Use of Swaps in Asset Liability Management -Rating Considerations by ssy92676

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									Use of Swaps in Asset Liability
    Management – Rating
        Considerations
            Ian Carroll
         Associate Director
           (415) 371-5060
       Ian_Carroll@sandp.com
                              Asset-Liability Management

      •Swaps May Be Used to Reduce All-in Issuer Debt Costs
             • Managing Variable Rate Exposure May Introduce New Risks
      •Cash Flow Analysis is Key Driver of Credit Ratings For State and Local
      Governments
             • Will Cash Flow Be Sufficient to Meet Debt Service and Other Current Liabilities?
             • Is Revenue Stream Historically Stable, Predictable?
      •Accrued Liabilities Are Paid Over Time
             • Fund Balances Indicate Likelihood of Long-Term Liabilities Being Met
               – Pension Liabilities and Other Post Employment Benefits
      •Rating Process Is Not Substantially Different
             • Standard & Poor’s Completes a Debt Derivative Profile for Each Variable Rate
               Transaction




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                           Credit Fundamentals

      •Management Policy and Practices
             •   Reviewed/Approved by Governing Body
             •   Address Current and Future Risks
      •Overall Financial Health
             •   Fund Balances
             •   Structurally Balanced Budgeting
             •   Historical and Projected Financial Performance
      •Cash Flow Analysis
             •   Current Liabilities
             •   Long-Term Liabilities




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                           Variable Rate Debt

             • Variable Rate Debt Often Has a Role in Asset-Liability Management
               – Reasons or Rationale for Variable Rate Debt:
                 » Pass on Savings to Stakeholders, Customers
                 » Build Reserve Levels
                 » Match Variable Asset Earnings to Variable Debt Service Costs




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                          Managing Risks

      •Risks Associated With Variable Rate Debt Can Be Managed
             •   Swaps – Synthetic Fixed Rate Debt
             •   Cash Balances – A Natural Hedge
             •   Rate Setting Flexibility in the Case of Unhedged Variable Exposure




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                            Rating Process For Swapped-to-Fixed
                            Bonds

        Analyze:
        • Issuer / issue credit fundamentals
        • Transaction and swap contract documents
        • Issuer debt and swap management plan
        • Assign rating and incorporate DDP Score
             •     Overall DDP Score, Component Scores (if applicable)
             •     Rationale for DDP Score
             •     Number of Swaps, Counterparties
             •     Net Variable Rate Exposure




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                                  DDP Factors


        Scored DDP factors include:
             • Issuer 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

             • Counterparty termination 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

             • Economic viability
              –   Determination whether or not the issuer could have an incentive to restructure or voluntarily
                  terminate a swap transaction due to ineffectiveness through potentially stressful economic
                  cycles.

             • Management
              –   Score based on Standard & Poor’s assessment of management experience and quality of swap
                  and debt management plan.




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                                     Average Number of Swaps per
                                     Municipal Issuer by Sector


                       18                                                            16
                       16
                       14
                       12
        Number of 10
         Swaps     8
                         6                                  5                                      4
                         4                3                                3

                         2
                         0
                                 Education                SLG       Healthcare   Housing   Transportation
      *Housing does not include California Hsg Fin Agy.




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                          Progress To Date
    • About 200 DDPs assigned across all sectors with various rating levels as of June 15,
    2005.
    • Average score is ‘2’ on a scale of ‘1’ to ‘5’.
    • In general, scores indicate that downside risk from debt derivatives is relatively remote,
    except for a few issuers.
    • Overall low degree of collateral posting risk and higher termination risk – avg score of ‘2’
    with handful of ‘3’
    • LIBOR based swaps and basis swaps contribute to slightly higher economic viability
    scores – avg score of ‘2’, with a handful of ‘3’
    • Highly rated counterparties contribute to average counterparty risk scores of 1
    • Management scores average = 2, although a handful of ‘3’, ‘4’ and ‘5’. This underscores
    the wide disparity among issuer sophistication in public finance.
    •No rating changes have resulted from DDP score assignment.
    • Positive feedback: adding transparency, first time anyone has shed light on these
    transactions, info has been lacking until now.
    • Our staff is now much smarter about these transactions and analytic quality has been
    enhanced by the DDP process.




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                             Swap Management Policies
             • S&P Article
               • Public Finance Criteria: Swap Management Policies, April 19, 2005


             • Swap Policy vs Swap Plan – different documents

             •Consult Management Checklist

             • Policy elements:
               • Purpose
               • Legal Authorization
               • Risk Controls
               • Continuing Oversight
               • Comprehensive Disclosure
               • Strategy



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               DDP Sector Distribution (6/15/05)

                       DDP Sector Distribution

                          Transportation
                                                  Higher
                             16 (8%)
                                                 Education
             Housing
                                                 21 (10%)
             7 (3%)


                                                        General
                                                      Government
             Healthcare                                73 (35%)
             89 (43%)




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             Overall DDP Score Distribution – All
             Issuers To Date (6/15/05)

                      Overall DDP Score Comparison



                      "3" Scores
                         7%                          "1" Scores
                                                        23%




              "2" Scores
                 70%




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             General Government DDP Score
             Distribution


                General Government Sector Score Distribution




                                                   "2" Scores
                                                      70%

             "1" Scores
                25%
                      "3" Scores
                         5%




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                              Average DDP Component Scores of
                              Issuers with a "2" Overall Score


                  5


                  4


                  3
      DDP Score
                                      2                                                    2                         2
                  2

                                                                1
                  1


                  0
                      Average Termination Score Average Counterparty Risk Average Economic Viability Average M anangement Score
                                                          Score                     Score

                                                        DDP Component Categories




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                              S&P Variable Rate Debt Metrics

      - Net Variable Rate Exposure Ratio:
                  Variable Rate Debt + Commercial Paper + Fixed-to-Floating Swaps
                                                  minus
                    Floating-to-Fixed Rate Swaps + Eligible Short-term Investments
                                               divided by
                                      Total Debt (Fixed + Variable)
      - Standard & Poor’s does not prescribe Net Variable Rate Exposure Limits By Sector
      - Proforma debt and swaps is modeled to determine “what-if” scenarios
      -The “right” ratio is case-by-case based on issuer’s cash flows
      -Not Included in Calculation:
             • Basis Swaps
             • Basis Exposure on Fixed to Floating and Floating to Fixed


      - Economic Viability Component of Debt Derivative Profile (DDP):
              – Measurement of Hedge “Ineffectiveness”
              - Compliment to Net Variable Exposure Ratio - Includes ALL swaps


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                           Average Net Variable Rate
                           Exposure by Sector

                                         Average NVRE by Sector

                         50.0%

                         40.0%

             Net Variable 30.0%      24.3%                 25.2%
                Rate      20.0%
                                                12.5%                              9.7%
                         10.0%                                        4.1%
                          0.0%
                                   Higher    General Healthcare    Housing Transportation
                                  Education Government
                                                         Sector

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