interest rates, foreign exchange rates, and other market
conditions. If a counterparty defaults on a transaction that
is "in the money" for Swapco, the potential for loss exists.
Thus, counterparty credit risk is a critical factor in assessing
capital levels. Swapco minimizes counterparty credit risk,
and potential capital usage, by limiting new transactions
to investment-grade counterparties rated 'BBB' or higher.
If a counterparty's credit rating subsequently deteriorates
below investment grade, exposures must be fully capitalized.
At Sept. 30, 1995, the company had $691.4 million of
customer receivables without regard to collateral posted to
or received from counterparties. Of this amount, nearly
93% was due from counterparties rated 'A' or higher
(see
Counterparty Credit Profile table below). Based on notional
amounts, exposure to counterparties rated 'A' or higher
was approximately 90%.
To mitigate the adverse impact from large counterparty
defaults, individual counterparties are subjected to concen-
tration tests. Large concentrations must be fully capitalized,
with increasing levels of coverage for lower rated counter-
parties. Exposures are calculated using either gross or net
conventions, depending on conservative interpretations of
the enforceability of netting provisions in each domicile.
Affiliate Exposures
Swapco could incur significant exposure 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 collat-
eral, including a market volatility cushion to offset a
potential increase in the affiliate exposure during an un-
matched termination period. Under the company's operat-
ing procedures, all collateral must be of the highest quality,
consistent with an 'AAA' rating. Swapco also fully capital-
izes 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 settled at
mid-market prices within eight days from a termination
event. Therefore, market risk is contained within a rela-
tively short termination period if Swapco's matched trans-
actions 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 requirements. Recently, Swapco
began providing each client 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 termination 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 collat-
eral. Fitch has compared the posted collateral cushion
against subsequent changes in the value of Swapco's
portfolio over the past two 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 liquidity through con-
servative investments in short-term, high-quality instru-
ments. At Sept. 30, 1995, Swapco maintained $109 million
of overnight repurchase agreements and cash. Swapco has
established a revolving credit facility with SBHC to meet
cash flow requirements from two-way collateral agree-
ments and other operating needs. The company has also
established a liquidity trigger to ensure that a minimum
level of liquidity is maintained through investments in cash
and cash equivalents. If Swapco fails this liquidity test, a
trigger event occurs. In a termination event, counterparty
Counterparty Credit Profile
($ Mil., As of Sept. 30, 1995)
Customer
Credit
Rating*
Receivables
Exposure (%)
AAA
324.8
47.0
AA
156.5
22.6
A
161.9
23.4
BBB
1.3
0.2
Other Acceptable
Counterparties
46.8
6.8
Total
691.4
100.0
*Long-term debt rating. Net exposure based on mark-to-market
valuations, excluding collateral received from or advanced to
counterparties. Note: Numbers may not add due to rounding.
Salomon Swapco Inc.
3
FITCH INVESTORS SERVICE, L.P.
