 1PortugalCities 50 13 7 5 1SpainAutonomous communities and provinces 20 5 3 2 1Municipalities 50 13 7 5 1SwitzerlandCantons 30 8 4 3 1United KingdomHousing associations 85 22 12 9 2Mass transit (precompletion) 150 39 21 15 5NHS trusts 60 16 8 6 1NHS PFI projects 90 23 13 9 2PFI accommodation projects 70 18 10 7 1Regional electric companies 60 16 8 6 1Universities 50 13 7 5 1Local governments 20 5 3 2 1Note: Capital charges can be adjusted if the insured obligation is denominated in acurrency that differs from the insurer’s c]apital base. *Expressed as a percent of averageannual debt service. See Table 5.original maturity of a municipal issue will determineits average annual debt service. Given the model’sfocus on years of debt service in default, the more debtservice that can be in default during the worst-caseyears, the greater the aggregate claims. The reportedweighted average municipal capital charges for thevarious diversified ‘AAA’ rated insurers over the pastfew years has ranged from 7%-16%. Capital chargesfor corporates and financial institutions are applied tothe par value of insured bonds.Losses for ABS (see table 4) are a function of thedifference between the first-loss protection providedin the transaction and the level of first-loss protectionnecessary for the transaction to achieve an‘AAA’ rating, the credit gap. (See chart 2,“Structured Finance Capital Charge Formula,” fora detailed description and examples of the structuredfinance capital charge formula.) Speculativegradeobligations receive capital charges at least 2xthe investment-grade capital charge.Certain obligations may have deteriorated to theextent that a near-term default cannot be ruled out.In these cases, called discrete losses, Standard &Poor’s will assume that the transaction defaultsimmediately and remains in default throughout thelife of the depression scenario. In such cases,reserves must be equal to the actual debt service forthe given exposure. Similarly, Standard & Poor’sassumes that bonds already in default will remainin default unless there is abundant reason to believethe default will be cured.Losses on debt service reserve funds are assumed tooccur in the year immediately preceding the depressionand in the first year of the depression, reflectingthe fact that these funds are the first to be used tomeet debt service when an issuer defaults. The capitalcharge for a debt service reserve is 50% of the sector’snormal (average annual debt service) charge,applied to the entire amount of the surety policy.Capital charges will also be assessed againstnon-bond insurance products or services such asmunicipal investment contract businesses. Theseare nonstandard business lines where capital is atrisk. Standard & Poor’s will analyze each operationto determine the risk it poses, either directlythrough financial guaranty insurance policies orindirectly as a potential drain on capital, to theinsurance company.In the event of a major credit event, such asHurricane Katrina, incremental theoretical losses aregenerated so that a sensitivity analysis relative to theexisting capital base can be undertaken. These theoreticaldiscrete losses are derived in consultationwith Standard & Poor’s sector or regional experts.In most credit event cases, the incremental lossesinclude a potential claims component and a ratingsmigration component. For example, in the case ofwww.standardandpoors.com309

Other CriteriaBond Insurance AdministrationThe Public Finance Department’s bond insurnace administration group is a keyintermediary between the insurance companies, the issuers, the bond market,the bond insurer ratings group, and the investor community, coordinating theactivities associated with providing insured and underlying credit ratings for newbond issues.Issuers must request a Standard & Poor’s rating on insured transactions. Inthose instances when an issuer does not choose to have Standard & Poor’s ratethe insured transaction, Standard & Poor’s will not issue, publish, or automaticallyassign the insurer’s financial strength rating to the transaction.For both new issue and secondary market debt, Standard & Poor’s does notprovide any official rating for insured debt until, and unless, an executed final insurancepolicy is made available. In the new issue market-where an issuer and itsunderwriters or advisers are in the process of negotiating, selling, or closing on abond issuance and an insurance policy is expected but not yet final-unless arequest for an underlying rating was made to Standard & Poor’s, no representationof a rating should be used or made. Once an insured rating is requested and thepolicy has been executed and presented to Standard & Poor’s, the enhanced ratingon the issue can be established.For debt issuers utilizing bond insurance, but with parity debt rated by Standard& Poor’s on an uninsured basis, it is necessary to submit the relevant transactiondocuments to Standard & Poor’s, in addition to the insurance company. Standard &Poor’s must review the proposed debt issuance to assess any outstanding, uninsuredparity debt ratings. In certain instances, issuers may plan to go to market on anuninsured basis but later change their mind and choose to use bond insurance. Inthose instances, the rating released on the debt issue may initially be based on theissuer’s own credit quality (uninsured rating), and is then subsequently revised toreflect the insurer’s financial strength rating once a policy has been issued byan insurer.All bond insurance policies are expected to cover 100% of scheduled principaland interest on a timely basis. Such policies should constitute an unconditional,irrevocable, and legal, valid, and binding obligation of the insurer in effect for thelife of the issue. If the primary credit obligor fails to make a payment, timely paymentis assured to bondholders by providing sufficient time under the terms of thepolicy for the trustee to notify the bond insurer. If an issuer defaults, there is nomandatory acceleration of liability, and payments will continue to be made by theinsurer based on the original schedule. The risk of monies being recaptured froma bondholder if the primary obligor becomes bankrupt (preference risk) mustbe covered in the insurer’s standard policy, in an endorsement, or by theissue’s structure.For help with public finance-related administrative issues and assistance inreaching bond insurance administrative personnel located in other ratings groupsat Standard & Poor’s, please call (1) 212-438-2074.Hurricane Katrina, it was assumed that hardest hitcredits generated claims immediately. For remaining,severely affected credits in the region, assumptionswere made about ratings declines, which carriedwith them higher capital charges.Losses can be moderated by various forms of soft(third-party) capital, such as business that has beenceded (reinsured) to third parties. Losses might alsobe moderated by unconditional, irrevocable banklines of credit. As in reinsurance, credit for thesefacilities is based on the credit quality of the bankand the appropriate structuring of the documentationso that the facility works in the context of ourmodel’s assumptions and requirements. A finalform of third-party capital for the industry is custodialtrust contingent preferred stock facilities. Ingeneral, the mechanics of these facilities establishtrusts that then enter into agreements that allow abond insurer to put its preferred stock to the trusts,at which time holders of the trust securities willbecome holders of the bond insurer’s preferredstock. Prior to that time, the trusts must be investedin high-quality (AAA/A-1+), short-term liquidassets. In terms of the dynamics of the model, reinsuranceand line of credit remittances are viewed asreductions to overall losses. Conversely, the contingentpreferred stock facilities are viewed as an additionto capital because of the issuance of bondinsurer preferred stock and corresponding receipt ofcash from the trust.Investment incomeExisting investments earn at their embedded rateand new investments earn at assumed conservativerates of interest throughout the forecast period.During the depression years, investment income isreduced to reflect defaults on non-‘AAA’ ratedbonds held for investment. Common stocks and allsecurities rated below ‘A’ are assumed to becomeworthless at the beginning of the depression. Lossesfrom the sale of investments are recognized in (1)the first two years of the depression because ofassumed interest-rate movements that result in aninverted yield curve and long-term rates rising atleast 600 basis points, and (2) throughout thedepression on certain less-than-top-rated instrumentsto reflect reduced liquidity in the markets.Premium written and earnedFor existing business, premiums are written andearned at their imbedded premium rates. For thegrowth book of business, premiums reflect currentmarket conditions and business plans. Because ofintense competition among insurers for many years,premium rates became a focus of attention regardingthe ability of insurers to maintain their capitaladequacy. In an environment where competitiveforces are causing premium rates to decline,Standard & Poor’s model picks up a significantamount of the effect of changing premium ratesbecause it forces the insurer to write new businessfor three years before the depression starts.Margin Of SafetyThe culmination of all the assumptions associatedwith the creation of a worst-case balance sheet andincome statement is the company’s ending, postdepressioncapital position. While important in its own right,and while solvency following a severe claims-payingenvironment is expected for an ‘AAA’ company, the310 Standard & Poor’s Public Finance Criteria 2007

Bond Insurancemargin of safety measurement provides greater insight.The margin of safety expresses ending capital in thecontext of the scale of the company. The margin ofsafety accomplishes this by relating total claims-payingresources (ending statutory capital plus losses) to losses.Thus, a margin of safety of 1.25x signifies thatending capital exceeded losses by 25%. Stated anotherway, losses could have been 25% larger without drivingthe statutory capital below zero.The margin of safety is a useful tool that allowsfor analysis of capital adequacy trends for individualcompanies and capital strength comparisons amongthe different insurers. Some bond insurers use themeasurement for capital planning purposes. Theminimum margin of safety for ‘AAA’ rated bondinsurers is 1.25x. For ‘AA’ and ‘A’ rated insurers theminimums are 1.0x and 0.8x, respectively. Theseminimum values can be adjusted slightly lower incases where the insurer is owned by a single highlyrated entity that has expressed continued support forthe company.Single-Risk Guidelines And AnalysisWhereas the capital adequacy model addressesthe question of capital relative to a severe,widescale claims-paying environment, single-riskstandards and analysis look at capital and ratingstability in the more likely context of occasionallarge discrete defaults by individual obligors. Aninordinately large exposure to a defaulting issueror issue could threaten a bond insurer’s rating,particularly in a nondepression environmentwhere the default is an isolated event and is notrelated to a general economic downturn.For this reason, Standard & Poor’s has insurerspecific,single-risk guidelines that limit exposuresto individual issuers or issues in the case of assetbackedtransactions. The approach is based on theassumption that any issuer or issue could suffer alarge discrete loss, despite investment-grade underwritingstandards, and measures the possible lossagainst the earnings power of the company.Investment-grade credits are not immune to default,and the single-risk standards reflect the furtherassumption that the severity of the loss will begreat, in the context of the obligor’s sector.The criteria for maximum single-risk exposure isbased on two key assumptions: (1) that the maximumloss allowable is a function of how much abond insurer could write off and still maintain itsexisting rating, and (2) that the expected loss onany issuer is a function of the issuer’s market sector.The loss tolerance (how much an insurer could loseand retain its rating) relating to a single issuer isequal to twice the company’s core earnings (seetable 5). Core earnings include adjustments fortaxes, advanced refundings, capital gains and losses,and nonrecurring income statement items.This approach conservatively identifies potentialearnings net of any nonrecurring items. Because anylarge loss would shelter a significant amount ofearnings from taxes, pretax earnings are used in thecalculation. In addition, since refunded earned premiumscan vary greatly, refunded earned premiumsfor the base year are compared with the lowest levelof premiums earned from refundings over the priorfive years. The lower amount is included in the coresingle-risk earnings calculation. This methodologynormalizes some of the income statement components(thereby reducing loss-tolerance variability)and facilitates the single-risk planning process.For unseasoned financial guarantors—those thathave yet to develop a significant level of core earnings—themaximum allowable exposure to a lossfrom a single issuer is expressed as a percent of originalsurplus. The percent used is equal to twice thepredictable, yet conservative, rate a seasoned bondinsurer could earn on its existing surplus for one year.Currently, a 12.5% rate of return is assumed for thesepurposes. Single-risk limits for unseasoned companiesremain based on original surplus adjusted for subsequentcapital infusions until core earnings are sufficientto generate a higher computed loss tolerance.The single-risk categories for each sector areshown in tables 6 and 7. Based on the relativedegree of risk between the categories and the earningspower of a seasoned company or the assumed12.5% rate of return for an unseasoned company,the maximum exposures to a single-risk by categoryare shown in table 5. These relationships imply thatCategory 3 obligations are considered to have twicethe loss potential of Category 1, while Category 6obligations are considered to have four times theloss potential of Category 1. In other words, thelower the risk sector, the greater the insured principalamount of debt that an insurer can cover relativeto its earnings or capital base.Single-risk loss potentials for ABS are determinedon a case-by-case basis using the samecredit-gap concept employed to determine capitalcharges. A company’s earnings power or capitalbase is used to determine its loss tolerance foreach transaction. ■www.standardandpoors.com311

