Methodology for Counterparty Risk in Structured Finance Structured Finance

Transcription

1 Methodology for Counterparty Risk in 11 August 2017 Contacts Guillaume Jolivet Carlos Terré Karlo Fuchs Managing Director Managing Director Executive Director

2 Methodology for Counterparty Risk in Table of Contents 1. Introduction Areas of application Summary Methodology Materiality of counterparty risk as a guiding principle Definition of excessive counterparty exposures Transaction-specific assessment of remedies Financial counterparties Definition of financial counterparties Effective remedies for material exposures to financial counterparties Servicer risk Servicer commingling risk Liquidity risk when a servicer is replaced Resolvable financial institutions as servicers Other counterparties Credit quality assessment of counterparties... 8 Appendix I. Definitions and applicable conventions... 9 Appendix II. Bail-in waterfall for bank obligations (subject to resolution) Appendix III. Quantifying expected loss from servicer commingling Appendix IV. Summary of counterparty roles and remedies August / 15

3 Methodology for Counterparty Risk in 1. Introduction This document is an update of Scope Ratings (Scope) Methodology for Counterparty Risk in, initially published in August This updated methodology includes i) a change in section 4.4 regarding the delay for taking action, from 14 days to 30 days, to align with market standards as well as the clarification of some cases where standard replacement trigger levels may not apply; ii) a reference to insurers and guarantors in section 4.7; and iii) editorial changes to improve readability and align this document with changes to the methodology to rate banks. Aside from those minor editorial changes and clarifications, this update does not propose any material changes to our rating approach. Existing structured finance or covered bond ratings are not impacted by this update. 2. Areas of application Scope Ratings uses the Methodology for Counterparty Risk in to assess counterparty risk in structured finance transactions, covered bonds and other debt ratings that rely on structured finance techniques. The methodology applies to European securitisations and covered bonds, but may be applied selectively to non-european transactions where appropriate. The methodology should be read in conjunction with Scope s General Rating Methodology, Scope s assetspecific methodologies and Scope s considerations on Legal Risks in. 3. Summary This methodology explains how we analyse counterparty risks and their mitigants, and the impact of these on the ratings assigned by Scope. Counterparties can introduce financial or operational risk to an issuer of a rated instrument. Non- or malperformance by the counterparty on its obligations may result in liquidity risk (e.g. payment interruption) or solvency risk, resulting in losses for the transaction. Scope s key concepts for assessing counterparty risk are: 1) Materiality of exposure. We classify counterparty exposures as excessive, material or immaterial. We assess this based on the potential impact of the crystallisation of the risk according to our analysis (see Figure 1). 2) Type of exposure. We distinguish between financial and operational risks. 3) Effectiveness of remedies. We assess the effectiveness of proposed remedies to mitigate or reduce the risk exposure to a counterparty in the specific context of the transaction. Counterparty risk classification Materiality of risk Excessive Material Immaterial Rating impact if not mitigated 7 notches or more From 1 to 6 notches No impact Available remedies Collateral Replacement Other Not needed Effectiveness of remedies Ineffective Partially effective Fully effective N/A Materiality of remaining risk after remedies Excessive Sizeable Immaterial Rating impact (including mitigants) Link to Counterparty Quantify rating impact None Source: Scope Ratings 11 August / 15

