The rating of asset-backed securities, a product of structured finance, constitutes an “issuance rating” and differs from the methodology measuring the overall default probability of an issuer, i.e., an “issuer rating.”
While an ABS issuance, i.e., the rating of a security, encompasses the risks of the issuer, it is limited to the maturity, volume, and collaterals of that specific security.
Highlighted topics and examined areas in the rating of structured finance products are summarized below:
1. Structural and Legal Framework
Asset-backed securities are issued by a legal entity termed as an “asset financing fund,” formed by a financial institution with the founder status as required by legislation. This fund, structured as a Special Purpose Vehicle, is managed by a board of directors, audited by an auditor, and subject to independent audit. While transferring underlying assets to this fund, topics such as the corporate structure, independence of the fund mangement, default isolation in mutual agreements with the originator, transfer and guarantees of underlying assets, and investor rights are examined within the context of the structural and legal framework analysis. Subsequently, the segmentation of the asset-backed security based on maturity, risk groups, or other criteria is examined, evaluating the compatibility of these segments with defined yield rates, payment priorities, and cash flows; Trigger and precautionary mechanisms are assessed in case of potential loss or regulatory violations.
2. Originator and Service Provider
In evaluating the originator transferring receivable assets and, if different, the servicer conducting collection, delinquency/default tracking, and payments to investors, factors such as their reputation, past performance metrics, rigor and effectiveness of credit approval processes, and past default rates of underlying assets are considered.
3. Underlying Assets
In the analysis of underlying assets, factors such as the collection and payment method based on the type of security, compliance of assets with predefined selection criteria, distribution based on maturities, risk ratings, age groups, geographic regions, and other relevant criteria are examined; Collateral structures and, if any, insurances; Factors such as NPL ratios, maturity and collection rates are evaluated.
4. Cash Flow
Cash flow analysis involves conducting cash flow projections based on redemption structure, type, and duration, modeling interest sensitivities and yield rates in different scenarios. Assuming the modeled cash flow, interest sensitivities and returns based on defined costs are examined, and potential risks are evaluated.
5. Credit Enhancing Factors
Additional security margins and measures can be implemented in structuring asset-backed securities. Of these, the “risk retention obligation” is mandatory by regulation, set at a minimum of 5% of the issuance volume. Accordingly, the source institution or issuer fund is obliged to acquire 5% of the issued securities. However, based on the risk structure of underlying assets, both the source institution and the fund may undertake additional risk retention through purchases. Additionally, reinforcement margins can be provided through overcollateralization, and third-party guarantees and further financial insurance mechanisms can be defined. In the analysis of credit enhancing factors, all these additional securities are evaluated.
6. Macroeconomic and Sectoral Factors
Beyond the structural risks of the asset-backed security, undoubtedly, sectoral, macroeconomic, and systemic risk factors also influence the outcome. The potential impacts of macroeconomic developments such as growth, unemployment, inflation on the asset pool and sensitivity to various confidence indices are examined. The associated sector(s) of the underlying assets are additionally examined for growth, trends, and volatility, evaluating the sensitivity of the asset pool to these factors.
7. Stress Testing
The model, considering all these factors, is tested under base and stress scenario assumptions, and based on the results, a final risk measure is determined and converted into a letter grade.