Welcome to the Summer 2019 issue of The Journal of Structured Finance. Issuance through the first half of the year is running slightly behind the levels of a year ago.
Structured Finance Issuance, 2019H1 vs. 2018H1
Sources: Asset-Backed Alert, Commercial Mortgage Alert.
However, that hardly means that the year’s first half had been dull. One important development during the second quarter was S&P’s update to its criteria for rating CLOs (Ghetti et al. 2019a, 2019b; Kobylinski, Ghetti et al. 2019; Kobylinksi, O’Keefe et al. 2019; S&P Global Ratings 2019). The update somewhat relaxed the rating agency’s standards. Bloomberg identified the update as a development that could “kick off another round of rating shopping in Europe’s CLO market” (Husband 2019). Several aspects of the update are notable. First, S&P re-designated a substantial portion of its CLO methodology from being criteria to being merely “guidance” (Ghetti et al. 2019a, 2019b). The distinction is important because analysts can deviate from guidance but not from criteria (Van Acoleyen et al. 2017). Additionally, guidance can be changed or rescinded without all the procedural checks and balances that apply to criteria.
Second, S&P seems to have also modified the stress scenarios used for calibrating all of its criteria across sectors. The result is a relaxation of the stress levels associated with each rating category. (S&P Global Ratings 2019, p. 40; Wiemken et al. 2018, 9–10; Adelson et al. 2009, 13–14).1 Exhibit 2 shows the change.
S&P Criteria Stress Scenario Relaxation
Sources: Wiemken et al. 2018 pp. 9–10 and Adelson et al. 2009 pp. 13–14 for “Before”; S&P Global Ratings 2019 p. 40 for “After.”
The change in the parameters for the stress scenarios is interesting on several levels. First, S&P did not make a general announcement that it was relaxing or modifying the stress scenarios. The relaxed parameters first appeared last fall, but in a non-criteria report titled “S&P Global Ratings’ CLO Primer” (Marty et al. 2018). Second, the idea of describing a specific scenario with a range rather than a point value is odd. A scenario must be specific for use as a calibration benchmark. Third, it appears that authors of the change took liberties in interpreting the phrase “as much as” in the original scenario descriptions.
A third notable aspect of the CLO criteria update relates to S&P’s use of historical data as part of the rationale for the update. S&P asserted that the performance of CLO collateral loans through the 2008 downturn justified easing the criteria (Anderberg et al. 2019; S&P Global Ratings 2019, 41–42; Polizu et al. 2019). However, the rating agency seems to have overlooked a key point in its analysis. That is, that the corporate sector overall performed better (under the same metrics) through the 2008 episode than in prior downturns. In other words, the 2008 downturn was concentrated in the financial sector, and regular corporate credits—the type included in CLOs—experienced an atypically low degree of stress (Exhibit 3).
5-Year Static Pool Speculative Grade Corp. Default Rates (%)
Sources: Vazza et al. 2018 Table 32, Ou et al. 2019 Exhibit 53.
This issue of the JSF starts with an article about the role of ABS CDOs (i.e., CDOs backed by MBS) in the 2008 financial crisis. Authors Larry Cordell (Federal Reserve Bank of Philadelphia), Greg Feldberg (Yale University), and Danielle Sass (University of Illinois) review extensive performance data and conclude that total losses on ABS CDOs were a whopping $410 billion, of which $325 billion was borne by holders of triple-A-rated and “super senior” securities. Those results seem to bear out some of the strident criticisms that the product received in the years following the crisis.
The issue’s second article discusses the impending demise of LIBOR and the introduction of its potential replacement, SOFR. This topic is definitely a hot one for structured finance professionals. Author Tom Hughes supplies both the background context for the story and a discussion of issues that remain unresolved. To be sure, the LIBOR-SOFR story will be one that the whole market will have to follow closely through 2021 and beyond.
The third article proposes changes to the system for modifying residential mortgage loans that are insured or guaranteed by the federal government (i.e., FHA/VA/USDA loans). Authors Laurie Goodman and Karan Kaul (both of the Urban Institute) propose a system for modifying such loans to have below-market interest rates while being able to remain in Ginnie Mae pools. Some readers may view the proposal as quite controversial because it would introduce a modest (but potentially non-trivial) amount of credit risk into Ginnie Mae securities (gasp).
The fourth article examines several ways for structured finance investors to generate excess returns in the global market. Author Tracy Chen of Brandywine Global Investment Management compares RMBS investment opportunities in Spain, the US, and China. She presents a framework and a decision-making process for evaluating opportunities across markets.
This issue’s fifth article presents a model of home price appreciation (HPA) volatility. The authors, David Zhang (MSCI) and Lihua Zhang (Zhejiang University of Technology), assert that a volatility component of HPA causes it to fluctuate around a long-term trend. They present an analytically tractable model and conclude that the period of oscillation varies for different MSAs.
The sixth article offers a probing—and quite technical—consideration of Moody’s “correlated binomial default distribution” (Witt 2004). Author Joe Pimbley, who is the editor of the The Journal of Derivatives, identifies certain anomalies in the Moody’s framework and proposes an alternative.
This issue’s final article proposes a mechanism to reduce the funding costs for renewable energy projects in India. It envisions using cash reserves to cover the risks of payment delays and defaults by state-owned electricity distribution companies that have contractually agreed to purchase electric power from renewable energy projects. Authors Gireesh Shrimali (Stanford University), Vaibhav Pratap Singh (Climate Policy Initiative), and Vinit Atal (University of Chicago) conclude that it should be possible to substantially boost the credit quality of many renewable energy projects in India by providing payment security support covering 12 months of payments.
This issue includes my report on the 8th Annual Investors Conference on CLOs and Leveraged Loans, which was held on May 20–21 in New York. It also includes highlights from GlobalCapital and a selection of industry news items from the Structured Finance Association (formerly known as the Structured Finance Industry Group), in both cases covering Q2 2019.
As always, we welcome your submissions. Please encourage those you know who have good papers or who have made good presentations on structured finance- or project finance-related subjects to submit them to us.
Submission guidelines can be found at http://jsf.pm-research.com/authors. If you have comments or suggestions, you can e-mail me directly at M.Adelson{at}PageantMedia.com.
Mark Adelson
Editor
ENDNOTES
↵1 S&P developed and published the scenarios in 2009 as part of the initiative to regain credibility in the wake of the 2008 financial crisis. The stress scenarios were part of a general effort to enhance the comparability and transparency of S&P ratings. That effort, in turn, was one of the expressions of the 27 “leadership actions” that S&P announced in 2008 and pursued through mid-2011 (Sweeney and Atkins 2008, Standard & Poor’s 2011).
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