The road to credibility
Triple A structured finance debt has suffered an immense loss of credibility, particularly in the US ABS CDO sector, which is beset by defaults. Triple A CMBS and CLOs, though not facing default, are clearly of a different order than pristine prime RMBS Triple As. This huge variability has meant that, in many eyes, anything structured finance-related gets tarred by the same brush. William Thornhill reports.
Forget Triple A: as long ago as September 2007, UBS's head of CDO research, Douglas Lucas predicted that even the super senior debt would see not just rating migration but principal loss.
Of the 122 ABS CDOs backed by US sub-prime mortgages that he studied, 10% of bonds suffered a collateral loss of 37% leading to an expected tranche loss of 1%. At junior Triple A level, collateral losses of 24% would affect 30% of bonds, leading to an expected tranche loss of 20%. At that time Lucas said this constituted the biggest ever failure of credit risk management or of ratings.
David Preston, a CDO analyst at Wachovia Capital Markets, said that to date 328 of the 730 ABS CDOs issued between 2002 and 2007 in the US are currently in an event of default. They had a nominal value at issuance of US$325bn, representing a little over half the total US$642bn of ABS CDOs that were issued.
The later issues are in much worse shape. A staggering 72% of deals issued in the second half of 2006 are now in EoD, while as many as 78% of deals issued in 2007 are in EoD. Yet as terrible as that is, the overall global picture for structured finance is actually much, much brighter.
Over the last 30 years, 19% of global structured securities that were originally rated Triple A have been downgraded. Better still, only 0.7% have defaulted, according to S&P. In the last year, 24% of global structured finance S&P rated Triple As have been downgraded and just 0.2% have defaulted.
This illustrates a key point that the market currently chooses not to recognise: although the Triple A downgrade rate has been relatively high, particularly for US sub-prime ABS CDOs – the global default rate for Triple A structured finance transactions is still very low –no different, in fact, from other asset classes.
Though Triple As cannot ever be bullet-proof, both their downgrade rates and default rates are significantly lower than for junior rated structured finance debt. Despite the sub-prime debacle, these top-rated instruments have done what they're supposed to do – deliver a genuinely lower risk credit exposure to investors.
No credit rating can assess market valuation or investment suitability. According to Martin Winn an S&P spokesperson, Triple A is "not a guarantee that the market value of a security will never fall." The trouble is that market value has, and continues to play, a very negative role in the psychology and perception of all structured finance debt, irrespective of rating. The market value and related liquidity of many Triple A instruments has fallen heavily, "even when, in our opinion, their creditworthiness has not been significantly impaired,” Winn added.
Take the UK prime RMBS market. HBOS' Permanent Triple As, like all UK master trusts, can withstand as much as 16 times loss coverage of the early 1990s UK recession. That is about as bullet-proof as Triple A ratings can get. Yet, with the meltdown of structured investment vehicles and other key constituents of the ABS investor base, the spread pick up in the secondary market is around 600bp to 700bp above three-month Libor – compared to around 10bp at launch. It is mistakenly tarred by the same brush as genuinely poor credit securitisations, such as US ABS CDOs. There is a perception that all structured finance debt is basically toxic, and a Triple A rating has been essentially meaningless in combating that perception.
Because both UK prime RMBS and US ABS CDOs were originally rated Triple A, it is perhaps understandable why these perceptions arose. But the fact that not all Triple A securitisations are created equal explains the staggering level of ignorance that, even today, is seen at the highest level of governance. This was exemplified by the UK government's decision to provide a credit indemnity on Triple A prime UK RMBS – despite the fact that there is no specialist ABS investor who wants it. Investors are happy with Triple A UK prime RMBS credit.
Bank of America-Merrill Lynch research hit on this point when it wrote: "The convoluted logic may conclude that if an instrument needs government credit guarantee, that instrument must be really bad, which – as we have been arguing for years now – is not the case with UK prime RMBS."
European prime worries
Though the evidence for losses in the prime Triple A RMBS is non-existent, this is certainly not the case across Triple A ratings in other sectors and jurisdictions.
An obvious comparison is UK prime with UK non-conforming. Both are UK RMBS and both are substantially rated Triple A.
There have been no Triple A prime UK RMBS downgraded to date, according to Peter Dossett who heads up Fitch's RMBS surveillance team, and neither does he anticipate any imminently, according to Fitch stress tests. By contrast, in the UK non-conforming RMBS market there have been 35 UK RMBS Triple A tranches that have been downgraded: nine due to performance, three due to monoline downgrades and 23 due to the Lehman Brothers insolvency.
It is modest compared to the US, but clearly a UK non-conforming RMBS Triple A rating is not the same as a Triple A prime RMBS rating. To the uninitiated they are both UK RMBS, so naturally one product has become tainted by the other by association.
Another European market where Triple A ratings appear to be unequal is Spain. Prime Spanish RMBS can trade anywhere between 300bp over three month Euribor and 60 cents of par (which is several thousand basis points over three-month Libor). This illustrates the huge disparity of the market's view about their respective ratings.
This may be because the product has become tainted by a few high LTV RMBS which were marketed as prime. Triple A Spanish securitisations have also been let down by the SME CLO sector, where a few deals that have high regional concentrations and large exposures to the real estate developer sector have hit problems.
To restore confidence in ratings all types of investor, both specialist and non specialist, must believe that Triple A structured finance debt corresponds to a base threshold on the likelihood of default, irrespective of jurisdiction or asset class. But this is far from the case today.
That maybe because rating agencies can only determine the credit support needed to get to Triple A, and thus meet the minimum default threshold, based on empirical evidence. This crisis will give them much better historical data points to achieve that aim but there are always bound to be some sectors that perform generally worse, or better than others.
In attempting to address these concerns, the credit rating agencies have undertaken supplementary measures. "We recognise that confidence in Triple A securitisation ratings is low," said Ian Linnell, head of structured finance for EMEA at Fitch. He pointed out that Fitch increasingly concentrates on providing information beyond the traditional rating. This takes the form of break-loss analysis, stress tests, rating outlooks and enhanced pre-sale reports that highlight "key criteria assumptions and exposure to model risk," Linnell said.
S&P and Moody's have also adopted new measures with the latter, for example, providing V scores. These are a relative assessment of "the potential variability around the various inputs to a rating determination," and are therefore intended to rank transactions by the potential for significant rating changes.
Despite their laudable aim, V scores assigned to Triple A structured finance debt may serve to emphasise the variability of structured finance Triple As ratings. Some products, like cash CDOs, will always tend to have higher V scores than other asset classes.
Another proposed solution was the addition of a suffix to the Triple A structured finance rating, but this has thrown up other potential problems. Industry associations warned that regulated investors might consider a structured finance Triple A to be inferior to a corporate Triple A rating. The concern was that this might force them into a sale of assets that they would have otherwise been comfortable holding.
Alongside that, the agencies have also changed their assumptions, to take account of much more conservative economic scenarios. Recent examples include action taken by Moody's in the CMBS sector in March 2009.
Moody's said up to 30% of all the senior EMEA CMBS notes could be downgraded by up to four notches, while 60% of mezzanine debt could be downgraded up to seven notches. The introduction of more conservative rating assumptions is also prevalent in leverage loan CLO sector with mezzanine pieces taking the worst hits.
By assuming a more severe stress it is hoped that the bad rating news gets factored in sooner rather than later. This should limit potential for a slow drip-feed of prospective negative rating actions which would further undermine confidence. But such an outcome is not a foregone conclusion.