Securitization in questions and answers: rating analysis of structured finance instruments

Securitization in questions and answers

Structured finance transactions are highly diverse both in terms of types of securitized underlying assets, issuance terms, applied enhancement mechanisms and other conditions, as well as the primary credit risk factors, and therefore rating approaches vary too. In this analytical commentary, we will briefly describe the main stages and principles of rating analysis with regard to different types of securitization transactions.

What is the nature of credit ratings of structured finance instruments and obligations?

The credit ratings that ACRA assigns to structured finance instruments and obligations are the Agency’s subjective opinion on the probability of occurrence and magnitude of losses on rated obligations (both in terms of the timeliness of making payments for individual components of the obligation — for example, coupon payments — and the completeness of fulfillment of all obligations for the rated instrument).

The model component of the rating analysis of structured finance instruments centers around determining the mathematical distribution of the probability of default (PD), as well as the loss given default (LGD) on different time horizons. The product of these values reflects the expected loss (EL).

Credit ratings are assigned using idealized tables of probability of default and expected loss by comparing the estimated expected loss for the rated instrument over the term until its legal maturity with the idealized values in the table. Credit ratings are assigned using the structured finance scale and is given the (.sf) postfix.

What sources of information do rating agencies use to analyze transactions?

Information provided by the originator of securitized assets and/or the transaction organizers serves as the main source for information for rating analysis:

• Securities issuance documents;

• Contract documentation with all the issuer’s counterparties;

• Questionnaire data regarding the asset portfolio with loan-by-loan breakdown;

• Schedule for repayment of securitized obligations in the transaction’s collateral portfolio;

• Report on the audit of reliability of data in the portfolio carried out according to approved audit procedures;

• Retrospective data on default rates, recovery of losses, full and partial early repayment of the originator bank’s loan products with characteristics that are comparable to the securitized assets;

• Data on statistical anomalies of loan portfolio indicators observed due to the materialization of external risk factors.

What does quantitative analysis of structured finance transactions involve?

In most cases, quantitative analysis of structured finance transactions is carried out in two successive stages:

• Analysis of the securitized portfolio of assets in order to identify its risk characteristics, as well as to determine both the most probable and most conservative scenarios for changes in its main parameters during the life of the rated instrument;

• Analysis of the structure of the issue of the rated instrument, taking into account endogenous credit enhancement mechanisms in the context of the results obtained at the previous stage.

What indicators of the credit quality of the portfolio does the quantitative analysis of securitized assets produce?

Quantitative analysis of securitized portfolios of assets begins with an assessment of the current credit quality of individual loans included in the portfolio. Given the type of asset, as well as the level of concentration of the portfolio in terms of the number of loans in the portfolio and the maximum share of individual borrowers, the calculation of individual default probabilities and/or levels of expected losses is carried out either using portfolio analysis methods (for example, using a polyparametric comparative approach, which consists of a step-by-step comparison of each asset with a starting, or reference, loan), or by assigning a full rating or credit score (this method is less commonly used). The next stage is determining the overall credit quality of the portfolio based on the results of individual assessment.

Practice shows that each type of asset has key characteristics that determine its credit quality. For example, for mortgage loans this is the ratio of loan size to collateral value (LTV), for retail loans it is historic default rates, for SME loans it is the industry that the company belongs to and its age.

The forecast horizon for securitization transactions matches the planned maturity of rated instruments, therefore the result of quantitative analysis of a securitized portfolio of assets is usually the mathematical distribution of the probability of occurrence and magnitude of losses in the portfolio, as well as its basic characteristics — expected value and standard deviation (Fig. 1).

Figure 1. An example of a log-normal distribution of expected losses across a portfolio of retail loans

What is the statistical basis for the model assumptions in quantitative asset analysis?¹

The development of rating models implies a detailed statistical analysis of various types of historical data on various types of loan portfolios. For example, when developing a model for analyzing mortgage portfolios, ACRA identified trends in the impact of key characteristics of individual loans on the level of overdue debt, which made it possible to identify and justify model assumptions, as well as take into account the specifics of the national mortgage lending market. A loan provided to a borrower who is over the age of 40, has a secondary education, and can officially confirm their income (by way of an NDFL-2 certificate) specifically to purchase an apartment has a much lower possibility of default than untargeted loans secured by real estate or loans provided to borrowers who are younger than 25, only possess a high school education and can confirm their income using a certificate according to the form provided by the creditor or their employer.

