■Full collateralization of swaps by the counterpar-
ty prior to a downgrade to below ‘BBB’; or
■A provision for the counterparty to secure, at its
cost, a third-party guarantee or replacement
counterparty rated at least ‘BBB’ in the event of a
downgrade of the original counterparty to below
‘BBB’; and
■Provision for mandatory counterparty termina-
tion below ‘BBB’, or
■A provision that allows the issuer to optionally
terminate the swap, at any time, for any reason.
Economic viability
Economic viability is scored on a 1 through 4 scale
based on whether the issuer could have an incentive
to restructure or voluntarily terminate all or a por-
tion of its swap transactions due to the ineffective-
ness of the hedges over the long term. We have
determined that it is important to analyze the eco-
nomics and long-term cash flow strength of deriva-
tive structures since the voluntary termination or
restructuring of the hedge through execution of
additional hedges is potentially costly and time con-
suming, accompanied by real economic and oppor-
tunity costs. These costs are in addition to the
unexpected interest costs resulting from the ineffec-
tive hedges. However, economic viability is of rela-
tively less importance from a near to intermediate
term credit risk perspective relative to termination
and collateral posting risk or management. For this
reason, the economic viability component of the
DDP score will be assigned a 15% weighting, simi-
lar to counterparty risk.
To determine long-term economic viability, we
will stress test the potential ineffectiveness of an
issuer’s swap portfolio through a proprietary basis,
or variable interest expense, model. The model
incorporates our high and low stress interest rate
curves and tax-exempt bond price assumptions.
Scores are assigned based on the overall amount of
long-term basis exposure. The lower the overall
basis exposure on a portfolio level, the lower the
economic viability score (scores of 1 or 2), while
the higher the overall basis exposure, the higher
the scores (3 or 4). Lower scores reflect the poten-
tial for higher economic viability of the issuer’s
swap structure over the long term while higher
scores indicate lower economic viability over the
long term. In some cases, issuers with high eco-
nomic viability scores may in fact have achieved
high economic viability at least in the short-term
since the derivative structure itself made the trans-
action possible in the current market environment.
While this is a valid argument in the short run,
high potential ineffectiveness or basis exposure can
be problematic in the long-term as a variable, orunknown, budget expenditure leading to or exacer-
bating cash flow stress.
Management
Management is scored on a 1 through 4 scale based
on our assessment of management knowledge and
sophistication through analysis of its swap and debt
management policies and overall strategy.
Management is weighted at 35% due to the signifi-
cance of an issuer’s knowledge and sophistication in
structuring its derivative contracts to both minimize
risks and achieve the intended purpose of the hedg-
ing program. We consider various factors in assess-
ing the quality of management of the swap
program, including the quality of the issuer’s writ-
ten policy and hedging strategy. The written policy
should be original and tailored to the issuer’s
unique situation and incorporate near, intermediate,
and long-term strategies and parameters. Factors
considered in assessment of the overall quality of
management and the written policy and plan
include:
■Formal approval of written documents by the
issuer’s governing body;
■Swap risks identified and discussed in the context
of the issuer’s financing plans;
■Annual management review and discussion of
hedging strategies;
■Commitment to complete and comprehensive dis-
closure of swaps in audited financial statements
above and beyond required GASB or FASB
parameters;
■Monitoring of swaps with semi-annual valuation
by a third party
■Policies on legal provisions, including optional
swap terminations, collateral, or swap insurance;
and;
■Counterparty diversification or a minimum rat-
ings policy for counterparties;
■A net variable rate exposure policy.
A comprehensive swap management policy will
include the above consideration and should also
include a discussion of risks and rewards of swaps
and variable rate debt, senior management person-
nel responsible for monitoring swap risks, maxi-
mum level of variable rate debt and swap exposure,
counterparty exposure limitations, collateral poli-
cies and procedures, and a detailed description of
and rationale for all derivative transactions entered
into or that are contemplated.Additional Factors
Swap valuation
An issuer’s swap portfolio may be stress tested to
determine the maximum potential exposure if the
issuer has a high final DDP score, high net variableCross Sector Criteria42 Standard & Poor’s Public Finance Criteria 2007