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

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