In structured finance transactions, counterparties and supporting parties have payment obligations that have to be considered in Standard & Poor's Ratings Services' cash flow and credit analyses. Our counterparty and supporting party criteria state that we reflect the credit risk of the counterparty in rating structured finance transactions.
Our framework applies the criteria to structured finance and certain U.S. public finance transactions with a long-term rating of 'AAA'. Certain aspects of the criteria will also apply to asset-backed commercial paper (ABCP) and U.S. public finance commercial paper programs with a short-term rating of 'A-1+'. We intend to publish more detailed articles that will address the application of the criteria to securitization structures that allow for early termination with no loss to investors upon a default by the credit default swap counterparty ("terminating de-linked structures", which are most common to synthetic CDOs) and covered bonds to take into account the specific nature of these transactions. We will also provide additional guidelines for applying the criteria to transactions rated below 'AAA', to the 'AA' and 'A' rating categories. This new framework is effective as of this publication date.
In analyzing the impact of a counterparty downgrade on the rated transaction, consideration is given to:
The ratings on the counterparty, both long-term and short-term;
The period of exposure the transaction has to that counterparty;
The immediacy and extent of the counterparty's failure on the ability of the rated transaction to meet its obligations; and
The existence of structural features to replace or collateralize or otherwise mitigate the exposure to the counterparty's creditworthiness in the rated transaction.
Our revised criteria framework considers the nature of the link between the rating on the notes in the transaction and the rating on the counterparty by recognizing that there is a continuum between weak-linked analysis and completely de-linked analysis. In a weak-linked (also known as "hard-linked") analysis, the rating on the notes is directly linked to the long-term rating on the counterparty. In the de-linked approach, structural features significantly reduce the likelihood of the rating on a transaction's notes being negatively affected by a lowering of the counterparty's rating.
The approach presented here can be described as a soft or partial link to the rating on the counterparty. It provides a framework for expanded eligibility of counterparty ratings based on structural risk mitigating factors agreed to by the counterparty.
This article supersedes the following articles: "Request For Comment: Revised Counterparty And Supporting Party Criteria", published on Nov. 13, 2006, "Global Interest Rate and Currency Swaps: Calculating the Collateral Required Amount," published on Feb. 26, 2004, and "Standard & Poor's Global Interest Rate and Currency Swap Counterparty Rating Criteria Expanded," published on Dec. 17, 2003.
Approach To Counterparty Risk
The application of the criteria to achieve the partial link approach would apply when the terms of the transaction would result in a high likelihood of replacement of the counterparty if it becomes ineligible. The counterparty may have given a firm commitment to replace itself under these circumstances or the transaction may be structured to provide economic incentives that would increase the likelihood of an ineligible counterparty being replaced. In some cases, we would look for additional draw-to-cash provisions if a suitably rated counterparty were not found.
The Role Of A Counterparty Within A Transaction
When applying the criteria, counterparty risk will be classified into three categories, based on the way the counterparty is participating in the transaction:
Eligible direct support counterparties,
Eligible derivatives counterparties, and
Eligible other support counterparties.
A general framework for the application of the criteria is presented, rather than a detailed, rules-based approach. We recognize the possibility that certain obligations may be capable of being structured to meet the definition of a number of categories. In these instances, we would look to understand the nature of the risk being addressed in order to apply the appropriate eligibility criteria.
Within each category, guidelines are given for the types of obligations and instruments that would qualify under this framework. Rating triggers and the remedy period upon a trigger breach are also detailed. We do not consider that either the triggers or the remedies are exhaustive, and would direct market participants to focus on the principles upon which the criteria are based. See "Appendix I" for a summary of the key features of the three categories.
SECTION I. ELIGIBLE DIRECT SUPPORT COUNTERPARTIES
Definition
Eligible direct support counterparties may serve as counterparties on eligible direct support obligations. We draw a distinction between eligible direct support obligations in term transactions and those used in short-term CP programs.
For term transactions, eligible direct support obligations would include all obligations that provide direct credit or liquidity support, either for the full amount or a portion of the enhancement exposure. Eligible direct support obligations in term asset-backed transactions include:
Letters of credit (LOCs),
Guaranteed investment contracts (GICs),
Guarantees,
Liquidity agreements, and
Reserve accounts that provide either credit or liquidity enhancement. In these cases, both the financial institution holding the account and the investment securities held by the account would be defined as applicable direct support counterparty exposures.