4 Methodology for Counterparty Risk in Scope analyses the nature and amount of the residual counterparty risk exposure after considering the effectiveness of proposed remedies. If the remedy is ineffective or residual risk is considered material, the rated transaction might be linked to the counterparty s credit risk. Credit risk substitution, i.e. a counterparty s replacement, is a common remedy against the deteriorating credit quality of a counterparty that provides services to the transaction. Scope also considers other remedies that adequately isolate the transaction s credit risk from a counterparty s credit quality. Identified replacement trigger levels mark the minimum credit quality for a counterparty that Scope deems sufficient to shield a transaction from counterparty credit risk. Scope s trigger levels build on post-crisis realities including the new regulatory and supervisory framework for banks such as bail-in and stronger prudential metrics resulting in a limited likelihood for banks to default within the short timeframe. For material exposures, financial institution counterparties with BBB and S-2 credit quality or higher, combined with appropriate risk substitution triggers can support up to AAA on a structured finance transaction. Counterparties with BB and S-3 or higher, combined with appropriate risk substitution triggers, can support up to A+ rated tranches (see Figure 2). Replacement triggers for financial counterparties Highest rating AAA AA A BBB Replacement Loss of BBB, S-2 Loss of BB, S-3 Note: when risk substitution is not implemented within 30 days, Scope expects the full collateralisation of the exposure. Source: Scope Ratings For unregulated financial counterparties or those operating in a non-brrd environment, Scope assesses whether the applicable regulatory body is likely to follow a resolution approach for the entity or whether the entity could fail. Such an analysis may result in Scope taking a transaction-specific approach, and the generic triggers highlighted in Figure 2 above may not directly apply. 4. Methodology 4.1. Materiality of counterparty risk as a guiding principle The starting point in our counterparty risk analysis is the assessment of the counterparty exposure and its potential materiality to the credit risk of the transaction. Depending on the impact on the rated notes credit quality, we classify such an exposure as excessive, material or immaterial. Excessive exposures generally relate to financial counterparty obligations and usually result in a strong linkage between the credit risk of the rated instrument and the credit quality of the providing counterparty. Excessive exposures can be mitigated. However, mitigation consistent with the target rating on the notes would likely require risk substitution triggers higher than those highlighted in Figure 2, and is often considered uneconomical when implemented by means such as collateralisation. Material exposures arise from financial or operational risks. When these exposures are not judged to be excessive, Scope assesses whether the proposed remedies sufficiently protect the rated notes or reduce their exposure from the risk of nonor mal-performance by the counterparty. Immaterial exposures do not significantly affect the expected loss on a rated instrument (for example, when Scope considers the credit failure or non-performance of a counterparty to be sufficiently remote, or its consequences as irrelevant). Immaterial exposures are generally disregarded in the assessment. Financial exposure to payment systems (including central-bank accounts), clearing houses, certain operational exposures or some very short exposures to highly rated paying agents are usually classified as immaterial. If a counterparty provides multiple services that are immaterial to the transaction in isolation, but material in conjunction (financial or operational services), or result in overdependence on the counterparty for the ongoing performance of the rated security, strong remedies similar to those for financial counterparties may be implemented. The ratings assigned to covered bonds are strongly linked to the credit quality of the issuer and reflect a rating uplift determined according to the Covered Bond Rating Methodology. 11 August / 15

5 Methodology for Counterparty Risk in 4.2. Definition of excessive counterparty exposures Central to the calculation of materiality is the analysis of a counterparty s failure to perform and whether this might significantly impact the transaction or lead to its termination. If we determine this to impact the rated instrument negatively by seven notches or more, usually under the consideration of structural remedies other than risk substitution triggers, then we consider that the instrument has an excessive exposure to the counterparty. An excessive exposure results in a direct linkage between the credit quality of the transaction and that of the counterparty. Excessive exposures can be mitigated, but mitigation consistent with the target rating of the notes would likely require risk substitution triggers higher than those highlighted in Figure Transaction-specific assessment of remedies When assessing materiality, the type of counterparty exposures and proposed remedies, we use the following analytical framework as a starting point. As a guiding principle we consider proposed risk-mitigation features in the specific context of the transaction, reflecting: Contractual provisions in the documentation; The maximum net amount of a financial obligation at risk; The maximum duration of the exposure to the counterparty; The level of disruption caused in the transaction by an operational performance failure; Complexity of the relevant counterparty role; Availability of alternative service providers as well as the functioning and depth of relevant markets; Current rating, rating rationale, and rating outlook of the counterparty. The need for a transaction-specific view reflects our opinion that even with legally-binding remedies, transactions may still be insufficiently isolated from such risks at times of stress. Recent history shows that originators cannot always find adequately rated or willing counterparties to step in as successors when needed. Further, contracted replacement timings take longer than contractually agreed (especially in times of general stress). We generally distinguish between financial and operational counterparty exposures. In the case of non-performance, financial obligations can have an immediate credit impact. This demonstrates how the uninterrupted performance by the financial counterparty is essential for the timely and full payment to the noteholders. Typical financial counterparty exposures comprise bank accounts, liquidity facilities or derivative counterparty exposures. The amount of exposure at risk to the counterparty can be considerable and harder to replace for derivative obligations than for other types of financial obligations. To avoid a contagion of the transaction s credit quality, this often requires additional mitigants, such as collateralisation, to facilitate a replacement. All financial counterparties exposures can be mitigated by collateralisation if the collateral held by a counterparty does not introduce additional credit risk. High costs for the collateralisation of certain obligations, or the standardisation of certain financial counterparty obligations with limited replacement costs, usually result in the early removal of the counterparty from the transaction as the most common remedy. Replacement triggers mark the minimum credit quality of a counterparty that Scope deems sufficient to shield a transaction from counterparty risk. The trigger levels identified by Scope build on the new regulatory and supervisory framework for banks (bail-in, stronger prudential metrics) and on the resulting limited likelihood for banks to default over a short-term period (see also Appendix II). Financial institutions with a BBB credit quality, combined with appropriate risk substitution triggers can support the highest ratings (up to AAA rating) on a structured finance transaction (see Figure 2). Certain other counterparty obligations which introduce mainly operational risk can translate into financial (i.e. liquidity and solvency) risks for the transaction in the event of non-performance. In general, risk can be mitigated through pre-arranged operational remedies (such as back-up or contingent bank accounts), procedures to redirect payments and regular cash sweeps, or the availability of a hot back-up servicer. In rating reports we generally provide a list of relevant financial and operational support counterparties, including information on their roles, in addition to the usual remedies and whether we believe these adequately mitigate identified risk. If our analytical view results in alternative considerations or assumptions in the context of a specific transaction, we disclose them. 11 August / 15

