Of the myriad credit events contained in a munic-
ipal interest rate swap, the “additional termination
event” of a rating downgrade trigger, or collateral
posting under a credit support document, are the
most likely to occur since they are triggered by
involuntary credit events. Other standard ISDA
events of default and termination—failure to pay,
bankruptcy, merger without assumption, and so
forth—are incorporated into ratings. For this rea-
son, we will score, as a key factor for this compo-
nent, the likelihood of an issuer (or swap insurer)
triggering termination or collateral posting based
on our rating transition and default data. The credit
“spread” or gap between the issuer’s (or swap
insurer’s) current rating and the meaningful collat-
eral or termination rating trigger level is determined
and scored appropriately. For swaps with collateral
provisions, Standard & Poor’s attempts to discern
the meaningful collateral rating trigger through
analysis of the swap’s actual maximum potential
exposure compared to the issuer’s liquidity reserve
levels. Once the meaningful collateral rating trigger
is determined, Standard & Poor’s is able to accu-
rately score termination and collateral posting risk
using the appropriate rating trigger.
The final score for the termination and collateral
posting risk section is the product of the weighted
average of ISDA swap document scores.
Weightings are based on the risk-adjusted notional
amount of swaps provided by a counterparty rela-
tive to the issuer’s total risk-adjusted swap notional
amount outstanding. Standard & Poor’s adjusts
each swap’s notional amount based on its interest
rate sensitivity relative to a baseline swap’s sensi-
tivity, effectively placing less emphasis on swaps of
shorter durations and more emphasis on swaps of
longer durations. The baseline swap is a fully
amortizing swap with an average life of 19 years.
This “dollar duration” methodology captures
swaps’ sensitivity to changes in interest rates and is
used as a proxy, for scoring purposes only, of the
swap’s maximum potential exposure. Swaps with
higher volatility, therefore, have a greater impact
on the termination and collateral posting risk
analysis than swaps with lower volatility.
If an issuer has scored a 3 or 4 on any of its ISDA
documents or on the termination and collateral post-
ing risk score itself, Standard & Poor’s will evaluate
the actual MPE under the applicable transaction(s)
and compare it to the issuer’s unrestricted reserves;
that financial analysis will be factored into the rating
(see Interpretation above for more details).
Counterparty risk
The counterparty risk section of the DDP is
scored on a 1 through 4 scale based on the likeli-
hood of a counterparty default, that could cause
the issuer to lose its ability to replace its hedge
position. Counterparty credit risk is generally
low for the majority of issuers due to usage of
highly rated counterparties (typically rated ‘A+’
or higher) and provisions for full collateraliza-
tion of swaps prior to significant rating counter-
party downgrades. For this reason, and the fact
that most municipal bond transactions are not
swap dependent—in the sense that the loan does
not require the swap for repayment—counterpar-
ty credit risk is weighted at 15% in the overall
DDP analysis.
To determine a final counterparty risk score to
be used in the DDP, Standard & Poor’s will score
and weight the likelihood of a counterparty credit
deterioration based on a rating transition to the
‘BBB’ rating level. The ‘BBB’ rating level is used
since this is the lowest rating permitted under
Standard & Poor’s rating criteria for counterparties
in U.S. public finance swap transactions.
Furthermore, to the extent a counterparty is down-
graded to below ‘BBB’ the likelihood of termina-
tion payment recovery is significantly diminished
due to the potentially massive collateral calls from
the counterparty’s other creditors. Similar to the
termination and collateral posting risk scoring sec-
tion, Standard & Poor’s does not consider stan-
dard ISDA swap event of default and termination
factors as significant termination events since they
are already incorporated into counterparty ratings.
Therefore, a ratings downgrade is the credit event
most likely to occur. The counterparty risk scoring
methodology gives issuers credit for securing high-
ly rated counterparties and penalizes issuers for
securing lower rated counterparties. Similar to the
termination and collateral posting risk section,
counterparty risk scores are assigned by ISDA doc-
ument and weighted according to risk-adjusted
notional amounts. The final score for counterparty
risk will be the weighted average of each counter-
party’s ISDA swap document score, with weight-
ings based on the risk-adjusted notional amount of
swaps provided by a counterparty relative to the
issuer’s total risk-adjusted swap notional amount
outstanding. If an issuer has scored a 3 or 4 on the
counterparty risk component, or on any specific
ISDA document, Standard & Poor’s will evaluate
the MPE under the applicable transaction(s) and
compare it to the issuer’s unrestricted reserves; that
financial analysis will be factored into the rating
(see Interpretation for additional information).
At this time, our rating transition and default data
indicate that counterparty risk scores are as follows:
Notwithstanding these counterparty risk scores,
mitigating factors that would warrant a counter-
party risk score of 1, include:Debt Derivative Profile Scoreshttp://www.standardandpoors.com 41