Playing Battleship Moodys New Approach to Assessing Swap

Counterparties in Structured Finance Cash Flow Transactions

Briefing Note 27 November 2013
www.blplaw.com
1 INTRODUCTION

1.1 On 12 November 2013, Moodys Investors Service, Inc. (Moodys) updated its methodology
for assessing the rating impact of hedge counterparties (Hedge Counterparties) on
structured finance cash flow transactions1 (the New Moodys Criteria). The New Moodys
Criteria significantly overhauls the now out-of-date Moodys criteria which had been used by
the structured finance industry since 20102 (the Old Moodys Criteria).

Since Moodys issued Requests for Comment on 2 July 2012 and 18 July 2013, the industry has
been largely prepared for the changes introduced by the New Moodys Criteria for quite some
time.

1.2 This Briefing Note provides a detailed overview of the New Ratings Criteria, particularly in
respect of the following:-

(a) the fundamental changes introduced to Moodys historical approach;

(b) the linkage tables; and

(c) the new pro forma ISDA Schedule and CSA provisions.

This Briefing Note has been written primarily from the perspective of EU securitisations.

2 FUNDAMENTAL CHANGES TO MOODYS APPROACH

The New Moodys Criteria represents a significant shift in the manner in which the rating
agency historically determined the ratings effect of Hedge Counterparties on securitisations.

Moodys used to take the general view that the creditworthiness of a Hedge Counterparty that
had agreed at the outset to adhere to the rating triggers and prescribed remedial action would
be de-coupled from the creditworthiness of the relevant securitisation. The Old Moodys Criteria
specified the following:-

[Where a Counterparty substantially adheres to the Moodys criteria], Moodys

opinion is that that [sic] this would substantially mitigate the impact of Counterparty
exposure on the expected loss of the cashflow transaction. As such, the contribution
of the Counterparty to the expected loss of the cashflow transaction need not be
modelled and the Counterparty credit risk is effectively de-linked from the credit risk
of the cashflow transaction.

However, the recent downgrade of banks exhibited a limitation in Moodys historical approach
(and indeed in the historical approach of other major rating agencies). Due to the poor
financial climate, a large number of downgraded Hedge Providers were simply unable to take
the prescribed remedial action (particularly replacing themselves with Hedge Counterparties
meeting the necessary ratings following their breach of the transfer trigger) within the
expected timeframes.3

Another limitation in the Old Moodys Criteria was the one size fits all approach being applied
to all Hedge Counterparties. For instance, the Old Moodys Criteria did not provide an optionality
for different triggers in return for the obligation to transfer a greater amount of collateral.
Furthermore, the Old Moodys Criteria was intended for use only where Moodys had assigned
initial ratings of Aaa, Aa1, Aa2 and/or Aa3 to the liabilities of a cashflow transaction. However,

1
Approach to Assessing Swap Counterparties in Structured Finance Cash Flow Transactions, 12 November 2013.

2
Framework for De-Linking Hedge Counterparty Risks from Global Structured Finance Cashflow Transactions, 18
October 2010.

3
The New Moodys Criteria still assumes a replacement period of around 100 business days (or 65 business days
where a suitable entity has committed to manage the replacement process on behalf of the issuer).

Berwin Leighton Paisner November 2013 01

 there has since then been movement in the industry to seek lower ratings for securitisations,
especially in light of the country limits imposed by the rating agency.

A fundamental change in the New Moodys Criteria has been a distancing by the rating agency
from the concept of de-linkage altogether. As discussed in Paragraph 3 below, under the New
Moodys Criteria the rating agency will employ four interconnecting linkage tables (the
Linkage Tables) to assess more holistically the rating impact of a Hedge Counterparty on a
securitisation tranche. When making this assessment, Moodys aim is to take into account the
following factors:-

(a) the present rating of the Hedge Counterparty;

(b) the rating trigger provisions in the swap documentation;

(c) the type and tenor of the relevant swap;

(d) the amount of credit enhancement supporting the relevant notes;

(e) the size of the relevant tranche; and

(f) the rating of the notes before accounting for the effect of linkage.

As the 2013 Request for Comment succinctly put it:-

We no longer believe it is appropriate to label transactions as either linked or de-linked

according to whether the swap documentation is consistent with a particular set of criteria. We
therefore intend to withdraw our de-linkage framework as a separate report and assess the
rating impact of swap counterparty exposure solely in accordance with the holistic approach
described in this report.

3 LINKAGE TABLES

The New Moodys Criteria specifies the following four steps for assessing the rating impact on
the securitisation notes if a Hedge Counterparty and an issuer enter into a swap to hedge the
relevant cashflows:-

Step 1 Determining the probability of the securitisation becoming unhedged.