6 Methodology for Counterparty Risk in 4.4. Financial counterparties Definition of financial counterparties Financial counterparties provide financial services related to securitisation. Those counterparties include credit enhancement providers, liquidity providers, account banks (where collections or reserve funds are held) or derivative counterparties. Scope assesses the materiality of exposures and the implemented remedies in the specific context of the transaction. Adequate remedies include prefunding or draw-to-cash provisions in the case of liquidity facilities or other easy-tocollateralise exposures. For a remedy to sufficiently shield the transaction, it should be executed within 14 calendar days. It can only be effective if the bank accounts to which the cash is transferred are in line with eligibility expectations. This also assumes Scope can draw sufficient legal comfort on the draw-to-cash provision in the bankruptcy remoteness analysis Effective remedies for material exposures to financial counterparties In cases where exposure is material, the following remedies (see Figure 2) against counterparty risk may apply: Investment grade 1 financial institutions can support transactions or tranches up to AAA. At the outset, institutions agree on effective remedies upon a downgrade of the issuer rating to below either a BBB or S-2 rating (the BBB/S-2 trigger). Institutions may replace themselves with an eligible counterparty, or obtain unconditional and irrevocable guarantees from another eligible entity within 30 days. If such remedies are not implemented in time, the financial institution must post sufficient collateral until replacement is completed. Sufficient collateralisation should cover the next payment obligation, the current mark to market of the exposure, plus a volatility buffer that captures the likely volatility of the exposure up to its next valuation. Financial institutions with an issuer rating of at least BB and S-3 can support transactions or tranches rated up to A+ so long as the bank is important for the economic and financial system of the relevant country typically resulting in being resolvable. At the outset of the transaction, institutions agree on effective remedies upon a downgrade of the issuer rating to below either a BB or S-3. Substitution remedies should already be available, i.e. contracted but not activated, to facilitate the swift implementation. We believe that negative credit migration for resolvable banks will be slower than for non-systemically relevant banks. Contractual replacement provisions nominate an independent third party that, in addition to the counterparty, has both the responsibility and ability to find and effect a replacement. For most critical roles, outgoing counterparties agree at the outset to cover counterparty replacement costs. The incoming counterparty assumes similar obligations and commits to the same remedial actions as the outgoing counterparty. Counterparties have the same operational capabilities to fulfil contractual obligations. If a trigger has been breached and no replacement is achieved within the applicable timeframe, Scope considers the efforts undertaken and the resulting rating implications of the remaining counterparty exposure on a case-by-case basis. In the context of the resolution regime (see Appendix II for a typical bail-in waterfall) collateralised derivative counterparty obligations constitute secured liabilities. The ranking of secured liabilities in the bail-in waterfall and the remote likelihood of a bank failing to provide services during a resolution at the proposed trigger levels support the corresponding rating levels of the instrument without introducing undue risk. Other financial obligations owed to or provided by regulated financial institutions that are subject to a resolution regime are ranked differently in a bail-in scenario, but retain a very remote risk of being bailed in as derivative obligations. We therefore envisage the same rating trigger for all financial obligations. Scope may take a transaction-specific approach, and generic triggers highlighted in Figure 2 above may not directly apply under certain situations. For financial counterparty companies that are not regulated as banks or operate in a non-brrd environment, Scope assesses whether the applicable regulatory body is likely to follow a resolution approach for the entity or whether the entity could fail. For instruments rated below maximum achievable rating suggested in Figure 2 generic triggers highlighted may also not directly apply. 1 For counterparty exposures Scope generally relies on its own credit assessments. The assessment can be a public or private rating, which are monitored over the life of the transaction. We would expect that a counterparty whose rating is close to a rating trigger is not under review for downgrade. 11 August / 15

