The credit rating agencies play a major role in the securitization process is to help investors to make informed decisions regarding investment in the underlying securities. As guardians of the public through their research, analysis, and grading of various risks, rating agencies are expected to protect investors against taking excessive credit risk. The ratings allow institutions such as insurance companies and pension funds, who are prohibited to invest in securities rated below investment grade by their respective regulators, to actively participate in the securitized market as investors. Investment grade rating conveys information to the investors that the underlying instrument will pay coupon interest and principal according to the terms of the indenture.
Rating agencies play a pivotal role in the securitization process as the ultimate appraiser of the underlying pool of collateral. In their process of appraising and evaluating the likelihood of default by subjecting the cash flows of the pool of underlying assets to stress tests under severe market conditions, various risks are priced to determine the fair market value of the new securities. Investors acceptance of the ratings as a well defined standard, as well as the appropriateness of the amount of credit enhancement, are paramount for a successful securitization process for ABS, as they need not perform individual appraisals for the new instruments that could be prohibitively costly. Assuming credit risk analysis is undertaken for a rated security, the decision to invest turns into consideration of market or interest rate risk, and analysis of duration and convexity of the underlying instrument.
Issuers seek ratings to improve the liquidity and marketability of their issue, and to capture the interest rate savings associated with a higher rating; without a rating, the issuer might not secure credit, or might secure it only at a substantially higher cost.
Role of Credit Rating Agencies in Securitization Process
- Analyzes individual assets in the pool, compares them to the historical performance of assets in its data bank, and subjects the pool to stress tests based on severe market conditions.
- Looks at the seasoning of the pool, as mortgages are more likely to default in the first four years.
- Evaluates geographic diversification of the loans.
- Projects the amount of credit enhancement needed based on the worst-case scenario.
- Secures legal certification that assets transferred to the SPV are “true sale”, and thus legally isolated from the reach of originator.
Ratings agencies and investors prefer a diversified pool of mortgages spread across the nation as opposed to one concentrated in a particular region, as regional recessions may jeopardize the performance of the pool. Furthermore, a larger pool provides benefits to both investors and the conduits, as the fixed cost of securitization is spread over a larger amount, thus providing economies of scale. The quality of the pool of the loans and geographic dispersion determines the quality of the underlying securities credit-enhanced by a third party. Private mortgage conduits are financial entities usually affiliated with major banks, insurance, and or manufacturing companies that buy residential or commercial loans and pool them into a portfolio from which asset backed securities are issued to investors in the capital market.
When any credit rating agency rates a securitized pool of assets, it initially assigns a ‘provisional rating’. The provisional rating assigned is valid for a period of 90 days, before which the originator must comply with the following:
- Submit copies of all executed transaction documents to credit rating agency.
- Submit a letter from the trustee confirming that the transaction documents have been executed to the trustee’s satisfaction.
- Furnish representation and warranties as stipulated by credit rating agency.
- Submit an auditor’s certificate where required.
- Submit the required legal opinion from an independent counsel.
Upon receipt of the above documents, credit rating agency examines if the documents are in line with the transaction structure as envisaged at the time of assigning provisional rating. If the documentation and the other compliance’s are to credit rating agency satisfactions than agency issues a letter of compliance for the transaction formalizing rating.
Typical Due Diligence Done at the Time of Rating
Credit rating agency carries out a through due diligence for all rating, before and after the provisional rating.
- Originator due diligence: The due diligence of originator and the risks control mechanism give a fairly good idea of the originator assets portfolio vis-à-vis industry benchmarks, and forms critical inputs in the stipulation of the credit enhancement levels for transaction.
- Pool due diligence: Agency check if all pool contracts adhere to stipulated selection criteria. Auditor’s statement are obtained to ensures that all information furnished to rating agency relating to the pool has been verified and found to be correct and true.
- Transaction structure: Rating agency analyses the structure for each transaction to adequately assess any risks which investors might face. This is extremely important as the structure is becoming more complex.
- Legal due diligence: The legal team also checks the draft transaction documents, to identify any legal issues pr legally untenable clauses. The basic documentation examined is the trust deed, assignment agreement/deed of assignment, service agreement and cash collateral agreement. The corporate undertaking or guarantee is also examined where relevant.
Surveillance Process Adopted by Rating Agency
Rating agency believes it is of vital importance to monitor pool performance so that it is in line with the outstanding rating. Surveillance is necessary because the receivables from the pool of assets are used to service investors payouts. The investor’s recourse is thus limited to these receivable, and to credit enhancements, if any provided by the originator.
Additionally, complex structures have been introduced recent times in the securitization market, with issuances incorporating staggered payouts mechanisms, floating rate instruments and trigger based structures. These complexities require close monitoring by the trustee and the rating agency to ensures that the instruments adhere to the originally stipulated and appropriate action is initiated at the right time in case of any deviation.
Rating agency has set up a dedicated surveillance team to monitor the performance of rated pools. Transaction is monitored on a monthly basis and the key parameter is tracked. This is done on the basis of monthly servicer reports provided by servicer/trustees. The reports are checked for accuracy and performance analysed. Thereafter, the team interacts with the concerned parties to understand the reasons behind the trends, and the likely steps have been or need to be undertaken to arrest adverse fluctuations in the pools performance.
A comprehensive review is under taken at least once a year, unless warranted more frequently by deviations in the monitorables from rating agency estimates.
Key monitorables of rating agency surveillance process:
- Collective performance: The collection performance is analysed in terms of monthly collection ratio (MCR) and cumulative collection ratio (CCR).The MCR gives the flow element of the pool collection performance and acts as an early warning indicator. The CCR reflects the stock element of the pool collection performance.
- Delinquency level: Credit rating agency analysis the overdue levels in terms of various delinquency buckets. This analysis provides an estimate of the credit losses in the pool to date and gives an indicator of future losses.
- Counter party credit quality: Rating agency also monitors the credit quality of the counter parties involved in the transaction. These include the servicer, the trust, the retention account bank, the cash collateral bank or guarantor and the swap counter party.
- Credit support: The credit enhancement available indicates the level of cushion in the transaction. This cushion is required to withstand relevant stress levels for the corresponding rating category. This parameter rounds off the overall analysis and ensures that the outstanding rating is current.
In addition the credit rating agency monitors other parameters such as prepayment, collection efficiencies and collateral utilization.