Step 2 Determining the incremental loss that the securitisation as a whole will incur if it
becomes unhedged.

Step 3 By using the output from Step 2, determining the incremental loss that the relevant
tranche of notes will incur if the securitisation becomes unhedged.

Step 4 By using the outputs from Steps 1 and 3, determining the linkage-adjusted ratings of
the notes.

The output from each step is determined by reference to the information fed into a Linkage
Table.

Since parties have some latitude in choosing the information to be fed into a Linkage Table
(particularly in Step 1), the process can be likened to the popular board game Battleship where
players can calibrate their shots.
Moodys has also developed a freely available Excel tool (the Swap Linkage Tool) for
determining the rating impact electronically.

Step 1: Probability of Becoming Unhedged

Step 1 is arguably the most crucial of the four steps in determining the overall rating impact of
a Hedge Counterparty on the securitisation notes.

A securitisation will become unhedged if the Hedge Counterparty fails to transfer collateral
following its breach of the collateral trigger and/or if the Hedge Counterparty defaults without
first transferring the swap or obtaining a guarantee following its breach of the transfer trigger.

Berwin Leighton Paisner November 2013 02

 In a significant departure from the Old Moodys Criteria, the Step 1 Linkage Table permits
parties to select the collateral and transfer triggers and the amount of collateral to be posted
upon breach of the selected collateral trigger.

By triangulating (i) the existing ratings of the Hedge Counterparty (or its guarantor), (ii) the
selected collateral and transfer triggers and (iii) the amount of collateral, the likelihood of the
securitisation becoming unhedged can be determined.

In essence, the Step 1 Linkage Table yields the maximum notching uplift (if any) to a Hedge
Counterpartys own senior unsecured rating.

Step 1 allows a Hedge Counterparty the option to agree to provide one of the following three
amounts of collateral:-

Original collateral amount. This amount is determined in accordance with formulae

specified in Appendix B to the New Moodys Criteria. The original collateral amount is the
same amount of collateral as the Second Trigger Collateral Amounts (daily posting) from the
Old Moodys Criteria.
Alternative collateral amount. This is an amount not determined by reference to any set
formulae but which Moodys expects to be at least equal to the mark-to-market of the
relevant swap.4
Enhanced collateral amount. This amount can be either the enhanced collateral
amount or the enhanced collateral amount (assisted replacement), each of which is
determined in accordance with formulae specified in Appendix B. The latter, which is smaller
than the former, applies where a suitable entity has committed to manage the replacement
process on behalf of the issuer.
The quantum of an enhanced collateral amount is greater than either the original collateral
amount or the alternative collateral amount.

A higher existing rating of the Hedge Counterparty, higher collateral and transfer triggers and the
use of an enhanced collateral amount (rather than the original collateral amount or the
alternative collateral amount) will yield a higher notching uplift.

For example (Example 1), if the senior unsecured rating of a Hedge Counterparty is A2 and
the selected collateral and transfer triggers are both A3, then (i) under original collateral, the
probability of becoming unhedged is Aaa and (ii) under enhanced collateral, the probability of
becoming unhedged is Aaa.

To use another example (Example 2), if a Hedge Counterparty is rated A3, the selected
collateral trigger is A3 and the selected transfer trigger is Baa2, then (i) under original collateral,
the probability of becoming unhedged is Aa3 (i.e. an uplift of three notches) and (ii) under
enhanced collateral, the probability of becoming unhedged is Aa2 (i.e. an uplift of four notches).

The following are some important points to bear in mind:-

No Swap Linkage. If the Step 1 Linkage Table yields the probability of being unhedged as
being Aaa, then the New Moodys Criteria considers swap linkage to not be present generally.
Therefore, the remaining Steps 2 to 4 would not apply. (This is the case in Example 1.)
Minimum Triggers. No value is given to collateral triggers and transfer triggers set below Baa2
and Baa1, respectively.
Collateral notching uplift. Moodys gives the same notching uplift to a collateral trigger set at
A3 or above. Therefore, there is no incentive to set the collateral trigger any higher than A3.
Value to Rating Triggers. Moodys gives no value to ratings triggers that are (i) defined by
reference to the rating of the notes from time to time or (ii) conditional upon the rating agency
continuing to rate the notes.

4
Moodys assumes a collateral trigger has no value if the alternative collateral amount is less than the mark-to-
market value of the relevant swap.

