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

Long-Term Municipal Poolsexposure, or any noteworthy component scores.The MPE measures how much a counterparty couldexpect to lose on a transaction over the life of thetransaction if the other counterparty failed to performits obligations on the swap. MPEs are typicallytwo standard deviation value-at-risk calculationsusing relatively standard techniques for projectingpotential paths of future interest rates. MPEs areinfluenced by the swap’s notional amount, averagelife, and the terms of the trade—fixed-to-floatingswap, floating-to-fixed, floating-to-floating—andthe optionality embedded in the swap. We will askthe issuer to calculate a MPE for swaps that are indanger of terminating early. If necessary, we willuse the MPE and measure it against the issuer’s liquidityreserves to determine the credit impact ofswap termination.Net variable rate exposureWe will calculate a net variable-rate interest exposureratio for all issuers of variable rate debt and/orswaps for use in conjunction with any DDP score.The net variable exposure measures the potentialrisk to an issuer’s revenue stream and reserve levelsresulting from rising variable rates. Net variablerate exposure ratio incorporates all current interestrate derivatives, fixed and floating rate debt, andany natural hedges (i.e., qualified investment assetsdesigned to offset interest rate risk). The exposureratio will also be calculated on a pro forma basis togauge prospective levels of variable exposure, giveneither proposed derivatives structures or futurebond issuance. For example, some issuers haveentered into swaptions that may become effective inthe future, depending upon the level of interestrates. If we are concerned that a counterparty mayhave an incentive to terminate a fixed-to-floatingrate swaption on an issuer, we will assess the potentialexposure of future variable interest rates for theissuer through the net variable rate exposure calculation.Another example is an issuer that partiallyhedges a 30-year variable rate issue for 10 yearswith a floating-to-fixed rate swap. Through thissimulation, we are able to determine the impact ofrollover risk, or the risk that the issuer will not beable to re-hedge its variable rate exposure uponexpiration of the swap.ConclusionIn an effort to hedge risks, many entities are enteringinto derivative instruments that have a long,successful history. Understanding the risks associatedwith these types of agreements is critical. Withour DDP, Standard & Poor’s adds an independentevaluation of the risks associated with certain derivativesand the potential impact on credit qualityand ratings. ■Long-Term Municipal PoolsStandard & Poor’s Ratings Services criteria for ratingpools of municipal obligations reflects the fact thatthe likelihood of default of bonds secured by a pool ofassets is a function of both the expected distribution ofdefaults within the asset pool, and the level of over-collateralizationavailable to cure those defaults. The likelihoodthat an obligor will cause a bond pool todefault depends on the obligor’s credit quality and theinfluence of that obligor on the total performance ofthe pool (the pool’s relative concentration or diversity).To the extent that additional funds (through reserves orcoverage) can provide protection against a certain levelof obligor defaults, then a rating commensurate withthe probability of exceeding that amount of loss maybe assigned to the pool bonds. Higher pool ratingstherefore require higher over-collateralization to protectagainst higher cumulative default probabilities.In the absence of any over-collateralization, stepupobligations on the part of participants, or otherstructural enhancements, pool ratings will typicallyfall to a level at or near the rating of the lowestratedparticipant. Pool programs without step-upprovisions are not eligible for ratings above the ratingof the weakest participant if the pool containsfewer than 10 separate obligors.While the theory behind the pool criteria wouldappear straightforward, the application provesmore difficult. Determining the cumulative defaultprobability distribution for a pool of obligationsbecomes extremely difficult as the size of the port-www.standardandpoors.com43