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Structured Finance Ratings

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Presentation on theme: "Structured Finance Ratings"— Presentation transcript:

1 Structured Finance Ratings
LUISS Guido Carli Facoltà Economia e Commercio Roberto Paciotti Senior Director S&P Structured Finance EMEA 23 November 2012

2 Agenda Fundamental Ratings Vocabulary Structured Finance Ratings
Case Study: RMBS Ratings Performance update – five years on ...

3 General This presentation is a summary of certain of Standard & Poor’s criteria, rating definitions, methodologies and other information. The information herein has been taken from Standard & Poor’s publications either listed in the “References” page at the end of these slides or as noted on individual slides. While the information herein is it is believed to be correct, readers are requested to verify any statement with such publications.

4 Fundamental Ratings Vocabulary

5 What are Credit Ratings?
Credit Ratings, among other things... Are opinions about relative risk Are an opinion about the ability and willingness of an issuer to meet its financial obligations in full and on time Are, also, an opinion about the credit quality of an individual debt issue and the relative likelihood that the issue may default Are not investment advice, or buy, hold or sell recommendations. They are just one factor investors may consider in making investment decisions Our views on creditworthiness, among other things, encompass Likelihood of default Payment priority Recovery Credit stability Source: Standard & Poor’s Guide to Credit Rating Essentials

6 General Summary of Some of the Opinions Reflected by S&P’s Long Term ICR
Investment Grade AAA: Extremely strong capacity to meet financial commitments. Highest rating. AA: Very strong capacity to meet financial commitments A: Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances BBB: Adequate capacity to meet financial commitments, but more subject to adverse economic conditions Speculative Grade BB: Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial or economic conditions B: More vulnerable to adverse business, financial or economic conditions, but currently has the capacity to meet financial commitments CCC: Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments. Source: Standard & Poor’s Guide to Credit Rating Essentials

7 Stress scenario examples for ratings comparison: 1929 Crisis
Duration 43 months Real GDP Decline 26.5% Unemployment Peak 24.9% US Industrial Production decline 47% Home Building decline 80% Stock Market Decline 85% Deflation Peak 25% Stress Level AAA Notes The worst depression in the US history, involving very high unemployment, and sharp decline in GDP and industrial Production

8 Historical Inverse Correlation Between Rating Level And Defaults
Source: Default, Transition, and Recovery: 2011 Annual Global Corporate Default Study And Rating Transitions Table Mar-2012

9 Structured Finance Ratings

10 What is Securitization?
Securitization is a type of financing in which the lender (originator) or some other entity sells a discrete pool of assets (e.g. auto loans, residential mortgages etc.) to a “special purpose vehicle” (SPV), which funds the acquisition through issuance of bonds, notes or other obligations (e.g. ABS, RMBS, Structured Credit, etc.) The creditworthiness of a securitization instrument generally relies on the capacity of the SPV to timely repay scheduled interest and principal to the investors The source of payment is generally the cash flow from the assets (stressed at various rating levels) Credit quality within the various “tranches” of debt issued by the SPV may rely upon different forms of credit enhancement Different tranches of debt are created with different rating levels, among other things to appeal to different investors with different risk tolerances

11 Typical Transaction Structure
Originator Purchase Consideration Sale of Assets SPV Subscription Proceeds Debt Securities Investors

12 Tranching and Credit Enhancement
Special Purpose Vehicle Assets Liabilities Various assets providing a weighted average coupon (Net of Fees) of 5.00% 90.00 % Senior AAA rated class at 3.00% Class CE Senior 10% Mezzanine 5% Junior 2.5% Not Rated 0% 5.00% Mezzanine A rated class at 3.20% Subordination 2.50% Junior BBB rated Class at 4.50% 2.50% NR 5.00% 5.00% Net Collateral WAC – 3.10% Bond WAC=2.90% Initial Excess Spread

13 Why Securitize? Some reasons proposed by market participants
Lower cost of funds Manage regulatory and economic capital requirements Diversify funding sources and liquidity options Accelerate cash flow More stable source of income Manage asset-liability profile Limit originator’s credit risk

