Posting collateral with a significant cushion is an important mitigant of risk in covered bond and structured finance cross-currency swaps, while only allowing counterparty replacement with little or no provision of collateral beforehand exposes investors to extra risks, Fitch said today (Wednesday).

Fitch, Canary Wharf

The rating agency said that it has observed proposals that focus on earlier replacement obligations, with lower or no collateral posting commitments before replacement, and that these do not adhere to its criteria. In practice, downgraded counterparties invariably elect to post collateral in the first instance, it added, because replacement can take considerable time.

“Without collateral providing ample support, both structured finance and covered bond issuers can accumulate significant exposure to cross-currency swap counterparties that may exceed the level of credit protection available to even the most senior notes,” said Grant England, senior director in Fitch’s structured finance team. “An unmitigated default of the counterparty can lead to losses being allocated to all noteholders.”

Under Fitch criteria collateral is expected to be posted if a counterparty is downgraded below A or F1 (if replacement is not completed). The criteria also expect downgraded swap counterparties ultimately to be replaced, according to the rating agency, with counterparties supporting AAAsf notes expected to be replaced upon a downgrade below BBB- or F3 at the latest.

Fitch said that it considers a combination of documented collateral posting and replacement obligations to be the most effective way to mitigate the large counterparty exposures that can arise in cross-currency swaps.

By excluding options to post collateral, the issuer becomes exposed to the risk of what the rating agency described as jump-to-default, which arises when it is impossible to replace the swap on a timely basis and either no or limited collateral has been posted in the interim.

“Such limited timeframes and options also constrain the ability of counterparties to novate swaps in an orderly fashion,” said Fitch. “In turn, this increases the likelihood of future documentation changes from counterparties who, contrary to upfront documentation, seek to post collateral post-downgrade.”

It noted that increased liquidity costs, for example stemming from regulations such as Basel III, are largely behind moves for reduced upfront documented collateral posting obligations.

The rating agency defended its criteria for “volatility cushions” for cross-currency swaps, which allow for added collateral to be posted beyond marking a position to market to stem potential movements in swap value during the time to secure a replacement counterparty. Fitch noted that some market participants have commented that they are high in comparison with other rating agencies’. It acknowledged that the appropriate size of volatility cushions is subjective, but said that historical analysis of currency movements shows that small cushions offer very limited protection to issuers and noteholders in potentially extended stressed conditions after swap counterparty default.

“For example, a 2.5% volatility cushion would have been inadequate to fully cover UK pound/US dollar currency movements during an assumed 45 day replacement period for 26.3% of historical observations,” said the rating agency. “Increasing the cushion to 14.0% reduces the percentage of observations not covered during this period to just 0.4%.”