Playing Battleship Moody s New Approach to Assessing Swap Counterparties in Structured Finance Cash Flow Transactions Briefing Note 27 November 2013

Transcription

1 Playing Battleship Moody s New Approach to Assessing Swap Counterparties in Structured Finance Cash Flow Transactions Briefing Note 27 November

2 1 INTRODUCTION 1.1 On 12 November 2013, Moody s Investors Service, Inc. ( Moody s ) updated its methodology for assessing the rating impact of hedge counterparties ( Hedge Counterparties ) on structured finance cash flow transactions 1 (the New Moody s Criteria ). The New Moody s Criteria significantly overhauls the now out-of-date Moody s criteria which had been used by the structured finance industry since (the Old Moody s Criteria ). Since Moody s issued Requests for Comment on 2 July 2012 and 18 July 2013, the industry has been largely prepared for the changes introduced by the New Moody s Criteria for quite some time. 1.2 This Briefing Note provides a detailed overview of the New Ratings Criteria, particularly in respect of the following:- (a) (b) (c) the fundamental changes introduced to Moody s historical approach; the linkage tables; and the new pro forma ISDA Schedule and CSA provisions. This Briefing Note has been written primarily from the perspective of EU securitisations. 2 FUNDAMENTAL CHANGES TO MOODY S APPROACH The New Moody s Criteria represents a significant shift in the manner in which the rating agency historically determined the ratings effect of Hedge Counterparties on securitisations. Moody s used to take the general view that the creditworthiness of a Hedge Counterparty that had agreed at the outset to adhere to the rating triggers and prescribed remedial action would be de-coupled from the creditworthiness of the relevant securitisation. The Old Moody s Criteria specified the following:- [Where a Counterparty substantially adheres to the Moody s criteria], Moody s opinion is that that [sic] this would substantially mitigate the impact of Counterparty exposure on the expected loss of the cashflow transaction. As such, the contribution of the Counterparty to the expected loss of the cashflow transaction need not be modelled and the Counterparty credit risk is effectively de-linked from the credit risk of the cashflow transaction. However, the recent downgrade of banks exhibited a limitation in Moody s historical approach (and indeed in the historical approach of other major rating agencies). Due to the poor financial climate, a large number of downgraded Hedge Providers were simply unable to take the prescribed remedial action (particularly replacing themselves with Hedge Counterparties meeting the necessary ratings following their breach of the transfer trigger) within the expected timeframes. 3 Another limitation in the Old Moody s Criteria was the one size fits all approach being applied to all Hedge Counterparties. For instance, the Old Moody s Criteria did not provide an optionality for different triggers in return for the obligation to transfer a greater amount of collateral. Furthermore, the Old Moody s Criteria was intended for use only where Moody s had assigned initial ratings of Aaa, Aa1, Aa2 and/or Aa3 to the liabilities of a cashflow transaction. However, 1 Approach to Assessing Swap Counterparties in Structured Finance Cash Flow Transactions, 12 November Framework for De-Linking Hedge Counterparty Risks from Global Structured Finance Cashflow Transactions, 18 October The New Moody s Criteria still assumes a replacement period of around 100 business days (or 65 business days where a suitable entity has committed to manage the replacement process on behalf of the issuer). Berwin Leighton Paisner November

