Due to the criteria revisions discussed in this
report, 271, or 54% of the 505 scores changed. Of
the 54% that changed, 26% were revised upward
(got worse), and 28% were revised downward (got
better). Eight issuers, or less than 2% of the total
scores changed more than a half-point (0.5) as a
result of the recalibration. All others changed up or
down by a half point only.
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 collateralization of a
transaction or, worse, early termination resulting
from credit or economic reasons. DDPs are inte-
grated into Standard & Poor’s rating analysis for
swap-independent issuers and are one of many
financial rating factors. Standard & Poor’s consid-
ers tax-secured GO bonds and general revenue
bonds—health care, higher education, transporta-
tion, and utility—as swap-independent, as absence
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. However, state housing finance agencies, the
largest issuers of swap dependent issues, are eligible
for DDPs as part of issuer credit ratings, since these
ratings apply to the agency’s general credit and not
to any structured financing specifically.
Background
Over-the-counter debt derivatives, such as interest rate
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 and concerned about public purpose entities’
involvement in what was once exclusively a corporate
risk management tool. Many issuers—traditionally,
fiscally conservative entities—spurred by rising
expenses, restrictive refunding rules, and revenue limi-
tations, 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 expenditure
relief. 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 the health care, nonprofit, and utility sec-
tors, derivatives have provided competitive advantages
when used in conjunction with traditional financing
techniques. In all cases, debt derivatives have intro-
duced new risks and altered the credit profiles of
issuers. However, as evidenced by the preponderance
of DDP scores of ‘2’ or less (75%), it is evident that
most issuers scored to date have prudently approached
their derivatives activities.
Standard & Poor’s originally developed DDP
scores to enhance the transparency of municipal
derivative structures and their overall impact on
credit quality. Derivative impact has always been a
part of Standard & Poor’s analysis; the DDP scor-
ing method incorporates existing municipal swap
rating criteria and codifies that criteria into an easy-
to-understand risk score.Interpretation
Final DDP scores of 1, 1.5, and 2 indicate that the
credit risk from debt derivatives is minimal to low,
whereas DDPs above 2 indicate that there is a moder-
ate or high degree of risk from the swap transactions.
Low DDP scores are one factor of many included in
the credit analysis that determines a rating and are
not in and of themselves an indication of upward rat-
ing potential or an endorsement of any specific deriv-
ative transaction as being beneficial to the issuer’s
financial position.
Furthermore, moderate to high DDP scores are
also one factor of many and do not in and of them-
selves indicate a potential rating downgrade due
specifically to derivatives, or that any specific trans-
action will not benefit the issuer’s financial posi-
tion. As part of the rating analysis, Standard &
Poor’s will cite an issuer’s overall DDP score in con-
junction with the net variable interest exposure
ratio. In some cases, we may also cite DDP compo-
nent scores to highlight high component scores,
speculative transactions, or transactions entered
into under fiscal stress, that may be indicative of
other fundamental credit weaknesses.
To determine whether a moderate to high final
DDP score, high net variable exposure, or any note-
worthy component scores are sufficient to influence
an issuer’s rating, we will seek to determine an
issuer’s derivatives portfolio’s maximum potential
exposure (MPE), which is a value-at-risk (VAR) cal-
culation of a derivatives transaction. Net variable
interest rate exposure, on the other hand, measures
the potential risk to an issuer’s revenue stream and
reserve levels resulting from rising interest rates (seeDebt Derivative Profile Scoreshttp://www.standardandpoors.com 391.0 Minimal
1.5 Very low
2.00 Low
2.5 Low-to-moderate
3.0 Moderate
3.5 Moderate-to-high
4.0 HighDDP Score Risk Descriptor