Standard & Poor's is considering a revision of its criteria for Debt Derivative Profile (DDP) scores following a year of implementation of the methodology. Standard & Poor's developed DDP scoring for U.S. Public Finance in September 2004 to enhance the transparency of municipal derivative structures and the impact on credit quality. Derivative impact has always been part of Standard & Poor's rating analysis and criteria; the DDP scoring methodology merely incorporated existing municipal swap rating criteria into an easy-to-understand risk score which is used as part of the rating analysis. The impetus for making revisions to the DDP is to enhance the value of the analysis while placing more emphasis on near- and intermediate-term risks and relatively less emphasis on longer-term risks that do not add or detract materially from an issuer's current rating. This article explains the proposed criteria revisions and seeks comments on them. We do not expect ratings to change as a result of this criteria revision, although 300 to 350 scores will be revised.
Background
Over-the-counter debt derivatives, such as swaps and caps, have for decades been used as hedges in the capital markets, but appreciably by municipal issuers only in the last several years. Issuers, investors, regulators, and citizens have become increasingly focused on public purpose entities' involvement in what was once exclusively a corporate risk management tool. Many issuers?traditionally, fiscally conservative entities--spurred by a sluggish economy and rising expenses, have started to use derivatives as hedges to lower borrowing costs and reduce interest rate risk. As a fixed cost, debt service is a difficult budget item to control and swaps can provide some relief to both costs and tax law-limited refundings. Several states, including Pennsylvania, Michigan, and North Carolina, have granted statutory authority to local jurisdictions to enter into hedges for debt, further fueling the surge in municipal derivatives activity. In all cases, debt derivatives have altered the credit profiles of issuers--in some cases heightening risk, although in most cases reducing it.
Current Criteria Summary
Although many factors are considered, the DDP scores principally indicate an issuer's potential financial loss from over-the-counter debt derivatives (swaps, caps, collars) due to early termination resulting from credit or economic reasons. DDPs have been integrated into Standard & Poor's rating analysis for swap-independent issuers and can be a key financial rating factor. Standard & Poor's considers tax-secured GO bonds and general revenue bonds?health care, transportation, and utility--as swap-independent, as failure of the swap would not preclude the issuer from repaying its bonds. Swap dependent issuers, mostly housing and structured financings, are not eligible for DDPs since ratings on these transactions already incorporate cash flow stress testing of all derivative risks.
The DDP is scored on a scale from 1 to 5. To reach the overall DDP score, each debt derivative is scored, risk-adjusted based on potential volatility, and then aggregated to arrive at an overall score. The four factors that comprise the DDP are as follows:
Issuer termination and collateral posting risk ;
Counterparty termination credit risk;
Strength of the hedge and economic viability of the swap structure; and
Quality of swap and debt management policies and procedures.
Final DDP scores of 1 and 2 indicate that the impact from debt derivatives on an issuer's financial profile is manageable and represents a neutral credit factor; a DDP of 3 indicates moderate to higher credit risk, while DDPs of 4 and 5 are an indicator of increased credit risk. Depending upon other credit fundamentals, DDP scores of 3, 4, and 5 may influence the rating. Other factors that influence the DDP score's impact on a rating include:
Maximum potential exposure, or value-at-risk, vis-?-vis reserve levels, which is a stress test for the potential worst-case market value loss resulting from a derivatives trade. Value at risk is incorporated into the rating analysis if the DDP score indicates the potential for early termination; and
Net variable rate exposure, which measures the potential risk to an issuer's revenue stream and reserve levels resulting from rising interest rates. The exposure ratio incorporates debt derivatives and will be calculated on a current basis, although Standard & Poor's will use the net variable rate ratio to model "what-if" scenarios in order to gauge prospective levels of variable interest exposure, given either proposed derivatives structures or future bond issuance.
Proposal Summary
Of the 340 issuers with DDP scores to date, about 22% of issuers received an overall score of '1'; 65% received an overall score of '2'; 13% received an overall score of '3'; and no issuers received an overall DDP scores of '4' or '5'. When Standard & Poor's issues an overall DDP score for an issuer, whole numbers are used as the overall score rather than the "raw" or calculated score (e.g. 1.53) that is produced by the component scoring and weighting methodology described above. Standard & Poor's rounds the raw score up or down with cutoffs at each 0.50 to arrive at the overall DDP score. For example, a raw score of 1.53 is rounded to a overall DDP score of '2' just as a raw score of 2.49 is rounded down to a overall DDP score of '2'. Because an issuer with a raw score of 1.53 has relatively less risk than issuer with a raw score of 2.49, Standard & Poor's saw a need to more accurately reflect these relative risk levels in ratings. The proposal below has three components and has been backtested among the 340 issuers with DDP scores. Standard & Poor's has determined that this proposal more accurately reflects the relative risks associated with debt derivatives among municipal bond issuers.
The proposed criteria contain the following key elements.
