In January, Fitch Ratings put out a report that highlighted ratings volatility in securitizations that are retained by European originators, primarily to use as collateral for funding with the European Central Bank (ECB).

The agency said there were originators that had seen their triple-A notes cut as a result of counterparty downgrades and had not kept faith with deal documents by trying to maintain the rating. There was not much incentive to do so: as long as the deal remained above A-minus, it could continue to be used for ECB funding.

Fitch sees more of this happening and warned that it will take into account this kind of behavior by originators when rating their future deals.

Given that the ECB has recently loosened its criteria, one might assume there would be a higher price to pay if originators let deals experience ratings volatility. For two asset classes - residential mortgages and SME loans - they now have to reach only A-minus at the outset and cannot fall below that rating through the term of the ECB funding. By issuing at this level, originators would obviously have no ratings wriggle room.

However, since the new rule was passed in December, the evidence suggests that originators are still aiming for triple-A at the outset, players said.

One area, however, could spell more trouble for the use of ABS for ECB funding: the Bank's flirtation with allowing more whole loans to be repo-able. This could obviate the need to structure an ABS deal in the first place.

Fitch Finger-Wags

Fitch's commentary on ratings volatility in retained deals was prompted by a handful of retained transactions in which the originator did not replace a counterparty that had been downgraded past a threshold necessary for the agency to keep the counterparty delinked from the transaction rating. In these cases the counterparty was specifically the account bank.

"Because of the replacement trigger, we're able to delink the transaction from the counterparty," said Grant England, senior director in Fitch's global structured finance group. And the counterparty was typically the originator itself. "If the transaction is going to be dependent on a particular bank, then it cannot be delinked," England added.

A press officer for the ECB said the Bank had taken note of the Fitch commentary. "The Eurosystem monitors the collateral which is eligible for credit operations on an ongoing basis," he said via e-mail.

The new rule that allows RMBS and SME-loan-backed deals to have an initial rating of A-minus to be repo-able also entails additional criteria that must be met. Meanwhile, other asset classes still have to be triple-A from the outset. "The distinction between initial ratings and current ratings for ABS still exists in many cases," the ECB spokesman said.

Thorsten Klotz, managing director in the structured finance group of Moody's Investors Service, pointed out that, given that there is no widespread investor base to which many originators must cater, transactions that are structured to be retained typically do not have the mechanisms to protect investors that are featured in market-issued transactions. Cash-diversion triggers in the case of too many defaults, for instance, are often not present or they are set at levels that make such triggers ineffective.

As an example of a retained deal that failed to replace a downgraded counterparty, England cited S.p.A, whose senior notes Fitch cut to 'A-' in October of 2010 following the agency's move to lower the account bank Banca Monte dei Paschi de Siena (BMPS) to 'A-'. BMPS was also the commingling risk guarantor, in addition to being the originator. After being amended, the definition of eligible investment and eligible institution became inconsistent with Fitch's counterparty criteria for notes rated 'AA-' or above. As a result, the agency felt that the notes were no longer delinked from BMPS' rating.'s senior tranche amounts to about €1.7 billion.

Moody's has kept these notes at triple- A, even though it cut the ratings of BMPS to 'Baa1' from 'A2' in October 2011. Standard & Poor's has also noticed that there are originators that have not replaced downgraded counterparties in retained deals.

"This is a trend that we have seen and will continue to monitor," said Lapo Guadagnuolo, the lead analytical manager of European structured finance at S&P. "Our criteria, such as those covering counterparties, are clear and transparent about the rating impact resulting from any changes to a deal's original documentation."

Passive Acceptance

Originators, however, have not been observed actively working to weaken the structure of highly rated retained notes, players said. The phenomenon has been more one of passive acceptance.

On the flip side, there have been instances of originators actively strengthening deals in order to continue to qualify for ECB funding. "We've seen Irish deals pull NPLs out of structures to retain ratings," said Conor Downey, a partner at Paul Hastings.

Originators in Spain and Italy have been availing themselves of ECB funding most frequently in the past year.

"Issuers there currently can still get the triple-A," said Moody's Klotz, who also noted that while the new ECB rules allowed SME loan deals and RMBS to be repo'd at the single-A level, issuers were still shooting for a triple-A. He said it could be that issuers realize that if they get ECB funding with a single-A transaction, they are particularly vulnerable to defaults that could quickly put the single-A rating - and hence ECB funding - at risk.

But the terms are onerous for new issuance, with a series of fairly steep haircuts. Downey said that for a new deal a bank is lucky to get 50% of the value of the transaction.

Players also said that given the sovereign- provoked downgrades on the continent, finding counterparties that will enable a deal to get triple-A at issuance is becoming more and more difficult.

As Downey pointed out, even with the relaxed initial-rating criteria for RMBS and SME-loan-backed deals, the ECB still makes it harder for structured finance deals to be repo'd than for other kinds of debt such as covered bonds and straight vanilla paper from banks.

In addition, the ECB has expressed interest in widening the eligibility of whole loan pools for collateral funding. Downey said that the ECB has for a long time allowed loans from real operating companies to be repo'd but that loans to investment vehicles have not been eligible. If the Bank does allow for more loans originated by banks to be repo'd, the need for ABS funding in the less granular asset types could start to evaporate. "There would be a trend away from ABS repos," Downey said.

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