Eligible direct support obligations would exclude bond insurance as well as those obligations included in the definition of eligible derivatives obligations and eligible other support obligations. The criteria potentially could apply to mortgage pool insurance policies, which are generally weak-linked to the transaction rating, but only if the insurers change the structure of the policies to include the rating downgrade remedies described below.
For ABCP structures, eligible direct support obligations would be limited to liquidity facilities and other arrangements designed to address a temporary mismatch in the payment of cash flows. Credit facilities such as program-wide credit enhancement and investment accounts are excluded from the definition of eligible direct support obligations in the application of the criteria.
While we recognize that including these credit support providers for structures with short-term ratings would be logically consistent with how we have applied our long-term rating approach, we also wish to maintain the distinction in relative credit risk between the 'A-1+' and 'A-1' categories.
Applying The Criteria To Eligible Direct Support Counterparties
For an eligible direct support counterparty to participate in a 'AAA' rated transaction, the minimum rating is a short-term rating of at least 'A-1', or a long-term rating of at least 'A+', if it has no short-term rating.
We assume that at the outset of the transaction, each eligible direct support counterparty would specify a set of contractual remedies that would apply if it became ineligible. The remedy should be applied within 60 calendar days of a counterparty becoming ineligible and the downgraded counterparty should bear the cost of obtaining these remedies.
Remedy options may include a Day 1 covenant by the counterparty to use commercially reasonable efforts to (i) replace itself with an eligible direct support counterparty, or (ii) find an appropriately rated guarantor. Where a guarantor is provided, we would expect the guidelines for the application of guarantee criteria to be applied.
However, finding a replacement or a guarantor may not be possible. Therefore, the transaction documents should provide for a draw-to-cash or pre-funding option with no loss to the noteholders, to be applied within 60 calendar days of the eligible direct support counterparty becoming ineligible.
We split eligible direct support counterparties into two groups: those that provide credit or liquidity facilities and those that act as account providers or issue investment securities.
Counterparties providing credit or liquidity facilities
These may include credit enhancement LOCs, GICs, guarantees for credit and liquidity exposures, and liquidity facilities. This section applies to long-term 'AAA' transactions, with a more limited application to 'A-1+' ABCP programs.
For both long-term transactions and ABCP programs, the transaction documentation at closing would reflect the counterparties' agreement to the provisions listed here, including which parties bear the cost of replacement. The downgraded counterparty would bear the costs related to securing a replacement or guarantor or these costs would otherwise be covered at no cost to the transaction. The replacement counterparty would also be obligated to agree to the same downgrade and remedy provisions that bind the original counterparty.
Long-term transactions.
An entity rated a minimum of 'A-1' (or 'A+' and above if it has no short-term rating) that provides credit enhancement of up to 100% of the transaction is now deemed compatible with a 'AAA' issue rating, under certain conditions. The entity would commit in writing that if its rating is lowered below 'A-1' (or 'A+' if it has no short-term rating), within 60 calendar days of the downgrade, it will find a replacement counterparty or guarantor rated at least 'A-1' (or 'A+' and above if it has no short-term rating) or draw to cash the full remaining obligation.
ABCP programs.
ABCP structures with an 'A-1+' or 'AAA' program rating may include up to 100% liquidity support from entities rated at least 'A-1', under certain conditions. Upon a downgrade below 'A-1', the entity would, within 60 calendar days, find a replacement liquidity provider or guarantor rated at least 'A-1' or draw to cash the full amount of the obligation.
For 'A-1' liquidity providers to be eligible to support an 'A-1+' ABCP program, we assume that the liquidity providers are not bearing any credit risk in the structure as we would still expect that the credit support would be sized to an 'A-1+' standard. Traditionally, liquidity providers may have assumed certain credit risks in ABCP structures relating to legal uncertainties in the structure, interest rate and basis risks, receivables dilution risk, and "short tail" credit risk associated with a bank's obligation to fund for outstanding CP prior to the maturity of the underlying asset. Therefore, in such instances, the 'A-1' guideline cited above would not apply to any situations where the liquidity banks are obligated to take ultimate credit risk. Furthermore, these criteria do not provide for applying the 'A-1' standard to either the asset pools or rated securities in which 'A-1+' rated ABCP programs may invest. In addition, 'A-1' rated issuers may not achieve 'A-1+' ratings by issuing or investing in short-tenor securities.
