Providing Credit Ratings For Securitizations
One of the ways that rated securities of a special purpose entity (SPE) can obtain their credit rating is by the backing of a third-party swap. Swap agreements can be used to modify or supplement cash flow of SPE assets to meet investor demands. Typically, swaps are used to transfer currency and interest rate risk to a third-party swap provider. For example, an SPE may hold fixed rate assets, denominated in a non-dollar currency while investors may require dollar payments with a floating rate coupon. A swap would allow the SPE to achieve investor objectives by allocating asset credit risk to the investors while swapping currency and interest rate risk to the third party swap provider. The swap provider, in this case, would provide floating-rate dollar payments to the SPE in exchange for fixed, non-dollar payments being generated by the SPE"s assets. SPE swap structures can take three forms: (1) "-dependent," (2) "asset-independent" and (3) "swap-independent."
Swap-Dependent
In a "swap-dependent" structure, the cash flow from the SPE"s assets are paid to the swap provider and, in turn, payments from the provider flow through the SPE to the holders of the rated securities. The investors trade certain market risks for indirect exposure to the SPE"s swap provider. A credit rating for the SPE securities would be based on the lower of the credit rating of the swap provider (or its guarantor) and the credit rating of the SPE"s assets.
The obligations of the swap provider in this type of structure are contingent on the SPE making its required payments under the swap. A default by the SPE would relieve the provider from its obligation to make payments under the swap. This would result in a shortfall of cash to make payments on the rated securities. Further, the swap provider would likely be entitled to share in the proceeds from any disposition of the SPE"s assets resulting in material losses for the holders of the rated securities.
Asset-Independent
In contrast to the swap-dependent structure, the terms of an "asset-independent" swap can require the swap provider to make payments to the SPE even if the SPE has defaulted in its payment obligation to the provider as a result of a default affecting the SPE"s assets. In this type of structure the credit rating for the SPE securities is based solely on the creditworthiness of the swap provider (or its guarantor).
The failure by the SPE to make its required payments under the swap still constitutes an event of default but the default does not relieve the swap provider of its swap payment obligations. However, the swap provider may elect to terminate the swap and make a termination payment to the SPE. The termination payment is equal to the difference between the principal amount of the rated securities, together with accrued interest, and the proceeds from the sale of the SPE"s assets (which proceeds could be deemed to be zero if the assets cannot be sold).
Swap-Independent
A third structure is a "swap-independent" structure. As is the case in the other structures described above, the SPE passes to the swap provider cash generated from the SPE"s assets and the swap provider makes payments in turn to the SPE that are used to make payments to the securityholders. However, in this structure, a rating agency ignores the swap in issuing its rating for the SPE securities, assuming that the swap may terminate before the rated securities mature.
If the swap were to terminate, one of two things would happen: The holders of rated securities would receive a pro rata distribution of the SPEÕs assets or the investors would receive a pro rata share directly from the SPE of the cash flow being generated by the SPEÕs assets. In such an event, the character of the cash received by the investors could change. If for example, the swap had been ÒconvertingÓ asset cash flow from euros to dollars, the investors might find that following the swapÕs termination, they were now being paid in euros. Accordingly, the credit rating is based on the likelihood of a default affecting the cash flows of the SPEÕs assets rather than ongoing performance of the swap provider.
The Role Of Swaps In Synthetic Structures
Credit Default Swaps
Credit derivatives are the backbone of structured vehicles such as synthetic CDOs or CLOs. Through the use of credit derivatives, such as a credit default swap or total return swap, a cash flow CDO structure can be replicated as a synthetic CDO without the need to purchase and physically transfer assets to a SPE. In a representative structure, an SPE sells credit protection and acquires credit risk through a credit default swap on a single obligation, a single obligor or a reference pool of loans, bonds or other obligations. The SPE also sell securities to investors and invests the proceeds in eligible collateral such as deposit accounts or AAA bonds to pay the credit protection buyer if there are defaults on the obligations in the reference pool or to repay investors at maturity. The credit protection buyer pays periodic premiums to the SPE, which, when combined with interest earned on the collateral pool, can be used by the SPE to make periodic interest payments to the investors. At maturity, if there has been no default in the reference pool, the collateral is liquidated and the proceeds are paid to the investors.
The defaults covered by the credit default swap may include payment defaults, bankruptcy, material cross-defaults and downgrades below a specified level. Sometimes restructurings are also included as a default trigger, although appropriately defining the breath of a restructuring trigger can become quite complex.
If there is a default, the loss can be cash or physically settled. If cash settlement is being used, the protection payment is the difference between the par value of the reference obligation and its post-default value. If physical settlement has been chosen, the SPE will actually receive the defaulted obligation in exchange for paying par to the protection buyer. Loss payments can occur as defaults arise or after cumulative losses have exceeded a loss threshold. Loss payments can also be triggered only upon the 1st, 2nd, 3rd or nth obligation or entity to default. If and when the nth entity or obligation experiences a loss, the loss settlement process begins. To meet its loss payment obligation under the credit default swap, the SPE will liquidate collateral as necessary.
Total Return Swaps
The credit default swap structure can be effectively replicated substituting a total rate of return swaps for the credit default swap. In this alternative, the SPE receives the total rate of return on the pool of obligations. The SPE, in turn, passes that total return to its investors, less funding costs and any arranger fees. The return to investors can be enhanced with the premium paid be the swap counterparty to the SPE as payment for the SPEÕs assumption of the credit default risk of the asset pool. If a default occurs, the total return received by investors becomes the recovery value of the defaulted obligation.
Conclusions
Swaps have become a critical component of the synthetic securities market. The ability to use swaps to reconfigure and transform cash flows make them equally important for securitizations and other structured financings.
