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

Cross Sector CriteriaThese remedies should be limited to the swap agreementand should not be written into or cross-defaultedto the bond indenture. Depending on how interestrates at the time of termination compare with thefixed rate on the swap, the issuer could owe a terminationpayment to the counterparty or receive a terminationpayment from the counterparty.Collateral posting riskCollateral posting risk is the risk that the issuer isrequired to post collateral in favor of the swapcounterparty in advance of a swap terminationevent and final bond repayment. Collateral postingrisk is a double-edged sword for many issuers. Onthe one hand, collateral postings can be a creditpositive since these reserves mitigate a sudden liquiditydrain of having to make a large terminationpayment in the event of swap termination. On theother hand, collateral posting poses a credit risk assome issuers credit quality would be impacted bycollateral posting in the same way credit would beimpacted following a termination payment.Many swap documents have symmetrical creditprovisions, requiring issuers to post collateral atidentical rating thresholds as the swap counterparties.Although important from a swap counterparty’sperspective for protection against issuertermination, collateral posting in advance of terminationis problematic from a ratings perspective.This is because in the event of collateralization bythe issuer, swap providers effectively become seniorsecured creditors, thereby impairing bondholderprotection. To the extent collateralization byissuers impairs bondholder protection materially,Standard & Poor’s will take this into account duringthe ratings process. However, in the event collateralizationdoes not impact liquidity materially,termination risk would be fully mitigated andtherefore, represent a credit positive. Standard &Poor’s DDP scoring methodology captures the likelihoodof collateral posting risk as more fullydescribed below.Involuntary termination analysisIf Standard & Poor’s considers involuntary terminationto be a possibility, as indicated by a overallDDP score of ‘3’ or ‘4’ or a termination and collateralposting risk score of ‘3’ or ‘4’, this risk must bequantified through analysis of the swap’s maximumpotential exposure (MPE) provided by the issuer.Analysis of termination risk and its impact on theissuer’s rating is covered in the DDP criteria.Voluntary terminationsAlthough any swap is callable at any time if bothparties agree to the cancellation and cash settlementhas occurred, municipal swaps typically are notoptionally callable at any time for any reason byeither party, without the other party’s consent,unless a specific option to do so is built into thecontract itself. Issuers typically need to purchasethis option from counterparties. Standard & Poor’slooks to see that issuers build market price optionaltermination clauses into swap documents, whichwill give them flexibility for cancelling the swapshould this become necessary, either for the refundingof associated bonds or other market-driven reasons.In most cases, optional terminations of swapsoccur to the extent the termination results in aneconomic benefit to the issuer, even if a terminationamount is paid to the counterparty.Termination payment source and lienMuch focus is placed on the early termination ofswap contracts. While the probability of this riskwill be scored in the DDP through a rating transitionanalysis, it is important for issuers to thinkthrough a contingency plan if the swap doesunwind and the issuer will owe a settlementamount that is due immediately. Many bond transactionsthat include a swap make the lien of theswap payments and termination payment on paritywith the debt service. This does not causeStandard & Poor’s great concern if the issuer hasrevenue-raising capability and good liquidity. It alsois not a concern if the swap termination events havebeen limited to credit events that are being reflectedin the rating on the bonds. However, on the otherend of the spectrum are the balance sheets thatcould not withstand a large cash outflow in amonth’s notice.Involuntary termination risk mitigation strategiesTwo of the most common ways to mitigate theeffect of termination payments to an issuer are subordinatingtermination payments to the debt serviceon the bonds and including provisions in the swapagreement that allow the issuer to stretch out thepayments over a period of time.Subordinated lienSince the termination payment can be large, and itis difficult to predict the timing and size of the payment,cash settlement of a termination payment canbe subordinate to debt service. While a subordinatedlien will get the issuer over the hurdle of paymentof debt service for that period of time, it isimportant to note that the settlement payment tothe counterparty still must be paid in full. Thiscould hurt the issuer’s liquidity and thereforeimpair its ability to pay debt service in the future.Amortization of termination paymentThis alternative focuses on the issuer’s financialflexibility to withstand the cost of an early terminationregardless of its capacity to increase rates and34 Standard & Poor’s Public Finance Criteria 2007