Swaps used by the vast majority of municipal issuers present minimal downside risks to them and may have the potential to improve their financial condition over a longer period of time, Standard & Poor's said in a report published yesterday.
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Peter Block, director at Standard & Poor's and lead author of the report titled Credit FAQ: Debt Derivative Profiles, said the average debt derivative scores to date -- calculated using the debt derivative profile criteria the agency released in September --"indicate that as a whole, debt derivatives do not carry large amounts of downside risk, and may in fact benefit credit quality to the extent that strategies are managed and turn out as expected."
He said that Standard & Poor's has assigned about eighty DDP scores, and the average score awarded was two, which represents the second-lowest risk exposure. Most of the issuers receiving Standard & Poor's scores have structured fairly conservative, plain vanilla hedging programs, Block said. The issuers scored are from various sectors, including tax-secured, health care, higher education, transportation, housing, and utilities, Standard & Poor's said.
Peter Shapiro, managing director at Swap Financial Group LLC in an interview yesterday agreed with Standard & Poor's findings. "Our experience is that for the lion's share of issuers, the trade-off between the risk and benefits of using derivatives has been in favor of benefits. Our clients have been mostly two's and one's," he said.
The DDP is a risk indicator for public finance debt derivatives -- primarily interest rate swaps --expressed on a scale ranging from one through five, with one representing the lowest risk and five representing the highest risk. The overall DDP score reflects an average of four scored factors, including counterparty risk, termination risk, economic viability, and management, all of which are also scored on a one through five scale, and weighted equally.
Many issuers that scored a two also received "component scores greater than two, which indicates that debt derivatives do carry some longer term liquidity and cash flow risks, despite their intent of hedging or minimizing risk. In the handful of cases where swaps are a material credit concern, the DDP score reflects this fact and has, and will be highlighted as a key factor driving the rating decision," the report said.
Block said that most municipal issuers have only started using swaps in the past three years. As a result, it is "hard to tell" the amount that swaps have contributed to their cash flow. An assessment of the benefits of such swaps would be from a limited timeframe, he said.
One issuer that has used swaps since 2000 is the California Housing Finance Agency. Director of financing Bruce Gilbertson said it has about 109 fixed-payer swaps outstanding worth roughly $4.2 billion. The agency has used swaps "not necessarily to increase cash flows, but to reduce lending rates offered to homebuyers and developers," he said.
Gilbertson said that using swaps allows the agency to lock up a cost of funds that is substantially lower than it would have obtained without the swaps. The agency has a debt derivative score of two, he added.
Shapiro said that the New York City Municipal Water Finance Authority, an issuer that sold $2.03 billion of municipal bonds last year and a Swap Financial client, scored a one. "The most important reason is that [the authority] uses swaps to a small extent," Shapiro said. He said that as the issuer's use of swaps increase, the likelihood is that the score may move closer to a two.
In evaluating the DDP score, Block stated in the report that users of the information should note that the commentary or narrative support for a DDP score is at least as important as the score itself, and that the two pieces of information should be used together.
