Summary of Rating Methodologies for Structured Finance Products
Rating and Investment Information, Inc.
Apr 1, 2020
Table of Contents
Chapter 1: General ...... 5 Subchapter 1: Positioning of Rating Methodologies and approach to structured finance products . 5 Subchapter 2: Basic of credit rating method for SF products ...... 7 Subchapter 3: Monitoring method of credit ratings ...... 11 Chapter 2: Particulars: Risks regarding structure ...... 15 Subchapter 1: Structure of asset transfer ...... 15 Subchapter 2: Structure of asset holding (SPV) ...... 18 Subchapter 3: Structure of asset administration ...... 25 Subchapter 4: Structure of external credit enhancement ...... 39 Subchapter 5: Structure of external liquidity enhancement ...... 42 Subchapter 6: Structure of cash flow distribution ...... 44 Chapter 3: Particulars: Risks regarding underlying assets ...... 46 Subchapter 1: Installment receivables ...... 46 Subchapter 2: Lease receivables (finance lease) ...... 53 Subchapter 3: Residential loan receivables ...... 58 Subchapter 4: Japan Housing Finance Agency MBS ...... 67 Subchapter 5: Consumer loan receivables ...... 72 Subchapter 6: Corporate loan receivables ...... 78 Subchapter 7: Promissory note receivables ...... 82 Subchapter 8: Accounts receivable...... 84 Subchapter 9: Bonds ...... 88 Subchapter 10: Derivative transactions (credit default swap, etc.) ...... 93 Subchapter 11: Other monetary receivables (including trust beneficial interest) ...... 99 Subchapter 12: Real estate (real estate-backed trust beneficial interest) ...... 101 Subchapter 13: Real estate non-recourse loans ...... 104 Subchapter 14: Development-type real estate ...... 106 Subchapter 15: Security deposit receivables ...... 109 Subchapter 16: Guaranteed receivables ...... 112 Subchapter 17: Medical fee receivables/Dispensing fee receivables ...... 116 Subchapter 18: Monthly clear (credit card) receivables ...... 118 Subchapter 19: Projects (including PFI) ...... 122 Subchapter 20: Business cash flow, etc...... 137 Subchapter 21: Sub-performing loans, etc...... 138
2/184
©Rating and Investment Information, Inc.
Subchapter 22: Monetary receivables from airline companies and aircraft ...... 140 Subchapter 23: Other Assets (excluding those specified in the other subchapters) ...... 144 Chapter 4: Particulars: Cash flow risk ...... 147 Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) ...... 147 Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) ...... 155 Subchapter 3: Analysis method for real estate securitization ...... 157 Subchapter 4: Analysis method for project finance ...... 165 Subchapter 5: Analysis method for business cash flow, etc...... 169 Subchapter 6: Analysis method using cash flow test ...... 171 Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure ...... 173 Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products ...... 175 Subchapter 9: Deleted ...... 177 Subchapter 10: Analysis method of risk transfer transactions ...... 178 Subchapter 11: Analysis method for aircraft finance ...... 179 Chapter 5: Particular: Monitoring ...... 181 Subchapter 1: Monitoring of credit ratings of underlying assets and parties involved in the structure...... 181 Subchapter 2: Monitoring for the large pool approach ...... 181 Subchapter 3: Monitoring for the small pool approach ...... 182 Subchapter 4: Monitoring of rated products backed by real estate ...... 182 Subchapter 5: Monitoring of short-term products backed by promissory note receivables, accounts receivable, etc...... 182 Subchapter 6: Monitoring of rated products backed by project and business cash flow, etc...... 183 Subchapter 7: Monitoring of rated products backed by monetary receivables from airline companies and aircraft ...... 183 Subchapter 8: Monitoring of credit ratings for programs ...... 183
3/184
©Rating and Investment Information, Inc.
(Notes)
“Basic issues” in Chapters 2 and 3 present facts.
“Risk factors” in Chapters 2 and 3 describe major risk factors.
“Response to risk” in Chapters 2 and 3 means responses to risk by originators, arrangers, etc. If there are multiple responses to one risk factor, any one response may be used either alone or in combination with another response.
“Perspective for evaluation” in Chapters 2 and 3 means R&I’s perspective for evaluating “Response to risk.” If any response other than “Response to risk” described is performed, R&I will perform an evaluation as to whether or not such a response is appropriate.
The “entities acceptable to R&I” described in this Summary are those corporations to which R&I assigns undisclosed credit ratings and whose appropriateness R&I acknowledges in such a context.
“Structured finance products (SF Products)” mean securitized products, derivative products, and other SF Products, but do not include J-REIT.
“Securitized products” mean those products by which corporations seek to raise funds primarily by applying a structure of one sort or another with the backing of specified assets only.
“Derivative products” primarily mean repackaged bond products with relatively high creditworthiness in which derivative transactions are embedded.
“Other SF Products” mean those products for which creditworthiness is enhanced primarily by applying a structure of one sort or another to corporate finance.
4/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
Chapter 1: General
Subchapter 1: Positioning of Rating Methodologies and approach to structured finance products
R&I’s rating methodologies are established in accordance with the Credit Rating Activities Basic Policy and the Rating Determination Policy. The rating methodologies prescribe the “rating approach” to be applied to credit ratings of structured finance products (hereinafter referred to as “SF Products”) on the basis of qualitative and quantitative logical systems. A credit rating for an individual transaction is assigned on the basis of these rating methodologies. The rating processes, procedures, specific calculation methods, etc., are prescribed in separate manuals. R&I is pleased to publish this document, “Summary of Rating Methodologies.” The Summary of Rating Methodologies consists of a general discussion of R&I’s basic approach to rating methodologies and an item-by-item discussion describing risks associated with structure, risks associated with underlying assets, analysis methods by approach, and monitoring methods for credit ratings. The general discussion represents broader concepts covering topics under the item-by-item discussion.
R&I performs credit ratings with the aim of rendering them trustworthy. This aim is achieved by: (i) clear-sighted ratings and (ii) ratings with features of stability and continuity. Assigning clear-sighted ratings results in ratings featuring stability and continuity. To this end, it is critical to have an accurate vision of the future. R&I achieves such an accurate vision of the future through the following analytical processes. First, R&I seeks to understand the actual conditions of transactions by identifying and analyzing credit risk factors that lie behind risks associated with structures and underlying assets, respectively. Then, after performing a cash flow analysis on the basis of the outcome of an analysis of these credit risk factors, R&I performs a comprehensive evaluation and assigns a credit rating finally, taking into account the outcome of the analysis of those credit risk factors that have not been worked into the cash flow analysis. The rating methodologies adopted in these processes must be selected in an appropriate manner according to the specific structure of the transaction involved and the attributes of the relevant underlying assets. The rating methodology to be adopted may be singular, partial, or multiple. In any event, a trustworthy credit rating must be assigned using expert knowledge and skills in accordance with the prescribed rating methodology.
5/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
A case in which there is no rating methodology would mean a case in which there is no description of any approach whatsoever in any of the chapters for rating methodologies. For example, the case of a product linked to equity indices would fall under this category. A rating method would be deemed to exist if there is an approach of one kind or another or even a partial description thereof in any of the chapters.
6/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
Subchapter 2: Basic of credit rating method for SF products
Section 1: Identifying products to be rated When assigning credit ratings, R&I first identifies SF Products that would be subject to credit rating (products to be rated). The main attributes by which products to be rated are identified include issuer’s name, product’s name including issue number, issue date, redemption date, interest rate, issue amount, etc. These attributes are prescribed in transaction agreements. In addition to securities and loans, products subject to credit rating include “purchase receivables” that are prescribed in the so-called Basel II Supervisory Regulations, derivative contracts, programs, and other products. Types of credit ratings to be assigned to products subject to credit rating vary depending upon whether or not the period between issue date and redemption date is less than one year. If the period is less than one year, the product is deemed in principle to be a short-term financial obligation, and a Short-term Rating would be assigned to the product. Otherwise, a Long-term Issue Rating would be assigned. If, for the purpose of assigning a Short-term Rating, there exists no specific means of assigning a Short-term Rating to a product subject to a credit rating, R&I would first determine a Long-term Issue Rating in accordance with the applicable rating methodology, and thereafter determine a Short-term Rating by replacing the Long-term Issue Rating with a Short-term Rating. Therefore, the rating methodologies would basically be described with respect to Long-term Issue Ratings. It should be remembered that, for the purpose of the said replacement, creditworthiness under a Long-term Issue Rating would be judged from the possibility of default (default risk) and the possibility of loss in the event of default (recovery risk), whereas creditworthiness under a Short-term Rating would be judged only by default risk, and recovery risk would not be taken into account.
Section 2: Putting contracts in order Because credit ratings are R&I’s opinions on the certainty of an issuer fulfilling its obligations as contracted, it would, for the purpose of assigning ratings, be necessary to put contracts in order and identify the relevant contracts. Generally, SF Products are designed in such a manner that they would not fall into default or result in a legal arrangement as a result of default. Hence, R&I evaluates SF Products from the perspective of whether or not they are insolvent with respect to the initial principal redemption method and interest payment method. When performing credit ratings for SF Products, R&I typically puts contracts involving them in order based on the concept of default as laid out in the Rating Determination Policy. With respect to
7/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
ordinary SF Products, R&I evaluates the certainty of principal repayment and interest payments up to the time of final redemption. R&I may evaluate the creditworthiness of products whose interest is linked to performance on the basis of only on-time principal redemption as a contract, because it is not possible to specify the amount of interest to be paid. R&I also evaluates interest on interest-only debts. Generally, events falling outside the scope of evaluating credit ratings of SF Products are defined as delays or losses arising from causes such as changes in tax or legal systems, etc. that can be applied broadly and uniformly to market participants, irrespective of the design or transactions of such SF Products, the fraudulent acts of parties involved in the structure, grounds attributable to investors or exercise of rights by investors, etc.
Section 3: Collecting materials R&I collects such materials as transaction-related agreements, data/material on underlying assets, data on performance, and monitoring data, etc. for the purpose of assigning credit ratings. Materials collected are used for identification and analysis of credit risk factors (Section 4), cash flow risk analysis (Section 5), and comprehensive evaluation (Section 6). R&I determines and assigns a credit rating finally by synthesizing all pieces of information used for an analysis. Subsequent to assigning a credit rating, R&I collects monitoring data periodically or as needed, and performs monitoring services (Subchapter 3).
Section 4: Identification and analysis of credit risk factors Based on the materials collected , R&I identifies important credit risk factors that are deemed to affect the products to be rated. To identify credit risk factors, the materials collected are examined in line with the actual conditions of the products to be rated, and appropriate parts of the materials are used for the credit rating. Specifically, it is necessary to organize credit risk factors into structure-related items and underlying asset-related items, and then R&I confirms the presence or otherwise of credit risk with respect to each of such items, and if presence is confirmed, checks the level of credit risk. With respect to structure, R&I identifies credit risk factors related primarily to legal risk and to strength of structure from transaction-related agreements. With respect to underlying assets, R&I identifies primarily credit risk factors that could cause change to cash flows by analyzing the data/material on underlying assets.
8/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
I. Risks regarding structure R&I analyzes risks regarding structure primarily from the three perspectives of transfer, holding, and management. In the course of formation of an SF Product, whether assets are transferred (assigned) to a legitimate special-purpose vehicle (hereinafter referred to as an “SPV”) and how the assets are subsequently held and managed are confirmed. In addition, R&I confirms the details of such structures as external credit enhancement, liquidity enhancement, and cash flow distribution, if they are built in the transaction. Principal credit risk factors are listed below: Conflict of interest True sale Business risks regarding SPV Risks regarding SPV’s capital relationships Risks regarding SPV’s personal relationships SPV’s ring fence Commingling risk attributable to servicer bankruptcy Liquidity risk attributable to servicer bankruptcy Risk regarding swap counterparty bankruptcy Risk regarding bankruptcy of financial institution where deposits are made Risk regarding custodian bankruptcy Risk regarding diminution in value of targets of excess cash management Risk regarding business framework of important parties involved in structure Risk regarding external credit enhancement provider/external liquidity enhancement provider Risk that external credit enhancement/external liquidity enhancement would not be provided Risk regarding timing of credit enhancement Risk regarding waterfall Risk regarding master trust
9/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
II. Risks regarding underlying assets R&I analyzes risks regarding underlying assets primarily from the following perspectives: Understanding of basic nature of underlying assets Credit risk factors by underlying asset type In each Section of Chapter 3, R&I seeks to identify major credit risks by underlying asset type. If there is no section that directly corresponds to the underlying asset type, multiple sections are adopted in combination or a section on a similar underlying asset type is adopted.
Section 5: Cash flow risk analysis R&I performs a cash flow risk analysis on the basis of its analysis of the aforementioned risk factors and materials collected. R&I analyses the impacts that servicer bankruptcy, structure of cash flow distribution, changes in cash flow of underlying assets, etc., may exert on the relevant SF Product’s ability to repay principal and pay interest. R&I uses appropriate parts and periods of performance-related data, when analyzing changes, etc. in cash flows of underlying assets. In addition, R&I confirms the flow of funds described in transaction-related agreements, when examining the structure of cash flow distribution. If there are items that cannot be worked into the identification and analysis of individual credit risks as certain facts, but which should be considered as being highly likely in the future, R&I incorporates these qualitative factors into the cash flow risk analysis in order to assign a clear-sighted credit rating.
Section 6: Comprehensive evaluation R&I takes into account those credit risk factors contained in the outcome of the cash flow analysis (Section 5) and the outcome of the credit risk analysis (Section 4) that were not worked into the cash flow risk analysis, and performs a comprehensive evaluation in light of the definitions of rating symbols.
10/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
Subchapter 3: Monitoring method of credit ratings
Section 1: Basic approach The basic approach and the rating methodology that R&I adopts in credit ratings during the monitoring period are, in principle, the same as those it adopts when assigning initialcredit ratings. R&I assigns credit ratings by taking the position that, also during the monitoring period, it is important to investors that credit ratings are R&I’s clear-sighted opinions with features of stability and continuity. When assigning credit ratings, R&I seeks to understand the actual conditions of the SF products, in the light of which it develops an accurate vision of the future.
Section 2: Monitoring intended to capture changes occurring in and around the product subject to rating Essentially, credit ratings should be appropriately evaluated by reflecting the situations of the time. If, after the initial rating is assigned, the environment and the conditions of the rated product or the assumptions used for a cash flow analysis change, the rating may be changed appropriately each time, depending upon the degree of such a change. Therefore, R&I continuously monitors credit ratings unless it declares in advance it will not monitor specific credit ratings. R&I changes credit ratings, if the environment and the conditions of the rated product recognized when assigning a credit rating or the assumptions used for the cash flow risk analysis change materially. Conversely, credit ratings do not change unless such a material change occurs. It should be noted that, during the monitoring period, some materials such as performance results of the underlying asset pool, which did not exist when initially assigning a credit rating, become available, whereas other materials such as data on the attributes of obligors within the underlying asset pool usually cannot be obtained.
Section 3: Placement and retention on, and removal from, the Rating Monitor R&I may place a raｔed product on the Rating Monitor if it recognizes that the probability of a change in the credit rating is high as a result of a change in the relevant product during the monitoring period, but ample time would be required to determine the necessity or otherwise for the rating change, or if a totally unexpected circumstance comes into being and ample time would be required to determine the necessity or otherwise for the rating change. When a rated product is placed on the Rating Monitor to indicate that an event that will affect the creditworthiness has occurred, the Rating Monitor with “direction uncertain” may be used, regardless of the possibility of a rating change. In principle, R&I may remove a rated product from the Rating Monitor if it becomes possible to
11/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
incorporate the impacts of events into a credit rating. When a new event that makes R&I consider placement on the Rating Monitor has occurred regarding a rated product that has already been on the Rating Monitor, R&I may take a rating action of “retention on the Rating Monitor”.
12/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General
(Reference 1) Basic approach to credit ratings of SF Products
Identifying products to be rated Putting contracts in order
Collecting materials Chapter 2: Risk regarding structure
Identification of credit risk factors Chapter 3: Risk regarding underlying assets
Chapter 2: Risk regarding structure Chapter 1: Credit risk factor Chapter 3: Risk regarding underlying assets General (Perspective for evaluation of credit analysis risk factor analysis)
Outcome of credit risk factor analysis (quantitative/qualitative) Outcome of credit risk factor analysis not used in cash flow risk Cash flow risk analysis Chapter 4: Cash flow risk analysis (Perspective for cash flow risk analysis)
Outcome of cash flow risk analysis
Comprehensive evaluation => Credit rating Chapter 5: Monitoring
13/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 1: General (Reference 2) Places of Reference for Summary of Rating Methodologies for Typical Products As these rating methodologies present descriptions by credit risk factor and analytical method for SF Products, if specific SF Products are subject to a rating, it would be a combination of these item-by-item topics. For this reason, principal places of reference with examples of typical products are shown below. Please note that certain products do not neatly fall under the category of a typical product. Chapter 1: Chapter 2: Product name Chapter 3: Underlying assets Chapter 4: Cash flow risk analysis General Structure ABS (Installment) All As appropriate Subchapter 1: Installment receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test ABS (Lease) All As appropriate Subchapter 2: Lease receivables (finance lease) Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test RMBS All As appropriate Subchapter 3: Residential loan receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test RMBS (Agency MBS) All As appropriate Subchapter 4: Japan Housing Finance Agency MBS Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test ABS (Loan) All As appropriate Subchapter 5: Consumer loan receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test CLO, CBO All As appropriate Subchapter 6: Corporate loan receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 9: Bonds Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) ABS (Notes receivable) All As appropriate Subchapter 7: Promissory notes receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) ABS (Accounts receivable) All As appropriate Subchapter 8: Accounts receivable Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Credit-linked products All As appropriate Subchapter 9: Bonds Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) (CLL, CLN, FTD, SCDO) Subchapter 10: Derivative transactions Subchapter 7: Analysis method based on credit ratings of underlying assets and parties (credit default swap, etc.) involved in the structure Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products JGB repackage, CB repackage All As appropriate Subchapter 9: Bonds Subchapter 7: Analysis method based on credit ratings of underlying assets and parties Subchapter 10: Derivative transactions (credit default swap, involved in the structure etc.) Repackaged products All As appropriate Subchapter 11：Other monetary receivables (including trust Subchapter 7: Analysis method based on credit ratings of underlying assets and parties (Fund securitization, deposit receivables, beneficial interest) involved in the structure beneficial interest, etc.) Real estate securitized products All As appropriate Subchapter 12: Real estate (real estate-backed trust beneficial Subchapter 3: Analysis method for real estate securitization (Single-borrower-type) interest) Real estate securitized products All As appropriate Subchapter 13: Real estate non-recourse loans Subchapter 3: Analysis method for real estate securitization (Multi-borrower-type) Real estate securitized products All As appropriate Subchapter 14: Development-type real estate Subchapter 3: Analysis method for real estate securitization (Development-type) ABS (Occupancy security deposits) All As appropriate Subchapter 15: Security deposit receivables Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure CLO (Guarantee loans) All As appropriate Subchapter 16: Guaranteed receivables Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure ABS (Medical fee) All As appropriate Subchapter 17: Medical fee receivables/Dispensing fee Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) receivables ABS (Monthly clear) All As appropriate Subchapter 18: Monthly clear (credit card) receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Project finance All As appropriate Subchapter 19: Projects (including PFI) Subchapter 4: Analysis method for project finance Business securitization products & LBO All As appropriate Subchapter 20: Business cash flow, etc. Subchapter 5: Analysis method for business cash flow, etc Real estate secured loan All As appropriate Subchapter 21: Sub-performing loans, etc. Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) Aircraft financing All As appropriate Subchapter 22: Monetary receivables from airline companies Subchapter 11:Analysis method for aircraft finance and aircraft ABCP All As appropriate Subchapter 7: Promissory note receivables Subchapter 7: Analysis method based on credit ratings of underlying assets and parties Subchapter 8: Accounts receivable involved in the structure
14/184 Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Chapter 2: Particulars: Risks regarding structure
In this Chapter, with respect to identifying and analyzing credit risks factors presented in Subchapter 2, Section 4 of the General Discussion, principal risk factors are enumerated from the aspect of risks regarding structure, and perspectives on their evaluation are presented. A Subchapter is set out for each type of structure. Basic issues of structure are discussed in Section 1 of each Subchapter, and an analysis of principal credit risk factors that are conceivable in the structure is discussed in Section 2. In the analysis of credit risk factors, the contents of risk factors are presented first, and then principal risk countermeasures and perspectives for the evaluation thereof are presented.
Subchapter 1: Structure of asset transfer
Section 1: Basic issues
I. Purpose of structure The purpose of the structure of asset transfer is to ensure that ownership of underlying assets is transferred to the SPV as issuer of the SF Product, in order to distribute cash flows generated from underlying assets to investors without hindrance.
II. Composition of structure The claims (including the claims that have not actually accrued) are transferred basically in accordance with procedures for assigning the claims prescribed in the Civil Code. The underlying assets are transferred to the SPV after the positioning of claims to be transferred in the contractual relationship leading to monetary claims as underlying assets is clarified, and after other contractual rights/obligations are appropriately arranged. Underlying assets in the forms of promissory notes and bonds, for which rights are clearly defined and market practices for asset transfer procedures are firmly established, are transferred to the SPV in accordance with law and market practices. Underlying assets in the form of real estate are transferred to the SPV by assignment of the ownership, etc. of the underlying real estate.
15/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
III. Principal parties involved in the structure Originator, arranger, SPV
Section 2: Analysis of credit risk factors
I. Conflict of interest with parties involved in the transfer
A. Risk factors The interests of originators, etc., normally conflict with those of investors. Hence originators, etc. (of which interests conflict with investors) may inflict a credit loss on investors to maximize their own interests.
B. Principal risk countermeasures and perspectives for evaluation
1. Securing measures to prevent conflicts of interest Conflicts of interest are prevented by establishing appropriate selection criteria and clarifying assignment and risk transfer procedures that fit the characteristics of the underlying assets.
2. Partial holding of SF Products by originators, etc. Conflicts of interest are expected to be prevented because originators, etc., bear losses of SF Products by holding part of them.
With respect to 1 or 2 above, an evaluation is made from the perspective of whether or not conflicts of interest are dealt with in an adequate manner. If the underlying assets are required to be similar to the reference pool, a credit rating is not, in principle, assigned unless 1 or 2 above is addressed. If the underlying assets are not required to be similar to the reference pool, an evaluation is made in the light of the characteristics of the underlying assets.
II. Risks regarding true sale
A. Risk factors If the originator falls into bankruptcy, assignment of the underlying assets is denied, and funds for principal repayment and interest payment on SF Products run short. Even if assignment is not denied, transfer of the underlying assets may be viewed not as a sale/purchase but as the originator’s secured transaction in the process of its legal bankruptcy procedures.
16/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
B. Principal risk countermeasures and perspectives for evaluation
1. Measures to assure true sale If R&I mainly considers the points listed below in the light of the characteristics of the underlying assets, and determines that the probability of risks associated with true sale becoming obvious is remote, it may assign a higher credit rating than the originator’s creditworthiness. If measures to assure true sale are inadequate, R&I determines a credit rating on the basis of the originator’s credit rating. The following are examples:
(i) Intentions of parties involved
(ii) Validity of asset assignment, fulfillment of perfection requirements
(iii) Transfer of legal control authority
(iv) Transfer of economic risk
(v) Absence of secured claims
An evaluation is performed from the perspective of whether or not measures for assuring true sale are adequate.
2. Originator’s eligibility If the originator is in a state of insolvency upon transfer, there would be a risk that assignment per se is denied by the originator’s bankruptcy trustee at the time of the originator’s bankruptcy. If, as a countermeasure against such a risk, the originator subjects itself to an accounting audit and obtains unqualified clean opinions, R&I would not see any particular problem. If the originator does not subject itself to an accounting audit, R&I would check its creditworthiness as it would not be possible to completely cast aside assignment denial risk on the basis of the originator’s creditworthiness, etc. An evaluation is performed from the perspective of whether or not the probability of assignment denial risk becoming obvious is high.
17/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Subchapter 2: Structure of asset holding (SPV)
Section 1: Basic issues
I. Purpose of structure To have an SPV play the roles of holding underlying assets and distributing cash flows generated from the underlying assets to investors in a stable and continuous manner, it is generally necessary to make such an SPV a “box” (or conduit) equipped with a high degree of bankruptcy remoteness. If cash flows generated from underlying assets are blocked due to a factor other than the underlying assets, it is not possible to fulfill the needs of the originator or the investors. To fulfill such needs, the SPV as issuer of the SF Products is required to hold the underlying assets and distribute cash flows generated from the underlying assets to the investors in a stable and continuous manner.
II. Composition of structure An SPV can take the form of a trust or a corporation (joint-stock corporation, special-purpose company, general incorporated association, limited liability company, Cayman SPC, etc.). For the purposes of SF Products formed in Japan, SPVs of trust type are often used for their bankruptcy remoteness features, and are assured under the Trust Act.