Other CriteriaGovernment Investment PoolThe primary objective of a government investmentpool (GIP) is the prudent managementof public funds on behalf of state and local governments.GIPs are established to offer cost-effectiveinvestment vehicles in which municipalitiesand public entities pool their idle cash and operatingfunds while earning a competitive rate ofreturn and providing safety and liquidity. GIPsare operated by U.S. states, counties, cities andother public entities and generally serve as investmentvehicles for public investors in the state ormunicipal jurisdiction.State-level pools are generally run by treasurersthat are either elected or appointed officials of thestate. In general, state-sponsored GIPs serve as avoluntary, professionally managed, investmentoption for operating funds for municipalities withina state. Some state pools have been in existence formore than 25 years. Many municipalities invest instate-run GIPs as they offer a cost-effective investmentvehicle. School districts are often mandated toinvest surplus funds and operating money in staterunpools. Other public entities see GIPs as analternative to self-management or to private moneymarket funds.County-sponsored GIPs are popular in Californiaand Washington. In California, elected countytreasurers run most county pools. These countytreasurers are responsible for management not onlyof their own county funds, but also of the managementof public entities (i.e., school districts) fundslocated within the respective county. County governmentsin California maintain investments poolsfor their operating and capital funds as well as forthe investment of underlying local governments.Other government/private-sponsored GIPs maybe formed through inter-governmental agreementsor directly by private firms. For example, theFlorida Local Government Investment Trust(FLGIT) was created through the joint efforts of theFlorida Association of Court Clerks and the FloridaAssociation of Counties. The first privately sponsoredGIP was the Pennsylvania Local GovernmentInvestment Trust (PLGIT), formed in early 1981.Over time, GIPs have undergone a significanttransformation due to new regulations intended totighten operations and establish more stringentinvestment criteria. The greater scrutiny stems fromincreased awareness of the risks associated withinvesting in seemingly “safe” pools, as demonstratedby some well-publicized losses suffered by a fewGIPs. Fortunately, many states have heeded the callfor more oversight and disclosure by adopting theguidelines recommended by public associations suchas, the National Association of State Treasurers(NAST), the Government Finance Officer’sAssociation (GFOA), the Association of PublicTreasurers of U.S. & Canada (APT US&C) and theGovernment Accounting Standards Board (GASB).The investment practices and guidelines calledfor the adoption of formal and clear investmentobjectives, written and approved investment policiesand full disclosure of pool objectives and policies.Many pools have established advisory boardsto provide oversight to pool managers and to setbasic investment guidelines and operating policies.However, some GIPs delegate control and investmentdecision-making responsibilities to the poolmanager or fiduciary, with limited oversight andwith no formal board. Proper controls begin withestablished investment policies and suitable oversight.GIP advisory boards add a much-neededlevel of oversight and help ensure that these policiesare adhered to and are consistent with apool’s objectives.Such oversight-whether performed by a boardof pool participants or an outside, independentservice-should be part of all GIP programs,regardless of the experience and track record ofthe pool’s manager.To provide an additional level of oversight, statesand public investor associations have requested andreceived Standard & Poor’s ratings on GIPs.Standard & Poor’s maintains ratings (both publicand private) on approximately 70 GIPs or fundstargeted to public entities. Standard & Poor’s hastwo types of pool ratings: Stable NAV Pool Ratingsand Variable NAV Pool Ratings. Stable NAV GIPscan differ in their level of risk taking, internal oversight,participant services, and external reporting.GIPs are generally not registered with the SECunder the Investment Company Act of 1940, butmany pools do choose to follow the investmentguidelines of SEC Rule 2a-7 of the InvestmentCompany Act governing U.S. money market funds.These pools seek to provide a stable net asset value312 Standard & Poor’s Public Finance Criteria 2007

Government Investment Pool(NAV) to their participants and are run like moneymarket funds.Standard & Poor’s has analyzed stable NAV ormoney market GIPs that maintain maximumweighted average maturities (WAMs) from 60 daysto 365 days. Standard & Poor’s believes that toprovide adequate capacity to maintain principalvalue and limit exposure to loss, a pool’s WAMshould be limited to 90 days or less. For a fundwith a 90-day WAM, it would take a 200-basispoint increase in interest rates (with no cash withdrawals)to lose principal or “break the dollar.” Ata 365-day WAM, it would only take an increase ofapproximately 50-basis points to put the pool’sprincipal value at risk. Standard & Poor’s believesthat when the investment objective of a GIP is toprovide participants with a stable NAV (like anSEC registered money market fund), individualsecurities’ final maturities (excluding floating-ratenotes) should not exceed one year.Standard & Poor’s refers to longer-term GIPS,managed for a higher level of total returns, as variableNAV pools since they are similar to bondfunds. For GIPs that pay out a variable NAV ormarket value, longer maturities can be appropriate,provided that proper disclosure is made to participantsregarding the level of principal value at risk.The Government Accounting Standards Board(GASB) Statement 31 effected on June 15, 1997requires GIPs that report amortized cost values tofollow the SEC’s Rule 2a-7 money market fundguidelines. GASB 31 calls for GIPs to report a constantNAV. GIPs that don’t follow Rule 2a-7 guidelinesare required to report a variable NAV or marketvalue as bond funds report.Pool sponsors have taken the initiative to educatetheir participants on the objectives, risk levels andliquidity of their pools. In the past, many poolswere managed like “hybrid-type funds”, that is theywere invested in a mix of short-term (less than oneyear)and long-term investments. The pools paidout dollar-for-dollar to participants upon withdrawals,regardless of the pool’s current marketvalue or current NAV. Over time, more and morepools have opted to create a short-term liquiditypool that are managed like money market fundswith shorter maturities and more frequent pricing(i.e., stable NAV or money market pools). To satisfyinvestors demand for a higher yielding product,some state/counties have created short-term variableNAV or longer term (bond fund-like) pools fortheir participants’ longer-term investment needs.For example, the Georgia Office of Treasury andFiscal Services launched the bond fund GIP calledGeorgia Extended Asset Pool in July 2000 to complementGeorgia Fund 1, a money market GIP. TheCity of Long Beach divided its pool into liquid andlonger-term portfolios. Other cities and states havecreated similar two-tiered investment pools-one fordaily operating and short-term needs (liquiditypool) and one for longer term needs.Over the last several years, several states andother issuers with surplus high quality, short-tointermediateterm fixed-income assets have soughtto use these funds as back-up liquidity support fortheir short-term debt issues. A public or privatecredit quality and volatility rating from Standard &Poor’s can provide the ongoing analysis of a pool’scredit quality, liquidity, operating procedures andmanagement required to provide “self liquidity” forshort-term debt such as variable rate demand notesand tax-exempt commercial paper. Several statespools, including Texas Treasury, and other municipalissuers from the Higher-Ed, HealthCare, andPrivate-Foundations have requested Standard &Poor’s to conduct ongoing assessments of the liquidityof their fixed-income portfolios identified asthe liquidity source.Stable Net Asset Value (NAV) Pool Ratings CriteriaStandard & Poor’s ratings criteria for stable net assetvalue (NAV) investment pools is largely the same asits principal stability fund ratings (also know asmoney market fund ratings) criteria given the similarityin investment objectives of these investmentvehicles. Therefore, all references to money marketfunds in the following ratings criteria article alsoapply to government investment pools (GIPs) or anyother pool of assets that seek to maintain a stableNAV. For further information and in-depth analysisplease refer to the most recent Standard & Poor’sFund Ratings Criteria publication.A stable NAV or money market fund rating is asafety rating, expressing Standard & Poor’s opinionon the ability of a fund to maintain principal valueand limit exposure to loss due to credit, market,and/or liquidity risk. Ratings can range from‘AAAm’ to ‘Dm’, with the ‘m’ denoting a moneymarket fund.(See table, “Principal Stability Fund RatingsDefinitions”). The ‘m’ distinguishes the money marketfund rating from a Standard & Poor’s traditionaldebt rating. A traditional debt rating is usuallynot subscripted and indicates a borrower’s ability torepay principal and interest on a timely basis. Amoney market fund rating is not directly comparableto a debt rating because of differences in investmentcharacteristics, rating criteria, and the creditworthinessof portfolio investments. Distinct criteriawere established for each rating category.www.standardandpoors.com313

Other CriteriaRating approach and processA stable NAV pool or money market fund ratingreflects Standard & Poor’s opinion of the safety ofinvested principal based on an analysis of portfoliocredit quality, market price exposure, and management.Credit quality incorporates the credit risk ofsecurities and the counterparty risk of transactionbasedinvestments, such as repurchase agreements(repos). Market price exposure relates to the potentialfor a decline in the market value of a moneymarket fund’s assets. Within this area, Standard &Poor’s looks at weighted average maturity (WAM),liquidity, investment concentration, variable-ratesecurities, securities lending and reverse repos, shareholdercomposition, and NAV deviation proceduresto name a few. In addition, the analysis of managementis based on a meeting with senior fund officials,and on both public and private information.The rating process begins when Standard &Poor’s receives a written request to rate a particularpool or fund. At this point, the analystassigned to the fund asks for certain pertinentinformation regarding the fund. Upon review ofthe information, the analyst schedules a managementmeeting with fund officials. The analyst nextdiscusses the fund with a rating committee composedof senior Standard & Poor’s Fund Services’analysts. The committee examines all relevantinformation uncovered in the rating process.Following the analyst’s rating presentation, thecommittee votes on a final rating. Subsequently,this rating is monitored on a weekly basis toensure accurate and current ratings. Additionally,Standard & Poor’s conducts annual managementreview meetings for each rated fund to evaluateany changes that may have occurred in policy, philosophy,personnel, operations, and controls.Credit qualityCredit quality analysis is focused on the risks associatedwith the quality, type, and diversity of theinstruments that comprise the portfolio. The creditquality assessment for each instrument is based onthe rating that Standard & Poor’s has assigned tothe security. The minimum credit quality standardsfor each pool are based on the fund’s rating categoryand maturity structure. For example, pools rated‘AAAm’ are expected to maintain at least 50% insecurities rated ‘A-1+’ by Standard & Poor’s withno more than 50% in securities rated ‘A-1’ byStandard & Poor’s. Additionally, securities that areon Standard & Poor’s CreditWatch list with negativeoutlooks should be limited to maturities of 30days or less. For further information and in-depthanalysis please refer to the most recent Standard &Poor’s Fund Ratings Criteria publication.Repurchase agreements (Repos)While Standard & Poor’s recognizes the importanceof the collateral securing repurchase agreements(repos), our main focus with regards to the risk inthese securities is the creditworthiness of the counterparty.Generally speaking, the underlying securitiesin traditional repos are typically ineligibleinvestments for money market funds, either becauseof their maturity (longer than 397 days) or type(e.g., certain mortgage-backed securities). A fundthat takes possession of such collateral will have tosell it as soon as possible. Any delay in a fund’sability to sell the securities could create both liquidityand market risks that are inappropriate formoney funds. This is especially true for non-traditionalcollateral, as these security types (e.g., noninvestmentgrade corporates, equities) possess higherpotential price volatility than traditional collateral.For these reasons, Standard & Poor’s ratings criteriacalls for all counterparties used by highly ratedmoney market funds to be rated either ‘A-1’ or‘A-1+’. The following bullets outline specific repocriteria for ‘AAAm’ rated money market funds andpools:■ The aggregate amount of all repos (regardless ofthe rating) with maturities of more than sevencalendar days may not exceed 10% of a fund’stotal assets.■ Overnight repos with any single ‘A-1’ issuer arelimited to no more than 25% of a fund’s totalassets.■ Repos with maturities beyond overnight and lessthan or equal to seven days with any single Issuer(‘A-1+’) are limited to no more than 25% of afund’s total assets.■ Repos with maturities beyond overnight and lessthan or equal to seven days with any single issuer(‘A-1’) are limited to no more than 10% of afund’s total assets.For these criteria, the maturity of a repo isdefined as the absolute maturity of the agreement.If, however, the agreement contains a put thatwould result in a lower effective maturity for theagreement, Standard & Poor’s will review the repodocumentation to be certain of the unconditionalnature of the put feature. Standard & Poor’s hasthe same criteria for both triparty and deliverablerepos. However, where a tri-party repo is used,Standard & Poor’s will examine the fund adviser’sprocedures ensuring that the proper type andamount of collateral is received. Standard & Poor’srepo diversification criteria for funds rated ‘AAm’,‘Am’ and ‘BBBm’ is identical to the bullets aboveexcept for the permitted exposure to ‘A-2’ issuers314 Standard & Poor’s Public Finance Criteria 2007

