Moody's FFELP ABS downgrades signal cracks in legacy sector

12 January 2018
Moody's Investors Service downgraded 26 classes of FFELP ABS subject to CFTC swap margin posting requirements on Thursday, following years of advocacy work on behalf of former Moody's rating analyst and Debtwire ABS alum Bill Harrington. Harrington, now a senior fellow at the Croatan Institute, lobbied the rating agencies, SEC, CFTC and others to require full collateralization of embedded ABS swaps and properly assess the risk of legacy deals which contain them.
 
While the CFTC issued a no-action letter for legacy ABS with embedded swaps on 27 October, the no-action letter "does not materially increase the likelihood that, if a counterparty defaults, the SPV will enter into a new swap with a replacement counterparty," Moody's wrote in a press release Thursday. "Moreover, the relief does not affect initial margin requirements," Moody's wrote. 
 
Moody's downgraded bonds from nine FFELP ABS, seven of which are sponsored by Navient. Harrington identified 35 additional deals sponsored by Navient which also contain flip clause swaps and may also be subject to negative rating action. For now, it appears as though Moody's has chosen to focus on those deals with an embedded currency swap. 
 
The rating agency published its revised methodology for assessing structured finance counterparty risk on 26 July. The CFTC's swap margin rules were implemented on 1 March and swaps which were excuted on or before that date are excluded from the CFTC's margin rules. 
 
Moody's wrote that it could further downgrade FFELP ABS ratings if collateral paydowns slow further as a result of low voluntary prepayments, high deferment, forbearance and IBR rates, which are already threatening and/or modeled to not repay classes by their final maturity dates, as previously reported. Other circumstances which the rating agency wrote would warrant further rating action include a US government downgrade or downgrades of senior unsecured debt or counterparty risk assessments on relevant swap counterparties.
 
The CFTC and prudential regulators define a legacy swap which is amended in any manner as a new swap subject to existing swap margin rules.
 
Swap replacement market 'a mirage'
 
The replacement market for highly rated swap providers for legacy unmargined, uncleared swaps with RAC provisions “has been a mirage since 2008,” according to Harrington. The enforceability of a flip clause — the central issue in legacy Lehman Brothers litigation (Lehman Brothers Special Financing Inc. v. Bank of America National Association) — is the “last and not the first nail in the replacement coffin,” he wrote in a 17 July letter to CFTC Chair Chris Kirkpatrick.
 
There are two types of rating triggers designed to protect against counterparty credit risk. Transfer triggers require a downgraded counterparty to transfer the swap to a higher-rated counterparty, while collateral triggers require the downgraded party to post collateral, according to Moody's. However, neither improves the likelihood of counterparty replacement upon default, the rating agency wrote in a 12 December report.
 
Legacy ABS residual valuation
 
Failure to replace a swap counterparty, in and of itself, may not trigger an ABS event of default; rather, the deal will continue until maturity or counterparty default, Harrington said. Still, the issue may portend a look at the valuation of residuals of ABS which contain these legacy swaps.
 
A swap provider of an unmargined, uncleared swap with RAC provisions and a flip clause does not “enjoy security in securitization 100% of the time,” as SFIG wrote in a letter to the CFTC and prudential regulators which asked for a no-action letter on the matter on 11 July, he wrote. Conversely, when flip clauses are upheld, an uncleared swap asset is “instantaneously transformed into a fixed claim of USD 0.00,” Harrington wrote in the 17 July letter.
 
Harrington was a Moody's SVP and global analyst for uncleared swaps with RAC provisions and flip clauses and other types of derivative contracts from 1999 to 2010, when he resigned to pursue advocacy for financial stability. He has long argued that unmargined, uncleared swaps with RAC provisions and a flip clause were the gateway component of the securitizations — CDOs, CDS and RMBS — that caused the financial crisis. “Without margin posting, the securitization sector cannot come clean and mature into a sector that helps grow the US economy rather than harms the country by causing financial crises and bailouts,” Harrington wrote in the July letter.
 
In August, Harrington filed a report with Moody's integrity hotline urging attention to the matter. Much of his advocacy work can be accessed here.