DBRS has released its methodology for rating U.S. letter of credit (LOC)-supported structured finance deals.
An LOC is a form of credit substitution or enhancement. Direct pay letters of credit have been utilized by municipalities and, more recently, by issuers of student loans.
In its approach, the rating agency reviews the terms of the LOC and analyzes its structural, operational and legal components.
In LOC-supported offerings, the LOC is an irrevocable obligation issued by a highly rated financial institution, which as the letter of credit provider, obligates the LOC provider to make both bond principal as well as accrued interest payments. This is aside from the obligation to redeem bonds under certain circumstances and to generally pay the tendered bonds' purchase price.
According to DBRS, if structured appropriately, an LOC effectively replaces the credit and liquidity risk of the bond issuer with the credit and liquidity risk of a usually higher rated LOC provider.
This is why in assigning and monitoring the bond ratings issued with this type of credit enhancement, the agency considers the both the LOC provider's long-term senior unsecured and short-term ratings, and not the bond issuer's financial strength or the structured cashflows supporting the bonds.
Direct pay LOC supported deals have various features including lessening credit exposure as well as bankruptcy preference and issuer default risks by replacing these with the higher rated LOC provider's credit exposure, preference, and default risks.
LOC funds used to pay bondholders are typically maintained in an account separate from all other trust held funds and transaction accounts and are lien-free, DBRS explained.
This factor protects bondholders from claims that the funds might be seen as the issuer's assets in case of an issuer’s bankruptcy proceeding. Outstanding bonds are bought by the LOC provider when certain events occur such as the expiration of the LOC, a change in the bonds' interest rate mode, or a substitution of the LOC by an LOC issued by another LOC provider, DBRS stated.
LOCs can be replaced or substituted when the LOC expires or terminates or when certain reductions in the LOC provider’s rating take place, according to DBRS.