III. Principal parties involved in the structure SPV, holder of voting shares, creditor (investor in SF Products, entity to which managerial business agents are dispatched, etc.), securitization service agent (director, employee, etc.), trustor, trustee, beneficiary
Section 2: Analysis of credit risk factors This Section sets out measures for enhancing the bankruptcy remoteness features of an SPV of corporation type. The structure for bankruptcy remoteness features is evaluated from the following four perspectives: Business risks Risks regarding capital relationship Risks regarding personal relationship Ring fence
18/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
With respect to SPVs of trust and other types that are not dealt with in this Section, R&I confirms whether or not they are highly bankruptcy remote from these four perspectives in the same manner. In the case of a trust—unlike the case of an SPV of corporation type—an SPV of trust type basically does not have risks regarding capital relationship or risks regarding personal relationships, among these four perspectives. The absence of capital relationship risks is due to the fact that there are no shareholders. The absence of personal relationship risks is due to the fact that there are no directors, and the trustee, who is a third party, performs operations as a good manager. Hence, in the case of an SPV of trust type, perspectives as to whether or not business risks are limited and a ring fence is in place are important. R&I confirms the restrictions inherent in business risks on the basis of the purpose of a trust, and evaluates the ring fence from the perspective of whether or not the underlying assets are distinguished and segregated from the trustee’s own assets.
I. Business risks
A. Risk factors An SPV as an issuer of SF Products is established for the specific purpose of conducting securitization business (business related to services for issuance, maintenance, and management of SF Products). Generally, however, a corporation is allowed to conduct business activities freely within the limits of laws and regulations, therefore, it is allowed to conduct business activities other than securitization business. Principal risk factors associated with business risks include: Risk that money earmarked for securitization business is diverted to another business Risk of creditors of another business filing a bankruptcy petition
B. Principal risk countermeasures and perspectives for evaluation
1. Taking necessary measures In the section setting out the purpose of establishing a company in the articles of incorporation or in the section for the parties’ representations and warranties in a related contract, the risk that business risks may become obvious or an incentive for taking an action that causes such a risk is eliminated by prescribing items such as those listed below. The following are examples: Not conduct another business (excluding ancillary business indispensable for securitization business) Not bear any debt obligations other than those for securitization business An evaluation is performed from the perspective of whether or not business risks are
19/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
properly confined.
II. Risks regarding capital relationship
A. Risk factors An SPV is allowed to raise funds for conducting business activities by issuing shares. The shareholders who hold voting shares (hereinafter referred to as “Shareholders”) can influence the securitization business by exercising their voting rights. If an SPV issues new shares, the number of Shareholders may increase. The presence of voting shares gives rise to the following principal risks regarding capital relationships: Shareholders can exert a material adverse influence on the securitization business. For the benefit of parties related to Shareholders, Shareholders can submit and pass a resolution to dissolve an SPV. Additional voting shares can be issued. If the Shareholders of additional shares are not positive about the securitization business, they can exert a materially adverse influence on the securitization business by exercising their voting rights.
B. Principal risk countermeasures and perspectives for evaluation
1. Taking necessary measures In the section covering voting shares in the articles of incorporation or in the contract covering assignment of voting shares, the risk that the relevant risks may become obvious or an incentive for taking an action to cause such a risk is eliminated by prescribing items such as those listed below. The following are examples: Shareholders to be third parties who are independent of interested parties Shareholders to be made to waive their rights to file a bankruptcy petition Exercise of voting rights by holders of voting rights to be restricted (for example by creating a charitable trust to prevent voting rights attached to the shares from being exercised) Condition for consent by creditors (bond administrator, investors, etc.) to issue any additional voting shares to be imposed An evaluation is performed from the perspective of the relationship between the SPV and Shareholders.
20/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
III. Risks regarding personal relationship
A. Risk factors Directors, etc., are allowed to exert an influence on business activities through resolutions of the board of directors. The principal risk factors regarding personal relationship include: Risk that directors, etc., can perform an act that may have a material adverse influence on the securitization business (business operation for the benefit of interested parties) Risk that directors, etc., may file a bankruptcy petition at the request of interested parties Risk that persons who might have conflicts of interest with the securitization business may become directors, etc. Risk that retirement of SPV’s officers and employees may have a material adverse influence on the securitization business
B. Principal risk countermeasures and perspectives for evaluation
1. Taking necessary measures Directors, etc., are to be appointed from among attorneys at law, CPAs, etc., who are not officers or employees of any interested party, and who are to be dispatched under a dispatch contract, and the risk that relevant risks may become obvious or an incentive for taking an action to cause such a risk is eliminated by prescribing items such as those listed below in the relevant dispatch contract, service contract, etc. The following are examples: Take measures to prevent any adverse influence from being exerted on the securitization business by appointing attorneys at law, CPAs, etc., who are not influenced by any capital relationship as directors, etc. Directors, etc., to be made to waive their rights to file a bankruptcy petition An evaluation is performed from the perspective of whether or not the SPV is subject to personal influences.
IV. Ring fence In cases where multiple SF Products are issued by the same SPV against differing underlying assets, a measure fulfilling the function of a partition (fence) to prevent losses incurred on respective SF Products from mutually affecting one another is referred to as a ring fence.
A. Risk factors In case a business corporation issues multiple debt securities, and if any problem occurs for one reason or another with the recovery of claims of a creditor holding specific debt securities, the creditor may expect to recover the claims by seizing the assets of the business corporation in question. By virtue of their product design, principal repayment and interest
21/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
payment on SF Products are made from the cash flows of specific underlying assets that are assigned. If an SPV issues multiple SF Products against different underlying assets (Product A and Product B) to investors who are subject to differing interests, and if an event occurs that for the purpose of the recovery of claims on a specific SF Product (Product A), other assets of the SPV (underlying assets for Product B) are seized, principal repayment and interest payment on one SF Product (Product B) would be affected by the bankruptcy of another SF Product (Product A).
B. Principal risk countermeasures and perspectives for evaluation
1. Only one SF Product to be issued by one SPV The creditor would not be subject to any differing interests as two or more SF Products are not issued. Hence, a ring fence is assured.
2. Ring fence to be assured while multiple SF Products are issued by one SPV The arranger specifies the assets that creditors (Creditor A and Creditor B) may claim, respectively, by clarifying the underlying assets (Underlying Asset A and Underlying Asset B) for the respective SF Products (Product A and Product B). Having done that, the arranger takes the following measures to inhibit creditors’ bankruptcy filings or incentives therefor by applying the same measure to all SF Products: To create a security interest in each of the underlying assets for SF Products (fulfillment of perfect requirements) To prescribe segregated administration of underlying assets by SF Product in the relevant contract To prescribe limited recourse and non-petition provisions pertaining to investors and parties involved in the structure, in the relevant contract With respect to SF Products to be issued in the future, measures will be taken to ensure that the abovementioned measures are taken. When it is not possible to create a security interest in underlying assets, a ring fence is assured by implementing measures to enhance the ring fence features that would fit the characteristics of the relevant issues. An evaluation is performed from the perspective of whether or not an SPV is properly ring-fenced. If the ring face is found to be inadequate, credit ratings for all SF Products issued against differing underlying assets are in principle be set at the same level.
22/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
V. Bankruptcy remoteness of SPV for transactions backed by Projects, etc.
A. Risk factors In the case of transactions that are backed by projects, business cash flow, etc., or monetary receivables from airline companies and aircraft, the company leading the business (the sponsor) often controls the entire project by injecting capital in the SPV, dispatching directors and employees, and assuming the main operations, subject to certain restrictions and conditions. Hence, the sponsor plays a leading role in the SPV’s operations. In such case, the sponsor’s bankruptcy may have negative consequences on the SPV’s business continuity.
B. Principal risk countermeasures and perspectives for evaluation
1. Implementation of necessary measures The bankruptcy remoteness of an SPV is determined based on a comprehensive judgement regarding the restrictions and conditions established to enhance the SPV’s bankruptcy remoteness and independence from the sponsor. If it is deemed difficult for the SPV’s business to be continued in the event of sponsor bankruptcy, the credit rating of the product subject to rating is capped at the creditworthiness of the sponsor. On the contrary, if the SPV’s business can be continued, the credit rating of the product subject to rating can exceed the creditworthiness of the sponsor, depending on the level of impact of an event of sponsor bankruptcy. An evaluation is performed from the perspective of whether or not the SPV’s business can be continued in the event of sponsor bankruptcy. Examples include the following:
(i) Economic rationality of the project.
(ii) Substitutability of the project’s business management and operations.
(iii) Existence of an alternative sponsor.
(iv) Whether the various project-related agreements allow for changes to the parties involved.
(v) Whether the transaction scheme adopts sufficient measures to facilitate business succession, including the following three examples:
(a) Appointment of an independent director for the SPV.
(b) Establishment of security interest against the SPV’s shares held by
23/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
the sponsor.
(c) Establishment of security interest against the assets held by the SPV (assets required to carry through the project).
(vi) Whether a direct agreement is concluded between the public sector and creditors (in the case of PFI).
24/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Subchapter 3: Structure of asset administration
Section 1: Basic issues
I. Purpose of structure The purpose of the structure of asset administration is to properly administer and dispose of the underlying assets held by an SPV and to properly administer money received by the SPV and pay out in the manner prescribed in the relevant contract.
II. Composition of structure Generally, an SPV as an issuer of SF Products, as a formality, does not have a framework to hire employees and perform administrative services on its own. Therefore, an SPV finds it necessary to outsource the services needed to administer and dispose of underlying assets to a third party. Depending upon the types of underlying assets, principal services that an SPV may outsource include servicing of monetary claims, property management of real estate, and the custody of securities. Appropriate structures are set up, as needed, for assuring the continuity of these administrative services. The structures for administering and paying money received by an SPV include placement of deposits and other forms of funds management, swap transactions to hedge cash flow mismatches, and payment of necessary expenses.
III. Principal parties involved in the structure Servicer, swap counterparty, financial institutions where deposits are placed, custodian, surplus fund investment vehicle
Section 2: Analysis of credit risk factors
I. Commingling risk arising from bankruptcy of servicer
A. Risk factors Normally, an SPV outsources the servicing of underlying assets to a servicer. The servicer sets a specific collection period, and hands the funds collected from obligors during the collection period over to the SPV on the delivery date. If the servicer falls into bankruptcy before handing the funds collected over to the SPV, and if the servicer’s own assets and the collected funds are not segregated, the funds collected may be treated as part of the servicer’s own assets and the SPV may be treated in the same manner as other creditors in the course of
25/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
handling the servicer’s bankruptcy. As a result, the commingling risk that the collected principal of and interest on the relevant underlying assets may be lost becomes obvious.
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinate structure (addition of amount equal to commingling loss to subordinate portion) It is possible to enhance the certainty of principal repayment and interest payments on the senior portion by adding an amount equal to the commingling loss to the subordinate portion. An evaluation is performed from the perspective of whether or not enhancement by means of the subordinate portion is adequate. If the servicer is highly creditworthy and the underlying assets are also reasonably creditworthy, R&I may opt not to assume the possibility of bankruptcy for a specific period from the beginning of an issue.
2. Cash reserve for the amount equal to commingling loss An amount equal to commingling loss is set aside as a cash reserve to provide for the relevant risk. An evaluation is performed from the perspective of whether or not the amount of the cash reserve is adequate.
3. Advance payment The servicer pays in advance a specific amount to the SPV prior to the date of delivery of collected funds. If the relevant risk becomes obvious, the advance payment retained beforehand by the SPV is offset by an amount equal to the commingling loss. An evaluation is performed from the perspective of whether or not the amount of advance payment is adequate.
4. Countermeasure by means of cash reserve or advance payment based on rating trigger If the servicer’s creditworthiness deteriorates, a countermeasure is taken in the form of “2. Cash reserve for the amount equal to commingling loss” or “3. Advance payment.” An evaluation is performed from the perspective of whether or not the measure for a rating trigger is effective and adequate.
5. Replacement of servicer based on rating trigger As the relevant risk is one that is not obvious unless the servicer falls into bankruptcy, the occurrence of commingling risk is avoided by replacing the servicer as of the time the servicer’s creditworthiness deteriorates.
26/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
An evaluation is performed from the perspective of whether or not the measure for a rating trigger is effective and adequate.
6. Setoff with seller interest Seller interest corresponding to an amount equal to the commingling loss is established. If the relevant risk becomes obvious, seller interest is offset by an amount equal to the commingling loss. An evaluation is performed from the perspective of whether or not the countermeasure against the relevant risk is adequate.
7. Changing the redemption method of seller interest Seller interest corresponding to an amount equal to the commingling loss is established. If the relevant risk becomes obvious, it is possible to enhance the certainty of principal repayment and interest payment on the senior portion by subordinating the redemption order of seller interest to that of the senior portion. An evaluation is performed from the perspective of whether or not the countermeasure against the relevant risk is adequate.
8. Servicer being a financial institution participating in the deposit insurance system If account in which the collected funds are processed falls under the category of a “deposit for settlement” or the delivery obligation of collected money falls under the category of a “specific settlement obligation,” and the collected funds are treated as separate deposits or suspense receipt, the full amount is likely to be protected under the deposit insurance system. An evaluation is performed from the perspective of whether or not commingling risk occurs after confirming that the full amount is protected under the deposit insurance system, and that measures are taken to limit the length of time during which the funds collected are retained by the servicer.
9. Case of direct remittance of funds from obligor to SPV Commingling risk does not occur if funds are remitted directly from the obligor to the SPV, without passing through the servicer.
10. Case in which there is no risk countermeasure The relevant risk is one that it is not obvious insofar as the servicer does not fall into bankruptcy. An evaluation is performed on the basis of the servicer’s creditworthiness.
27/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
II. Liquidity risk arising from servicer bankruptcy
A. Risk factors If the servicer to whom servicing of underlying assets is outsourced by the SPV falls into bankruptcy, servicing may not be continued. Even if servicing is continued, it may be suspended for a specific period. Under such circumstances, payment of interest on rated products or payment of expenses necessary for maintaining the schemes may be temporarily delayed. Amounts for liquidity countermeasures necessary to respond to the relevant risk vary depending upon underlying assets, schemes, timing of notices to obligors, periods required until servicing by the backup servicer can be resumed in a normal manner, etc.
B. Principal risk countermeasures and perspectives for evaluation
1. Cash reserve for the amount of liquidity enhancement The amount necessary for liquidity enhancement is secured as a cash reserve to provide for the relevant risk. Normally, a cash reserve is secured from the beginning of the issue to provide for servicer bankruptcy. However, with respect to a highly creditworthy servicer, a cash reserve is not accumulated from the outset, and a specific moratorium may be placed on the accumulation period. An evaluation is performed from the perspective of whether or not cash reserve and other risk countermeasures are adequate.
2. Backup lines from liquidity enhancement providers including financial institutions To respond to the relevant risk, backup lines are accorded by liquidity enhancement providers including financial institutions. When performing an evaluation, the validity and adequacy of the backup lines are confirmed.
3. Expenses having been paid Liquidity risk does not occur if interest and expenses are paid at the beginning of the issue.
4. Servicer being a financial institution participating in the deposit insurance system Under the deposit insurance system, there are two ways by which to process the bankruptcy of a financial institution: funding support method and insurance payment method. Depending on which method is adopted, the timeliness of payments may vary. The funding support method assumes that the bankruptcy of a financial institution will be dealt with over a weekend and processing is performed smoothly so that the financial
28/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
institution may refund deposits, whereas under the insurance payment method the Deposit Insurance Corporation of Japan serves as a contact through which to refund deposits, hence the handover of collected funds may be delayed temporarily. Depending on the financial institution, it is necessary to put in place enough liquidity enhancements in advance to support the payments of interest on SF Products and of expenses in case the insurance payment method is adopted. An evaluation is performed from the perspective of whether or not measures for dealing with the relevant risk are appropriate.
5. Countermeasure by means of cash reserve based on rating trigger If the servicer’s creditworthiness deteriorates, cash necessary for liquidity enhancement is secured as a cash reserve. An evaluation is performed from the perspective of whether or not the trigger level is adequate and effective in consideration of the servicer’s short-term fund contribution capabilities.
6. Case in which there is no risk countermeasure The relevant risk is one that is not obvious insofar as the servicer does not fall into bankruptcy. An evaluation is performed on the basis of the servicer’s creditworthiness.
III. Risk regarding swap counterparty bankruptcy Swap transactions include cash flow swaps, interest rate swaps, currency swaps, asset swap as well as interest rate caps etc., which are conducted for the purpose of hedging a mismatch between the cash flow received from the underlying assets and the cash flow to be applied towards principal repayment and interest payment on the product subject to rating.
A. Risk factors Generally, if a swap counterparty falls into bankruptcy, a swap contract is terminated early and the cash flow mismatch becomes obvious.
B. Principal risk countermeasures and perspectives for evaluation
1. Risk countermeasures based on rating trigger If appropriate measures against a deterioration in the creditworthiness of a swap counterparty are taken in advance, R&I may assign a higher credit rating to the SF Product than that assigned to the swap counterparty. The appropriate measures include putting in place a structure for the initial swap counterparty to take the following measures if the credit rating of the swap counterparty ceases to fulfill the sufficient level:
29/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
(1) Select a swap counterparty that meets the sufficient level, and cause it to take over all swap contracts.
(2) Cause a financial institution that meets the sufficient level to provide a guarantee for the relevant swap transaction.
(3) With respect to an asset with high liquidity such as cash, a pledge collateral in an amount at least equal to that deemed necessary by R&I and in a form that is satisfactory to R&I.
(4) Take any other credit enhancement measures that R&I may deem to be appropriate.
An evaluation to determine the sufficient level of swap counterparties and financial institutions is performed primarily from the perspective of the fungibility of the relevant swap transaction. The sufficient level that is deemed appropriate according to the fungibility and the replacement of Issuer Rating with Short-term Rating are described in the following tables.
Table: Sufficient level for swap counterparty and financial institution Rating for product rated AAA through AA- A+ through A- Relatively high a-1 or higher a-2 or higher Sufficient fungibility level Relatively low a-1+ or higher a-1 or higher fungibility
Table: Replacement of Issuer Rating with Short-term Rating Issuer Rating Short-Term Rating AAA through AA- a-1+ A+ through A- a-1
2. Pledge of collateral If the swap counterparty falls into bankruptcy and the swap contract is terminated early, it becomes necessary to conclude a new swap contract on the same terms and conditions to avoid any cash flow mismatch. As the defaulting swap counterparty is called upon to bear any cost necessary for replacing the swap contract, collateral is pledged to ensure that such cost is borne by the defaulting swap counterparty. Adequacy or otherwise of the amount of collateral so pledged is evaluated from the perspective of whether or not the swap counterparty’s creditworthiness may have any influence on the creditworthiness of the SF
30/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Product. Some SF Products have a structure in place whereby the product is redeemed early upon termination of the relevant swap contract. In such cases, the secured debt obligations to be preserved by collateral is not the replacement cost, but is the source of funds to cover early redemption of the rated product including price fluctuations of underlying assets. Hence, the adequacy of collateral amount and cash flows for early redemption needs to be evaluated from a different perspective. For further details of evaluation methods, please refer to Subchapter 8 of Chapter 4: “Analysis method for measures to reduce counterparty risk of derivative products.”
3. Taking the measure of lump-sum advance payment Measures such as advance payment in lump-sum of money payable by the swap counterparty under the swap contract are taken to provide for the swap counterparty’s bankruptcy; provided, however, that at time of the swap counterparty’s bankruptcy, analysis should be obtained as to whether or not the swap counterparty’s receiver may consider the relevant contract to be a bilateral contract not performed by both parties, and hence is likely to demand termination of the swap contract, and the appropriateness or otherwise of the said measures should be evaluated in the light of such analysis.
4. Guarantee in favor of swap counterparty To provide for the eventuality that the swap contract is terminated early as a result of the swap counterparty’s bankruptcy and a cash flow mismatch becomes obvious, a guarantee covering the swap counterparty’s debt obligations under the swap contract is obtained from a third party. An evaluation is performed from the perspective of whether or not the relevant guarantee is valid. The credit rating is evaluated on the basis of the guarantor’s creditworthiness.
5. Case in which there is no risk countermeasure The credit rating is evaluated on the basis of the swap counterparty’s creditworthiness.
IV. Risk regarding bankruptcy of financial institution with which deposits are placed
A. Risk factors In the cases of SF Products, funds including those generated and collected from underlying assets and the pre-established cash reserve are typically retained in a deposit account established with a depositee financial institution until such funds are applied to principal repayment and interest payments on the relevant SF Products. If such a depositee financial
31/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
institution falls into bankruptcy, there is a risk of cash flows being reduced.
B. Principal risk countermeasures and perspectives for evaluation
1. Risk countermeasure based on rating trigger If appropriate measures against a deterioration in the creditworthiness of a depositee financial institution are taken in advance, R&I may assign a higher credit rating to the SF Product than that assigned to the depositee financial institution. The appropriate measures include putting in place a structure for, if the credit rating of a depositee financial institution ceases to fulfill the sufficient level specified in the below table, moving the deposits as promptly as possible (within roughly one month) to another financial institution that fulfills the sufficient level.
Table: Sufficient level for deposit account Rating for rated product AAA through AA- A+ through BBB- Short-term Rating for depositee a-1 or higher a-2 or higher financial institution
If the depositee financial institution is not assigned a Short-term Rating, Issuer Rating may be replaced with such a Short-term Rating (See table below). Even if the depositee financial institution is not assigned either a Short-term Rating or an Issuer Rating, an account with any financial institution R&I may find acceptable may be used.
Table: Basic replacement of Issuer Rating of depositee financial institution with Short-term Rating Issuer Rating Short-term Rating AAA through AA- a-1+ A+ through A- a-1 BBB+ through BBB- a-2
An evaluation is performed from the perspective of whether or not the measures are effective and adequate.
2. Risk countermeasures by processing collected funds through an account protected under the deposit insurance system If a deposit account is established with a financial institution participating in the deposit insurance system and the funds collected are processed through an account
32/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
protected by deposit insurance, any loss caused by the bankruptcy of a depositee financial institution is limited. If liquidity for the purpose of paying interest on SF Products or paying expenses is secured to provide for any temporary delay in paying deposit insurance, it is unnecessary to take any countermeasures against a loss caused by the bankruptcy of a depositee financial institution. An evaluation is performed from the perspective of whether or not the relevant funds are deposited with an account protected by deposit insurance.
3. Case in which there is no risk countermeasure An evaluation is performed on the basis of the creditworthiness of the depositee financial institution.
V. Risk regarding bankruptcy of custodian
A. Risk factors An SPV typically concludes a custody contract with a custodian and holds securities through an intermediary of such a custodian. The custodian performs services for administration/custody of securities and receipt/payout of principal and interest under the SPV’s instructions. Given the popularization of paperless securities and the progress of cross-border settlements, a custodian operating on a global scale (a global custodian), if it finds it necessary to do so, normally administers and takes custody of these securities through the intermediary of a custodian (a sub-custodian), who is well acquainted with the business system/practice of the country where the relevant securities are domiciled (by means of a hierarchical arrangement). Principal risk factors associated with custodians include the following: Risk that bankruptcy of a custodian (global custodian or sub-custodian) causes loss of clients’ assets (commingling loss of actual securities and principal repayment/interest payments) or causes delays in principal repayment/interest payment. (Problems related to legal systems of countries concerned) Risk that may arise from any incident occurring at a securities clearing institution (or a transfer institution in the case of Japan)
B. Principal risk countermeasures and perspectives for evaluation
1. Sub-custodians R&I is of the view that a global custodian manages risks associated with sub-custodians and hence the probability of any risk arising from the bankruptcy of a sub-custodian is extremely remote, and basically no risk countermeasure is required.
33/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
2. Global custodian (where proper business framework can be confirmes) The perspectives from which the magnitude of risks coming into being in the wake of the bankruptcy of a global custodian are evaluated are described in items (1) and (2) below: (1) The global custodian’s own assets and clients’ assets are segregated and administered separately. (Commingled administration of clients’ assets is accepted, but the relevant rights must be managed by means of control ledgers.) (2) Principal of and interest on the relevant bonds fulfill any one of the following requirements: (i) Principal and interest payments on the relevant securities do not become part of the global custodian’s own assets. (ii) Principal and interest payments on the relevant securities are fully protected following the global custodian’s bankruptcy. (iii) The period during which money is retained by the global custodian is sufficiently short.
If the perspectives described in items (1) and (2) above are in place, the probability of any risk arising from the bankruptcy of a custodian is extremely remote and basically no risk countermeasure is required. For example, if the relevant securities are in the form of Japanese government bonds (book-entry), the perspectives described in items (1) and (2) are in place if an appropriate business framework is set up.
3. Global custodian (risk countermeasure based on rating trigger) If the perspectives described in item (1) and (2) above are not in place, the relevant risk is mitigated by establishing a rating trigger. Criteria corresponding to rated products are as follows:
Table: Sufficient level for custodian Rating for rated product AAA through AA- A+ through BBB- Custodian’s Short-term Rating a-1 or higher a-2 or higher
34/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Table: Basic replacement of Issuer Rating with Short-term Rating Issuer Rating Short-Term Rating AAA through AA- a-1+ A+ through A- a-1 BBB+ through BBB- a-2
If the Short-term Rating of a custodian ceases to fulfill the sufficient level for a custodian, its contractual status under the relevant custodian contract and assets on deposit must be assigned as promptly as possible (roughly within one month) to another custodian who fulfills such sufficient level. If a custodian is not assigned a Short-term Rating, its Issuer Rating may be replaced with a Short-term Rating. Even if a custodian is not assigned either a Short-term Rating or an Issuer Rating, any custodian that R&I finds acceptable may be used.
