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

Debt Derivative Profile ScoresDue to the criteria revisions discussed in thisreport, 271, or 54% of the 505 scores changed. Ofthe 54% that changed, 26% were revised upward(got worse), and 28% were revised downward (gotbetter). Eight issuers, or less than 2% of the totalscores changed more than a half-point (0.5) as aresult of the recalibration. All others changed up ordown by a half point only.Although many factors are considered, the DDPscores principally indicate an issuer’s potentialfinancial loss from over-the-counter debt derivatives(swaps, caps, collars) due to collateralization of atransaction or, worse, early termination resultingfrom credit or economic reasons. DDPs are integratedinto Standard & Poor’s rating analysis forswap-independent issuers and are one of manyfinancial rating factors. Standard & Poor’s considerstax-secured GO bonds and general revenuebonds—health care, higher education, transportation,and utility—as swap-independent, as absenceof the swap would not preclude the issuer fromrepaying its bonds. Swap dependent issuers, mostlyhousing and structured financings, are not eligiblefor DDPs since ratings on these transactions alreadyincorporate cash flow stress testing of all derivativerisks. However, state housing finance agencies, thelargest issuers of swap dependent issues, are eligiblefor DDPs as part of issuer credit ratings, since theseratings apply to the agency’s general credit and notto any structured financing specifically.BackgroundOver-the-counter debt derivatives, such as interest rateswaps and caps, have for decades been used as hedgesin the capital markets, but appreciably by municipalissuers only in the last several years. Issuers, investors,regulators, and citizens have become increasinglyfocused and concerned about public purpose entities’involvement in what was once exclusively a corporaterisk management tool. Many issuers—traditionally,fiscally conservative entities—spurred by risingexpenses, restrictive refunding rules, and revenue limitations,have started to use derivatives as hedges tolower borrowing costs and reduce interest rate risk. Asa fixed cost, debt service is a difficult budget item tocontrol and swaps can provide some expenditurerelief. Several states, including Pennsylvania,Michigan, and North Carolina, have granted statutoryauthority to local jurisdictions to enter into hedges fordebt, further fueling the surge in municipal derivativesactivity. In the health care, nonprofit, and utility sectors,derivatives have provided competitive advantageswhen used in conjunction with traditional financingtechniques. In all cases, debt derivatives have introducednew risks and altered the credit profiles ofissuers. However, as evidenced by the preponderanceof DDP scores of ‘2’ or less (75%), it is evident thatmost issuers scored to date have prudently approachedtheir derivatives activities.Standard & Poor’s originally developed DDPscores to enhance the transparency of municipalderivative structures and their overall impact oncredit quality. Derivative impact has always been apart of Standard & Poor’s analysis; the DDP scoringmethod incorporates existing municipal swaprating criteria and codifies that criteria into an easyto-understandrisk score.InterpretationFinal DDP scores of 1, 1.5, and 2 indicate that thecredit risk from debt derivatives is minimal to low,whereas DDPs above 2 indicate that there is a moderateor high degree of risk from the swap transactions.Low DDP scores are one factor of many included inthe credit analysis that determines a rating and arenot in and of themselves an indication of upward ratingpotential or an endorsement of any specific derivativetransaction as being beneficial to the issuer’sfinancial position.Furthermore, moderate to high DDP scores arealso one factor of many and do not in and of themselvesindicate a potential rating downgrade duespecifically to derivatives, or that any specific transactionwill not benefit the issuer’s financial position.As part of the rating analysis, Standard &Poor’s will cite an issuer’s overall DDP score in conjunctionwith the net variable interest exposureratio. In some cases, we may also cite DDP componentscores to highlight high component scores,speculative transactions, or transactions enteredinto under fiscal stress, that may be indicative ofother fundamental credit weaknesses.To determine whether a moderate to high finalDDP score, high net variable exposure, or any noteworthycomponent scores are sufficient to influencean issuer’s rating, we will seek to determine anissuer’s derivatives portfolio’s maximum potentialexposure (MPE), which is a value-at-risk (VAR) calculationof a derivatives transaction. Net variableinterest rate exposure, on the other hand, measuresthe potential risk to an issuer’s revenue stream andreserve levels resulting from rising interest rates (seeDDP Score1.0 Minimal1.5 Very low2.00 LowRisk Descriptor2.5 Low-to-moderate3.0 Moderate3.5 Moderate-to-high4.0 Highwww.standardandpoors.com39