Moody's Investors Service this week will issue a report reassuring the municipal market that interest rate swaps in and of themselves will not negatively impact the credit quality of issuers as the derivatives relate to Rule 133 of the Financial Accounting Standards Board.
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Diane Viacava, vice president and senior credit officer, noted that the report, "Swaps and The Municipal Market: The Impact of Swaps and FASB 133 on Municipal Credit Quality," was prompted by issuers who were concerned that the principles of FASB 133 would have an adverse impact on their credit ratings.
FASB 133 establishes accounting and reporting standards for the derivative instruments and requires issuers to disclose gains or losses on swaps on income statements.
"Moody's looks beyond the mandated accounting and reporting changes to determine the underlying economic reality of the transaction and the cash flow impact on the municipal issuer," Viacava wrote in the report.
In analyzing the issuer's information, the rating agency would attempt to find out the purpose of the swap. If the instrument is seen as legitimately hedging exposure that the firm has been forced to disclose under FASB, it may not factor it into account, Viacava said in an interview.
But the agency's ratings decision may be different if the swap is speculative, she said, adding that the lion's share of municipal interest rate swaps are hedged. The repercussions of FASB 133 and its impact on the financial statements of municipal issuers reporting under FASB standards are already being felt in the municipal market with fiscal year 2001 financial results," the report said. Many tax-exempt issuers had entered into swap transactions in their attempts to hedge variable or fixed-rate debt as a part of their overall debt structure.
However, due to the strict criteria imposed by FASB, any municipal swap using The Bond Market Association index as its variable rate-index cannot employ the shortcut accounting method that nets the change in market value of the swap against the unrealized gain or loss in the value of the underlying hedged debt. The result is that generally tax-exempt issuers will face significant swings in earnings impact from its swap transactions due to interest rate fluctuations.
But any decision on ratings changes would be based upon the issue, tax status, and nature of the financial report, along with various other factors.
In the past, swaps were erroneously perceived primarily as off-balance-sheet financings that were improper, according to Viacava. In general, Moody's believes that the prudent use of derivatives, including interest rate swaps, can be an effective tool in meeting funding needs and managing a balance sheet while limiting risk, she said.
Issuers are increasingly using the interest rate swaps along with other derivatives as part of their debt strategy and asset-liability management.
Viacava explained that issuers need to have an informed and intelligent management, and a prudent investment strategy.