VI. Risk regarding value diminution of surplus fund investment vehicles
A. Risk factors In certain cases of SF Products, retained funds are invested in vehicles. If the value of the relevant investment vehicle is diminished, the amount of cash flow decreases.
B. Principal risk countermeasures and perspectives for evaluation
1. Risk countermeasure based on rating trigger If appropriate measures against a deterioration in the creditworthiness of an investment vehicle are taken in advance, R&I may assign a higher credit rating to the SF Product than that assigned to the investment vehicle. The appropriate measures include putting in place a structure for, if the credit rating of an investment vehicle ceases to fulfill the sufficient level specified in the below table, switching to another investment vehicle that fulfills the sufficient level as promptly as possible (within roughly one month). An evaluation is performed from the perspective of whether or not the measure is effective and adequate.
Instruments that can qualify as investment vehicles include CP, loans on banking account of a trust bank, Japanese government bonds, government-guaranteed bonds, unsecured call loans, CP gensaki, government bond repos, and time deposits. The relevant investment vehicle needs to be redeemed at the time of maturity or early cancellation in the same denomination of currency as that of the rated product and in an amount at least equal to the amount invested. The sufficient level for investment vehicles is described in
35/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
the table below. The sufficient level for investment vehicles is established by Short-term Ratings for the assets invested, according to the credit rating of the SF Product. In the cases of investing in CP gensaki and government bond repos, the relevant sufficient level is determined according to the Issuer Ratings for the counterparties of the transactions.
Table: Sufficient level for investment vehicle Rating for rated product AAA through AA- A+ through BBB- Short-term Rating for a-1 or higher a-2 or higher investment vehicle
If an investment vehicle is not assigned a Short-term Rating, an Issuer Rating may be replaced with such a Short-term Rating. (See table below.) If an investment vehicle is not assigned any credit rating, it is possible to invest in such a vehicle if R&I finds it acceptable.
Table: Basic replacement of Issuer Rating for financial institution with Short-term Rating Issuer Rating Short-term Rating AAA through AA- a-1+ A+ through A- a-1 BBB+ through BBB- a-2
If any loss of principal is likely to be incurred at the time of early cancellation of an investment vehicle such as a CP, the sufficient level for the investment term is applied, in which case the maturity of the relevant investment vehicle is set at a date prior to the time of payment of the SF Product. (In the case of Japanese government bonds or government-guaranteed bonds, it is unnecessary to fulfill the sufficient level prescribed in the table below.)
Table: Sufficient level based on investment term AAA through BBB+ through A+ through A- Rating for rated product AA- BBB- Investment vehicle with a a-1 or higher a-2 or higher a-2 or higher term of up to 3 months Investment vehicle with a term of more than 3 months a-1+ a-1 or higher a-2 or higher but up to 6 months
36/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
2. Case in which there is no risk countermeasure An evaluation is performed on the basis of the creditworthiness of the relevant surplus fund investment vehicle.
VII. Risk regarding business framework of material parties involved in the structure
A. Risk factors If the servicer, SPV’s administrative agent, or any other important party involved in the structure is not fully equipped with the business ability or framework necessary for executing the scheme for an SF Product, a loss on payment to investors may be incurred as a result of administrative errors, etc. In addition, business continuity may be disrupted by the bankruptcy, etc. of an important party involved in the structure.
B. Principal risk countermeasures and perspectives for evaluation
1. Business administration framework risk If an important party involved in the structure is present, its business management framework, business experience, and track record are checked. An evaluation is performed from the perspective of whether or not there is any obstacle to the operation of the relevant SF Product. In particular, it is critical to assure continuity of collection operations in the event of the bankruptcy, etc. of a servicer. Collection continuity risk is evaluated from the perspective of whether or not appropriate backup measures are taken.
VIII. Risks regarding management and investment of funds for transactions backed by Projects, etc.
A. Risk factors Generally, the risk of a decrease or mismatch in cash flows may arise when a financial institution with which the funds collected or cash reserves are deposited, an entity in which surplus funds are invested, or a swap counterparty, among others, falls into bankruptcy.
37/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
B. Principal risk countermeasures and perspectives for evaluation
1. Implementation of measures by project-controlling entity to ensure business continuity. In the case of transactions backed by projects, business cash flow, etc., and monetary receivables from airline companies and aircraft, the project-controlling entity or the lender, among other parties involved, is expected to be proactive in ensuring business continuity (e.g. syndicated loans). Measures to mitigate the risk of a decrease in cash flows and to avoid any adverse effects on the lender and other parties involved due to a rise in risks associated with the deterioration of creditworthiness or bankruptcy of a financial institution with which funds are deposited, an entity in which surplus funds are invested, or a swap counterparty, among others, can be expected to be taken. An evaluation will be performed from the perspective of whether or not a project-controlling entity exists, and by ensuring that the terms of the agreements do not place the lender and other parties involved at a disadvantage.
38/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Subchapter 4: Structure of external credit enhancement
Section 1: Basic issues
I. Purpose of structure The certainty that the debt obligations of a SF Product are performed as promised is increased by preparing for any loss of underlying assets due to credit risk factors.
II. Composition of structure Credit enhancement includes “internal credit enhancement,” which is set up within the framework of securitization, and “external credit enhancement,” which is credit enhancement other than that inherent in the scheme (or is one that is intended to be provided by a third party). External credit enhancement includes guarantees, backup lines used in credit events, banks’ letters of credit, etc. The scope of credit enhancement, identity of credit enhancement provider, timing of credit enhancement, credit enhancement method, etc., are laid down in a written contract.
III. Principal parties involved in the structure Credit enhancement provider, recipient of credit enhancement
Section 2: Analysis of credit risk factors
I. Risk regarding credit enhancement provider
A. Risk factors As a result of the credit enhancement provider’s default, there is a risk that credit enhancement will not be provided.
B. Principal risk countermeasures and perspectives for evaluation
1. Risk regarding credit enhancement provider An evaluation is performed on the basis of the credit enhancement provider’s creditworthiness.
2. Senior/subordinate structure If there are multiple credit enhancement providers, products carrying varying tiers of ranking for the distribution of cash flows may be created to provide for the risk that cash
39/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
flows might be reduced as a result of default by one credit enhancement provider. An evaluation is performed from the perspective of whether or not credit enhancement by the subordinated portion is adequate.
II. Risk that credit enhancement will not be provided
A. Risk factors If a credit enhancement contract contains numerous requirements that the right holder must fulfill when requesting the credit enhancement provider to provide credit enhancement, or numerous causes for denial of or immunity from provision of credit enhancement, there is a risk that credit enhancement will not be provided.
B. Principal risk countermeasures and perspectives for evaluation
1. Providing unconditional and irrevocable credit enhancement To provide for the risk that credit enhancement might not be provided, credit enhancement provided for the relevant receivables is to be unconditional and irrevocable. Unconditional and irrevocable credit enhancement deprives the credit enhancement provider of its right of defense of notification/reference, therefore, it enhances the certainty that credit enhancement is provided. An evaluation is performed from the perspective of whether or not the relevant credit enhancement is valid.
2. Limiting the requirements for requesting provision of credit enhancement or causes for denial of or immunity from provision of credit enhancement Requirements for requesting provision of credit enhancement or causes for denial of or immunity from the provision of credit enhancement are limited to make it possible for credit enhancement to be provided easily. In the cases of ABCP and ABL programs, measures are taken to make it impossible for the credit enhancement provider to refuse to extend credit unless the SPV falls into bankruptcy. An evaluation is performed from the perspective of whether or not the relevant credit enhancement is valid.
40/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
III. Timing for credit enhancement
A. Risk factors As the timing of credit enhancement may extend beyond the SF Product’s payment due date, there is a risk that cash flows might run short.
B. Principal risk countermeasures and perspectives for evaluation
1. Credit enhancement that matches the SF Product’s redemption date The timing of credit enhancement should match the SF Product’s redemption date, so that the relevant redemption may be made as scheduled. An evaluation is performed from the perspective of whether or not collection from the relevant credit enhancement is adequate.
2. Liquidity enhancement to cover a temporary cash shortfall occurring prior to the provision of credit enhancement To provide for any cash shortfall caused by administrative procedures for credit enhancement, a liquidity enhancement provider is set up. An evaluation is performed from the perspective of the timeliness of liquidity enhancement, and on the basis of the liquidity enhancement provider’s creditworthiness.
41/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Subchapter 5: Structure of external liquidity enhancement
Section 1: Basic issues
I. Purpose of structure The certainty that principal repayment and interest payments on a SF Product are performed as promised is enhanced by preparing for non-performance of contractual obligations under an SF Product due to liquidity risk.
II. Composition of structure Liquidity enhancement includes backup line and charges forward. The scope of liquidity enhancement, identity of liquidity enhancement provider, timing for liquidity enhancement, and liquidity enhancement method, etc., are to be laid down in a written contract.
III. Principal parties involved in the structure Liquidity enhancement provider, recipient of liquidity enhancement
Section 2: Analysis of credit risk factors
I. Risk regarding liquidity enhancement provider
A. Risk factors As a result of the liquidity enhancement provider’s default, there is a risk that liquidity enhancement will not be provided.
B. Principal risk countermeasures and perspectives for evaluation
1. Liquidity enhancement provider’s default risk An evaluation is performed on the basis of the relevant liquidity enhancement provider’s creditworthiness.
2. Replacement of liquidity enhancement provider based on rating trigger If the creditworthiness of a liquidity enhancement provider deteriorates, such an entity will be replaced with another liquidity enhancement provider with a creditworthiness equal to or higher than that of the rated product. An evaluation is performed from the perspective of whether or not the trigger level is adequate and effective in consideration of the liquidity enhancement provider’s short-term
42/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
fund contribution capability.
II. Risk that liquidity enhancement will not be provided
A. Risk factors If a liquidity enhancement contract contains numerous requirements that the right holder must fulfill to request the liquidity enhancement provider to provide liquidity enhancement, or numerous causes for denial of or immunity from providing liquidity enhancement, there would be a risk that liquidity enhancement might not be provided in a timely manner.
B. Principal risk countermeasures and perspectives for evaluation
1. Limiting the requirements for requesting provision of liquidity enhancement or causes for denial of or immunity from providing liquidity enhancement Requirements for requesting the provision of liquidity enhancement or causes for denial of or immunity from providing liquidity enhancement are limited to make it possible for liquidity enhancement to be provided easily. In the cases of ABCP and ABL programs, measures are taken to make it impossible for the liquidity enhancement provider to refuse to make a loan unless the SPV falls into bankruptcy. An evaluation is performed from the perspective of whether or not the relevant liquidity enhancement is valid.
43/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
Subchapter 6: Structure of cash flow distribution
Section 1: Basic issues
I. Purpose of structure The order of the distribution of cash flows generated from underlying assets for SF Products is prescribed contractually. Generally, the senior/subordinate framework is formed by building a structure for cash flow distribution.
II. Composition of structure Generally, cash flow distribution methods include the sequential method, the pro rata method, etc. The sequential method is a structure whereby redemption to junior tranches is made after redemption to senior tranches is completed. In contrast, the pro rata method is a structure whereby redemption is made for both senior tranches and junior tranches, while the initial percentage of tranches is maintained. The sequential method is believed to be the safer of the two. SF Products’ redemption methods include lump-sum redemption, controlled amortization, pass-through redemption, etc. Basically, a tranche carrying a higher priority ranking of waterfall than that of another creditor in the distribution of cash flows is assigned a higher credit rating.
III. Principal parties involved in the structure Trustee, SPV’s administrative agent
Section 2: Analysis of credit risk factors
I. Risk regarding waterfall
A. Risk factors Depending upon the order of waterfall, there is a risk that principal repayment and interest payment on the rated product or payment of expenses cannot be made.
B. Principal risk countermeasures and perspectives for evaluation
1. Prescribing the order of payment appropriately in a written contract An evaluation is performed from the perspective of whether or not the written contract
44/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 2: Particulars: Risks regarding structure
is appropriate. If necessary, a cash flow test is performed on the order of payment prescribed in the written contract. An evaluation is performed from the perspective of whether or not there is an adequate amount of cash flow for the SF Product.
II. Risk regarding master trust
A. Risk factors Adding to underlying assets may cause the quality of the pool of underlying assets to change, as a result of which the risk of default may increase.
B. Principal risk countermeasures and perspectives for evaluation
1. Re-evaluate subordinated portion each time underlying assets are added An evaluation is performed from the perspective of whether or not the enhancement by the subordinated portion is adequate.
2. Eligible receivables A deterioration of quality is prevented by setting up eligible receivables. An evaluation is performed from the perspective of whether or not the criteria for eligible receivables are appropriate.
45/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Chapter 3: Particulars: Risks regarding underlying assets
In this Chapter, perspectives for evaluating the identification and analysis of credit risk factors discussed in Section 4 of Subchapter 2 of the General Discussion are presented by citing principal risk factors from the aspect of risks regarding underlying assets. One subchapter is devoted to each underlying asset type. In Section 1 of each subchapter, basic issues about the structure are discussed. In Section 2, the analysis of principal credit risk factors that are conceivable in the structure is discussed. In the analysis of credit risk factors, the substance of risk factors is presented first, and then principal risk countermeasures against them and perspectives for evaluation are presented.
Subchapter 1: Installment receivables
Section 1: Basic issues
I. Cause for creation Installment receivables are created when the purchaser of merchandise pays for merchandise or the rights (or consideration for merchandise or service provider) under an installment sale contract. Credit card purchases (“comprehensive-type credit purchases”) involve purchases of consumer items with credit cards, whereas installment sales (“individual-type credit purchases”) are typically intended for purchases of items such as automobiles and motorcycles that are more expensive than those purchased with credit cards. Cellular phones are another item sold by installment sales. In the cases of credit card purchases, if the scheme for assigning receivables from member stores to the card company is adopted (as in the cases of bank cards) or if receivables are assigned from another card company to the originator through the intermediary of an international brand, typically such assignment is not perfected against third parties.
II. Transfer method The originator assigns installment receivables to the assignee under an assignment contract. Perfection requirements against third parties are fulfilled by registration pursuant to the Law Regarding Special Exceptions to the Civil Code with Respect to Perfection Requirements for
46/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Assignment of Movables and Claims (hereinafter referred to as the “Special Perfection Law”). Generally, perfection requirements against obligors are initially withheld, but are promptly fulfilled if the originator falls into bankruptcy or if otherwise needed by giving a notice to or obtaining consent from the obligors pursuant to Article 467 of the Civil Code or sending certificates of registered matters to the obligors pursuant to the Special Perfection Law. In installment sales of a tie-up loan scheme (installment sales scheme under a four-party contract), there are cases in which tie-up loans are advanced from a trust account of a trust bank as the tie-up financial institution, and a credit rating is assigned to the trust beneficial interest backed by cash flow generated from the tie-up loans. In such cases, because the installment receivables are not assigned to an SPV, the asset assignment procedure or true sale of the assignment is not an issue.
III. Management method Payment schedules for obligors of installment receivables are fed into a database, repayments are collected by account transfer procedures, and reconciliations are performed each month. Normal reminder notices are sent at specified periods of delinquency, and receivables of more than the specified periods of delinquency are reclassified as administered receivables. Such servicing activities are normally outsourced to a servicer, and the originator is appointed as the initial servicer.
IV. Characteristics of cash flow Generally, cash flows from installment receivables have the following characteristic features: Scheduled cash flows are normally payments of a fixed monthly amount (either in a fixed amount of principal or in a fixed amount of principal and interest). Some obligors are obligated to make an additional payment in a bonus month. Certain installment receivables such as those for agricultural equipment are subject to a high degree of seasonality and cash flows tend to converge on a specific season. Principal and interest in cash flows under original contracts may be recognized differently from those managed by an SPV. Monthly cash flows may decrease as a result of default or delinquency of obligors of installment receivables. If the obligor falls into bankruptcy or becomes delinquent repeatedly and there is little prospect of collection, the relevant receivables are generally reclassified as administered receivables, and no cash flows can be expected from the obligor. A prepayment causes cash flows to change. In such a case, the risk of a change in future cash flows ceases to exist. Normally, future interest decreases.
47/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
If there are counterclaims between the originator and the obligor, offsetting may be asserted and the principal may decrease. Due to cancellation/cooling-off of installment sales contracts, installment receivables cease to exist and cash flows decrease. If, in the case of a product involving the rendering of a service, and a member store falls into a state in which it is unable to perform the relevant service, the right of defense for payment suspension is exercised, and cash flows decrease. If the relevant product involves a specified continuous service (“tokutei keizokuteki ekimu”), the installment sales contract is cancelled early, irrespective of whether or not the cooling-off period has elapsed, and cash flows decrease. Cash flows of revolving payment installment receivables may vary as a result of the obligors’ prepayments, additional purchases, or amendment of their repayment.
Section 2: Analysis of credit risk factors
I. Obligor default risk
A. Risk factors If the obligor under the installment sales contract (obligor) becomes insolvent, the amount of principal and interest collected decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Member store Type (gender) of obligor Age of obligor Resident area of obligor Merchandise
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default loss of original installment receivables, the amount of principal decreasing as a result of such default loss is secured as a subordinated portion. If any guarantees are in place on installment receivables, the performance of such guarantees by the relevant guarantors may be worked into the analysis while the guarantors are alive. An evaluation is performed from the perspective of whether or not enhancement provided by the subordinated portion is adequate and whether or not the guarantors are
48/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
capable of performing their guarantees.
2. Cash reserve To provide for the risk that cash flows decrease as a result of default loss of original installment receivables, the amount of principal that decreases as a result of such default loss is secured as a cash reserve. If any guarantees are in place on the installment receivables, the performance of such guarantees by the relevant guarantors may be worked into the analysis while the guarantors are alive. An evaluation is performed from the perspective of whether or not the cash reserve is adequate and whether or not the guarantors are capable of performing their guarantees.
3. Default trap To provide for the risk that cash flows decrease as a result of default loss of the original installment receivables, an amount equivalent to the default loss is supplemented by the excess spread. An evaluation is performed from the perspective of whether or not the default trap function is effective and adequate.
II. Prepayment risk (prepayment)
A. Risk factors As a result of prepayment by the obligors of their debt obligations under installment sale contracts prior to final maturity, the principal is collected early but the amount of interest collected is less than it would have otherwise have been. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Type (gender) of obligor Age of obligor Resident area of obligor Merchandise Outstanding balance as of the time of securitization Installment sales fee rate
B. Principal risk countermeasures and perspectives for evaluation
1. Changing the redemption method on the rated product to a pass-through By redeeming the principal of the rated product in tandem with principal repayment on the underlying assets, while the interest collected on the underlying assets decreases, interest payments on the rated product also decrease, hence the influence that the relevant risk has on the rated products is scaled back.
49/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
An evaluation is performed from the perspective of whether or not it is possible to respond to a mismatch between the cash flows of the rated product and those from the underlying assets.
2. Setting subordination amount In case of the scheme in which the subordinated portion is redeemed while the senior portion remains, creditworthiness could deteriorate if, in relation to the remaining senior portion, an excessive amount of subordinated portion is redeemed using the prepayment-collected principal. The relevant prepayment risk does not occur if a structure is in place so that the excessive amount of subordinated portion is not redeemed (setting the subordination amount, etc.). An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate.
III. Dilution risk (cancellation, setoff, non-performance of service, unlawful acts of member stores, etc.)
A. Risk factors If there is any risk of dilution of original receivables on the grounds that the obligor’s assertion of defense is not restricted, the cash flow ceases to exist as a result of emergence of the relevant risk. The level of decrease and fluctuations of cash flows vary depending upon the dilution risk. Principal dilution risks include: Setoff by obligor holding counterclaims Cancellation/cooling-off by obligor Member store’s non-performance of service Member store’s unlawful acts/unfair sales Dilution of principal as a result of prepayment
B. Principal risk countermeasures and perspectives for evaluation Risk countermeasures vary depending upon types of dilution risk. Therefore, a credit risk rating is performed according to the risk countermeasure deemed necessary in the light of laws and ordinances and industry practices. Principal risk countermeasures are as follows:
1. Eligible receivables If installment receivables with dilution risk are not treated as eligible receivables, an evaluation is performed from the perspective that no dilution occurs as a result of the relevant risk.
50/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
2. Senior/subordinated structure (addition of amount equal to dilution loss to the subordinated portion) An amount equal to the influences of the decreased portion of cash flows caused by dilution risk is added to the subordinated portion. An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate.
IV. Characteristics of cash flow for revolving payment installment receivables
A. Risk factors Cash flows of revolving payment installment receivables may vary as a result of the obligors’ prepayments, additional purchases, or amendment of their repayment. Cash flows decrease or delay mainly due to an increase in default receivables, a delay in principal collection (a decrease in principal payment rate) stemming from delinquencies and a decrease in yields. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligors’ gender (type) Resident area of obligors Initial debt balance and debt balance at the time of securitization Credit limit Annual income of obligors Number of loans of obligors
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To Provide for the risk that cash flows may decrease as a result of the characteristics of revolving payment installment receivables, the decreasing amount is set aside as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. Default trap To provide for the risk that cash flows decrease as a result of the default loss of the original underlying receivables, the amount equivalent to the relevant default loss is supplemented using the excess spread. An evaluation is performed from the perspective of whether or not the default trap function is effective and adequate.
51/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
3. Performance triggers Performance triggers to be adopted if certain parameters(default rate, princioal payment rate, yield) reache a specific level include “early redemption triggers,” which accelerate principal redemption of the senior portion by changing the redemption method, and “dynamic reserve triggers,” which include accumulation of cash reserves for credit enhancement out of the excess spread. An evaluation is performed from the perspective of whether or not the performance triggers are effective and adequate.
52/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 2: Lease receivables (finance lease)
Section 1: Basic issues
I. Cause for creation Lease (finance lease) receivables are created generally by a transaction whereby a leasing company purchases the property that is desired by the user of the leased property (“User”) and leases the relevant property to the User. There are various types of lease transaction, which include leases with maintenance service contracts including auto leases with maintenance service contracts, software leases where software as the object of copyright is the leased property, subleases where sublessor, with the consent of the title holder, leases the leased property to the User through multiple leasing companies, leases for government agencies where national government agencies and local public authorities are the Users, prepaid leases where leasing companies receive advance payments, leases with purchase option where the User has the right of option to purchase the leased property at expiration of the lease contract, and used-property leases where used properties are leased.
II. Transfer method The originator assigns lease receivables to the assignee under an assignment contract. Perfection requirements against third parties are fulfilled by registration pursuant to the Special Perfection Law. Generally, perfection requirements against obligors are initially withheld, but are promptly fulfilled if the originator falls into bankruptcy or if otherwise needed by giving a notice to or obtaining consent from the obligors pursuant to Article 467 of the Civil Code or sending certificates of registered matters to the obligors pursuant to the Special Perfection Law.
III. Management method Payment schedules for the obligors of lease receivables are fed into a database, repayments are collected by account transfer procedures, and reconciliations are performed each month. Normal reminder notices are sent at specified periods of delinquency, and receivables with more than the specified periods of delinquency are reclassified as administered receivables. Such collection services are normally outsourced to a servicer, and the originator is appointed as the initial servicer.
53/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Characteristics of cash flow Generally, cash flows from lease receivables have the following characteristic features: Scheduled cash flows are normally paid in a fixed monthly amount (fixed amount of principal and interest). Principal and interest in the cash flows under the original contracts may be recognized differently from those managed by an SPV. Monthly cash flows may decrease as a result of default or delinquency of the obligor of the lease receivables. If the obligor falls into bankruptcy or becomes delinquent repeatedly and there is little prospect of collection, the relevant receivables are generally reclassified as administered receivables, and no cash flows can be expected from the obligor. Although not accepted in principle, early cancellation may be allowed with respect to those receivables that, in the judgment of the originator, must be cancelled early for business strategy reasons. Nevertheless, the principle still holds that future lease payments must be collected in full as prescribed damages. In addition, a finance lease has a characteristic feature of full payout, and future interest does not decrease. If a lease contract is deemed to constitute a sale/purchase contract, an amount equivalent to interest as the balance of lease payments remaining as of the time of early cancellation minus the amount equivalent to principal is diluted, and cash flows consequently decrease. If a lease contract is deemed to constitute a rental contract, an amount equivalent to lease payments (principal and interest) remaining as of the time of early cancellation is diluted, and cash flows consequently decrease. In the case of a lease contract with a provision for service (maintenance, etc.), if the relevant service cannot be performed, the right of defense for payment suspension is exercised, and cash flows decrease. If the leased property cannot be used or the originator falls into bankruptcy, the relevant lease contract may be terminated as a bilateral contract not performed by both parties, and cash flows may decrease.
Section 2: Analysis of credit risk factors
I. Obligor default risk
A. Risk factors If the obligor under the finance lease contract (obligor) becomes insolvent, the amount of principal and interest on lease receivables collected decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors:
54/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Articles covered by the lease transaction Type and business of obligor (in the case of a corporation); age of obligor (individual) Location/resident area
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default loss of the original receivables, the amount of principal decreasing as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not enhancement provided by the subordinated portion is adequate.
2. Default trap To provide for the risk that cash flows decrease as a result of a default loss of the original receivables, an amount equivalent to the default loss is supplemented by the excess spread. An evaluation is performed from the perspective of whether or not the default trap function is effective and adequate.
