How much higher can a rating agency grade a structured finance deal over its respective sovereign? While a perennial topic in emerging markets, it has not historically been a big issue in Europe.

A rash of downgrades could be making it one.

With Greece grinding ever closer to default, Portugal and Ireland split-rated between investment grade and junk, and other countries knocked off their triple-A or even double-A pedestals, there are now legions of transactions in Europe rated several notches above the sovereign where their assets are domiciled.

In the case of Greece, at press time the differential went so far as eight notches at Fitch Ratings, where the country is 'CCC', and nine notches at Moody's Investors Service, where it was 'Ca'. At Standard & Poor's, the potential spread between the highest-rated Greek deals and the government was also nine notches.

The consensus is that a default-related pullout from the euro would compress, if not eliminate, the ratings differentials at all three agencies, resulting in downgrades for Greek ABS and MBS. It would also lead the agencies to revamp their approach to Greek deals.

But some players are the starting to question whether the uplifts enjoyed by Greek structured deals are already too big, given the current risk of Greece exiting the euro. They may also be too big to reflect the less traumatic scenario of Greece defaulting while staying in the euro.

Others are comfortable that, on a deal-by-deal basis, ample enhancement and robust collateral provide a fairly effective shield against the stresses that would be unleashed by the government's default. Pricing in the secondary market also seems to bear this out.

Greece's borderline-default rating explains the wide span between the agencies' ratings on its sovereign debt and structured finance deals, which is novelty in the eurozone. The differential tends to be no more than six notches for other European sovereigns below the 'A' category and their respective structured finance deals.


Mining the Gap

In general terms, rating a structured finance transaction above a respective sovereign implies that the transaction could continue to perform even if the government has defaulted on its obligations.

All the agencies allow for wider differentials for deals in the eurozone than those in emerging markets.

"We believe that the credit risks of operating or investing in a European Monetary Union member, or country risks, are less closely correlated to sovereign creditworthiness than in other regions," said S&P in a report that explained this exceptionalism. "A number of factors mitigate country risk, including but not limited to lower foreign exchange risk...and an institutional framework that would support transactions."

S&P analysts did not return a request for comment on this article.

Fitch, for its part, determines the structured finance ratings cap for countries, which must take into account the overall country ceiling for all kinds of transactions. Sovereign analysts set the country ceiling.

"The main difference with emerging markets is that the eurozone has a country ceiling of triple-A," said Marjan van der Weijden, head of EMEA structured finance at Fitch. "Because it's all one currency, transfer and convertibility (T&C) risks are vastly reduced."

The country ceiling captures the risk that a country could impose exchange controls, which in the agency's view is significantly reduced in the eurozone. "While risks of redenomination and other forms of political interference could arise in those countries, Fitch considers these on a case-by-case basis," the agency said in a report on its methodology. As with S&P, Fitch sees the free movement of capital, along with a strong institutional and political framework, as sharply cutting the risk of exchange controls.

For cross-border deals, T&C risks in emerging markets, in contrast, loom larger for Fitch and its peers. Their country ceilings - which are generally closer to the sovereign ratings than in the EMU - very much take into account the hazard that a country would impose exchange controls.

One atypical rating that Fitch applies to structured finance deals in emerging markets and not in Europe is the challenge factor, which the agency assigns to a country based on various local factors, political and regulatory, to determine the likelihood that an SF deal will survive the insolvency of its originator/seller.

Moody's also has an effective cap on structured finance deals in a given country. The highest achievable rating for deals from a specific country is based on two things: how bad conditions can become in the economy and the financial system, and the sensitivity of the assets to certain rare events affecting the local economy or the banking sector.

In the eurozone there is an added critical nuance. The cap is in theory triple-A for all transactions within the EMU, but in practice it has to be approached on an individualized basis, especially now that the eurozone has countries that on Moody's scale are in sub-investment grade territory, including Portugal (Ba2) and Ireland (Ba1), as well as Greece.

"Generally the country ceiling is supposed to capture systemic risk," said Ning Loh, vice president and senior credit officer at Moody's. "In emerging markets the country ceiling tends to be very close to the sovereign rating, but the case of Europe is unique."

The structured finance analysts have to decide whether a given deal can approach or even hit the ceiling. As the nine-notch uplift experienced by Greek deals is anomalous - with six the more common limit - and Portugal and Ireland are rated below 'Baa3', many ratings in the sector are now well below the triple-A category.


Getting into Greece

The notching for Greek structured finance deals evolved as the troubles facing the sovereign gathered intensity throughout the past year.

Moody's Loh said that following Greece's downgrade to 'Caa1' in June 2011, the structured finance cap was set at 'Ba1'. After a further downgrade on July 25, the agency decided to keep the limit at 'Ba1'. But in November, as the situation in Greece deteriorated, Moody's put on review for downgrade all Greek structured finance deals - which ranged in ratings from B3(sf) to Ba1(sf) and covered nine tranches of six ABS, 19 tranches of eight RMBS and one tranche in a CLO. As of press time, there were still deals at 'Ba1' on review for downgrade.