7 Methodology for Counterparty Risk in 4.5. Servicer risk If a servicer fails to perform, it can expose a transaction to additional losses or liquidity risk for the issuer, or a combination of both Servicer commingling risk Commingling risk arises when cash belonging to the issuer is mixed (commingled) with cash belonging to the servicer or is deposited in an account held in the name of the servicer. The materiality of this risk depends on several factors: i) the credit quality of the servicer; ii) the legal framework under which the servicer performs its function; iii) whether the servicer operates with pledged accounts such as escrow accounts; iv) whether collections from obligors can be easily stopped upon a servicer event (i.e. the case of direct-debit collections); v) the length of servicer holding periods as a function of the frequency of cash sweeps; and, generally, vi) the characteristics of the receivables which determine the amount and potential clustering of collections around certain dates. Scope considers how well any structural protection feature, such as a dedicated commingling reserve or guarantee, delinks risk from the servicer. For example, a reserve in the issuer s name which fully covers collections over a stressed servicer holding period effectively delinks a transaction from servicer commingling losses. However, total delinking from the servicer might not be possible, or even desired. In such cases, Scope will incorporate any uncovered exposure to the servicer into the analysis. For more details, see Appendix III Liquidity risk when a servicer is replaced A defaulted servicer must be replaced upon its insolvency, which poses liquidity risk for the issuer as the portfolio may remain unserved for a prolonged period. Servicer replacement can be time-consuming for several reasons, for example, a lack of alternatives in the market, operational problems in accessing payment information on the credits and the obligors, or the operational complexity of migrating certain servicing processes to a new platform. Securitisations with unrated servicers often feature backup servicing arrangements to reduce the time needed to complete the handover to a new servicer. In certain cases, a failure of the servicer may even give rise to an increase in loan delinquencies if collections cannot be operationally recovered. Scope evaluates the practicality of replacing a servicer and analyses the strength and clarity of replacement provisions. Scope also assesses the risk that senior fees and expenses might deplete available liquidity and thus leave the rated instrument unprotected. For more details please see Appendix I and Appendix III Resolvable financial institutions as servicers Resolvable financial institutions should continue to operate as a going concern and honour operational obligations if financial impairment occurs, for at least the duration of the resolution process. This view provides reasonable comfort that structural features protecting a securitisation against counterparty risk could be implemented before the risk effectively crystallises. This view particularly applies to servicing disruptions when the servicer of the securitised assets is a regulated and resolvable bank. Nevertheless, securitisation transactions may feature unrated servicers that may not be regulated the same as banks. A jump to default of such servicers would result in extra losses for investors or the temporary interruption of payments. Furthermore, a defaulted servicer has to be readily replaced to avoid more delinquencies and defaults, which could increase losses in the transaction. For those servicers, Scope evaluates their initial viability, alignment of interests with the transaction, and incentives to perform Other counterparties A direct credit impact on the transaction may also arise upon the operational failure of counterparty agents. The issuer has no financial exposure to those agents but their non- or mal-performance could be disruptive to the transaction. If the replacement of such counterparties is swift, it will not expose the transaction to additional risk. Such counterparties include collection agents, calculation agents, trustees, asset managers and special servicers. To analyse the risk of operational disruption, Scope takes into account the specific context of the transaction and focuses on the track record of the agents, their economic incentives, and their operational standards including standard of care and general liability standards. Scope also evaluates the practicality of replacing the agent and analyses the strength and clarity of replacement mechanisms in the transaction. Our analysis also considers if fees are available to pay both a replacing agent and the party responsible for finding it. When such counterparties are rated, rating-based counterparty replacement triggers can simplify the monitoring of a likely credit impact for the rated notes, but other remedial solutions may be affected (see following section Credit quality assessment of counterparties ). 11 August / 15