14 Typical Transaction Structure
Transaction Parties SPV Assets and Liabilities Credit and Cash Flow Supports Arranger Originator Underwriter(s) Credit Enhancement Purchase Consideration Sale of Assets Swap Provider Liquidity Enhancement RoN SPV Servicer Subscription Proceeds Debt Securities Derivative Products Bank Account Paying Agent Investors Other Facilities

15 The Rating Process for a “Generic” Structured Financing
Overview Typically one day visit at the originator offices to review the procedures that could affect the securitization Credit and Cash Flow Analysis Analysis of the credit quality of the portfolio of assets to be securitized and its forecast cash flows Documentation Analysis of transaction documentation Legal Analysis Analysis of the transaction’s legal structure and issues Committee Presentation of transaction analysis to the rating committee Issuance of the Rating

16 Legal Criteria: Bankruptcy Remoteness of SPV
The organizational documents of the SPV generally provide for: Restrictions on Objects and Powers The limited purposes of the SPV must be carried out No Reorganization or Changes of Ownership of the SPV The SPV must agree not to engage in any liquidation, merger, or asset sale Debt Limitations on the SPV SPV is restricted from incurring additional indebtedness

17 Legal Criteria: Bankruptcy Remoteness of SPV (cont)
The organizational documents of the SPV generally provide for: Separateness Covenants Covenants designed to provide comfort that the SPV’s assets would not be deemed to be part of the controlling party’s insolvency estate if the controlling party becomes insolvent Independent Director for the SPV At least one of the directors of the SPV must be “independent” (as such term is used in our criteria) from the participants Security Interest over Assets of the SPV The SPV should grant a security interest over its assets to the Noteholders

18 Legal Analysis: True Sale
The transfer of the asset constitutes a “true sale” if the sale can be defended against third party claims that the transfer amounted only to a “pledge” or “loan” of the assets A true sale is designed to transfer legal title to the assets from the transferor to the SPV so that in an insolvency of the transferor, creditors of the transferor cannot argue that the assets belong to the transferor (and thus be available to satisfy creditor claims). In other words, a true sale is designed to protect the SPV’s ability to make timely payment of principal and interest on the rated securities Under the Securitization Law, the sale of the receivables to the SPV constitutes True Sale upon (i) publication in the Official Gazette and (ii) registration in the Companies Registrar S&P expects a true sale of the assets to be achieved no later than the closing date and requests legal confirmation of the true sale

19 Legal Analysis: Commingling Risk
The issue of commingling occurs when cash belonging to the SPV is mixed (or “mingled”) with cash belonging to a third party or goes into an account in the name of a third party. In law, if property (such as cash) is mixed or commingled in such a way that it cannot be precisely identified, in the insolvency of a party to the mixing or mingling that party, this cash is unavailable for debt service payments until the court makes a determination about the rights of the respective “mixing” parties Under its criteria, S&P believes that commingling risk is mitigated if the third party is rated at or above a certain level (“eligible”) If the third party is not “eligible”, S&P will assume that thirty days worth of transaction cashflows will be lost to noteholders

20 Case Study: RMBS Ratings

21 Credit Analysis Overview
In a typical RMBS transaction, proceeds from mortgage servicing is used to repay principal and interest on rated notes Credit risk analysis of the mortgage pool is therefore an integral part of the rating process The analysis consists primarily of loan level review and a WAFF and WALS review The credit risk analysis estimates the expected losses that could, in our estimation, occur in the mortgage pool under different stress scenarios This estimate results in an indicative level of target credit support that is, in our view, commensurate with a particular rating level

22 Analysis outline Loan Level Analysis
for each loan and for each rating scenario estimate The foreclosure frequency (FF) The loss severity (LS) assumes more foreclosures and greater losses at higher rating levels: in other words, the higher the rating, the more “stressful” the scenario WAFF (weighted average foreclosure frequency) x WALS (weighted average loss severity) is how S&P assesses the expected loss of the loan portfolio WAFF and WALS returns a preliminary indicator of the credit support required for the securitization to continue to pay timely principal and interest under a given rating scenario