II. Prepayment risk (early cancellation)
A. Risk factors As a result of early cancellation by the obligors of their debt obligations under the lease contracts prior to final payment date and full amount of future lease payments is established as prescribed damages, principal of and interest on lease receivables are collected early. As a result, the amounts of principal and interest to be collected in the future decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Articles covered by lease transaction Type and business of obligor (corporation); age of obligor (individual) Location/resident area
B. Principal risk countermeasures and perspectives for evaluation
1. Retaining collected interest In case a structure whereby an amount equivalent to future interest collected at the time of early cancellation is secured as retained money and is used as needed, an evaluation is performed from the perspective that the amount of interest on underlying assets collected in the future decreases, but prepayment risk does not occur as a portion equivalent to the
55/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
relevant decrease is retained.
2. Changing the redemption method on the rated product to pass-through By redeeming the principal of the rated product in tandem with principal repayment on underlying assets, while the interest collected in the future on underlying assets decreases, interest payments on the rated product also decrease, hence the degree of influence that the relevant risk has on the rated products is scaled back. An evaluation is performed from the perspective of whether or not it is possible to respond to a mismatch between cash flows of the rated product and those from the underlying assets.
3. Setting subordination amount In case of the scheme in which the subordinated portion is redeemed while the senior portion remains, creditworthiness could deteriorate if, in relation to the remaining senior portion, an excessive amount of subordinated portion is redeemed using the prepayment-collected principal. The relevant prepayment risk does not occur if a structure is in place so that the excessive amount of subordinated portion is not redeemed (setting the subordination amount, etc.). An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate.
III. Dilution risk (risk associated with various other lease transactions)
A. Risk factors If, in connection with various lease transactions, there is any dilution on the grounds that the characteristics of a finance lease are not maintained or the obligor’s assertion of defense is not restricted, the principal and interest to be collected cease to exist as a result of the relevant risk. The level of decrease and fluctuations of cash flows vary depending upon the dilution risk. Principal lease transactions include: Auto leases with maintenance service provision Leases with maintenance service provision Software leases Subleases Lease for government agencies Advance payment leases Leases with purchase option Leases of used properties
56/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
B. Principal risk countermeasures and perspectives for evaluation A credit rating is judged according to the risk countermeasure deemed necessary in the light of the contractual form of a lease transaction, judicial precedents, and industry practice. Principal risk countermeasures are as follows:
1. Eligible receivables If lease receivables with dilution risk are not treated as eligible receivables, an evaluation is performed from the perspective that no dilution occurs as a result of the relevant risk.
2. Senior/subordinated structure (addition of amount equal to dilution loss to the subordinated portion) An amount equal to the influences of the decreased portion of cash flows caused by dilution risk is added to the subordinated portion. An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate.
57/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 3: Residential loan receivables
Section 1: Basic issues
I. Cause for creation Residential loan receivables are created generally as obligors, when purchasing their residential houses, conclude loan agreements with financial institutions and residential loans are executed. The residential loan receivables discussed in this Subchapter basically refer to those covering residential properties, and include loan receivables covering apartment buildings and investment condominium buildings.
II. Transfer method The originator assigns residential loan receivables to the assignee under an assignment contract. Perfection requirements against third parties are fulfilled by registration pursuant to the Special Perfection Law. Generally, perfection requirements against obligors are initially withheld, but are promptly fulfilled if the originator falls into bankruptcy or if otherwise needed by giving a notice to or obtaining consent from the obligors pursuant to Article 467 of the Civil Code or sending certificates of registered matters to the obligors pursuant to the Special Perfection Law.
III. Management method Payment schedules for the obligors of residential loan receivables are fed into a database, repayments are collected by account transfer procedures, and reconciliations are performed each month. Normal reminder notices are sent up to five times of delinquency, and receivables with six times or more of delinquency are reclassified as administered receivables and direct recovery from properties in question would be commenced. For such recovery/collection services to be performed properly, it is critical that comprehensive transactions with clients are present and the business infrastructure of a financial institution handling residential loans is in place. Hence, in a normal case of securitization, recovery/collection services during the term of a transaction are outsourced to the originator.
IV. Characteristics of cash flow Generally, cash flows from residential loan receivables have the following characteristic features: Scheduled cash flows are determined by the method for repayment of the relevant residential loan. There are two principal types of repayment: annuity repayments (“gannri kintou,” fixed monthly amount consisting of principal and interest), and principal-equal
58/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
repayments (“gankin kintou,” monthly payment consisting of equal principal payment amount plus interest depending on the remaining outstanding balance). Cash flows vary depending upon whether or not bonus repayments are utilized. In the case of annuity repayments, a certain fixed amount is paid each month. In the case of principal-equal repayments, a certain fixed amount of principal is paid each month. If the interest rate applicable to the underlying receivables is variable or fixed with options, initial scheduled cash flows may vary according to fluctuations of interest rates. Cash flows change as a result of the obligors’ partial or full prepayment. If there are counterclaims (such as deposits) between the originator and the obligors, and if the originator falls into bankruptcy, cash flows may decrease due to a setoff. If the credit guarantee company becomes bankrupt, and if the guaranteed underlying receivables become defaulted receivables, cash flows from the performance of the relevant guarantee decrease. If the underlying receivables become defaulted receivables and recovery is made from the relevant collateral, cash flows from property sale decrease due to the decline in the property sale price.
Section 2: Analysis of credit risk factors
I. Obligor default risk
A. Risk factors If the obligor under the residential loan contract (obligor) becomes insolvent, the amount of principal and interest collected decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: LTV and DTI for residential loan receivables Obligor’s annual income and occupation Time elapsed since loan execution, and timing of loan execution Product attributes of residential loan receivables (intended use, restrictions on LTV, restrictions on DTI, income level, presence or otherwise of senior liens, property locations, property types, terms of interest rate, competitive conditions, etc.)
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default loss of original
59/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
receivables, the amount of principal decreasing as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not enhancement provided by the subordinated portion is adequate.
II. Prepayment risk (full or partial prepayment)
A. Risk factors As a result of full or partial prepayment by the obligors of their residential loan receivables, the amount of interest collected on residential loan receivables decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: LTV and DTI for residential loan receivables The obligor’s income and occupation Time elapsed since loan execution and timing of loan execution Balance of residential loan receivables outstanding at the time of securitization Product attributes of residential loan receivables (intended use, restrictions on LTV, restrictions on DTI, income level, presence or otherwise of senior liens, property locations, property types, terms of interest rate, competitive conditions, etc.)
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure (addition of negative carry portion to subordinated portion) To provide for the risk that interest collected from the original receivables decreases (negative carry risk), the amount of principal equivalent to the negative carry is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not enhancement provided by the subordinated portion is adequate.
2. Changing the redemption method on the rated product to pass-through By redeeming the principal of the rated product in tandem with principal repayment on underlying assets, while the interest collected in the future on underlying assets decreases, interest payments on the rated product also decrease; hence, the degree of influence that the relevant risk has on the rated products is scaled back. An evaluation is performed from the perspective of whether or not it is possible to respond to a mismatch between cash flows of the rated product and those from the underlying assets.
60/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Post-default recovery fluctuation risk (recovery from guarantee)
A. Risk factors If the credit guarantee company is called upon to perform its guarantee for the recovery of residential loan receivables that defaulted, but if the relevant credit guarantee company falls into bankruptcy, the amount of principal recovered from the defaulted receivables decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Guarantee contract Creditworthiness of the credit guarantee company
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure (addition of portion of decreased recovery after the default to the subordinated portion) If the guarantee on the underlying receivables is not performed, to provide for the risk arising from post-default recovery fluctuations caused by the decline of collateral value, the amount of principal equivalent to the decrease of the post-default recovery is secured as the subordinated portion. If the contents of the guarantee contract are such as to guarantee residential loan receivables that default, recovery by performing the guarantee is feasible insofar as the credit guarantee company exists, and post-default recovery does not fluctuate. An evaluation is performed from the perspective of whether or not enhancement provided by the subordinated portion is adequate, considering the capabilities of the guarantee performance by the credit guarantee company.
IV. Post-default recovery fluctuation risk (recovery from collateral)
A. Risk factors If the credit guarantee company falls into bankruptcy when recovering defaulted residential loan receivables, the underlying collateral is foreclosed on. If the mortgagee is the originator, the underlying collateral is foreclosed on as the mortgage accompanies assignment of receivables. Ordinary residential loan receivables are jointly and severally guaranteed by the credit guarantee company and the mortgage is established whereby a secured claim under the mortgage is the credit guarantee company’s indemnification rights of guarantee obligations. In this case, by virtue of the fact that the mortgagee and the creditor of the residential loan are not the same entity, a mortgage does not accompany assignment of receivables. Therefore, only the right of claim for performance of the guarantee can be
61/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
recovered from the defaulted residential loan receivables after the credit guarantee company’s bankruptcy. However, from the perspectives of continuity of the guarantee business, the probability of the behavior of the receiver for the bankrupt credit guarantee company, and past case examples of the processing of bankruptcies of credit guarantee companies, R&I is of the view that recovery to a degree comparable to the minimum collateral property sale price is possible. With respect to recovery from collateral, the amount of principal recovered from defaulted receivables decreases due to the decline in the value of the collateral property. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Mortgagee Attributes of collateral properties (type and geographical distribution) LTV for the residential loan receivables Time elapsed since loan execution; timing of loan execution
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure (addition of subordinated portion to the portion of decreased recovery after the default) To provide for the risk arising from fluctuations in recovery from the mortgage pledged for the defaulted underlying receivables, the amount of principal for which recovery decreases after default is secured as the subordinated portion. The positioning of recovery from the mortgage varies according to the type of mortgagee. If the mortgagee is the originator, the mortgage accompanies the receivables and recovery is made from the collateral property. If the mortgagee is the credit guarantee company, the positioning of the guarantee service within the credit guarantee company’s business is checked. If the guarantee service is positioned as the main business of the credit guarantee company, recovery at the time of the credit guarantee company’s bankruptcy is considered as being at least comparable to recovery from the collateral. An evaluation is performed from the perspective of recovery rate based on the location of the collateral.
62/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
V. Dilution risk (offset)
A. Risk factors If an obligor offsets its residential loan receivables with claims against an assignor (originator) (such as deposits, if any) to perfect against the assignment of the underlying assets (assignment of the claims), cash flows from the residential loan receivables decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Amount of counterclaims Originator’s business industry (Whether the industry is an industry in which the obligors have counterclaims) Originator’s creditworthiness
B. Principal risk countermeasures and perspectives for evaluation
1. Indication of the obligors’ waiver on their rights of defense through setoff against the assignment of the claims
If an obligor indicates waiver of its rights of defense through setoff against the assignment of the claims, the possibility of the obligor’s being protected against the assignee through offset upon and after such indication will, in principle, be removed. An evaluation is performed from the perspectives of the validity of obligors’ indication of waiver of defenses for the assignment of claims through setoff, as well as the timing of such indication.
2. Perfection against obligors An originator as assignor notifies the obligors of the assignment of claims, or the obligors accept (consent on the assignment is obtained from the obligors), to perfect against the obligors. However, please take note that the rights of defense against the assignment of claims would not necessarily be cut off completely only through perfection against the obligors. An evaluation is performed from the perspective of sufficient actions taken for perfection against the obligors and responses to setoff risk (the amount of claims against the originator against which the obligors can be protected against an assignee through setoff (if any) and the sufficiency of measures against it, using the timing of perfection against the obligors being obtained as a reference point).
3. Cash reserve equivalent to the amount of a setoff As deposits, the purpose of which is not for settlements, of more than ten million yen,
63/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
which are not protected under the Deposit Insurance Act, can be subject to a setoff, the relevant amount is retained in the cash reserve account. An evaluation is performed from the perspective of whether or not the cash reserve is adequate.
4. Risk countermeasure based on rating trigger If the originator’s creditworthiness deteriorates, an amount equivalent to a setoff is secured as a cash reserve. An evaluation is performed from the perspective of whether or not the rating trigger measure is effective and adequate.
5. Risk countermeasure based on originator’s creditworthiness An evaluation is performed from the perspective of the originator’s creditworthiness and the amount equivalent to a setoff.
64/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
VI. Interest rate fluctuation risk associated with underlying receivables
A. Risk factors If the interest rate applicable to a residential loan contract is a variable interest rate, the interest collected decreases as the market interest rate falls. If the repayment method is equal monthly payments with interest, collection of the principal is delayed as the market interest rate rises. If the interest rate is a fixed interest rate with options, the interest collected fluctuates depending upon the interest type selected following completion of the fixed interest rate period. Fluctuations of cash flows are typically influenced by the following factors: Fluctuations of market interest rate/residential loan interest rate Obligors’ preference for interest rate
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that occurs due to a decrease of interest collected from underlying receivables, an amount of principal equivalent to the relevant risk is secured as the subordinated portion. An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate. Interest rate risk for RMBS is the risk that occurs when both the interest rate on the residential loan receivables (entry interest rate) and the interest on RMBS (exit interest rate) are variable interest rates, or either one of them is a variable interest rate. This risk can be classified broadly into the following three types:
(i) Negative carry risk Negative carry risk occurs when the payment of the exit interest rate and expenses exceeds that of the entry interest rate. The negative spread portion is paid for out of the collected principal, and the source of funds for redeeming the RMBS principal is diluted.
(ii) Mismatch risk Mismatch risk may arise if both the exit interest rate and the entry interest rate are variable interest rates. Generally, 1MLIBOR and short-term prime rates, etc. are used for the exit interest rate, whereas the entry interest rate in most cases is linked to short-term prime rates or long-term prime rates. In this case, there is a gap in the timing for interest rate determination. If interest rates fluctuate sharply, there is a mismatch in interest rate determination, hence the risk that a negative spread occurs may arise.
65/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
(iii) Principal repayment reduction risk If the entry interest rate is a variable interest rate, the timing of a review of the repayment amount varies from that of a review of the base interest rate. Base interest rate is often reviewed once every six months, while repayment amount is typically reviewed once every five years with a specific upper limit such as up to 1.25 times. If the base interest rate for a residential loan rises sharply, the principal portion within the total repayment amount decreases and the principal balance hardly decreases, thereby making a larger amount exposed to default risk.
66/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 4: Japan Housing Finance Agency MBS
Section 1: Basic issues
I. Cause for creation Japan Housing Finance Agency MBS (the “JHF MBS”) are Japan Housing Finance Agency bonds issued by JHF and secured by trust beneficial interests in residential loan receivables. JHF MBS are issued pursuant to the Japan Housing Finance Agency Act (the “JHFA Act”). This Subchapter deals with those JHF MBS that are secured by residential loan receivables outstanding under JHF’s Securitization Support Programs (Purchase Type) and by receivables on residential loans directly provided by the Government Housing Loan Corporation (“GHLC”) as JHF’s predecessor. JHF MBS can be classified broadly into the following five types: GHLC Monthly MBS (March 2001 – March 2007) GHLC S-series MBS (August 2005 – December 2006) JHF Monthly MBS (May 2007 – date) JHF S-series MBS (May 2007 – date) JHF T-series MBS (June 2018 – date)
The underlying receivables are created as financial institutions advance residential loans fulfilling the purchase criteria of the Securitization Support Program (Purchase Type) to the obligors purchasing residential houses and sell the relevant residential loans to JHF or as JHF (including GHLC) advances the residential loans directly to the obligors.
The scheme for the Monthly MBS is illustrated below: Under JHF MBS, residential loans are placed in third-party beneficiary trusts with investors as beneficiaries. JHF issues JHF MBS to investors. Unless or until a beneficial interest trigger event occurs, JHF redeems JHF MBS in accordance with the collection of principal of the relevant beneficial interest. The structure is such that, if a beneficial interest trigger event occurs, JHF MBS is extinguished and the beneficial interest serving as collateral is instead delivered to investors.
67/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
(Monthly MBS)
直接融資のBorrowers of Direct Loans 利用者
Payment of principal and Private financial interest Provision of institutions 元利払い residential住宅ローンの貸付 loans Provision of participating in Residential loans residential住宅ローンの貸付 Securitization purchase住宅ローン買取代金 proceeds Borrowersフラット35 of 証券化支援事業Support 機構 （買取型）に参加 JHF (GHLC) 信託銀行Trust bank Flatの利用者 35 Loans する民間金融機関Program （公庫） Entrustment機構MBSを担保するた of (Purchase Type) residentialめに住宅ローンを信託 loans as Payment元利払い of 住宅ローンの買取Purchase of residential collateral for JHF 住宅ローン回収金の引渡しloans, remittance of MBS principal and residential loan payments interest Payment of principal元利払い and 売却代金 Issuance機構MBSの発行 of Agency MBS
interest proceeds Bonds sale
Investors投資家 JHF信託受益権の行使事由に該当すると、機構 MBS are extinguished if trust beneficialMBSは消滅して投資家が信託受益権を取 interest event is triggered. Investors得し、信託債権からの元本償還および配当 acquire trust beneficial interest andを受領する receive principal/interest payments from the entrusted loan receivables.
Loan receivables of four months or longer in arrears are dealt with differently under the types of JHF MBS. JHF Monthly MBS and JHF T-series MBS come with a scheme whereby JHF is entitled to redeem JHF MBS early in the same proportion as that for any loan receivables on which payments are overdue by four months and loan receivables for which loan terms have been amended, and relevant receivables are delivered to JHF on an as-is basis. In contrast, under GHLC Monthly MBS and S-series MBS, JHF is entitled to replace with other eligible receivables those loan receivables on which payments are overdue by four months and loan receivables for which loan terms have been amended.
II. Transfer method Residential loan obligors shall accept that any claims under their contracts are transferred by financial institutions to the Agency as loans are provided, and that any rights of offset, payment, invalidation, cancellation, and other defense held against financial institutions shall subsequently be waived, by which they shall not be asserted against the Agency and its successor. Further, unconditional written consent with certified dates are obtained from the obligors of residential loans prior to March 2020 to fulfill perfection requirements against the obligors and third parties. When residential loan receivables are assigned from JHF to the trust, perfection requirements against third parties are fulfilled by means of registration pursuant to the Special Perfection Law. Perfection requirements against the obligors are withheld at the time the trust is assigned, but are fulfilled as needed.
68/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Management method Prior to the occurrence of a beneficial interest trigger event, JHF manages residential loan receivables. As to the management method after occurrence of a beneficial interest trigger event, please refer to Section 1 – III “Management method” under Subchapter 3 “Residential loan receivables.”
IV. Characteristics of cash flow Generally, cash flows from residential loan receivables have the following characteristic features: (Prior to occurrence of a beneficial interest trigger event) Scheduled cash flows are determined by the repayment method of the relevant residential loan. There are two principal types of repayment: annuity repayments with interest and principal-equal repayments. Cash flows also change depending upon whether or not bonus repayments are utilized. In the case of annuity repayments with interest, a certain fixed amount is paid each month. In the case of principal-equal repayments, a certain fixed amount of principal is paid each month. Cash flows also change as a result of the obligors’ partial or full prepayments. In this case, the risk of change in future cash flows decreases. (GHLC Monthly MBS and S-series MBS) JHF is entitled to replace any loan receivables on which payments are overdue by four months or longer. (JHF Monthly MBS and JHF T-series MBS) JHF is entitled to redeem JHF MBS early in an amount calculated by dividing the outstanding balance of loan receivables on which payments are overdue by four months or longer by “1 + overcapitalization ratio.” Redemption method of JHF MBS is pro-rata amortization with a fixed overcollateralization ratio.
(After occurrence of a beneficial interest trigger event) Scheduled cash flows are determined by the method for repaying the relevant residential loan. There are two principal types of repayment: annuity repayments with interest and principal-equal repayments. Bonus repayments may or may not be utilized. In the case of annuity repayments with interest, a certain fixed amount is paid each month. In the case of principal-equal repayments, a certain fixed amount of principal is paid each month. Cash flows change as a result of the obligors’ partial or full prepayments. In this case, the risk of a change in future cash flows decreases.
69/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
If the underlying receivables become defaulted receivables and recovery is made from the relevant collateral, cash flows decrease due to the decline in the property sale price. Redemption method of JHF MBS is sequential amortization.
Section 2: Analysis of credit risk factors
I. Deterioration in JHF’s creditworthiness
A. Risk factors The creditworthiness of JHF MBS will deteriorate as a result of a deterioration in JHF’s creditworthiness.
B. Principal risk countermeasures and perspectives for evaluation
1. Loan receivables offered as security JHF MBS are secured by residential loan receivables that are placed in third party beneficiary trusts. If a beneficial interest trigger event occurs with JHF, investors acquire the beneficial interests backed by the relevant residential loan receivables. When making credit-rating judgments, given the facts that loan receivables offered as security have sufficient overcollateralization and the provisions of the Corporate Rehabilitation Law limiting an issuer’s ability to dispose of collateral are not applied to JHF, R&I is of the view that a rating for JHF MBS can be higher than JHF’s issuer rating (i.e., notching up is possible). Specifically, if stress test results on loan receivables as security are equivalent to AAA and AA through A, a rating on JHF MBS can be higher than the issuer rating by three notches and two notches, respectively. The stress test result for loan receivables as security is a measure of what level of stress scenario the credit enhancement of the loan receivables offered as security satisfy against the default risk of the residential loan receivables.
II. Deterioration of stress test result of loan receivables offered as security
A. Risk factors As cases of default by obligors increase, the credit enhancement of loan receivables offered as security becomes less adequate.
B. Principal risk countermeasures and perspectives for evaluation
1. Establishment of overcollateralization The structure is such that, after the occurrence of a beneficial interest trigger event,
70/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
JHF MBS is extinguished and investors acquire the beneficial interests backed by the residential loan receivables. As the relevant beneficial interests become those backed by the residential loan receivables after the occurrence of a beneficial interest trigger event, the relevant risk is basically the same as that described in Subchapter 3 “Residential loan receivables.” Credit enhancement for defaults is calculated on the basis of repayment historical data, taking into account the attributes of the receivables and the timing of the occurrence of a beneficial interest trigger event. With respect to attributes of receivables, R&I focuses its attention on the percentage of obligors with a high LTV, percentage distribution by occupation, percentage of low-income earners, percentage of obligors with a high DTI, percentage distribution by loan type, percentage distribution by property location, etc.
(Notes) R&I’s views on timely payment, commingling loss risk, and offset risk associated with JHF MBS are as follows: (1) Timely payment and commingling loss risk Although liquidity enhancement and credit enhancement to respond to commingling loss risk are not in place, given the political positioning of the Securitization Support Programs, the probability that timely payment of JHF MBS will be lost or a commingling loss will arise as a result of the occurrence of a beneficial interest trigger event is considered to be low. (2) Offset risk As JHF does not accept deposits, any setoff risk is considered to be limited.
2. Overcollateralization and JHF’s buyback (JHF MBS’s early redemption) or replacement of delinquent receivables with directly financed receivables Overcollateralization is put in place to provide for the risk that cash flows will decrease due to default losses arising within the underlying assets. Prior to the occurrence of a beneficial interest trigger event, JHF deals with the risk through buyback (JHF MBS’s early redemption) or replacing receivables on which payments are overdue by four months or longer with directly financed receivables.
71/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 5: Consumer loan receivables
Section 1: Basic issues
I. Cause for creation Generally, consumer loan receivables are created as consumers borrow money from consumer loan provider companies under consumer loan contracts according to their financing needs. There are two methods in general, one is “Kyokudo-gaku keiyaku method” that allows additional borrowing up to the credit limit without a new contract, and the other is “Shōsho kashitsuke method” that requires a new contract to be concluded for each loan.
II. Transfer method The originator assigns consumer loan receivables to the assignee under an assignment contract. Perfection requirements against third parties are fulfilled by registration pursuant to the Special Perfection Law. Generally, perfection requirements against obligors are initially withheld, but are promptly fulfilled if the originator falls into bankruptcy or if otherwise needed by giving a notice to or obtaining consent from the obligors pursuant to Article 467 of the Civil Code or sending certificates of registered matters to the obligors pursuant to the Special Perfection Law. If the originator is subject to regulations of the Money Lending Business Law, the originator as assignor gives notification of the provisions of Articles 24, paragraph 1 of the Money Lending Business Law to the assignee pursuant to such provision. Generally, the assignee withholds notification prescribed in Article 24, paragraph 2 of the Money Lending Business Law unless or until otherwise required.
III. Management method Payment schedules for obligors of consumer loan receivables are fed into a database, repayments are collected by account transfer procedures, etc., and reconciliations are performed each month. Under the revolving payment sliding-balance method, which is one of the common methods for repaying consumer loan receivables, the repayment amount varies depending upon the outstanding balance at the time of borrowing or repayment, hence the obligor’s scheduled payment amount may vary at any time. Normally, reminder notices are sent up to certain specified times of delinquency, and receivables with more than the specified times of delinquency are reclassified as administered receivables. Such collection services are normally outsourced to a servicer, and the originator is appointed as the initial servicer.
72/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Characteristics of cash flow Generally, cash flows from consumer loan receivables (Kyokudo-gaku keiyaku method ) have the following characteristic features: In addition to monthly payments of a certain fixed amount (either a fixed amount of principal or a fixed amount of principal and interest), the obligors’ repayment methods include the sliding-balance-at-repayment method, which relies on the debt balance outstanding at the time of repayment, and the sliding-balance-at-borrowing method, which relies on the debt balance outstanding at the time of borrowing. Cash flows may vary depending upon the obligors’ additional borrowings, partial prepayments, etc. Monthly cash flows may decrease as a result of default or delinquency of obligors of the consumer loan receivables. If any obligor falls into bankruptcy or becomes delinquent repeatedly and there is little prospect of collection, the relevant receivables are generally reclassified as administered receivables, and no cash flows can be expected from the obligor in question. Cash flows also vary as a result of the obligors’ prepayments, additional borrowings, or amendment of their repayment tables. If there are any counterclaims between the originator and the obligors, an offset may be asserted and the amount of principal may decrease.