8 Methodology for Counterparty Risk in 4.7. Credit quality assessment of counterparties Scope can rate structured finance transactions that involve counterparties, guarantors, or insurers that do not have a public rating by Scope. Scope generally relies on its own assessments of counterparties. When counterparty risk exposure is judged excessive, Scope relies on a rating produced by its credit rating team 2. When the exposure is judged material, Scope assesses and monitors the development of the risk based on available public ratings from ECAIs (External Credit Assessment Institutions) available on Bloomberg or similar recognised financial information providers, but reserves the right to adjust the ratings as necessary. Rating-based counterparty replacement triggers can simplify the monitoring of a likely credit impact for the rated notes. Clear, transparent, independently monitored and enforceable covenants referencing financial or operational triggers may also provide sufficiently robust measures that shield other counterparty exposures from impacting the credit quality of the notes. Similarly, risks arising from unrated counterparties may be structurally mitigated without reference to ratings. For example, provisions for daily cash sweeps (not material considered individually) placed into a deposit account under the name of the issuer can remedy against commingling risks; but this is only effective if the account is shielded in line with expectations for general financial counterparties. Other such remedies include additional credit enhancements, liquidity facilities, or payments made into a lockbox account that limits servicers access and involves robust procedures that ensure moneys are ultimately transferred to an eligible deposit account. The above illustrates that Scope does not expect a one-size-fits-all remedy but considers financial and operational covenants tailored to a specific transaction. Appendix I and Appendix IV provides some examples and rationales for this. Other counterparty obligation breaches of proposed financial or operational covenants should, within 30 days, result in a contractual requirement to: Be replaced with another eligible counterparty; Provide additional mitigants such as eligible guarantees or a liquidity facility, or redirect collections directly to the issuer s bank account. 2 Either a public rating or private monitored rating. 11 August / 15

9 Methodology for Counterparty Risk in Appendix I. Definitions and applicable conventions General convention Transaction parties may choose to provide mitigants as presented in this document but are not obliged to follow this methodology. Scope will compare the issuer s or arranger s remedies with this methodology to establish a rating opinion. Replacement commitment A pre-committed transfer to another eligible party by the service provider allows a securitisation s creditworthiness to be isolated from a credit deterioration of the counterparty. Generally, the exposure that rests with a service provider should be transferred to another eligible party upon a breach. This party steps in on the same terms as the current provider, and any such transfer is neutral to the rated debt. Typically, a service provider either commits to finding its replacement within a predetermined period, or agrees to obtain a guarantee from an adequately rated entity in line with our methodology. The provision of external accounts is standard for banks. Costs to maintain issuer bank accounts do not differ materially between countries and banks. We do not believe that the replacement provision needs to rest with the original bank account provider. If the issuer or trustee commits to undertake reasonable efforts to maintain bank accounts with eligible financial institutions, we believe this would not hinder a transaction with the highest rating. Replacement period Trigger levels for a replacement are set such that a counterparty can still provide services without exposing investors in rated debt to uncertainties driven by either the potential resolution or moratorium of a regulated bank, or the potential insolvency of the service provider. To ensure an orderly transfer and avoidance of operational risks, a replacement period of 30 calendar days for uncollateralised exposures is adequate in our opinion. Certain exposures can avoid a credit impact if the exposure is sufficiently collateralised after 30 days, but should be replaced within 60 calendar days at the latest. To remain creditneutral in the meantime, sufficiently detailed information should be provided. Other replacement triggers based on financial and operational covenants Not all parties providing services to a transaction are rated financial institutions. In the case of unrated, primarily operational service providers, remedies can take the form of financial or operational covenants. We assess whether the proposed financial-ratio-based or operational triggers, typically independently verified, can adequately substitute for credit-risk-based triggers aimed at reducing service or payment disruption risk. Assessing the proposed covenants in context of the transaction reflects our understanding that a replacement could also in certain circumstances introduce uncertainties and risks to transactions. Replacing smoothly running processes at an incrementally higher risk might in certain instances be tolerable, and even preferable compared to the likely disruption caused by switching the service provider. Financial and operational covenants Covenants addressing liquidity risk Daily cash sweeps to eligible bank accounts in the issuer s name can, in our view, largely isolate a transaction from the commingling risk that results from collection agents or other service providers receiving cash on behalf of the issuer. We observe that liquidity facilities which cover three to six months of interest are sufficient to mitigate potential payment disruptions caused by servicer replacement. To establish the size of a liquidity facility, the rationale should not only focus strictly on a certain number of months and the likely exposure that needs to be covered, but also reflect when moneys need to be paid to investors, covering at least one payment period. 11 August / 15