23 Foreclosure Frequency (FF): Benchmark Pool
S&P assumes a base FF at each rating level reflecting the probability of foreclosure for each loan in the benchmark pool under each rating scenario Base Foreclosure Frequency for a Benchmark Pool Rating Base Foreclosure Frequency (%) AAA 15 AA 10 A 8 BBB 6 BB 4

24 Foreclosure Frequency: Benchmark Pool
Performing Status Residential Purpose First home function Secured by a first-charge mortgage Maximum LTV ratio of 80% Non self-employed borrower Geographically distributed throughout Italy Loan amount below €400,000 Originated at branch level Nonmodular: fixed/floating for life Seasoned less than 80 months

25 Foreclosure Frequency: Deviation from the Benchmark Pool
If a loan displays characteristics that deviate from the benchmark pool, S&P assumes such loan will have an increased or a decreased FF in comparison with the base assumptions Characteristics affecting Base FF and Related Adjustments Characteristic Affect on Base Foreclosure Frequency Commercial Properties Base Multiplied by 1.5 to 2.0 Second Home Base Multiplied by up to 1.3 Buy to Let Base Multiplied by up to 1.8 Non First Charge Mortgage Base Multiplied by up to 1.5 Repayment Method Base Multiplied by 1.2 LTV ratio < 50% Base Multiplied by 0.8 LTV ratio > 80% Base Multiplied by up to 5.0 Self Employed Borrower Up to 25% addition to base “Jumbo” Loans Up to 20% addition to base Modular Loans Seasoning >18 months Final FF reduced by 10% to 25% Geographic concentration Typically 10% Originator penalty Typically between 5% and 10%

26 Foreclosure Frequency: Loan Level Adjustment Rationale
Occupancy Status Does the borrower live in the property or is it an investment? Which is more risky? Owner Occupied Buy to Let

27 Foreclosure Frequency: Loan Level Adjustment Rationale
Occupancy Status Does the borrower live in the property or is it an investment? Which is more risky? Owner Occupied Buy to Let  Multiple to base of 1.8

28 Foreclosure Frequency: Loan Level Adjustment Rationale
Priority Ranking Is there another secured mortgage on the subject property ranking higher than the mortgage being analyzed? Is the first charge or the second charge mortgage more risky? No, this has the first charge on this property Yes, this has the second charge on this property

29 Foreclosure Frequency: Loan Level Adjustment Rationale
Priority Ranking Is there another secured mortgage on the subject property ranking higher than the mortgage being analyzed? Is the first charge or the second charge mortgage more risky? No, this has the first charge on this property Yes, this has the second charge on this property  Multiple to base of 1.5

30 Foreclosure Frequency: Loan Level Adjustment Rationale
Repayment Method Is the borrower paying interest only or principal and interest on the loan? Which more risky? Repayment (Principal and Interest) Interest Only – 8 years

31 Foreclosure Frequency: Loan Level Adjustment Rationale
Repayment Method Is the borrower paying interest only or principal and interest on the mortgage? Which more risky? Repayment (Principal and Interest) Interest Only – 8 years  Multiple to base of 1.2

32 Foreclosure Frequency: Loan Level Adjustment Rationale
Loan To Value This captures the amount of direct borrower investment in a property Which mortgage is more risky? 100% LTV 40% LTV

33 Foreclosure Frequency: Loan Level Adjustment Rationale
Loan To Value This captures the amount of direct borrower investment in a property Which mortgage is more risky? 100% LTV  40% LTV Multiple to base of between 1.0 and 5.0

34 Foreclosure Frequency: Loan Level Adjustment Rationale
Jumbo Loan Size Is this a Large Loan? Which is more risky?

35 Foreclosure Frequency: Loan Level Adjustment Rationale
Jumbo Loan Size Is this a Large Loan? Which is more risky? €  Multiple to base of 1.2

36 Foreclosure Frequency: Loan Level Adjustment Rationale
Seasoning How old is the loan? Which more risky? 12 months 12 years

37 Foreclosure Frequency: Loan Level Adjustment Rationale
Seasoning How old is the loan? Which more risky? 12 months  12 years Foreclosure Frequency reduced by 10%-25%

38 Foreclosure Frequency: Loan Level Adjustment Rationale
Geographic Concentration Are the mortgages in the pool distributed throughout the country or concentrated in one area? Which is more risky? 100% in throughout Veneto 100% throughout Italy

39 Foreclosure Frequency: Loan Level Adjustment Rationale
Geographic Concentration Are the mortgages in the pool distributed throughout the country or concentrated in one area? Which is more risky? 100% in throughout Veneto  100% throughout Italy All loans in a concentrated region receive an addition to the adjusted base of 10%.

