By Fitch Ratings Credit Policy Group analysts Roger Merritt and Claire Mezzanotte in New York and Ian Linnell in London.
In recent weeks, Fitch Ratings has taken negative ratings actions with respect to a number of major banks and non-bank financial institutions. These actions reflect the increasingly difficult operating environment adversely impacting asset quality, liquidity and profitability measures. Many of these entities operate on a global scale and maintain substantial presence in the structured finance marketplace through various credit-sensitive roles, such as full or partial liquidity support provider; letter of credit provider; trustee; servicer or back-up servicer; derivative counterparty, and investment account provider.
An entity's ability to participate in one or more of these roles depends in part on its credit profile as described by its rating. Structured finance investors frequently inquire as to the degree of importance and the impact, if any, on transactions involving a downgraded entity. Fitch's response to the effect of an entity downgrade on the rating of a security depends on a number of variables, including specific ratings-based guidelines, the degree to which the security's rating is dependent on the rating of the entity and, most important, Fitch's current structured finance ratings criteria.
Notwithstanding the transaction documents, the downgrade of a particular entity may not necessarily result in ratings action by Fitch. Typically, if transaction documents and Fitch's current criteria conflict, any ratings action will be driven by Fitch's current ratings criteria. A decision by Fitch to take ratings actions, following an entity downgrade, depends on our structured finance criteria which, in many instances, sets certain minimum ratings guidelines for credit-sensitive roles. The following is a summary of the credit-sensitive roles found within structured finance transactions, and Fitch's current ratings criteria for structured finance securities.
Liquidity Support: Structured finance securities may rely on full or partial liquidity support to protect against cash shortfalls resulting from asset/liability mismatches, market disruptions and delinquencies. Where a security relies on partial or full liquidity support in the form of liquidity facilities, the security's rating usually is closely linked to the rating of the liquidity provider. Exceptions do exist, however, in those instances in which the degree of reliance on external liquidity is small and/or redundant sources of liquidity are present.
For asset-backed commercial paper (ABCP) programs with 100% liquidity support, the program rating is closely linked to the rating(s) of the liquidity provider(s), with very few exceptions. For commercial paper rated in Fitch's highest short term rating category of F1+,' the preponderance of liquidity support must come from liquidity providers with a rating of F1+.' A breach of the F1+' rating would result in collateralization of the exposure, replacement of the liquidity provider or a program downgrade.
Letters of Credit: In the case of securities in which the rating is full supported by a bank letter of credit, the rating will be directly affected by Fitch's downgrade of such bank's rating.
Trustee: Depending on the specific transaction and local market practice, trustees play varying roles under the trust indenture or other transaction legal documents. Generally speaking, Fitch's criteria for eligible trustees is BBB' or higher.
In certain instances, though, Fitch's criteria are set at a higher standard. Trustees in certain types of structured finance transactions (U.S. CMBS/RMBS, for example) may also be required to advance cash in the event of temporary shortfalls in borrower collections, if the servicer fails to advance. In these cases, Fitch sets a minimum rating at F1' to reflect the expectation of back-up liquidity support.
Derivatives and Repurchase Agreements: Structured finance transactions may incorporate interest rate or foreign currency swaps/caps/floors to manage potential cash flow mismatches between the underlying assets and the rated securities. For AAA' rated securities, Fitch's criteria for derivative counterparties is F1' or higher for liquid hedging instruments. Similarly, repo counterparties are expected to maintain an F1' or higher rating. If the counterparty's rating falls below F1,' the counterparty is expected to provide collateral against the net mark-to-market exposure, as well as some degree of overcollateralization which acts as a buffer against potential price variations in between collateral posting dates. The level of expected overcollateralization depends on the market price volatility of the relevant collateral. In the event the counterparty does not adequately collateralize the exposure, a suitably rated replacement counterparty is expected to guaranty or assume their role. Absent one of these such remedies, negative rating action may result.
In synthetic transactions and other credit derivative structures, the trust often depends on the credit default swap counterparty to make periodic premium payments, which in turn comprise the spread for the security's coupon. In transactions that contemplate termination, the credit default swap counterparty would typically need a rating of at least F1' for AAA' rated securities. Alternatively, upon being downgraded below F1', the counterparty could immediately prepay or collateralize its next payment obligation, and prepay or collateralize the following payment on each payment date thereafter. It is important to note that in certain balance sheet structures, which do not contemplate termination, a direct rating dependency may exist.
Permitted Investments: Proceeds arising from the underlying assets in a rated transaction may be invested with the seller/servicer, an eligible account holder or other entity defined in the transaction's legal documents. Under Fitch's criteria, investments typically must mature by the next defined interest payment date to avoid market risk, and funds should be invested in highly rated, liquid securities (F1' or F1+' depending on the coupon frequency).
Funded synthetic structures are somewhat unique since the entire transaction proceeds typically are invested in a collateral account for purposes of 1) satisfying protection payments under the credit default swap and 2) timely redemption of the securities at maturity. For this reason, for AAA' rated securities the transaction proceeds generally are invested in F1+' or higher rated collateral that conforms to certain additional criteria related to liquidity/market risk.
Commingled Funds: Generally, for entities rated F1,' funds may be commingled and invested for thirty days prior to remitting to the trustee. Higher rated entities may commingle for longer periods of time, while lower rated entities "sweep" funds to the trustee more frequently as a protection against commingling risk.