Standard & Poor's Ratings Services is requesting comments on its proposed framework for applying derivative counterparty criteria to covered bonds rated 'AAA'.
Our covered bond rating methodology blends the traditional structured finance approach with that of financial institutions analysis. Following the release of the criteria article that applies to structured finance transactions ("Revised Framework For Applying Counterparty And Supporting Party Criteria," published on May 8, 2007), we seek to apply the derivative counterparty criteria aspects of that framework to the rating of covered bonds.
If adopted, this framework could be applied to all derivatives used in covered bonds that are issued under specific covered bond legislation (legislation-enabled covered bonds). We consider that derivatives employed in programs using structured finance techniques that are not governed by specific covered legislation (structured covered bonds) typically resemble those instruments used in traditional structured finance transactions far more closely, and therefore these fall under the general structured finance framework.
If this framework is adopted, these published articles will no longer apply to covered bonds:
"Extended Criteria on Collateral Agreements for Swaps in the Cover Register of Covered Bonds" (published on Jan. 5, 2005).
"Criteria for Swaps Included in the Cover Register of German Pfandbriefe" (published on Dec. 3, 2003).
Most legislation-enabled covered bonds rated to date cover interest rate and currency risks by using the available overcollateralization even though most covered bond legislation defines derivatives as eligible assets. This article proposes clear counterparty guidelines and assumptions for use if derivative contracts are included in covered bond pools. Issuers can then choose whether to address market risks by taking it into account in the overcollateralization or by hedging through derivative contracts.
Proposal Summary
The covered bond framework outlined in this proposal applies to derivative obligations that cover market risks such as interest rate and foreign exchange risks. We reflect the credit risk of these derivative counterparties in the ratings on the covered bonds.
Structural mitigants, as seen in structured finance transactions, reduce the likelihood of the rating on a covered bond being negatively affected by the lowering of the counterparty's rating. In addition, covered bonds benefit from an ongoing management of the derivative portfolios, which leads to differences compared with other structured finance transactions, for example:
Margin payments are paid net across derivative products and currencies (a process known as "netting"),
There are a larger number of derivative counterparties, which reduces reliance on any single counterparty.
It is common practice in the covered bond market to use daily mark-to-market valuations, rather than the weekly mark-to-market valuations common in structured finance transactions.
While the covered bond framework is based on the general structured finance framework, it differs in the following key points:
Remedies for ineligible derivative counterparties include the obligation to replace themselves (rather than using commercially reasonable efforts).
Covered bond ratings may also benefit from overcollateralization if an ineligible derivative counterparty is not replaced. This will depend on the specifics of each covered bond.
Response Deadline
We would like to encourage all market participants to submit written comments on one or more aspects of the proposed criteria. During the consultation period, which will end on Oct. 31, 2007, we will be meeting with various market participants to solicit their views on this proposal. We will review the comments received and will inform you in due course on our progress. In particular, we would like to draw attention to the following issues.
Do you think that the replacement of derivative counterparties is adequately addressed by their replacement obligations and the need to post collateral? Please comment on your reasons.
What are your views on the netting arrangements? Do they lead to a reduction in a counterparty's incentive to post collateral or replace itself?
What value do you attribute to the issuer's commitment to increased overcollateralization to cover interest rate and currency risk?
The covered bond is assumed to bear the termination payment to the ineligible derivative counterparty. How do you view this aspect of the proposal?
Until Oct. 31, 2007, comments on this proposal may be sent to CriteriaComments@standardandpoors.com or to any of the individuals listed at the top of the article.
Covered Bond Rating Methodology: An Overview Of Derivative Counterparty Risk
Our covered bond rating methodology is a hybrid one; it blends the traditional structured finance approach with that of financial institutions analysis. Covered bonds have recourse to the bank and to the cover pool, and there is a dependence on management discretion regarding the risk profile of the cover pool assets.
While covered bonds are direct obligations of the issuing entity secured on a segregated pool of assets, covered bond issuers traditionally seek a rating, typically 'AAA', that is higher than their own issuer credit rating. Consequently, when assigning a rating to a covered bond, our starting point is to assume the insolvency of the issuer, so that the sole means of repaying covered bondholders in a timely manner would be the cash flow generated by the segregated cover pool.