Berwin Leighton Paisner November 2013 03

 Collateral Management. Careful consideration should be given to the issuers collateral
account, the account bank rating and whether there are any operational obstacles to posting
collateral (e.g. a Credit Support Annex (a CSA) not having been executed on closing).
Otherwise, Moodys may apply haircuts to the collateral notching uplift.
OTM Swaps. Where the swap is likely to be out-of-the-money (OTM) to the issuer, Moodys
may give an additional notching uplift to take into account that the issuer will not need collateral
to pay a replacement premium.
Negative Factors. The following factors which can negatively impact the notching uplift:-
(i) the swap documentation not being substantially consistent with the pro
forma ISDA Schedule and CSA provisions (please see Paragraph 4 below);

(ii) the Hedge Counterparty being entitled to transfer the swap without the
issuers prior consent;

(iii) the Hedge Counterparty also being the security trustee (or equivalent) under
the securitisation;

(iv) automatic early termination applying in respect of the Hedge Counterparty

upon the occurrence of the ISDA Bankruptcy Event of Default (the position
is exacerbated where automatic early termination applies and there is no
flip clause); and

(v) in certain instances where the issuer has an option to prepay the notes on
an anticipated repayment date.

Guarantors. Moodys has specified additional requirements in respect of guaranteed swaps (i.e.
where a Hedge Counterparty is relying upon a guarantors ratings to achieve the desired
notching uplift.)

Step 2: Loss to securitisation if it becomes unhedged

Step 2 seeks to determine the loss to a securitisation if it were to become unhedged.

As discussed above, a securitisation will become unhedged if the Hedge Counterparty fails to transfer
collateral following its breach of the collateral trigger and/or if the Hedge Counterparty defaults
without first transferring the swap or obtaining a guarantee following its breach of the transfer
trigger.

The greater the significance of a particular swap to a securitisation, the greater the loss the
securitisation would potentially suffer if the relevant Hedge Counterparty fails to take the prescribed
remedial action or otherwise defaults. The Guidance Notes to the New Moodys Criteria use the
following example:-

the impact of losing a long-dated cross currency swap that is hedging 100% of a
securitisation is likely to be much greater than that of losing a short-dated swap hedging
10% of the same securitisation.

The Linkage Table accompanying Step 2 places swaps depending on their types and tenors in one of
nine loss categories ranging from 5% to 70% of the asset pool. Generally, cross-currency swaps are
placed in the highest loss categories followed by fixed-floating and basis.

For example, a cross-currency swap whose tenor is greater than ten years but less than or equal to
twenty years is placed in Category 9 (70%). A fixed-floating swap whose tenor is greater than seven
years but less than or equal to eleven years is placed in Category 5 (30%). A basis swap whose
tenor is less than or equal to ten years is placed in Category 1 (5%).

Berwin Leighton Paisner November 2013 04

 The following are some important points to bear in mind:-

Interest Rate Caps. For the purposes of the Linkage Table, interest rate caps are considered to
be equivalent to fixed-floating swaps.
Tenor. Tenor refers to the weighted average life (WAL) of the relevant asset pool, taking into
account prepayments and applicable amortisation triggers. If the tenor of a swap exceeds 20
years, then the Step 2 Linkage Table does not apply and Moodys will assess Step 2 on a case-
by-case basis.
Hedging of Asset Pool. The Linkage Table assumes that the relevant swap hedges 100% of the
relevant asset pool. Where the swap hedges a smaller portion of the asset pool, Moodys will
reduce the transaction loss linearly.
Currencies and Indices. The Linkage Table applies to swaps denominated in certain currencies
(and, in the case of basis swaps, referencing certain indices). These currencies and indices are
specified in the Guidance Notes to the New Moodys Criteria. For all other swaps, Moodys
determines the Step 2 output on a case-by-case basis.

Step 3: Loss to tranche if securitisation becomes unhedged

Step 3 seeks to determine the anticipated loss to the relevant tranche by reference to the Step 2
output and the credit enhancement available to the noteholders of that tranche.

The Step 3 Linkage Table shows that, as the amount of available credit enhancement increases, the
anticipated tranche loss decreases.

Broadly speaking, the available credit enhancement means the amount of over-collateralisation,
subordination and reserves benefitting the particular tranche.

For example, where the Step 2 output is Category 5 (30%) and (i) the available credit enhancement
is greater than 1% and less than or equal to 5%, the anticipated tranche loss is TL10 or (ii) the
available credit enhancement is greater than 10% and less than or equal to 15%, the anticipated
tranche loss is TL8.

Step 4: Linkage-Adjusted Ratings

By using the outputs from Steps 1 and 3 as well the rating of the relevant tranche (but without
taking into account swap linkage), Step 4 produces the linkage-adjusted ratings for that tranche.

