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

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