Standard & Poor's latest study of post-default recovery levels in structured finance transactions marks its fifth default survey since 2001. The survey deals with cash flow characteristics rather than secondary market analysis and uses its original ratios to calculate loss severity and recovery rates.
"Our survey refers to the liability side of the repackaged securities rather than the underlying collateral," said Erkan Erturk, primary credit analyst at S&P. "We define the recovery rate as the cash flow that investors' receive as a percentage of the original balance, up to maturity."
Structured securities, unlike corporate issues, tend to suffer principal losses gradually over time, as poor collateral performance eats through the credit enhancement and erodes principal.
"In the corporate world, it is easier for creditors and debtors to get a snapshot once a Chapter 11 bankruptcy is filed," said Al Sawyers, a partner at Orrick, Herrington
The 2006 study includes updated default data. It covers 476 defaulted structured finance securities, up from last year's sample of 348.
Additional observations strengthen the trend between original ratings and ultimate recovery rates, and "provide better clarity on the relationship between ratings and defaults," Erturk said.
Higher ratings, on average, are associated with lower realized losses and higher principal repayments.
There is continued support for investors' expectations that recoveries in the secured markets are higher overall than those obtainable from corporate issues.
"While our study supports that theory overall, it may not hold for particular sectors," Erturk said.
He cited manufactured housing as an example, emphasizing that this is intuitive rather than explicit in the study.
For the first time the report separately examines securities that have matured, and either paid off or recovered, leaving no outstanding balance. Also, CDO data is now included, but to a limited extent. The average recovery rates for CDOs are the most variable due to the small sample size.
Most structured finance defaults occurred after 2001, with the impact of the 2001-2003 recession continuing to be seen in 2004. This lag indicates that it probably takes about three years of continued observation of the collateral to ascertain the full impact on the subordinates, though the senior tranches may continue to perform well.
"The distinction between tranches is a crucial one for investors, since seniors have less to worry about," Sawyers said.
While rating agencies may take satisfaction in the correlations between higher ratings and lower default rates, those conclusions may not directly serve what investors need to know.
"From their own perspective, the rating agencies are doing a good job, since so few well-rated loans get into trouble," said Michael Youngblood, a managing director of asset-backed securities research at Friedman, Billings Ramsey & Co.
For his investors, Youngblood tracks loss rates and loss severities of loans in the underlying pools.
"Even if the losses are never material enough to cause a default on the security, they will be sufficient to affect weighted average lives or durations," he said.
While every subprime security will see defaults on underlying loans, and some magnitude of realized losses, that performance will only show up on annual analytic or surveillance reports.
"Few will be defaulted in rating agency terms," Youngblood said.
There is another limitation in the study design: not every sector is best represented in the data. ABS data points are overly concentrated in manufactured housing and franchising loans.
Secondary pricing is hard to obtain. Without it there is no way to validate recovery expectations.
"We have to rely on the trustee reports to determine observed experience," Erturk said.
While the S&P study would take into account any recovery payments shown on trustee statements, recoveries from third parties might flow in later.
"How should one count recoveries from third parties?" asked Mark Adelson, director-head of structured finance research at Nomura Securities.
Adelson cited the example of Commercial Financial Services, a company that securitized credit card receivables through 13 transactions under the name SMART (Securitized Multiple Asset Rated Trust). In 1998, CFS filed for bankruptcy and the SMART transactions got pulled in.
"It looked like the investors would only get back 7%. But they sued the dealers and trustees and ended up recovering about 70% from third parties," Adelson said.
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