Fitch: New China ABS Structures to Reduce Liquidity Risk
OREANDA-NEWS. New liquidity provisions in Chinese asset-backed securities (ABS) are emerging as the market matures. These provisions - such as trapping collection cash flows after closing, to fund reserve accounts - can effectively mitigate structural liquidity risks, says Fitch Ratings.
The Chinese ABS market is divided into three different structures to mitigate liquidity risk. A number of transactions - including the most recent auto ABS transactions issued by Ford, Volkswagen and BMW - have distinct liquidity facilities funded at closing. Others, such as recent auto ABS transactions issued by Nissan and GMAC and the majority of Chinese CLOs, have no liquidity funds at closing and trap excess upon downgrade of the originator by local Chinese ratings agencies. A third structure is now emerging under which cash flows will be trapped immediately after closing until the liquidity reserve is fully funded.
Fitch has only assigned ratings to structures with liquidity facilities fully funded at closing. But we also believe that funding the facility from cash flows within the first few payment periods would be likely to mitigate liquidity risk, subject to the structure employed.
In evaluating structured finance transactions, Fitch looks closely at how deals are structured to mitigate payment interruption risk. Payment interruption refers to a disruption to the collections process affecting the ability of transactions to maintain timely payments to noteholders - eg in the event of servicer termination or operational failure that prevents collections to be processed. Payment-interruption risk can be mitigated by providing cash reserves or a liquidity facility from an eligible counterparty.
A liquidity facility from a third party is not often used in Chinese securitisation transactions. Reserve funds are a more commonly used feature in China to mitigate payment-disruption risk. There are two types of reserve funds, though. One is prefunded at closing, which is a common feature in virtually all global auto ABS transactions. The other is unfunded at closing but can be built up by trapping excess cash flow if servicers' ratings drop below the threshold required by domestic rating agencies. Fitch does not believe the latter structure by itself sufficiently mitigates the risks to achieve international ratings in the 'AA' category.
Chinese ABS transactions typically have no back-up servicing arrangements in place. Most Chinese ABS originators are rated much lower than their ABS bonds by international rating agencies. Servicer termination is a real possibility in higher-rating stress scenarios. Trapping based on rating triggers mitigates the cliff risk of servicer termination, though Fitch does not take a view of funding based on rating triggers of other rating agencies as our rating methodology and rating scale are different. In addition, payment disruption can be driven by reasons other than servicer termination - such as system failure - which can not be addressed by funding upon servicer rating triggers.
Fitch has recently seen issuers looking to structurally mitigate the liquidity risk within transactions by trapping collection cash flows after closing to fund reserve accounts. The trapping of cash flows on the first payment date to fund liquidity reserves, can effectively mitigate payment disruption risk. Fitch assumes payment disruption will last for a time period constituting the longer of three months and one payment period. For auto ABS, the cash reserve is typically sized at the 1%-1.5% of initial collateral balance - which can be trapped, if placed on the top of waterfall - or in other cases placed after senior expenses and note interests, within the first few collection periods. Such a structure provides investors sufficient protection against payment-disruption risk.