"Back in June, we considered that the Ba1 cap was positioned such that an orderly restructuring of Greek government debt would likely have no further impact on Greek structured finance deals," said Loh. "But subsequent events have increased the risk of a disorderly default of Greece on its debt, increasing the likelihood of high-severity events that would have a material impact on such deals."

The agency is now considering the risk of a messy default. The messier the potential default, the shorter the distance between the SF cap and the sovereign.

"As a result, we are currently reassessing the highest achievable rating for Greek structured finance transactions," said Loh.

At Fitch, which presently rates Greece 'CCC', there are Greek structured finance deals rated 'BBB-', the cusp of investment grade. "We work on the assumption that if Greece defaults it will be an orderly restructuring," said van der Weijden. "If our base assumption of an orderly restructure changed to disorderly and a potential exit from the eurozone, then our 'BBB-' cap no longer holds and noteholders almost certainly will not receive timely payments."

Both Fitch and Moody's said that whether or not Greece abandons the euro makes a crucial difference.

Even in an ugly default scenario, as long as Greece remains in the eurozone, assets would stay denominated in euros. But an exit from the monetary union and consequent redenomination of assets could lead to the sort of misadventure Argentina embarked on when it cut the peso loose from its dollar peg in 2002. The predictable result was massive defaults. MBS in that country did not stand a chance as the dollar value of collateral pools fell by about two-thirds.

Greece - and any other beleaguered European sovereigns that swap the euro for a local currency - would suffer a similar fate. "No exit from the eurozone would underpin the ability to maintain ratings of structured finance and covered bond transactions above the sovereign and above the bank ratings," said Bank of America Merrill Lynch in its 2012 outlook for the sector.

Yet, if for some reason a rating agency believes that the T&C risk of a eurozone exile is lower than the sovereign itself, then there could be structured deals kept above the government. There are plenty of examples in emerging markets. But the extreme stress of a euro exit scenario would likely cause T&C risk to skyrocket - at least for a time. That, on top of the related damage wrought by redenomination, would likely leave deals within arm's length of the sovereign rating.

But even under the assumption that a eurozone exit does not happen, players are not necessarily comfortable with the wide differential between the highest ratings on structured finance deals and their respective sovereigns in the eurozone, particularly in the case of Greece, where the ratings are so low.

"The bottom line is that as long as the country's in the eurozone, you can justify a large differential," said Alexander Batchvarov, head of international structured finance at BofA Merrill. "But that differential should contract the lower the country goes."

While Batchvarov added that ample credit enhancement can mitigate sovereign risk, as a country creeps toward default the hazards of a rush on banks, people deliberately not paying their obligations and weakened enforceability of contracts rises enough to call into question a wide gap between structured finance deals and their respective sovereign.

"The behavior of governments and consumers alike near and post-sovereign and bank default is highly unpredictable, [and] the risks of default at individual or company level are likely to rise significantly," BofA Merrill said in its outlook report.


Wading in Waterfalls & Pools

European exceptionalism, at any rate, has strong roots and many champions.

As a result, worries about the intrusion of government risk into a deal's future performance are not as pronounced as they would be in other regions.

With sovereign crises raging all around them, European ABS investors are keeping their eyes squarely on waterfalls and pools.

For instance, triple-B product that is the first in line to receive payment in a capital structure - and therefore is typically a downgraded version of its former triple-A self - is pricing tighter than triple-B product that has always been a subordinated or mezzanine tranche.

"People are paying attention to which tranche is going to be paid first," said Philippe Pagnotta, head of European ABS pricing at Markit. "People aren't paying [as] much attention to the ratings."

He pointed out that triple-B notes in U.K. nonconforming CMBS transactions are hovering at the same spread levels as double-B-rated senior paper of Greek CMBS with a comparable weighted average life.

This would indicate that in some deals the market feels that the wide differentials between Greek deals and the sovereign are not only justified, they may even be a touch conservative.

Non-AAA investment-grade and sub-investment-grade ratings for the senior-most tranches are a new phenomenon for Europeans. As such, there is no history of spread and rating behavior of below-triple-A senior-most tranches vis-à-vis mezzanine tranches of the same rating, said BofA Merrill Lynch.

But the U.K. offers some, albeit scant, evidence that the former would experience lower ratings migration and spread volatility.

Pagnotta added that many deal downgrades have not been connected to the performance of collateral and were rather triggered by methodology changes or sovereign downgrades. For players more focused on the strength of asset pools and not constrained by rating mandates, those downgrades have not been of great consequence.

"At the end of the day, in structured finance you have collateral," said Roman Kalyuzhny, senior analyst of European ABS pricing at Markit. "Whereas, in the case of a country default, what can you repossess?"

During the recent global financial crisis, most kinds of prime European structured finance deals traded wide to their respective sovereigns, which was a change from the boom years when they actually traded tight to, or in line with, their government benchmarks. But since sovereign risk in the region has heated up - and prime deals have shown a degree of resilience - the spread relationship has reverted, with sovereigns trading wide to prime ABS.

And, judging by pricing, a good chunk of the market feels this not only makes sense for deals with assets domiciled in sovereigns rated single-A or higher but also for those with collataral in Greece, Portugal and Ireland, which are triple-B and below.

This year will be an interesting test of just how divorced these deals remain from sovereign risk - whether in terms of pricing or ratings.

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