Cover pools usually contain residential and commercial real estate mortgage loans or loans made to public sector entities. Because these assets, and the covered bonds issued, can be denominated in a number of different currencies and pay a variety of interest rates, many issuers will hedge these risks using derivative contracts registered in the cover pool. Our covered bond rating approach assumes pari passu treatment of the obligations to derivatives counterparties with the obligations under the covered bonds.
Typically, derivative contracts are structured to be able to survive the insolvency of the issuer so that they can continue to mitigate risk.
For those swaps that do not follow the assumptions outlined in this article, our cash flow analysis will consider potential interest rate and currency risks. As a result, the available assets (including the overcollateralization) would have to take into account these stressed amounts.
Use of structural features in the swap contract to mitigate the derivative counterparty credit risk
In our covered bond framework, we consider the impact of a derivative counterparty downgrade on the rating on the covered bond. To reduce the likelihood of the lowering of a counterparty's rating having a negative impact on the covered bond rating, the counterparty can use collateralization provisions (regarding the posting of specified amounts of collateral) and replacement undertakings as structural risk mitigants.
As in structured finance transactions, when analyzing the link for covered bonds, we consider:
The long- and short-term ratings on the counterparty;
The period of exposure the covered bond has to that counterparty;
The immediacy and extent of the counterparty's failure on the issuer's ability to meet its obligations; and
The existence of structural features to replace, collateralize, or otherwise mitigate the exposure to the counterparty.
When the terms of the swap documentation make it highly likely that the counterparty will be replaced if it becomes ineligible, the link is much reduced. The derivative counterparty may give a firm commitment to replace itself or the swap structure may include strong economic incentives for replacement, such as requiring the counterparty to post increasing amounts of collateral as the issuer's exposure to it rises.
Reliable overcollateralization can further mitigate derivative counterparty risk
In addition to the likelihood of replacement, we recognize that overcollateralization in covered bonds may provide a further layer of enhancement that mitigates the exposure to the derivative counterparty. This is because the issuer typically provides higher levels of overcollateralization than are required by the respective regulatory frameworks or to attain the target rating.
This added overcollateralization could absorb risk arising from ineligible swap counterparties failing to replace themselves.
We recognize this overcollateralization as a further mitigant if it is considered to be a structural feature. For example, the covered bond issuer could provide a covenant to maintain dynamic overcollateralization levels that support the target rating.
Comparison Between The Covered Bond Framework And The General Structured Finance Framework
The proposed covered bond framework is based largely on the general structured finance framework for eligible derivative counterparties. It provides for expanded eligibility of counterparty ratings based on structural risk mitigating factors agreed to by the counterparty. It also accounts for further structural risk mitigants provided by the covered bond issuer. Our approach to rating covered bonds considers the impact of and interaction between these features.
The guidelines given under this framework have been designed to increase the likelihood of replacing the counterparty and thus reducing the link between the rating on the covered bonds and the rating on the derivative counterparty.
Differences and their effects on our rating approach
Posting of collateral is handled differently in covered bonds because of their specific nature and because of certain standards established in the market:
The issuer and the derivative counterparty are both banks that have to comply with regulatory capital and risk management guidelines.
Each counterparty will net its exposure across currencies and derivative products to more effectively meet its regulatory capital requirements and will net margin payments to increase operational efficiency.
Protection is provided via a large number of contracts with a multitude of counterparties.
As a result, our approach to rating covered bonds considers the impact of the netting described above and daily mark-to-market valuations on collateral on the economic incentive for the ineligible derivative counterparty to replace itself. As the incentive to replace itself could be reduced or even eliminated as a consequence of netting, the derivative counterparty could mitigate this risk by giving a firm commitment to replace itself.
Similarities and their effects on our rating approach
In this covered bond framework, we have not altered the structured finance framework in regard to:
Rating triggers for eligible derivative counterparties;
Type of remedies, such as collateralization, replacement or providing a guarantor;
Remedy periods;
Documentation of remedies on Day 1 of the swap transaction; and
Cost absorption of remedies by the derivative counterparty.
Although rating triggers and the remedy period upon a trigger breach do not differ from the general structured finance framework, they are also detailed in this article.
Rating Guidelines And Remedies For Derivative Counterparties
Definition of eligible derivatives counterparties
Eligible derivatives counterparties, as defined in the general structured finance framework, may participate in eligible derivative obligations, which include all derivative-type transactions, such as currency or interest rate swap agreements.
