Fitch: Pending US Swap Rules Could Impact Structured Finance Transactions

NEW YORK & LONDON--()--Pending derivative regulations including swap margin posting requirements are creating uncertainties for both new and existing structured finance transactions, according to Fitch Ratings. Scheduled to go into effect in March 2017, the new rules require daily posting of two-way variation margin on affected derivatives.

While new swaps executed after March 1, 2017 would clearly be affected, Fitch's interpretation of the current proposals is that in the event of a replacement of a derivative counterparty in an existing transaction, the consequent contractual agreement between issuer and replacing derivative counterparty would have to obey two-way daily variation margining. In Fitch's view, this aspect has the potential to create a significant barrier to the ability of transaction parties to find suitable replacement entities on equivalent economic terms.

The Structured Finance Industry Group (SFIG) has previously requested and received a 'no action position' from the U.S. Commodity Futures Trading Commission (CFTC) for certain commission regulations applicable to swaps with legacy special purpose vehicles (see CFTC Letter No. 15-21). Given the nature of this no-action position it is conceivable that it will be extended to the two-way margin posting requirements.

Background:

Fitch's structured finance ratings rely on effective counterparty risk mitigants, among which the assumption that counterparties will implement remedial actions upon becoming ineligible. If the likelihood of appropriate remedial actions is substantially reduced, potential rating actions could follow. The U.S. Prudential Regulators' non-cleared margin requirements for covered swap entities are scheduled to be effective for all financial end users of derivative contracts by March 1, 2017. The impact of these rules on structured finance will be substantial with all in-scope derivatives requiring daily posting of two-way variation margin; this is in contrast to European regulations, which to date have sought to exempt structured finance issuers from similar margin posting requirements. Counter to existing market practice, Fitch expects structured finance issuers will start to face two-way margin requirements on their derivative exposures.

Fitch understands that the scope of the requirements extend to all U.S. issuers as well as a U.S. financial institution facing non-U.S. issuers. The extent to which a non-U.S. bank with significant U.S. operations facing a non-U.S. issuer would be impacted remains unclear. In addition Fitch understands that existing derivatives, to the extent that no changes are made to the contractual agreements in place, will remain outside of the margin requirements. In contrast, modifications to existing transaction terms or novation to a replacement counterparty would bring that transaction into scope and therefore, subject to the two-way margin posting requirement.

In structured finance transactions rated by Fitch to date, collateral is typically posted under a one way agreement in favour of the issuer. This allows for the issuer to mitigate its credit risk whilst avoiding the introduction of a volatile, and potentially large, obligation to the transaction. By contrast, the swap counterparty is required to take credit risk to the issuer, usually in exchange for seniority in the ranking of payments due to it, as stipulated in most transaction's priority of payments.

Fitch considers that, in the absence of specific mechanisms dealing with the margin posting requirement, the introduction of a daily variation margin obligation on the issuer could be incompatible with the relatively predictable cashflows received by an issuer and owed under its debt securities. One concern of this regulatory change is that two-way collateral posting could make the future use of derivative contracts such as interest rate swaps uneconomical or impossible in Structured Finance. Some transactions rated by Fitch use instruments, such as interest rate caps, which do not have as volatile a mark to market. By definition a purchased option will never have a liability to the buyer once any associated premium has been settled. The requirement for variation margin to be paid by an issuer would arise only if the mark to market of its derivative position becomes, from its own perspective, a value less than zero. As a purchased option has a floor in its value to the buyer of zero, these instruments do not present a potential margin outflow for issuers and are consequently not a concern for collateral implications.

In its 'Counterparty Criteria for Structured Finance and Covered Bonds' Fitch considers a commitment to remedial action as a key mitigant against counterparty risk. Many securitisation derivatives contain obligations to replace a counterparty upon downgrade below a defined minimum level. Fitch's interpretation of the current proposals is that in the event of a replacement of a derivative counterparty, the consequent contractual agreement between issuer and replacing derivative counterparty would have to obey two-way daily variation margining. In Fitch's view, this aspect has the potential to create a significant barrier to the ability of transaction parties to find suitable replacement entities on equivalent economic terms. In the event that an issuer can only replace a counterparty on differing terms it would raise the requirement to seek consent from other parties to the transaction. The requirement to obtain relevant consent would extend the time in which replacement counterparty can be sought exposing the transaction to increased risk in the intervening period.

Fitch considers the extent to which the requirements may impact the potential for an issuer to source a replacement counterparty to be dependent on the jurisdiction of the issuer. While the full extent of any impact remains unclear, Fitch considers the greatest impact is likely to be felt in the U.S. where it may become more difficult to transfer some existing arrangements to a new counterparty. In Europe Fitch considers that the implications are likely to be felt through a reduction in the number of available market participants, the scope of which will be dependent on the breadth of the definition of a U.S. entity imposed.

Fitch will continue to monitor developments as these regulatory changes are brought into effect. In particular Fitch will continue to review challenges to its assumptions with regards to the replacement of counterparties and will comment further as appropriate. In the U.S., a possible 'no action position' from the CFTC could, in Fitch's view, make the replacement of legacy swaps more likely and therefore reduce replacement risk arising from the upcoming regulation.

Additional information is available at www.fitchratings.com.

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Fitch Ratings, Inc.
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Director
or
Kevin Duignan, +1-212-908-0630
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Contacts

Fitch Ratings
Andreas Wilgen, +1-212-908-0778
Managing Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Duncan Paxman, +44-203-530-1428
Director
or
Kevin Duignan, +1-212-908-0630
Managing Director
or
Media Relations:
Sandro Scenga, +1-212-908-0278
New York
sandro.scenga@fitchratings.com