Downgrades on subordinated tranches may be more severe for European structured finance transactions with interest subordination triggers than for those without, Fitch Ratings analysts said.

Interest subordination triggers are common features across all European structured finance sectors and countries.

These triggers are designed to protect senior investors by allowing for the re-allocation of subordinated notes’ interest to a lower level in the priority of payments.

This helps maintain amortization of senior notes’ principal if defined cumulative default thresholds or principal amortization deficits are breached. When a transaction includes multiple subordinated notes, each subordinated note will have its own defined trigger.

The recent interest deferral trigger breaches on three classes of notes, one issued by Madrid RMBS II and two by Madrid RMBS III, have caused investors to take a closer look at this structural feature.

The breach of these triggers was caused by the significant deterioration in collateral performance in these high loan-to-value (HLTV) pools as well as the short six-month default definition employed in these transactions .

“Performance-related triggers which push subordinated notes’ interest payments down the priority of payments offer extra protection to senior notes’ principal when performance is deteriorating sharply," said Rui J. Pereira, head of the Spanish structured finance team at Fitch. "Therefore, the credit position worsens for the subordinated notes once the triggers are breached, to the point that interest deferral may occur. Where such triggers exist and performance is deteriorating rapidly, the rating of the subordinated notes could see sharper adverse rating action than those of transactions without such a trigger.”

Pereira said that the probability of such trigger breaches and any related rating actions will depend on the credit performance of each individual transaction, the manner in which triggers are defined, and the absolute attachment points of such triggers.


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