These agreements are typically documented using the ISDA swap agreement framework or the Master Agreement For Financial Derivative Transactions ("Rahmenvertrag für Finanztermingeschäfte") framework.
Minimum ratings depending on type of swap counterparty
The minimum ratings for an eligible derivatives counterparty to participate in a 'AAA' rated covered bond 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+' or above 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.
For guarantors of unrated derivative counterparties to be eligible, they must meet the same rating thresholds. The guarantee must reflect our guarantee criteria assumptions in "European Legal Criteria for Structured Finance Transactions" (published on March 23, 2005).
Remedies for derivative counterparties
The Day 1 documentation should specify all remedies. Examples of rating triggers and the relevant remedies are detailed here for ease of reference.
Most counterparties become ineligible on being downgraded below 'A-1' (or below 'A+ if no short-term rating is available). Financial institutions become ineligible only when downgraded below 'A-2' (or below 'BBB+' if no short-term rating is available). A financial institution rated 'A-1' (or down to 'A+') may remain in the transaction if it institutes the following remedies, at its own expense:
Within 10 business days, post collateral equal to 100% of the swaps' netted mark-to-market value. The collateral posted is subject to haircuts (we expect to publish the applicable haircuts in the final criteria article). The haircuts are calculated at 1/overcollateralization rate (see "Appendix I" for a description of the calculation).
Rather than continuing to support the covered bond by posting collateral as above, the counterparty may choose to find an eligible replacement or an eligible guarantor. In that instance, collateral should still be posted within 10 business days of the initial downgrade. The obligations of the replacement counterparty would need to meet those of the initial counterparty.
Remedies for an ineligible counterparty would include that it must, at its own expense:
Within 10 business days, post collateral equal to 125% of the swaps' netted mark-to-market value. The collateral posted is subject to haircuts, which are calculated at 1/(overcollateralization rate times 125%). Note that cash used as collateral will also be multiplied by 125% (see "Appendix I" for a description of the calculation); and
Within 60 calendar days, find an eligible replacement or an eligible guarantor and obtain confirmation from us that the ratings will not be affected.
If the derivative counterparty finds a replacement, we do not expect the rating on the covered bonds to be negatively affected by a lowering of the derivative counterparty's rating. But if no replacement is found, and the covered bond issuer has not undertaken to maintain a sufficient level of overcollateralization, a downgrade remains a possibility.
If collateral is not posted, the derivative counterparty is not replaced, or a guarantor is not obtained within the remedy period, the covered bond issuer should have the option to terminate the swap.
If the covered bond issuer chooses to terminate the swap, termination payments may be due from the cover pool to the ineligible derivative counterparty. In structured finance transactions, these termination payments are structured not to reduce payments to the noteholders, e.g., they are subordinated to those payments. By contrast, in covered bonds, there is no priority of payments. Therefore, termination payments due to the ineligible derivative counterparty would need to be paid when due and could negatively impact other payments due to the covered bond holders. To address this risk, we would expect to re-run the covered bond asset and liability cash flows and would take into account the termination payments as reported by the covered bond issuer.
In addition, if there is no eligible counterparty in place, and in the absence of other structural enhancements, we would expect to re-run the covered bond asset and liability cash flows, assuming that the pool will now need to absorb the market risk previously taken by the derivative counterparty.
Ratings on covered bonds will therefore reflect the ability of the overcollateralization to cover any prevailing credit, liquidity, and unhedged currency, or interest rate risks as well as any termination payments due.
Collateralization.
As described in the general structured finance framework, collateral in the form of securities rather than cash would also be subject to market-value haircuts (see "Revised Framework For Applying Counterparty And Supporting Party Criteria" and "Appendix II"). Haircuts for collateral posted in covered bonds would be based on daily mark-to-market valuations, which are the market standard for covered bonds.
Collateral posting should be completed within 10 business days of a downgrade of the derivative counterparty below 'A-1' or 'A-2'.
The criteria framework does not require legal opinions to be provided upon collateral posting. When the collateral amount is posted, internal mark-to-market quotes are acceptable.
Replacement.
The transition to a new counterparty should be economically and operationally seamless for the covered bond issuer, or the third party—e.g., special trustee or "Sachwalter"—that is responsible for administering the cover pool.
