WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES

WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES

In Chapter 15, we described the factors that the rating agencies— Moody’s Investors Service, Standard & Poor’s, and Fitch—consider in assigning a credit rating to a corporate bond. Here we discuss the fac- tors considered by rating agencies in assigning a credit rating to an asset-backed security.

In analyzing credit risk, the rating agencies focus on (1) credit qual- ity of the collateral, (2) the quality of the seller/servicer, and (3) cash flow stress and payment structure. We discuss each below.

Credit Quality of the Collateral Analysis of the credit quality of the collateral depends on the asset type.

The rating agencies will look at the underlying borrower’s ability to pay and the borrower’s equity in the asset. By the “borrower” we mean the individual or business entity that took out the loan. In our Farm Equip- ment Corporation illustration, the borrowers are the entities that pur- chased the farm equipment via an installment sales contract. The borrower’s equity will be a key determinant as to whether a borrower has an economic incentive to default or to sell the asset and pay off a loan.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

For example, suppose three years ago a farmer purchased equipment that currently has a market value of $200,000 and the outstanding balance of the installment sales contract is $30,000. The farmer’s equity in the equipment is $170,000 ($200,000 minus $30,000). It is highly unlikely that the farmer will default on the installment sales contract. It would be expected that the farmer would sell the equipment to realize the equity of $170,000 rather than default and have the equipment repossessed. In contrast, if the equipment has a market value of $200,000 but the out- standing balance of the installment sales contract is $320,000, it is likely that the farmer will default if the farmer does not have the ability to pay.

The rating agencies will also look at the experience of the origina- tors of the underlying loans and will assess whether the loans underly- ing a specific transaction have the same characteristics as the experience reported by the issuer. That is, the originator of the loan or installment sales contract—Farm Equip Corporation in our illustration—will have a credit department that will assess whether to extend credit to a cus- tomer. If the underwriting standards are lax, then this will be reflected in high default rates; tough underwriting standards will be reflected in low default rates. Rating agencies will assess the underwriting standards by looking at historical default rates of an originator and will monitor the default rates over time to determine if there has been a deterioration or an improvement in underwriting standards.

In addition to default rates, rating agencies will look at historical recovery rates. It is the default rates combined with recovery rates that determine what the potential loss will be. For example, suppose that the historical recovery rate is 40% and that the historical default rate for the collateral is 2%. This means that for every $100 of collateral, there will be defaults of about $2. Of the $2 of defaults, $0.80 will be recov- ered and therefore $1.20 will be lost. This is a rate of 1.2% and is referred to as the loss rate.

The concentration of loans is examined by rating agencies. The underlying principle of asset securitization is that the large number of borrowers in the collateral pool will reduce the credit risk via diversifi- cation. If there are a few borrowers included in the collateral pool that are significant in size relative to the entire pool balance, this diversifica- tion benefit can be lost, resulting in a higher level of default risk. This risk is called concentration risk. Rating agencies will set concentration limits on the amount or percentage of loans or receivables from any one borrower. If the concentration limit at issuance is exceeded, the issue will receive a lower credit rating than if the concentration limit was not exceeded. If after issuance the concentration limit is exceeded, the bonds may be downgraded.

Borrowing Via Structured Finance Transactions

Quality of the Seller/Servicer All loans and receivables must be serviced. These responsibilities are ful-

filled by a third party to an asset-backed securities transaction called a servicer. While viewed as a “third-party,” in many asset-backed securi- ties transactions, the servicer is effectively the originator of the loans used as the collateral for the corporation seeking funding.

The servicer may also be responsible for advancing payments when there are delinquencies in payments (that are likely to be collected in the future) resulting in a temporary shortfall in the payments that must be made to the investors in the securities issued in a structured finance transaction.

The role of the servicer is critical in a structured finance transaction. Therefore, rating agencies look at the ability of a servicer to perform all the activities that a servicer will be responsible for before they assign a credit rating to the bonds issued. For example, the following factors are reviewed when evaluating servicers: servicing history, experience, servic- ing capabilities, human resources, financial condition, and growth/com- petition/business environment.

Based on its analysis, a rating agency determines whether the servicer is acceptable or unacceptable. If a servicer is unacceptable, a structured finance transaction will not be rated. The rating agency may require a “backup” servicer if there is a concern about the ability of a servicer to perform.

Remember that the issuer of an asset-backed security, the special purpose vehicle, is not a corporation with employees. It simply has loans and receivables. The servicer therefore plays an important role in assuring that the payments are collected from the borrowers.