By tweaking one aspect of its methodology for rating securitizations, Moody’s Investors Service has set the stage for more downgrades of deals issued out of peripheral Eurozone countries.
The agency is seeking to more fully incorporate country risk into deals, in particular folding in the rare probability of any number of extreme scenarios, such as bank collapses and currency redenomination risk.
“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.”
Shortly after announcing the changes in mid March, the agency put 60 tranches on review for downgrade in the economically beleaguered countries of Spain, Italy and Ireland. Some 41 of the affected tranches are in residential mortgage-backed securities transactions, while seven are asset-backed deals.
What is more, the new approach will be folded into peripheral European ABS and RMBS that had been put on downgrade review last year.
The agency said it expected the adjusted methodology to generally lead to three-notch downgrades.
In a separate report, the analysts at Bank of America Merrill Lynch welcomed the new methodology as an improved approach to incorporating sovereign risk into securitizations. They added: “[It also] addresses the concerns we had regarding rating compression due to the lowering of [local currency credit ceilings] in the European periphery.”
What’s Behind the Changes
In a March 11 special report, Moody’s explained that there were deals located in countries where its standard analytic approach was insufficient. To better reflect the true risk faced by these transactions, Moody’s added two metrics: the local currency country risk ceiling (LCCRC), and a minimum level of credit enhancement (MCE) for particular asset classes and markets.
Moody’s pointed out in the report that key to understanding the impetus for the methodology adjustment is the strong interplay between a government, macroeconomic conditions, and a country’s banking sector. “The occurrence of one event often worsens the condition of another...potentially creating a vicious cycle,” it said.
Given what has happened in Greece, and more recently the anxiety surround a bank tax in Cyprus, it is easy to see how these events can feed off each other and push an economy toward a catastrophe.
The flow chart on the next page shows the factors under each category that can generate a dangerous feed-back loop with each other.
Although exceedingly rare, a severe event such as a messy government default or banking system collapse can contaminate a structured finance transaction in a number of ways, Moody’s said.
For starters, it can drastically weaken asset performance. A government under stress, for instance, may choose to impost austerity measures that will send unemployment up and hurt consumer asset performance.
Financing availability can get strangled as well. Banks headquartered in a distressed sovereign — whether they were the cause of the distress or not — are often ill equipped to keep extending credit.
In addition, macroeconomic crises can eat into asset values. “The reduction in value can impair the performance of structured financing transactions where proceeds from the sale of assets are essential for making payments on the rated securities,” the agency said.
And finally, banks and other potential counterparties in structured finance transactions are vulnerable to downgrades in times of crisis. This is yet another channel of contamination for ABS and MBS.
As a result, in those countries where there is a possiblity — however slim — of a severe event, securitizations will not be able to achieve a level of ratings as high as they could previously.
Local Currency Country Risk Ceiling
“[The LCCRC] broadly addresses risks in a given sovereign that arise from political, institutional, financial and economic factors within or affected on that country,” Moody’s said. It added that these risks run the gamut from political instability to expropriation of assets to currency redenomination.
In an apparent nod to the peripherals, the agency even cited as one of the extreme risks the possible exit of a country from a monetary zone.
The LCCRC is a metric that neither portfolio diversification nor credit enhancement can mitigate.
Minimum Credit Enhancement
Moody’s uses a specific credit enhancement level to come up with a loss distribution for portfolios affected by sovereign risk. “For specific asset classes in specific jurisdictions, we determine minimum credit enhancement amounts commensurate with losses associated with the [LCCRC],” the agency said. “We use minimum credit enhancement for structured finance transactions whenever we believe our traditional methodologies do not capture the full extent of risk.”
And as the agency sees it, even a track record of asset performance does not speak to what can happen in a rare severe scenario.
The minimum credit enhancement for deals in a given country is also derived from where that country ranks in a number of metrics. “We expect defaults and losses to be lower in a sovereign with...greater economic or institutional strength or lower private sector debt leverage.”
Other factors are brought to bear as well, such as the higher vulnerability of some asset classes to macroeconomic and government distress than others.
The upshot is that higher enhancement will be needed for deals within certain troubled countries to achieve the same ratings as before, and in many instances, no enhancement will save deals from downgrades, especially where the country ceiling has fallen.
“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 the 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.
As BofA Merrill explains in its interpretation of the new methodology, “a lower LCCRC...does not necessarily mean lower minimum credit enhancement — in fact the credit enhancement may remain the same even if the maximum rating is much lower in order to reflect the rail risk (higher probability of a high loss scenario).”
This should lead to a more consistent stress from senior to subordinated.
“It’s the whole loss distribution that’s affected [and] you have to factor more losses throughout the capital structure,” said Moody’s Senior Credit Officer Ning Loh.