Moody’s: securitisation fraught with op risk

NEW YORK – The performance of a securities transaction depends not only on the creditworthiness of the underlying pool of creditors but also on the effective performance of various transaction parties. A short note from Moody’s Investors Service, Operational risks in securitisation to be revisited,  released in November, looks at the operational risk pitfalls firms could face and problems involved in transactions that might be overlooked.

Moody’s says there is no special reason it has decided to publish what is usually the result of an internal exercise. “This is a special comment indicating what we’re focusing on right now. We thought it would be useful to communicate our thoughts on these issues to the markets,” says Kent Becker, the note’s author.
He says there has been more attention paid to operational risk recently as several transactions, some supported by well-performing collateral, have had their credit quality downgraded primarily because of the non-performance of a securitisation party.

Moody’s gives several examples of transactions that went wrong:

• In October, Moody’s placed on watch for possible downgrade all classes of notes issued by four issuers of securitisation transactions for DSB Bank in the Netherlands. The rating action was triggered by emergency action from the Dutch central bank in relation to DSB’s insolvency. Moody’s considered the impact of operational risks arising from potential challenges in the transfer of servicing arrangements when taking action on the notes.
• Ocala Funding is a securities vehicle providing funding for residential mortgages in the US originated by Taylor, Bean & Whitaker Mortgage Corporation (TB&W). Before funding by Ocala, eligible mortgages require Freddie Mac approval and forward sale commitments with a qualified counterparty. Bank of America (BoA), the collateral agent and custodian, used Colonial Bank as bailee for Ocala. When Colonial failed to deliver collateral – about $1.6 billion in cash and mortgage notes – BoA sued Colonial, which then went into receivership under the Federal Deposit Insurance Corporation (FDIC). BoA is now in dispute with the FDIC over the collateral and, as a result, cash and other collateral are not available to repay Ocala’s outstanding securities. Ocala notes defaulted and were downgraded from P-1 to Not Prime.
• Residential mortgage-backed securities, a widely used type of bond, serviced by TB&W missed their August and September payments because the transactions’ accounts were frozen by the FDIC. While an agreement to transfer servicing has been reached, resolution remains a work in progress between the FDIC and TB&W. The securities were downgraded from Aaa to Aa3.
• Several German residential mortgage-backed securities transactions were downgraded in June due to the lack of a back-up servicing arrangement for the role of their servicer and cash manager, GMAC RFC, which is part of international financial services group GMAC Financial Services. A payments disruption could result in the issuer being unable to allocate funds when payments are due. If the inability to pay were to exceed grace periods, noteholders could experience principal or interest payment defaults and losses.

Moody’s says that, once a servicer enters into administration, its employees might lack proper motivation or seek employment elsewhere, disrupting normal workflow and collection activities. Access to funds available in trust accounts could be delayed and the available funds might not be distributed to the noteholders in timely fashion if the servicer is unable to instruct the trustees to make the payment.

Becker says the type of assets securitised and the country of operations are other considerations in assessing whether a back-up is necessary and efficient. Standardised assets with a history of successful transfers might be less vulnerable to back-up servicing risk than specialised asset types. Transactions in Europe, the Middle East and Africa (EMEA) differ from those in the US in that the trustee is generally not responsible for servicing or finding a replacement servicer. So there is a greater need for back-up arrangements in EMEA securitisations, he says.

Moody’s says it will reassess its trust account benchmark. However, it warns “it is not a simple issue”

The cash manager in an asset-backed securities/mortgage-backed securities deal prepares servicing reports and provides instructions for the paying agents to move cash in preparation for noteholder distributions. In the US, the servicer is generally the cash manager, with the trustee as the back-up. In the EMEA region the cash manager can either be the servicer or an unrelated party to the servicer, and the trustee does not serve as a back-up cash manager. Back-up cash managers might be necessary to reduce the risk of a transaction suffering a payment default from lack of a cash manager in EMEA. This risk is exacerbated when swaps with tight grace periods are in place, Moody’s says.

In the event of a servicing disruption, cashflow from the underlying assets could decline substantially due to collateral deterioration, bankruptcy or servicing transfer. Cash available to meet interest expenses for notes reduces the likelihood of an interest payment default. Deciding on the size of the liquidity necessary depends on a number of factors, including the credit strength of the sponsor, asset type and the ease of transfer.
Rating guidelines, which have been in place for more than 20 years, are based on the notion that trust accounts, whether cash or securities, are protected if a bank failed. In light of what happened with Ocala, Moody’s says it will reassess its trust account benchmark. However, it warns: “Since not all failed banks are subject to FDIC receivership and banks regulated by different parties have different rules, it is not a simple issue.”

Moody’s says it is evaluating transaction features to mitigate operational risk and will publish further comments, including a series looking at operational risk and how it affects credit in different geographic regions. In the meantime, Moody’s says it will continue to monitor transactions for exposure to operational risks and “take rating actions on transactions we believe are most vulnerable to such risks”.