Fitch Ratings is wavering on part of its plan to loosen rules for banks that sell derivatives contained in securitizations and covered bonds.
The company is readying a series of adjustments to its guidelines for transactions that rely on counterparties in the $700 trillion derivatives market. Swaps can be used to turn mortgages in one currency into securities in another or to create floating-rate bonds out of fixed car loans.
The ratings firm said in a March report that as part of the overhaul it may expand the types of assets that downgraded counterparties can post as collateral to maintain grades on securitized or covered bonds, or that lower-rated banks can use with new deals. Eligible collateral, which now includes only cash and government debt rated at least AA-, may extend to corporate notes, covered bonds and securitized debt.
Allowing securitized debt as collateral would be “disastrous,” said William Harrington, who worked at Moody’s Investors Service for 11 years before retiring in 2010 as a senior vice president in its derivatives group. The risks include a potential chain of exposures and ratings between deals and banks “that will play out in a hall of mirrors.”
Debt from the more than $4 trillion securitization market such as mortgage bonds can be harder to trade and tougher to value. In 2007 and 2008 those characteristics roiled financial firms, funds and so-called structured investment vehicles, whose top-rated debt then formed a $400 billion market before often losing most of its value.
Revisions This Month
While a move to include these assets has merits, “that’s the one area we could see perhaps not included in the final criteria,” said Stuart Jennings, a Fitch analyst who is working with colleague Grant England on its changes.
The revised protocols should be finished this month with otherwise minor adjustments, the London-based analysts said last week in a telephone interview. England called the various changes in many cases not a “relaxation” of requirements, saying they were “definitely not related to any commercial interest or need to keep the structured finance market going.”
Fitch is facing pressure for the overhaul as European banks’ ratings are lowered amid their region’s debt crisis and regulators worldwide begin forcing lenders to hold more liquid assets to gird for events such as downgrades.
A “scarcity” of “safe assets” is also being created by cuts to highly rated nations’ grades and rising collateral needs as more swaps trading shifts to clearinghouses and lenders increase secured borrowing from central banks, the International Monetary Fund said in an April report.
Avoiding New Risks
Fitch is trying to help the securitization market overcome how these trends are reducing the number of banks willing or able to serve as counterparties, while avoiding new risks for transactions, its analysts said. Outstanding deals may be damaged if a counterparty defaults and can't be replaced.
“It’s not an easy task but that what’s we’re trying to achieve,” Jennings said. “Eligible banks in certain countries, particularly Spain and Italy, have dwindled to one or two.”
David Land, a money manager at St. Paul, Minnesota-based Advantus Capital Management Inc., which oversees about $22 billion, said he was “surprised that they might accept collateral that’s harder to mark and less liquid.”
Fitch is considering the change because it would include protections that “from a theoretical perspective could be mitigants,” England said. Bonds would be counted only with a “haircut,” or discount, to their stated value of perhaps 30 percent to 40 percent, and only be accepted if highly rated and of a type with a solid pricing history, the analysts said.
The debt also couldn’t be “correlated” with a transaction by being from the same issuer or counterparty, England said. At the same time, highly rated government bonds are proving “not as safe as they used to be” amid Europe’s crisis, Jennings said.
Fitch’s derivatives criteria would apply to covered bonds, or securities backed by both loans and issuers’ repayment pledges, in cases where ratings on notes exceed those on the seller in that more than $3 trillion market.
The ratings firm’s “exposure draft” said the company also plans to start to allow counterparties with junk ratings as low as BB- to support BBB, or investment-grade, bonds if they post collateral, as well as allow banks with BBB- ratings, a step above speculative grade, to support debt within the category without collateral.
The firm, which isn’t changing its “fundamental” benchmark of requiring grades of at least A to support top-rated securities without collateral, wanted to offer more options for other scenarios, England said.
Fitch may also lower the required amount of collateral, which is needed to protect against losses if a derivative counterparty defaults and must be replaced, in a way that in some instances ignores the type of volatility seen after Lehman Brothers Holdings Inc.’s 2008 collapse.
“We felt we didn’t need to cover the extreme events of 2008” because they are unlikely to happen, and even if they do they may benefit a securitization’s swap positions or a counterparty may not collapse, Jennings said.
Harrington, the former Moody’s analyst, said he’s come to believe transactions relying on derivatives, which represent most of the market, particularly in Europe, should all be downgraded as currently structured because the swaps create additional risks. It’s disheartening that Fitch is moving in the opposite direction of reducing protections, he said.
“Nobody understands the issues well enough to stand up and defend the deals,” Harrington said.