Fundamental Methodologies of Structured Finance Ratings

Structured finance and the role of ratings agencies came under intense scrutiny immediately after the markets crisis of 2008. Joining ABN on the fundamental methodologies of Structured Finance ratings is Jason Lightfoot, Portfolio Manager for fixed interest at Futuregrowth Asset Management.

Absol providing financing risk management and advisory solutions that’s a capital to redefine topless first and foremost about what makes structured finance different in terms of applying rating standards through thanks very much maybe just to give you some background in terms of how these structures actually work so for example a bank would basically moved assets

Off its balance sheet into a special purpose vehicle so if example residential mortgages for example and they would then raise financing in the market on the back of those underlying assets that they obviously offer as security to you to the market so basically they’ll issue a various range of notes underneath that structure and obviously offer a spirit above there

Is fee in terms of those those notes being offered all right we’re told that the rating follows a particular process of which there is some sort of an arranger in the form of an investment bank could you explain that process to us i mean basically the banks have the relationships with the investors so they’ll ultimately bring the deal to the various participants

In the market and sometimes obviously as i mentioned banks try to move assets off their own balance sheets and they use the internal debt capital markets teams to solve those assets to the market all right now also told that there are pools of undifferentiated risks where you look at the portfolio and you will allocate the risk accordingly whether somebody earns

Property has invested in cash other assets just explain to us how you determine what are undifferentiated risks and obviously yatim you look at the online asset sets that you potentially would want to buy and what the reference s it might be my theater residential mortgages or commercial bet mortgages as well so all in the case of a receivable situation where you’d

Look at standalone receivables and for example it comes down in the receivable secured ization recently so you need to look at the quality of that online pool and then in terms of the spreads why do they tend to differ across the miller rated security i mean some that does differ depends on the underlying quality of the asset for example for example recently absa

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Issued a residential mortgage backed straws action in the market and there was a big chunk of sort of subordination below the triple-a rated notes and more recently there was another note that was issued and that’s prior to slightly less than that and it was quite surprising on that on the back of it and then tops basically based on go ahead finish so it’s based on

Another line in which the appetite and how what they deem the quality order of the fit specific book to be yeah i’m in a rush i’m moving ahead swiftly here jason what advantage the structured finance have over traditional corporate credit instruments that are also being used i mean what’s nice in structured finance is that as an investor you have hard security of

A particular asset that you looking to provide funding for example i mean normally you provide loans to corporates on an unsecured basis so by moving into escalation would actually getting a look through to the underlying assets there’s lots of talk about regulation 28 its impact on the pension fund industry your views yeah there’s this definitely deep dissonance

From our perspective in the specter of regulation 28 looking to further entrench the role of retina agencies inspector of arbit resolve credit risk so it’s concerns around the fact that you know it’s making vistas lazy investors need to do their own homework in terms of assisi credit risk and i mean credit rating energies are inherently conflicted i mean they

Receive the an income stream from other ranges and borrowers and they’re actually on fatigue issues at the end of the day as as investors are alright jason we have andrew here who’s our guest host and he’d like to raise a few points i think jason very key touches on the issue of conflict of interest and i think that the rating agencies it has to be the definition

Of a conflict you get paid to give a rating to an instrument very often they’re instrumental in the creation of that instrument so that comes up at the rating the other thing is around perception and i’d like sort of gesture jason’s views are that is that too often opinion is treated as fact in these instances is if you look at the can of the product that they’re

Actually putting out there is you see that they say that the assumptions that they make are valid at a point in time and that those assumptions of their opinion and if those assumptions change as was the case in the credit crisis and fall apart there’s a lot of their models were way too optimistic and and when it comes to the pension transfer surely this has to be

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A big concern exactly even that’s why i’m that you’d be saying that entrenching craig agencies as a authority of power is really not a good thing at all ultimately it’s an opinion at the end of the day or it’s important that investors to thorough due diligence and do their current analysis and cells when window kathi’s these instruments and before they actually buy

It and that’s the main reason why we had this blow-up where investors were just looking at the credit rating of a particular asset and as i’d find it’s two-way rated nothing’s going to happen and ultimately things blew up okay what we know jason is that you know the regulatory environment may be shifting in south africa but it’s also being influenced very strongly

By vince internationally basel 3 and new rules of capital adequacy new rules on scrutiny of assets and new rules on risk management how’s that going to impact on structured finance so we’ll probably see a lot of more deals in this africa market because particularly ball 3 is going to make a whole lot more onerous for for banks and they’re gonna have to hold a

Lot more capital for deal that they all concessions that they lend money to so there’s going to be probably quite a lot of flood of new transactions coming to the market and it’s more important that we she gets and deal with the financial issues all right ultimately what is a rating mean basically the rating is an assessment of credit quality served it ranges

From triple-a right aren’t you i mean trouble not sure will be – which is deemed i investment grade so steamed your ability to repay in what your career quality is okay and in terms of the volatility of the ratings i mean andrews refer to credibility yeah i mean the problem is with great writing entities they have this view that investors one to rate instability

So they’re trying to look through sire all those things got there they don’t take forward little confused i don’t actually adopt changes when things go bad so in my view is that investors really do want retton politic so if slang changes from one month to the next it’s not a con sort of problem i mean it’s assisting and signifying the underlying trade risk that’s

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Residing a particular structure what sort of scenarios do you apply in terms of managing the stress or pre-empting the potential stress that an asset could enter into going forward when these various things i mean certain to residential mortgage-backed relations is ultimately what your carry right right might be on a property that’s example if the whole structure

Has to default what’s your ultimate recovery rate going to be for you as an investor and then finally if you could just explain to us the transparency of the system there is a sense that ratings agencies use a lot of smokes and mirrors they do and that’s a lot of distance around that as a wall i mean ultimately if if one wants to bring clear-rite or anything ages

Into regulation they need to be assist i mean worth what are they worth a nice tree is one of eight processors what are the incentives so there is a lot of smoke and mirrors but ultimately i mean the view is that you know to a certain degree ratings are later and then also jason just before we leave i’m a woman i’m allowed to change my mind so this is the final

Final question i mean a lot of focus right now is on sovereign debt issues and the credit ratings of nations and that’s what we’re talking about we’re not looking at corporates very much we’re not looking at assets that people are trading in in terms of trying to spread their investment where is there this disconnect and how can somebody who’s looking at south africa

Wanting to invest in south african securities or wanting to invest in south african equities or whatever asset class they want to look at do they need to look at the broader picture or can they focus at the micro picture when they always look through ultimately through to that online rating of a particular country that large invest in juice you know obviously their

Comparative comparing at you see us as a triple-a rating i mean whether or not or not that is valid or not

Transcribed from video
Fundamental Methodologies of Structured Finance Ratings By CNBCAfrica