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

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