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

Debt Derivative Profile ScoresOf the myriad credit events contained in a municipalinterest rate swap, the “additional terminationevent” of a rating downgrade trigger, or collateralposting under a credit support document, are themost likely to occur since they are triggered byinvoluntary credit events. Other standard ISDAevents of default and termination—failure to pay,bankruptcy, merger without assumption, and soforth—are incorporated into ratings. For this reason,we will score, as a key factor for this component,the likelihood of an issuer (or swap insurer)triggering termination or collateral posting basedon our rating transition and default data. The credit“spread” or gap between the issuer’s (or swapinsurer’s) current rating and the meaningful collateralor termination rating trigger level is determinedand scored appropriately. For swaps with collateralprovisions, Standard & Poor’s attempts to discernthe meaningful collateral rating trigger throughanalysis of the swap’s actual maximum potentialexposure compared to the issuer’s liquidity reservelevels. Once the meaningful collateral rating triggeris determined, Standard & Poor’s is able to accuratelyscore termination and collateral posting riskusing the appropriate rating trigger.The final score for the termination and collateralposting risk section is the product of the weightedaverage of ISDA swap document scores.Weightings are based on the risk-adjusted notionalamount of swaps provided by a counterparty relativeto the issuer’s total risk-adjusted swap notionalamount outstanding. Standard & Poor’s adjustseach swap’s notional amount based on its interestrate sensitivity relative to a baseline swap’s sensitivity,effectively placing less emphasis on swaps ofshorter durations and more emphasis on swaps oflonger durations. The baseline swap is a fullyamortizing swap with an average life of 19 years.This “dollar duration” methodology capturesswaps’ sensitivity to changes in interest rates and isused as a proxy, for scoring purposes only, of theswap’s maximum potential exposure. Swaps withhigher volatility, therefore, have a greater impacton the termination and collateral posting riskanalysis than swaps with lower volatility.If an issuer has scored a 3 or 4 on any of its ISDAdocuments or on the termination and collateral postingrisk score itself, Standard & Poor’s will evaluatethe actual MPE under the applicable transaction(s)and compare it to the issuer’s unrestricted reserves;that financial analysis will be factored into the rating(see Interpretation above for more details).Counterparty riskThe counterparty risk section of the DDP isscored on a 1 through 4 scale based on the likelihoodof a counterparty default, that could causethe issuer to lose its ability to replace its hedgeposition. Counterparty credit risk is generallylow for the majority of issuers due to usage ofhighly rated counterparties (typically rated ‘A+’or higher) and provisions for full collateralizationof swaps prior to significant rating counterpartydowngrades. For this reason, and the factthat most municipal bond transactions are notswap dependent—in the sense that the loan doesnot require the swap for repayment—counterpartycredit risk is weighted at 15% in the overallDDP analysis.To determine a final counterparty risk score tobe used in the DDP, Standard & Poor’s will scoreand weight the likelihood of a counterparty creditdeterioration based on a rating transition to the‘BBB’ rating level. The ‘BBB’ rating level is usedsince this is the lowest rating permitted underStandard & Poor’s rating criteria for counterpartiesin U.S. public finance swap transactions.Furthermore, to the extent a counterparty is downgradedto below ‘BBB’ the likelihood of terminationpayment recovery is significantly diminisheddue to the potentially massive collateral calls fromthe counterparty’s other creditors. Similar to thetermination and collateral posting risk scoring section,Standard & Poor’s does not consider standardISDA swap event of default and terminationfactors as significant termination events since theyare already incorporated into counterparty ratings.Therefore, a ratings downgrade is the credit eventmost likely to occur. The counterparty risk scoringmethodology gives issuers credit for securing highlyrated counterparties and penalizes issuers forsecuring lower rated counterparties. Similar to thetermination and collateral posting risk section,counterparty risk scores are assigned by ISDA documentand weighted according to risk-adjustednotional amounts. The final score for counterpartyrisk will be the weighted average of each counterparty’sISDA swap document score, with weightingsbased on the risk-adjusted notional amount ofswaps provided by a counterparty relative to theissuer’s total risk-adjusted swap notional amountoutstanding. If an issuer has scored a 3 or 4 on thecounterparty risk component, or on any specificISDA document, Standard & Poor’s will evaluatethe MPE under the applicable transaction(s) andcompare it to the issuer’s unrestricted reserves; thatfinancial analysis will be factored into the rating(see Interpretation for additional information).At this time, our rating transition and default dataindicate that counterparty risk scores are as follows:Notwithstanding these counterparty risk scores,mitigating factors that would warrant a counterpartyrisk score of 1, include:www.standardandpoors.com41