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 is to be borne by the derivative counterparty being replaced. Before the replacement counterparty or guarantor is put into place, the issuer should obtain confirmation from us that the ratings will not be affected.
Netting.
Covered bond issuers typically enter into many derivative contracts with each derivative counterparty and usually a high number of derivative counterparties support the same covered bonds. Therefore, it is market standard that those payment obligations are netted for each derivative counterparty across products (interest rate and currency swaps) and currencies to avoid making multiple individual payments on each valuation date. As a result, where collateral is needed, the collateral amount provided by the derivative counterparty would refer to the mark-to-market value of the "netted" obligations, not of the single obligation.
This is a key distinction between structured finance and covered bond transactions. Because covered bond exposures are commonly netted, the amount of collateral to be posted may be reduced. The netted amount may even be zero or negative. This may reduce or even remove the incentive for the derivative counterparty to replace itself.
To mitigate this risk, a derivative counterparty is expected to give a firm commitment to replace itself if it becomes ineligible. Furthermore, it is assumed that it will perform daily mark-to-market valuations of the amount to be posted and deliver such collateral as required.
Other Swap Considerations
Asymmetric swaps collateralization
Our covered bond framework is based on the assumption that cover pools should not be expected to post collateral because this would reduce the cover assets, affect the cash flows, and weaken the rating on the covered bonds.
However, the covered bond issuer may post collateral in the name of the cover pool if there is no recourse and no set-off in the case of its insolvency, and if the failure of the covered bond issuer to pay or to post additional collateral does not trigger other negative effects, such as early termination of the hedge.
Documentation for the posting of collateral
At the start of a swap transaction, the issuer should enter into the credit support annex (CSA), or similar documentation (such as the "Besicherungsanhang" in the German market) with an eligible derivatives counterparty. The documents should contain provisions for the delivery of collateral, as well as properly referenced market-value tables for the counterparty criteria. Either the eligible derivatives counterparty or the calculation agent is responsible for calculating mark-to-market requirements and posting/maintaining the collateral in accordance with the documentation.
Swap market considerations
We recognize that simply documenting on a swap form an obligation that is not traded or common in the swap market will not automatically enable the derivative counterparty 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 value of the contract would reflect these features.
Counterparties seeking to apply this criteria framework to less liquid swaps should understand the implications of the framework, which obliges them to find a replacement and to post the mark-to-market value of the derivative contract. Similarly, the market should understand and consider the risk of a downgrade of the covered bonds if a replacement is not found and other structural enhancements are not provided.
Using the issuer credit rating
In many markets, the covered bond issuers are highly rated. We consider that an issuer credit rating of 'A-1' or higher (or 'A+' or higher if the issuer has no short-term rating) is sufficient to cover market risks—such as foreign exchange or interest rate risk—that may arise in the covered bonds. In this case, the issuer credit rating becomes a substitute for a counterparty hedge, and the issuer becomes a supporting party to the covered bond rating.
If the issuer chooses this option, it should put in place on Day 1 a covenant that upon its downgrade to 'A-2' or below, it will post collateral and/or arrange for an eligible swap in accordance with the guidelines in "Remedies for derivative counterparties." It must also bear the cost of those remedies.
Default And Termination Events
Under the covered bond framework, acceptable default and termination events that would enable the derivative counterparty to terminate an agreement with the covered bond issuer are generally limited to the following specific master agreement items.
If the documentation is based on ISDA definitions, default events should generally be limited to:
Failure to pay or deliver,
Bankruptcy, and
Merger without assumption.
Termination events should generally be limited to:
Illegality,
Tax events, and
Tax events upon merger in combination with a tax representation.
If the documentation is based on the Master Agreement (as used with Luxembourg "lettres de gage" or German "Pfandbriefe"), default events should be generally limited to "failure to pay or deliver" and termination events to "insolvency."
It should be noted that the eligible default or termination events listed above refer to the cover pool and that the criteria are intended such that the counterparty's ability to terminate the swap agreement is limited as much as possible. We do not consider the list of default and termination events to be exhaustive and would review further default and termination events on a case-by-case basis.
Consideration of specific regional legislation in respect of default and termination events
Under certain legislations, such as those in Germany and Luxembourg, legislation-enabled covered bonds are issued by the bank, rather than a separate issuing entity and the assets are separated from the bank's book by being registered in the cover register.