10 Methodology for Counterparty Risk in Covenants addressing solvency risk For unrated entities, we believe asset-performance-based replacement triggers are more effective at limiting risks than triggers based on an event of default. This reflects the insolvency administrators preference to preserve functions that create recurring income. The more standardised the asset, the easier the potential asset performance disruption can be mitigated if alternative back-up servicers can be identified early. Depending on the complexity of the assets or the servicing process, having cold or hot back-up servicers can address these concerns 3. Regular confirmation of positive net cash flow and regular audits from reputable audit firms can provide additional comfort on the servicer s solvency. Other operational covenants Proposed operational provisions will be evaluated in context of the relevant third-party servicing market, evidence of successful transfers, and the appropriateness of servicing fees. We also assess whether regulatory or consumer-protectiondriven requirements could affect timely replacement. Other operational covenants include: Pre-approved notification forms for debtor notifications to ensure timely perfection of interest as well as contractual obligations to redirect payments upon the breach of predefined triggers. The contractual provision of a regular update on pool and debtor data including specified data backup provisions (to trustee). Public ownership with strong governance and operational track record, as well as restrictions on changes to the ownership structure or business strategy. Issuer/transaction bank accounts Sums used to repay the notes transit through various bank accounts domiciled in one or several banks. The insolvency of a bank holding one of these accounts may affect repayment of the notes. While banks are highly regulated, they are not bankruptcy remote, in contrast to typical special-purpose entities. Moneys on bank accounts could therefore become commingled and eventually lost if a bank is placed under moratorium or restructured and eventually declared bankrupt by regulators. To support highly rated transactions, investors must be adequately shielded from the risk of moneys being trapped or even lost. When assessing the effectiveness of replacement triggers, we recognise the importance of the bank account to the transaction. In certain jurisdictions, structural mitigants (e.g. investments in highly rated and liquid securities with no additional risks) or legal mitigants (trust or custodian accounts) can isolate funds against the insolvency of an institution providing accounts for the transaction. A detailed legal review of such structures determines whether there are differences with regards to the full and timely access to such funds. Collection accounts for servicers The transaction usually ensures that funds are transferred to the bank account of the originator, seller or servicer before being finally remitted to the issuer account. Noteholders can be exposed to payment interruption and/or commingling risk if an originator/seller or servicer is experiencing liquidity or insolvency problems. This risk is assessed by examining general legal provisions (including the required consent from or notifications to obligors), operational covenants, additional transaction-specific structural mitigants, or the counterparty s credit risk. Liquidity facilities Liquidity facilities are typically used to support a transaction s ability to make timely payments to noteholders. They do not provide credit support, but mitigate timing mismatches or other payment disruptions arising from the default of other counterparties or borrowers. Terms and conditions can indicate the ability to renew a facility and how much this would cost. Unless fully collateralised, the accounts are opened at the outset of the transaction, and if the facility is not renewed as expected, the facility would become fully drawn prior to expiry date. 3 We generally distinguish between cold, warm and hot back-up servicers. The categorisation indicates the readiness and speed with which they take over servicing a portfolio. Whereas a cold back-up servicer only receives a back-up of the data file, hot back-up servicers already incorporate the relevant obligor data in their systems, perform a parallel processing, and have established relevant procedures and processes to ensure that a replacement can become effective within days rather than weeks. 11 August / 15

11 Methodology for Counterparty Risk in We regard as excessive any exposure to liquidity facilities that provides very substantial liquidity or very material credit support to a transaction (as in the case of ABCP conduits). If the liquidity facility is very important to the transaction, we typically link the transaction to the credit risk of the liquidity provider. Paying agents Paying agents are responsible for distributing funds to noteholders. While the non-performance of such counterparties could lead to delayed payments, such agents only hold funds for a short period, usually one or two days. This potential operational risk can be mitigated by choosing counterparties with a proven record and experience. We seek to understand whether counterparties have a solid credit profile and whether the transaction documents outline likely remedial actions if a counterparty can no longer perform its functions. Calculation agents Structured finance issuers, due to their typical setup as special-purpose vehicles, rely on calculation agents to value derivative exposures. These valuations establish potential collateralisation needs under contracts, and can be provided by a large number of counterparties. As the main remedy for derivative counterparties is their replacement, the risk of nonperformance is generally tolerable. Cash administrators or cash managers Cash administrators typically manage short-term investments during payment periods and only act as an agent for the transaction based on procedures set forth in the transaction documents. The role of the above counterparty types can usually only introduce operational, but not credit or liquidity, risk to a transaction. Choosing counterparties with a proven record and experience in the functions they are commissioned for can prevent risk from materialising. Servicers Securitisation issuers are typically set up as special-purpose vehicles that rely on banks or corporations to manage the relationship with obligors, monitoring their performance and eventually enforcing the obligation. We evaluate the proposed covenants for servicers in the context of the level of standardisation in processes, systems and their scalability. Other important considerations are the portfolio composition by product or asset type, the used remittance form (direct debit/ transfers) or payment characteristics (amortising/bullet). Soft factors such as governance, service practices or size of the franchise also have to be taken into account in the qualitative assessment to determine whether or not proposed remedies are effective (see previous section, Other replacement triggers based on financial and operational covenants ). Commingling risk Commingling risk occurs when funds placed in the account of an entity are or could be commingled with funds from third parties. See Appendix III. Originator set-off Set-off may be invoked by a debtor that holds a monetary cross-claim against the seller or originator. In this case, the debtor may be entitled to be absolved from honouring the creditor s claim to the extent of the cross-claim. Set-off might vary significantly by jurisdiction, asset class and transaction structure. Set-off exercised by a debtor in relation to the asset may substantially reduce or completely cancel out the enforceable claim, i.e. proceeds payable to the issuer. Where such cross-claims exist or are likely to come into existence, Scope examines whether documents relating to the asset contain waivers of set-off and whether these are valid under the relevant jurisdiction. In case such waivers have not been agreed on or are not recognised by the applicable jurisdiction, Scope assesses whether any features have been implemented in the structure to mitigate the negative impact of set-off. Otherwise, Scope evaluates whether the credit risk of the originator must be factored into the rating. If the mitigation does not take the form of an appropriately sized reserve or similar features, but rather of indemnities or substitution rights granted by the originator, Scope evaluates whether those indemnities or substitution rights affect the true sale of the securitised asset. Set-off may also create challenges for the structure if invoked by transaction parties other than the debtors of the claims generated by the asset, for example, the account bank. In this case, Scope examines how set-off is treated in the transaction documents mentioned below and how it affects the structure. 11 August / 15