1a)
The DDP scale will be condensed to a four-point scale from a five-point scale and definitions of numerical scores will be revised as follows:
'1' ? no risk to very low risk
'2' ? low to moderate risk
'3' ? moderate to high risk
'4' ? high and very high risk
or
1b)
In order to distinguish between fine gradations of risk and provide more granularity, Standard & Poor's is considering eliminating the numerical scoring system in favor of a word based system. Each numerical score above was split into two components and the words correlate to the numbers as follows. The more refined scale, using words instead of numbers, allows finer gradations within the scale.
No risk = '1'
Very low risk = '1'
Low risk = '2'
Low-to-moderate risk = '2'
Moderate risk = '3'
Moderate-to-high risk = '3'
High risk = '4'
Very high risk = '4'
and
2)
The DDP component scores will be re-weighted as follows:
Collateral posting / termination risk ? 35% from 25%
Management ? 35% from 25%
Counterparty risk ? 15% from 25%, and
Economic viability ? 15% from 25%
and
3)
Four of the seven factors of the termination / collateral posting risk component category will be eliminated as scored factors. These include:
Termination payment methodology (first method vs. second method);
Termination pay-out methodology (lump sum vs. amortized);
Termination payment lien (senior vs. subordinate); and
Cross default.
Background For The Criteria Revisions
Standard & Poor's pioneered the credit analysis of debt derivatives in public finance through creation of the DDP in the fall of 2004. During the past year of implementation, we have compiled extensive data on public finance issuers' use of derivatives and the associated risks as they relate to credit quality and ratings. This new data is the foundation for the proposed criteria changes. The goal of the DDP revisions is to improve the DDP's applicability to ratings, thereby adding further value to Standard & Poor's analysis.
Revised DDP scale
The modified score range of 1 through 4 narrows the possibilities for overall score outcomes; however, the definitions of the scores broaden the possible interpretation of risk from debt derivatives in order to allow for scoring the wide spectrum of issuers, derivative structures, and risk profiles found in public finance. Standard & Poor's has found that, in general, debt derivatives are low risk for most entities, although there are in fact fine gradations of risk, including quality of management. If we opt for the word-based scale, we will better able to distinguish the fine gradations of risk for use in the overall credit analysis.
Re-weighting of component scores and elimination of four of seven factors in termination/collateral posting risk
Standard & Poor's will place more emphasis on near- and intermediate-term risks and less emphasis on longer-term risks that would not likely affect the issuer's current rating. This will be accomplished through a re-weighting of component scores used to determine the final DDP score and elimination of four of seven factors in the termination/collateral posting risk component section.
It has become evident that a major source of risk to municipal bond ratings from swaps relates to involuntary collateral posting and termination under swaps. In general, collateral and termination triggers are based on ratings and are symmetrical between the swap dealer and the municipal counterparty. This symmetry, combined with the long-dated nature of most swaps, and the relative ratings volatility of the two counterparties, means that swap dealers will likely be subject to an involuntary termination or be required to collateralize the swap obligation before the issuer ? even though dealers are often initially rated higher than the governmental entity. Indeed, U.S. public sector entities have historically exhibited substantially lower default rates and rating transitions than corporate entities. Because of this fact, most interest rate swaps executed for U.S. municipal bond issuers are relatively safe from the counterparty risk perspective. For this reason and the fact that most municipal transactions are not swap dependent in the sense that municipal bonds do not require the swap for bond repayment, counterparty risk will have less weight assigned in the DDP analysis. However, it is still possible, of course, that issuers will need to post collateral, or if downgraded lower, be forced to unwind the swap. This aspect of derivatives risk is of primary importance from a credit perspective as it pertains to liquidity levels. Building upon this concern, the issuer's management and monitoring of counterparties, collateral levels and valuations, and negotiating the swap terms in the first place is of utmost importance to the overall success of the transaction. For this reason, Standard & Poor's will weight termination/collateral posting risk and management more heavily in the DDP analysis. Standard & Poor's has also found that the cash flow aspect of derivative risk is of relatively less importance from a near- to intermediate-term credit perspective. For this reason, the economic viability component will be assigned less weight as part of the DDP methodology.
Entities To Which The Criteria Are Applied
The main applications of the DDP criteria to date have been for swap independent municipal bond issuers and issues. An estimated 350 issuers and their debt have ratings that incorporate a DDP analysis.
Implementation
Standard & Poor's current plan is to begin applying the proposed criteria in the first quarter of 2006 as issuers are reviewed. A small amount of scores are expected to change if the numerical scale is chosen. However, if we opt to convert scores to a word-based system, all issuers' scores will be converted at the same time. In this case, we would expect some risk characterizations to change, but only slightly.
Procedure For Commenting
Standard & Poor's will be grateful for all comments on these proposed criteria changes. Comments may be emailed to criteriacomments@standardandpoors.com. The deadline for comments is Jan. 31, 2006.