Cash draw mechanics.
For both 'AAA' and 'A-1+' rated notes, In the event of a cash draw due to the downgrade of the counterparty, the proceeds are to be held in a deposit account with an eligible direct support counterparty. In other words, an entity that is downgraded below 'A-1' is not eligible to hold cash that serves as credit support. Alternatively, the proceeds may be invested in appropriately rated securities and held by a custodian, both of which would be provided by an eligible direct support counterparty (see "Counterparties providing investments, reserve accounts, and custodian accounts" below).
The deposit or custodial account would be in the name of the trustee on behalf of investors, not in the name of the counterparty or custodian. Once the draw-to-cash or securities occurs, the direct support agreement terminates. The issue rating becomes de-linked from that on the downgraded counterparty, but is soft-linked to the rating on the deposit account provider or custodian. In either case, we would review the legal documentation relating to the replacement of the counterparty or a draw to cash in order to affirm the rating on the transaction's notes.
Furthermore, the obligation to draw-to-cash the full remaining obligation may involve not just principal payments but also ongoing interest payments—as in the case of GICs. In these cases, the draw-to-cash should be appropriately sized to take account of all payment obligations over the remaining transaction life.
Counterparties providing investments, reserve accounts, and custodian accounts
This section applies to long-term 'AAA' transactions. It does not apply to 'A-1+' ABCP programs at the conduit level but may be applied to the underlying long-term transactions that are funded by the conduit.
"Eligible" or "permitted" investments that have maturities of up to 60 calendar days rated at least 'A-1' (or 'A+' or higher if it has no short-term rating) are now deemed compatible with a 'AAA' issue rating. Eligible investments rated at least 'A-1' (or 'A+' or higher if it has short-term rating) with terms greater than 60 days but including a provision to remove the investments from the transaction within 60 days of a downgrade below 'A-1' (or 'A+' if no short-term rating) at no loss to the structure are also compatible with a 'AAA' issue rating.
Reserve accounts, deposit accounts, and other similar accounts that provide direct liquidity and/or credit enhancement, hold the principal proceeds of a debt issuance, or hold eligible investments invested from those proceeds are deemed compatible with an 'AAA' issue rating, provided that:
The proceeds or eligible investments are held at a financial institution rated at least 'A-1' (or 'A+' or higher if it has no short-term rating); and
If the account provider's rating falls below 'A-1' (or below 'A+' if it has no short-term rating), the funds would be moved within 60 calendar days to another account provider that is rated at least 'A-1' (or 'A+' or higher if it has no short-term rating).
Examples of these accounts include spread, cash collateral, prefunding, principal funding, principal accumulation, and yield supplement accounts. (For further details see "Counterparties providing credit or liquidity facilities" above.)
Custodian accounts, which hold either cash or collateral for the benefit of a third party, would be rated at least 'A-1' (or 'A+' and above if it has no short-term rating). In certain jurisdictions, such as the U.S. and U.K., funds held in true corporate trust, custody, or fiduciary accounts are deemed to be sufficiently isolated from the insolvency risk of the bank, such that the above-cited minimum counterparty ratings need not apply. We will review these situations on a jurisdiction-by-jurisdiction basis in light of the applicable legal and regulatory analysis.
SECTION II: ELIGIBLE DERIVATIVES COUNTERPARTIES
Definition
Eligible derivatives counterparties may participate in eligible derivative obligations, which include all derivative-type transactions. The most commonly seen derivatives in rated transactions are:
Swap agreements (currency, interest rate, commodity, credit default, asset, or total return swaps),
Repurchase agreements,
Securities lending contracts, and
Puts, calls, and options.
These agreements would typically be documented using the ISDA swap agreement framework or the TBMA/ISMA Master Repurchase Agreement framework.
A separate article will address how to apply these criteria to covered bonds.
Applying The Criteria To Eligible Derivatives Counterparties
This section applies to long-term 'AAA' transactions and 'A-1+' CP programs at the asset pool level. Only in specific cases might it apply to 'A-1+' CP programs at the program level.
