Despite the recent woes in the economic environment, the default risk of European structured finance securities and their ratings has so far been largely unaffected, writes S&P's Andrew South.
Given the scale and depth of the recent financial crisis and recession, European structured finance over the past two-and-a-half years has exhibited relatively weaker credit performance than at any time since the market’s inception in the late 1980s. However, in absolute terms, credit performance has remained robust, with a cumulative default rate of only 0.39% over the period.
While credit performance is generally quantified by analysing the number of rating movements, some market participants may also wish to consider equivalent statistics based on issuance volumes. This approach gives greater weight to larger tranches, where the most investor funds are actually deployed—notably those more senior in the capital structure and those in asset classes where transactions are typically larger.
Considering the cumulative rating transition and default rates since the beginning of the current financial crisis – here taken to be in mid-2007 until the end of 2009 – credit performance in European structured finance has been comparatively robust. In fact, while tranches outstanding in mid-2007 accounted for an original issuance volume of e1,858bn, those that had defaulted by the end of 2009 accounted for only e7bn, thus the 0.39% cumulative default rate.
Performance diverges by geography
It is important to distinguish between different sectors and geographies. The credit performance of structured finance in Europe, for example, has differed markedly from that in the US, which saw a default rate of 4.29% (compared with 0.39% in Europe) and a downgrade rate of 40.6% (12.4% in Europe) over the same period.
Credit performance has also diverged significantly across asset classes. For example, European transactions backed by highly granular pools of loans to consumers have performed far better than those backed by less granular pools of corporate credit risk. European consumer asset classes – the combination of residential mortgage-backed securities (RMBS), covered bonds, and consumer asset-backed securities (ABS) – showed a default rate of only 0.03% over the period, and a downgrade rate of only 2.5%. By contrast, negative credit performance over the crisis has been focused in the other asset classes – collateralised debt obligations (CDOs), commercial mortgage-backed securities (CMBS), and corporate securitisations – which have seen an aggregate default rate of 0.86% and a downgrade rate of 25%.
Finally, credit performance differed markedly by position in the transaction’s capital structure. For investment-grade ratings, the default rate was only 0.36% and the downgrade rate 12.2%, compared with 4.17% and 35.8%, respectively, for speculative-grade ratings.
Investment-grade tranches accounted for more than 99% of European structured finance in mid-2007, and AAA-rated tranches alone accounted for 82%.
Defaults uncommon, downgrades limited
Rating downgrades are generally more common than defaults. However, the cumulative downgrade rate for European structured finance was still only 12.4% between mid-2007 and the end of 2009, meaning ratings have been stable – or even raised – over the course of the crisis for nearly 90% of the sector.
While the recent recession has been comparatively severe, Standard & Poor’s rating analysis typically assesses whether structured finance securities can continue to meet their payment obligations in recessions that may be even more severe than the recent one. In general, the more stressful an economic scenario we believe a security is able to withstand without defaulting, the higher we might rate it. The recent economic environment has not, in our opinion, significantly heightened the default risk of many highly rated European structured finance securities and their ratings have consequently been unaffected to date.
On an annual basis, the trend in default rates improved slightly in 2009 compared with 2008, falling to 0.15% from 0.18%. In 2008, defaults occurred across the capital structure in certain types of leveraged CDO structures, such as constant proportion debt obligations (CPDOs) and CDOs of structured finance securities. The unprecedented volatility in market prices of their underlying assets was a significant driver of defaults for even senior, relatively large tranches in these transactions. By contrast, in 2009 most defaults occurred among very small tranches originally rated in the CCC category, notably in Spanish ABS and RMBS. The remaining defaults, in CDO and CMBS transactions, for example, were also focused on relatively small, speculative-grade tranches.
Investment grade turns in strong performance
Lastly, credit performance over the crisis to date has differed markedly by position in the capital structure. For investment-grade ratings, the default rate was only 0.36% and the downgrade rate 12.2%, compared with 4.17% and 35.8% respectively for speculative grade. For AAA ratings, the default rate was 0.30% and the downgrade rate was 9.1%. Investment-grade tranches accounted for more than 99% of European structured finance in mid-2007, and AAA-rated tranches accounted for 82%.
Andrew South, senior director, Standard & Poor’s Ratings Services