In those instances, the entity signing the contract with the derivative counterparty will be the bank and in the case of Germany and Luxembourg, the terms of the Master Agreement provide that insolvency, failure to pay, or failure to deliver are eligible default and/or termination events. As our criteria are intended to address that the swap is still available in the issuing bank's insolvency, default events such as insolvency, failure to pay or failure to deliver of the issuing banks should not lead to a termination of the swap. In these cases, to qualify under this framework the swap documentation should clarify that these eligible default and/or termination events refer only to the separated cover pool, and does not apply to the issuing bank. Alternatively, the eligible default and termination events for the derivative counterparties may be removed. Standard & Poor's considers insolvency, failure to pay, or failure to deliver of the cover pool to be rating remote.
Under French regulations, hedging counterparties are granted the same priority claim on the assets of the "société de credit foncier" (SCF) as the "obligation foncière" holders (Article 98). In return, the intention of the law is to ensure that an SCF's bankruptcy does not result in the termination of the swap agreements into which it has entered. SCFs cannot be considered truly bankruptcy-remote because they can incur unsecured indebtedness in addition to the obligations foncières. Therefore, the swap documentation generally removes bankruptcy of the SCF as an eligible event of default (Section 5 (a)(vii), ISDA Master Agreement).
Specific bodies of legislation may throw up further exceptions not included in this framework. We will review the swaps under these bodies of legislation and will decide how to treat these exceptions on a case-by-case basis.
Information Requirements
Before contracting a derivative transaction, we expect covered bond issuers to provide sample documents. If ISDA is used, the documents should include:
ISDA Master Agreement,
Swap confirmation,
Schedule to the ISDA Master Agreement, and
CSA.
Similarly, covered bond issuers using the Master Agreement for Financial Derivative Transactions should provide Standard & Poor's with:
Master Agreement,
"Anhang für Deckungsgeschäfte zu dem obengenannten Rahmenvertrag für Finanztermingeschäfte," and
"Besicherungsanhang zu dem obengenannten Rahmenvertrag."
We will review the relevant swap documentation to assess if the covered bond framework has been applied. Once this has been confirmed, the derivatives can be taken into account in our cash flow analysis. Any subsequent changes, for example, in the course of annual reviews, should be communicated to us to ensure that the then-current framework is applied.
Appendix I: Basic Concepts In The Collateralization Guidelines For Eligible Derivative Obligations
These guidelines should be used to determine the amount of collateral that derivative counterparties should post within the covered bond framework.
Collateral required amount
We base our collateralization guidelines on the termination value of the eligible derivative obligation. This value—commonly referred to as the financial contract's mark-to-market—typically represents the cost of finding a replacement counterparty or the value of payments lost if the counterparty defaults. When a derivative counterparty becomes ineligible, the collateral required amount for its obligations is stressed at 125% of the contract's net termination value.
Eligible securities overcollateralization rates
Counterparties may post either cash or eligible securities as collateral. The overcollateralization rates for eligible securities reflect the market's assumptions regarding how much value the collateral will lose when it is sold (we expect to publish the eligible securities and the applicable base overcollateralization rates in the criteria article that follows this consultation period).
The base overcollateralization rates apply when an eligible derivative counterparty posts collateral. When a derivative counterparty becomes ineligible, these rates are stressed at 125% of the applicable base rate. The overcollateralization rates that apply to a derivative transaction are based on the specific types of eligible security that may be posted as collateral.
Calculation of mark-to-market values
Our assumptions when setting out our covered bond guidelines include daily mark-to-market valuations. However, the covered bond framework does not assume a predetermined or predefined method for calculating the marks. Instead, the values are calculated using market practice and the calculation agent's standard operating procedures (including those related to mark-to-market frequency) as a guide. In these cases, bespoke overcollateralization rates may be requested.
Termination option of the covered bond issuer
The possibility that an ineligible derivative counterparty may fail to cure a related downgrade within 60 calendar days should be documented as a termination option that the covered bond issuer or the relevant administrator of the cover pool may exercise. Any failure to cure the downgrade by one of the remedies described in "Rating Guidelines And Remedies For Derivative Counterparties" in time may result in a lowering of the rating on the covered bonds if no other remedy is applied.
