Standard & Poor's recently affirmed its existing AAA' ratings on all Japanese asset-backed, mortgage-backed, and commercial real estate-backed issues (77 public ratings in total) following the downgrade of Japan's sovereign local and foreign currency ratings to AA+' with a stable outlook on Feb. 22, 2001 (see note below). The ratings affirmations are based primarily on the robust credit enhancement levels imbedded in these highly structured financings. Such enhancement levels, which serve as a first-loss equity cushion protecting investors from defaulted receivables in the underlying asset pools, are deemed sufficient to allow for full and timely debt repayment, even under a scenario where the government is unable or unwilling to meet its own debt obligations. The securitization market's strong performance in Japan over its eight-year history provides additional evidence of these securities' inherent credit quality. In total, risks stemming from the worsening economic conditions in Japan are fully incorporated in the stress assumptions underpinning Standard & Poor's ratings on domestic and cross-border structured transactions. Key elements of economic stresses that may lead to a deterioration in pool performance, financial system disruption, or capital controls have also been factored into Standard & Poor's analysis and ratings of these issues.

As is the case with rating traditional issuers of debt, rating structured transactions above the sovereign implies that the structured obligations - asset-backed, mortgage-backed or commercial real estate-backed securities - would continue to perform in an economic scenario in which the government itself has defaulted. For most structured issues, the primary risk deriving from a sovereign stress scenario is that the same macroeconomic factors that underlie a sovereign default are also likely to lead to deteriorating credit performance in any securitized asset pool whose underlying obligors are domiciled in that country. Because the performance of the underlying assets is assumed to weaken because of a more difficult economic environment, credit enhancement levels might have to be raised to offset these higher risks and justify a given rating level.

Enhancement levels provide AAA'

In the case of Japan, existing stress assumptions have already factored in severe recession-type scenarios that do not require further tightening in the context of a marginal revision of the sovereign rating from AAA' to AA+'. The historical delinquency and charge-off data upon which Standard & Poor's expected case and worst-case loss assumptions are based already reflect a somewhat stressful economic environment. In some cases, additional stress is applied to account for a company's lack of abundant and reliable historical performance data. In other cases, a company's operating practices cause additional uncertainty. For example, a discretionary or inconsistent charge-off policy may make it difficult to quantify the actual amount of losses that would be incurred by a securitized asset pool. In such a case, unless the issuer is able to restate its actual losses to reflect a more standard charge-off policy, losses would be estimated by adding together actual historical charge-off rates and late-stage (over 90-day) delinquency rates.

Additionally, most Japanese ABS and MBS receivables pools that are secured by some form of hard collateral, such as automobiles, equipment, or homes, do not benefit from recovery credit normally granted as a result of the foreclosure and liquidation of such collateral upon an obligor payment default. This is due to certain legal, structural, or other practical concerns, which may prevent the securitization vehicle from realizing recoveries under a worst-case scenario. Therefore, the stress multiples that are typically used to develop a worst-case loss scenario (typically three to five times the base levels under a AAA' scenario) are actually being applied to a gross default amount rather than to a net default amount. Most Japanese structured transactions also benefit from additional credit enhancement, usually in the form of both cash reserves and overcollateralization, which is intended to cover liquidity and operational risks resulting from a servicer bankruptcy. In each of the above cases the enhancement, while sized to cover a specific risk, is typically not segregated - thus creating a large, fungible pool that is available to cover any investor payment shortfall, be it credit or noncredit-related.

Moreover, a structural strength inherent in many Japan ABS and most MBS structures is that 100% of principal collections from the underlying asset pool is allocated sequentially to pay down the most senior debt tranche. Thus, credit enhancement protecting the most senior tranche grows over time as a percentage of outstanding debt, provided the worst-case credit scenario doesn't materialize.

