Tuesday, March 31, 2009

Fitch Reviews Asset-Backed Risk After Lehman Losses

Posted on Bloomberg by Neil Unmack:

Fitch Ratings is considering changes to the way it assesses counterparty risk in asset-backed bond deals to limit losses in the market roiled by the collapse of Lehman Brothers Holdings Inc.

The New York-based credit-rating firm will start seeking comment today from bankers, investors and regulators on proposals including requiring counterparties to put up more collateral against losses and preventing lower-rated institutions from taking on the role. Asset-backed bonds that don’t meet the resulting criteria may be downgraded.

“We don’t want to go out there and say ‘this is what you’ve got to do now,’” Stuart Jennings, a managing director at Fitch in London, said in an interview on March 27. “We need a dialogue with the market.”

Fitch downgraded 39 mortgage-backed bonds last year sold by Lehman’s Eurosail program where the investment bank was the counterparty, and in February cut Betula Funding 1 BV, a collateralized debt obligation that relied on failed Icelandic lender Landsbanki Islands hf. Standard & Poor’s is also reviewing counterparty risk in asset-backed bond deals amid the worst economic slump since the Great Depression.

Issuers of asset-backed securities enter into contracts with banks or insurers, known as counterparties, to hedge against potential losses caused by differences between the loans they package into debt and the bonds they sell to investors. These losses can result from differences in currencies and interest rates.

Injecting Collateral

Investors may suffer losses should a counterparty fail because they have to pay another bank to take on the role. Debtholders lost money after Lehman’s failure in September because the U.S. investment bank defaulted suddenly before a replacement could be found.

Fitch downgraded Betula Funding 1, which packaged buyout loans, by 12 steps last month to B, five levels below investment grade, because Landsbanki’s collapse exposed the transaction to currency and interest-rate movements.

The ratings company proposes counterparties set aside cash throughout the lifetime of an asset-backed bond to cover the potential cost of finding a replacement. Fitch currently requires counterparties post collateral if their rating is cut to below a certain level.

Government Support

Fitch’s alternative proposals include requiring counterparties carry the highest credit ratings or benefit from a certain level of government support. Such criteria would be less efficient at reducing risk than regularly posting collateral, and would limit the number of eligible counterparties, according to the ratings firm.

Another way of reducing risk may be for banks to set up a clearinghouse for counterparty agreements used in asset-backed deals, the ratings firm said.

Fitch will publish final requirements for asset-backed bonds after a one-month consultation period and give issuers of the securities time to reorganize deals to avoid downgrades.

Fitch will also review its criteria for counterparty risk in so-called covered bonds, which pool mortgages and other loans but differ from asset-backed debt in that the assets remain on the issuer’s balance sheet, Fitch said in a separate statement.

The covered bonds criteria will be “broadly consistent” with the asset-backed debt rules, the statement said.

S&P will “update the market once it’s finished” its own review of counterparty risk announced in October, said Mark Tierney, a London-based spokesman.

Thomas Lemmon, a New York-based spokesman for Moody’s Investors Service, wasn’t immediately available for comment.

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