3 there has since then been movement in the industry to seek lower ratings for securitisations, especially in light of the country limits imposed by the rating agency. A fundamental change in the New Moody s Criteria has been a distancing by the rating agency from the concept of de-linkage altogether. As discussed in Paragraph 3 below, under the New Moody s Criteria the rating agency will employ four interconnecting linkage tables (the Linkage Tables ) to assess more holistically the rating impact of a Hedge Counterparty on a securitisation tranche. When making this assessment, Moody s aim is to take into account the following factors:- (a) (b) (c) (d) (e) (f) the present rating of the Hedge Counterparty; the rating trigger provisions in the swap documentation; the type and tenor of the relevant swap; the amount of credit enhancement supporting the relevant notes; the size of the relevant tranche; and the rating of the notes before accounting for the effect of linkage. As the 2013 Request for Comment succinctly put it:- We no longer believe it is appropriate to label transactions as either linked or de-linked according to whether the swap documentation is consistent with a particular set of criteria. We therefore intend to withdraw our de-linkage framework as a separate report and assess the rating impact of swap counterparty exposure solely in accordance with the holistic approach described in this report. 3 LINKAGE TABLES The New Moody s Criteria specifies the following four steps for assessing the rating impact on the securitisation notes if a Hedge Counterparty and an issuer enter into a swap to hedge the relevant cashflows:- Step 1 Step 2 Step 3 Step 4 Determining the probability of the securitisation becoming unhedged. Determining the incremental loss that the securitisation as a whole will incur if it becomes unhedged. By using the output from Step 2, determining the incremental loss that the relevant tranche of notes will incur if the securitisation becomes unhedged. By using the outputs from Steps 1 and 3, determining the linkage-adjusted ratings of the notes. The output from each step is determined by reference to the information fed into a Linkage Table. Since parties have some latitude in choosing the information to be fed into a Linkage Table (particularly in Step 1), the process can be likened to the popular board game Battleship where players can calibrate their shots. Moody s has also developed a freely available Excel tool (the Swap Linkage Tool ) for determining the rating impact electronically. Step 1: Probability of Becoming Unhedged Step 1 is arguably the most crucial of the four steps in determining the overall rating impact of a Hedge Counterparty on the securitisation notes. A securitisation will become unhedged if the Hedge Counterparty fails to transfer collateral following its breach of the collateral trigger and/or if the Hedge Counterparty defaults without first transferring the swap or obtaining a guarantee following its breach of the transfer trigger. Berwin Leighton Paisner November

4 In a significant departure from the Old Moody s Criteria, the Step 1 Linkage Table permits parties to select the collateral and transfer triggers and the amount of collateral to be posted upon breach of the selected collateral trigger. By triangulating (i) the existing ratings of the Hedge Counterparty (or its guarantor), (ii) the selected collateral and transfer triggers and (iii) the amount of collateral, the likelihood of the securitisation becoming unhedged can be determined. In essence, the Step 1 Linkage Table yields the maximum notching uplift (if any) to a Hedge Counterparty s own senior unsecured rating. Step 1 allows a Hedge Counterparty the option to agree to provide one of the following three amounts of collateral:- Original collateral amount. This amount is determined in accordance with formulae specified in Appendix B to the New Moody s Criteria. The original collateral amount is the same amount of collateral as the Second Trigger Collateral Amounts (daily posting) from the Old Moody s Criteria. Alternative collateral amount. This is an amount not determined by reference to any set formulae but which Moody s expects to be at least equal to the mark-to-market of the relevant swap. 4 Enhanced collateral amount. This amount can be either the enhanced collateral amount or the enhanced collateral amount (assisted replacement), each of which is determined in accordance with formulae specified in Appendix B. The latter, which is smaller than the former, applies where a suitable entity has committed to manage the replacement process on behalf of the issuer. The quantum of an enhanced collateral amount is greater than either the original collateral amount or the alternative collateral amount. A higher existing rating of the Hedge Counterparty, higher collateral and transfer triggers and the use of an enhanced collateral amount (rather than the original collateral amount or the alternative collateral amount) will yield a higher notching uplift. For example ( Example 1 ), if the senior unsecured rating of a Hedge Counterparty is A2 and the selected collateral and transfer triggers are both A3, then (i) under original collateral, the probability of becoming unhedged is Aaa and (ii) under enhanced collateral, the probability of becoming unhedged is Aaa. To use another example ( Example 2 ), if a Hedge Counterparty is rated A3, the selected collateral trigger is A3 and the selected transfer trigger is Baa2, then (i) under original collateral, the probability of becoming unhedged is Aa3 (i.e. an uplift of three notches) and (ii) under enhanced collateral, the probability of becoming unhedged is Aa2 (i.e. an uplift of four notches). The following are some important points to bear in mind:- No Swap Linkage. If the Step 1 Linkage Table yields the probability of being unhedged as being Aaa, then the New Moody s Criteria considers swap linkage to not be present generally. Therefore, the remaining Steps 2 to 4 would not apply. (This is the case in Example 1.) Minimum Triggers. No value is given to collateral triggers and transfer triggers set below Baa2 and Baa1, respectively. Collateral notching uplift. Moody s gives the same notching uplift to a collateral trigger set at A3 or above. Therefore, there is no incentive to set the collateral trigger any higher than A3. Value to Rating Triggers. Moody s gives no value to ratings triggers that are (i) defined by reference to the rating of the notes from time to time or (ii) conditional upon the rating agency continuing to rate the notes. 4 Moody s assumes a collateral trigger has no value if the alternative collateral amount is less than the mark-tomarket value of the relevant swap. Berwin Leighton Paisner November

