by Bill Harrington
Sometimes, digging into a tough problem uncovers more and more trouble for the affected parties, and no easy solutions.
For instance, review of the swap margin rules indicates that the margin requirements will apply to existing swaps that are amended in any wayafter the relevant compliance date — 1 March 2017 for most financial end users including ABS issuers.
Accordingly, an ABS issuer that is party to an existing swap as of 1 March 2017 is likely to retain its swap provider until maturity of the swap so as to continue shielding it from the margin requirements. To do otherwise, i.e., change a swap provider midstream, an ABS issuer would have to either: 1. amend the existing swap; or 2. terminate it and enter into a new swap. Either course will obligate a swap provider to ensure that the swap complies with the margin requirements immediately.
Under the parallel rules for swap margin of the prudential regulators and CFTC, respectively, an amended swap is a new swap and subject to the margin requirements, no exceptions for any financial end users that are otherwise subject to the requirements, such as ABS issuers. The prudential regulators are the FDIC, Federal Reserve Board, FCA, FHFA, and OCC.
As an aside, the question of whether the securitization entities of “captive finance companies” benefit from the TRIPRA exemption for new swaps, and thus amended ones, remains open. The CFTC still had not responded to the following question — Does the hedging swap of an SPV of a “captive finance company” benefit from the TRIPRA exemption from margin requirements? — at the time of this writing. Debtwire ABS first posed this question more than a week ago, as previously reported (see article, 4 August).
Margin requirements makes swap amendments prohibitively expensive?
The costs to comply with the margin requirements — which are likely to be high for new ABS issuers, as previously reported (see article, 16 May) — are likely to be insurmountably high for an ABS issuer that amends an existing swap. An issuer in this situation will almost certainly lack both the financial and infrastructure resources to post and collect margin on a daily basis, as previously reported (see article, 4 November 2015).
For its part, a swap provider may balk entirely at amending an existing swap because doing so could entail booking a loss equal to the cost of complying with the margin requirements, which would not have been factored into the initial swap price. While swap providers routinely post and collect margin on a daily basis, only the subset of those that have been downgraded significantly post margin to ABS issuers and even these providers typically post only once a week rather than daily.
Being tied to an initial swap provider is a sea change from the longstanding schema for ABS issuers under which they are expected to amend swaps to effect remedial actions by downgraded providers. Remedial actions include: novation of a swap to a new swap provider with a better credit profile; adoption and activation of credit support documents; and lowering the rating triggers that activate the remedial actions.
Under this schema, which is laid out in rating methodologies and incorporated into deal and swap documents, ratings largely exclude ABS losses that can arise from impairment of a swap provider. These methodologies all rest on an explicit assumption that a swap counterparty that has been downgraded can be seamlessly replaced by a stronger one and an implicit assumption that swaps can easily be amended to effect this replacement, based on a comprehensive review of the relevant methodologies of DBRS, Fitch, Moody’s and S&P.
In the rating world, all swap providers are interchangeable and few if any are so weak as to preclude the assignment of AAA ratings to senior ABS. Moreover, rating agencies seem to be concentrated on preserving this blasé approach to assessing the providers of swaps and other derivatives, irrespective of the looming compliance date of 1 March 2017. In fact no rating agency has updated its methodology to reflect the margin rules or even published a proposal to do so.
For instance, Fitch introduced a Derivative Counterparty Rating in a new bank methodology dated 15 July. For many banks, Fitch will set the rating of derivative contracts above the issuer default rating — which itself often reflects the prospect of government support — on the expectation that resolution authorities will prop up all derivative contracts of a failing bank, based on review of the methodology.
Fitch doesn’t obligate itself to evaluate a portfolio of derivative contracts before upgrading — portfolio attributes such as the presence or absence of margin posting and collecting seem to be at best incidental factors. Nor will Fitch upgrade the derivative portfolios of only those banks that set aside additional reserves and hold margin.
Moody’s employs a similarly breezy approach in citing the expectation of resolution support for derivative contracts — irrespective of whether or not they benefit from margin provisions — in notching the contracts above other bank ratings, which can themselves reflect of government support. Moody’s introduced this approach in March 2015 and has cited it as rationale for stabilizing and upgrading ratings for ABS when issuers are party to swaps with downgraded providers, as previously reported (see article, 1 July).
Third party evaluators pick up the rating slack with respect to counterparty risk?
Will third-party valuation firms act where rating agencies won’t — i.e., differentiate between deals that are otherwise similar but for the presence of a swap and the credit risk of a swap provider?
For instance, the outstanding classes of the three private SLABS that Sallie Mae sponsored in 2010 — SLM Private Education Loan Trust (SLM) 2010-A, 2010-B and 2010-C — are all rated Aaa. However, SLM 2010-A is party to no swap whereas SLM 2010-B and SLM 2010-C are each party to a Prime- Libor swap with Royal Bank of Scotland, plc. Moreover, both swaps are large — each notional roughly matches the rated bonds outstanding of the respective deal — and potentially long-lived. SLM 2010-B and 2010-C each have a class of notes with a legal final maturity in the 2040’s, as does SLM 2010-A, according to reports on the Navient website and Moody’s announcements.
