Duff & Phelps is set to drop its requirement that for an asset-backed securitization from a non-triple-A jurisdiction to win a triple-A rating it must incorporate an originator-funded offshore liquidity reserve until it pays down, according to an upcoming report from the agency.

Instead, Duff may only insist that the offshore reserve is temporary, with originators obliged to "fund the liquidity reserve for several months at first, and if the local currency rating drops to a certain level, the reserve would fill up with the excess cash flow of the deal," explained Greg Kabance, vice-president of international structured finance in Hong Kong. "This way, the bankers and issuers are happier because it makes the deal more economical, and we are comfortable because we're setting the trigger tight enough so that it's still investment grade."

The agency clarified its criteria in response to demands of the Hong Kong mortgage-backed market (the agency rates Hong Kong at single-A plus), but the concept will be applicable to other countries. Until now, it maintained that only securitizations with external credit enhancement, such as an offshore cash reserve for the life of the deal or a monoline wrap, can breach the local currency sovereign rating. However, that requirement was not economical for many arrangers, Kabance added.

The clarification comes on the heels of a recent report detailing why Duff believes some form of external enhancement is necessary to allow ABS deals above the local currency rating of the sovereign, using residential mortgages in Hong Kong as an example. Traditional forms of credit enhancement are not enough to guard against so-called event risks such as political interference or a breakdown in the country's legal or banking system that often follow a sovereign default, said the agency.

In Hong Kong's case, such risks could interrupt the cash flows in MBS deals, where the government is heavily involved in the property market and faces the possibility of political interference from mainland China. For that reason, attaining a triple-A rating for a Hong Kong transaction would be impossible without external credit enhancement, concluded the agency.

The issue of whether transactions should be rated over the local sovereign ceiling without an offshore liquidity reserve or a wrap splits the international rating agencies down the middle, with Standard & Poor's and Duff on one side and Moody's and Fitch IBCA on the other. Moody's and Fitch are happy to rate deals above the sovereign ceiling, as long as a swap counterparty is in place to mitigate the currency convertibility, substitution and transferability risks. - VC

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