Recent bank failures have cast doubt on whether existing structural mechanisms are sufficient to protect securitization transactions from the credit risk of the counterparties on which they rely. In cases where Lehman Brothers and certain Icelandic banks were a crucial counterparty, for example, existing mechanisms did not protect structured finance bondholders from downgrades and in some cases defaults.
Esoteric and off-market counterparty positions have been a feature of structured finance transactions for some time.
Sourcing replacement counterparties for the most "plain vanilla" counterparty exposure in the current market environment is difficult. Finding replacement counterparties for esoteric and off-market positions, in particular, would be very unlikely.
Fitch is seeking feedback on an exposure draft published last month in which the agency outlines a number of possible options through which counterparty risk could be addressed in structured finance transactions. This article provides a summary of the Fitch proposals detailed in the exposure draft.
Recent counterparty failures have had a material impact on exposed structured finance transactions and the principle of "isolation" that underpins structured finance. Achieving such isolation is now more difficult than ever.
A key assumption of Fitch's current counterparty criteria is that a rated counterparty would not "jump to default" from a high investment-grade rating level of 'A'/'F1', but would be expected to see a more gradual decline in credit quality following a downgrade below this level sufficient to allow remedies to be pursued within a 30-day window. However, there are a number of recent examples where highly rated bank counterparties defaulted within a shorter period due to liquidity problems.
Meanwhile the widespread use of rating triggers, which are also incorporated in a number of financial contracts outside of structured finance, can themselves exacerbate "cliff risk". Counterparties downgraded below the rating trigger are often required to post collateral, which, at a time of financial distress, may contribute to further counterparty credit deterioration, thereby potentially becoming a "self fulfilling prophecy". As a result, the "success" of rating triggers may itself have undermined their effectiveness.
Other examples of lessons learned relate to assumptions regarding the replaceability of counterparties, the need for clear counterparty operational guidelines and the extent of transaction risk embedded with counterparties and their capacity to fulfill remedies in the event of a trigger breach.
There is no single "one size fits all" solution, but rather the specific counterparty exposure position needs to be assessed for each transaction. In assessing this position, Fitch will separate counterparties into three basic categories, based on the role(s) each entity has in the transaction:
* Swaps and other derivative counterparties;
* Direct support counterparties such as issuer account banks, liquidity facility providers and guarantors; and
* Other indirect support counterparties such as collection account banks.
Fitch's primary proposal for swaps and other derivative counterparties sees any counterparty rated at least 'BBB+' and 'F2' as an eligible derivative counterparty, provided that collateral is posted - with at least weekly updates - from day one of the securitization transaction. Counterparties that are at the minimum rating level and on Rating Watch Negative (RWN) or Negative Outlook would not be eligible as counterparties for new transactions, due to the prospect of potential near-term disruption to the transaction.
While this proposal will, in Fitch's view, not eliminate counterparty dependency, it will nevertheless substantially reduce the relative risk and thereby support the "isolation" of a structured finance transaction from its counterparty, and hence allow for all ratings, including 'AAA'.
Among other positives, this offers increased protection not only against gradual credit deterioration, but also reduces "jump-to-default" risk. Meanwhile, any contribution to "cliff risk" by rating triggers is significantly reduced as collateral will be posted continuously on a gradual basis from closing rather than in one go on breaching a rating trigger.
Esoteric or non-market swaps would likely be discouraged. Due to the costs associated with posting collateral, there would be an incentive to create structures that reduce counterparty dependency and risk, which would maximize the possibility of replacement. Meanwhile, the universe of potential counterparties would be expanded due to the lower rating eligibility threshold than that currently in place.
However, a drawback is the increased transaction cost. The concept of posting collateral from day one would also be new for the structured finance market and could cause some initial market disruption.
Alternative options to address swap counterparty risk in structured finance transactions include raising the Issuer Default Rating (IDR) threshold for the existing trigger or introducing a support rating floor component, based on willingness and capability for government support, to the trigger.
