News Analysis
Swap downgrades 'justified, necessary'
Fitch downgraded Deutsche Bank's ratings last month, stating that the bank is no longer a suitable counterparty for top rated securitisations. While the downgrade was prompted by issues relating to that bank specifically, other bank downgrades could - and, it is argued, should - follow.
Deutsche Bank's long-term issuer default rating (IDR) was downgraded from single-A minus to triple-B plus and its short-term IDR was downgraded from F1 to F2. The bank's viability rating was downgraded from single-A minus to triple-B plus and all debt and deposit ratings were also downgraded by one notch.
Fitch's counterparty criteria allow a triple-B plus rating to support ratings in the single-A category without providing collateral, but Deutsche Bank will need to post collateral to remain a counterparty for higher rated structured notes. The bank's London branch can support bonds rated double-A, because it has higher long-term deposit and derivative counterparty ratings.
Former Moody's svp William Harrington argues that posting extra collateral does not nearly go far enough and that "no structured finance securities should ever be rated triple-A". He adds: "Deutsche Bank is finally being called to task and that is a good thing because the numbers on these derivatives simply do not add up."
Harrington continues: "Fitch has suggested that Deutsche Bank will need to provide extra collateralisation, but that only works when the transaction is in the money. Out of the money, flip clause enforceability does not work. The rating agency is ignoring the fundamental fact that the trust has exposure to the swap both in and out of the money."
The bank is understood to have already posted collateral as the counterparty for interest rate swaps for €524m of Dutch mortgage bonds. Its approach to other deals is less clear.
"I have found three SLM legacy deals - and there might well be others out there - where Deutsche Bank New York is a swap counterparty. It is a currency swap counterparty on SLM 2005-9 and balance guaranteed Libor swap counterparty on SLM 2006-A and SLM 2006-B," says Harrington.
If those deals are out of the money, then they will have more exposure to potential non-enforceability of flip clauses. Harrington believes that the issues are far deeper than Deutsche Bank as an isolated entity, and instead reach to the core of swaps themselves as the market uses them.
"These deals, as they are currently structured, do not work. The swaps are done on the cheap. If the swaps had provisions for margin posting, which would admittedly increase costs, then that would go a very long way to dealing with counterparty risk," says Harrington.
He continues: "This is a big hole the industry has dug for itself. I believe they were counting on receiving a no action letter, but there has been no letter. Now the swaps cannot be amended without losing their grandfathering status, so it is not just Deutsche Bank but a whole host of swaps that should be downgraded."
Margin posting would be expensive and trap cash for longer. More resources would be required up front, with either access to assets to support margin posting or the buying of more up front to put more receivables into the deal. This may be necessary, however, to fix what Harrington sees as a fatal flaw at the heart of the system.
"All US ABS backed by a swap should be downgraded. US swap margin rules only allow 'replacement' for deals that exchange margin daily. No US deal with a swap, including the three Navient deals with a Deutsche Bank swap, can post margin," says Harrington.
He adds: "A solution is needed, however, because these swaps are one of the original sins of the industry. This is a long festering problem that should not have been allowed to fester."
Fitch says that the Deutsche Bank downgrades were driven by continued pressure on the bank's earnings and prolonged implementation of its strategic reorientation, announced in March. The rating agency no longer expects revenue to demonstrate any clear signs of franchise recovery this year and believes further restructuring costs will continue to erode net income.
20/10/2017 11:31:37
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