Moody’s Investors Service has changed how it incorporates sovereign risk into structured finance transactions.
The tweaked approach will inevitably result in some ratings downgrades. “The biggest impact will be in Europe, where the local currency ceilings have moved,” said Neal Shah, managing director at Moody’s. “And if we see material developments across the globe we’ll have to consider how to apply the framework.”
Transactions linked to the peripheral countries - Greece, Portugal, Spain - seem likely to fare worse.
Certain deals, then, might need more enhancement than before to earn - or hold on to - the same ratings.
“If a maximum achievable rating of ‘Aaa(sf)’ previously corresponded to a 10% credit enhancement, a 10% credit enhancement would correspond to a new maximum achievable rating of ‘Baa2(sf)’ in order to recognize an increased probability of high loss scenarios,” the agency said in a report.
The modified methodology comes after the agency collected feedback from market players on how the fast erosion of a country’s credit strength can contaminate structured deals.
Moody’s is using additional factors in its analysis “to account for the impact of situations where the availability of information limits the predictability of severe stress scenarios in a given country and prevents the use of our standard analytical approach.”
The additional factors are the cap on the local currency rating of a transaction and the minimum level of credit enhancement for a given asset class and market. The local currency country ceiling is cap on the rating of structured deals backed by domestic assets. It covers non-diversifiable country risks.
As Moody’s points out epically catastrophic events — such as a messy government default or collapse of a banking system — may be rare but they can hammer away at the performance of asset pools, choke off avenues of financings, and send asset values plunging.
All can severely destabilize a deal, pushing up losses and compromising its ability to repay investors.
This is where the local currency ceiling and credit enhancement come in. “The possibility of low probability, severe events occurring constrains the maximum rating a transaction can retain or achieve, [while] the minimum credit enhancement addresses the potential severity of losses arising from stressed events that historical asset performance does not always reflect.”
Moody’s Senior Credit Officer Ning Loh said that in a sovereign risk scenario under the changed methodology “it’s the whole loss distribution that’s affected [and] you have to factor more losses throughout the capital structure.”