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Salomon - MOODYS (Page 4)

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Salomon - MOODYS
Swapco provides for "mirrored" transactions to eliminate market risk--the potential for
net exposure to vary with movements in market rates, even in the absence of counter-
party default. Each of Swapco's transactions with a counterparty will be mirrored by a
precisely offsetting transaction with Salomon Brothers Holding Company. As a result,
any change in the value of Swapco's position with an unrelated counterparty will be ex-
actly offset by a change in the value of the mirrored transaction with SBHC. In effect,
market risk is transferred from Swapco to SBHC. In addition, both SBHC and Swapco
are required to secure their obligations to each other with collateral to be delivered to a
third-party custodian (initially, Chemical Bank). SBHC will be required to pledge collat-
eral equal to the net mark-to-market (computed daily) owed by SBHC on its back-to-
back transactions with Swapco. SBHC will post additional collateral to reduce
Swapco's exposure to market fluctuations during termination. Moreover, during any pe-
riod in which the rating of the long-term debt of Salomon Inc is below Baa3, SBHC will
post collateral in excess of the amount normally required.
Swapco would, however, be subject to market risk in the unlikely event that SBHC is
no longer capable of providing mirrored positions. If SBHC should become insolvent,
or fail to meet its obligations to Swapco, the subsidiary would be subject to valuation
changes as market rates move. To limit that risk, the structure ensures that if certain
trigger events should occur, counterparty transactions would be terminated and valued
at mid-market (halfway between bid and offer) prices, determined on the basis of mar-
ket inputs and Swapco's valuation models then in effect. Such valuations by Swapco
will be verified by an independent auditor (initially, Price Waterhouse). Rather than
gradually wind down Swapco's books, all transactions between Swapco and its coun-
terparties would automatically terminate. Settlement of net positions would then occur
within a period of several business days. Trigger events include a failure by SBHC to
post required collateral, capital, or liquidity (each subject to a cure period), a down-
grade of Swapco's rating below A3, and any bankruptcy or similar proceedings involv-
ing Salomon Inc or SBHC.
Limiting Swapco's Risks
Swapco will have an ongoing exposure to credit risk -- the potential that a counterpar-
ty will default when Swapco's position with that counterparty has net positive value to
Swapco. That exposure represents the replacement cost of each transaction and will
depend on prevailing and anticipated levels of interest rates, exchange rates, and
stock prices. The Swapco structure addresses this exposure in its Minimum Required
Capital formula.
Swapco calculates required capital in a dynamic way. Swapco's minimum capital re-
quirement will equal at least $175 million and will tend to increase as the volume of
transactions grows. In general, capital will be sufficient to withstand any event, or com-
bination of events, that is at least as likely to occur as a default by a Aaa-rated entity.
Hence, capital will increase as Swapco's exposure to below-investment-grade counter-
parties increases and as Swapco's net exposure to certain counterparties becomes
more concentrated. More specifically, capital will depend on the largest set of exposures
to individual or to small groups of counterparties, classified by rating. In view of the po-
tential for simultaneous defaults by counterparties within a single country, capital will
also be related to exposure to counterparties within any nation rated below Aaa.
Additional capital may be provided as a percentage of gross exposure in countries
where the status of netting is uncertain.
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