¹ Using mortgage loans as an example.

The key characteristic that determines the credit quality of a mortgage loan is LTV, i.e. the ratio of the loan amount to the value of collateral. In this case, there is a direct relationship: the lower the LTV, the lower the probability of default. This is explained quite simply — borrowers who pay a first installment that is equal to or exceeds a significant portion of the mortgage loan, first, are better off, second, prefer to rely on their own efforts rather than borrowed funds, and, third, should financial difficulties arise, are more motivated to ensure uninterrupted loan servicing to prevent the loss of their house or investments. In addition, LTV directly impacts recovery rates, and hence the total amount of loss given default. In particular, ACRA’s statistics show that the peak of default events in mortgage portfolios takes place in the first few years of asset life. If the initial LTV exceeds the 60–70% threshold, the lender may not be in position to recover losses on a defaulted loan by enforcing the collateral. In case of a downturn in the real estate market, the lender may suffer losses even when the LTV is as low as 50%.

ACRA applies a similar analytical approach to other types of loan portfolios.

What is the quantitative analysis of the structure of transaction assets?

The purpose of securitization transaction rating analysis is to estimate the expected loss on notes. Therefore, rating agencies model the probability characteristics of the portfolio of collateral, looking at the note issue structure and all available credit enhancement mechanisms. In addition to the expected default level, the credit quality of notes is also considerably affected by the amount of cash available to the issuer on each coupon date within the entire outstanding period. The free cash flow is used to compensate default amounts, and it depends on the spread between the average interest rate for the collateralized portfolio and the coupon rate, the proportion of senior and junior tranches, the time distribution of defaults in the collateralized portfolio, and the recovery rates of defaulted assets, the periods for recovery of delinquent amounts and collateral, and the current expenses of the issuer. The predictive cash flow calculations include transaction triggers for early and/or accelerated amortization of securities and the existence of additional credit enhancement mechanisms such as liquidity funds. Therefore, determining the impact of subordination on a credit rating is a rather complex iterative process that uses scenario analysis technology to simulate the different and mostly interdependent characteristics of the portfolio and notes.

The prediction model includes the scenarios of major deterioration of the overall economic situation and stress in local market segments. Therefore, even in the case of economic recession or deterioration of some markets and economic sectors, losses on the structural finance instruments rated AAA(ru.sf) are highly likely to be zero. The credit quality of these notes is close to the OFZs and bonds of the most reliable domestic issuers.

What is the qualitative analysis of a securitization transaction?

• Reviewing originators’ business processes and servicing procedures for securitized assets.

The Agency usually holds a rating meeting at the originator’s head office with its senior management and representatives of different departments in charge of underwriting, issuing and maintaining securitized assets, and enforcement. During the meeting, the originator’s representatives describe in detail all the nuances of the business processes that may affect the initial and subsequent credit quality of the securitization portfolio, demonstrate their IT systems, and disclose the specifics of applying credit risk management policies, etc.

• Legal analysis.

ACRA reviews all legal, contract and issue documents that determine the legal capacity and obligations of the issuer of rated secured notes. The key purpose of the analysis is to compare the initial description of the transaction structure and note servicing procedure with the actual legal implementation of all terms of asset sales and maintenance, as well as the procedure for making coupon payments and distributing cash flows in the transaction. An important purpose of the analysis is to verify the effectiveness of the sale, that is, the actual segregation of the risk of the securitized asset and the credit risk of third parties, including the originator.

• Reviewing the legal and contractual framework that regulates the special legal status of the SPV and minimizes the likelihood of its bankruptcy.

All relevant information obtained during the qualitative analysis is disclosed in detail in the rating report.

How do rating agencies monitor the portfolio quality after the definitive rating is assigned?

Rating agencies receive regular reports from the servicer on the status of the securitized portfolio and reports from the calculation agent on completed and forthcoming note payments. The rating agency reviews this data (including the dynamics of current amount of delinquencies and the number of defaults, amortization rate of mortgage loan and note portfolios, portfolio interest rate fluctuations, transac