The Ongoing Impact of Rating Downgrades on Structured Finance Transactions
Alex Campbell has advised on the impact of rating downgrades on over 80 structured finance transactions. In this article, Alex discusses some of the challenges involved with implementing remedial action following a rating downgrade.
Rating triggers in structured finance transactions
Due to the credit exposure that structured finance transactions have to their operating parties, the credit ratings of the bonds issued under them are determined by, among other things, the credit rating of those operating parties. As such, operating parties are required to stay rated above a certain minimum threshold in order for the highest rating of the issued bonds to be maintained.
The credit rating of a bond may be lowered where the rating of an operating party is downgraded below the threshold and where certain remedial action required under the transaction documentation to mitigate risk is not completed within a prescribed time period. Investors may be adversely affected where the rating of their bond investment falls below their minimum investment criteria and they are required to sell at a time other than of their choosing.
It is often challenging for parties to complete remedial action within the prescribed time period due to the complicated commercial and administrative issues that are involved.
In 2011, rating agencies downgraded their credit ratings for a number of major financial institutions, including RBS, Barclays and HSBC, due to changes in economic market trends and financial support from governments. The downgrades meant that some banks no longer met the minimum rating criteria required for account bank, liquidity facility provider and swap provider roles on transactions.
The downgrades in 2011 had a significant impact on the rating of some transactions and the remedial action that parties were required to undertake took many months to complete. Rating actions taken in 2014 and 2015 also had a significant impact on transactions and there may be more in the pipeline following the UK referendum vote to leave the EU.
Account bank rating triggers
GIC and other issuer accounts which are held at an account bank that is subsequently downgraded will typically need to be transferred on the same commercial terms to another financial institution that meets the relevant minimum rating threshold within a 30 day time period from the date of the downgrade.
Parties will first need to find a suitably rated financial institution that will agree to take on the account bank role. Finding such a financial institution can be challenging as there may only be one or two banks in the market that have both the suitable rating and the infrastructure to undertake the role. Replacement account banks will need to consider whether there is a sufficient business, financial or wider client relationship case for taking on the role.
Following the recent implementation of Regulation (EU) No 575/2013 with regard to liquidity coverage requirement for credit institutions, banks are required, in certain circumstances, to maintain a liquidity buffer which is equal to cash amounts held in bank accounts which are subject to a rating trigger with a 30 day transfer obligation. Replacement banks that are subject to the regulation may not be able to provide the same commercial terms as the outgoing bank on the date that the transaction was entered into due to the new increased costs involved. In such circumstances, it may be necessary to obtain confirmation from the rating agencies that the restructuring will not adversely impact on the rating of the bonds due to the higher costs and/or obtain trustee or noteholder consent prior to the transfer as it will not be on the same commercial terms as prescribed in the transaction documentation.
On some account bank restructurings, the issuer-level bank accounts are transferred to a replacement account bank but the originator-level collections accounts stay with the original account bank. This approach may be taken where, for example, the collection accounts receive payments by direct debit which the replacement account bank is not able to process and where funds are only held in the collection accounts on an intraday basis so the low credit risk means that the original account bank continues to meet the minimum rating criteria.
In such cases, it will be necessary to implement cash sweep arrangements between the two banks and this may give rise to operational complications, particularly where funds transferred from a collection account to a GIC account may need to be credited back quickly in the event of a direct debit indemnity clawback payment.
Failure to complete the remedial action within the prescribed 30 day time period may result in a bond rating downgrade. Market participants are currently considering alternative approaches to address account bank rating downgrades. These include allowing account banks to post collateral to help with delinking the rating of the account bank and the rating of the bond, appointing a suitably rated back-up replacement account bank in advance of a rating trigger breach so that the transfer can be implemented within the prescribed time period, and establishing some other form of back plan which helps address PRA and rating agency concerns.
Liquidity facility rating triggers
A liquidity facility that is provided by a financial institution which is subsequently downgraded will typically need to be replaced with a facility from a suitably rated alternative financial institution within 30 days from the downgrade. Alternatively, the issuer may have the right or obligation to make a stand-by drawing and hold the cash collateral at a suitably rated account bank. Financial institutions rarely agree to become replacement liquidity facility providers in the current market so the making of a stand-by drawing is a fairly common remedial action undertaken by issuers.
Whilst the making of a stand-by drawing complies with rating agency criteria, a drawing may incur greater costs for the issuer than the equivalent commitment fees on an undrawn facility. As a result, an issuer may wish to seek a noteholder direction at a noteholder meeting prior to making a stand-by drawing following a downgrade.
A deposit account at a suitably rated account bank will need to be established in advance of any stand-by drawing being made. Where the affected liquidity facility provider is also the account bank on a transaction, it may be necessary for the issuer to implement the account bank remedial action discussed above first, before making a stand-by drawing.
Swap rating triggers
A swap that is provided by a financial institution which is subsequently downgraded will typically need to be replaced with a swap from a suitably rated alternative financial institution within 30 days from the downgrade. Alternatively, the swap provider may be able to post collateral pursuant to the terms of a credit support annex.
The posting of collateral may be a complicated remedial action to implement where the establishment of collateral accounts is not contemplated in the relevant transaction documents. In these circumstances, it may be necessary to amend the transaction documents and for parties to enter into additional agreements to implement the arrangements. Such amendments may require trustee or noteholder consent and may take longer than 30 days from the downgrade to implement.
Rating triggers will to continue to be an important feature of structured finance transaction documents while investors continue to refer to credit ratings when considering an investment in a rated bond. However, pursuant to the Securitisation Regulation and the introduction of the new "simple, transparent and standardised" criteria for structured finance transactions, it may be easier for investors to undertake and rely on their own credit analysis when considering an investment and credit ratings may become less important in the future.