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If “X” represents the level of credit enhancement that was assigned to the ‘AAA’ class of securities, it is most likely due to the assessment that curve “A” is the most representative of the expected loss distribution, since this would be the only one of the two loss distributions that would not be expected to experience material losses with this level of credit enhancement. If, however, distribution “B” were to be the one occurring in reality, the “X” level of credit enhancement might not be sufficient to protect the ‘AAA’ noteholders against losses.

5.1.5 Models Cannot Capture Nuances Arising from Different Standards in Collecting and Processing Data

Even when the data used is technically correct, models cannot capture certain nuances associated with the underlying information. Different lenders use different standards when they generate the

data that are fed into the model. For example, using the loan-to-value (LTV) ratio in a model assumes that the appraisal of the underlying property was correct. However, a model cannot distinguish between originators who use stringent external appraisals to evaluate property values and originators who merely rely on an estimation of property prices based on property databases.

5.1.6 Different Timeframes can Yield Varying Credit Ratings

The length of the timeframe within which historic data has been obtained has important implications for the outcome. This is particularly relevant when it comes to analysing historical performance data. For example, the data available may relate to a period of benign economic conditions, which would not be an accurate proxy for potential adverse economic conditions in the future.

5.1.7 Operational Changes can lead to Inconsistencies in Data

Any statistical prediction with respect to the future performance of assets assumes a certain level of consistency between the credit quality of the sampled historic receivables and the quality of receivables to be originated in the future. However, if the originator goes through some operational changes, e.g. a merger or change in management, which resulted in different credit policies or a different customer base, the performance of future receivables is unlikely to be consistent with their past performance.

5.1.8 Economic Changes

Economic changes will have an impact on the performance of financial instruments. While certain assessments are made with respect to relevant economic indicators, these predictions cannot be precise due to the numerous factors driving these changes.

5.1.9 Realistic Expectations

It should be recognised that any statistical model has an inherent margin of error, even while assuming that the underlying data is 100% accurate and virtually all of the relevant factors were taken into account. Accordingly any model’s output should be viewed through a prism of realistic expectations as to what the data means and what extent of precision it can support.

5.2 Importance of Qualitative Analysis

Due to the limitations of statistical analysis, a comprehensive approach should include a blend of both quantitative techniques and qualitative judgement. In the context of securitisation, qualitative analysis provides an essential supplement to the qualitative analysis by (Ernst, 2001:1):

− validating or modifying the underlying data of the model;

− adding other important components, such as an assessment of the structure and legal elements, an analysis of the expected economic and industry trends, and an evaluation of the quality of origination, credit standards and servicing procedures; and

− questioning how reasonable the results of the quantitative analysis are by comparing them with similar transactions.

Rating agencies thus use a combination of quantitative and qualitative methods when conducting its rating analysis of securitisation transactions. The qualitative review not only verifies that the underlying data is correct, but also adds non-quantitative factors to the analysis and ensures that the final result is reasonable. The asset pool analysis is split between the two methods. To evaluate the credit quality of the assets, the rating agency conducts an operational review of the relevant parties to examine the origination process, the quality of credit appraisal and the efficiency of servicing. On the quantitative side it involves the use of relevant statistical models to simulate various scenarios of frequency of default and severity of loss. At the structural analysis stage, the strength and sustainability of the transaction structure is examined from various quantitative and qualitative angles. These include an evaluation of the financial structure, the cash flow waterfall, the legal issues and tax considerations. Simultaneously, quantitative modelling is being constructed to account for the transaction’s structural elements, such as excess spread, subordination of junior security classes, performance triggers, cash reserves and amortisation. Based on all of these elements, the analysis will reveal the level of expected loss with respect to each of the rated security classes. The final stage of the rating process is the rating committee during which the various pieces of the rating process are put together (Ernst, 2001:6 to 7).

The rating committee is the final step in the securitisation transaction’s rating process. The lead analyst’s role is to present the transaction to the committee members and explain the rating methodology. The following issues are typically addressed by the rating committee (Ernst, 2001:8):

− an overview of the transaction;

− underlying assets: positive and negative characteristics;

− originator: strategy, market position, origination process and underwriting practises;

− servicer (originator): collection and servicing methods, staff, information systems, backup systems;

− historic performance of assets: delinquency, default and recovery rates;

− transaction structure: parties and cash flow;

− cash waterfall: priorities and triggers;

− hedging mechanisms: interest rate and currency risk mitigation;

− liquidity facility;

− modelling: verification of the underlying data, assumptions, type of model, stress scenarios and results;

− legal issues: true sale, bankruptcy-remoteness of the SPV, security interest, enforceability of documents, tax considerations;

− preparing a list of follow-up questions;

− consideration of the credit enhancement levels and the rating of each class of securities; and

− final voting on ratings and credit enhancement levels.

An extensive discussion is held concerning the transaction’s structure, the relevant parties, the credit quality of the underlying receivables and the relevant legal issues, following which a vote is conducted with respect to the ultimate credit enhancement levels. An important objective of the committee is to

assess the soundness of the quantitative analysis, and this includes a rigid scrutiny of the models used by the analysts. The committee will typically evaluate the quality of the models’ underlying data, the models’ assumptions, the overall method and the stress scenarios that were tested. If any of this needs to be modified or re-verified, the committee’s vote will either be postponed or become subject to the new results.

6. CONCLUSION

Credit ratings play a very important role in securitisation transactions and the issuance of asset-backed securities. The structure of the transactions is generally complex, which makes the task of assessing the credit risk difficult for investors. Credit ratings provide a simple and objective assessment of default risk in the form of a symbol that is easy to comprehend. The framework used for assessing the risk of default in asset-backed securities involves three types of risk – credit risk, structural risk and legal risk.

Credit risk is the risk of default by the borrowers in the underlying loan pool backing the securities issued. Structural risk refers to the manner in which the transaction is structured to direct the cash flows from the underlying assets (loans) to the investors in the securitisation. Legal risk refers to the compliance with various laws and regulations, and issues relating to a true sale of the assets, the bankruptcy-remoteness of the issuer (SPV), and the legal enforceability of security.

The rating process involves an evaluation of the originator, the collateral (underlying assets) backing the securities issued, and the structure of the securitisation transaction. Such evaluation by the rating agency is performed through due diligence, stress testing and credit evaluation, which is followed by an appropriate legal review that provides confidence in the legal opinions relating to true sale of assets, enforceability of security, bankruptcy-remoteness and tax neutrality.

Securitisation involves the separation of the credit risk of the underlying assets from the credit risk of the originator. An evaluation of the originator is nevertheless important because of the potential impact on the ability of the originator to continue generating asset of an acceptable quality, which is especially important in revolving transactions. The quality of the underlying assets is an important factor in the level of credit risk absorbed by investors and consequently reflected in the ratings assigned to the asset-backed securities. The most important structural element of a transaction is the level of credit enhancement that is provided, which is another element that allows the credit rating of the asset-backed securities to exceed that of the originator.

In order for the rating agency to maintain its rating of the securities, it requires ongoing performance data on the transaction from the originator in the latter’s role as servicer. The servicer must also inform the rating agency of events and circumstances that may have an impact on the transaction. If worrisome trends are noted, corrective action needs to be taken to prevent the securities being downgraded. The rating agency uses the performance reports that it receives to prepare surveillance reports for the investors in the asset-backed securities.