National Association of State Treasurers Conference

1
National Association of State Treasurers
Conference

• Debt Derivative Profiles
• Eden Perry, Associate Director
• Public Finance Ratings
• New York
• 212-438-7967
• eden_perry_at_sandp.com

2
Rating Process

• Analyze
• Issuer / issue credit fundamentals
• Transaction and swap contract documents
• Issuer debt and swap management plan
• Assign DDP based on swap portfolio of issuer
• Description of the DDP score within the rating
  analysis
• Assign rating and outlook

3
Debt Derivative Profiles (DDP)

• Analytical / rating enhancement for all municipal
  bond issuers
• Risk score for debt-related derivatives scored
  through a five point system
• 1, 2 (low risk)
• 3 (moderate risk)
• 4, 5 (high risk)
• All factors scored from 1 to 5 and equally
  weighted at 25 in most cases.

4
Swap DocumentsNeeded for DDP

• ISDA master agreement
• Schedule
• Credit Support Annex
• Confirmation (draft or term sheet acceptable)
• Swap Management plan or policy

5
DDP Factors

• Scored DDP factors include
• Issuer termination / collateral posting risk,
• Counterparty termination risk,
• Economic viability (basis risk), and
• Management

6
Termination / Collateral Posting Risk

• Score based primarily on the risk that the issuer
  would default under the swap or trigger a
  collateral posting under credit support
  documents.
• Collateral posting is identical to payment of
  termination due to the typically long-dated
  nature of municipal swaps and the restricted
  nature of collateral
• Fifty percent (50) of the termination and
  collateral posting risk score is comprised of the
  likelihood of an issuer triggering an event of
  default or termination or collateral posting.
• Likelihood of an issuer being downgraded to one
  rating notch below the rating trigger is scored
  using Standard Poors rating transition data
  for the municipal issuers applicable sector (tax
  secured, utility, healthcare, higher education,
  transportation, housing).

7
Termination / Collateral Posting Risk (continued)

• Remaining 50 of termination / collateral posting
  risk score is based on strengths and weaknesses
  of six other factors which may exacerbate or
  heighten the risk of termination, including
• Ratings volatility (number of rating or outlooks
  changes in last three years) 15
• Swap duration (less than 10 years, 10-15 years,
  15-20 years, greater than 20 years) 15
• Termination payment methodology (first or second
  method, market quotation or loss) - 5
• Cross default provisions (parity debt,
  subordinate debt, or other debt) 5
• Lien of termination payments (parity or
  subordinate),
• Source of termination payments (taxes, net
  revenues, etc..) 5
• Provisions for payment of termination fee
  (term-out or lump sum) 5

8
Counterparty Risk

• Scored based on the risk that a counterparty will
  default and terminate a swap and the issuer will
  lose a positive swap valuation, thereby
  diminishing its ability to replace its hedge
  position
• Credit threshold is BBB-, which is one rating
  notch below Standard Poors minimum swap
  counterparty rating of BBB for plain vanilla
  swaps used in swap-independent transactions.
• Standard Poors criteria stipulates that
  issuers should replace counterparty at BBB
  level. Collateralization or replacement guarantee
  is also acceptable.
• Likelihood of a counterparty downgrade to BBB-
  (or BBB as applicable) is scored using
  Standard Poors rating transition data for
  financial institutions.

9
Counterparty Risk

• Mitigating factors, which would warrant a
  counterparty termination risk scored of 1,
  include
• The swap is plain vanilla (highly liquid) and
• The counterparty has provided insurance for
  termination payments from a monoline bond
  insurer or
• The counterparty must replace itself prior to
  being downgraded to BBB with a higher rated
  counterparty, or
• The counterparty must collateralize prior to
  being downgraded to BBB, or
• The counterparty will remain swap provider and
  produce a third-party guarantee rated at least
  BBB prior to being downgraded to BBB.

10
Economic Viability (Basis Risk)

• Determination whether or not the issuer could
  have an incentive to restructure or voluntarily
  terminate a floating-to-fixed rate transaction
  due to ineffectiveness of a derivative
  transaction through potentially stressful
  economic cycles.
• Assessment of long-term viability of a hedge
  through economic cycles is important since the
  unwinding, restructuring, or execution of
  additional hedges is potentially costly and time
  consuming, accompanied by real economic and
  opportunity costs.
• These costs are in addition to the additional,
  unexpected interest costs resulting from the
  ineffective hedges.
• Hedge ineffectiveness of a derivative portfolio
  is calculated through a proprietary basis
  exposure model, which incorporates Standard
  Poors stressful interest rate curves and
  tax-exempt bond price assumptions.
• The basis exposure for an issuers portfolio is
  measured by a ratio equal to the average annual
  additional interest paid on bonds divided by
  total derivative notional.
• Interest Rate Curves are Rating Category
  Dependent.
• BMA/LIBOR Assumption 75

11
Management

• Score based on Standard Poors assessment of
  management experience and quality of swap and
  debt management plan.
• Ten factors with either yes or no, gaining
  one point for each affirmative answer.
• Scored factors incorporate existing Standard
  Poors rating criteria for swap management plans
  including  
• Written Plan or Policy on Swaps and Other Debt
  Related Derivatives
• Written Plan Formally Approved by Governing Body
• Swap Risks Identified and Discussed (Verbal or
  Written)
• Annual Management Review of Swaps
• Comprehensive Disclosure of Swaps in Audited
  Financial Statements
• Valuation of Swaps (Semi-Annual Minimum)
• Counterparty Diversification or Minimum Ratings
  Policy
• Optional Swap Termination Policy
• Collateral or Insurance Policy
• Net Variable Rate Exposure Policy
• Scoring system is as follows 9-10 pts 1 7-8
  pts 2 5-6 pts 3 3-4 pts 4 1-2 pts 5

12
Factors Affecting DDPs Rating Impact

• Issuer rating and outlook
• Indicates sensitivity to high DDPs.
• Value-at-Risk
• The VAR for derivatives will be factored into the
  rating analysis only if risk of derivative
  termination is heightened, indicated either by a
  final DDP score of 4 or 5. Otherwise, scores of
  1,2, 3 do not warrant an VAR since swap
  termination is not considered likely in the near
  term.
• Data provided by issuer to SP
• Net Variable Rate Exposure
• Incorporates derivatives
• Measures potential risk from rising variable
  rates.
• Ratio calculated on a current basis
• Will model what-if scenarios in order to gauge
  prospective levels of variable exposure, given
  either proposed derivatives structures or future
  bond issuance.