Debt Derivative Profile (DDP) March 22, 2005

Author: Khai Nguyen

Definition:

Indicate an issuer’s potential financial loss from over-the-counter debt derivatives (swaps, caps,
collars) due to early termination resulting from credit or economic reasons.

§ Used to enhance the transparency of municipal derivative structures & the impact on credit
quality

§ Swap dependent issuers (mostly housing and structured financings) do not have DDP scores
since ratings on these transactions already incorporate cash flow stress testing of all derivative
risks.

§ Derivatives entered into to generate revenue or relieve rate pressures are seen as gambling on
interest rates and are viewed negatively in the overall analysis.

Scoring System:
(Low Risk) 1 2 3 4 5 (High Risk)

DDP Score Indication

1-2 Impact from debt derivatives is manageable and represents a neutral credit factor
3 Indicates moderate credit risk on an issuer’s financial profile
4-5 Possible indicator of increased credit risk on an issuer’s financial profile

Four Components of Scoring System:

1) Termination/Collateral Posting Risk

Based on the risk that the issuer defaults under the swap or triggers a collateral posting under
credit support documents.

2) Counterparty Risk
Based on the risk that a counterparty will default and terminate a swap and the issuer will lose
a positive swap valuation, thereby diminishing its ability to replace its hedge position.

3) Economic Viability of Swap Structure (Basis Risk)

Based on whether the issuer could have an incentive to restructure or voluntarily terminate a
transaction due to ineffectiveness of the swap over the longer term.

4) Management Risk
Based on S&P’s assessment of management experience and the quality of its swap and debt
management plan.

* Each of the factors are scored on a scale of 1 to 5, and in most cases equally weighted at
25%. The DDP equals the weighted average score of the factors.

Other Factors Affecting DDP Score:

§ Issuer Rating & Outlook: Indicates tolerance for a high DDP score

§ Swap Exposure: Absolute level of involvement with swaps, it will determine overall importance
of the DDP score (total derivative notional divided by total debt outstanding)

§ Value-at-risk versus Reserve Levels: Stress test for the potential worst-case market value loss
resulting from a derivatives trade

§ Net Variable Rate Exposure: Potential risk to an issuer’s revenue stream and reserve levels
resulting from rising interest rates

* Source(s): S&P Research - Public Finance Criteria: Debt Derivative Profiles