SLM 2010-B and 2010-C each have a large proportion of securitized loans that pay interest based on the Prime rate — hence, the swaps. SLM 2010-A has a relatively smaller percentage of Prime-based loans — hence, no swap. For as long as the swaps with SLM 2010-B and 2010-C perform, i.e., as long as Royal Bank of Scotland performs, the Aaa-rated classes of all three SLM 2010 deals have similar credit profiles.
However, Moody’s assigns an A3 to both the counterparty risk assessment and senior unsecured rating of RBS plc and a negative outlook to the entire UK banking system. Moreover, RBS plc amended the swaps with both SLM 2010-B and 2010-C on 14 April 2014 and the swap with the latter deal again on 5 August 2015. These amendments diluted investor protections that were present when the swaps were initiated, which has increased the deals’ reliance on RBS plc for the remainder of the swaps’ lives.
Moody’s issued RAC with respect to the 2014 and 2015 amendments. With respect to the former, “the transaction documents would have required the Royal Bank of Scotland plc to transfer the swap to a successor counterparty. Following the amendments, no transfer needs to take place as long as the counterparty posts an increased amount of credit support,” according to the Moody’s announcement of 14 April 2014.
RBS plc pushed the trend further for the swap with SLM 2010-C. “Several amendments to the swap agreements moderately increase the probability of the transactions becoming unhedged. However, since the swaps protect the noteholders against the basis risk between prime-rate indexed student loans and Libor-indexed notes, the potential loss on the notes is minimal,” according to the Moody’s announcement of 5 August 2015.
However, if the loss from being unhedged is truly “minimal”, why has Navient entered into Prime- Libor swaps for the private SLABS that it has issued since 2014? Debtwire ABS reported on these swaps and their costs on 16 May.
Further, why do Moody’s and other rating agencies only address the loss from being unhedged when the swap is in-the-money to an issuer but ignore the converse case — namely, that a default of RBS plc could also occur when the swap was out-of-the-money to the issuer and potentially obligate it to accelerate the swap and pay a termination amount?
Initial reviews suggests that other types of ABS issuers that are parties to swaps — such as CDOs of trust preferred securities; vintage CLOs, repackaged securities; and any deal with a currency or credit default swap — should also be distinguished by reliance to a swap provider.
Rorschach test — maybe the margin rules are a great solution?
Time is running out for the ABS world writ large — issuers, investors, rating agencies, swap providers, underwriters and at least some regulators — to paint itself out of the swap margin corner.
The ticking clock might be a boon, rather than a problem. Did ignoring the risk of a swap provider ever help investors? Why shouldn’t investors distinguish between both types of swaps and providers and buy deals accordingly?
Won’t margin posting by both an ABS issuer and a swap provider force deals to capitalize to reflect the risks to noteholders and allow them to decide whether to accept less risk and reward or vice-versa?
Lastly, margin posting may well consign flip clauses to where they belong — the dustbin of discredited schema that issuers used to construct deals that failed during the financial crisis. Litigation will continue for as long as flip clauses are included in ABS because a flip clause can’t possibly work for both an issuer and a swap provider. One or the other will take a significant loss even before the legal fees kick in.
A ruling by United States Bankruptcy Judge Shelley C. Chapman on 28 June to dismiss Counts I-XIX of one of the highest-profile cases —Lehman Brothers Special Financing Inc. vs. Bank of America National Association et al — demonstrates the magnitude of the ongoing flip clause debacle.
This case, which was filed almost six years ago on 14 September 2010, brought “adversary proceeding against some 250 defendant noteholders, note issuers, and indenture trustees seeking to recover approximately USD 1bn that was distributed to the defendant noteholders … in connection with the early termination of hundreds of swap transactions to which LBSF was a counter-party. ” In all, 44 transactions, primarily CDOs, were involved.
“Upon providing notice of an Event of Default under the Swaps and the Indentures, the Trustees liquidated the assets, including the Collateral securing the Issuers’ obligations under the Swaps and Indentures, and deposited the proceeds into accounts held by each Trustee for that purpose. The Trustees subsequently distributed the proceeds pursuant to the applicable Waterfall (the “Distributions”). In each instance, the Trustees applied Noteholder Priority because the Early Terminations were the result of an Event of Default and LBSF was the Defaulting Party. The amount of the proceeds of the liquidation of the Collateral was insufficient to make any payment to LBSF under the Waterfall after proceeds were paid pursuant to Noteholder Priority.”
Even so, many CLO issuers are holding on and still inserting flip clauses in priorities of payments, as reported on 4 August. Additional review shows 13 of 25 CLOs that have closed since 24 May contain flip clauses, according to the respective rating reports.
[Bill Harrington has been conducting research on the obligations and risks of derivative contracts in the structured finance sector for 15 years, most recently at Debtwire ABS and previously at Moody’s Investors Service. He has filed evaluations of rating processes and derivative methodologies with US and European regulators and with credit rating agencies. Bill has also worked as derivative structurer at Merrill Lynch and a currency analyst at Wharton Econometrics. Bill has an MBA from The Wharton School.]