5 Collateral Management. Careful consideration should be given to the issuer s collateral account, the account bank rating and whether there are any operational obstacles to posting collateral (e.g. a Credit Support Annex (a CSA ) not having been executed on closing). Otherwise, Moody s may apply haircuts to the collateral notching uplift. OTM Swaps. Where the swap is likely to be out-of-the-money (OTM) to the issuer, Moody s may give an additional notching uplift to take into account that the issuer will not need collateral to pay a replacement premium. Negative Factors. The following factors which can negatively impact the notching uplift:- (i) (ii) (iii) (iv) (v) the swap documentation not being substantially consistent with the pro forma ISDA Schedule and CSA provisions (please see Paragraph 4 below); the Hedge Counterparty being entitled to transfer the swap without the issuer s prior consent; the Hedge Counterparty also being the security trustee (or equivalent) under the securitisation; automatic early termination applying in respect of the Hedge Counterparty upon the occurrence of the ISDA Bankruptcy Event of Default (the position is exacerbated where automatic early termination applies and there is no flip clause ); and in certain instances where the issuer has an option to prepay the notes on an anticipated repayment date. Guarantors. Moody s has specified additional requirements in respect of guaranteed swaps (i.e. where a Hedge Counterparty is relying upon a guarantor s ratings to achieve the desired notching uplift.) Step 2: Loss to securitisation if it becomes unhedged Step 2 seeks to determine the loss to a securitisation if it were to become unhedged. As discussed above, a securitisation will become unhedged if the Hedge Counterparty fails to transfer collateral following its breach of the collateral trigger and/or if the Hedge Counterparty defaults without first transferring the swap or obtaining a guarantee following its breach of the transfer trigger. The greater the significance of a particular swap to a securitisation, the greater the loss the securitisation would potentially suffer if the relevant Hedge Counterparty fails to take the prescribed remedial action or otherwise defaults. The Guidance Notes to the New Moody s Criteria use the following example:- the impact of losing a long-dated cross currency swap that is hedging 100% of a securitisation is likely to be much greater than that of losing a short-dated swap hedging 10% of the same securitisation. The Linkage Table accompanying Step 2 places swaps depending on their types and tenors in one of nine loss categories ranging from 5% to 70% of the asset pool. Generally, cross-currency swaps are placed in the highest loss categories followed by fixed-floating and basis. For example, a cross-currency swap whose tenor is greater than ten years but less than or equal to twenty years is placed in Category 9 (70%). A fixed-floating swap whose tenor is greater than seven years but less than or equal to eleven years is placed in Category 5 (30%). A basis swap whose tenor is less than or equal to ten years is placed in Category 1 (5%). Berwin Leighton Paisner November

6 The following are some important points to bear in mind:- Interest Rate Caps. For the purposes of the Linkage Table, interest rate caps are considered to be equivalent to fixed-floating swaps. Tenor. Tenor refers to the weighted average life (WAL) of the relevant asset pool, taking into account prepayments and applicable amortisation triggers. If the tenor of a swap exceeds 20 years, then the Step 2 Linkage Table does not apply and Moody s will assess Step 2 on a caseby-case basis. Hedging of Asset Pool. The Linkage Table assumes that the relevant swap hedges 100% of the relevant asset pool. Where the swap hedges a smaller portion of the asset pool, Moody s will reduce the transaction loss linearly. Currencies and Indices. The Linkage Table applies to swaps denominated in certain currencies (and, in the case of basis swaps, referencing certain indices). These currencies and indices are specified in the Guidance Notes to the New Moody s Criteria. For all other swaps, Moody s determines the Step 2 output on a case-by-case basis. Step 3: Loss to tranche if securitisation becomes unhedged Step 3 seeks to determine the anticipated loss to the relevant tranche by reference to the Step 2 output and the credit enhancement available to the noteholders of that tranche. The Step 3 Linkage Table shows that, as the amount of available credit enhancement increases, the anticipated tranche loss decreases. Broadly speaking, the available credit enhancement means the amount of over-collateralisation, subordination and reserves benefitting the particular tranche. For example, where the Step 2 output is Category 5 (30%) and (i) the available credit enhancement is greater than 1% and less than or equal to 5%, the anticipated tranche loss is TL10 or (ii) the available credit enhancement is greater than 10% and less than or equal to 15%, the anticipated tranche loss is TL8. Step 4: Linkage-Adjusted Ratings By using the outputs from Steps 1 and 3 as well the rating of the relevant tranche (but without taking into account swap linkage), Step 4 produces the linkage-adjusted ratings for that tranche. For instance, if we were to apply the following inputs:- the relevant tranche rating (without swap linkage) being Aa1 (sf); from Step 1, the probability of becoming unhedged being Aa2 (i.e. Example 2); from Step 3, the anticipated tranche loss being TL8; and no special features which would result in upward or downward adjustment to the outputs from the Linkage Tables, the Step 4 Linkage Table will show the linkage-adjusted rating to be Aa1-. This indicates that, as a consequence of swap linkage, the rating of this tranche could be reduced by one notch to Aa1 (sf). Interestingly, although Moody s does not assign actual ratings with + or - indicators, they are nevertheless used in the Step 4 Linkage Table in order to permit greater granularity in showing swap linkage (and, therefore, the likelihood of the assessment which the rating agency will take). 4 PRO FORMA ISDA SCHEDULE AND CSA PROVISIONS The pro forma ISDA Schedule and CSA provisions (the New Pro Forma Provisions ) in the New Moody s Criteria are similar to the corresponding provisions in the Old Moody s Criteria. The following are some of the salient differences between the two provisions: Berwin Leighton Paisner November