For 'AAA' rated structured finance transactions, any counterparty rated at least 'A-1' (or 'A+' and above if it has no short-term rating) would be eligible to provide derivatives (including interest rate and currency swaps), provided it agrees to seek a replacement or guarantor and post "additional collateral" upon becoming ineligible. Counterparties that are financial institutions will continue to be considered eligible while rated 'A-2' (or 'BBB+' to 'A' if it has no short-term rating) provided it agrees to collateralize 100% of the contract's mark-to-market. Any counterparty replacement or guarantee will be subject to rating confirmation.
The criteria would not require legal opinions upon collateral posting or external mark-to-market quotes when the collateral amount is posted. Collateral posting should be completed within 10 business days upon a downgrade to 'A-2' (or 'BBB+' if it has no short-term rating) for collateral or upon becoming ineligible for additional collateral.
Minimum ratings
The minimum ratings for an eligible derivatives counterparty to participate in a 'AAA' rated transaction are:
Any entity that has a short-term rating of at least 'A-1' (or 'A+' or higher if it has no short-term rating);
A bank, broker/dealer, insurance company, structured investment vehicle (SIV), or derivative product company (DPC) that has a short-term rating of 'A-2' (or 'BBB+' to 'A' if it has no short-term rating), subject to collateral posting;
An unrated subsidiary of a rated bank, broker/dealer, corporation, or insurance company whose obligation is fully backed by an irrevocable and unconditional guarantee from an appropriately rated eligible entity; or
An unrated subsidiary of a rated bank, broker/dealer, or insurance company that we deem core or strategically important, if the group parent has a short-term rating of at least 'A-2' (or 'BBB+' or above if it has no short-term rating), subject to collateral posting where applicable.
Replacement
The transition to a new counterparty should be economically and operationally seamless for the securitization issuer. In applying the criteria, we assume that any replacement counterparty will agree to the same terms as those existing under the original contract. The cost of obtaining a replacement, inclusive of additional risk premiums and breakage costs, is to be borne by the counterparty.
Collateralization
Collateral posting standards will depend on the ratings on the eligible derivatives counterparty, as follows:
Eligible derivatives counterparties that are rated at least 'A-1' (or 'A+' or higher if it has no short-term rating), after applying the provisions set forth above, do not need to post collateral, regardless of the type of derivative.
Furthermore, eligible derivatives counterparties that have a rating of 'A-2' (or 'BBB+' to 'A' if it has no short-term rating) would post collateral.
Once a counterparty becomes ineligible, it is assumed that it would also post additional collateral.
Where collateral is needed, the eligible derivatives counterparty would cover at least 100% of the mark-to-market value of the obligation. Where additional collateral is needed, the ineligible derivatives counterparty would provide an additional amount that would be equal to at least 25% of the mark-to-market value of the obligation. (See "Appendix II" for a description of the calculation.)
Furthermore, the posted collateral, if it is in the form of securities rather than cash, would also be subject to market-value haircuts based on the market-value tables set forth in "Appendix III". These haircuts would differ depending on whether the counterparty is eligible or ineligible. The market-value tables assume weekly mark-to-market. If the actual mark-to-mark frequency differs from weekly, then different market value haircuts may apply.
The credit support annex, or similar documentation, should be entered into at the start of a transaction and contain provisions for the delivery of collateral, as well as properly referenced market-value tables for the counterparty criteria. The eligible derivatives counterparty or calculation agent would be responsible for calculating mark-to-market requirements and posting/maintaining the collateral in accordance with the documentation.
Remedies
Remedies for ineligible counterparties would be specified in the documents at the beginning of the transaction. These would include Day 1 covenants:
To immediately deliver (defined as within 10 business days of becoming ineligible) additional collateral no less than 25% of the mark-to-market of the obligation; and
To use commercially reasonable efforts to (i) replace itself with an eligible derivatives counterparty or (ii) find an appropriately rated guarantor.
Except for the posting of collateral and additional collateral as stated above, all other remedies would need to be implemented within 60 calendar days of a counterparty becoming ineligible.
If an ineligible counterparty is not replaced within the remedy period, in the absence of other structural enhancements, we would reflect the risk of that downgraded counterparty by lowering the ratings on the transaction to levels that could be supported by the counterparty's then-current rating. The presence of collateral and the amount of collateral (as well as possibly the ability to access it in an insolvency of the counterparty) would be taken into consideration in analyzing the transaction after a counterparty is downgraded.
