Municipal Structured Finance208 Standard & Poor’s Public Finance Criteria 2007
A
bond transaction backed by a letter of credit
(LOC) is typically issued by a municipal entity,
which serves as a conduit. The bond proceeds are
loaned to the underlying obligor, which is the entity
that bears the responsibility for repayment of the
debt. Banks provide LOCs, which cover full and
timely payment of principal and accrued interest in
exchange for annual commitment and drawing fees.
Standard & Poor’s Ratings Services has rated a
variety of structures, including fixed-rate bonds and
variable-rate put bonds. Fixed-rate bonds only
carry a long-term rating. Put bonds, which require
LOC coverage for purchase price, as well as for
principal and interest, carry a dual rating. In its
analysis, Standard & Poor’s seeks to ensure that the
likelihood of payment is equal to the likelihood of
the bank’s honoring draws on its LOC. The bond-
holder is insulated from any bankruptcy, default, or
lack of performance by the obligor.
The rating that Standard & Poor’s assigns to a
LOC-backed transaction is based on the LOC
bank’s issuer credit rating. Standard & Poor’s
applies the weak-link theory if two or more LOCs
combine to support a transaction. If each bank has
a several obligation, the transaction’s rating will be
that of the lowest-rated bank. Confirmation LOC
deals can earn ratings in accordance with the joint
support criteria.Preference Concerns
Standard & Poor’s is concerned that the payment of
debt could be recaptured from the bondholders as
an avoidable preference in the event of a filing of a
bankruptcy petition by the issuer, the borrower, or
any general partner or guarantor of the borrower. A
trustee in bankruptcy may set aside, or recapture,
certain payments on account of antecedent debt
made within a certain period of time prior to the
filing of a bankruptcy petition. The appropriate
preference period within the U.S. is 90 days (or 365
days in the case of any “insiders”).
Payment structure
There are several ways to address possible prefer-
ence problems, beginning with the choice of pay-
ment structure. The three basic structures are:
■Direct pay;
■Prioritized direct pay; and
■Standby LOC.
In a direct-pay structure, the primary source of
payment to bondholders is funds drawn under theLOC. This is the only source Standard & Poor’s
considers in its rating analysis. The LOC must
specifically state that the bank will pay with its
own funds or reference International Standby
Practices version 1998.
The prioritized direct-pay structure is similar to
direct pay. Bondholders are paid with LOC funds
as the secondary source if the trustee does not hold
sufficient preference-proof funds. Preference proof-
ing entails providing the trustee with funds for the
appropriate preference period before a payment
date and certifying that no bankruptcy has occurred
with respect to the depositor within such period.
In standby LOCs, the least common payment
structure, bondholders are paid first with nonpref-
erence-proof funds. Since this structure could allow
for the disgorgement of bond payments following a
bankruptcy, the LOC is sized to cover the maxi-
mum amount of preference payments, in addition
to its coverage of principal and accrued interest.
Upon a bankruptcy filing, the LOC is drawn upon
to establish an escrow fund for the preference risk.
To protect bondholders from the consequences of a
bankruptcy following a final payment, the LOC
expiration date must extend beyond the duration of
the appropriate preference period after such final
payment. At the conclusion of such period, if the
trustee does not receive evidence indicating that no
bankruptcy has occurred, the LOC shall be drawn
upon to establish an escrow fund.
Purchase price
Variable-rate demand bonds that use remarketing
proceeds as the initial source for purchase price
payments also raise preference concerns. The
remarketing proceeds that are used as a payment
source to tendering bondholders must be restricted.
These proceeds may not include funds from the
issuer (if not a municipal entity), the underlying
obligor (if not a municipal entity), any general part-
ner, or guarantor. The guarantors that raise this
concern would be those of the bonds or the loan
agreement, but not of the reimbursement agree-
ment. If there are no guarantors of the bonds or
loan agreement, then Standard & Poor’s may
request a written statement to this effect.
Preference opinions
In analyzing LOC-backed transactions, Standard &
Poor’s considers whether the payment of debt may
be recaptured from the bondholders as an avoid-