12 Methodology for Counterparty Risk in Appendix II. Bail-in waterfall for bank obligations (subject to resolution) Improved regulatory and supervisory oversight and additional regulations enable a more differentiated view on bank counterparties providing support for structured finance transactions. One such cornerstone in the EU is the Bank Resolution and Recovery Directive (BRRD), which ensures banks can become resolved using available funds (bail-in) rather than through external support (bail-out). More proactive regulation and supervision helps to contain the speed of a negative migration timing, effectively avoiding a jump to default of such banks. Even if a resolution takes place, counterparty obligations covered under these criteria constitute either secured liabilities (such as derivatives subject to margining) or senior unsecured debt according to the BRRD. Given their ranking in the bail-in waterfall, we believe these to be either initially excluded (derivative obligations) or to have a remote ranking in the order of bail-in although not the most remote (covered bonds are excluded from bail-in). Bail-in waterfall for banks subject to a resolution regime Order of bail-in in resolution (for EU banks) 1. Equity 2. Additional Tier 1 3. Tier 2 4. Other subordinated debt 5. Senior unsecured debt included in MREL and/ or TLAC 6. Other senior unsecured debt and non-preferred deposits (wholesale and institutional) 7. Preferred non-insured deposits (individuals and SMEs) 8. Deposit guarantee scheme (for insured deposits) Source: Scope Ratings Further supporting regulations are yet to be finalised and Scope recognises that various supervisory authorities in member states may deviate in their regulations 4. Depending on the individual circumstances, we will adapt the criteria to reflect these variations. 4 For example, new regulations in EU member countries might have implications on the effective ranking of eligible liabilities, which might have implications on our view of the appropriate level of replacement thresholds. 11 August / 15

13 Methodology for Counterparty Risk in Appendix III. Quantifying expected loss from servicer commingling Commingling risk arises when cash belonging to the issuer is mixed (commingled) with cash belonging to the servicer or is deposited in an account held in the name of the servicer. Servicer commingling can occur when the servicer is insolvent, or when there is a credit loss (collections are lost irretrievably) and/or a payment delay (collections are blocked temporarily). Scope takes into account several factors when assessing the potential impact of commingling risk: Credit quality and nature of the servicer and the risk of a credit deterioration when operations are disrupted. For example, a financial impairment may affect unregulated servicers differently versus regulated financial institutions. Jurisdiction and legal framework: account segregation. For example, servicer commingling risk reduces when the servicer operates on accounts which are either in the name of the issuer or are pledged to the issuer in a legal, valid, binding and enforceable way. Jurisdiction and legal framework: perfection of true sale. For example, servicer commingling risk increases when the servicer continues to collect obligors payments (even if passively) until obligors are notified of the assignment of the receivables, which perfects the true sale. Jurisdiction and legal framework: insolvency laws. For example, insolvency laws may affect the size of exposure at the risk of commingling losses, like when claw-back risk may compromise not just held collections but past collections as well which could be relevant if the servicer is also the originator and seller. Operational risk. For example, predefined processes for fulfilling the notification to obligors, with readily available contact data, clear responsibilities and powers, deadlines, etc. help reduce the risk of increased commingling exposures by shortening the obligor-notification period. Characteristics of the receivables. For example, the collection method (i.e. direct debit, manual transfers, checks, on-site payments), the clustering of collection dates in the month, or the speed of scheduled and unscheduled amortisation may result in increased exposure to servicer commingling losses. Scope adds the probability-weighted loss from servicer commingling to the credit losses from the portfolio to factor in the expected economic consequences of a servicing disruption. The loss from servicer commingling considers the stressed likelihood and severity of a jump to default of the servicer, resulting in the loss of issuer moneys held by the servicer. Scope infers the likelihood of servicer default for each period from the credit quality of the servicer, reviewed with a frequency we judge adequate in the context of the transaction. We consider a stress of three notches when calculating the probability of a jump to default of the servicer. We consider stressed exposures at risk on each period, which reflect a holding period that includes the obligor notification time and any potential claw-back period compromising collected amounts. The obligor notification time is the time needed to inform obligors that payments should no longer be directed to the defaulted servicer. The exposure for each holding period is calculated using the dates on which amounts held by the servicer are the largest. Additionally, we consider collections under a scenario of zero portfolio defaults. Typical stresses applied to the analysis of servicer commingling risk Element Servicer credit quality Stressed exposure period Obligor notification period Stressed holding period Assumptions Servicer credit quality minus three notches A maximum of i) one month; and ii) two times the cash sweep period The actual assumption will consider the specific characteristics of the transaction The sum of the stressed exposure period and the obligor notification period Maturity Contribution to portfolio expected loss = prob{servicer default} i (Collections over stressed holding period) i period i=1 11 August / 15