Multiple layers of protection

Commercial real estate-backed securitizations (CMBS) require a somewhat different analytical approach, in part due to the operating company characteristics inherent in these structures. The ability to cover current debt service is measured by the level of property cash flows relative to scheduled principal and interest (debt service coverage ratio), while the ability to repay ultimate principal is based upon the ability to refinance, or in a worst-case scenario, liquidate the property. The advance rates (loan-to-value ratio) assure that the property value can support ultimate principal repayment. As with ABS and MBS, the stress tests applied to the key variables impacting cash flow and ultimately the property valuation (lease, occupancy, and discount rates) are based largely on historical trends, which are already reflective of an unfavorable economic environment.

No defaults thus far

The strong credit quality of Japanese structured financings is further supported by this sector's stellar performance over its eight-year history. To date, there have been no defaults on any securitization issues rated by Standard & Poor's in Japan. In fact, there have been no downgrades or CreditWatch Negative actions on any Japanese securitization issues based on asset pool performance. Such rating actions were taken only in cases where a third-party guarantor's rating was downgraded. There have even been three instances where a servicer bankruptcy (Hokkaido Takushoku Bank Ltd., Japan Leasing Corp., and Life Co.) resulted in no payment defaults, investor losses, or rating changes. Given both the credit enhancement levels built into most structures to date, as well as the securitization market's strong historical track record in Japan across all asset classes, Standard & Poor's will continue updating its structured finance criteria to reflect these positive factors.

Low sovereign risk

In addition to the risk of deteriorating pool performance in relation to sovereign stress, a second critical rating concern impacting on structured ratings is the possibility of disruption in the financial system (e.g. freezing of bank accounts), which would prevent even able and willing obligors from making full and timely debt payments. Indeed, the governments of Brazil and Ecuador, among others, have invoked such measures during times of fiscal crisis. Such drastic government intervention in Japan, however, is deemed highly unlikely at this time. In other words, the risk of financial system disruption in Japan remains extremely remote.

A third type of risk, only relevant in the case of cross-border transactions, is that of restrictions on foreign currency transfer or convertibility. This arises as a result of direct sovereign intervention acts such as foreign exchange controls, a foreign debt moratorium, or any other measure the end-result of which is to prevent access to the foreign exchange needed for timely debt service. In cases where the securitized assets are local currency denominated and domiciled onshore and the rated debt is denominated in another currency, this risk can be addressed through a properly structured currency swap provided by an A-1+' rated swap counterparty or an appropriately collateralized swap structure that satisfies the requirements of a AAA' rated transaction. However, it is noteworthy that most currency swaps imbedded in cross-border securitizations allow an exclusion for "illegality" or "inconvertibility." This represents a structural weakness which may allow the swap counterparty to terminate its obligation to make the foreign currency investor payments in the event that exchange controls are imposed, even though it has received payment of yen from the securitization vehicle. However, stronger swap structures have emerged that require the counterparty to pay foreign currency regardless of any imposition of exchange controls so long as it receives payment of local currency. Such a structure should not pose a problem for large international banks since they can receive yen payments in Japan through a local branch and make foreign currency payments through their head offices or offshore branches. Notwithstanding these specific concerns, however, there is no impact at this time on any outstanding Japanese cross-border structured issues. Given the status and degree of integration of the yen in the world financial markets, Standard & Poor's views the risk of Japan directly intervening to limit the convertibility or transferability of the yen as being even more remote than the risk of a sovereign default.

Standard & Poor's will continue to closely monitor the performance of all of its rated Japanese ABS, MBS, and CMBS issues, based on the performance of the underlying asset pools securing those transactions, the legal structures they employ, and potential impact that the general economic situation in Japan may have on the credit quality of those transactions.

Note: In a separate action, Standard & Poor's placed four transactions (Maestro Securitisation Corp., MCL Auto Loan Funding Corp., OM Corp., and Soleil Funding Corp.) on CreditWatch owing to the type of swap arrangements they employ on the same day Standard & Poor's existing AAA' ratings on all ABS, MBS, and CMBS were affirmed. The transactions were placed on CreditWatch following the lowering of the ratings on First Chicago Tokio Marine Financial Products Ltd. to AA+' from AAA' with a negative outlook on Feb. 23, 2001.

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