40 Foreclosure Frequency: Loan Level Adjustment Rationale
Originator Penalty Is there anything about the Originator that concerns you? Which is more risky? Newly-established Originator Poor portfolio performance compared to peers Large number of manual overrides in underwriting process

41 Foreclosure Frequency: Loan Level Adjustment Rationale
Originator Penalty Is there anything about the Originator that concerns you? Which is more risky? Newly-established Originator  Poor portfolio performance compared to peers  Large number of manual overrides in underwriting process  Multiple to base for all loans, size is decided by committee.

42 Foreclosure Frequency: Example of FF Calculation
Current Loan Balance Prior Ranked Balance 0 € Valuation Seasoning 20 months Monthly Payment 100 Mortgage Term 9 years Self Employed Borrower Yes Rating Level AAA BBB Base FF 15.0% 6% LTV = 83% 1.3 Adjusted Base = 15% x 1.3 = 6% x 1.3 19.5% 7.8% Self Employed (+25%) +4.8% +1.95% Seasoning (-10%) (1.9%) (0.78%) Foreclosure Frequency 19.5% + 4.8% -1.9% 7.8%+1.95%-0.78% 22.4% 8.97%

43 Loss Severity: Market Value Decline
The sale proceeds received from a property are assumed to be less than the original valuation of the property, owing to a recessionary market value decline. These assumptions are based on an analysis of house price movements Market Value Decline for Italian Residential Properties Rating Market Value Decline (%) AAA 35 AA 30 BBB 26 BB 22 B 20

44 Loss Severity: Example of LS Calculation at the AAA level
Original Property Value Market Value Decline (35.000) € Residual Value Loan Balance (80% LTV) (80.000) € Market Loss (15.000) € Assumed Foreclosure Costs (i.e., legal fees and costs at 10% of loan balance) (8.000) € Total Loss (23.000) € Loss Severity ( = /80.000) 28.75%

45 Cash Flow Analysis Overview
The WAFF and WALS alone is insufficient for determining the credit enhancement required in a transaction as it does not take into account several important factors Effectively, the final credit enhancement figure will be determined through the simulation of the transaction’s asset and liability structure by means of a cash flow model When running cash flows, we seek to determine in which rating scenarios the transaction is able to meet: Timely payment of interest; Ultimate payment of principal, i.e within final maturity of the notes.

46 Cash Flow Analysis: Priority of Payments
In the cash flow model, payments are made according to the waterfall, which is specific of the transaction. Payments are made out of available funds (which basically comprise collections from the portfolio and payments from the swap counterparty). A typical waterfall could be: Pay Senior fees; Pay Amounts due to the swap counterparty Pay interest to class A Pay interest to class B Pay Class A amortization amount If Class A has been paid in full, then pay Class B amortization amount Replenish Cash Reserve Pay other expenses subordination of classes

47 Cash Flow Assumptions and Stresses
Amount of Default and Recovery (WAFF & WALS); Timing of Default (Slow / Fast); Interest Rate curve (High / Flat / Low); Prepayment Rate (High / Low); Timing of Recovery; Delinquencies; Reinvestment Rate; PDLs; Expenses; Spread Compression; Transaction specific stresses. We test the cash flow in all the possible scenarios (12) determined by the combinations of these 3 variables

48 Performance Update – five years on …

49 European SF performance over the past 5 years
Data in % * Excluding defaults Source: Standard & Poor's CreditPro

50 Gross default rates mid-2007- mid-2012
Source: statistics on S&P ratings * default percentages by initial issuance volume ** default percentages by number of ratings Default rates of European structured finance transactions during this period have outperformed Corporate default rates No Covered Bond defaults in the same time frame

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