14 Methodology for Counterparty Risk in Appendix IV. Summary of counterparty roles and remedies Counterparty Exposure Materiality Remedies Excessive N/A N/A Rating trigger to support highest instrument rating Result Link to the counterparty 5 Derivative counterparties Financial Material Collateralisation and replacement AAA to AA: risk substitution upon loss of BBB/S-2 (collateralisation until replacement); A to BBB: risk substitution latest upon loss of BB/S-3 (Alternatively: guarantee by a suitably rated institution) Compliant: no rating impact Else: quantify (including notching) Excessive N/A N/A Link to the counterparty Bank account providers Financial Material Replacement AAA to AA: risk substitution upon loss of BBB/S-2; A to BBB: risk substitution upon loss of BB/S-3; (Alternatively: guarantee by a suitably rated institution or draw to cash at a suitably rated bank) Compliant: no rating impact Else: quantify (including notching) Excessive N/A N/A Link to the counterparty Liquidity facility providers Financial Material Replacement/ Draw to cash AAA to AA: risk substitution upon loss of BBB/S-2; A to BBB: risk substitution upon loss of BB/S-3; (Alternatively: guarantee by a suitably rated institution or draw to cash at a suitably rated bank) Compliant: no rating impact Else: quantify (including notching) Servicers Financial/ Operational Material or Immaterial Replacement/ Operational covenants Operational covenants specific to the service provided (hot or cold back-up / performance-based triggers); or Rating-based triggers to be considered on a case-by-case basis Compliant: no rating impact Else: quantify (including notching) Paying agent Financial/ Operational Material or Immaterial Replacement/ Reduction of exposure Mitigating covenants specific to the service provided; or Rating-based triggers Compliant: no rating impact Else: quantify (including notching) Collection or calculation agents Operational Material or Immaterial Replacement/ Operational covenants Operational covenants specific to the service provided; or Rating-based triggers to be considered on a case-by-case basis Compliant: no rating impact Else: quantify (including notching) Trustee Operational Immaterial N/A N/A N/A 5 Excessive exposures can be mitigated, but mitigation consistent with the target rating on the notes would likely require risk substitution triggers higher than those highlighted in Figure 2 11 August / 15

15 Contact Scope Ratings AG Scope Ratings AG Headquarters Berlin Lennéstraße 5 D Berlin Phone London Suite Angel Square London EC1V 1NY Phone Oslo Haakon VII's gate 6 N-0161 Oslo Phone Frankfurt am Main Neue Mainzer Straße D Frankfurt am Main Phone Madrid Paseo de la Castellana 95 Edificio Torre Europa E Madrid Phone Paris 21 Boulevard Haussmann F Paris Phone Milan Via Paleocapa 7 IT Milan Phone info@scoperatings.com Disclaimer 2017 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings AG, Scope Analysis GmbH, Scope Investor Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot however independently verify the reliability and accuracy of the information and data. Scope s ratings, rating reports, rating opinions, or related research and credit opinions are provided as is without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or otherwise dam-ages, expenses of any kind, or losses arising from any use of Scope s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party, as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings AG at Lennéstraße 5 D Berlin. 11 August / 15