By Erkan Erturk, Ph.D., director, and Tom Gillis, managing director, Standard & Poor's
Executive Summary
This report provides a review of global structured securities during the period of 1978 to 2004, and combines certain elements of those previously published reports in order to compare the relative performance of each sector in the structured finance market.
Overall, global structured securities rated by Standard & Poor's performed better during 2004 than the last two years; also, the performance was better than the average annual experience observed during the 2000 to 2004 period. Additionally, the overall performance of structured finance ratings was slightly better than that of corporate ratings during 2004. The upgrade rate for structured finance securities (7.84%) was much higher than the downgrade rate (3.03%) during the year. This positive trend was noticeable among CMBS and RMBS ratings. A review of the rating performance suggests strength in European and U.S. CDO upgrades as well as continued strength among U.S. RMBS ratings. Moreover, there was a noticeable increase in upgraded securities in Latin America/Emerging markets as well as in the Japanese structured market.
On the downgrade side, U.S. ABS ratings were lowered due primarily to downgrades in the manufactured housing, aircraft, small business loans and franchise loan ABS subsectors. Other contributors to global structured finance downgrades during the year included a significant European and U.S. single-issue synthetic downgrades.
The following key points
were observed:
* The median credit spread of structured finance securities-rated AAA' has declined to 34 basis points in 2004, from 40 basis points in 2003, suggesting a tight spread environment.
* The structured finance market experienced a record issuance level during 2004.
* Overall, global structured securities experienced an average upgrade of about 12% of a notch per rating in their credit quality during 2004; the average number of notches changed per upgrade and downgrade were about 2.9 and negative 3.6, respectively
* European and U.S. CMBS and RMBS ratings performed well during 2004.
* Structured finance securities performed slightly better than corporate ratings in 2004.
* A few ABS asset types (such as manufactured housing, small business loans, aircraft and franchise loans) accounted for most of the downgrades in U.S. ABS during the year.
* Overall, 10.87% of structured securities experienced rating transitions. This compares with a rating transition rate of 14.95% for 2003 and a rate of 10.87% for 2002. This decline in the rating transition rate is due, to a certain extent, to a dramatic increase in the number of new ratings in the past year.
* The upgrade rate during the year was 7.84%, very similar to 7.94% in 2003. In other words, 7.84% of outstanding ratings were raised during 2004.
* The downgrade rate was 3.03% for global structured finance during 2004, down from a rate of 7.01% during 2003.
* Defaults and near-defaults (75%) during the year came primarily from previously downgraded securities.
This report documents Standard & Poor's long-term rating performance of global structured securities during 2004. It discusses overall rating trends and describes rating performance from a number of different perspectives. In addition to providing the 2004 performance, full transition tables are presented for structured finance, individual structured finance sectors as well as corporate ratings. In general, a rating transition is associated with the time period in which a security's rating performance is measured, such as 2004. A security's beginning and ending ratings during this period (and in any annual transition period) are used to calculate transition rates.
Merrill Lynch ABS Indices highlight the total return behavior of structured securities in recent years. The impact of lower interest rates since 2001 is also visible among the returns. The most noticeable one, however, is the negative annual return of minus 0.08% experienced in the manufactured housing ABS Index. This is not surprising given the poor rating performance of manufactured housing ABS securities in recent years. In regard to the median Libor spread of new structured securities rated by Standard & Poor's, overall it has declined in 2004. For example, the median spread declined to 34 basis points in 2004, from 40 basis points in 2003 for AAA' ratings. This trend is true for other rating categories as well. However, the spreads do vary greatly across sectors as shown by the 2004 observation because of the structural and prepayment characteristics of various structured securities.
Overall, 2004 was a record year with U.S. dollar-denominated issuance reaching $1.44 billion, 38% increase from the 2003 level. The global RMBS sector accounts for about 58% of this issuance level. Finally, we also show the distribution of global structured ratings outstanding at the beginning of 2004. The percentages give equal weights to each outstanding security, while ignoring the issue size. According to this measure, U.S. RMBS account for 43% of all outstanding structured securities, followed by U.S. ABS and U.S. CMBS ratings.
Rating Transition Across Region and Sector
There was a significant upgrade and modest downgrade volatility observed during 2004. In 2004, 7.84% of outstanding global securities rated by Standard & Poor's were upgraded and 3.03% of these securities were downgraded during the year. The upgrade rate of 7.84% was slightly lower than the 7.94% rate observed during 2003, but this was higher than the upgrade rate of 5.24% observed in 2002. The downgrade rate of 3.03% was lower than the 7.01% experienced in the previous year and lower than the rate of 5.63% experienced in 2002.
2004 U.S. ABS upgrade was lower than last year's experience. For instance, 1.66% of U.S. ABS ratings were raised during the recent year, down from 2.46 during 2003. With respect to downgrades, 7.51% of U.S. ABS ratings were lowered during 2004, down from 18.08% during 2003. European ABS performed relatively better than during 2003, exhibiting a downgrade rate of 10.67%, down from 13.86% in 2003. U.S. CDOs performed better and European CDOs performed relatively better this year than the last year. U.S. and European RMBS continued to experience a significant level of upgrades during 2004, and their downgrade rates were minimal. Finally, single-issue synthetics experience during 2004 was similar to the performance of 2003.
Vintage Performance
Reviewing global structured securities' rating performance in the context of the year of issuance is valuable in documenting the volatility of rating transitions. In other words, emphasizing rating performance by vintage year helps highlight the delayed impact of the economic environment at the time of issuance and credit cycles. Table 8 documents the rating performance during 2004 by various vintage years, suggesting that the 1995 through 2001 vintages were the hardest hit in terms of downgrades. On the upgrade side, the 1996 through 2002 vintages experienced the most upgrades during the year. In terms of percentages, the 1996 vintage experienced the most defaults during the year. The 1998 vintage was the worst vintage ever in terms of defaults and the 1987 vintage was the worst on the downgrade side. On the upgrade side, the 1993 vintage experienced the highest percentage of upgrade of 24%.
Rating Momentum
During 2004, defaults and near-defaults mostly came from previously downgraded securities. About 42% and 55% and of the 2004 downgrades came from previously stable and previously downgraded securities, respectively. The remaining 3% of downgrades were previously upgraded. Also, 75% of 2004 defaults came from previously downgraded securities. Comparatively, about 20% of 2004 upgrades came from previously upgraded securities. About 74% upgrades were previously stable. The results support the view that securities that experienced rating transitions were more likely to experience further rating transitions in the same direction. It is also true that previously stable securities were more likely to stay stable. Overall, a review of momentum in rating transitions shows that this trend holds across ABS, CDO, CMBS and RMBS sectors.
Structured Finance Defaults
The global structured finance market has experienced increased defaults in recent years. The number of defaults include all tranches without collapsing them. Of the total defaults, 457 events have occurred since year 2000, and 150 defaults took place only during 2003. Overall, the global RMBS sector has experienced the highest cumulative number of defaults at 209. The global ABS sector was the second highest with 200 defaults, and the global CMBS sector experienced 96 defaults. In terms of ratings, BB' and B' original full rating categories experienced 97 and 103 lifetime defaults, respectively.
Concluding Remarks
Global structured securities experienced lower downgrade volatility and performed better in terms of upgrades during 2004. The overall performance was also better than that of corporate ratings during 2004 and the poor performance experienced during 2003, suggesting a continued improvement in the rating performance of structured finance securities.
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