Government Investment Poolon an overnight or one day basis of 5% for ‘AAm’,10% for ‘Am’ and 25% for ‘BBBm’.To ensure that repos are properly secured,Standard & Poor’s looks for certain written representationsfrom all funds investing in repos.Regarding perfection of the fund’s security interestin repo collateral, Standard & Poor’s seeks writtenrepresentations that the fund takes delivery of thecollateral. For additional information concerningwritten representation, non-traditional repos collateral,and evaluating counterparties, please refer tothe most recent Standard & Poor’s Fund RatingsCriteria publication.Market price exposureThe most important part of money market fund orstable NAV pool analysis is judging a fund’s sensitivityto changing market conditions. Money marketfunds or stable NAV pools are required to calculateperiodically the market value of their assetsto determine if the fund’s actual NAV per sharematerially deviates from $1.00-and to take action ifthere is significant deviation. Deviations of greaterthan plus or minus 0.5% create a situation inwhich the fund must offer and redeem shares at aprice other than $1.00.Although GIPs and other pooled investment vehiclesdo not necessarily have this requirement, thesame fundamental risk principles apply.Recognizing this small margin for error,Standard & Poor’s focuses heavily on the potentialdeviation in market value (referred to as marketprice exposure). To determine each pool’s marketprice exposure, the following variable are analyzedfor each pool rating:■ Weighted, average maturity (WAM)■ Liquidity■ Diversification■ Index and spread risk■ Potential dilution of a pool’s participant assetbase, and■ Security and portfolio valuation methods.Weighted average maturity (WAM)Determination of market price exposure starts with anexamination of a fund’s susceptibility to rising interestrates. The portfolio’s Weighted Average Maturity(WAM)is a key determinant of the tolerance of afund’s investments to rising interest rates. Standard &Poor’s expects funds rated ‘AAAm’ to maintain amaximum WAM of 60 days or less. However, theactual maximum WAM depends on fund size, assetvolatility, liquidity needs and participant profile. Fundswith less than $100 million in assets and/or a highlyconcentrated shareholder/participant base may be limitedto a shorter WAM, unless fund management canmake a compelling argument otherwise.Standard & Poor’s is often asked to rate smalland start-up funds that have highly concentratedshareholder positions. Standard & Poor’s is concernedabout the impact that a large redemption byone or more of the major shareholders may have onthe NAV of the fund. Consequently, until a fundhas grown to at least $100 million with a diverseshareholder base, Standard & Poor’s will seekassurances that the fund will maintain a shorterWAM. Higher WAMs are considered appropriatefor funds in lower rating categories.LiquidityThe liquidity of portfolio investments is also of criticalimportance in determining market price exposureand maintaining a stable NAV because thedegree of liquidity can affect the market value ofinvestments. The liquidity of a security refers to thespeed at which that security can be sold for approximatelythe price at which the fund has it valued orpriced. Securities that are less liquid are subject togreater price variability. Certain securities may beliquid one day, and illiquid the next. In determininga fund’s rating, Standard & Poor’s considers eachfund’s liquidity needs and its ability to quickly sellportfolio holdings if the need arises to meet cashoutflows or large redemptions. In reviewing apool’s liquidity, Standard & Poor’s analysts takeinto consideration the types of investments, theirliquidity characteristics, and concentrations byissuers and affiliates. The potential for sizabledeclines in portfolio market value increases with theproportion of relatively illiquid or less liquid investmentsin the portfolio. Longer WAMs increase thefund’s vulnerability to interest rate movements.DiversificationAs a general rule, no single issuer should representmore than 5% of fund assets. However, if mitigatingcircumstances are present, a single issuer canrepresent up to 10% to 25% depending on thematurity of the investment. ‘AAA’ rated governmentissues are excluded from this condition (see sectionentitled Government Agency Concentration).Government agency concentrationLiquidity analysis is done for all issues, no matterwhat their credit quality. For example, underStandard & Poor’s ‘AAAm’ guidelines, a fund shouldgenerally have no more than one-third of its assetsinvested in the securities of any one governmentagency. While the credit quality of these agencies isnot typically a concern, adverse publicity about anagency can cause financial markets to shun its securities.This could pose liquidity problems for fundsholding large amounts of the given agency’s paper, assuch instruments’ market values may drop materiallybelow what the fund paid for them. Standard &www.standardandpoors.com315

Other CriteriaPoor’s one-third-concentration policy is a generalguideline. Funds with greater concentrations are subjectto a WAM adjustment factor and/or higher levelsof highly liquid securities.Index and spread risk in variableand floating rate securitiesVariable-rate notes (VRNs) and Floating-rate notes(FRNs) present unique market price risks. VRNsused in money funds are typically linked to conventionalmoney market indices, providing funds withyields that track short-term interest rate movements.These investments are designed to exhibitless interest rate risk when compared with fixedrateinvestments. However, this is not the case forall VRNs. Factors affecting the value of theseinstruments include index risk and spread risk.Index risk is the risk that the coupon of a VRN willnot adjust in tandem with money market rates.Index risk can be introduced by calculating thevariable-rate coupon based on one of the following:■ A non-money index■ A money market index in which the couponadjusts based on a multiple (or fraction) of theindex, and■ An index based on the difference (or spread)between two or more indices.When analyzing VRNs in money market funds,Standard & Poor’s compares the index used in thevariable-rate adjustment formula to a standardmoney market index (e.g., the Federal Funds Rate).Standard & Poor’s believes that for all money fundsrated ‘BBBm’ and above, the index should have acorrelation of at least 95% of the effective FedFunds Rate. Additionally by this measure, nonmoneymarket fund or NAV pool indices such asthe 11th District Cost of Funds Index (COFI) andthe 10-year Constant Maturity Treasury Index areclearly unsuitable, with historical correlations ofwell below 90%.Some VRNs may use indices that are well correlatedto traditional money market indices. Yet,because of their rate adjustment formulas, they stillintroduce significant price risk. The longer theremaining life of a variable-rate security, the more itbecomes susceptible to market price deteriorationassociated with spread risk, even when tied to ahighly correlated index. Because of the potentialimpacts of spread risk on the market prices ofVRNs, Standard & Poor’s expects that rated poolslimit the remaining maturity of U.S. governmentVRNs/Floating Rate Securities (FRNs) to two yearsfor ‘AAAm’, three years for ‘AAm’, four years for‘Am’, and five years for ‘BBBm’.Corporate and structured (e.g., asset backed securitiesor ABS) VRNs/FRNs have the added risk ofcredit deterioration and are limited to final maturitiesof 13 months or less for money market fundsregistered under Rule 2a-7. For rated pools, on acase-by-case basis, consideration will be given torequests to approve holdings of FRNs/VRNs forissuers other than ‘AAA’-rated sovereigns (i.e., corporatesand ABS) with time to final maturitygreater than 397 days but no more than two years.Before granting approval to extend the maturityrange of VRN/FRN holdings, Standard & Poor’swill seek assurance that ample liquidity can bemaintained by virtue of the fund’s size, diversifiedshareholder base and range of other assets and thatadequate resources are available to analyze andmanage credit risk.If such practice is approved, all such FRNs/VRNsmust have a Standard & Poor’s short-term rating of‘A-1+’. If the Issuer does not possess a short-termrating, a Standard & Poor’s long-term rating of‘AA’ or better is required. The total holdings of allsuch VRNs will be limited to no more than 5% perIssuer and no more than 10% of net assets of thefund. The percentage of VRNs in a fund also entersinto the rating analysis to determine a fund’s overallrisk profile and is factored in on a case-by-casebasis in conjunction with the fund’s other holdings.Investing in other money market fundsStandard & Poor’s criteria calls for rated governmentinvestment pools (GIPs) that invest in othermoney market funds (also called registered investmentcompanies or RICs) to carry an identical rating.For example, a Standard & Poor’s ‘AAAm’pool may only invest in Standard & Poor’s‘AAAm’ money market funds. Standard & Poor’smoney market fund criteria for rated pools generallycalls for a maximum 25% exposure to any onefund with no stated maximum exposure. However,while no maximum is stated, Standard & Poor’swill inquire as to the feasibility of one rated fundinvesting a majority of its assets in other ratedfunds. This includes an analysis of the rated fundsposition on fee rebates since investing in anothermoney market fund will ultimately cause the shareholderto be paying fees on two funds. In addition,there are percentage limits that the investing fundmay comprise of the fund it is investing in. This isbecause it would not be prudent for the fund toinvest in another rated fund if it were going tocomprise a significant portion of its assets.DilutionA money fund or pool’s market price exposure isalso affected by the flow of money into and out ofthe fund. Standard & Poor’s analyzesshareholder/participant characteristics and behaviorin order to assess each fund’s cash-flow volatility.Stable NAV pools issue and redeem shares at $1.00,provided that their market value is between $0.995316 Standard & Poor’s Public Finance Criteria 2007

Government Investment Pooland $1.005. Because funds can pay out $1.00 onshares that may actually be worth as little as$0.995, the remaining participants in the fundabsorb the difference. This is referred to as dilution;redeeming shares at a price above their actual marketvalue is diluting the value of the fund’s holdings.This situation could be significantly worse forstable NAV GIPs that do not employ frequentmarking-to-market because the pool’s true valuecan drop well below $0.995 without it being recognized.In analyzing the pool’s participant base,Standard & Poor’s examines the expected redemptioncharacteristics. It then models hypotheticalinterest-rate movements in conjunction with reasonablysevere levels of redemptions in order to judgethe potential dilution a fund may experience.Standard & Poor’s expects that a fund’s investmentsshould be tailored to its potential cash flow needs.For pools with a potentially volatile participantbase, a more conservative approach must be takenwith regard to WAM and liquidity.Shareholder characteristicsA money market fund’s market price exposure isalso affected by the flow of money into and out ofthe fund. Unexpected redemptions have a directinfluence on a fund’s NAV. Therefore, Standard &Poor’s reviews the characteristics of each fund’sshareholder/participant base to determine thepotential impact of share redemptions on marketprice exposure. This review of shareholder constituencyencompasses consideration of the number,average holding size, type of investor, historicalasset volatility, and the relationship managementhas with the participant. The proportion of voluntaryversus involuntary investors and the past historyof redemptions are also examined. Pools withhistories of volatile subscription and redemptionpatterns are expected to have shorter weightedaverage portfolio maturities.Portfolio valuationA Standard & Poor’s stable NAV pool or moneymarket fund rating directly addresses the ability ofa fund to maintain a NAV that does not deviate bymore than one-half of 1%. For a fund to effectivelystay within this narrow range, accurate pricing ofits securities is essential. Most stable NAV pool ormoney market fund instruments are highly liquidand easy to price. However, some complex, structured,and derivative securities present pricing difficulties.Complex and derivative securities often lackefficient, liquid markets. Trading in these securitiescan be infrequent, creating varying price quotesamong dealers and wide bid/ask spreads.The prices of these types of securities may bedetermined in a variety of ways, including dealerquotes, matrix pricing formulas, spreads to benchmarksecurities, pricing services, or even by thefund advisers themselves. All of these methods havedrawbacks. Dealer quotes on thinly (infrequently)traded securities often represent indicative pricinglevels and rarely constitutes an actual bid to purchasethe security. Matrix prices, pricing servicequotes, and spread calculations are not based onactual trades, and do not represent a price at whichanyone actually offered to purchase the security.These methods calculate a hypothetical price that isnot verifiable. Pricing by fund managers oftenoccurs when the manager either disagrees with theother pricing methods or holds securities so uniquethat other pricing methods are inadequate. Clearly,even if the fund manager can determine fair valueprices based on in-depth analytics, it is far fromcertain that any buyers are willing to purchase thesecurities at or near those prices.Before purchasing complex, derivative, or otherwiseilliquid securities, portfolio managers shouldcarefully examine the pricing issue. It is necessaryto evaluate the number of available pricing sources,with an eye toward identifying material discrepancies.Portfolio managers should also be aware ofpricing methodology, and should compare theresults to recent trading activity. It is inadvisable fora fund’s manager to solely accept the calculations ofa security’s issuer or dealer in determining the valueof an investment. This information may be eitherhighly biased or based on inaccurate assumptions,or both. Portfolio managers should not only be ableto determine their own fair value for securities thatare difficult to price, but need also to consider themarketplace for each security and the potentialvolatility that can be caused by inefficient marketpricing. If a fund adviser lacks the ability to assessthe potential market behavior of a security with ahigh degree of comfort, the security should not bepurchased for that money market fund.Net asset value (NAV) monitoringShould a fund experience a situation where stabilityof its $1.00 NAV is in jeopardy, there are severalactions the fund may take. These include withholdingdividends, selling securities to realize gains orlosses, valuing the shares at the market rather thanat amortized cost, or waiting out the situation todetermine if the problem is only temporary. In therating process, Standard & Poor’s reviews the formaland informal policies and procedures the fundhas in place to monitor and correct such situations.ManagementThe rating process includes a meeting between thefund’s officials and fund analysts from Standard &Poor’s. Standard & Poor’s evaluates the effectivenessof fund management in implementing awww.standardandpoors.com317