Scenarios
There are three scenarios that could arise for collateral posting and calculating overcollateralization rates. Those provided here apply to 'AAA' rated covered bonds.
Scenario 1: No collateral posting.
The derivative counterparty's rating may be high enough that no collateral posting is required. This scenario applies if the counterparty is either a financial institution or a corporate entity and 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: Unstressed collateral posting.
The derivative counterparty's rating may be high enough that collateral may be posted at an unstressed level. This scenario applies if the counterparty is a financial or similar institution and 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 the netted mark-to-market, if it is in favor of the cover pool. The overcollateralization rate for eligible securities is the base overcollateralization rate. The value of eligible securities to be posted is the product of the collateral required amount and the overcollateralization rate.
If, for example, it is assumed that the netted mark-to-market is $4 million in favor of the cover pool and eligible securities are being posted with a base overcollateralization rate of 102%, then the value of eligible securities to be posted is $4 million x 102% = $4,080,000.
Scenario 3: Stressed collateral posting.
An ineligible derivative counterparty would need to post a stressed level of collateral. This scenario applies if the short-term rating for financial institutions has ceased to be at least 'A-2' (or 'A-1' for a corporate entity). If there is no short-term rating this scenario applies, if the long-term rating of the financial institution has ceased to be at least 'BBB+' (or 'A+' for a corporate entity).
Once ineligible, both the collateral required amount and the base overcollateralization rates are stressed by an additional 25%. These stresses are intended to act as an economic incentive for the ineligible counterparty to cure the downgrade.
In this case, the collateral required amount is 125% of the netted mark-to-market, if it is in favor of the cover pool. The overcollateralization rate for eligible securities is 125% of the base overcollateralization rate. The value of eligible securities to be posted is again the product of the collateral required amount and the overcollateralization rate
Using the same example of a netted mark-to-market of $4 million in favor of the cover pool, the derivative counterparty will be "out of the money." The collateral required amount is $4 million x 125% = $5 million.
If it is assumed that eligible securities are being posted with a stressed overcollateralization rate of 127.5% (i.e., 102% x 125%), then the value of eligible securities to be posted is $5 million x 127.5% = $6,375,000.
Appendix II: Criteria For Collateral Agreements
The credit support annex or similar documentation (such as the "Besicherungsanhang" in the German market) uses technical parameters to specify the exact working of the collateral agreement. These need to be defined differently, mainly to accommodate the change in scale of the asset base from a typical securitization to a covered bond transaction.
Base currency of the eligible collateral
There is no further currency risk if the derivative counterparty provides collateral in the currency of the rated covered bonds. However, it is rare for the cover pool and covered bonds to be in the same currency and most covered bonds are issued in various currencies. Therefore, the derivative counterparty often provides collateral in different currencies. In covered bonds, a total pool of cover assets secures all of the issued covered bonds, so no direct allocation of specific cover assets to specific covered bonds is possible.
In Europe, the issuer's working currency is typically euros. Generally, if collateral is provided in another currency then it would be subject to further haircuts (we expect these to be published in the criteria article that follows this consultation period) to reflect potential foreign exchange fluctuations up to the next valuation date.
Threshold amount
This is the amount of unsecured credit that one party is willing to tolerate without holding any eligible collateral provided by the other party. Once either party exceeds its set threshold amount, the other party may request that it post collateral to cover the difference between its exposure and the threshold amount. If the derivative counterparty is posting collateral according to the remedy guidelines of this framework, the threshold amounts applicable to the derivative swap counterparty and the cover pool or SPE should be zero and infinity, respectively. The rationale is that the asset base backing the covered bonds is not typically sized to enable it to post collateral for all future fluctuations in interest or currency rates.
Minimum transfer amount
To avoid posting collateral for every small change above the threshold amount, a minimum transfer amount is set, so that a certain exposure in excess of the posted collateral may remain uncovered. This amount should be as low as possible. In the covered bond market, the level of tolerance depends on market volumes and may vary from country to country. For example, in Germany, the minimum transfer amount can be up to about €5 million for covered bond swaps.
Rounding Amount
Rounding tolerance should be as low as possible and adapted to the market volumes. For example, it is set at €100,000 in Germany.
Related Articles
"Revised Framework For Applying Counterparty And Supporting Party Criteria" (published on May 8, 2007).
"European Legal Criteria for Structured Finance Transactions" (published on March 23, 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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