Thursday, October 29, 2009

Counterparty risk concerns set to increase the cost of securitisation

Posted on Structured Credit Investor:

Continuing Lehman Brothers-related litigation has ensured that counterparty risk has remained in focus since the bank's collapse. However, recent legal challenges to the inverted subordination clause - combined with rising rating agency scrutiny around counterparties - could increase the cost of bringing a securitisation.

Counterparty risk management continues to be in focus, confirms Navigant Capital Advisors md Pawan Malik, partly because many institutions underestimated it prior to last year's financial crisis. "In the past, pricing was the dominant factor in choosing a derivative counterparty. Since the fall of 2008, corporates are more diligent in who they trade with and under what terms. ISDA Master Agreements are being re-negotiated, large corporates now prefer to have mutual Credit Support Agreements in place and the larger treasuries are even tracking their exposures to individual counterparties," he says.

The uncertainty around counterparty risk has been heightened by the aftermath of bankruptcies such as Lehman Brothers. The bank was a counterparty to many swaps with SPVs on structured finance transactions.

In order to achieve a triple-A rating, the swap documentation stated that if the SPV owed money on the derivative at the time of default of the counterparty bank, the SPV's payment would be subordinated to the rated notes of the SPV (known as the inverted subordination clause). This clause is now being challenged in the courts (SCI passim).

The inability of the Silverstone issuer to enter into a cross-currency swap - and thereby hedge its exposure to euro-denominated notes (see last week's issue) - is a result of such concerns, for example. The cost of entering into a cross-currency swap has increased significantly due to the fear that rating agencies may insist on cash collateral to hedge the risk if a legal precedent is set on the inverted subordination issue.

Fitch last week released its revised rating criteria for counterparty risk in structured finance transactions, which includes increased collateralisation expectations as a counterparty's credit profile deteriorates or for derivatives positions that are deemed to be less liquid (see separate News story).

"It will be interesting to see where the market goes from here," observes Malik. "If legal precedent is set, securitisation documentation may have to be rewritten. Irrespective, the cost of bringing a transaction will increase significantly as the related swaps are now more expensive."

Reto Bachmann, head of European ABS research at Barclays Capital, points out in a recent report entitled 'Better Structures: Counterparty Risk' (published in European Structured Products Weekly) that eliminating counterparty risk by removing counterparties from transaction structures may not be possible in the case of operations counterparties or not in investors' interests in the case of financial counterparties. The services of operations counterparties are essential to securitisations and so the best that can be done is to reduce the risk their failure presents to the structure, he notes.

One obvious way of achieving this is via careful selection of counterparties. But hot, warm and cold back-up servicers can also be employed to mitigate the damage caused by a failure of the current servicer; while not concentrating too many services at the same servicer could be another mitigation strategy.

However, it might be possible to eliminate some financial counterparties from a structure. For example, a liquidity facility could be replaced with a larger reserve fund and deferability of non-senior coupon payments; basis swap providers could be eliminated by only securitising mortgages that match the reference rate of the issued notes or issuing notes that match the reference rate of the collateral; fixed-to-floating swap providers could be avoided if investors in a fixed rate mortgage pool are willing to accept fixed rate notes; and currency swap providers could be avoided by only issuing bonds in the currency of the collateral. But the success of any of these potential alternatives ultimately depends on investor preference.

Whatever that preference may be, once a counterparty no longer satisfies its eligibility requirements, remedies have to be put in place. Bachmann notes that the classic three remedies remain: counterparty replacement by an eligible counterparty; a guarantee of the counterparty exposure by another eligible counterparty; and posting of collateral.

Meanwhile, an area of continuing debate among swap professionals is the S 2a) iii) clause in the ISDA Master Agreement, according to Malik. This clause allows the non-defaulting party to terminate a derivative contract at a time of their choosing. Furthermore, they can stop payments on the derivative.

Unsurprisingly, this clause is only exercised when the non-defaulting party is out of the money on the swap. Recent rulings in New York have challenged the ability of a non-defaulting party to indefinitely keep a contract open without making any payments (SCI passim).

The intention of S 2 a) iii) was probably to allow non-defaulted counterparties to keep a contract open for a short time to avoid systemic risk and give them some time to pay. According to the recent rulings, courts appear to have taken the view that some counterparties have misused this clause so they can avoid paying altogether - they claim it's only fair that they either pay up or terminate the contract.

"From the bankruptcy estate's perspective, it's also difficult to know how much is available to pay its unsecured creditors without some clarity on what is owed to the estate," Malik adds.

Finally, one issue that has caused much pain to counterparties but now appears to be being resolved is re-hypothecation of client assets by broker-dealers. This process enables a reduction in funding costs that dealers can give to counterparties and was considered to be routine before the crisis erupted in September 2008.

The experience has emphasised the fact that in a default scenario there is considerable uncertainty as to who the money 'belongs' to (especially if collateral is held in a general pool) - the defaulted bank or the client who deposited the security. "At the peak of the crisis, many hedge funds rushed to get their security out of broker-dealer accounts, which served to amplify the turmoil in the financial markets. Interestingly, after a period of extreme reluctance to allow re-hypothecation, many hedge funds are now happy to allow dealers to on-lend their securities to bring their funding costs down materially," Malik concludes.

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