Other Criteriadynamic portfolio process consistent with its statedinvestment goals. Standard & Poor’s believes thatthese meetings are central to a meaningful fund ratingservice. Management assessment considersexperience and track record in portfolio management,operating policies and risk preferences, credibilityand commitment to policies, and the extentand thoroughness of internal controls.ExperienceStandard & Poor’s judges each fund managementteam on its own merits. Focus is placed on the waythe fund is managed in relation to its shareholderbase and stated investment objectives. Standard &Poor’s closely examines how daily operations of thefund are conducted. This examination includes, butis not limited to, organizational structure, oversight,and depth of staff. An experienced fund managerwith a proven track record in money market fundsgreatly enhances a fund’s safety. This manager doesnot necessarily have to make every investment decision,but should be closely involved with fund oversight.It is also necessary to distinguish between anexperienced stable NAV pool or money marketfund manager and someone who has experiencemanaging long-term investments. Managing a stableNAV fund is very different from managing abond fund with a variable share price. Investmentpolicies and strategies that may be very prudent forbond funds can be disastrous for money marketfunds. The precision necessary to run a stable NAVpool or money market fund successfully requires adifferent mindset than is required in managingother fixed-income vehicles. An experienced fixedincomemanager does not necessarily translate intoan effective stable NAV pool or money market fundmanager. Therefore, Standard & Poor’s emphasizesthe level of experience in managing money marketfunds or stable NAV pools in its review of fundmanagement. Lack of experience can result in alower rating, more stringent ratings criteria (such asa shorter WAM), or both.Operating procedures and risk preferencesStandard & Poor’s evaluates the fund manager’soperating procedures and risk preferences in conjunctionwith each rating. A key component of thisreview is the investment decision-making process.Numerous investment decisions are made daily forall money market funds or stable NAV pools.Standard & Poor’s examines how these decisions aremade, who is charged with executing them, and theoversight procedures that are in place. Standard &Poor’s also focuses on the amount, type, and qualityof information used in making policy and investmentdecisions. This includes the size and capabilitiesof the credit research staff, the access to currenteconomic data and analysis, and the types of on-linebusiness information services used.Credit quality is one area that should be documentedwith formal written procedures. A fundadviser should establish an approved investment listas well as policies for adding or removing namesfrom that list. Additionally, a process and methodologyfor periodically evaluating the credit qualityof all approved investments should be established.Standard & Poor’s also expects clear and explicitinvestment policies for the pool including the use ofvariable rate securities (VRNs), structured notes,and derivative instruments. Fund investment policiesshould incorporate procedures on the approval,risk measurement, control, and limits related tothese investments. Fund managers should be able topresent an analytical basis for determining thatsuch securities are indeed eligible fund investmentsand have a reasonable likelihood of maintaining orrepricing to par at each reset until maturity. Thisanalytical basis should include a review of historicalindex behavior and sensitivity analysis.Internal controlsStandard & Poor’s closely considers the internalcontrols of fund advisers and pool managers.Included here are pricing policies, NAV deviationprocedures, depth of staff, stress-testing capabilities,asset flow monitoring, trade ticket verification, systemsbackups, and disaster recovery. Accurate pricingis a key factor in maintaining a stable NAV.Standard & Poor’s expects all investment advisersof rated money funds to have the ability to priceportfolio securities and calculate a fund’s actualNAV in-house, and to do so periodically. Advisersare expected to compare the market value of thefund to its amortized cost value on a weekly basis.In addition, managers should have built-in proceduresto check the pricing of outside providers andquestion any discrepancies that may occur.Investment advisers need to be able to calculateNAV, but they also need to have explicit writtenplans for dealing with any material deviation. NAVdeviation procedures are the responsibility of thepool’s manager and the advisory board, and shouldnot be left to a third-party administrator.Fund managers should also be reasonably preparedfor the unexpected. This entails the ability toperform “what if” and stress test analyses. Forexample, a fund manager should be able to calculatethe impact of any security purchase on the fund’sWAM. This calculation should factor in the influenceof sudden or unexpected redemptions in conjunctionwith the security purchase. In addition, fund managersshould have the ability to stress test both individualsecurities and entire portfolios. Individualsecurity tests should estimate price sensitivity under318 Standard & Poor’s Public Finance Criteria 2007

Government Investment Poolsevere interest rate movements. Portfolio testingshould stress the fund’s assets in aggregate under thesame interest rate scenarios, but should also measurethe impact of dilution on NAV assuming sizableredemption activity.It is also important to have detailed contingencymanagement and disaster recovery plans that aretested periodically. Earthquakes in Los Angeles andSan Francisco, floods in Houston and the Blackoutin the Northeastern U.S. are just a few past examplesof situations in which emergency action planshad to be executed.Standard & Poor’s rated government investmentpool(GIP) indicesStandard & Poor’s Rated GIP Indices are performanceindicators of rated GIPs that maintain a stablenet asset value (NAV) of $1.00 per share. As ofSeptember 2006, there are three GovernmentInvestment Pool indices:■ Standard & Poor’s Rated GovernmentInvestment Pool Index/All■ Standard & Poor’s Rated GovernmentInvestment Pool Index/Government■ Standard & Poor’s Rated GovernmentInvestment Pool Index/General Purpose TaxableThese indices provide a simple average of sevendayand 30-day net and gross yields, average days tomaturity, as well as the total assets of all pools publiclyrated in Standard & Poor’s two highest moneymarket fund rating categories: ‘AAAm’ and ‘AAm’.Variable Net Asset (NAV) Pool Ratings CriteriaStandard & Poor’s ratings criteria for variable netasset value (NAV) investment pools are the same asits fund credit and volatility ratings criteria.Therefore, all references to bond funds in the followingratings criteria article also apply to governmentinvestment pools (GIPs) or any other longertermpools of assets managed, like a fixed-incomebond fund, that provides a variable NAV.Ratings approach and processStandard & Poor’s assigns credit quality andvolatility ratings to GIPs that invest in fixed-incomeassets. The credit quality rating assigned to a fundaddresses the level of protection its portfolio holdingsprovide against losses from credit defaults.Credit quality ratings, which range from ‘AAAf’(highest level of protection) to ‘CCCf’ (least protection),are based on an analysis of the fund’s overallportfolio credit quality.Volatility ratings offer a current opinion of afund’s sensitivity to changing market conditions.Volatility ratings, which range from ‘S1’ (lowestvolatility) to ‘S6’ (highest volatility), are basedon an analysis of a fund’s investment strategyand portfolio level risk, including interest-raterisk, credit quality, liquidity, concentration, calland option risk, and currency risk. The effects ofvarious portfolio strategies, such as the use ofleverage, hedging, and derivative instruments, arealso factored into the rating. The goals ofStandard & Poor’s analysis are to uncover risksources in a managed fund’s portfolio and investmentstrategies and to assess the potential impacton its rate of return and NAV variability.Standard & Poor’s monitors each fund’s portfolioholdings on a monthly basis to maintain currentand accurate assessments of its credit quality andvolatility profile.Standard & Poor’s assigns volatility and creditquality ratings to funds on a request basis. Tomaintain the accuracy of the ratings, Standard andPoor’s requires fund management to provide portfolioand investment information to Standard &Poor’s on a frequent and timely basis. The ratingprocess is described below.The rating process for bond funds or variableNAV pool ratings includes an analysis of their portfoliolevel risk, historical performance, and management.After receiving and analyzing the informationrequired for a rating, Standard & Poor’s will conducta face-to-face management review meeting.Standard & Poor’s meets with fund managementofficials to evaluate the effectiveness of fund managementin implementing a portfolio strategy that isconsistent with its stated investment goals. Themeeting is focused on the following topics:■ Depth and stability of the fund managementteam■ Investment philosophy■ Operating policies, internal controls, and riskpreferences■ Credit risk■ Duration profile■ Use of leverage■ Investment targets■ Performance historyUpon completion of the management meeting,the Standard & Poor’s analyst then discusses his orher findings with a ratings committee and makes arating recommendation. The committee is composedof at least three senior analysts, as well as thelead and backup analysts. The committee reviewsand discusses the information uncovered in theanalysis and any open items from the managementmeeting, then votes on a rating(s) for the fund.Once a rating is issued, Standard & Poor’s monitorsthe fund on a monthly basis to ensure that anychanges in the portfolio or the fund management’soperating policies do not alter the fund’s rating(s).Standard & Poor’s also conducts an annual man-www.standardandpoors.com319

Other CriteriaVariable Net Asset Value (NAV) Pool Credit Quality Rating DefinitionsA Standard & Poor’s Bond Fund/Variable Net Asset Value (NAV) Pool credit qualityrating is an assessment of the overall credit quality of a fund’s portfolio. The ratingreflects the level of protection that the pool’s portfolio provides against lossesfrom credit defaults. Credit quality ratings, identified by the ‘f’ subscript, areassigned to bond funds and other actively managed funds that exhibit variable netasset values. These ratings are current assessments of the overall credit qualityof a fund’s portfolio. The ratings reflect the level of protection against lossesfrom credit defaults and are based on an analysis of the credit quality of theportfolio investments and the likelihood of counterparty defaults. Symbols anddefinitions follow:AAAfThe fund’s portfolio holdings provide extremely strong protection against lossesfrom credit defaults.AAfThe fund’s portfolio holdings provide very strong protection against losses fromcredit defaults.AfThe fund’s portfolio holdings provide strong protection against losses from creditdefaults.BBBfThe fund’s portfolio holdings provide adequate protection against losses fromcredit defaults.BBfThe fund’s portfolio holdings provide uncertain protection against losses fromcredit defaults.BfThe fund’s portfolio holdings exhibit vulnerability to losses from credit defaults.CCCfThe fund’s portfolio holdings make it extremely vulnerable to losses from creditdefaults.Plus or MinusThe ratings from ‘AAf’ to ‘CCCf’ may be modified by the addition of a plus (+) orminus (-) sign to show relative standing within the major rating categories.A credit quality rating is not a recommendation to purchase, sell, or hold a security,inasmuch as it is not a comment on the market price, yield, or suitability for a particularinvestor. The ratings are based on current information furnished by the fund or obtainedfrom other sources that Standard & Poor’s considers reliable. Standard & Poor’s doesnot perform an audit in connection with any rating and may, on occasion, rely on unauditedinformation The ratings may be changed, suspended, or withdrawn as a result ofchanges in, or unavailability of, such information, or based on other circumstances.agement review and portfolio strategy meeting toreview any changes made during the year.Fund credit quality ratings criteriaA Standard & Poor’s credit quality rating is anassessment of the overall credit quality of a fund’sportfolio. Credit quality ratings, identified by the ‘f’subscript, are assigned to bond funds and otheractively managed funds that exhibit variable NAVs.The ratings reflect the level of protection againstlosses from credit defaults and are based on ananalysis of the credit quality of the portfolio investmentsand the likelihood of counterparty defaults(see Variable Net Asset Value(NAV) Pool CreditQuality Rating Definitions).The credit quality rating captures the fund’s overallexposure to default risk and is based on a creditmatrix approach derived from Standard & Poor’shistorical default and ratings transition rates.Standard & Poor’s credit quality criteria calls forthe assets of a managed fund, and its counterparties,to be consistent with the credit quality rating.The assessment is based on the credit quality and/orratings of the investments held by the fund, as wellas the credit quality of the counterparties withwhich the fund engages in market transactions,such as swaps or repurchase agreements (repos).To evaluate a fund’s overall level of protectionagainst losses associated with credit risk,Standard & Poor’s applies the factors and scoresfrom the Credit Quality Matrix to the fund’s portfolioholdings. These credit factors and credit qualityscores are derived from Standard & Poor’s historicalratings stability and ratings transition studies. Thecredit factor for each of the long-term ratings categories(e.g., ‘AAA’, ‘AA’, ‘BBB’) were derived fromthe singular, discrete, worst-case one-year defaultrate experience and the average one-year ratingstransition experienced during a 20-year period. Theresulting credit factor for each long-term rating categoryassumes that the securities or holdings withineach rating category will exhibit the worst-casedefault rates and the average ratings transition ratesover a one-year holding period. The credit qualityrating assigned to a fund or pool of managed assetsdoes not address a fund’s ability to meet ‘paymentobligations’. For further information and in-depthanalysis please refer to the most recent Standard &Poor’s Fund Ratings Criteria publication.In conjunction with this analysis, Standard &Poor’s closely reviews the manager’s internal creditanalysis and security evaluation and surveillanceprocedures. Securities rated by other nationally recognizedstatistical rating organizations (NRSRO’s),but not rated by Standard & Poor’s, may be consideredeligible if there is an analytic basis for consideringthese securities as having comparable creditquality. Total exposure to non-Standard & Poor’srated securities in a rated bond fund should be25% or less, with no more than 5% in any oneissuer and may be subject to certain criteria adjustments.For further information and in-depth analysisplease refer to the most recent Standard &Poor’s Fund Ratings Criteria publication.Counterparty criteriaStandard & Poor’s has established minimum creditquality guidelines for counterparties that engage in320 Standard & Poor’s Public Finance Criteria 2007

