The Lehman Brothers bankruptcy was a turning point for the securitization market as counterparty risk assumed a role more important than any investor could have ever imagined.
In the aftermath, players must now rethink how to best isolate counterparty risk from a structured finance transaction.
The peak of the disaster was reached with Lehman's default and the so-called jump-to-default risk, which meant that Lehman was effectively removed from the market overnight. This jump-to-default risk negatively impacted the mechanisms of posting collateral, as well as limited the time to find other solutions. This meant that no gradual triggers were breached and various supporting measures were not used, as would be the case in the normal course of action. For example, if a swap counterparty is downgraded, then that entity would be required to post collateral or find a guarantor or a replacement.
"Lehman Brothers was involved in the issuance of a number of U.K. nonconforming RMBS as well as Dutch transactions," Barclays Capital analysts said. "Even though these were all standalone and effectively bankruptcy remote from the originator, various Lehman subsidiaries were acting as counterparties in these transactions in addition to acting as counterparties in a number of other transactions, particularly as a swap provider."
Lehman was also one of the most active counterparties in the CAT bond market. Although the sector performed well, fundamentals were strong and spreads attractive, Lehman's default negatively impacted transactions and temporarily damaged the sector's future outlook, making issuance too expensive for originators. The jump to default by Lehman Brothers also caused nine European CMBS transactions to lose counterparties. The loss caused the issuers to become un-hedged on interest rates or currencies or both.
According to transaction documentation, counterparties downgraded below the rating trigger usually needed to take mitigating action within 30 calendar days. The preferred remedy is posting collateral, at least initially. However, the need to fund collateral in the current environment can prove difficult since the ability to obtain additional funding to fulfill collateral posting obligations might be limited.
"As a result, the collateral commitments upon trigger breach can risk surpassing available liquidity and thereby contribute to a downward spiral of credit quality," Fitch Ratings analysts said. "The effect of these issues is compounded by the widespread use of rating triggers in a much wider universe than just rated structured finance transactions. Thus, the breach of rating triggers themselves can contribute to further counterparty credit deterioration, thereby potentially becoming a self-fulfilling prophecy."
The more widespread use of rating triggers has accelerated in recent years. "At the time when structured finance counterparty criteria were originally developed, rating triggers were largely used only in the domain of structured finance and, as such, were not generally viewed as such a major contributor to 'cliff risk,'" analysts said.
"Their more general market-wide use, in and of itself, means they can now exacerbate 'cliff risk' considerably when breached and have therefore potentially eroded the capacity to affect specified remedies following a breach within the given timeframes."
Before the Fall
Currently, structures include counterparty risk mitigants such as rating triggers, which lead to certain actions if the counterparty's rating is downgraded. In this case, the triggers specify a combination of replacing the counterparty, finding a guarantor for the counterparty obligation or posting collateral.
"As we have seen during the crisis, these triggers have not always helped to reduce the impact on the transaction: counterparties were not willing to take on more exposure, especially in the riskier structures, financial guarantors were downgraded to junk and counterparty downgrades were sometimes many notches, negatively impacting the collateral posting mechanism," said Markus Ernst, a senior ABS research analyst at Unicredit.
Issues such as replacement of swap providers have proved to be difficult in the current environment. "As the number of eligible counterparties diminished, it questioned our assumption of replaceability," said Andreas Wilgen, senior director in the structured finance group at Fitch. The remarks were made at a teleconference hosted by the rating agency in London last month.
To be sure, even six months after Lehman's fall, the trustee and servicer of its sponsored CMBS transactions have been unable to find a replacement counterparty. While this does not immediately threaten the deals, over the longer term, the concern is that without a new swap counterparty, the junior noteholders might become exposed to losses.
According to market analysts, as far as the fixed to floating interest rate swaps in the two deals are concerned, it is likely that, for now, the SPVs will be earning more on the fixed-rate assets (typically 5%) than they pay to floating-rate noteholders. In the long term, however, floating interest rate liabilities may exceed fixed-rate assets, and the SPVs would lose cash to the detriment of junior noteholders.
The servicer, Wilmington Trust, and the trustee, LaSalle Global Trust Services, released a statement saying it was "taking longer than previously anticipated to complete the termination and replacement of the swap agreements, including finding an appropriately rated replacement swap provider." This was because of the "uncertain and changing economic climate and the recent ratings downgrades of various financial institutions," the statement said, adding that it was unlikely the replacement swap agreement would be completed prior to April's payment date.
In December, Standard & Poor's downgraded the class E and F notes to 'D' following a note interest shortfall that occurred for reasons connected with the Lehman insolvency, including nonpayment under the swaps. As a result, the cash manager drew liquidity to meet shortfalls in interest due under the class A to D notes but not the class E and F notes.