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors If any obligor (obligor) of consumer loan receivables becomes insolvent, the amount of principal and interest collected decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligors’ gender (type) Resident area of obligors Initial borrowing balance and borrowing balance at the time of securitization Loan limit Annual income of obligors Number of loans of obligors
73/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
B. Principal risk countermeasures and perspectives of evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of the default loss of the underlying receivables, the amount decreasing as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. Default trap To provide for the risk that cash flows decrease as a result of the default loss of the original underlying receivables, the amount equivalent to the relevant default loss is supplemented using the excess spread. An evaluation is performed from the perspective of whether or not the default trap function is effective and adequate.
3. Performance triggers Performance triggers to be adopted if the default rate reaches a specific level include “early redemption triggers,” which accelerate principal redemption of the senior portion by changing the redemption method, and “dynamic reserve triggers,” which include accumulation of cash reserves for credit enhancement out of the excess spread. An evaluation is performed from the perspective of whether or not the performance triggers are effective and adequate.
II. Risk of decline in principal payment rate
A. Risk factors As the repayment amounts from obligors decrease (or the principal payment rate falls) as a result of amendments to repayment tables and increases in the number of delinquent obligors, the schedule of principal collection of consumer loan receivables is delayed. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligors’ gender (type) Resident area of obligors Initial borrowing balance and borrowing balance at the time of securitization Loan limit Annual income of obligors Number of loans of obligors
74/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure If the principal payment rate falls, a larger amount of principal is left outstanding and the amount that is hence be exposed to default risk increases. To provide for such risk, the subordinated portion is provided. An evaluation is performed from the perspective of whether or not enhancement by the subordinated portion is adequate.
2. Performance triggers Performance triggers to be adopted if the principal payment rate reaches a specific level include “early redemption triggers,” which accelerate principal redemption of the senior portion by changing the redemption method, and “dynamic reserve triggers,” which include accumulation of cash reserves for credit enhancement out of excess spread. An evaluation is performed from the perspective of whether or not the performance triggers are valid and adequate.
III. Risk of decline in yield
A. Risk factors As the interest rate applicable to the underlying receivables falls and the number of delinquent obligors increases, the amount of interest collected on the relevant receivables decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligors’ gender (type) Resident area of obligors Interest rate applied Initial borrowing balance and borrowing balance at the time of securitization Loan limit Annual income of obligors Number of loans of obligors
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure If the yield declines, the risk of cash flows decreasing arises. To provide for such risk, the subordinated portion is provided. An evaluation is performed from the perspective of whether or not the credit enhancement by the subordinated portion is adequate.
75/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
2. Performance triggers Performance triggers to be adopted if the yield reaches a specific level include “early redemption triggers,” which accelerate principal redemption of the senior portion by changing the redemption method, and “dynamic reserve triggers,” which include accumulation of cash reserves for credit enhancement out of excess spread. An evaluation is performed from the perspective of whether or not the performance triggers are valid and adequate.
IV. Withholding of notices prescribed in Article 24, paragraph 2 of Money Lending Business Law
A. Risk factors If the originator is subject to application of Money Lending Business Law, it is required to give written notification (“Article 24/Paragraph 2 Notification”) to the obligors, according to Article 24, paragraph 2 of the Money Lending Business Law, when assigning consumer loan receivables. If the Article 24/Paragraph 2 Notification is initially withheld, it is assumed the assignee of the consumer loan receivables cannot duly assert against the obligors unless or until the Article 24/Paragraph 2 Notification is given after replacement of the servicer. As a result, the amount of principal and interest collected on consumer loan receivables decreases. If the originator is not subject to application of the Money Lending Business Law or has already given Article 24/Paragraph 2 Notification to the obligors, the relevant risk does not arise. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: The originator Steps and requirements for sending Article 24/Paragraph 2 Notification
B. Principal risk countermeasures and perspectives for evaluation
1. Securitization procedures If steps for sending Article 24/Paragraph 2 Notification at the time of the servicer’s replacement are clearly established and if promptly sending Notification is possible when necessary, cash flows do not decrease. An evaluation is performed from the perspective of checking steps and requirements for sending Article 24/Paragraph 2 Notification, and whether or not it is possible to send the Notification promptly if needed.
76/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
V. Risk of claims for refund of overpaid interest
A. Risk factors If money-lending business companies have received from obligors interest at a rate that exceeded the upper limit prescribed in the Interest Rate Restriction Law, but was equal to or lower than the upper limit prescribed in the Law for Control, etc., of Acceptance of Contributions, Money Deposit and Interest, etc. (the gray-zone interest), and if the validity of deemed repayment is denied, the gray-zone interest received regarding the relevant receivables is deemed to retroactively constitute unjust enrichment, and is subject to a claim for refunding overpaid interest. As a result of claims for refunding overpaid interest, the amounts of principal and interest collected on consumer loan receivables decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factor: Interest rates applied (in the past and at present)
B. Principal risk countermeasures and perspectives for evaluation
1. Eligible receivables If the eligible receivables are consumer loan receivables that are not accompanied by the risk of claims for refunding overpaid interest, an evaluation is performed from the perspective that no risk of claims for refund of overpaid interest arises.
2. If the risk of claims for refund of overpaid interest is present An analysis is performed by estimating the risk of claims for refunding overpaid interest in a timely and proper manner. An evaluation is performed from the perspective of the rated product’s resilience against such estimates.
77/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 6: Corporate loan receivables
Section 1: Basic issues
I. Cause for creation Corporate loan receivables are created typically as obligors conclude loan contracts with lenders (including financial institutions) and lenders loan money.
II. Transfer method Corporate loan receivables are assigned under assignment contracts between lenders and assignees. Perfection requirements against obligors and third parties in respect of assignment are typically fulfilled by giving written notification with a certified date to the obligors or obtaining written consent with a certified date from the obligors pursuant to Article 467 of the Civil Code. If perfection requirements against the obligors are initially withheld, perfection requirements against third parties are typically fulfilled by registration of assignment of receivables prescribed by the Special Perfection Law. Perfection requirements against obligors are fulfilled by promptly sending written notification to or obtaining written consent from the obligors pursuant to Article 467 of the Civil Code or by giving notification to the obligors by delivering certificates of registration of receivables assignment to the obligors or by obtaining consent from the obligors if the lender falls into bankruptcy or if otherwise needed.
III. Management method Generally, the lender continues to collect corporate loan receivables as the relevant servicing services are outsourced by the assignee to the lender. Corporate loan receivables are collected typically as obligors credit funds with the bank account specified in the loan contract, and the servicer debits the contracted amount from the bank account on the contracted due dates.
IV. Characteristics of cash flow Generally, cash flows from corporate loan receivables have the following characteristic features: Repayment may take the form of installment repayment or lump-sum repayment at maturity. In the case of installment repayment, a specific grace period may be applied. Repayment in cases of corporate loan receivables typically takes the form of principal equal payments, and the contract amount of principal with interest is paid on the due dates. If any obligor holds counterclaims such as deposits against the lender, and if such counterclaims become offsettable, the obligor may insist on an offset and the cash flows
78/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
decrease. The obligors’ prepayments cause cash flows to vary, in which case future interest may be lost.
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors If any obligor becomes insolvent as a result of legal bankruptcy, the amount of principal and interest collected on corporate loan receivables decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligor’s creditworthiness Obligor’s business industry Obligor’s location Obligor’s main bank (main financing bank) Contracted repayment method (installment repayment, with a grace period, lump-sum repayment at maturity, etc.)
B. Principal risk countermeasures and perspectives for evaluation
1. Establishment of senior/subordinated structure To provide for the risk that cash flows decrease as a result of a default loss of underlying receivables, the amount of principal decreasing as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. If the senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed on the basis of the obligors’ creditworthiness.
II. Dilution risk (offset)
A. Risk factors If an obligor offsets its corporate loan receivables with claims against an assignor (lender) (such as deposits, if any) to perfect against the assignment of the underlying assets (assignment of the claims), cash flows from the corporate loan receivables decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factor:
79/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Amount of counterclaims Lender's creditworthiness
B. Principal risk countermeasures and perspectives for evaluation
1. Indication of the obligors’ waiver on their rights of defense through setoff against the assignment of the claims If an obligor indicates waiver of its rights of defense through setoff against the assignment of the claims, the possibility of the obligor’s being protected against the assignee through offset upon and after such indication will, in principle, be removed. An evaluation is performed from the perspectives of the validity of obligors’ indication of waiver of defenses for the assignment of claims through setoff, as well as the timing of such indication.
2. Perfection against obligors An assignor notifies the obligors of the assignment of claims, or the obligors accept (consent on the assignment is obtained from the obligors), to perfect against the obligors. However, please take note that the rights of defense against the assignment of claims would not necessarily be cut off completely only through perfection against the obligors. An evaluation is performed from the perspective of sufficient actions taken for perfection against the obligors and responses to setoff risk (the amount of claims against the lender against which the obligors can be protected against an assignee through setoff (if any) and the sufficiency of measures against it, using the timing of perfection against the obligors being obtained as a reference point).
3. Provision to prohibit setoff under a loan contract Where a provision of prohibiting setoff is included in an underlying agreement such as a loan contract in order to prevent setoff from being claimed, an obligor would not be able to assert defense through setoff against the assignment of claims if the said provision is effective. An evaluation is performed from the perspective of the effectiveness of a provision to prohibit setoff.
4. Establishment of rating trigger To provide for the risk that cash flows decrease as a result of offset by obligors, if the lender’s creditworthiness deteriorates, a cash reserve is established. An evaluation is performed from the perspective of whether or not the rating trigger measures are valid and adequate.
80/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Prepayments
A. Risk factors The obligors’ prepayments of their corporate loan receivables cause cash flows on the future interest portion to decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Amount repaid by the obligors Timing of repayments by the obligors
B. Principal risk countermeasures and perspectives for evaluation
1. Collection of future interest To avoid the risk that cash flows for the future interest portion decrease as a result of prepayments by obligors, it is agreed in the loan contract that future interest shall be collected concurrently with the prepayments. An evaluation is performed from the perspective of whether or not future interest can be collected.
2. Using a pass-through as a product repayment method Both interest collected on the loan receivables and interest paid on a SF Product decrease, and influences of cash flow decreases are reduced by repaying/redeeming the principal of the SF Product in concert with repayment of the principal of loan receivables. An evaluation is performed from the perspective of whether or not the mismatch between the cash flows of the rated product and those of the underlying assets can be handled.
3. Senior/subordinated structure To provide for the risk that prepayments of underlying receivables cause future interest to decrease, the amount of decrease as a result of prepayments is secured as the subordinated portion. SF Products at differing hierarchies of rank order of cash flow distribution are established. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
81/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 7: Promissory note receivables
Section 1: Basic issues
I. Cause for creation Promissory note receivables are created as obligors draw notes in exchange for the purchase of merchandise or provision of services in the course of commercial transactions with the originator.
II. Transfer method The originator assigns promissory note receivables to the assignee under an assignment contract. When assigning promissory note receivables, the originator typically provides unsecured endorsements and assigns the promissory note receivables in kind.
III. Management method Administrative work for collecting promissory note receivables is entrusted to the collection bank. When entrusting collection, the party requesting collection endorses for collection and assigns the promissory notes in kind to the collection bank. On the due date, the collection bank asks the promissory note exchange to collect the relevant promissory notes and deliver the collected funds to the party requesting collection.
IV. Characteristics of cash flow Generally, cash flows from promissory note receivables have the following characteristic features: Proceeds are paid in one lump-sum on the due date stated on the promissory notes. For the purpose of promissory notes receivable, acquisition by a bona fide third party, restrictions on assertion of defense arising from an in personal relationship, and payment discharge are allowed. Hence, basically, there is no possibility that the notes receivable will become diluted.
V. Electronically recorded claims Electronically recorded claims are monetary claims with respect to the creation or assignment of which the electronic records prescribed in the Electronically Recorded Monetary Claims Act constitute conditions for effectuation. Electronically recorded claims, while readily divisible and having other characteristic features that differ from those of promissory notes receivable, are claims from which effects comparable
82/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
to those of promissory notes receivable can be derived depending on how they are restricted.
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors If any obligor becomes insolvent, cash flows from promissory note receivables decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligor’s creditworthiness Obligor’s business industry Obligor’s location
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default loss caused by any obligor, the amount of decrease as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. If the senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed on the basis of the obligors’ creditworthiness.
83/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 8: Accounts receivable
Section 1: Basic issues
I. Cause for creation Accounts receivable are created as consideration for the purchase of merchandise or provision of services by the obligor in the course of commercial transactions with the originator.
II. Transfer method The originator assigns accounts receivable to the assignee under an assignment contract. Generally, perfection requirements against third parties are fulfilled by registration pursuant to the Special Perfection Law. Perfection requirements against the obligors, if initially withheld, are promptly fulfilled by sending a written notification to or obtaining consent from obligors pursuant to Article 467 of the Civil Code or by giving notification to obligors by delivering certificates of registered matters or obtaining consent from obligors if the originator falls into bankruptcy or if otherwise needed. If perfection requirements against the obligors are fulfilled at the time of assignment, perfection requirement against third parties and the obligors are typically fulfilled by obtaining the written consent of obligors with a certified date.
III. Management method The assignee typically outsources the collection of accounts receivable to the originator, and the originator continues to perform collection services. The originator collects the accounts receivable from obligors and delivers the funds collected to the assignee.
IV. Characteristics of cash flow Generally, cash flows from accounts receivable have the following characteristic features: Proceeds are paid on the promised due date. If there are any counterclaims between originator and obligors and the receivables become offsettable, the obligors insist on an offset and cash flows decrease. Merchandise returned and price reductions cause accounts receivable to be diluted and cash flows to decrease.
V. Electronically recorded claims Electronically recorded claims are monetary claims with respect to the creation or assignment of which the electronic records prescribed in the Electronically Recorded Monetary Claims Act
84/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
constitute conditions for effectuation. Accounts receivable, if created in the form of electronically recorded claims, are claims that can have characteristics comparable to those of promissory note receivables depending on how they are restricted.
Section 2: Analysis of credit risk factors
I. Obligors' default risk
A. Risk factors If any obligor becomes insolvent, cash flows from accounts receivable decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligor’s creditworthiness Obligor’s business industry Obligor’s location
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default loss caused by any obligor, the amount of decrease as a result of such default loss is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. If the senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed on the basis of the obligors’ creditworthiness.
II. Dilution risk (offset, merchandise returned, price reductions, etc.)
A. Risk factors In the case of offset, merchandise returned, price reductions, accounts receivables are diluted and cash flows decrease. And if an obligor offsets its accounts receivables with claims against an assignor (originator) to perfect against the assignment of the underlying assets (assignment of the claims), cash flows from the accounts receivables decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Amount of counterclaims
85/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Originator’s business industry and transactional form
B. Principal risk countermeasures and perspectives for evaluation
1. Countermeasure by making the originator pay on behalf of the obligor or buy back receivables If any dilution arises, the originator is made to pay on behalf of the obligor or buy back the relevant receivables. An evaluation is performed from the perspective of whether or not such advance payment or buyback is effective and on the basis of the originator’s creditworthiness.
2. Senior/subordinated structure To provide for the risk that cash flows decrease due to any dilution arising in the underlying assets, the amount of decrease as a result of the dilution is secured as the subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
3. Risk countermeasure by means of cash reserve To provide for the risk that cash flows decrease due to any dilution arising in the underlying assets, the amount of dilution is estimated and then countermeasures including establishment of cash reserve are taken. An evaluation is performed from the perspective of whether or not the cash reserve is adequate.
4. Indication of the obligors’ waiver on their rights of defense through setoff against the assignment of the claims
If an obligor indicates waiver of its rights of defense through setoff against the assignment of the claims, the possibility of the obligor’s being protected against the assignee through offset upon and after such indication will, in principle, be removed. An evaluation is performed from the perspectives of the validity of obligors’ indication of waiver of defenses for the assignment of claims through setoff, as well as the timing of such indication.
5. Perfection against obligors An originator as assignor notifies the obligors of the assignment of claims, or the obligors accept (consent on the assignment is obtained from the obligors), to perfect against the obligors. However, please take note that the rights of defense against the assignment of claims would not necessarily be cut off completely only through perfection against the obligors.
86/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
An evaluation is performed from the perspective of sufficient actions taken for perfection against the obligors and responses to setoff risk (the amount of claims against the originator against which the obligors can be protected against an assignee through setoff (if any) and the sufficiency of measures against it, using the timing of perfection against the obligors being obtained as a reference point). .
87/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 9: Bonds
Section 1: Basic issues
I. Cause for creation Bonds are issued pursuant to bond issuance procedures to finance, broadly from the market, the funds that issuers (or obligors) need for conducting their businesses. By issuer type, bonds are classified into government bonds issued by the national government, municipal bonds issued by the local governments, and corporate bonds issued by business corporations and financial institutions. By type of offering for subscription, bonds are classified into publicly offered bonds and privately placed bonds. Publicly offered bonds are offered broadly to an unspecified number of investors in general and mean those bonds subject to “Public Offering” as prescribed in the Financial Instruments and Exchange Act. Privately placed bonds mean those bonds that fall outside the purview of publicly offered bonds. For example, privately placed bonds are issued as initiatives of small- and medium-sized enterprises (SMEs) to diversify means of financing for which their main banks act as underwriters. In the cases of SF Products backed by bonds, there are basically two types as to the number of obligor: the singular-obligor type (such as a repackaged bond) and the multiple-obligor type (such as a CBO). The singular-obligor type entails transactions involving the obligor’s credit risk, whereas the multiple-obligor type entails transactions involving losses that may arise in the portfolio (obligors’ credit risk, and correlation risk associated with defaults occurring between obligors).
II. Transfer method Generally, bonds are transferred by transferring their ownership based on their movable characteristics, and their perfection requirements are fulfilled on the basis of constructive transfer with retention of possession. Transfer of ownership of bonds is typically prescribed under each country’s legal system. In Japan, the Act on Book-Entry Transfer of Corporate Bonds, etc. (currently the “Act on Book-Entry Transfer of Corporate Bonds, Shares, etc.”) was established to put the dematerialization of corporate bonds into place. The corporate bonds to which this Act is applicable are referred to as book-entry transfer corporate bonds. Assignment of book-entry transfer corporate bonds take effect as their assignee files an application for their book-entry transfer to its account (or the account managed by an account management institution or a book-entry transfer institution) and causes an increase or decrease in the face value of such bonds to be stated or recorded.
88/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Management method Management of bonds comprises bond custodial services and principal/interest-receiving services. For example, ownership of book-entry transfer corporate bonds is managed through an account management institution or a book-entry transfer institution. The account management institution manages book-entry transfer corporate bonds by stating or recording the balance held by bondholders in its customer account book and by registering the portion it holds and the portion held by its customers with a superior account management institution or book-entry transfer institution. Payments of principal/interest on book-entry transfer corporate bonds are made as the account management institution remits the necessary funds to accounts specified by customers after receiving payments of principal/interest on such bonds from a superior account management institution or a book-entry transfer institution. If book-entry transfer corporate bonds issued outside of the areas in which bondholders are located, custodial services may be utilized.
IV. Characteristics of cash flow Generally, cash flows from bonds have the following characteristic features: Expected cash flows are typically lump-sum redemptions. Expected cash flows comprise the amounts of periodic (e.g., semi-annual, quarterly) interest and principal as of the expected redemption date. Basically, there are two types of coupon: variable (such as LIBOR + α) and fixed. Some bonds are accompanied by a special provision (subordination provision) to the effect that, in the event of the obligor’s default, repayment on the bonds is subordinated to that on other debt obligations of the obligor. Some corporate bonds are accompanied by a bondholder’s right to convert them into shares of the obligor (corporate bonds with warrants). If such bonds are converted into shares, payments on bond principal/interest are discontinued. Some bonds are accompanied by an option whereby the obligor may redeem them early. If such an option is exercised, the bonds in question are typically redeemed early at a certain predetermined price. Some bonds are accompanied by an option whereby bondholders may demand early redemption. If such an option is exercised, the bonds in question are typically be redeemed early by a certain predetermined amount.
89/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Obligor’s default risk
A. Risk factors If the obligor becomes insolvent, the principal of and interest on the bonds decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Obligor’s creditworthiness Obligor’s location Obligor’s business industry
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure The magnitude of a loss arising in a bond portfolio from the obligor’s default is evaluated taking into account the obligor’s creditworthiness and degree of diversification of region and business industry. An evaluation is performed from the perspective of whether or not the amount of credit enhancement against the loss is adequate.
2. If the senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed on the basis of the obligor’s creditworthiness.
II. Risk associated with recovery from defaulted bonds
A. Risk factors If any bond falls into default, and if recovery from the defaulted bond can be structurally expected as a cash flow, the uncertainty over the amount recovered constitutes a risk factor. A bond default dictates the occurrence of a loss, but it is the amount recovered from the defaulted bond that dictates the ultimate amount of loss. The level of the amount recovered from the defaulted bond is typically influenced by the following factors: Presence or otherwise of collateral Status of the bond such as subordination or non-subordination Obligor’s location (which determines the applicable bankruptcy legal system) Obligor’s business industry
90/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
B. Principal risk countermeasures and perspectives for evaluation
1. If the underlying assets are in the form of a bond portfolio In the cases of secured bonds, recovery from collateral is evaluated. In the cases of unsecured bonds, the amount of recovery from the defaulted bond is evaluated by taking into account the status of the bond, the bankruptcy legal system applicable to the bond, the obligor’s business industry, etc. An evaluation is performed from the perspective of whether or not the amount of credit enhancement against the loss is adequate by working the recovery amount into the loss from the default.
2. If there is only one obligor The magnitude of recovery risk is evaluated on the basis of the presence or otherwise of collateral and of the status of the bonds in question, and is worked into the rating symbol of the rated product as needed.
III. Bonds’ price fluctuation risk
A. Risk factors If bonds are sold before the expected redemption date, the sale proceeds may be less than the face value of and the amount equivalent to the accrued interest on the bonds. Price fluctuation risk is typically influenced by the following factors: Liquidity of the bonds Creditworthiness of the bonds Duration of the bonds Market interest rates
B. Principal risk countermeasures and perspectives for evaluation The structure for not selling bonds during the term is typically in place to prevent the bonds’ price fluctuation risk from arising. An evaluation is performed on the fact that such a structure is prescribed properly in the agreement. If the case for disposition of the bond is limited, the magnitude of price fluctuations in such a limited situation is evaluated taking into account liquidity, creditworthiness, and duration of bonds, and market interest rates.
91/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Early redemption risk (exercise of option by obligor or bondholder or retirement by purchase)
A. Risk factors If the obligor or the bond holder exercises an option that makes it possible to redeem the bonds prior to the expected redemption date or if the obligor retires the bonds by purchasing them, expected cash flows from the underlying assets decrease depending on the terms of early redemption or purchase price. A judgment as to whether or not such an option should be exercised or such retirement by purchase should be made depends on the obligor’s financing plan/policy, market environment, etc.
B. Principal risk countermeasures and perspectives for evaluation
1. If the underlying assets are in the form of a bond portfolio The amount of decrease in principal and interest stipulated in a contract for early redemption is checked. If any loss of principal is expected to arise from early redemption, an evaluation is performed as to whether or not a reasonable amount of credit enhancement is in place. If no loss of principal is expected to arise and only a decrease in future interest is expected to arise, an evaluation is performed as to whether or not the burden of interest payment is properly managed by means of a structure whereby the rated product is redeemed by a pass-through in the wake of early redemption.
2. If there is only one obligor Basically, evaluation is performed as to whether or not the principal of and interest on the rated product can be adequately covered by the principal and interest received on early redemption. If the principal of and interest on the rated product cannot be adequately covered, an evaluation is performed as to whether or not the risk is properly hedged by a swap transaction, etc. An evaluation is performed as to whether or not provisions such as exercise of an option by SPV as bondholder or whether SPV should accept retirement by purchase are properly stipulated in the agreement so that no loss arises in the rated product under the contract.
92/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 10: Derivative transactions (credit default swap, etc.)
SF Products include bonds, etc., formed by combining repackaged bonds with a relatively high level of creditworthiness and derivative transactions. Such derivative products are offered for the purpose of providing investors with opportunities to invest through derivative transactions in interest rate risk, exchange risk, credit risk, etc. (“Derivative Products”). This Subchapter is devoted to a discussion of derivative transactions that are incorporated into Derivative Products.