Government Investment PoolVariable Net Asset Value (NAV) Pool Volatility Ratings DefinitionsA bond fund/variable net asset value (NAV) pool volatility ratings is a current opinionof a fixed-income fund’s sensitivity to changing market conditions relative tothe risk of a portfolio composed of government securities and denominated in thebase currency of the fund. Volatility ratings evaluate the fund’s sensitivity to interest-ratemovement, credit risk, investment diversification or concentration,liquidity, leverage and other factors.S1Bond funds that possess low sensitivity to changing market conditions are ratedS1. These funds possess an aggregate level of risk that is less than or equal to thatof a portfolio comprised of government securities* maturing within one to threeyears and denominated in the base currency of the fund. Within this category, certainfunds are designated with a plus sign (+). This indicates the fund’s extremelylow sensitivity to changing market conditions. These funds possess an aggregatelevel of risk that is less than or equal to that of a portfolio comprised of the highestquality fixed-income instruments with an average maturity of one year or less.S2Bond funds that possess low to moderate sensitivity to changing market conditionsare rated S2. These funds possess an aggregate level of risk that is less than orequal to that of a portfolio comprised of government securities maturing withinthree to sevenS3Bond funds that possess moderate sensitivity to changing market conditions arerated S3. These funds possess an aggregate level of risk that is less than or equalto that of a portfolio comprised of government securities maturing within seven to10 years and denominated in the base currency of the fund.S4Bond funds that possess moderate to high sensitivity to changing market conditionsare rated S4. These funds possess an aggregate level of risk that is less thanor equal to that of a portfolio comprised of government securities maturing beyond10 years and denominated in the base currency of the fund.S5Bond funds that possess high sensitivity to changing market conditions are ratedS5. These funds may be exposed to a variety of significant risks including highconcentration risks, high leverage, and investments in complex structured and/orilliquid securities.S6Bond funds that possess the highest sensitivity to changing market conditions arerated S6. These funds include those with highly speculative investment strategieswith rated S6. These funds include those with highly speculative investment strategieswith multiple forms of significant risks, with little or no diversification benefits.* Government securities (for S1 through S4 categories) are intended to signify the mostliquid, highest quality securities issued by a sovereign government. The ratings arebased on current information furnished by the fund to Standard & Poor’s or obtained byStandard & Poor’s from other sources it considers reliable. Standard & Poor’s doesnot perform an audit in connection with any rating, and may rely on unauditedfinancial information. The ratings may be changed, suspended, or withdrawn as a resultof changes in, or unavailability of, such information, or based on other circumstances.The rating is not a recommendation to purchase, sell, or hold any security held or issuedby the fund, inasmuch as it does not comment on market price, yield, or suitability for aparticular investor.market transactions with credit rated and volatilityrated funds.These market transactions may include, but arenot limited to repurchase agreements (repos),reverse repos, forward purchases, forward exchangecontracts, swaps and other hedging positions. Acounterparty’s failure to meet its obligations contractedwith a fund may impair the successful outcomeof its intended objectives. Due to this risk,Standard & Poor’s criteria calls for a counterparty’sminimum rating to be no less than one full ratingcategory below the fund’s rating for transactionsspanning one year or longer. For example, ‘AAAf’and rated funds would need to use ‘AA’ or betterrated entities for transactions equal to or greaterthan one year. Counterparty Criteria for all ratingcategories are as follows:■ AAAf—Long-term transactions (i.e., one year orlonger)-AA or better. Short-term (i.e., less thanone year): A-2 or better for overnight transactions;A-1 or better for longer than overnight.■ AAf-Long-term transactions (i.e.,one year orlonger)-A or better. Short-term (i.e., less than oneyear): A-2 or better for overnight transactions;A-1 or better for longer than overnight.■ Af—Long-term transactions (i.e., one year orlonger)-BBB or better. Short-term (i.e., less thanone year): A-2 or better.■ BBBf—Long-term transactions (one year orlonger)-BBB or better. Short-term (i.e., less thanone year): A-3 or better.Volatility ratings analysisStandard & Poor’s volatility ratings are designed torank or designate bond funds or variable NAVpools according to the degree to which they areexposed to the factors that ultimately lead to shareprice and return volatility. The volatility ratingsscale, which ranges from ‘S1’ (lowest sensitivity) to‘S6’ (highest sensitivity), expresses Standard &Poor’s current opinion of a fixed-income fund’s sensitivityto changing market conditions. The volatilityprofiles of the first four categories (‘S1’ through‘S4’) are measured and expressed on a relative basisto established government indices with differentmaturity bands (see Variable Net Asset (NAV) PoolVolatility Ratings Definitions), to provide investorswith market benchmarks for risk and return comparisons.Standard & Poor’s evaluation of funds forvolatility ratings includes:■ Portfolio risk analysis■ Historical risk analysis■ Management assessmentwww.standardandpoors.com321

Other CriteriaPortfolio and historical risk analyses often yieldsimilar results and reflect a long-term commitmentto a particular investment objective and risk-tolerancelevel by the fund’s adviser and portfolio manager.Where there are significant differencesbetween the current risk and historical risk profiles,management assessment becomes particularlyimportant. Discussions with fund managementabout investment policies and strategies, asset selection,internal research capabilities, and portfoliorisk monitoring help Standard & Poor’s to assessthe fund’s current and ongoing risk profiles. ThePrincipal Stability Fund Ratings (Stable NAV Pool) DefinitionsA principal stability fund rating (also known as a money market fund rating) is notdirectly comparable with a bond rating due to differences in investment characteristics,rating criteria, and creditworthiness of portfolio investments. For example, amoney market fund portfolio provides greater liquidity, price stability, and diversificationthan a long-term bond, but not necessarily the credit quality that would beindicated by the corresponding bond rating. Ratings are not commentaries on yieldlevels. A principal stability fund rating is not a recommendation to buy, sell, or holdthe shares of a fund. Further, the rating may be changed, suspended, or withdrawnas a result of changes in or unavailability of information related to the fund.AAAmFund has extremely strong capacity maintain principal stability and to limitexposure to principal losses due to credit, market, and/or liquidity risks.AAmFund has very strong capacity to maintain principal stability and to limit exposureto principal losses due to credit, market, and/or liquidity risks.AmFund has strong capacity to maintain principal stability, but is somewhat moresusceptible to principal losses due to adverse credit, market and/or liquidity risks.BBBmFund has adequate capacity to maintain principal stability. Nevertheless, adversemarket conditions and/or higher levels of redemption activity are more likely tolead to a weakened capacity to limit exposure to principal loss as a result of higherexposure to credit, market and/or liquidity risks.BBmFund has uncertain capacity to maintain principal stability, and is vulnerable toprincipal losses resulting from its exposures to credit, market, and/or liquidtiyrisks.DmFund has failed to maintain principal stability resulting in a realized or unrealizedloss of principal.GThe letter ‘G’ follows the rating symbol when a fund’s portfolio consists entirely ofdirect U.S. government securities.Plus or minus ratings may be modified (except ‘AAAm’) to show relative standing withinthe rating categories.primary goal is to evaluate the adviser’s effectivenessin maintaining an investment policy that isconsistent with the fund’s stated investment objectivesand investors’ expectations.The ratings analysis focuses on measuring quantifiableportfolio risk factors, including interest-raterisk, yield curve risk, credit risk, liquidity risk,options risk, and concentration risk. In addition,Standard & Poor’s also evaluates the pool’s totalreturn historical volatility. This review involves twotypes of analysis. First, the identification centers onthe level of volatility and distribution of monthlyreturns of the pool over a minimum of 36 monthsin relation to certain fixed-income asset classes andindices that Standard & Poor’s tracks on an ongoingbasis. The second analysis is focused on understandinghow past volatility relates to the pool’sinvestment objectives, the portfolio constructionprocess (including risk controls), and the fund’soutcome as a result of market developments thatoccurred during the period under review. The relevanceof this part of the analysis in the final volatilityrating will depend on the second step in the ratingprocess, or the portfolio analysis.The analysis of current portfolio risk is undertakento confirm (or not confirm) the continuation ofpast investment policies and their attendant risks.Portfolio analysis is designed specifically to evaluatewhether the fund has a greater chance of losingmore money (i.e., experience greater volatility) inthe short term than historical volatility of returnswould suggest. An abnormal short-term loss is onethat is inconsistent with the fund’s history, currentmarket conditions, or the fund’s stated investmentobjectives. Furthermore, while higher risk is oftenassociated with higher returns, higher risk alsomeans a greater uncertainty over all outcomes. Riskor volatility can manifest itself in either a continuousfashion or at discrete intervals, in which casethe illusion of low volatility can often prevail for anextended period of time. For example, interest-ratesensitive funds (such as funds that invest in highlycreditworthy securities like U.S. Treasury securities)often exhibit more volatility than funds that investin low-grade, high-yield, or illiquid securities; however,at times, these funds can exhibit high toextremely high volatility due to investor sentimentregarding increased default or liquidity risks.Portfolio analysis often incorporates stress-testingtechniques that examine the portfolio’s returns (orexpected returns) under various market scenarios,as well as for different portfolios. Portfolio levelrisk analysis is focused on understanding thesources or factors that contribute to risk, which, formost bond funds investing in marketable fixedincomesecurities, includes interest-rate/option risk,credit risk, and liquidity risk.322 Standard & Poor’s Public Finance Criteria 2007

Assessing Construction RiskInterest rate/option riskInterest-rate risk refers to the fact that the longerthe maturity of a security, the more uncertain andtherefore more risky the present value of its cashflows. Securities with an uncertain maturity, suchas, callable securities, or securities with embeddedoptions (e.g., like mortgage-backed bonds) are bynature riskier than those with a known maturity. Inaddition, the distribution of a security or a fund’scash flows along the maturity spectrum (or yieldcurve) is as relevant as the maturity itself. A bond’s(or pool’s) interest-rate risk is best measured by itsduration. Duration approximates the overall pricesensitivity of the portfolio to changes in interestrates. Duration is a more precise measure of interestrate risk than maturity because it takes into accountall of the bond’s cash flows. For example, whenrates rise by one half of 1% (or 50 basis points),the value of a pool with a duration of four yearswill decrease by about 2%.Credit and liquidity risksCredit and liquidity risks are distinct, althoughoften closely related. Credit risk refers to the possibilitythat an issuer may become unable or unwillingto meet its payment obligations on time or infull. Securities with higher credit risk trade on higheryields compared to lower credit risk securities,and the variations in such yield spreads are oftendescribed as spread risk. Liquidity risk refers to thepossible price penalty incurred when buying or sellinga particular security or asset for which there is alimited secondary market. Liquidity is also measuredby how quickly a security can be sold.Standard & Poor’s considers the effects of theserisks, among others, when evaluating the overallprice sensitivity of a fund. The relevant risk is theaggregate risk, measured after all diversificationbenefits are taken into account.Management assessmentFund manager assessment is an opportunity forStandard & Poor’s to gain an in-depth understandingof different factors that could affect a fund’soverall risk profile. Since fund managers can have asignificant impact on the fund’s future risk profile,Standard & Poor’s meets with fund managers todiscuss various portfolio risk related topics. Atthese meetings, Standard & Poor’s looks at managementsophistication and experience, the qualityof research support, dedication to controlling riskwithin established guidelines, portfolio strategies,and the frequency and extent of changes to portfolioholdings, among other factors. Even after a fundis rated, Standard & Poor’s meets with the fundmanagers at least annually.Credibility and commitment to policiesStandard & Poor’s judges each fund and its managementon its own merits. There is no ‘model’fund. Whether a fund has a retail or institutionalshareholder base, or favors an aggressive investmentapproach over a conservative strategy is notcritical. The important issue is how the fund ismanaged. Policies and strategies may differ fromfund to fund, but the degree to which managementhas control over them should not. Standard &Poor’s closely examines the daily operations of thefund, including organizational structure and depth,the degree of oversight and accountability, particularlyin the portfolio and risk management areas. ■Assessing Construction RiskConstruction risk is present in virtually all publicfinance transactions, but it typically introducescredit risk only in those transactions where debtservice payment is contingent on project completionand/or acceptance. Standard & Poor’s RatingsServices addresses construction risk directly in therating, either through an evaluation of the constructionprocess or, with credit support such as lettersof credit during the construction period. The depthof the evaluation of the construction process willvary by project; earthquake analysis is unchanged.For example, the analysis performed on a schoolbuilding will be less than that performed on an offcampusstudent housing project.Standard & Poor’s will adopt a continuum ofrisk approach to assessing construction risk. If thereis strong public support for a project, and the projectsare not complex, the construction analysis willfocus on the following issues:■ Project essentiality;■ Experience with similar projects;■ Contractor’s experience with the issuer/obligor;■ Project schedule and cost structure;■ Construction contingencies in the project budget;www.standardandpoors.com323

Other Criteria■ Duration of capitalized interest;■ Insurance coverage during construction, includingwhether coverage is sufficient to cover fullredemption of bonds in the event of damage ordestruction; and■ Full permitting and site approvals.The level of construction risk the project entailswill then be evaluated, and if determined to be minimal,a rating will be assigned, based on the obligor’screditworthiness. If the level of construction risksexceeds the normal threshold of most municipalprojects, further analysis will be undertaken, whichwould reflect the criteria used within Standard &Poor’s project finance group, and could include theuse of an outside construction consultant.Where no municipal entity agrees to pay debtservice upon completion, and where the projectmust be completed in order for debt service to bepaid, the project ratings will involve a full analysisof the risks of construction. These risks arethree-fold:■ Timely completion;■ Project performance—whether the project will bebuilt as anticipated or perform as expected; and■ Project cost.Each layer of risk can affect whether the projectwill produce the cash flow necessary to pay debtservice, generate sufficient demand as built, andwhether unanticipated costs will result in inabilityto pay debt service. These projects are likely toinclude many federal leases, public-private partnerships,affordable multifamily housing and nonrecourseprojects.Standard & Poor’s has used this approach forconstruction risk analysis for many years and hasdeveloped levels of construction risk based on comparableprojects. If construction risk is determinedto be appropriately low, a rating based on the obligor’screditworthiness may, all other things beingequal, be assigned. If the level of construction risk isexcessive, further analysis will be undertaken alongthe lines of the complex project criteria and couldinclude the use of a outside construction consultant.Even where a complex project analysis may notultimately be appropriate for certain projects,Standard & Poor’s may retain a construction consultantto advise on particular issues. The scope ofthe consultancy encompasses the following principleareas of inquiry:■ Review of plans and construction documents;■ Evaluation of the likelihood that the contractorwill perform based on historical performance onsimilar projects;■ Hard cost budget and construction schedule evaluation—whethercosts allocated for the projectseem reasonable, whether there is adequate contingency,and whether the construction timeframe is aggressive;■ Project location, special situations (wetlands,weather);■ Construction schedule;■ Whether construction is set in a union/nonunionenvironment;■ Names of borrower, architect, general contractor,or construction manager; and■ Review of drawings or plans for the proposedbuilding.A complex project’s rating rests, in part, on thedependability of its design, construction, and operation.Should the project fail to achieve timely completionor perform as designed, it will not be able tomake its scheduled payments. Standard & Poor’s criteriamay require the report of an “independent engineer”as an aid to identifying and summarizing constructionand other project risks, and certifying thatnotwithstanding those risks, the project will neverthelessbe able to operate in the manner designed,and to generate sufficient cash flow to enable it tomake its scheduled debt service payments.For complex projects, construction risk may bedivided into its preconstruction and postconstructionfacets. The former consists of:■ Engineering and design;■ Site plans and permits;■ Construction; and■ Testing and commissioning.Though a project’s design may attempt to limitconstruction difficulties, its construction programmay nevertheless adversely affect the project.Limited contractor and vendor experience with thetechnology can put a project at risk, as can a weaksecurity and warranty package. A constructionmanagement plan that fails to adequately controlconstruction fund disbursement can result in cashleakage. Designs requiring complicated sequencingof construction activities may also present delayand cost risks. Construction relying on commerciallyproven technology and experienced contractorscan mitigate much of the construction risk attributedto design.Construction And Vendor ExperienceFor complex projects, Standard & Poor’s reviewsthe performance record of equipment vendors andgeneral contractors in building comparable predecessorprojects. Higher-rated projects tend to featurevendors and contractors having broad experiencebuilding comparable projects and demonstratedrecords of meeting schedules. In addition, thebetter contractors will have demonstrated a patternof meeting budgets and avoiding liquidated damagepayments or other penalties. If project sponsors324 Standard & Poor’s Public Finance Criteria 2007