Application to terminating de-linked structures
The application of this framework to terminating de-linked structures (most commonly seen in synthetic securitizations, in particular synthetic CDOs) is limited to the minimum rating on the supporting party. For 'AAA' rated transactions, such counterparties may now have a rating of at least 'A-1' (or 'A+' or above if it has no short-term rating). Once rated below 'A-1' (or below 'A+' if there is no short-term rating), the downgraded counterparty would provide collateral in an amount to ensure full payment of interest and principal when the transaction terminates. The specifics around the amounts that need to be posted, the use of external marks-to–market, and legal opinions remain unchanged as per previous criteria for terminating structures. In particular for CDOs, these guidelines are outlined in "CDO Spotlight: Counterparty Risk In Structured Finance Transactions" (see details below). We will update this article addressing the application of this general criteria framework.
Swap market considerations
We recognize that the mere documentation on a swap form of an obligation that is not traded or common in the swap market will not automatically lead to an ability to replace the swap. Some derivatives may be more difficult to replace than others due to their complexity or bespoke nature, and the mark-to-market of the contract would reflect such features. Therefore, counterparties seeking to apply this criteria framework to less liquid swaps should understand the implications of having to find a replacement and their obligation to post the mark-to-market of the derivative contract. Similarly, the market should understand and consider the risk of a downgrade of the transaction if a replacement is not found.
Eligible direct support versus eligible derivative support
We recognize that in some cases it is difficult to draw a bright line between eligible direct support and eligible derivative support. We review these transactions on a case-by-case basis to determine the appropriate application of the eligible derivative support criteria. An important consideration in this review is the ability to apply the collateralization provisions in a rational way. In certain instances, the mark-to-market concept may not be applicable to determine the collateral amount to be posted.
SECTION III: ELIGIBLE OTHER SUPPORT COUNTERPARTIES
Definition
An eligible other support counterparty may support eligible other support obligations. This category covers counterparties that are not providing support that could be categorized as direct support or are not supporting a derivative transaction.
Eligible other support obligations may cover risk pertaining to:
Collection accounts,
Originator set-off and commingling (as an alternative to modeling and reserving the risk), and
Servicer and trustee advances.
Bank accounts that hold funds serving as credit or liquidity support—e.g., reserve accounts and certain custodian accounts—would be classified as eligible direct support.
Applying The Criteria To Eligible Other Support Counterparties
This section applies to long-term 'AAA' transactions. For 'A-1+' rated ABCP programs, the criteria would not apply at the program level but could be applied to the underlying individual long-term transactions funded by that program.
For 'AAA' rated notes, cash collections can be held in accounts of banks rated a minimum of 'A-2' (or 'BBB+' or above if it has no short-term rating) provided that within 30 calendar days of a downgrade the money is moved to another institution rated at least 'A-2' (or 'BBB+'). The obligation to find a substitute bank depositary upon such a downgrade rests with the servicer or the trustee. For this category, it would need to be demonstrated that the counterparty is not providing support that could be categorized as either an eligible direct support obligation or an eligible derivative obligation. We would expect this provision to apply primarily to "collection" and "payment" accounts through which the cash collections for a given payment period would flow.
For 'AAA' rated notes, the range of counterparties who can provide other support in structured financings may also include servicers rated a minimum of 'A-2' (or 'BBB+' and above if it has no short-term rating) in certain situations where principal and interest payments are held in the name of the servicer and may be commingled with its own funds for periods of time before the transfer of these amounts to the securitization vehicle. However, the application of this standard will vary depending on the potential magnitude and duration of the counterparty exposure. Such risk varies depending on the underlying payment patterns of the securitized assets, the transaction payment structure, and the applicable legal jurisdiction. If there is a downgrade of the counterparty below 'A-2' (or below 'BBB+' if it has no short-term rating), there are numerous possible remedies that could enable us to maintain the current rating on the notes. For example, the downgraded servicer may obtain a guarantor to cover the credit exposure to the servicer. Alternatively, the servicer may agree to shorten the timeframe during which it holds the cash collections in its own name or cease holding such monies altogether. Ultimately, however, any exposure to the servicer resulting from its holding or commingling of monies belonging to the securitization is covered by the credit enhancement. If a servicer is downgraded below 'A-2' (or below 'BBB+' if it has no short-term rating) and the rated notes face credit exposure that is not sufficiently covered by credit enhancement or mitigated by other remedies, it is possible that the rating on the notes would be downgraded to reflect the additional counterparty credit exposure.
