Standard & Poor's Ratings Services recently requested comments on the introduction of swap risk ratings for use in rating credit default swaps, primarily in the synthetic collateralized debt obligation (CDO) sector. With the conclusion of the comment period, Standard & Poor's will now assign these ratings to all credit defaults swaps rated globally.
At its simplest, a synthetic CDO is structured in an unfunded form, as a credit default swap between two parties. The buyer of protection transfers the risk of a single asset or portfolio of reference assets to the seller of protection and pays a fixed periodic premium. The seller may make a payment upon the occurrence of a credit event. The reference portfolio can either be static or dynamic.
When analyzing unfunded synthetic structures, Standard & Poor's focuses on determining the default probability of the underlying reference portfolio and assigns the appropriate recovery rates by reviewing the CDS confirmation, paying particular attention to the reference obligation and characteristics, the deliverable obligations and characteristics, the credit events, and the settlement mechanism. If the portfolio is dynamic, the trading limitations and manager also need to be reviewed.
Frequently Asked Questions
Which transactions qualify for swap risk ratings?
Swap risk ratings will be assigned upon request to all credit default swaps. Historically, Standard & Poor's assigned credit estimates or credit assessments to these types of obligations, primarily because no securities were issued at the inception of the transaction. As such, they did not qualify for ratings under Standard & Poor's existing definitions for traditional debt issue ratings. With the introduction of swap risk ratings, Standard & Poor's has broadened its definition of ratings to acknowledge the special structural features of these transactions.
Will swap risk ratings bear special identifiers?
Swap risk ratings will have qualifiers that indicate the type of risk that Standard & Poor's was asked to assess to distinguish them from traditional debt ratings. For example, a swap risk rating that is displayed as 'AAAsrp' indicates that the 'AAA' rating is a swap risk rating based solely on an analysis of the creditworthiness of the reference portfolio. An "srp" ("sr" for swap risk and "p" for portfolio) rating does not take into consideration the creditworthiness of the counterparties to the transaction.
What does a swap risk rating address?
All swap risk ratings take into consideration the creditworthiness of the reference portfolio. The swap risk rating designations are outlined below.
Portfolio ("srp" suffix) ratings only take into consideration the creditworthiness of the reference portfolio of the credit default swap;
Single counterparty–protection buyer ("srb" suffix) ratings take into consideration the creditworthiness of the reference portfolio and the buyer of protection under the swap transaction; and
Single counterparty–protection seller ("srs" suffix) ratings take into consideration the creditworthiness of the reference portfolio and the seller of protection under the swap transaction.
Because the terms of each swap transaction can be highly customized, a swap risk rating may address different risks. Therefore, swap risk ratings should not be viewed as benchmarks related to swap risk across different swap transactions.
A portfolio swap risk rating does not address any counterparty risk (including risk of periodic payments). Swap risk ratings for single counterparty addresses the counterparty risk of one of the counterparties to the swap transaction. None of the swap risk ratings address the specific amount of termination payments that would be payable under the swap transaction. Each swap risk rating letter states the specific risks addressed by each swap risk rating and the terms and conditions of each rated swap transaction.
How does a swap risk rating differ from a rating issued for credit-linked notes and other types of debt instruments?
There are two key differences between a swap risk rating and traditional debt instrument ratings. Swap risk ratings do not address the creditworthiness of an issuer or issue, rather the likelihood of termination of the swap based on the parameters evaluated: the portfolio and, if applicable, one of the counterparties. Swap risk ratings apply to unfunded transactions. For example, a swap risk rating portfolio ("srp") by itself does not address the likelihood of a swap termination because of either counterparty risk. Conversely, a swap risk rating single counterparty ("spb" or "srs") addresses portfolio risk as well as the respective buyer or seller counterparty to the swap transaction. The fundamental credit approach will be the same for both swap and traditional debt instrument ratings, including the analysis of the portfolio and the determination of losses.
Generally, a swap risk rating will be used by one or both transaction participants. For example, both the buyer and the seller will be interested in the portfolio aspect of the swap risk rating, while only a protection seller would want a swap risk rating single counterparty–protection buyer. Thus, unlike debt ratings that speak to relative creditworthiness to all potential investors in the market, swap risk ratings are instrument and counterparty specific.
Are there similarities between swap risk ratings and traditional debt ratings?
A bond investor receives interest on the entire principal amount of the bond and the return of initial principal upon the bond's final maturity. If the bond experiences any type of default, the investor would suffer a loss of principal. In a similar fashion, a seller of protection receives "interest" in the form of a periodic premium paid by the buyer of protection through the credit default swap. If no credit event has occurred before a credit default swap matures, the seller of protection has no additional outlay (equivalent to return of principal). If a credit event does occur, a seller of protection would be responsible to pay to a buyer of protection a loss amount (which is equivalent to the loss suffered by a bond investor).
Can a credit-linked note receive a swap risk rating?
No. Swap risk ratings will be assigned only to swaps.
Can a single transaction have both a swap risk rating and a traditional debt rating?
Yes. In cases where a transaction consists of unfunded and funded liabilities, most common in hybrid transactions, a swap risk rating may be assigned to the unfunded portion and traditional debt ratings may be assigned to the funded notes.
Will swap risk ratings be issued publicly?
Yes. We have received several requests globally to provide public swap risk ratings for credit default swaps. One of the drivers for public swap risk ratings has been the anticipation by investors and market participants that the Basel II rules may require public ratings for regulatory capital relief, an important factor in numerous swap transactions. Standard & Poor's will maintain ongoing surveillance of all public swap risk ratings.
How will you treat existing credit default swaps that are being surveilled?
Existing credit default swaps that have confidential credit estimates or confidential credit assessments will migrate to swap risk ratings that will become public at the request of a counterparty. Standard & Poor's will no longer assign credit estimates or credit assessments to credit default swap transactions. There will be no ratings impact on existing transactions because of this migration to swap risk ratings.