Assessing Construction Riskelect to use a fixed-price, turnkey construction contract,Standard & Poor’s verifies that the owners,developers and others have had favorable experiencewith the proposed contractor.While Standard & Poor’s does not identify specificvendors or contractors as appropriate for construction,it does examine the experience of contractorsand vendors in building comparable facilities,as well as overall performance records. Standard &Poor’s also considers the ongoing and future businessinterests of the contractor and key vendors.Experience has shown that business interests of contractors,vendors, and sponsors contribute as muchinfluence as legal obligations in ensuring on timeand under budget construction projects.Construction Funds ManagementManaging construction fund disbursements frequentlyprovides a mechanism to maintain leverageover the sponsor developer and contractors andthus helps to minimize construction risk in higherratedprojects. Active management by the lender orlenders or their representatives achieves this objective.Loan documents typically give lenders theright to closely monitor construction progress andrelease funds only for work that the lender’s engineeringand construction expert has approved asbeing complete. On projects seeking to raise capitalfrom a broader investor base, either through privateplacement or public debt issues, management ofconstruction funds becomes more difficult becauseindividual investors have no real capacity to overseeconstruction draws. For such projects, however,third-party trustees, acting in a fiduciary capacity,will generally manage disbursement of funds toprotect debt holders’ interest in the project.In general, the higher rated transactions will providethe following controls over construction funds:■ Retention of all debt-financed funds in a segregatedaccount by a trustee experienced in management ofproject construction, preferably an experiencedbank or other lender for these projects;■ Control over all disbursements from this accountto the project with disbursements made only forwork certified as complete by an independentproject engineer and/or mortgage servicerretained by the construction trustee solely forapproving disbursements and monitoring thecompletion of construction of the project on timeand on budget; and■ Right to suspend or halt disbursements when thetrustee, acting in consultation with the independentproject engineer, concludes that constructionprogress is materially at risk because of outsideevents, such as reversals or revocations of necessaryregulatory approvals, or changes in law orcost outside the levels anticipated by the budgetand schedule or failure to perform by contractors;and the authority to approve all changeorders;■ And the authority to approve all change orders.In order for the trustee to fund constructiondraws out of the construction fund, the followingshould be in place:■ An application and certification for payment (AIADocument G702) must should been completedand received by trustee certifying that constructionis in accordance with the plans for the project.■ The loan must be in balance—an amount necessaryto complete project should be on hand oravailable-remaining uses must equal sources.■ There should be no events of default underindenture, mortgage, ground lease or any otheroperating agreements.■ The owner and trustee should receive lienwaivers from the contractor and major subcontractorsprior to funding draws.■ The trustee should receive title insurance bringdowns(i.e. there should be no mechanic’s lienson the project) prior to funding draws.■ Any credit enhancements relied upon in the initialrating should continue to be in place (e.g.LOC or rated completion guarantee).■ The construction consultant and/or mortgageservicer, if used, should approve the constructiondraws.■ The trustee should withhold an applicableamount of retainage (between 5-10% as decidedin beginning of transaction).■ The trustee should receive certificate of occupancyand certification as to completion of projectand satisfaction of punch list items prior to finalrelease of funds from project fund.Construction Schedule And BudgetStandard & Poor’s assessment of construction riskincludes a determination of whether the contractorcan achieve the proposed construction schedule andbudget without costly delays or quality problems.Standard & Poor’s expects that the independentengineer will have reviewed detailed budgets andconstruction schedules and will have opined as totheir feasibility. Reports without defensible conclusionsabout schedules and budgets can raise concerns.Higher-rated projects will have contractorsand equipment vendors who have consistently providedservices on time. Budgets should include contingenciesto cover unexpected construction events(not merely uncosted items) during construction.www.standardandpoors.com325

Other CriteriaIn addition, Standard & Poor’s assesses the extentto which engineering and design are complete, withequipment procured when construction begins;investment-grade projects tend to have completedthese tasks earlier than noninvestment-grade projects.Standard & Poor’s analyzes the independent engineer’sconclusions on the adequacy of contingenciesfor schedule and budget, and related assumptions.Standard & Poor’s also evaluates performancerequirements and incentives for project contractorsalong with the financial and technical capacity ofthe contractors. Projects that require constructionmonitoring by an expert third party, such as anindependent engineer, enhance construction surveillancewith this oversight mechanism.Cash Flow ConsiderationsAnd Capitalized Interest CalculationsFor financings that are cash-flow dependent, suchas mortgage revenue bonds for multifamily finance,sufficient funds must be available to pay debt serviceduring the construction period. Project capitalizationshould demonstrate sufficient amounts ofcapitalized interest to ensure bondholders will bepaid in full and on time during construction. Theseconsiderations vary according to bond structureand use of credit enhancements, among otherthings. In situations where bond proceeds are usedto fund construction and there is no constructionperiod credit enhancement, Standard & Poor’s willanalyze the following:■ Earnings during the construction period. Likeother transactions, in which funds are held inescrow during development, Standard & Poor’swill stress the effect of investment earnings oncoverage levels. Standard & Poor’s analysisinvolves a comparison of construction fundinvestment earnings and the mortgage note interestrate. If the construction fund investment rateis lower than the mortgage interest rate, thencash flows should assume that all monies shouldremain in the construction fund account until thelatest date they can be drawn under the bonddocuments (late draw). If the mortgage rate islower than the construction fund rate, then itshould be assumed that all funds are drawn dayone and the mortgagor is making mortgage payments.On a case-by-case basis, income may beshown during the construction period,■ Length of construction period. Standard & Poor’swill assume a delay in reaching constructioncompletion, as well as lease-up and stabilization.Delays will vary depending on Standard & Poor’sanalysis of construction risk, including the opinionof an independent construction consultant insome instances. For low risk projects, a sixmonthdelay might be sufficient, whereas formoderate risk projects, one year might be inorder. High-risk construction may call for delaysof 18 months or longer.■ Rental income. Standard & Poor’s will examinecase-by-case whether rental income exists duringconstruction. An example of where rental incomecould be shown would be in low risk constructionsituations, such as military housing transactions,where units are on line at the outset of thetransaction and demand is extremely deep. In anyevent, Standard & Poor’s will assume maximumoccupancy of 95%. Occupancy assumptionscould be lower if the market analysis cannot substantiate95%.■ Trending of income and expenses. If rentalincome is present in a particular transaction, notrending of income and expenses will be takeninto account, except on a case-by-case basis.■ Debt service coverage. Coverage of debt shouldalways be at least 1x for investment grade ratings.Standard & Poor’s will determine case bycase what the coverage level should be dependingon analysis of construction risk and the rating onthe bonds.Shortfalls in bond cash flows can be covered byequity contributions or other paid-in cash at closing,letters of credit (LOCs), available funds underan HFA parity program and other rated creditenhancements.Covering Construction Risk With Credit EnhancementsWhen construction risk is moderate to high, creditenhancement during the construction and lease-upphase may be needed for investment grade ratings.This is often the practice in single-asset affordablehousing transactions. Credit enhancements are typicallyin the form of a LOC from a bank rated ashigh as the bonds, or Freddie Mac, Fannie Mae,GNMA, FHA insurance or guarantees.LOCsThe LOC should remain in place until the projectachieves stabilization at full occupancy at a predetermineddebt service coverage ratio for at least oneyear. Once the project achieves stabilization, theLOC may be released. The rating during the creditenhancement period will be limited by the rating ofthe credit enhancer. The LOC amount should coverbond principal amount and interest to a specifiedcompletion date. The trust indenture should have amandatory draw on the LOC and a correspondingmandatory redemption of the bonds from LOC proceedsin the event that the project does not reach326 Standard & Poor’s Public Finance Criteria 2007

Pension Fund Credit Enhancement And Related Guarantee Programscompletion and lease-up at specified debt service coverageby the specified completion date. Please see,“Public Finance Criteria: LOC-Backed MunicipalDebt” for a full description of Standard & Poor’s criteriarelating to letters of credit.Freddie Mac, Fannie Mae,GNMA guarantees/FHA insurancePlease see, “Public Finance Criteria: Ginnie Mae,Fannie Mae And Freddie Mac MultifamilySecurities,” and “Public Finance Criteria: FHAInsured Mortgages” for a full description of ratingcriteria. Construction risk is typically fully mitigatedby the insurance and guarantees; however, transactiondocuments must accurately reflect the mechanics ofthe program, cash flow considerations and capitalizedinterest calculations must be incorporated into theanalysis, and Standard & Poor’s assumes a “worstcase” receipt of guarantee and insurance proceeds.Turnkey Contracts As Credit EnhancementsSponsors often use “turnkey” (“soup-to-nuts”) contractson major projects as a means of shifting constructionrisk away from equity and lenders. In aturnkey contract, the builder promises to deliver theproject complete on a certain day, and takes allresponsibility for design, engineering, procurement,construction, and testing. All the project owner hasto do is pay the contract costs, and “get the keys”to a fully functioning project at the end of theprocess. In appropriate circumstances, turnkey contractscan shift risk to the extent that they may beviewed as an indirect type of credit enhancement byproviding for timely and full completion on pain ofdamage or penalty payments, on which the projectmight be able to rely for debt service. Nevertheless,prompt payment of liquidated damages is more adesideratum than a reality.Turnkey or other construction contracts cannoteliminate all risk. Some risk generally remains, suchas force majeure and change-of-law events, whichby definition, cannot be controlled by the vendorand contractor. ■Pension Fund Credit EnhancementAnd Related Guarantee ProgramsStandard & Poor’s Ratings Services, upon request,will assign ratings to issues secured by publicpension fund credit enhancement programs.Even though some enhancement programs arerelatively short-term in nature, or signify a fractionof a pension fund’s accumulated assets, Standard &Poor’s analytical approach for public pension fundcredit enhancement program issue ratings focuseson the long-term credit quality of the fund’s sponsor,along with the pension fund’s independence,management, and operating performance. In otherwords, a pension fund’s credit enhancement programis not viewed in a vacuum: extraordinaryasset and cash flow coverage of credit enhancementprogram obligations does not automatically translateinto superior credit quality. Nonetheless, creditenhancement programs remain an important creditconsideration and will be analyzed in the context ofhow the program fits within the pension fund’soverall management and operating profile.Pension Fund GuaranteesCredit enhancement programs and related guaranteespertain to the extension of a pension fund’screditworthiness to debt instruments of other entitiesthrough letters of credit (LOCs), guaranteeagreements, liquidity agreements for commercialpaper (CP) or other short-term instruments, or liquidityagreements to honor optional “put” provisionson variable-rate debt.In one respect, the extension of pension fundguarantees is similar to the investment risk undertakenby a pension fund in its normal course ofbusiness, in that pension fund assets are placed ata level of risk in return for current or future compensationfor undertaking the risk of lending orpromising to advance assets. However, it is importantto note that the extension of pension guaranteesleverages existing assets, in addition to thenormal investment risk associated with the directownership of financial securities.In the extreme case of a securities marketprice decline, losses on owned investments by apension fund could be aggravated by requirementsto honor guarantees or other financialcommitments extended by the pension fund,increasing the potential for losses of fund assetsand reducing the ability of the pension fund tohonor its standing obligations for benefit paymentsto retirees.www.standardandpoors.com327