In Fitch's opinion, these options are on an individual basis potentially weaker than ongoing collateral posting from day one, either because they would still leave structured finance transactions exposed to a degree of counterparty risk or because they have other disadvantages that Fitch believes render them less effective than Fitch's specified primary option.
However, rating trigger-based systems are well established and familiar to the market and the combined use of a higher threshold IDR trigger and a SRF minimum would have overcome recent "jump-to-default" experiences.
Direct Support Counterparties
In relation to direct support counterparties, which generally provide material direct credit or liquidity support to securitization transactions, Fitch proposes an IDR-based rating trigger. This alternative is essentially equivalent to Fitch's current counterparty criteria. However, based on the lessons learned and the significant counterparty dependency it is proposed to increase the rating trigger level to 'A+'/'F1+' or to provide an overlay with support rating floors.
Although an increased rating threshold for the trigger would reduce the potential pool of counterparties for these functions, the nature of the exposures in this section is more straightforward than most derivative counterparty positions and therefore replaceability may be less of a concern. The "jump-to-default" risk is to some extent still present, but in Fitch's view this is mitigated through the higher rating threshold or the availability of support.
For account banks, an alternative to an IDR trigger approach could be the creation of effective trust or escrow account structures that would clearly isolate the account in case of the insolvency of the bank. This would mitigate the credit exposure such that the counterparty risk is reduced to operational and liquidity factors such as the potential for a "stay" or other obstacles that could prevent timely access to funds or collateral. Additional mechanisms such as a liquidity facility or reserve account from a different counterparty could be used to overcome such obstacles. A key advantage is that few additional mitigating factors are needed if effectively established. However, trust and escrow accounts are not available for all jurisdictions and there is the potential for complications in the legal creation of the trust structure.
Typically originators look to fulfill one or more material direct counterparty roles for their own-originated transactions. Where an independent counterparty fulfills the role, this provides some comfort that no undue reliance on a single counterparty is present and that the function would find another independent counterparty replacement. This is not the case with originator counterparties. Fitch believes that for originators to act as counterparties for a material role within their own-originated transactions, further information and comfort should be provided.
Where several material roles are performed by a counterparty, then it may not be possible for the transaction to be effectively isolated from the risk of that counterparty. This is because of the considerable operational disruption that the demise of the counterparty could bring to the transaction, where so many material counterparty roles would need replacement simultaneously.
Even if structural mitigants are present, transactions may not achieve an effective isolation and ratings higher than a particular counterparty, if Fitch determines that an excessive dependency on such counterparty exists. Such analysis would be detailed in rating action commentaries and reports.
Indirect Support Counterparties
Other indirect support counterparties are those that perform ancillary, albeit crucial, roles to the transaction. This includes all functions that are not included in the direct support or derivative categories above. The counterparty roles and functions include, among others:
* Collection accounts;
* Qualified investments, provided they do not accumulate to substantial amounts;
* Paying and calculation agents; and
* Servicer and trustee advances.
Reserve accounts or funds providing liquidity support would be classified as direct support counterparties.
This category of counterparties has available structural mitigants similar to the ones already explored. Furthermore there is a huge variety of these counterparty roles and specific remedial action tailored to their specific counterparty risk may be needed.
Fitch's report Exposure Draft: Counterparty Risk in Structured Finance Transactions, which is available at www.fitchratings.com, expands on this article. Fitch is seeking market feedback on these proposals. Feedback can be sent to 'firstname.lastname@example.org', the deadline for comment is May 29.
Fitch recognizes that changing counterparty criteria with respect to its structured finance ratings could have a fundamental impact not only on its new and existing ratings, but also on the way market participants choose to address counterparty risk when structuring transactions. The intention of the report and this article is to open a dialogue with the market on this issue. The information gathered will be factored into developing the final criteria amendments.
Stuart Jennings is a managing director and risk officer for Fitch's EMEA structured finance group.
Andreas Wilgen is a senior director in Fitch's EMEA structured finance group.
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