Section 1: Basic issues
I. Cause for creation A derivative transaction is a transaction in which the price is determined on the basis of certain other basic variables (such as variables of underlying assets). If an SPV issues a Derivative Product (rated product), the cash flows of the rated product generally do not come in line with those of the underlying assets of the Derivative Product. To create cash flows for a rated product, the cash flows of the rated product’s underlying assets must be converted into cash flows for the rated product. For the purpose of this cash flow conversion, multiple derivative transactions are created when forming the rated product. Repo transactions, which are capable of generating similar economic effects, are also considered to be part of derivative transactions. A credit derivative is used for taking credit risk by means of a Derivative Product. A typical credit derivative is the credit default swap (“CDS”) contract, which addresses the credit risk of a reference entity. Under a CDS contract, the purchaser of the protection pays the seller of the protection a risk premium on the credit risk of a reference entity. If any credit event occurs to the reference entity during the credit event observation period, the seller of the protection pays the purchaser of the protection an amount equivalent to the loss caused by the credit event of the reference entity pursuant to the predetermined settlement procedure (physical settlement, cash settlement or auction settlement). CDS contracts are classified broadly into single-name type and portfolio type. The single-name type CDS is a transaction covering a singular reference entity, while the portfolio type CDS is a transaction dealing with a loss arising in a reference portfolio comprising multiple reference entities (or credit risk of reference entities and correlation risk associated with a default between reference entities). In terms of transactional forms, the portfolio-type CDS is classified into first-to-default type, which addresses the first occurrence of credit risk, and the CDO type addresses losses that exceed the “deductible” established in the reference portfolio. There are products that include the economic effects of a credit derivative by attaching a credit event provision to bonds issued from the MTN program of a financial institution or loans for financial
93/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
institutions.
II. Transfer method No transfer takes place since a new derivative transaction is initiated. With respect to the reference entity’s risk transfer undertaken by a credit derivative, it is customary to use model agreements and CDS definitions developed by International Swaps and Derivatives Association, Inc. (ISDA). Credit risk associated with the reference entity is transferred by concluding a CDS agreement, but the claims per se are not transferred.
III. Management method Generally, an SPV manages delivery of funds related to a derivative transaction by giving instructions to the collateral bond’s custodian, counterparty, and rated product’s payment agent on remittances among them without opening a deposit account for fund settlement. During the term, the accounting agent (normally the counterparty) calculates payment amounts and gives notices of payment amounts to contracting parties. Variable payments under a CDS agreement represent payments from the seller of the protection to the purchaser of the protection in the event that a credit event occurs to the reference entity, and the relevant payment occurs after the presence or otherwise of a credit event is recognized by ISDA’s Credit Derivatives Determinations Committee or by a credit event notice (where publicly available information from designated information sources is often demanded). Administrative procedures vary depending on settlement method (physical settlement, cash settlement, or auction settlement).
IV. Characteristics of cash flow Generally, cash flows from derivative transactions have the following characteristic features: A derivative transaction is a transaction of mutual payments between two parties. In a derivative transaction, both parties act as creditor and obligor. A derivative transaction is an equivalent transaction at the time a contract is concluded but, during the term, the market environment causes one party to generate a valuation gain and the other party to incur a valuation loss. The valuation loss is referred to as the replacement cost because it is the cost of concluding, at that time point, a new derivative transaction that generates economic effects comparable to those of the previous derivative transaction. There are transactions with an option to terminate the derivative transaction early. If terminating a derivative transaction early, the party incurring a valuation loss at market value pays the replacement cost to the other party.
94/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
There are transactions with an option to allow the counterparty to replace bonds constituting the underlying assets for the derivative transaction. In addition to risks associated with the bonds being repackaged, derivative transactions make it possible to additionally include interest rate risk, exchange risk, credit risk, etc., in the repackaged products. Under a CDS contract, the credit risk of the reference entity is transacted, but it is not necessary to hold any physical assets related to the reference entity. Under portfolio-type CDS contracts, there are transactions with an option to replace the reference entity.
Section 2: Analysis of credit risk factors
I. Counterparty’s default risk
A. Risk factors If the counterparty defaults, the derivative contract is terminated early, in which case the SPV must redeem the rated product early by selling the collateral bonds in the market. If, at the time of early termination of the derivative transaction, the SPV bears any payment obligations to the counterparty or if the market value of collateral bonds falls, the amount of early redemption of the rated product may be less than the amount of the principal and the amount equivalent to the accrued interest.
B. Principal risk countermeasures and perspectives for evaluation In the absence of any other special measure, risk is evaluated on the basis of the creditworthiness of the counterparty or the swap guarantor. If measures are taken to prevent the derivative transaction from being terminated early due to a cause attributable to the counterparty or to cover the amount of early redemption of the rated product with the face value of the bonds and the amount equivalent to the accrued interest, even if the counterparty defaults, the appropriateness of such measures is evaluated and it is possible to assign a higher credit rating to the rated product than that of the counterparty.
II. Early termination by exercise of option
A. Risk factors If either party terminates a derivative transaction early by exercising the termination option prior to the expected termination date, the face value of the rated product and the amount equivalent to the accrued interest may not be fully secured depending on the termination
95/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
method. Exercising the option depends on the market environment (such as market interest rate and interest rate spread).
B. Principal risk countermeasures and perspectives for evaluation
1. Adjusting termination method In the case of a contract in which the transaction is terminated early by exchanging the face value of the collateral bond and the amount equivalent to the accrued interest with the (physical) bonds, an evaluation is performed on the basis of the counterparty’s creditworthiness. If the transaction is to be terminated early by a method whereby the price fluctuation risk of the bonds and the swap is not hedged, a credit rating cannot, in principle, be assigned. An evaluation is performed from the perspective of the influences the termination method may have on principal/interest payments on the rated product.
III. Reference entity’s default risk
A. Risk factors If a credit event occurs with the reference entity during the credit event observation period, the SPV pays the counterparty an amount equivalent to the loss caused by the reference entity’s credit event pursuant to the predetermined settlement procedure (physical settlement, cash settlement or auction settlement). The level and fluctuations of the loss caused by the occurrence of the event are typically influenced by the following factors: Reference entity’s creditworthiness Reference entity’s location Reference entity’s business industry Definition of credit event
B. Principal risk countermeasures and perspectives for evaluation
1. In the case of the portfolio type The magnitude of a loss caused in the reference portfolio by the reference entity’s default is evaluated taking into account the obligor’s creditworthiness, degree of diversification of location and business industry, and definition of credit event, and adequacy of the amount of credit enhancement against the loss is checked.
2. In the case of the single-name type A credit rating is evaluated by understanding risk as the reference entity’s creditworthiness.
96/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Amount of loss caused by credit event
A. Risk factors The amount of a loss caused by the reference entity with which a credit event has occurred varies depending on the reference entity’s delivery obligations (in the case of physical settlement) or on the obligation to obtain the price (in the case of cash settlement or auction settlement). Fluctuations of loss amount due to differences in the attributes of the status of the obligation represent a risk factor. A credit event dictates the occurrence of a loss, but the reference entity’s loss amount ultimately dictates the loss amount. The level of loss amount is typically influenced by the following factors: Status of obligations to be settled Reference entity’s location (which determine the applicable bankruptcy legal system) Reference entity’s business industry Settlement method after occurrence of a credit event
B. Principal risk countermeasures and perspectives for evaluation
1. In the case of the portfolio type The amount of a loss is evaluated by taking into account the status of debt obligations to be settled, bankruptcy legal system applicable to the reference entity, reference entity’s business industry, settlement method after occurrence of credit event, etc. An evaluation is performed by checking the adequacy of the amount of credit enhancement against the loss.
2. In the case of the single-name type The magnitude of recovery risk is evaluated on the basis of the status of debt obligations to be settled, and is worked into the credit rating of the rated product as needed.
V. Reference entity replacement option (managed type)
A. Risk factors A situation may arise where the investment manager enormously reduces the quality of the reference portfolio by replacing, incorporating, or excluding the reference entity.
B. Principal risk countermeasures and perspectives for evaluation The investment manager sets the investment criteria with a view to maintaining and enhancing the credit standing of the reference portfolio. The investment criteria are mainly made up of rating criteria, diversification criteria, and criteria on issue replacements and investment. However, the investment criteria vary depending on the severalty of the schemes
97/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
(defensive type/active type). For the purpose of evaluating the presence or otherwise of the abovementioned risk, the contents of the investment criteria, the investment manager’s ability, and the high likelihood of compliance with investment criteria are checked.
VI. Risk of dispute over derivative contract
A. Risk factors Depending on the bankruptcy legal system applicable to the counterparty, a dispute over rights may arise, and early termination of a derivative contract may be delayed.
B. Principal risk countermeasures and perspectives for evaluation If the counterparty to a derivative contract falls into bankruptcy, the derivative contract is terminated early. However, the counterparty typically concludes a large number of derivative contracts with various parties. For this reason, the derivative contract may not be terminated immediately after the counterparty’s bankruptcy (and systematic risk may become obvious). In such a case, early termination of the rated product is delayed. In the course of performing an evaluation for a credit rating, the possibility that the principal of the rated product and the accrued interest up to the time point of the counterparty’s bankruptcy will be ultimately paid is evaluated. This evaluation has no bearing on whether or not a measure to reduce counterparty risk has been taken (and timely payment is outside the scope of evaluation). However, if a measure to reduce counterparty risk has been taken at the time of the counterparty’s bankruptcy to cover the principal of and accrued interest on the rated product up to the time point of the counterparty’s bankruptcy, it is necessary to confirm the validity of such a measure on the strength of written legal opinions. Although these written legal opinions are subject to the influences of future judicial precedents, law amendments, changes in legal interpretations, etc., credit rating judgments are not be limited by the counterparty’s credit rating if the probability of such influences is considered to be low.
98/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 11: Other monetary receivables (including trust beneficial interest)
Section 1: Basic issues
I. Cause for creation Other monetary receivables are created as the right of claim for money is acquired for some reason or other.
II. Transfer method Normally, other monetary receivables are assigned under an assignment contract. The transfer method varies depending on the legal form of the receivable, but measures are generally fulfilled perfection requirements against the obligor and third parties.
III. Management method Monetary receivables are assigned to an SPV, and their administration is typically re-entrusted to the assigner.
IV. Characteristics of cash flow Characteristics of cash flows from other monetary receivables are based on those from monetary receivables.
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors There is a risk that obligors will become insolvent and are typically influenced by the following factor: Creditworthiness of other monetary receivables
B. Principal risk countermeasures and perspectives for evaluation
1. If senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed on the basis of the obligors’ creditworthiness.
2. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default on other monetary
99/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
receivables, the subordinated portion is provided. An evaluation is performed from the perspective of whether or not the credit enhancement provided by the subordinated portion is adequate.
100/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 12: Real estate (real estate-backed trust beneficial interest)
Section 1: Basic issues
I. Cause for creation Real estate is specified by registration of description, and ownership and other rights are perfected against third parties by registration of rights. Real estate-backed trust beneficial interest is created as the right to receive profits arising from property rights when property rights in real estate have been assigned to a trustee in accordance with a trust agreement.
II. Transfer method Generally, real estate is transferred from an originator to an SPV through a sale. In the case of ownership rights, perfection against third parties is achieved by registration of rights. In the case of real estate-backed trust beneficial interest, perfection against third parties and obligors is achieved by written consent with a certified date from the trustee.
III. Management method Generally, a real estate owner outsources operations, including building and facilities maintenance, tenant-related activities (advertising for new tenants and management of existing tenants) and reporting, to an outside professional.
IV. Characteristics of cash flow Cash flows generated from real estate have the following main characteristic features: Expected cash flows can be broadly classified into cash flow from real estate leasing and cash flow from real estate sale. Cash flow from real estate leasing is primarily the rental income generated based on the tenant lease agreement. Rental income may be suspended or changed due to the termination or revision of the lease agreement, but such risk can be mitigated by the stability of the lease agreement, diversification of the tenant base, and competitiveness of the property, among other factors. Cash flow is also affected by changes in maintenance and management costs, among others, given that cash flow is rental income less such costs. Cash flow from real estate sale is primarily the sale proceeds received from the buyer. Real estate assets have the characteristic features of i) strong individuality, ii) large transaction sizes, and iii) diverse range of risks. Hence, compared to stocks and other financial products, the liquidity of real estate assets is low. It therefore generally takes time for a
101/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
transaction to close following the decision to sell a property.
Section 2: Analysis of credit risk factors
I. Fluctuation risk associated with cash flow from real estate leasing
A. Risk factors Cash flow may decrease if vacancy rates rise, rent levels decline, or operating expenses increase, causing a shortfall in funds for interest payments and scheduled principal payments during the transaction period. The degree of decrease in cash flow is mainly influenced by the following factors: Weak tenant demand due to sluggish economic conditions, etc. Decline in property competitiveness due to greater competition, aging degradation, etc. Occurrence of accidents and disasters, and materialization of environmental risks.
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/ subordinated structure The certainty of payments on the senior portion can be enhanced by establishing a senior/ subordinated structure regarding the hierarchy of payments involving cash flows from leasing operations. An evaluation is performed from the perspective of the appropriateness of the hierarchy of payments and the level of cushion against decreases in cash flow.
2. Cash reserve, etc. An amount equivalent to the interest and principal payments and the expenses required to maintain the transaction scheme for a specific period is secured by a cash reserve, etc.. An evaluation is performed from the perspective of the adequacy of the level of cash reserve, etc.
3. Insurance coverage As countermeasures against earthquake risk, earthquake insurance coverage and the securing of a cash reserve, among other measures, are considered when the PML exceeds a certain level based on expert evaluation. Risks of fire disasters and damage compensation are generally covered by fire and liability insurance. An evaluation is performed from the perspective of the adequacy of the insurance coverage and other measures.
102/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
II. Fluctuation risk associated with market value
A. Risk factors Funds for principal repayments may run short or refinancing activities may prove unsuccessful if the market value of the underlying real estate declines, and thus cash flow from real estate sale decreases. The degree of market value decline is mainly influenced by the following factors: Deterioration of the real estate sale/purchase market conditions Deterioration of the financial environment Upturn in the yield demanded by investors Significant decrease in cash flow from leasing operations
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure The certainty of principal repayment on the senior portion can be enhanced by establishing a subordinated portion to respond to the risk of a decline in market value. An evaluation is performed from the perspective of the adequacy of the level of credit enhancement provided by the subordinated portion.
2. Assignment of right to control the real estate sale to the lender The certainty of principal repayment can be enhanced by establishing in advance a structure that assigns the lender the right to control the real estate sale following a certain event such as the scheduled repayment date. An evaluation is performed from the perspective of the effectiveness of the structure.
3. Structure pertaining to refinancing activities
The certainty of refinance can be enhanced by establishing in advance a structure for the borrower to execute and report refinancing activities as a countermeasure against refinance risk. An evaluation is performed from the perspective of the effectiveness of the structure.
103/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 13: Real estate non-recourse loans
Section 1: Basic issues
I. Cause for creation Real estate non-recourse loans limit the source of repayment to cash flows generated by a specified real estate. Generally, such loans are executed under a loan contract between an SPV, whose purpose is to hold real estate or real estate-backed trust beneficial interest, and a financial institution. This Subchapter also applies to specified bonds which are backed by real estate or real estate-backed trust beneficial interests and issued under the Act on Securitization of Assets.
II. Transfer method In the case of a corporate-type SPV, loan receivables are transferred under a sale and purchase agreement. In the case where the SPV is a trust, loan receivables are entrusted under a trust agreement. The transfer is perfected against third parties and obligors by written consent with a certified date from the borrower.
III. Management method Servicing of non-recourse loans transferred to an SPV is typically outsourced to the lender (originator) or a specialized servicer. Special servicing of defaulted loans is often outsourced to a special servicer.
IV. Characteristics of cash flow Cash flows generated from real estate non-recourse loans have the following main characteristic features: Expected cash flow comprises interest and principal paid by the borrower. Many transactions do not make scheduled principal payments during the transaction period, and even if such payments are made, the amount would represent a very small proportion of the total principal amount. In general, interest and principal are paid with cash flows generated through leasing operations. Final repayment of principal is performed using funds procured through the sale of the underlying real estate or refinancing. Principal may be repaid in full before the scheduled repayment date. In the case where a loan extension period (tail period) is provided, the structure often allows for the suspension of dividend payments to equity investors and for the retained
104/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
funds to be used to repay principal. The interest spread usually steps up during the extension period. Interest and principal payments for the tail period are subject to delinquency penalty charges. A senior/subordinated structure is established against equity and subordinated loans regarding interest and principal payments.
Section 2: Analysis of credit risk factors
I. Fluctuation risk of principal recovery amount
A. Risk factors The amount of principal recovery decreases when the sale price of the underlying real estate falls below initial projections. The level of decrease in cash flow is mainly influenced by the following factors: Deterioration of real estate sale and purchase market conditions Deterioration of the financial environment Significant decrease in cash flows generated through leasing operations.
B. Principal risk countermeasures and perspectives for evaluation
1. Countermeasures against fluctuation risk associated with market value of underlying real estate Please refer to “II. Fluctuation risk associated with market value”, Section 2, Subchapter 12.
2. Senior/subordinated structure In the case of SF products that are backed by real estate non-recourse loans, a subordinated portion is established as cushion against a potential decrease in principal recovery amount. An evaluation is performed from the perspective of the adequacy of credit enhancement provided by the subordinated portion.
3. Principal recovery A structure is established to enhance the probability of principal recovery on the loan, such as the outsourcing of servicing to a servicer with strong track record. An evaluation is performed from the perspective of the effectiveness of the structure.
105/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 14: Development-type real estate
Section 1: Basic issues
I. Cause for creation Development-type real estate discussed in this Subchapter refers to land that is subject to development and the building to be constructed. Real estate is specified by registration of description, and ownership and other rights are perfected against third parties by registration of rights. The registration of description and registration of preservation of ownership rights regarding the building is achieved following its completion. Real estate-backed trust beneficial interest is created as the right to receive profits arising from property rights when property rights in real estate have been assigned to a trustee in accordance with a trust agreement.
II. Transfer method Generally, real estate is transferred from an originator to an SPV through a sale. In the case of real estate ownership rights, perfection against third parties is achieved by registration of rights. In the case of real estate-backed trust beneficial interest, perfection against third parties and obligors are achieved by written consent with a certified date from the trustee.
III. Management method Generally, an SPV outsources development operations, such as cost/ schedule management and negotiations with contractors of construction work, to a real estate developer.
IV. Characteristics of cash flow Cash flows from development-type real estate have the following main characteristic features: Rental income is not generated until the construction of the building is completed and the building is occupied by tenants. Additional expenses may be incurred as a result of changes in building design, occurrence of accidents and natural disasters, etc. Cash flows prior to completion of the building are covered by cash reserves and additional capital contributions made during the transaction period, among other sources. Please refer to Section 1 IV., Subchapter 12 (Real Estate) for cash flow characteristics pertaining to real estate after completion.
106/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Pre-development risk
A. Risk factors The planned construction work may not be launched as scheduled. Pre-development risk is mainly influenced by the following factors: Acquisition of administrative permits and approvals Negotiations with landowners, neighborhood residents, etc. Treatment of environmental issues such as soil contamination
B. Principal risk countermeasures and perspectives for evaluation An entity that will bear the risk and take measures to resolve issues when such risk materializes is appointed. This entity is typically the developer, or any other entity that is involved in the project as the development business operator or equity investor. An evaluation is performed based on the creditworthiness of the entity that bears the risk.
II. Construction project completion risk
A. Risk factors The planned construction work may be delayed of suspended. Construction project completion risk is mainly influenced by the following factors: Changes in building design, specifications, etc. Occurrence of accidents or natural disasters Bankruptcy of construction work contractor and breach of the construction work contract agreement Bankruptcy of development business operator and breach of the development business contract agreement
B. Principal risk countermeasures and perspectives for evaluation
1. Clarification of bearer of risk An entity that will bear the risk and take measures to resolve issues when such risk materializes is appointed. The entity is typically the construction work contractor, acting under the construction work contract agreement. In some cases, the risk may be taken on together or shared with the development business operator. An evaluation is performed based on the creditworthiness of the entities that bear the risk.
107/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
2. Credit enhancement
Credit enhancement to mitigate the risk of default of the bearers of risk is achieved through back-up agreements, performance guarantee insurance and construction completion guarantees, among other measures.
An evaluation is performed from the perspective of the effectiveness and adequacy of credit enhancement measures.
3. Cash reserves
Cash reserves and cash advancement lines are provided to cover for cost overruns.
An evaluation is performed from the perspective of the adequacy of cash reserves.
Please refer to Section 2, Subchapter 12 (Real Estate) regarding the treatment of risks following the completion of the building. It is important to note, however, that new buildings lack historical track record. Hence, the risk of cash flows deviating from initial expectations is relatively high for new buildings when compared with real estate that are already in operation.
108/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 15: Security deposit receivables
Section 1: Basic issues
I. Cause for creation Generally, security deposit receivables are created when the real estate’s lessee deposits money under a lease contract concluded with the lessor. The money so deposited is referred to as a guarantee deposit (shiki kin), security deposit (hoshou kin), construction cooperation money (kensetsu kyouryoku kin), etc.; but, regardless of its name, its legal characteristics are prescribed in each lease contract. A guarantee deposit has the characteristics of collateral for damages that may be caused by delinquency in rent payment or any other non-performance of contractual obligations, and would, in the absence of non-performance on the part of the lessee as of the time of expiration of the lease contract, be returned to the lessee at the time of the lessee’s departure from the real estate. Hence, it has the nature of temporarily entrusted money. A guarantee deposit is generally not considered to fall within the scope of this Subchapter because it is closely linked to the lease contract and independent transfer of the right of claim for the return of a guarantee deposit is often restricted by a special provision. As the legal positioning of security deposits and construction cooperation money (“security deposit, etc.”) varies from one case to another, if the right to claim the return of a security deposit, etc. (“security deposit receivables”) is to be treated as an underlying asset, it is necessary to assess the characteristics of the security deposit, etc., with respect to each and every lease contract, and confirm any provision that is intended to protect the rights of the creditor (lessee). Generally, if a loan contract is concluded separately or if the lease contract contains a provision similar to that contained in a loan contract, then money deposited by the lessee is considered to have financial characteristics and legally to be loaned money.
II. Transfer method Security deposit receivables on security deposit, etc., if deemed to be loaned money, are considered to be independently transferable, depending on the contents of the loan contract concerned. As in the cases of corporate loan receivables, the right to claim the return of a security deposit, etc., is transferred pursuant to an assignment contract or a trust contract.
III. Management method Security deposit receivables are managed by creditors pursuant to the respective real estate lease contracts or loan contracts.
109/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Characteristics of cash flow Generally, cash flows from security deposit receivables have the following characteristics: Principal amounts, interest amounts, repayment methods, etc., are prescribed in the respective real estate lease contracts or loan contracts. Security deposit receivables are often kept without paying interest for a specific period, and are thereafter repaid in equal principals without paying interest or with a specific amount of interest.
Section 2: Analysis of credit risk factors
I. Default risk of obligors of security deposit receivables
A. Risk factors If any obligor of security deposit receivables becomes insolvent, the amount of principal on security deposit receivables collected decreases. The level of decrease and fluctuations of the principal are typically influenced by the following factors: Obligors’ creditworthiness Number of obligors, attributes (individual/corporate), past default records, etc. Guarantor’s creditworthiness if security deposit receivables are guaranteed by the originator or a third party
B. Principal risk countermeasures and perspectives for evaluation
1. If the senior/subordinated structure is not in place (obligors’ default risk) An evaluation is performed with respect to the creditworthiness of obligors or guarantors of security deposit receivables.
II. Cash flow mismatch
A. Risk factors Funds for interest payments on a rated product may run short due to the absence or small amount of interest income from security deposit receivables during the term.
B. Principal risk countermeasures and perspectives for evaluation
1. Discount of principal The source of funds for interest payment on the rated product is secured by allocating the principal portion of security deposit receivables to the principal of and the interest on the rated product.
110/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
An evaluation is performed from the perspective of whether or not the contents of the contract prescribing the allocation of the principal portion of security deposit receivables to the principal of and the interest on the rated product are appropriate.
2. Cash reserve The sources of funds for interest payments on the rated product are provided by cash reserves, etc. An evaluation is performed from the perspective of whether or not cash reserves, etc. are adequate.
111/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 16: Guaranteed receivables
Section 1: Basic issues
I. Cause for creation Guaranteed receivables are created as receivables between obligors and creditors, and guarantors guarantee such receivables.
II. Transfer method The originator assigns guaranteed receivables to the assignee under an assignment contract. If receivables (as principal right) are transferred to another party, guarantees (as secondary right) are also transferred. Please refer to the subsection entitled “Transfer method” under the Subchapter for each type of receivable.
III. Management method Receivables are collected by the interested party entrusted to perform collection services. If debt obligations are performed, no guarantee is performed by guarantors. If an obligor becomes insolvent due to legal bankruptcy and the relevant receivables fall into default, the interested party requests the guarantor to perform its guarantee. The guarantor, if so requested, performs its guarantee prescribed in the guarantee contract in the manner prescribed therein.
IV. Characteristics of cash flow Generally, cash flows from guaranteed receivables have the following characteristics: If the receivables are performed, payments are made as promised. If the receivables are not performed, the guarantee amount specified in the guarantee contract is performed within the period specified therein. Generally, the guarantee takes the form of joint and several guarantees without any right of defense (such as defense of demand or defense of debtor's solvency). Caution must be exercised if the guarantee to which the receivables are attached is a guarantee with the right of defense of demand or the right of defense of obligor’s solvency.
