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

Cross Sector Criteria■ Full collateralization of swaps by the counterpartyprior to a downgrade to below ‘BBB’; or■ A provision for the counterparty to secure, at itscost, a third-party guarantee or replacementcounterparty rated at least ‘BBB’ in the event of adowngrade of the original counterparty to below‘BBB’; and■ Provision for mandatory counterparty terminationbelow ‘BBB’, or■ A provision that allows the issuer to optionallyterminate the swap, at any time, for any reason.Economic viabilityEconomic viability is scored on a 1 through 4 scalebased on whether the issuer could have an incentiveto restructure or voluntarily terminate all or a portionof its swap transactions due to the ineffectivenessof the hedges over the long term. We havedetermined that it is important to analyze the economicsand long-term cash flow strength of derivativestructures since the voluntary termination orrestructuring of the hedge through execution ofadditional hedges is potentially costly and time consuming,accompanied by real economic and opportunitycosts. These costs are in addition to theunexpected interest costs resulting from the ineffectivehedges. However, economic viability is of relativelyless importance from a near to intermediateterm credit risk perspective relative to terminationand collateral posting risk or management. For thisreason, the economic viability component of theDDP score will be assigned a 15% weighting, similarto counterparty risk.To determine long-term economic viability, wewill stress test the potential ineffectiveness of anissuer’s swap portfolio through a proprietary basis,or variable interest expense, model. The modelincorporates our high and low stress interest ratecurves and tax-exempt bond price assumptions.Scores are assigned based on the overall amount oflong-term basis exposure. The lower the overallbasis exposure on a portfolio level, the lower theeconomic viability score (scores of 1 or 2), whilethe higher the overall basis exposure, the higherthe scores (3 or 4). Lower scores reflect the potentialfor higher economic viability of the issuer’sswap structure over the long term while higherscores indicate lower economic viability over thelong term. In some cases, issuers with high economicviability scores may in fact have achievedhigh economic viability at least in the short-termsince the derivative structure itself made the transactionpossible in the current market environment.While this is a valid argument in the short run,high potential ineffectiveness or basis exposure canbe problematic in the long-term as a variable, orunknown, budget expenditure leading to or exacerbatingcash flow stress.ManagementManagement is scored on a 1 through 4 scale basedon our assessment of management knowledge andsophistication through analysis of its swap and debtmanagement policies and overall strategy.Management is weighted at 35% due to the significanceof an issuer’s knowledge and sophistication instructuring its derivative contracts to both minimizerisks and achieve the intended purpose of the hedgingprogram. We consider various factors in assessingthe quality of management of the swapprogram, including the quality of the issuer’s writtenpolicy and hedging strategy. The written policyshould be original and tailored to the issuer’sunique situation and incorporate near, intermediate,and long-term strategies and parameters. Factorsconsidered in assessment of the overall quality ofmanagement and the written policy and planinclude:■ Formal approval of written documents by theissuer’s governing body;■ Swap risks identified and discussed in the contextof the issuer’s financing plans;■ Annual management review and discussion ofhedging strategies;■ Commitment to complete and comprehensive disclosureof swaps in audited financial statementsabove and beyond required GASB or FASBparameters;■ Monitoring of swaps with semi-annual valuationby a third party■ Policies on legal provisions, including optionalswap terminations, collateral, or swap insurance;and;■ Counterparty diversification or a minimum ratingspolicy for counterparties;■ A net variable rate exposure policy.A comprehensive swap management policy willinclude the above consideration and should alsoinclude a discussion of risks and rewards of swapsand variable rate debt, senior management personnelresponsible for monitoring swap risks, maximumlevel of variable rate debt and swap exposure,counterparty exposure limitations, collateral policiesand procedures, and a detailed description ofand rationale for all derivative transactions enteredinto or that are contemplated.Additional FactorsSwap valuationAn issuer’s swap portfolio may be stress tested todetermine the maximum potential exposure if theissuer has a high final DDP score, high net variable42 Standard & Poor’s Public Finance Criteria 2007