Since then, S&P said that the liquidity documentation has been amended to clarify that liquidity will be available for the class E and F notes. As a consequence, on the January interest payment date the interest due on the class E and F notes was paid in full and the October shortfall was made whole.
"Total liquidity facility drawings currently stand at E2.3 million [($3 million)]," S&P said. "We understand that the issuer and its financial adviser expect to replace the issuer-level swaps by the next interest payment date in April. Depending on the new swap arrangements, there are scenarios in which sufficient excess cash may be generated to repay the liquidity facility that was tapped as a result of the Lehman insolvency."
If sourcing replacement counterparties for the most "plain vanilla" counterparty exposure in the current market environment is difficult, Wilgen said that esoteric hedging structures in particular would need special attention as "replaceability" is all the more doubtful. On the one hand, defining esoteric created a challenge in itself, Wiggin said, because what was not counted as esoteric one day could evolve as such the next. However, a high degree of optionality and conditionality or credit support are strong indicators of esoteric structure.
Solutions Ahead
After a detailed review of these existing mitigants, analysts at Fitch proposed that the winning formula for beating counterparty exposure might be in using the right combination of mitigants to maximize a transaction's isolated position. The rating agency has outlined different solutions to facilitate market transparency and avoid potential negative issues related to counterparty risk in adverse scenarios and currently has a draft of these proposals out for market commentary.
The new criteria options address the potential interaction between rating triggers and "cliff" risk, which has been highlighted by recent bank failures. This relationship can itself undermine the effectiveness of rating triggers as a mitigant, as the extent of actions that have to be taken on trigger breaches can further impact the counterparty's credit profile in the near term.
The agency has suggested posting collateral from day one, raising triggers to a higher level and supplementing rating triggers with Fitch's "support floor" ratings. Fitch said that the aim behind its revisions is to further promote the isolation principle of structured finance and reduce counterparty dependency, and also reduce the risk of contributing to the vicious cycle of decline in credit quality profiles of counterparties themselves.
"None of these remedies eliminates counterparty risk completely, which is probably impossible, but they present enhancements to the current approach that incur the lessons learned," Fitch's Wilgin said.
In the absence of structural remedies, Fitch plans to cap the securitization note ratings at the lowest counterparty rating, or treat it similarly to a secured corporate obligation incorporating potential high recovery prospects and analyze the transaction in the absence of the support provided by the counterparty (this may be feasible for only some of the counterparty roles).
For swaps and other derivative contracts, Fitch proposed two options. The primary option calls for collateral posting on day one. For CDS transactions (termination), the collateral ensures that the automatic termination does not result in a loss to noteholders. For other swaps and other hedges used in cash structured finance, the collateral should allow for appointment of replacement counterparties. The collateral amount would increase if the rating falls below an threshold.
Possible alternatives suggested by the rating agency would be to supplement the current criteria with IDR-rating-based triggers at a higher threshold, e.g., 'A+'/'F1+', and analysts explained that a Support Rating Floor in the 'A' category can indicate that the likelihood of a default is sufficiently remote to support 'AAA' ratings. "Neither Lehman or Iceland would have had the support ratings floor and would therefore not have been listed as a counterparty," Wilgin said.
One market source added that by adjusting a bank's existing underlying rating to allow it to be more forward looking and proactive, events such as the Lehman default could have been avoided. "In the case of Lehman, had the ratings been adjusted prior to the final situation, we would not have had the jump to default situation," he said.
Clearing houses may present an alternative in the future, although Wilgin added that these alternatives have a larger degree of downside to them.
Proposal Under Review
Fitch said that it recognized that "there is no single 'one size fits all' solution and said that the specific counterparty exposure position needs to be assessed for each transaction. Changing the 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.
Once new criteria changes are in place, Fitch said existing ratings will not be "grandfathered" - instead, a grace period following the implementation of the new criteria will be applied. The ultimate impact on transaction ratings will depend on the final position in relation to the new counterparty criteria when published after the consultation period, the materiality of the counterparty exposure to the transaction and the extent to which counterparties choose to comply with the new criteria.
One market source, however, questioned the willingness of counterparties to go along with the changes proposed. "Once the new criteria changes are in place, if collateral posting is the final route to take for the third-party bank providing post-currency swap arrangement to a few deals, will it actually be contractual to follow the new criteria?" he asked. "If banks say this is too much, can they walk away from it and leave the rating to do whatever and not post collateral?"
Stuart Jennings, director in the structured finance group at Fitch, said that these were issues that Fitch was considering. "How far beyond strict contractual obligations might banks be prepared to go or decide just not to it," he said.
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