112/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Guaranteed receivables’ individual risk
A. Risk factors There are various types of guaranteed receivable. As risk varies according to the type of a guaranteed receivable, it is necessary to specify the type of guaranteed receivable. Please refer to “A. Risk factors” under the Subchapter for each type of receivable.
B. Principal risk countermeasures and perspectives for evaluation Please refer to “B. Principal risk countermeasures and perspectives for evaluation” under the Subchapter for each type of receivable as they vary according to type of receivable.
II. Guarantor’s default risk
A. Risk factors If any guarantor defaults, the risk that the guarantee will not be performed arises despite the receivables falling into default. The risk that the guarantee will not be performed is typically influenced by the following factor: Guarantor’s creditworthiness
B. Principal risk countermeasures and perspectives for evaluation
1. Guarantor’s default risk An evaluation is performed on the basis of the guarantor’s creditworthiness.
2. Senior/subordinated structure To provide for the risk that any of the guarantees provided by multiple guarantors will not be performed due to a particular guarantor’s default, the amount that decreases as a result of such a guarantor’s default is provided as a subordinated portion. An evaluation is performed from the perspective of whether or not the credit enhancement provided by the subordinated portion is adequate.
113/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Risk that guarantee will not be performed
A. Risk factors If there are a number of requirements that the holder of rights (typically creditor) must fulfill to demand that the guarantor performs the guarantee under, or escape clauses in, the guarantee contract, the risk that the guarantee is not performed arises despite the receivables falling into default. The risk that a guarantee will not be performed is typically influenced by the following factor: Contents of guarantee contract
B. Principal risk countermeasures and perspectives for evaluation
1. Cause guarantor to provide a guarantee in the form of joint and several guarantee To provide for the risk that a guarantee is not performed and cash flows decrease, the guarantor is required to provide a joint and several guarantee. By providing a joint and several guarantee, the guarantor does not hold the right of defense of demand or the right of defense of obligor’s solvency; therefore, the certainty that the guarantee is performed can be enhanced. An evaluation is performed from the perspective of whether or not the joint and several guarantee is effective.
2. Restrict requirements necessary for demanding guarantee performance and escape clauses, and establish a senior/subordinated structure To ensure that a guarantee is performed readily, requirements necessary for demanding performance of the guarantee and escape clauses are restricted. In addition, to provide for the risk that the guarantee is not performed, the amount that is reduced as a result of non-performance of a guarantee is provided as a subordinated portion. An evaluation is performed from the perspective of whether or not the credit enhancement provided by the subordinated portion is adequate.
3. Restrict requirements necessary for demanding performance of guarantee and escape clauses, and deal with risk by means of cash reserve, etc. To ensure that the guarantee is performed readily, requirements necessary for demanding performance of the guarantee and escape clauses are restricted. In addition, to provide for the risk that the guarantee is not performed, the amount for which the guarantee is not performed should be estimated, and a cash reserve, etc., should be established. An evaluation is performed from the perspective of whether or not the cash reserve, etc., is adequate.
114/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Timing for performance of guarantee
A. Risk factors If the timing for performing a guarantee extends beyond the due date for the receivables, cash flows as of the expected collection date decrease. The level of decrease and fluctuations of cash flows are typically influenced by the following factor: Procedures for performance of guarantee
B. Principal risk countermeasures and perspectives for evaluation
1. Set the redemption timing of a SF Product to match the timing of the performance of a guarantee To provide for any delay in the performance of a guarantee, an SF Product is structured so that the timing of repayment/redemption of the principal of the SF Product matches the timing for performing the guarantee. Negative impacts of a delay in cash flow generation are reduced by having the timing of repayment/redemption of the principal of SF Product match the timing for performing the guarantee. An evaluation is performed from the perspective of whether or not performance of the guarantee is adequate.
2. Establish cash reserve as liquidity enhancement To provide for any delay in collection as a result of performance of a guarantee, a cash reserve is established. An evaluation is performed from the perspective of whether or not the cash reserve is adequate.
3. Appoint liquidity enhancement provider To provide for any delay in collection as a result of the performance of a guarantee, a liquidity enhancement provider is appointed. An evaluation is performed from the perspective of whether or not liquidity enhancement is provided in a timely manner.
115/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 17: Medical fee receivables/Dispensing fee receivables
Section 1: Basic issues
I. Cause for creation Medical fees are the consideration for clinical examinations and treatments performed by a medical institution, 30% of which is normally borne by the patient and 70% is paid from the public healthcare insurance system. Medical fee receivables are created when medical institutions bill Social Insurance Medical Fee Payment Fund and Federations of National Health Insurance (hereinafter referred to collectively as the “Funds, etc.”) for the medical fees payable from the public healthcare insurance system. Dispensing fee receivables are created when dispensing pharmacies perform dispensing services based on prescriptions and bill the Funds, etc.
II. Transfer method The originator assigns medical fee receivables to an assignee under an assignment contract. Because it is structured so that the Funds, etc., as obligors credit payments directly to the SPV, perfection requirements are generally fulfilled from the outset against third parties and obligors by means of notice with a certified date pursuant to Article 467, paragraph 2 of the Civil Code.
III. Management method A medical institution bills Funds, etc., for medical fees through detailed statements of medical fees (“medical practitioner’s receipts”). The Funds, etc., review medical practitioner’s receipts and bill the insurer after sending a written communication on increase/decrease of medical fee scores to the medical institution. The insurer also performs its own review, and pays medical fees to the Funds, etc. The Funds, etc., in turn pay medical fees to the bank account specified by the medical institution. The medical institution, if unsatisfied with the assessment of the Funds, etc., is entitled to re-submit a bill at a later date.
IV. Characteristics of cash flow Generally, cash flows from medical fee receivables have the following characteristics: Normally, expected cash flows are generated quickly as payments are credited within less than two months after the amount of medical fee receivables is finalized. If the medical fee scores (amounts) are reduced as a result of a review by the Funds, etc., cash flows decrease.
116/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Default risk of the Funds, etc., as obligors
A. Risk factors As a result of default by the Funds, etc., as obligors, the principal of medical fee receivables collected decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factor: Insurer
B. Principal risk countermeasures and perspectives for evaluation
1. Creditworthiness of medical fee receivables In the light of the country’s universal health insurance system, the creditworthiness of medical fee receivables is deemed to be equivalent to that of the sovereign state.
II. Dilution risk (restitution, reduced medical fee scores, delays, claim for return of overpaid fees, voluntary restitution, etc.)
A. Risk factors A risk may arise that medical fee scores (amount) claimed decrease as a result of a review by the Funds, etc. As a result of reduced medical fee scores, the principal of medical fee receivables collected decreases. The level of decrease and fluctuations of cash flows generally are influenced by the following factors: Type of insurance (national insurance/social insurance) Medical fee system (review criteria and scores) and timing for revision thereof Medical categories Period subject to rating Amount of past medical treatment Recommendations for restitution by individual guidance, independent auditors, etc.
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure The portion of cash flows that decreases as a result of the risk of reductions by the Funds, etc., is secured as the subordinated portion. An evaluation is performed from the perspective of whether or not the credit enhancement provided by the subordinated portion is adequate.
117/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 18: Monthly clear (credit card) receivables
Section 1: Basic issues
I. Cause for creation Monthly clear (credit card) receivables are created when a purchaser pays for a commodity or service (or the consideration to the party from whom the commodity or service is provided) in a single payment under a card-shopping contract. If the method of assigning receivables from member stores to the card company is adopted (as in the cases of bank cards) or if receivables are assigned from a different card company to the originator through an international brand as an intermediary, such receivables are generally not perfected against third parties.
II. Transfer method The originator assigns monthly clear receivables to the assignee under an assignment contract. Perfection requirements against third parties are fulfilled by registration pursuant to the Special Perfection Law. Generally, perfection requirements against obligors are initially withheld, but are promptly fulfilled if the originator falls into bankruptcy or if otherwise needed by giving a notice to or obtaining consent from the obligors pursuant to Article 467 of the Civil Code or sending certificates of registered matters to the obligors pursuant to the Special Perfection Law.
III. Management method Payment schedules for obligors of monthly clear receivables are fed into a database, repayments are collected by means of account transfer procedures, and reconciliations are performed each month. Normally, reminder notices are sent up to specified times of delinquency, and receivables with more than the specified times of delinquency are reclassified as administered receivables. Such collection services are normally outsourced to the servicer, and the originator is appointed as the initial servicer.
IV. Characteristics of cash flow Generally, cash flows from monthly clear receivables have the following characteristic features: Expected cash flows represent amounts of single payments. Normally, no interest accrues. Monthly cash flows decrease as a result of default or delinquency of obligors of monthly clear receivables. If an obligor falls into bankruptcy or becomes delinquent repeatedly and there is little prospect of recovery, the receivables in question are generally reclassified as
118/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
administered receivables, and no cash flows can be expected from such an obligor. If there are counterclaims between the originator and the obligor, offsetting may be asserted and the amount of principal may decrease. Cancellations cause monthly clear receivables to be extinguished and cash flows to decrease. If, in the case of a product involving the rendering of a service, a member store falls into a state in which it is unable to perform the relevant service, cash flows decrease with the obligor’s exercising the right of assertion of defense for payment suspension. If the relevant product involves specified and continuous service, cash flows decrease with the obligor’s cancelling card-shopping contract early, irrespective of whether or not the cooling-off period has lapsed.
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors If any obligor of monthly clear receivables becomes insolvent, the amount of principal of monthly clear receivables collected decreases. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Member stores Type (gender) of obligor Age of obligor Resident area of obligor
B. Principal risk countermeasures and perspectives for evaluation R&I makes judgments on credit ratings according to the risk countermeasure as follows:
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default losses of underlying receivables, the amount of a decrease as a result of default losses is secured as a subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
119/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
II. Dilution risk (cancellation)
A. Risk factors If the assertion of defense against the transfer of underlying assets is not restricted and an obligor cancels a card-shopping contract by canceling a purchase of commodities as objects of monthly clear receivables, the monthly clear receivables are extinguished. The level of decrease and fluctuations of cash flows are typically influenced by the following factors: Type (gender) of obligor Resident area of obligor Balance outstanding as of the time of securitization
B. Principal risk countermeasures and perspectives for evaluation R&I makes judgments on credit ratings according to risk countermeasures as follows:
1. Senior/subordinated structure (addition of amount equal to dilution loss to subordinated portion) An amount equal to the influences of the decreased portion of cash flows caused by cancellation is added to the subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. Buyback of underlying receivables while the originator is alive If the originator buys back canceled underlying receivables, the evaluation is performed from the perspective that dilution will not arise from cancellation while the originator is alive.
III. Dilution risk (change of payment method)
A. Risk factors If the payment method is changed from single payment to revolving payment or installment payment, cash flows decrease and are delayed. The level of decrease and fluctuations of cash flows are typically influenced by the following factor: Underlying contracts
B. Principal risk countermeasures and perspectives for evaluation R&I makes judgments on credit ratings according to risk countermeasures as follows:
1. Senior/subordinated structure (addition of amount equal to dilution loss to subordinated portion) An amount equal to the influences of the decreased portion of cash flows caused by the
120/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
change of payment method is added to the subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement provided by the subordinated portion is adequate.
2. Buyback of underlying receivables while the originator is alive If the originator buys back the underlying receivables for which the payment method is changed, an evaluation is performed from the perspective that dilution does not arise from cancellation while the originator is alive.
3. Eligible receivables If receivables for which the payment method cannot be changed are treated as eligible receivables, an evaluation is performed from the perspective that no dilution risk arises from the change of payment method.
IV. Dilution risk (offset, non-performance of service, unlawful acts of member stores, etc.)
A. Risk factors If there is any dilution risk for underlying assets on grounds such as that the receivables’ obligor assertion of defense is not restricted, as a result of the emergence of such risk, cash flows cease to exist. The level of decrease and fluctuations of cash flows vary depending upon the dilution risk to be handled.
B. Principal risk countermeasures and perspectives for evaluation Risk countermeasures vary depending upon types of dilution risk. Therefore, a credit rating is performed according to the risk countermeasure deemed necessary in the light of laws and ordinances and industry practices. Principal risk countermeasures are as follows:
1. Senior/subordinated structure (addition of amount equal to dilution loss to subordinated portion) An amount equal to the influences of the decreased portion of cash flows caused by dilution risk is added to the subordinated portion. An evaluation is performed from the perspective of whether or not the enhancement from the subordinated portion is adequate.
2. Eligible receivables If the monthly clear receivables with dilution risk are not treated as eligible receivables, an evaluation is performed from the perspective that no dilution arises from the relevant risk.
121/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 19: Projects (including PFI)
Section 1: Basic issues
I. Cause for creation Project finance refers to transactions backed by cash flows from a specific business (project). Projects that are best suited for project finance are stable, long-term projects that generate strong cash flows. These are primarily infrastructure-related projects, such as power generation (e.g., photovoltaic, wind, biomass, geothermal), transportation (e.g., airports, roads), water and sewerage systems, and public facilities. The assets required to carry through projects comprise tangible assets such as buildings and facilities, and intangible assets such as rights under the agreements of the project. A project is created when a business is planned, a decision is made to execute the project, and the various agreements are concluded. Note that project finance includes transactions backed by PFI（Private Finance Initiative） projects. PFI is a method that uses private funds and leverages management and technical skills held by the private sector for the building, maintenance, operation, and so on, of public facilities. PFI aims to provide public services more effectively and efficiently compared to services offered directly by central and regional governments, and other public entities. A basic flow chart that illustrates the analysis method for project finance is provided at the end of this Subchapter (Appendix 3).
II. Transfer method A SPV either develops a new project or acquires an existing project. In the case of new projects, the SPV constructs new buildings and facilities for the project as the promoter, and concludes new agreements for the project as the party to the contract. In the case of existing projects, the transfer of underlying assets is achieved through the sale of the buildings and facilities and the transfer of project-related contractual status, among other measures.
III. Management method The assets required to carry through a project are held by an SPV. The project is managed directly by the SPV or through an Asset Management (AM) service provider. The development of the project is typically handled by a project developer or Engineering, Procurement, and Construction (EPC) service provider, and the operations and maintenance are handled by an Operations and Maintenance (O&M) service provider.
122/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
IV. Characteristics of cash flow Typically, cash flows from project finance have the following characteristic features: Generally, cash flows generated by a specific project are the only source of funds for repayment. Generally, the term of a project is long, and so is the term of debt repayment Infrastructure-related projects of high importance typically exhibit strong business continuity. Cash flow stability depends on the durability and robustness of the main facilities. Projects may be relatively easy or difficult to operate. Generally, cash flow volatility caused by the operator’s capability is high and the substitutability of service providers (O&M, AM, etc.) is low in the case of projects that are relatively difficult to operate. Cash flows generated by a project with only one or a small number of purchasers (off-takers) generally relies on the creditworthiness or the substitutability of such off-takers. Projects with an unspecified number of purchasers (e.g., airports) tend to be affected by the economic and competitive environment. In the case of PFIs, cash flow characteristics vary depending on the form of revenues and importance of operation of the project’s SPV. When cash flows rely on the operating revenues of a PFI project operated by an SPV (financially self-standing projects), the characteristics would resemble those of a typical project finance transaction. On the other hand, when a SPV receives payments from the public sector for the public services offered by the project (service-providing projects) in installments, the certainty of cash flows relies on the creditworthiness of the public sector that makes payments to the SPV.
Section 2: Analysis of credit risk factors The following is a list of credit risk factors by phase of project:
123/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
■Development/ construction phase prior to launch of business I. Sponsor's willingness and capability (expertise, operating structure, track record), and business continuity in case of sponsor bankruptcy 1. Sponsor's willingness and capability (expertise, operating structure, track record) 2. Business continuity in case of sponsor bankruptcy Ⅱ. Appropriateness of business plan Ⅲ. Appropriateness of risk-sharing between public and private sectors in PFIs Ⅳ. Acquisition of ownership or leaseholds of project site, administrative permits and approvals, etc. 1. Securing of project site 2. Acquisition of administrative permits and approvals, etc. 3. Impact on surrounding environment Ⅴ. Development risks （including construction risks） 1. Functionality, reliability, durability and robustness of facilities 2. Capability and substitutability of EPC service provider or project developer 3. Completion Risk
■Operation phase after launch of business Ⅵ. Business operation and management 1.Operation and management capabilities, and substitutability of O&M service provider/ sponsor 2.Decision-making and management capabilities, willingness, and substitutability of AM service provider/ sponsor 3. Capabilities and impact of bankruptcy of other parties involved Ⅶ. Revenues 1.Volume and unit price of products and services sold 2. Terms of agreement with off-taker, creditworthiness and substitutability of off-taker 3. Event risk 4. Stability of policies and regulations associated with execution of project Ⅷ. Expenses 1. Procurement of raw materials and fuels 2. Terms of agreement with supplier, creditworthiness and substitutability of supplier 3. Reasonableness of maintenance/ start-up costs and operating expenses 4. Reasonableness of other major expense items 5. Rise in prices, wages and interest rates
■Risks associated with events and transaction scheme Ⅸ. Accidents and natural disasters, etc. 1. Probability and impact of accidents and natural disasters, etc. 2. Casualty insurance coverage 3. Cash reserves 4. Provision of credit enhacement by sponsor Ⅹ. Refinance risk 1. Probability of successful refinancing 2. Probability of sale of project
124/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
I. Sponsor’s willingness and capability (expertise, operating structure, track record), and business continuity in case of sponsor bankruptcy
A. Risk factors A project’s sponsor not only invests capital in the project, but also often controls the entire project by providing the initial capital to set up the SPV, dispatching directors and other staff, assuming the main operations such as O&M services, and formulating the business plan. In other words, the sponsor plays a leading role in the operations of the SPV. In addition, the sponsor may engage in the development and construction of facilities as the project developer or EPC service provider. Hence, a project may not be carried through if the sponsor does not have the willingness or capability (expertise, operating structure, track record) to do so. In the case where the sponsor operates the SPV, the SPV may not be able to continue operations in the event of sponsor bankruptcy if the substitutability of operations is low, the probability of finding a replacement for the sponsor is low given the economic situation of the project, or the transaction scheme does not facilitate the succession of the SPV’s business. In addition to the above, an event of sponsor bankruptcy may be detrimental to the continuity of the project or certainty of cash flows, depending on the sponsor’s role in the project and its contractual status, among other factors.
B. Principal risk countermeasures and perspectives of evaluation
1. Sponsor’s willingness and capability (expertise, operating structure, track record) R&I evaluates whether or not the sponsor has sufficient willingness and capability (expertise, operating structure, track record) to carry through with the project, depending on the sponsor’s involvement in the project. Formulating of business plan: Please refer to II. “Appropriateness of business plan” in this Section. Development and construction: Please refer to V.B.2. “Capability and substitutability of EPC service provider or project developer” and V.B.3. “Completion Risk” in this Section. O&M services: Please refer to VI.B.1. “Operation and management capabilities, and substitutability of O&M service provider/ sponsor” in this Section AM services: Please refer to VI.B.2. “Decision-making and management capabilities, willingness, and substitutability of AM service provider/ sponsor” in this Section.
125/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
2. Business continuity in case of sponsor bankruptcy The sponsor typically plays a leading role in operating the SPV. Therefore, R&I evaluates the project’s business continuity in the event of sponsor bankruptcy. O&M services: Please refer to VI.B.1. “Operation and management capabilities, and substitutability of O&M service provider/ sponsor” in this Section. AM services: Please refer to VI.B.2. “Decision-making and management capabilities, willingness, and substitutability of AM service provider/ sponsor” in this Section. Independence of SPV: Please refer to V. “Bankruptcy remoteness of SPV for transactions backed by projects, etc.” in Section 2, Subchapter 2, Chapter 2. Sponsor support, etc. When certain risks are mitigated by sponsor support and other measures, R&I evaluates such support based on the terms of the agreements and the sponsor’s creditworthiness, among other factors.
II. Appropriateness of business plan
A. Risk factors In order to execute a project, an appropriate and effective business plan (from the project’s development to termination/ exit) must be formulated. The project’s effectiveness will be affected by whether the business plan takes into account the actual situation pertaining to the development and operations of the project. If the project’s business plan is formulated by or the development is undertaken by a sponsor that does not have the necessary willingness or capability (expertise, operating structure, track record), the project may prove unsuccessful.
B. Principal risk countermeasures and perspectives for evaluation R&I determines the appropriateness and effectiveness of the business plan based on a review of the project’s business continuity, fluctuation risk associated with cash flows, event risks, and other risks factors. R&I also confirms the sponsor’s willingness (policy, incentives) and its ability to formulate a business plan (expertise, operating structure, track record). An evaluation is performed from the perspective of the appropriateness and effectiveness of the business plan.
126/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Appropriateness of risk-sharing between public and private sectors in PFIs
A. Risk factors In the case of PFIs (including concessions), the project may prove unsuccessful if the framework of the project is not appropriate.
B. Principal risk countermeasures and perspectives for evaluation In the case of PFIs (including concessions), R&I determines the appropriateness of a project’s framework based on the sharing of risk and rights between the public and private sectors, and the terms of the project-related agreements. An evaluation is performed from the perspective of the appropriateness of the project’s framework.
IV. Acquisition of ownership or leaseholds of project site, administrative permits and approvals, etc.
A. Risk factors A project’s execution or business continuity may be hindered if the rights that are necessary to use the land during the term of the project are not secured, the necessary administrative permits and approvals are not obtained or maintained, or there is strong opposition from neighboring residents, among other reasons.
B. Principal risk countermeasures and perspectives for evaluation
1. Securing of project site R&I confirms that the rights to use the site during the term of the project (including the construction period) have been acquired or is expected to be acquired. If there is uncertainty regarding the ownership of rights, an assessment is conducted on the level of such risk and its impact. An evaluation is performed from the perspective of whether or not the rights to use the site have been acquired appropriately, and whether or not the risks posed by issues pertaining to the ownership of rights, if any, on the project’s execution will be limited.
2. Acquisition of administrative permits and approvals, etc. R&I examines the status regarding acquisition of necessary permits and approvals for the development and execution of the project, implementation of necessary procedures, and securing of necessary rights (including environmental assessments and other procedures pertaining to environmental issues), to confirm that such processes have been taken or are highly likely to be taken. An evaluation is performed from the perspective of whether or not the necessary permits and approvals, among others, have been acquired. If
127/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
such permits and approvals have not been acquired, R&I will evaluate whether or not the risks posed by the lack of such permits and approvals on the project’s execution will be limited.
3. Impact on surrounding environment R&I ensures that the project (during its construction and operation) does not cause significant adverse effects on the surrounding environment and local residents. R&I also confirms that the necessary measures, such as explanations to the local residents, have been conducted and hence, the risk of the project’s development or execution being interrupted by complaints and opposition from local residents is low. An evaluation is performed from the perspective of whether or not the risk of such events hindering the project’s execution is limited.
V. Development risks (including construction risks)
A. Risk factors A project’s cash flows may fall short of expected levels or its business continuity may be lost if the facilities that are built are not adequate in terms of their functionality, reliability, durability, and robustness. In addition, if the investor in the product subject to rating (debt) finances the project from the construction stage, the investor faces risks associated with the project’s buildings and facilities not being completed, the construction falling behind schedule, or the completion of construction being delayed due to various conditions not being satisfied (time-overrun). There is also the possibility of development costs exceeding the initial plan (cost-overrun), which could cause a decline in cash flows or difficulties in business continuity. The level of risk will depend on the timing of the financing of the product subject to rating, but the factors that could lead to a building not being completed as scheduled would include the following: Archaeological findings Environmental issues Non-attainment of building functions, insufficient technology Occurrence of accidents and natural disasters Bankruptcy of EPC service provider or project developer
B. Principal risk countermeasures and perspectives for evaluation
1. Functionality, reliability, durability, and robustness of facilities R&I confirms the functionality, reliability, durability, and robustness of the facilities based on their specifications, track record of the manufacturer and product, third-party
128/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
certifications obtained, track record and maturity of the key technologies involved, and the result of the construction completion inspection. R&I also refers to technical reports and other materials provided by technical consultants and other specialists as necessary. In the case of existing projects, R&I confirms the project’s operational track record and the opinion on the facilities expressed by technical consultants and other materials. An evaluation is performed from the perspective of the adequacy of the functionality, reliability, durability, and robustness of the facilities.
2. Capability and substitutability of EPC service provider or project developer An evaluation is performed from the perspective of the capability (expertise and technological capability, operating structure and track record) and substitutability of the EPC service provider and the project developer. R&I also confirms whether adequate measures have been taken to ensure substitutability in the event of their bankruptcy.
3. Completion Risk Considering the project’s development plan and the business plan, R&I identifies risk factors which could cause cost overruns and delays on the construction period and evaluates probability of occurrence of those risk factors. R&I also confirms the terms and exemptions of the completion guarantee by the EPC service provider, the creditworthiness of the EPC service provider, coverage range of insurance, level of cash reserves, and transaction schemes, among other factors. An evaluation is performed from the perspective of the probability of cost overruns and delays on the construction period, and the adequacy of those risk countermeasures.