Other CriteriaRating AnalysisIn order to rate a credit enhancement programissue, the pension fund itself is first assigned a publicissuer credit rating. For credit enhancement programs,areas of analysis include a review of:■ Legal authorization for the extension of pensionguarantees (statutory, constitutional, or via permittedinvestment guidelines);■ Legal priority of pension fund guarantees relativeto the fund’s obligation to pay pension benefits;■ Enforceability of pension fund guarantees;■ Legally permissible guarantees or extension offund credit, including direct debt guarantees, CP,LOCs, liquidity agreements, and guaranteedinvestment contracts;■ Maximum permitted program exposure amountrelative to the pension fund’s: percentage of totalinvested assets; percentage of normal annual netcash flow (income and contributions minusrequired annual pension benefit payments); andpercentage of annual pension benefit payments;■ Types of guarantees that may be undertaken orincurred by a pension fund, by generic industrycredit risk (e.g., municipal debt guarantees, corporatedebt guarantees, small business loans, currencyrisk or interest-rate risk, etc.);■ Risk concentration limits or guidelines, as theyrelate to industry or single-issuer guarantee risk;■ Maturity or liquidity risk to the pension fund,depending on the nature and proposed types ofinstruments to be guaranteed;■ The legally available highly liquid asset portfolioand its composition in terms of credit quality,volatility, and weighted average maturity; and■ The management, monitoring, and oversight proceduresfor the legally available highly liquid assets.Asset liquidation planFor pension fund credit enhancement programs thatrequire immediate access to liquid assets, a detailedasset liquidation plan will be reviewed (seeStandard & Poor’s self liquidity criteria). The abilityof a fund’s asset management team to liquidateassets on a same day basis (if necessary) is a keyfactor in the evaluation of a pension fund creditenhancement program.Very specific written liquidation procedures arerequired and should detail:■ Persons responsible (including alternates) for executingthe asset liquidation;■ The sequence of steps that must be undertakenby all parties to effect liquidation; and■ The timing of notifications to the appropriateparties to ensure that sufficient funds are availableto pay program obligations on a same-daybasis, if necessary.Assessing CreditworthinessThe strengths associated with any specific extensionof a public pension fund’s creditworthiness will be afunction of the specific terms included in the guaranteeor LOC agreement. As with any debt instrumentthat may contain credit enhancement from an outsideparty, the credit rating value of a guarantee maybe weakened or rendered unratable if there are conditionsor provisions that would allow the guaranteeto be terminated, unenforceable, or dishonored.An analysis of the pension fund’s financial riskmanagement and operating principles will be undertakento check that execution of the credit enhancementprogram will ensure policy compliance. Ingeneral, laws, statutes, or formal policies limitingthe extension of pension fund creditworthinessreduce the potential risk to pension assets andrequired sponsor fund contributions to maintainthe solvency of the pension fund for the short-andlong-term. The absence of formal plans to manage,monitor, and limit or control the extension of pensionfund credit will impact the assessment of thepension fund.Finally, in addition to limits on the extension ofpension fund credit, the risks associated with theprojects or debts to be guaranteed will be analyzedfor their impact on the safety of pension fundassets. In situations where the parameters for theextension of pension fund credit are very broad,concerns over potential increased risk could translateinto lower pension fund ratings, and, undercertain circumstances, into added credit stress forthe sponsor governments. ■328 Standard & Poor’s Public Finance Criteria 2007

Public Pension FundsPublic Pension FundsStandard & Poor’s Ratings Services has enhancedits public pension fund rating criteria to incorporatean evaluation of a public pension fund’s issuercredit rating, including reviewing the underlyingcharacteristics that comprise the fund’s sponsorcredit quality, independence, management controls,and operating and financial performance. An additional,though separate, credit considerationincludes the pension fund’s credit enhancement orrelated guarantee program. (See Public FinanceCriteria: Pension Fund Credit Enhancement AndRelated Guarantee Programs)BackgroundPublic pension funds are vehicles for accumulatingfinancial assets to advance-fund employee retirementdefined benefits that have been earned by, andpromised to public employees as part of their compensation.Employee retirement defined benefitobligations represent the long-term liabilities promisedby the pension fund’s sponsor. Generally, boththe sponsor and the employee, through regular contributions,share pension benefit funding. Typicalemployee defined pension benefits include monthlystipends based on a formula, including years ofservice and final salary.Public pension fund asset management mainlyfocuses on increasing accumulated assets throughinvestment income and appreciation. However, pensionfunds may also engage in alternative means ofrevenue generation, such as credit enhancementprograms, which generate fee income through theextension of the fund’s guarantee of debt instrumentsof other entities. Standard & Poor’s viewspublic pension funds as entities that are intrinsicallylinked to their respective government sponsor interms of contribution support and benefit obligationmodifications. Standard & Poor’s criteria doesnot de-link pension fund rating factors from thoseof its sponsor.Rating MethodologySpecifically, under Standard & Poor’s enhancedpublic pension fund criteria, the creditworthiness ofa public pension fund is a function of performancein the following basic analytical areas:■ Sponsor credit quality;■ Pension fund independence;■■Pension fund management; andPension fund operating and financialperformance.Sponsor Credit QualityAlthough public pension funds are generally legallyseparate financial entities, their strength and solvencyare a function of the willingness and ability ofsponsor governments to ensure that the definedbenefits are provided through the timely paymentof required contributions, and the maintenance ofan adequate funding level. Moreover, public pensionfund employee benefit liabilities are tied to,and are negotiated and determined by the governmentsponsor. One of the items evaluated in thecontext of a pension fund rating is whether a governmentviews pension benefits as a means toachieve labor settlement, since those costs may haveno substantial immediate effect on the sponsor’sannual budgets or taxes.Standard & Poor’s views well-funded publicpension funds as having the ability to withstand ashort-to mid-term disruption in sponsor contributions,or enhancements of employee benefits dueto the long-term nature of employee retirementbenefit obligation accruals and disbursements, aswell as the large share of income derived byreturns on existing investments. Yet, even thougha well-funded pension fund can likely continue tomake benefit payments in the short-to mid-term, aprolonged reduction or absence of sponsor contributionpayments and/or enhanced benefit liabilitieswill affect the fund’s long-term operating andfinancial performance.Due to these fundamental relationships betweensponsor and fund, including the ability of governmentsponsors to recover from periods of financialweakness, Standard & Poor’s analytical approach topublic pension fund ratings limits the upward ratingspread between the sponsor and pension fund toone full rating category (three notches). In otherwords, if a government sponsor’s general credit ratingwere ‘A’, then the highest potential rating thatthe corresponding pension fund could earn wouldbe ‘AA’. Conversely, it is possible that a pensionfund may be viewed as less creditworthy than itssponsor if Standard & Poor’s considers the fund’sremaining basic analytical areas to be deficient.www.standardandpoors.com329

Other CriteriaAnalytical evaluationStandard & Poor’s analytical approach to publicpension fund ratings begins with determining thegovernment sponsor’s general creditworthiness,which includes examining the sponsor’s pension contributionhistory. In evaluating the sponsor’s creditworthiness,that is, its ability to continue to makepension contributions in the context of its otherfinancial obligations and commitments, considerationwill be given to the strength and priority ofrequired contributions relative to other financial obligationsof the government sponsor. Standard &Poor’s will determine if the sponsor’s pension contributionsare discretionary or constitutionally protected,or, if there is a legal priority for pension contributionsrelative to other financial commitments.Standard & Poor’s will also examine the sponsor’sfunding objectives, along with the sponsor’s willingnessand ability to cure funding deficits. Moreover,Standard & Poor’s will calculate how significant thepension funding requirements and liabilities are relativeto the sponsor’s operating budget.Public pension funds are typically single-employerdefined benefit plans, or multiple-employer(agent or cost-sharing) defined benefit plans sponsoredby state or local governments. In multipleemployerplans, the pension fund receives contributionsfrom a number of governments and theiremployees. A government that is the sole sponsorfor the public pension fund may provide severalseparate plans for different classes or types ofemployees. Funding levels and requirements mayvary, so it would not be accurate to assume oneplan’s creditworthiness could serve as a proxy foranother plan funded by the same sponsor.Multiple-employer pension plans may or may notinclude state funding participation. To assess thecreditworthiness of the government sponsor wherethere is no state participation, a portfolio analysisof the credit characteristics of the local governmentparticipants is necessary. Where a multiple-employerplan includes both state and local governmentemployees and funding requirements, such as acost-sharing plan, the state’s credit rating will besignificantly weighted—under a multiple-employercost-sharing program, the state is typically thelargest employer and contributor, therefore makingthe plan substantially dependent on the state’s creditworthinessfor its ongoing solvency.For multiple-employer teachers’ retirement systems,with or without state-required funding ofcontributions, the state’s general credit rating maystill be viewed as a proxy for the underlying creditworthinessof the governmental sponsors, sincestates traditionally provide substantial fundingresources to local school districts for educationalexpenses, and teachers’ salaries and other compensationare usually the largest component of schooldistrict spending.The ability of the public pension fund to exceedthe sponsor’s general credit rating by up to one fullrating category will hinge on the strength of thefund’s three remaining basic analytical areas.Pension Fund IndependenceStandard & Poor’s considers independence as beingan essential factor in deciding whether the pensionfund’s credit rating can exceed that of its sponsor.The assessment of independence is largely qualitativein nature and includes a thorough documentationanalysis and a meeting with fund officials.Issues to consider include:■ Are pension board directors appointed independently,with staggered terms, or do they serve atthe pleasure of the government sponsor?■ Are operating and/or investment decisions vestedsolely in the management of the pension fund, orare they influenced or determined by the governmentsponsor’s representatives?■ Are contribution rates determined independently,based on actuarial needs, or are they merely afunction of the sponsor’s annual budget process,subject to the sponsor’s financial condition on ayear-to-year basis?■ Can pension assets be reclaimed or diverted by,and to, the government sponsor for other uses?■ How can actuarial assumptions used to determinepension-funding levels be influenced orrevised?Despite the inherent connection between pensionfund and sponsor, the degree to which a pensionfund can demonstrate that its managerial structureand operations are independent of sponsor controland influence is a credit factor. Although the sponsortypically sets the retirement benefits promisedto employees, many pension funds are designed toretain significant autonomy in direct managementand operating areas.In general, credit strength will be accorded to apension fund where it can be verified that the fundcan operate independently of its sponsor in the followingareas:■ Legal authority: the basis for the establishment,organization, and operation of the pension fund;■ Management: the basis for election or appointmentof those charged with responsibility forpension fund administration;■ Policy making authority: investment guidelines,asset allocation, and risk management, and, overallcontrol of asset portfolio;330 Standard & Poor’s Public Finance Criteria 2007

Public Pension Funds■■Operating and financial performance: the basisfor establishing funding objectives, performancegoals, and financial targets; andDetermination of funding requirements and actuarialassumptions.Pension Fund ManagementA key factor of Standard & Poor’s public pensionfund rating process is assessing the execution of thefund’s management in the context of the fund’sindependence, and operating and financial performance.An assessment of fund management is derivedfrom understanding managerial techniques; fundingobjectives, investment objectives, and risk aversionstrategies, document analysis comprises the balance.Although management has little control over theability of the sponsor to make contributions oremployee retirement benefit modifications, managingits operations and finances in a prudent mannerare factors over which the fund can exert significantinfluence. It is important to note that the assessmentsof pension fund management and independencego hand in hand.Standard & Poor’s public pension fund managementassessment guidelines borrow heavily from itsexisting life insurance and fund rating criteria, andseek to determine whether a pension fund is maintainingtransparent and thoroughly planned managerialand risk acceptance policies, while simultaneouslygenerating sufficient returns to fund its currentand future benefit obligations.Areas of focus for a review of managementincludes the pension fund’s:■ Organization;■ Operational effectiveness; and■ Financial risk management.OrganizationStandard & Poor’s considers strong organization asbeing essential to effectively managing a public pensionfund, and the fund’s management experiencemust support the operational strategy to producethe desired results of maximizing asset growth andincome, within the specified risk tolerance. Whenanalyzing organization, Standard & Poor’s will, forinstance, determine whether the fund maintainstransparent operating principles and controls, aswell, as a sound organizational structure. Issues toconsider include:■ How old is the fund and how is the fundorganized?■ What are management’s goals and how arestrategies developed?■ How large is the pension fund in terms of staffand function, and what is the role of the boardof directors and government sponsor(s)?■ How involved is the board of directors in themanagement of the pension fund, including a discussionof committees such as audit and financescommittees;■ Are written policies and procedures communicatedto fund staff and signed by staff annually (i.e.a Code of Ethics)?■ Do investment managers possess a proven trackrecord, what is that track record, and how closelyare they monitored?■ What type of internal audit controls does thefund adhere to?Operational effectivenessOperational effectiveness involves assessing a pensionfund’s ability to execute chosen funding andoperating objectives and follow through with actualperformance. Standard & Poor’s also evaluates management’sexpertise and understanding in terms ofoperating the fund and managing investments. Anassessment of the adequacy of audit and control systemsis essential. Standard & Poor’s must evaluatewhether the strategies and objectives managementhas chosen are consistent with the fund’s capabilitiesand principles. Furthermore, public pension fundsoften employ private financial firms to assist withinvestments and operations, and a review of thepolicies and strategies governing these relationshipsis imperative. Issues to consider include:■ What are the fund’s specific operating and financialgoals or targets, and how has the fund performedcompared with these goals?■ Does management maintain any form of operatingand/or strategic forecasts that are tied tofuture retiree benefit payments or other anticipatedliabilities?■ Does management maintain any form ofcontingency planning?Financial risk managementA major component of the review of a pensionfund’s financial risk management is the investmentdecision-making process, as asset quality andinvestment performance are integral to a fund’soperations and solvency. Numerous investmentdecisions are made frequently for invested funds,and Standard & Poor’s examines how these decisionsare made and who is responsible for executingthem. Evaluating financial risk acceptanceallows Standard & Poor’s to understand management’sviews on financial goals, asset structure,and board oversight.Standard & Poor’s analysis begins with a comprehensivereview of the pension fund’s permittedinvestment guidelines, asset allocation strategy, andrisk management policies. The ultimate responsibilitywww.standardandpoors.com331

