Monday, February 15, 2010

Europe’s ABS currency-swap exposure

Original posted on FT Alphaville by Izabella Kaminska:

Back in January, a US court rather controversially decided that claims of a Lehman Brothers special purpose vehicle — to which the bank was a counterparty — should not be subordinated to other creditors.

As the FT commented at the time:

It is a controversial ruling which will be closely scrutinised for its implications for the structured products and derivatives markets.

Judge Peck decided on Monday that a provision that would normally subordinate Lehman’s claims is unenforceable under US bankruptcy law. The decision goes against a ruling by the English courts last summer which determined that a group of investors in the vehicle should be paid ahead of the failed bank in its unwinding.

While the above decision was always going to have far-reaching implications for structured product and derivative markets, a recent note from BarCap draws attention to the implications for Europe’s ABS market.

One concern, it turns out, is Europe’s beloved use of embedded swaps in ABS deals for the purpose of hedging out interest-rate, basis and currency risk. These, it seems, are hedged out in exchange for credit risk.

Usually this is considered acceptable because even though the swaps undergo mark-to-market gains and losses over the life of an ABS transaction, the fact that the notes are supposed to be hedged over the life of the transaction means gains and losses have no discernible “real-world consequence” for noteholders.

In the event of early termination, however, payments are positioned senior to those noteholders. As BarCap explain:

…should a swap be terminated early, mark-to- market gains and losses can indeed play an important role: a termination payment equal to the mark-to-market amount may be due to be paid by the swap counterparty suffering a mark-to-market loss to the counterparty enjoying a mark-to-market gain. These termination payments are often senior to the notes in European ABS cashflow waterfalls, just as is typically the case with regular swap payments.

However, there is one important exception — a swap provider bankruptcy. In this scenario payouts are subordinated to those of noteholders:

If the swap provider enjoys a mark-to-market gain, the transaction is obligated to make a corresponding payment; to ensure that making such a payment does not result in payment shortfalls to noteholders in the transaction upon its due date (and possibly an event of default under the notes), said swap termination payment is commonly subordinated to note payments if the termination payment results from the bankruptcy of the swap counterparty.

Except, as Barclays Capital points out, due to the US Lehman SPV ruling this scenario has potentially been flipped around for US swap providers. As BarCap explain:

Given the prevalence of swaps in European ABS structures, the risk that US law could apply to securitisations governed by UK law is a considerable concern.

The good news, according to the analysts, is that interest-rate or basis swaps would only ever expose noteholders to losses on the interest component of total payments — a substantially smaller sum than the principal component. What’s more, there’s less chance of a US swap provider going bankrupt in the first place because the crisis is waning.

The bad news, however, is that currency swaps reflect a much bigger concern. As BarCap note:

By contrast, currency swaps apply to the interest and the principal components of the swapped notes’ total payments and are therefore of greater concern.

Although, even here there is an upside:

…in many European ABS transactions that use currency swaps, only some notes are swapped into a currency different from the currency of the collateral – the smaller the proportion of total note notional swapped into a different currency, the smaller the transactions’ overall exposure. In addition, European ABS structures may have multiple currency swap providers, reducing the exposure to any one counterparty.

That said, despite the immediate risk to European ABS being reasonably contained, BarCap say there is still the chance of extensive ratings actions to come. They cite Fitch as follows:

“Following the completion of analysis of any securities placed on RWN, the ratings of these securitized notes could become credit-linked and downgraded to the level of the counterparty. Specifically, if a downgrade is warranted, higher-rated tranches would likely be downgraded to the counterparty rating, which is between ‘AA’ and ‘A’ in most SF transactions”.

Related links:

Ghost of Lehman hits ABS
– FT Alphaville
Lehman SPV ruling sparks controversy
– FT Alphaville

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