Moody's bank swap ratings may halt ABS downgrades

A new methodology for rating bank derivatives liabilities may save ABS vehicles facing downgrades, and open up new counterparties for asset managers

Moody's changes may rescue stricken ABS vehicles

A recent update to Moody's bank rating methodology could rescue structured finance vehicles with poorly rated swap counterparties.

"When I first saw this, I thought, ‘Wow, Christmas has come early'," says one asset-backed securities (ABS) structurer at a European bank in London.

ABS issuers and dealers are celebrating a change in the way Moody's assesses the counterparty credit risk of derivatives trades, which it believes are unlikely to be bailed-in if a bank enters resolution proceedings.

Structured finance vehicles use derivatives to hedge their interest rate and currency risks. The standard swaps documentation for ABS contains two ratings triggers that reference a dealer's senior unsecured debt rating. If a bank is downgraded below the first trigger it must post collateral to the ABS vehicle; if the second trigger is breached it must pay a replacement counterparty to step into the trade – otherwise, the entire structure could face a possible downgrade.

Moody's new counterparty risk assessment (CRA), introduced in March, assesses the chances of a dealer defaulting on specific obligations and commitments such as derivatives, rather than the risk of a more general default.

When I first saw this, I thought, ‘Wow, Christmas has come early

This is based on its view of how regulators would behave in a crisis scenario. For instance, the European Union's Bank Recovery and Resolution Directive does not specifically exempt derivatives from bail-in – however if they are, the rules require the bailed-in swaps to be closed-out first.

Moody's says that as resolution authorities will want to keep critical functions operating and avoid contagion across the financial system, it assumes regulators will grant exemptions for instruments such as swaps and covered bonds from bail-in. Others point to regulators' desire to insert temporary stays on termination rights into derivatives contracts to avoid mass close-outs if a bank runs into trouble.

As a result, such obligations can be rated a number of notches higher than senior unsecured debt.

"Regulators seem to be rightly focused on avoiding contagion and market disruption in resolution scenarios. The European bail-in legislation for derivatives clearly requires resolution authorities to close-out positions and then net collateral against exposures before unsecured capacity for bail-in can be determined, so it's easy to understand how Moody's and other market participants concluded that derivatives bail-in is less likely to occur than on senior unsecured debt," says Rory McHugh, head of structured finance derivatives and automated treasury solutions at the Royal Bank of Scotland (RBS) in London.

Welcome news

This is welcome news for ABS vehicles. Several dealers involved in ABS deals have fallen below the second trigger following a series of bank ratings downgrades since 2012. However, finding other counterparties to step into the trades has been extremely tricky due to the dearth of highly rated banks and the complexity of the pricing involved.

Moody's has downgraded a number of ABS structures this year for failing to secure replacement counterparties. Notes linked to Arena 2011-II were downgraded in February, after it failed to take remedial action following the downgrade of RBS to Baa1 last March, for example, while Aire Valley Mortgages was downgraded the following month for similar reasons.

Moody's updated its methodology for assessing the credit quality of swap counterparties to structured finance transactions on May 16, with the CRA replacing the senior unsecured debt rating as the main reference. The rating agency began issuing CRAs the same month, which to date have tended to be one or two notches above a dealer's senior unsecured rating.

For instance, BNP Paribas and Deutsche Bank have CRAs of Aa3 and A1 respectively, compared with senior unsecured ratings of A1 and A3.

The CRAs could be a boon for legacy ABS deals facing downgrades due to poorly rated swap counterparties. Dealers below the second trigger contractually have to find a new counterparty or take another "remedial measure" if the triggers are breached. However, that remedial measure can include changing the swap documentation to reference the CRA instead of the senior unsecured rating.

"Given the Moody's CRA is their assessment of derivatives counterparty risk, it seems the right reference point to use within derivatives documentation," says McHugh.

For many transactions, this would lift the counterparty above the second trigger – which means the structure would no longer have to find a replacement counterparty.

Even if a counterparty's CRA is below the second trigger, or if the bank does not take remedial action to change the swaps documentation, Moody's is less likely to downgrade the ABS, as it now uses the CRA as its main reference instead of the senior unsecured rating. McHugh notes, however, that the agency will also give less credit to the documentation and triggers given they are no longer active.

Cheaper swap prices

Meanwhile, dealers say the new CRAs will result in cheaper swap prices for new ABS deals, as the higher ratings will reduce the chances of a bank breaching the triggers. Under bank liquidity rules dealers must hold enough liquid assets to cover collateral outflows following a three-notch downgrade, so moving further away from a collateral trigger translates into cheaper pricing, according to the ABS structurer.

The CRA could also allow asset managers to enter into derivatives trades with a wider range of counterparties. Investment management agreements typically state that asset managers can only trade derivatives with banks above a certain credit rating – but the spate of downgrades in the banking sector has withered the number of possible counterparties, especially for longer-dated swaps.

Simon Freedman, a director in the UK liability driven investment solutions team at RBS in London, says that with Moody's effectively making the CRA its preferred metric for derivatives trades, it should be the de facto reference point for determining whether an asset manager can trade with a particular counterparty.

Some European asset managers, however, are sceptical about relying on the CRA, as the various resolution regimes have yet to be tested.

Dealers will also be pushing for any derivatives contracts with ratings clauses – for example, those that require the payment of margin if a trigger is breached – to reference the higher CRA instead of the senior unsecured rating that is the current market standard.

Freedman says collateral documentation, known as a credit support annex (CSA), will have to be renegotiated to incorporate the incoming uncleared margin rules in the coming months anyway, so that will be an ideal point to amend the ratings references as well.

"That will be an obvious point for the market to focus on. If market participants want to continue to trade over-the-counter derivatives bilaterally, they will need to amend their CSAs at that point in time," says RBS's Freedman.

Fitch is also considering introducing a similar assessment, while S&P's plans are unknown.