Set-off risk will be treated in a similar manner. Exposure to a seller rated a minimum of 'A-2' (or 'BBB+' or above it has if no short-term rating) is generally deemed compatible with a 'AAA' rated transaction. Set-off risk arises if the underlying borrowers in a securitized asset pool have the right to set-off or net their contractual payment obligations against any deposits or other obligations owed to them by the seller following the latter's bankruptcy or insolvency. Application of this standard, however, may also vary depending on the asset class, transaction structure, and applicable law in a jurisdiction.
Additionally, servicers and trustees rated at least 'A-2' (or 'BBB+' or higher if it has no short-term rating) that provide advances for delinquent receivables which are deemed ultimately recoverable are generally compatible with 'AAA' rated notes. Servicer or trustee advance mechanisms are most often found in RMBS (residential mortgage-backed securities) and CMBS (commercial mortgage-backed securities) structures, and certain U.S. public finance transactions. However, these criteria may not apply in situations where the transaction structure would allow for disproportionately large exposures to the servicer or trustee. We will review these situations on a case-by-case basis.
The application of the framework outlined in this section would not preclude transactions from being structured such that the counterparty risk for indirect support obligations would be de-linked from the issue rating. In those instances, a variety of credit enhancement methods may be used to achieve this de-linked approach (e.g., joint support criteria or modeling and reserving for those risks appropriately).
In "Appendix I" we provide a summary of the key features of the different categories of counterparty risk. For eligible derivative obligations, we provide in "Appendix II" the guidelines to determine the collateral posting requirements, and in "Appendix III" we give the overcollateralization rates for eligible securities.
Appendix I: Features Of Counterparty Categories
Key features of the three categories of eligible counterparties are included in tables 1-3.
Replace with another, seek guarantor, or reserve accordingly
30 calendar days
Day 1 covenant to provide these remedies
Appendix II: Collateralization Guidelines for Eligible Derivative Obligations
These guidelines should be used to determine the collateral posting requirements when applying the counterparty and supporting party criteria to eligible derivative obligations. They apply for all derivative agreements where the calculations described below can be made.
The guidelines do not replace the collateralization guidelines for credit derivative transactions that are de-linked and structured to terminate with no loss. (See "Application to terminating de-linked structures" in "Section II" above and "CDO Spotlight: Counterparty Risk In Structured Finance Transactions," detailed below.)
The Basic Concepts
Collateral required amount
Where collateral posting is required for an eligible derivative counterparty, the collateralization guidelines are based on the termination value of the eligible derivative obligation. From an SPE's perspective, the termination value—commonly referred to as the financial contract's mark-to-market—typically represents the cost of finding a replacement derivative counterparty or the value of payments lost should the derivative counterparty default. When a derivative counterparty becomes ineligible, the derivative obligation's collateral required amount is stressed, such that it becomes 125% of the contract's termination value.
Eligible securities overcollateralization rates
Either cash or eligible securities may be posted as collateral (see "Appendix III" for a list of eligible securities). For eligible securities, the overcollateralization rates reflect market practice assumptions regarding a liquidation loss of the collateral upon realization to cash. The base overcollateralization rates apply when an eligible derivative counterparty is posting collateral. When a derivative counterparty becomes ineligible, then the overcollateralization rates are stressed, such that they become 125% of the applicable base overcollateralization rate. The overcollateralization rates applicable to a transaction are based on the specific types of eligible security that may be posted as collateral.
Grace period
Whenever a rating change necessitates collateral posting or additional collateral posting by a derivative counterparty, the collateral or additional collateral, as the case may be, will need to be posted within 10 business days of the related rating event. This obligation will need to be documented by the counterparty on Day 1 of the transaction.
Calculation of MTM
These guidelines assume, among other things, weekly mark-to-markets (see "Appendix III" for assumptions). However, the general framework does not envisage a predetermined or predefined method for calculating the marks. Rather, market practice and the calculation agent's standard operating procedures (including those related to mark-to-market frequency) may be used for calculating the marks. In such cases, bespoke overcollateralization rates may be requested.
SPE's termination option
The possibility that an ineligible derivative counterparty may fail to cure a related downgrade within 60 calendar days (either by way of replacement or guarantor) will need to be documented as a termination option in favor of the SPE. The securities holders may elect to exercise this termination option through the trustee. In any event, any failure to timely cure the downgrade may result in a lowering of the rating on the securities.