Other Criteriafor any pension fund typically lies with its board ofdirectors or trustees, and board members are usuallyelected and/or appointed to oversee the fund’s investmentsand management. Boards entrust staff andinvestment managers with handling the fund’s dayto-dayaffairs, and policies are typically establishedthat delineate management’s tolerance for risk.Boards must establish effective procedures forreviewing and enforcing these policies.Standard & Poor’s expects public pension fundsto maintain detailed policies documenting theamount, type, and quality of information used inmaking investment, asset allocation, and risk managementdecisions. This includes the size, breadthof understanding, and capabilities of the credit andrisk research staff, as well as access to current economicdata and analysis. Once investment and riskmanagement strategies are understood, Standard &Poor’s reviews the pension fund’s allocation ofassets among investments such as fixed income,domestic and international equities, real estate, andother invested assets. The assets are evaluated forcredit quality and diversification. Asset concentrationsby type and maturity, credit quality, industry,geographic location, and within single issuers areevaluated.The pension fund’s asset allocation is also examinedto determine liquidity in relation to its liabilities.Standard & Poor’s reviews the portfolio’s liquiditybecause the fund may need to liquidate assetsquickly to pay liabilities such as capital calls, guarantees,or credit enhancement programs. Issues toconsider include:■ Is there a defined risk management process inplace to ensure that assets are managed withintheir objectives and established risk parameters?■ Does the fund have predetermined limits foracceptable levels of risk, and are these guidelinesdetailed or general?■ What policies are in place for investments ortrading by investment managers and how arethey monitored?Pension Fund Operating And Financial ConsiderationsObligations and expendituresPension fund liabilities are derived from the retireebenefits incurred as a result of sponsor governmentPublic Pension Fund Evaluation: Fund ManagementStrong Adequate WeakManagement maintains a clear and Management generally follows a basic Management does not maintain or follow a basiccomprehensive set of operating and set of principles, objectives, set of principles, objectives, and strategies.funding principles, objectives,and strategies.and strategies.Board is independent, highly qualified, Board is independent. Board is not independent and/or is not involved.and willing to exercise proactive judgment.Organizational structure fits principles, Organizational structure does not fully Organizational structure impedes implementationobjectives, and strategies. foster principles, objectives, and strategies. of principles, objectives, and strategies.Audit and control systems are Audit and control systems are average. Audit and control systems are weak and/orextensive and transparent.are ignored.Management has considerable expertise, Management lacks expertise, depth, and Management lacks ability to understand anddepth, and breadth, and is engaged in, and breadth, but maintains good control over control its operations.has demonstrated an ability to exerciseits operations.strong control over its operations.Strategies and objectives chosen are Strategies and objectives include some Strategies and objectives include manyconsistent with the fund’s capabilities contradictions with the fund’s capabilities contradictions with the fund’s capabilities andand principles. and principles. Achievement of some principles, and many goals appear unattainable.objectives appears unlikely.Maintains very conservative operating Has no commitment to maintaining Disregards any reasonable standards forand financial targets. conservative operating and operating and financial targets.financial targets.A set of comprehensive investment, A set of comprehensive investment, Has no defined set of investment, assetasset allocation, and risk acceptance asset allocation, and risk acceptance allocation, and risk acceptance policies andstandards in place. policies and standards are formally in place.policies and standards are formally in place.in place.Investment, asset allocation, and risk Investment, asset allocation, and risk Investment, asset allocation, and riskacceptance policies are often, but not acceptance policies are not adhered to. acceptance policies are not adhered to.always, adhered to.Fund consistently performs well Fund usually performs well against Fund often misses objectives/strategies/targets.against objectives/strategies/targets.objectives/strategies/targets.332 Standard & Poor’s Public Finance Criteria 2007

Public Pension Fundscompensation agreements with employees and planstructure obligations. Among these are:■ Monthly stipends based on plan formula;■ Disability entitlements; and■ Death benefits.An important focus of this area will be on theprocess of how benefits are revised and whetherthere are built-in factors that could cause futurepension benefits to increase substantially. Examplesare pension benefit increases or accelerations thatcould increase or accelerate payments of pensionbenefits, such as early retirement legislation, orchanges in the method of calculation of eligiblecompensation as the basis for pension payments. Inaddition, Standard & Poor’s will need to assess thehistory of retiree benefit enhancements or otherchanges, and how any modifications were compensatedfor in terms of funding.Other areas to be reviewed are the vesting rightsof employees, as well as obligations for terminationpayments by the plan when an employee withdrawsfrom the plan or government employment.Pension Fund Unfunded Actuarial AccruedLiability And Funded RatioA pension fund’s unfunded actuarial accrued liability (UAAL) and funded ratio aretied to the fund’s actuarial value of assets (AVA) and actuarial accrued liability(AAL). The UAAL is established by subtracting the fund’s AVA from the fund’s AAL.When the difference is a positive number, it means that the AVA is not sufficient tocover the AAL. Conversely, when the difference is a negative number, it means thatthe AVA exceeds the AAL. The funded ratio is derived by dividing the fund’s AVAby the AAL, and is important in quantifying the adequacy of the pension fund’saccumulated assets.Assessing Pension Fund Operating And Financial PerformanceIn addition to the UAAL and funded ratio, Standard & Poor’s employs a variety ofquantifiable metrics in order to gauge a pension fund’s operating and financialperformance. These metrics include:■ Actuarial discount rate assumptions.■ Return on investments, return on assets (change in net assets divided bytotal assets), and return on net assets (change in net assets divided bynet assets).■ Total margin (change in net assets divided by total revenue).■ Pension benefit expense service delivery efficiency■ Annual pension expense (employer contributions) as a percentage of thesponsor’s budget.■ UAAL as a percentage of the sponsor’s budget.■ UAAL per capita (for the sponsor’s population).■ UAAL as a percentage of the sponsor’s per capita income.■ Historical pension fund balance sheet and liquidity trends.■ Historical pension fund income statement trends.Furthermore, Standard & Poor’s will closely examinethe pension fund’s actuarial assumptions,including funding method, asset valuation smoothingassumptions, mortality, and inflation. Analyticalquestions include:■ Is participation optional, allowing for competingplans and possible withdrawal of participants’and sponsors’ contributions and shares of assetsinto other pension plans?■ Under what conditions can employee terminationwithdrawals occur and what has been the historicalexperience?■ If non-vested, do employees have rights to theircontributions alone, or are they also entitled tobenefits with respect of employer contributionsmade on their behalf?■ If termination payments are made to the employees,do sponsor contributions remain in the planor revert to the sponsor?■ Has there been a change in actuaries and/or haveany significant actuarial assumptions been altered?Operating and financial performance measurementsStandard & Poor’s employs trend analysis to assesspublic pension fund operating and financial performance.Depending on the metric, the trendanalysis timeframe can range from three to tenyears, and the analysis will determine the underlyingfactors behind positive or negative changes.Standard & Poor’s will conduct its trend analysis inthe context of the pension fund’s various managementfactors, which include funding objectives andfinancial risk acceptance.Standard & Poor’s begins its operating and financialperformance trend assessment by analyzing thepension fund’s funding ratios. Specifically,Standard & Poor’s will look at the pension fund’sunfunded actuarial accrued liability (UAAL) andthe funded ratio.Overall, the higher the funded ratio, the morelikely that accumulated assets will be able to supportannual benefit obligations. Generally,Standard & Poor’s will favorably view a pensionfund with a funded ratio trend that is stable orincreasing. Although funded ratios that are 100%or higher are viewed most favorably, Standard &Poor’s understands that keeping a pension system ator near full funding is a very difficult balancing actand may not be desirable.For example, very strong funding levels can resultin greater pressure to increase benefit levels.Further, in actuarially funded pension systems, fullfunding results in downward pressure on the contributionrate and, in some cases, outright contributionholidays. Benefit enhancements and/or contributionholidays have the potential to pressure thewww.standardandpoors.com333

Other Criteriapension fund’s operations and funding status in theevent of an adverse investment environment.Standard & Poor’s will consider the fund to be ofweaker quality when there is consistently belowaverage funded ratios or where the pension systemis closer to pay-as-you-go status (no accumulatedassets, with benefits funded as an annual expense).Standard & Poor’s analyzes the pension fund’scurrent and historical investment returns comparedwith benchmark return targets that have beenimputed into actuarial assumptions. Accordingly, athorough evaluation of the assumed discount rate,including the discount rate’s level of conservativenessand actual rate of return, will be conducted.Investment losses can result in the substantial weakeningof the fund’s asset portfolio, potentiallyPension Fund Rating Documentation■ The statute or constitutional provisions that establish the organization andoperation of the pension fund.■ Five years of audited financial reports for the pension fund sponsor(s).■ Five years of audited financial reports for the pension fund.■ Current pension fund actuarial report with detailed actuarial assumptions.■ Statutory or constitutional requirements for annual sponsor fundingcontributions, and, the terms for employee vesting of plan benefits andemployee contributions and refunds.■ The pension fund’s operating and funding principles, objectives, and strategies.■ Description of current pension fund board and management.■ Statutory and/or formal regulations or guidelines that control allowableinvestments, asset allocation, and risk management.■ Ten-year history of pension fund accumulated assets, as well as pension fundUAAL, funded ratios, sponsor contributions, employee contributions, andinvestment performance.■ Five-year trend of investment allocation.■ Description of pension plan benefits and changes (if any) over the past fiveyears, plus statutes governing benefit changes.■ Authorizing legislation permitting the extension of guarantees by the pensionfund, including any limit on the types or amounts of permissible guarantees.■ Specific terms and documentation of the credit enhancement program(or related guarantee) and capital call requirements, if any.■ Description of the priority of debt guarantees vis-à-vis pension benefit obligations.■ Legal opinions on validity and enforceability of pension fund guarantees.■ List of current obligations guaranteed by pension fund and a description ofproposed and/or future debt obligations that may be considered forfuture guarantees.■ Current and historical, legally available liquid asset balances that arededicated to the existing or proposed credit enhancement program,as well as monitoring procedures.■ Detailed credit enhancement program asset liquidation plan.■ Monthly cash flow statements.resulting in decreased liquidity, reduced flexibilityin terms of covering pension payments, andincreased dependence on the government sponsorfor higher contributions. In analyzing investmentincome and performance, focus will be placed onhow much investment income derives from actualcash payments (such as interest, dividends, andrental income) as opposed to investment incomegenerated from capital appreciation.Standard & Poor’s evaluates various performancemetrics in order to assess operating efficiency andasset maximization. Standard & Poor’s employsperformance ratios such as return on assets, returnon net assets, and total margin. These metrics areuseful in providing insight as to how effectively thepension fund is able to augment its operatingincome and leverage its asset base. Standard &Poor’s also uses a service delivery efficiency ratiothat looks at what percentage of total annual pensionfund expenses are specifically for retirementbenefits. Consistently maintaining a very high servicedelivery ratio (one that approaches 100%) overtime is a credit strength. Conversely, in cases whereadministrative or other expenses consistently comprisea larger share of operating expenses, or wherethere is tremendous fluctuation in service deliveryrequirements, suggest credit weakness.Standard & Poor’s conducts a historical analysisof the makeup of the fund’s balance sheet andincome statement. Specifically, Standard & Poor’swill seek to understand and annually compare thecomposition and movement of the fund’s assets andliabilities in relation to their respective total bases.Finally, Standard & Poor’s assesses the pensionfund in relation to the government sponsor in orderto determine how material the pension fund’s operationsand liabilities are to the sponsor. Standard &Poor’s will look at the sponsor’s annual pensioncontribution relative to its own budget, which willreveal the level of financial resources needed to regularlysupport the pension fund, and is analogous toa debt service carrying charge calculation regularlyconducted for general debt credit analysis. A calculationof the UAAL relative to the sponsor’s operatingbudget will be an important indicator as to thesignificance and rate of change of the unfunded liability.Similarly, the unfunded pension liability willbe analyzed in terms of UAAL per capita (using thegovernment sponsor’s population) and UAAL as ashare of per capita income (using the per capitaincome of the government sponsor’s population).Although pension fund liabilities are not generallyconsidered to be “hard” debt, they are considered tobe debt-like in nature, and it is useful to make pensionfund burden comparisons that are similar innature to general credit debt burden ratios. ■334 Standard & Poor’s Public Finance Criteria 2007