A crucial component of completing a securitization, especially for a first transaction, is maximizing the portion of the AAA rating from the rating agencies. Some of the issues that the rating agencies address are given in Sections 5.10, 5.11, and 5.12.
5.10.1 Operational history
For a new ABS issuer, rating agencies will first look to operational history. A greater degree of historic arrears and performance information will help to improve credit enhancement levels (by reducing the level of assumptions the rating agency would otherwise make instead of missing information). Three years of historic information is typically the minimum, 5 years is OK, 10 years is better, and anything above 15 years is fantastic, since it shows the performance through a full economic cycle.
The agencies will also look to establish the issuer’s long-term viability as a servicer by examining its management expertise.
Table 5.5. Non-compliance and risk weights
Non-compliance to Additional risk weight
(%)
New risk weight (%)
Ensure disclosure by originator, sponsor, or original lender of
the retention of net economic interest 1,000 110
Monitor (undertake surveillance) the ongoing performance
of securitization positions 750 85
Stress-test securitization positions 500 60
Understand, analyze, and record (i.e., undertake due diligence) of
—the risk characteristics of individual securitization positions
—the risk characteristics of underlying exposures
—the reputation and loss experience in earlier securitization transactions of originators and sponsors
—statements and disclosures made by originators or sponsors about due diligence on securitized exposures
—collateral valuation methodologies used to value collateral that supports the transaction
—structural features of the securitization that can impact the transaction’s performance
250 250 250 250 250 250
35 35 35 35 35
35
For multiple breaches: Risk weights are additive, but capped
at max. 1,250 135
5.10.2 Operating procedures
Credit rating agencies will want a detailed understanding of your credit procedures, including:
. Loan/Card-underwriting criteria and approval process . Terms of the loans
. Credit monitoring and collection procedures . Delinquency and charge-off policy.
5.10.3 Differences in rating approaches
Credit enhancement is determined by the rating agencies, after evaluating the current, historical, and future performance of the pool of assets backing the structured finance bond. To establish its size, though, the rating agencies use different approaches.
Moody’s, for instance, applies the expected loss (EL) approach, where they determine the expected losses in the pool under various scenarios. Under this approach, the expected severity of loss to investors as well as their frequency or probability of occurrence is determined. The rating agencies simulate the expected cash flows that the pool could generate, determining the potential losses that it could accumulate.
Some go further by linking the expected loss to the level of reduction of the internal rate of return (IRR) of the bond: the higher the IRR reduction, the lower the bond rating.
Other rating agencies base their assessment on the so-called weak link approach: under this methodology, the rating agencies look at the confluence of different entities and assets in the structure and determine where the structure could ‘‘break’’ (i.e., the weakest link in the chain of assets, counter
parties, and entities). The final rating of the security can never be higher than the weakest link in the structure. On that basis, the rating agency could determine the probability of first-dollar loss, which is a methodology used by Standard & Poor’s as well as Fitch’s.
It is also important to understand that more often than not an asset-backed security is rated by at least two rating agencies. Each of them may use a different approach to derive the ratings and may focus on different factors or weigh the same factors differently to determine the performance under stress scenarios and related expected loss.
The credit enhancement which the respective asset-backed security carries is the highest required by any one of the rating agencies in order to achieve the desired bond rating. In this respect, it is worth investigating any split ratings that exist, especially on lower rated tranches of the securitization bonds.
5.10.4 Ratings mapping
In order to understand an originator’s or issuer’s internal rating system, rating agencies will analyze how closely the rating system aligns with the agency’s own public credit rating scale. This analysis typically results in the credit rating agency mapping table. Although the agency may, as part of this exercise, share this information freely with the originator or issuer, it is typically not published as part of the agency’s rating analysis as it represents proprietary information for the bank.
Ratings mapping exercise
Areas that are investigated as part of the agencies’ mapping exercises are as follows:
. Comparing historical losses per the originator’s internal rating classes vs. rating agency loss experience per rating category
. Comparing default occurrence per the originator’s internal rating classes vs. rating agency loss experience per rating category
. Establishing the originator’s rating dispersion compared with rating agency ratings
. Comparing the originator’s ratings of non-publicly rated companies prior to obtaining public ratings
. Comparing the originator’s rating transition experience to rating agency transition matrices . Qualitative assessment of the originator’s internal rating system (e.g., consistency, back testing,
auditing).
Once completed and assuming that the bank’s internal rating does not change or has been recalibrated, the agency may be able to reuse the derived mapping table as part of any further issuance for this particular originator or bank and any of its subsidiaries that use a similar internal rating table. In practice, this may be reflected in a quicker rating process for repeat issuance by the same originator and may reduce overall costs for assigning the credit ratings.
Although there are several ways in which originators can map the external credit ratings (Fitch, Moody’s, and S&P) to its internally used ratings, it is recommended to use a similar or easily recognizable scale and classification for internal ratings.
Figure 5.1. Rating agency rating table and an internal rating scale.
Copyright #2011 Markus Krebsz, www.structuredfinanceguide.com All rights reserved.
This could easily be achieved by adding a simple prefix prior to the actual internal rating (e.g., an
‘‘i’’). An external AAA rating could then be directly translated and mapped to an internal rating of
‘‘iAAA’’ which is more intuitive than, for instance, an ‘‘SP22’’ rating (given that there are 22 steps on the S&P long-term credit rating scale.)
Furthermore, someone who is not fully familiar with or who does not understand the meaning of such an internal rating will not require the tedious use of a ratings mapping table. As an added benefit, staff who are not using internal ratings frequently, and external parties such as auditors, regulators, rating agencies themselves, etc. will find a rating table which mirrors external long-term credit ratings much more intuitive.
Another important determinant when mapping the rating is finding a sensible level of granularity.
Underlying risks can be more accurately represented by having a sufficiently granular breakdown of the internal rating scale. This holds particularly true for loans with lower ratings and, therefore, higher risk. The availability of granular-enough internal ratings can potentially make or break a securitiza
tion transaction. It is not unheard of for a bank to have refined its internal rating scale following an asset readiness study in order to allow future securitization for these particular assets and to support adequate treatment and pricing of riskier assets.