Legal opinions
In general, we do not request legal opinions. Rather, the delivery of legal opinions addressing the enforceability of posted collateral depends on the derivative counterparty's own standard operating procedures and market practice.
The Scenarios
There are three scenarios that could arise for collateral posting and calculating overcollateralization rates. Those provided here apply to 'AAA' and 'A-1+' rated transactions. Further guidelines will be published for other investment-grade rated transactions.
Scenario 1: No collateral posting
Here, the derivative counterparty's rating is high enough so that no collateral posting is required. This counterparty, which may be either a financial institution or a corporate entity, is considered to be "eligible" if it has a minimum short-term rating of 'A-1', or, if there is no short-term rating, a minimum long-term rating of 'A+'.
Scenario 2: Un-stressed collateral posting
Here, the derivative counterparty's rating is high enough so that collateral may be posted at an un-stressed level. This counterparty, which would need to be a financial or similar institution, is considered to be "eligible" if it has a minimum short-term rating of 'A-2' or, if there is no short-term rating, a minimum long-term rating of 'BBB+'. A corporate derivative counterparty meeting these rating thresholds would not be an eligible derivative counterparty.
In this case, the collateral required amount is equal to the greater of:
Mark-to-market multiplied by 100%, or
0.
In this case, the overcollateralization rate applicable to eligible securities is equal to:
Base overcollateralization rate multiplied by 100%.
Example 1 of scenario 2.
Transaction rating: 'AAA'.
Mark-to-market: $4 million, in favor of the SPE (i.e., $4 million). Here, the derivative counterparty is "out of the money".
Collateral required amount = Greater of (i) $4 million x 100% or (ii) $0 = $4 million.
If, for example, it is assumed that category 1 eligible securities are being posted with a base overcollateralization rate of 102% (i.e., 102% x 100%), then:
Value of eligible securities to be posted = $4 million x 102% = $4,080,000.
Example 2 of scenario 2.
Transaction rating: 'AAA'.
Mark-to-market: $4 million, in favor of the derivative counterparty (i.e., negative $4 million). Here, the derivative counterparty is "in the money".
Collateral required amount = Greater of (i) negative $4 million x 100% or (ii) $0 = $0.
If, for example, it is assumed that category 1 eligible securities are being posted with a base overcollateralization rate of 102% (i.e., 102% x 100%), then:
Value of eligible securities to be posted = $0 x 102% = $0.
Scenario 3: Stressed collateral posting
Here, the derivative counterparty is "ineligible". This counterparty is deemed "ineligible" once its short-term rating ceases to be rated at least 'A-1' (for financial institutions, 'A-2') or, if there is no short-term rating, its long-term rating ceases to be rated at least 'A+' (for financial institutions, 'BBB+'). In this case, both the collateral required amount and the base overcollateralization rates are stressed an additional 25% compared with the unstressed levels. These stresses are meant to keep clear the idea of the financial contract's and the eligible securities' price variability and are intended to act as an economic incentive for the ineligible counterparty to cure the downgrade.
In this case, the collateral required amount is equal to the greater of:
Mark-to-market multiplied by 125%; or
0.
In this case, the overcollateralization rate applicable to eligible securities is equal to:
Base overcollateralization rate multiplied by 125%.
Example 1 of Scenario 3.
Transaction rating: 'AAA'
Mark-to-market: $4 million, in favor of the SPE (i.e., $4 million). Here, the derivative counterparty is "out of the money".
Collateral required amount = Greater of (i) $4 million x 125% or (ii) $0 = $5 million
If, for example, it is assumed that category 1 eligible securities are being posted with a stressed overcollateralization rate of 127.5% (i.e., 102% x 125%), then:
Value of eligible securities to be posted = $5 million x 127.5% = $6,375,000.
Example 2 of Scenario 3.
Transaction rating: AAA.
Mark-to-market: $4 million, in favor of the derivative counterparty (i.e., negative $4 million). Here, the derivative counterparty is "in the money".
Collateral required amount = Greater of (i) negative $4 million x 100% or (ii) $0 = $0.
If, for example, it is assumed that category 1 eligible securities are being posted with a stressed overcollateralization rate of 127.5% (i.e., 102% x 125%), then:
Value of eligible securities to be posted = $0 x 127.5% = $0.