For instance, if we were to apply the following inputs:-

the relevant tranche rating (without swap linkage) being Aa1 (sf);
from Step 1, the probability of becoming unhedged being Aa2 (i.e. Example 2);
from Step 3, the anticipated tranche loss being TL8; and
no special features which would result in upward or downward adjustment to the outputs from
the Linkage Tables,

the Step 4 Linkage Table will show the linkage-adjusted rating to be Aa1-. This indicates that, as a
consequence of swap linkage, the rating of this tranche could be reduced by one notch to Aa1 (sf).

Interestingly, although Moodys does not assign actual ratings with + or - indicators, they are
nevertheless used in the Step 4 Linkage Table in order to permit greater granularity in showing swap
linkage (and, therefore, the likelihood of the assessment which the rating agency will take).

4 PRO FORMA ISDA SCHEDULE AND CSA PROVISIONS

The pro forma ISDA Schedule and CSA provisions (the New Pro Forma Provisions) in the New
Moodys Criteria are similar to the corresponding provisions in the Old Moodys Criteria.

The following are some of the salient differences between the two provisions:

Berwin Leighton Paisner November 2013 05

 Triggers. The Old Moodys Criteria pre-legislated the two collateral triggers (set at A3/P-2 and
Baa1/P-3 , respectively) and the transfer trigger (set at Baa1/P-3 ). On the other hand and as
discussed in Paragraph 3 above, the new Moodys Criteria permits the Hedge Counterparty to
select one collateral trigger and the transfer trigger.
As a result, the New Pro Forma Provisions no longer refer to First Rating Trigger
Requirements, Second Rating Trigger Requirements, Moodys First Trigger Additional
Amounts, Moodys Second Trigger Additional Amounts and the proviso that an Event of
Default under the CSA would only occur after the application of the Second Rating Trigger
Requirements. Rather, the New Pro Forma Provisions refer to Qualifying Collateral Trigger
Rating, Qualifying Transfer Trigger Rating, Collateral Trigger Requirements and Moodys
Additional Amounts.

Transfer Provisions. The transfer provisions under the New Pro Forma Provisions have been
simplified.
Definition of Guarantee. The definition of guarantee in the New Pro Forma Provisions has
been widened to include a requirement that the guarantor and the issuer are resident for tax
purposes in the same jurisdiction.
Collateral Amounts. The New Pro Forma Provisions allow the Hedge Counterparty to use
various collateral options (i.e. original collateral amount, enhanced collateral amount, enhanced
collateral amount (assisted replacement)), each of which has its own set of definitions in the
CSA. It is worth noting that the relevant set of definitions in the CSA may themselves by
replaced with alternative language in Appendix B.
Where the Hedge Counterparty opts for an alternative collateral amount (the limitations of
which are discussed in Paragraph 3 above), the expectation is that it would specify its own
formulae/definitions.

In the case of each collateral option, the valuation percentages in Appendix B would apply.

As discussed in Paragraph 3 above, it is important that the swap documentation is substantially

consistent with the New Pro Forma Provisions so that there is no negative impact of the Step 1
notching uplift. The Guidance Notes to the New Moodys Criteria list the following specific
examples that generally prevent substantial compliance: (i) no executed CSA, (ii) departure
from trigger-related Additional Termination Events and Events of Default, (iii) departure from
the Exposure definition modifications, (iv) transfer obligations that are limited in time or set to
a standard lower than commercially reasonable efforts and (v) departure from calculation
modifications.

5 CONCLUSION

The New Moodys Criteria is a significant development in the manner in which the rating agency
determines the ratings effect of Hedge Counterparties on securitisations. It is expected that the
extensive guidance embedded in the Linkage Tools as well as the Swap Linkage Tool will assist
market participants in ascertaining the manner in which the rating agency is likely to implement
its methodology in respect of existing and future securitisations.

In the 2013 Request for Comment, Moodys predicted that the implementation of the New
Moodys Criteria is likely to be rating-neutral for most structured finance transactions, but will
probably result in some negative rating actions (generally limited to rating downgrades between
one and three notches).

On 14 November 2013, Moodys placed on review for downgrade the ratings of 150 notes in 48
residential mortgage-backed securities (RMBS) and 17 notes in 14 asset-backed securities (ABS)
due to swap counterparty exposure. At the same time, Moody's placed on review for upgrade
three tranches in two RMBS. It remains to be seen how many other existing securitisations will
be affected by the implementation of the New Moodys Criteria.5

5
https://www.moodys.com/research/Moodys-reviews-for-downgrade-EMEA-RMBS-and-ABS-transactions-due-PR-
286515

Berwin Leighton Paisner November 2013 06

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