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

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