7 Triggers. The Old Moody s Criteria pre-legislated the two collateral triggers (set at A3/P-2 and Baa1/P-3, respectively) and the transfer trigger (set at Baa1/P-3 ). On the other hand and as discussed in Paragraph 3 above, the new Moody s Criteria permits the Hedge Counterparty to select one collateral trigger and the transfer trigger. As a result, the New Pro Forma Provisions no longer refer to First Rating Trigger Requirements, Second Rating Trigger Requirements, Moody s First Trigger Additional Amounts, Moody s Second Trigger Additional Amounts and the proviso that an Event of Default under the CSA would only occur after the application of the Second Rating Trigger Requirements. Rather, the New Pro Forma Provisions refer to Qualifying Collateral Trigger Rating, Qualifying Transfer Trigger Rating, Collateral Trigger Requirements and Moody s Additional Amounts. Transfer Provisions. The transfer provisions under the New Pro Forma Provisions have been simplified. Definition of Guarantee. The definition of guarantee in the New Pro Forma Provisions has been widened to include a requirement that the guarantor and the issuer are resident for tax purposes in the same jurisdiction. Collateral Amounts. The New Pro Forma Provisions allow the Hedge Counterparty to use various collateral options (i.e. original collateral amount, enhanced collateral amount, enhanced collateral amount (assisted replacement)), each of which has its own set of definitions in the CSA. It is worth noting that the relevant set of definitions in the CSA may themselves by replaced with alternative language in Appendix B. Where the Hedge Counterparty opts for an alternative collateral amount (the limitations of which are discussed in Paragraph 3 above), the expectation is that it would specify its own formulae/definitions. In the case of each collateral option, the valuation percentages in Appendix B would apply. As discussed in Paragraph 3 above, it is important that the swap documentation is substantially consistent with the New Pro Forma Provisions so that there is no negative impact of the Step 1 notching uplift. The Guidance Notes to the New Moody s Criteria list the following specific examples that generally prevent substantial compliance: (i) no executed CSA, (ii) departure from trigger-related Additional Termination Events and Events of Default, (iii) departure from the Exposure definition modifications, (iv) transfer obligations that are limited in time or set to a standard lower than commercially reasonable efforts and (v) departure from calculation modifications. 5 CONCLUSION The New Moody s Criteria is a significant development in the manner in which the rating agency determines the ratings effect of Hedge Counterparties on securitisations. It is expected that the extensive guidance embedded in the Linkage Tools as well as the Swap Linkage Tool will assist market participants in ascertaining the manner in which the rating agency is likely to implement its methodology in respect of existing and future securitisations. In the 2013 Request for Comment, Moody s predicted that the implementation of the New Moody s Criteria is likely to be rating-neutral for most structured finance transactions, but will probably result in some negative rating actions (generally limited to rating downgrades between one and three notches). On 14 November 2013, Moody s placed on review for downgrade the ratings of 150 notes in 48 residential mortgage-backed securities (RMBS) and 17 notes in 14 asset-backed securities (ABS) due to swap counterparty exposure. At the same time, Moody's placed on review for upgrade three tranches in two RMBS. It remains to be seen how many other existing securitisations will be affected by the implementation of the New Moody s Criteria s.com/research/moodys-reviews-for-downgrade-emea-rmbs-and-abs-transactions-due-pr Berwin Leighton Paisner November

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