investment-grade counterparties rated
`BBB' or higher. If a counterparty's
credit rating subsequently deteriorates
below investment grade, exposures
must be fully capitalized.
At June 30, 1997, the company had
$722.4 million of uncollateralized cus-
tomer receivables. Of this amount,
more than 90% was due from counter-
parties rated 'A' or higher (see Counter-
party Credit Profile, page 2). Based on
notional amounts, exposure to counter-
parties rated `A' or higher was approxi-
mately 87%.
To mitigate the adverse impact from
large counterparty defaults, individual
counterparties are subjected to concen-
tration tests. Large concentrations
must be fully capitalized, with increas-
ing levels of coverage for lower rated
counterparties. Exposures are calcu-
lated using either gross or net conventions,
depending on conservative interpreta-
tions of the enforceability of netting
provisions in each domicile.
Affiliate Exposures
Swapco could incur significant expo-
sure to affiliates since all transactions
are offset with SBHC, and Swapco also
guarantees certain affiliate derivative
transactions. To minimize this risk,
Swapco's exposure to SBHC is calcu-
lated on a daily basis and fully offset
with eligible collateral, including a mar-
ket volatility cushion to offset a potential
increase in the affiliate exposure during a
termination period. Under the com-
pany's operating procedures, all collateral
must be of the highest quality, consistent
with an `AAA' rating. Swapco also fully
capitalizes any exposures on guaranteed
affiliate transactions to offset current and
potential liabilities.
Market Risk Management
Swapco eliminates market risk through
offsetting, matched transactions with
SBHC. Swapco's termination structure
calls for all transactions to be cash set-
tled at midmarket prices within 18 days
following a termination event. There-
fore, market risk is contained within a
relatively short termination period if
Swapco's matched transactions with
SBHC cease to exist due to a trigger
event. Trigger events include SBHC
bankruptcy; a downgrade of Swapco
below `A'; or Swapco's inability to
meet capital, collateral, or liquidity re-
quirements. Swapco provides each cli-
ent with a quarterly summary of the
mark-to-market termination value of
all trades using mid-market prices.
To protect against adverse movements
in the portfolio's value during a termi-
nation period, SBHC posts sufficient
collateral to cover an adverse market
change based on historical measures of
volatility. Swapco applies several short-
term, statistical measures of volatility
and applies the most stressful outcome
to determine required collateral. Fitch
has compared the posted collateral
cushion against subsequent changes in
the value of Swapco's portfolio over the
past four years. The results provide
confidence that Swapco's collateral
cushion is sufficient to protect against
market movements during an eight-
day termination period.
Funding and Liquidity
Swapco maintains a high degree of li-
quidity through conservative invest-
ments in short-term, high-quality
instruments. At June 30, 1997, Swapco
maintained $405 million of overnight
repurchase agreements and cash. Swapco
has established a revolving credit facil-
ity with SBHC to meet cash flow re-
quirements from two-way collateral
agreements and other operating needs.
The company has also established a
liquidity trigger to ensure that a mini-
mum level of liquidity is maintained
through investments in cash and cash
equivalents. If Swapco fails this liquid-
ity test, a trigger event occurs. In a termi-
nation event, counterparty agreements
are structured so that payments due to
Swapco are made in advance of Swapco's
payments to counterparties, which serves
as an additional liquidity cushion.
Swapco has the ability to issue short-
and long-term debt to fund collateral
posted under bilateral agreements.
Fitch has indicated that it would rate up
to $250 million in senior long-term debt
and short-term debt `AAA' and `F-1+',
respectively.
Capitalization
At June 30, 1997, Swapco had $278 mil-
lion of capital to support $752 million
Salomon Swapco Inc
Fitch Investors Service, L.P.
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