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Non-rated structured finance issuance to gain traction?
The issuance of structured finance securities without credit ratings is tipped to become more prevalent in the coming year as investment managers re-staff and use internal resources to carry out detailed credit analysis. However, even some of the rating agencies' strongest critics argue that ratings will continue to play an important role in the sector.
Last week it was reported that Highland Capital Management is preparing a corporate CLO that would not feature credit ratings. Credit Suisse is also understood to have sold a US RMBS to investors over the summer - again without the use of credit ratings.
"One can assume that deals that have been distributed so far without credit ratings have been reverse-engineered or tailor made with a specific investor in mind," says John Uhlein, founder and managing partner of Grenadier Capital. "However, I expect deals like this will become more prevalent as real money investors begin to re-staff and use internal resources to do their analysis."
He explains: "Over the past five years, there have not been many 'real money' investors in structured finance. Those that bought the triple-A bonds generally would rely on credit ratings, monoline guarantees and then would hedge their position to the monoline through CDS. This approach discouraged active analysis on the investors' part."
Uhlein suggests that a real money investor is, for example, one that would buy a triple-B tranche having fully understood the risks involved. "That sort of investor has to come back, and to some extent is beginning to return already."
Joel Telpner, partner at Jones Day in New York, says that he has worked on numerous transactions in the past that were nothing more than unrated CLOs. "These were bespoke transactions where a hedge fund, for example, would want exposure to a specific loan portfolio and through total return swaps or CDS the economies of the portfolio would be passed on to the hedge fund," he notes. "Now it may appear that some issuers are returning to the past, with smaller, bespoke deals for clients that don't necessarily need rated transactions."
He adds: "There's also still a lot of reluctance from traditional structured credit investors to fully trust credit ratings, so there may be little point in creating deals for an investor base that has not yet returned to the table. I believe for a primary CLO market to return, investors will likely look for shorter maturities, less leverage and shorter reinvestment periods. It is likely that investors are going to want to do a lot more of their own internal due diligence on deals. Accordingly, static portfolios may be more attractive."
However, analysts at PF2 Securities Evaluations suggest that it is not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. The firm cites three areas where investors will lose out absent a rating: structural protection, having an extra eye on deal terms and analytics, and liquidity.
"While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side," says PF2. "The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers' aggressive interpretation of the terms of the indenture. These 'lessons' resulted in, for example, the implementation of the triple-C bucket haircut, which aims to disincentivise managers from building 'fantasy' par or interest coverage by buying lowly-rated securities."
On surveillance and analytics of securities, PF2 notes that - even if there is disagreement over the analytics side of CLO ratings - rating agencies provide the investor with an additional pair of eyes on the deal terms. "While there are - and will always remain - certain loopholes and ambiguities, one can only imagine how many more difficulties would have arisen if it weren't for the trained eye of the rating analysts," the PF2 analysts observe.
They add that ratings bring consistency to deals, which in turn brings liquidity. "Consistency is good - it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower."
But, despite rating agencies working hard to improve the quality of their underwriting, it is too early to say whether they can truly implement effective long-term control over the underwriting process - including keeping ratings current - unless there are built in incentives, according to Uhlein. "Too often the underwriting/rating becomes stale as soon as it is written, without effective surveillance," he says. "There are many ways to change this: from subordinating a portion of the rating fees depending on the accuracy of the rating; rating fees paid over the life of the deal, with the fee subject to forfeiture or reduction upon downgrades that are determined based on pre-defined criteria - of course this too will create a conflict of interest and oversight; to rating agencies being paid by investors for their work, as opposed to issuers."
Uhlein adds that while investors seek a common ground by which to compare disparate deals, some rating agencies do not give the investors appropriate information with respect to the potential severity of loss, and this is a serious shortcoming. "The rating model needs to incorporate severity, as the rating is often used to calculate capital charges, which is meaningless when the potential severities can be radically different," he concludes.
There is progress being made in this direction, however, with Fitch recently introducing loss severity ratings (SCI passim).
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