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

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