Appendix III: Overcollateralization Rates For Eligible Derivative Obligations
Table 4 below provides overcollateralization rates for eligible securities posted under an eligible derivative obligation. The collateral required amount is multiplied by these rates to determine the value of eligible securities to be posted (see "Appendix II").
The following assumptions apply to the table, which will be updated periodically:
There will be a weekly mark-to-market.
The eligible securities being posted are denominated in the same currency as the transaction's rated liabilities.
"Floating" refers to floating-rate bonds, and "fixed" refers to fixed-rate bonds.
The term "corporate bonds" includes both U.S. and European corporate bond issuances. Additional base overcollateralization rates covering other jurisdictions or regions will be published in the future.
The structured finance assets apply globally to Australian, Asian, European, and U.S. issuances.
The base overcollateralization rates apply only to eligible derivative counterparties (as described above). For ineligible counterparties, these base overcollateralization rates are stressed (see "Appendix II").
The base overcollateralization rates here may differ from overcollateralization rates that may be derived for a rating on a market-value transaction (including market-value CDOs, SIV-lites, SIVs, and extendable CP programs). The overcollateralization tables and parameters for market-value transactions and the related assumptions can vary, based upon pool size, diversification, and liquidation horizon. Each of these parameters would contribute to the designation of transaction-specific overcollateralization levels that differ from those in the table.
The weighted-average life is the duration-adjusted expected (or stated) maturity for the bond. This duration differs from the one based on the legal final maturity stated in the bond indenture and is based on amortization assumptions.
If an asset to be posted is not in one of the table's categories, it does not constitute eligible securities. Examples of non-eligible collateral would include equity, chattel, and non-marketable securities.
Table 4
Overcollateralization Rates For Eligible Securities Posted Under An Eligible Derivative Obligation
Category description
Eligible securities
WAL
Base overcollateralization rate
Cash
Cash
N/A
100
Category 1
U.S. treasuries (current coupon, constant maturity), 'AAA' U.S. agencies, 'AAA' covered bonds (floating), 'AAA' sovereign bonds (floating), 'AAA', 'AA' credit card ABS (floating), 'AAA', 'AA' auto ABS (floating), and 'AAA' U.S. student loan ABS (floating)
Less than five years
102
U.S. treasuries (current coupon, constant maturity), 'AAA' U.S. agencies, 'AAA' covered bonds (floating), 'AAA' sovereign bonds (floating), 'AAA', 'AA' credit card ABS (floating), 'AAA', 'AA' auto ABS (floating), and 'AAA' U.S. student loan ABS (floating)
Greater than or equal to five years and less than or equal to 10 years
108
Category 2
'AAA' covered bonds (fixed), 'AAA' sovereign bonds (fixed), 'A' credit card ABS (floating), 'A' auto ABS (floating), 'AAA' CMBS (floating), 'AAA' CDO (floating) 'AA', 'A' U.S. student loan ABS (floating), and 'AAA, 'AA' corporate bonds (fixed or floating)
Less than five years
105
'AAA' covered bonds (fixed), 'AAA' sovereign bonds (fixed), 'A' credit card ABS (floating), 'A' auto ABS (floating), 'AAA' CMBS (floating), 'AAA' CDO (floating), 'AA', 'A' U.S. student loan ABS (floating), and 'AAA', 'AA' U.S. and European corporate bonds (fixed or floating)
Greater than or equal to five years and less than or equal to 10 years
115
Category 3
'BBB' credit card ABS (floating), 'BBB' auto ABS (floating), AA', 'A' CDO (floating), 'BBB' U.S. student loan ABS (floating), and 'A' corporate bonds (fixed or floating)
Less than five years
125
'BBB' credit card ABS (floating), 'BBB' auto ABS (floating), 'AA', 'A' CDO (floating), 'BBB' U.S. student loan ABS (floating), and 'A' corporate bonds (fixed or floating)
Greater than or equal to five years and less than or equal to 10 years
140
Related Articles
"
CDO Spotlight: Counterparty Risk In Structured Finance Transactions " (published on March 7, 2005).
All related articles are available on RatingsDirect, the real-time Web-based source for Standard & Poor's credit ratings, research, and risk analysis, at www.ratingsdirect.com.
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