VI. Business operation and management
A. Risk factors A project’s cash flow may decrease or its business continuity may be lost when the project is not or cannot continue to be operated appropriately. The risks associated with the business operation and management of the project are typically influenced by the following factors: Importance and difficulty of operations Complexity and stability of facilities Technological maturity
B. Principal risk countermeasures and perspectives for evaluation
1. Operation and management capabilities, and substitutability of O&M service provider/ sponsor An evaluation is performed from the perspective of the capability (expertise, operating
129/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
structure, track record) and substitutability (continuity of O&M services) of the O&M service provider (or the sponsor, in the case where O&M services are provided by the sponsor), and based on the level of expertise required for the operations of the project. The level of maturity and track record of the technology adopted are also taken into consideration. If a back-up service provider is available, R&I confirms the capability of the back-up service provider and the adequacy of the scheme to substitute O&M services. If no back-up service provider is available, R&I confirms the continuity of O&M services until a replacement service provider is selected and operations are succeeded by this entity.
2. Decision-making and management capabilities, willingness, and substitutability of AM service provider/ sponsor An evaluation is performed from the perspective of the decision-making and management capabilities, willingness (policy and incentive), and substitutability (continuity of AM services) of the AM service provider (or the sponsor, in the case where AM services are provided by the sponsor or the director, etc., of the SPV dispatched by the sponsor), and based on the level of expertise required for the operations of the project. The level of maturity and track record of the technology adopted is also taken into consideration. If a back-up service provider is available, R&I confirms the capability of the back-up service provider and the adequacy of the scheme to substitute AM services. If no back-up service provider is available, R&I confirms the continuity of AM services until a replacement service provider is selected and operations are succeeded by this entity.
3. Capabilities and impact of bankruptcy of other parties involved R&I confirms the capabilities (expertise, operating structure, track record) of the parties involved other than those mentioned above, as well as the impact of their bankruptcy on the project. Examples would include key parties other than O&M and AM service providers that are involved in the project’s operation and the continuity of warranties on the products and functions of the main facilities provided by the manufacturers. An evaluation is performed from the perspective of the appropriateness of the services and products provided by the key parties involved, the capabilities of such parties, and the impact of an event of bankruptcy of such parties.
VII. Revenues
A. Risk factors Cash flows may decrease if sales volumes decline during the operation period. The
130/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
probability and extent of a decrease in cash flows is typically influenced by the following factors: Changes in the volume and unit price of the products and services sold (e.g., type of contract, existence of market risk, demand/supply trends, decline in capacity utilization due to facility failures and other causes, functional deterioration of facilities, changes in production of electricity due to changes in the amount of insolation and wind conditions in the case of power generation projects, restrictions due to curtailment) Terms of the agreement with the off-taker, creditworthiness and substitutability of the off-taker Event risks Stability of policies and regulations associated with the execution of the project
B. Principal risk countermeasures and perspectives for evaluation
1. Volume and unit price of products and services sold Cash flows may fall short of expected levels due to fluctuations in the volume and unit price of products and services sold. In such case, the project’s capacity to generate cash flows and the predictability of cash flows is examined by taking into account various factors that affect the project’s revenues. Such factors would include the existence of market risk, demand/ supply trends, terms of the agreement with off-takers, decline in capacity utilization due to facility failures and other causes, functional deterioration of facilities, changes in production of electricity due to changes in the amount of insolation and wind conditions in the case of power generation projects, and restrictions due to curtailment. Attention is also given to the fact that the risk of facility performance is relatively high in the case where the technology used has limited track record and is low in maturity. An evaluation is performed from the perspective of the adequacy of the cushion available to withstand a decline in cash flow, and by taking into consideration the project’s capacity to generate cash flows and the predictability of cash flows.
2. Terms of agreement with off-taker, creditworthiness and substitutability of off-taker An evaluation is performed by confirming the terms of the agreement with the off-taker, and from the perspective of the off-taker’s creditworthiness and substitutability, and whether or not adequate measures for substitution are in place.
3. Event risk Cash flows may fall short of expected levels due to events such as terrorist attacks and pandemics. An evaluation is performed from the perspective of the possibility of
131/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
occurrence of such events and their impact, as well as the adequacy of the cushion available to weather a decline in cash flows.
4. Stability of policies and regulations associated with execution of project A project’s execution may be hindered and its cash flow may decrease or its business continuity may be lost as a result of unexpected changes in government policies and regulations. An evaluation is performed from the perspective of the stability of policies and regulations.
VIII. Expenses
A. Risk factors Cash flows may decrease if expenses during the operating period exceed expectations. It is therefore necessary to determine the cost structure and the factors that could cause costs to fluctuate, and to take into consideration such fluctuation risk (volume and price) on an item by item basis in the evaluation. The probability and extent of a decrease in cash flows is typically influenced by the following factors: Changes in the volume and price of raw materials/ fuels, restrictions (e.g., form of contract) Terms of the agreement to procure raw materials/ fuels, competitiveness regarding procurement Supplier’s creditworthiness, capability (operating structure and track record) to supply raw materials/ fuels and substitutability Increase in expenditures to maintain the project’s buildings and facilities in operating condition Increase in operating expenses Rise in prices and wages Rise in interest rates
B. Principal risk countermeasures and perspectives for evaluation
1. Procurement of raw materials and fuels R&I confirms the means of raw material/ fuel procurement, and determines whether or not the volumes or prices are subject to change. For example, if prices of raw materials/ fuels rise, the cost to procure sufficient volumes may exceed initial expectations. An evaluation is performed from the perspective of the stability and continuity of raw material/ fuel procurement and the adequacy of the cushion available to weather a decline in cash flows caused by fluctuations in raw material/ fuel costs.
132/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
2. Terms of agreement with supplier, creditworthiness and substitutability of supplier When raw materials/ fuels are supplied by a specific supplier, an evaluation is performed from the perspective of the terms of the agreement with the supplier, as well as the supplier’s capability (expertise, operating structure, track record) and substitutability. If the supplier cannot be substituted, R&I assesses the stability and continuity of raw material/ fuel procurement in consideration of the supplier’s creditworthiness.
3. Reasonableness of expenditures to keep the project’s buildings and facilities in operating condition and operating expenses A reasonable level of expenditures to keep the project’s buildings and facilities in operating condition (recurring expenses to maintain facility performance) and other operating expenses are taken into account. It is important to note that the risk of expenses exceeding initial expectations is higher for facilities that adopt technologies that have limited track record and are low in maturity. An evaluation is performed from the perspective of whether or not the expected level of expenditures to maintain the project’s buildings and facilities in operating condition and operating expenses is reasonable, and whether or not the cushion to weather a decline in cash flows, cash reserves, and other measures are adequate.
4. Reasonableness of other major expense items An evaluation is performed from the perspective of whether or not the expected level of expense from items other than those mentioned above are reasonable, and whether or not the cushion to weather a decline in cash flows, cash reserves, and other measures are adequate in light of the project’s cost structure.
5. Rise in prices, wages and interest rates An evaluation is performed from the perspective of the adequacy of the cushion to weather the decline in cash flows due to a rise in prices, wages or interest rates.
IX. Accidents and natural disasters, etc.
A. Risk factors A project’s cash flow may decrease due to damage to the project’s buildings and facilities or discontinuation of operations in the event of accidents and natural disasters, among others. The probability and extent of a decrease in cash flows is typically influenced by the following factors: PML (probable maximum loss) of the project’s buildings and facilities Availability and terms of insurance coverage
133/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Sponsor support Structural measures, such as cash reserves
B. Principal risk countermeasures and perspectives for evaluation
1. Probability and impact of accidents and natural disasters, etc. The probability of events such as accidents and natural disasters is evaluated, and the PML value and other risk indicators regarding the project’s buildings and facilities are reflected in the cash flow analysis as necessary. An evaluation is performed from the perspective of the adequacy of the cushion to weather the decline in cash flows.
2. Casualty insurance coverage Casualty insurance may be provided to cover for a decrease in cash flows and accrual of recovery expenses to a certain extent. An evaluation is performed from the perspective of the adequacy of the insurance contract (extent of coverage, terms and conditions, etc.).
3. Cash reserves Cash reserves in an amount equivalent to interest and principal payments and operating expenses for a certain period may be secured to provide against a decrease in the project’s cash flows or accrual of recovery expenses. An evaluation is performed from the perspective of the adequacy of cash reserves.
4. Provision of credit enhancement by sponsor The sponsor may implement credit enhancement measures (such as rules for additional capital contributions) to provide against a decrease in the project’s cash flows or accrual of recovery expenses. An evaluation is performed from the perspective of the sponsor’s creditworthiness and substitutability, and whether or not adequate measures for substitution are in place.
X. Refinance risk
A. Risk factors In the case of transaction schemes that assume refinancing, the principal of the product subject to rating may not be repaid if refinancing proves unsuccessful. The probability of fund procurement is mainly affected by the following factors: Deterioration of financial environment Rise in interest rates Widening of spreads Decrease in cash flows
134/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
B. Principal risk countermeasures and perspectives for evaluation
1. Probability of successful refinancing R&I confirms whether or not the transaction scheme adopts measures to enhance the probability of refinancing, such as allowing for sufficient time and appointing a financial advisor for refinancing activities. R&I also assesses the probability of finding a provider of funds for refinancing should the financial or business environment deteriorate considerably, based on the expected DSCR levels at the time of refinancing and the depth of the market for such transactions, among other factors. An evaluation is performed from the perspective of the probability of successful refinancing.
2. Probability of sale of project When the sale of a project is an available option, the funds necessary to repay principal may be procured by selling the project at a fair price should refinancing activities prove to be unsuccessful. An evaluation is performed from the perspective of the adequacy of the scheme for the sale of the project, and based on a comparison between the outstanding debt amount at the time of refinancing and the expected net proceeds from the sale of the project.
135/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
(Appendix 3) Basic flow of analysis method for project finance
Ⅰ.Identification and analysis of risk factors
Analysis of project
Analysis of risk factors including appropriateness of Chapter 3
business plan, operating capability and (Risks regarding
substitutability of sponsors/ operators, cash flow underlying assets) fluctuation risk and events of natural disasters, among others.
Analysis of structure Chapter 2 Analysis of risk factors associated with the terms of (Risks regarding contract of the transaction scheme and debt, and other structure) legal risks.
Ⅱ. Cash flow analysis Chapter 4
Analysis of standard scenario Assessment of probability of debt repayment under a standard scenario deemed reasonable by R&I
Analysis of stress scenarios Establishment of various stress scenarios and assessment of debt repayment stress tolerance under each scenario
Ⅲ． Comprehensive evaluation ⇒ Assignment of credit rating
136/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 20: Business cash flow, etc.
Section 1: Basic issues
I. Cause for creation Business assets, business cash flow, etc., are created from the business activities of corporations, etc.
II. Transfer method Business or assets concerned may or may not be transferred. If they are transferred, the originator or the corporation concerned secures bankruptcy remoteness by executing true assignment of the business or assets concerned.
III. Management method Normally, the corporation concerned continues to conduct business activities.
IV. Characteristics of cash flow Business cash flow, etc., may fluctuate according to changes in business environment, competitiveness, etc.
Section 2: Analysis of credit risk factors
I. Changes in business environment, competitiveness, etc.
A. Risk factors Business cash flow, etc., may fluctuate according to changes in business environment, competitiveness, etc.
B. Principal risk countermeasures and perspectives for evaluation An evaluation is performed on the basis of influences that changes in business environment, competitiveness, etc., have on business cash flow, etc.
137/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 21: Sub-performing loans, etc.
Section 1: Basic issues
I. Cause for creation Sub-performing loans, etc., mean sub-performing loans, non-performing loans, real estate mortgage loans (loan secured by real estate), etc., to corporations, sole proprietors, and individuals, and are created due to either one of the following causes:
1. Sub-performing corporate loan receivables are created as the obligor’s creditworthiness falls below its initial creditworthiness in a general loan receivable.
2. Loans are made upon establishing a security interest in real estate, etc., on the grounds that the obligor’s creditworthiness is low or the intended use of loaned funds is for purchase of real estate, etc.
II. Transfer method Sub-performing loans, etc., are assigned by financial institutions, etc., to the assignee under assignment contracts. Assignment is normally perfected against third parties at the time of assignment by registration pursuant to the Special Perfection Law, and is perfected against obligors at the time of the servicer’s bankruptcy by forwarding certificates of registered matters to the obligors pursuant to the Special Perfection Law. Perfection requirements against obligors and third parties may also be fulfilled by forwarding written notices with a certified date to the obligors or obtaining written consent with a certified date of the obligors pursuant to Article 467 of the Civil Code.
III. Management method The assignee collects sub-performing loans, etc., by entrusting the relevant collection services to the assigner or the servicer.
IV. Characteristics of cash flow Generally, cash flows from sub-performing loans, etc., have the following characteristic features: Due to the fact that the obligors’ creditworthiness is low, delinquency rate and default rate often remain higher than those of other underlying assets. Interest rate for the loans secured by real estate is generally higher than that of other underlying assets.
138/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Obligors’ default risk
A. Risk factors If any obligor becomes insolvent, the amount of principal/interest collected on the loan receivables decreases.
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that cash flows decrease as a result of default losses on underlying receivables, the amount of decrease as a result of default losses is secured as a subordinated portion. Analysis of collection of principal/interest from the obligors prior to their insolvency is performed from the perspectives of attributes and dispersion of receivables pool and characteristic features of the issue.
II. Fluctuation risk associated with recovery from collateral
A. Risk factors If the value of collateral declines, the amount of recovery from defaulted receivables decreases.
B. Principal risk countermeasures and perspectives for evaluation
1. Senior/subordinated structure To provide for the risk that arises from fluctuations in the amount recovered from security interest attached to defaulted underlying receivables, the amount of decrease of that recovered from security interest is secured as a subordinated portion. The estimated amount recovered from collateral provided by the insolvent obligor is analyzed on the basis of the attributes of collateral, LTV, historical performance data on recovery rates, etc. In addition, the special servicer’s recovery capability and recovery strategy are checked.
139/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 22: Monetary receivables from airline companies and aircraft
Section 1: Basic issues
I. Cause for creation Procurement of aircraft by airline companies and others may be financed through SPVs backed by monetary receivables (lease and loan receivables) from airline companies and aircraft (including engines).
II. Transfer method An aircraft is acquired by signing an order agreement with the aircraft manufacturer in the case of new aircraft, and a purchase agreement with the seller in the case of used aircraft. Monetary receivables from airline companies backed by aircraft are created.
III. Management method Management of aircraft, such as maintenance and insurance coverage, is basically handled by the airline company using the aircraft.
IV. Characteristics of cash flow Generally, cash flows from monetary receivables from airline companies have the following characteristic features: Possibility of repayment of monetary receivables from airline companies depends on the airline companies’ creditworthiness and proceeds from the sale of aircraft, among other factors. Aircraft are pledged as collateral in order to collect on the monetary receivables from airline companies. If payments on monetary receivables are ceased in the event of an airline company’s bankruptcy, funds are recovered by repossessing and selling the aircraft. The amount recovered by selling the aircraft depends on the bankruptcy legal system and collateral execution framework in the airline company’s country of residence, aviation market conditions, price stability/ liquidity of the aircraft, and the capability of the agent handling the repossession and sale of the aircraft. Aircraft demand is expected to continue to expand. Meanwhile, there are only a few manufacturers supplying aircraft. Hence, although the situation may vary depending on the aircraft model and other factors, the price stability and liquidity of aircraft are relatively high.
140/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Section 2: Analysis of credit risk factors
I. Default risk of airline companies
A. Risk factors Cash flows may decrease if payments on monetary receivables are ceased in the event of an airline company’s bankruptcy.
B. Risk countermeasures and perspectives for evaluation Basically, default risk is evaluated based on the airline companies’ creditworthiness. The definitions of events of default for the underlying monetary receivables from airline companies may differ from those for the rated product, such as in the case of EETC (Enhanced Equipment Trust Certificates). In such a case, the possibility of repayment of the rated product by maturity will be evaluated from the perspective of the possibility of continued repayment of monetary receivables from airline companies in the event of an airline company’s bankruptcy and the sufficiency of funds that can be recovered through measures such as the sale of the aircraft.
II. Price fluctuation risk of aircraft
A. Risk factors If an airline company falls into bankruptcy and payments on monetary receivables are ceased, the aircraft will be repossessed and funds will be recovered through measures such as the sale of the aircraft. In such a situation, the amount recovered will fluctuate in accordance with the price of the aircraft. Also, aircraft are typically traded in U.S. dollars. Hence, if the rated product is denominated in currencies other than U.S. dollars, there is currency risk associated with the need to convert the proceeds from the sale of the aircraft into the relevant currencies.
B. Risk countermeasures and perspectives for evaluation It is possible to enhance the certainty of principal repayment and interest payments on the rated product by pledging collateral of value that appropriately exceeds the amount of the rated product. An evaluation is performed from the perspective of whether or not the collateral value is sufficient against the amount of the rated product.
141/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
III. Validity of collateral pledge on aircraft and possibility of collateral execution
A. Risk factors Basically, collateral is required to be pledged pursuant to the legal framework in the country in which the aircraft is registered (the country of residence of the airline company). If the establishment of right of collateral is invalid, there is a risk that the right of collateral cannot be exercised. Even if the collateral is pledged appropriately, the collateral may not be executed immediately in cases such as where the aircraft is subject to the bankruptcy proceedings of an airline company.
B. Risk countermeasures and perspectives for evaluation Validity of collateral pledge is evaluated from the perspective of whether or not the right of collateral is appropriately established. Possibility of collateral execution is evaluated from the perspective of its adequacy based on the bankruptcy legal system and framework for collateral execution in the airline company’s country of residence.
IV. Risk of aircraft damage and accidents
A. Risk factors An aircraft may become unusable if damaged or in the event of an accident. Furthermore, claims for damages may be filed in the case of an accident.
B. Risk countermeasures and perspectives for evaluation As a countermeasure against such risks, hull insurance, war risk insurance, and liability insurance coverage is typically provided. An evaluation is performed from the perspective of whether or not sufficient insurance coverage is provided.
V. Refinance risk
A. Risk factors Cash flows decrease when the transaction fails to refinance the amount needed to perform on its obligations to investors.
B. Principal risk countermeasures and perspectives for evaluation
1. Establishment of refinancing scheme It is possible to enhance the certainty of refinancing by establishing an adequate time
142/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
frame to engage in refinancing activities and a process to select a refinancing arranger, among other schemes. An evaluation is performed from the perspective of adequacy of the refinancing scheme.
2. Establishment of scheme for sale of aircraft Even if the refinancing fails, sufficient funds can be procured if the aircraft is sold at an appropriate price. An evaluation is performed from the perspective of the adequacy of the scheme to sell the aircraft.
143/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
Subchapter 23: Other Assets (excluding those specified in the other subchapters)
Section 1: Basic issues
I. Cause for creation Corporations, etc., may raise funds using structured finance backed by assets held by them.
II. Transfer method Assets may or may not be transferred. If they are transferred, bankruptcy remoteness will be achieved by true sale of the underlying assets.
III. Management method Normally, the corporation concerned continues to conduct the business operation and management of the underlying assets.
IV. Characteristics of cash flow The value of underlying assets and related expected business cash flows may fluctuate depending on the business environment, market trends, and competitiveness, etc. The value of underlying assets and related expected business cash flows may fluctuate depending on the capabilities of business operation and management of the corporation concerned, etc.
Section 2: Analysis of credit risk factors
I. Price fluctuation risk of underlying assets
A. Risk factors Principal and interest payment on the product subject to rating shall be collected basically through the sale of underlying assets. The amount of recoveries may fluctuate depending on the price of underlying assets.
B. Principal risk countermeasures and perspectives for evaluation It is possible to enhance the certainty of principal repayment and interest payments on the rated product by setting underlying assets with a value substantially exceeding the amount of
144/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
rated product. An evaluation is performed from the perspective of sufficiency of asset value compared to the amount of the rated product.
II. Liquidation risk of underlying assets
A. Risk factors Depending on the liquidity and others, underlying assets may not be liquidated at an expected price.
B. Principal risk countermeasures and perspectives for evaluation An evaluation is performed from the perspective of liquidity of the assets and whether sufficient time is allowed for the assets to be liquidated.
III. Business cash flows fluctuation risk
A. Risk factors The amount of business cash flows, etc., from underlying assets may fluctuate depending on a change in the business environment, market trends, and competitiveness, etc.
B. Principal risk countermeasures and perspectives for evaluation An evaluation is based on the impact of changes in the business environment, market trends, and competitiveness, etc. on the business cash flows, etc., expected from the underlying assets.
IV. Refinance risk
A. Risk factors Refinancing of a required amount may not be possible.
B. Principal risk countermeasures and perspectives for evaluation The feasibility of refinancing can be enhanced by allowing a sufficient time for refinancing activities and establishing a framework for selecting a refinancing arranger, among other things. An evaluation is performed from the perspective of sufficiency of the refinancing structure.
145/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 3: Particulars: Risks regarding underlying assets
V. Business operation and management capability of underlying assets
A. Risk factors The value of underlying assets and related expected business cash flows may decrease when the underlying assets is not operated and managed appropriately.
B. Principal risk countermeasures and perspectives for evaluation An evaluation is performed from the perspective of sufficiency and substitutability of the parties’ capabilities of operating and managing the business (policies, operating structure, and track record, etc.).
146/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Chapter 4: Particulars: Cash flow risk
Further to the subject of cash flow risk analysis discussed earlier in Chapter 1, Subchapter 2, Section 5, this Chapter is responds to specific analysis methods by devoting one Subchapter to each method. In each Subchapter, an SF Product to which an analysis method is applied and the relevant analysis method are summarized.
Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach)
This Subchapter addresses credit ratings of SF Products, the underlying assets of which are a monetary receivables pool of a large number of small-lot obligors, separated from monetary receivables created by the originator’s business. The large pool approach is intended to analyze default losses, etc., arising in the monetary receivables pool on the assumption that if, with respect to the credit ratings of such products, the receivables pool cut off for the purpose of securitization is dispersed by a large number of small lots, the performance of such a pool is basically analogous to that of the originator’s business. The large pool approach is taken primarily by establishing a standard scenario and a stress scenario for the underlying assets. It is important to properly evaluate performance arising in the monetary receivables pool primarily from the perspectives of the future prospects of such performance and fluctuation risk based on an understanding of their actual condition as of the time of the analysis. The default rate is the principal performance data source of the analysis. If, in addition to default rate, prepayment rate, dilution rate, etc., can be analyzed in keeping with the above-described basic concept, the large pool approach is adopted. This Subchapter presents the basic concept by citing an example of default rate, and adds reminders on performance data other than default rate as needed.
Section 1: Summary of large pool approach Citing analysis of default rate as an example, the large pool approach is summarized as follows:
1. Sort the characteristic features of underlying assets (securitization pool) for the rated product.
2. Gather historical data that are deemed to have characteristic features similar to those of
147/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
the securitization pool and are useful for determining the standard scenario.
3. Examine historical data, and then measure the default rate for the historical data’s pool to be measured (reference pool).
4. Examine the difference between the characteristic features of the securitization pool and those of the reference pool, and then establish the standard scenario of the default rate for the securitization pool by applying appropriate adjustments to the standard scenario of the reference pool as needed.
5. Establish the stress scenario of the default rate by targeted rating on the basis of the standard scenario in the light of the definitions of rating symbols for the targeted ratings.
6. Calculate a loss amount under the stress scenario, and treat such amount as the amount of credit enhancement necessary for the targeted rating.
Section 2: Sorting characteristic features of receivables pool The main items characterizing the securitization pool and the reference pool (or the “receivables pool”) that are used for comparing these two pools include: cause for the creation of receivables, distribution of items having influences on the level and fluctuations of default rate (geographic region, business industry, etc.), credit collection framework, and definition of default.
Section 3: Gathering historical data When gathering historical data, similarities between the securitization pool and the reference pool are compared from their respective attribute distributions. The main historical data include those related to the originator’s business that constitute the creation causes of the securitization pool and those related to similar businesses in the industry to which the originator belongs (including but not limited to data prepared by credit research companies and database companies).
Section 4: Establishing the standard scenario The standard scenario means the scenario that would be established as being probable in the future based on a comprehensive understanding of the internal and external environment such as structure of the issue, economic conditions, and legal systems in which the securitization pool is placed. The default rate for the reference pool is measured according to the characteristic features of the historical date examining, for example, trend and outlook of market environment, credit collection
148/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
policy, attribute distributions, data trend, and data outliers. The standard scenario for the securitization pool is determined, with adjustments applied as needed, after examining differences in the characteristic features of the securitization pool and the reference pool. For example, if default is defined more narrowly for the reference pool than for the securitization pool, the default rate for the standard scenario is set higher than that of the reference pool referring to historical data with respect to differences in definition. If the default rate is found to vary according to the attributes (for example, credit scores) of the securitization pool, the default rate for historical data on the reference pool is measured by each of such attributes, and the weighted average default rate for the amounts obtained with such attributes is established as the standard scenario for the entire securitization pool. The standard scenario may surpass or fall below the average past level, depending on actual conditions and future prospects observed and foreseen at the time of the analysis.
Section 5: Establishing the stress scenario The stress scenario for default rate means the scenario established according to the targeted rating on the basis of the degree of reliance on the business cycle, degree of diversification of exposure, attribute distributions, etc. When establishing the stress scenario, variations of historical data on the reference pool are analyzed and R&I’s knowledge obtained from its past rating track records are taken into account. The principal examples of methods for establishing the stress scenario are illustrated below:
I. Establishing the stress scenario based on stress multiples The basic configuration of the stress scenario corresponding to the targeted rating is established by multiplying the standard scenario by a specific stress multiple (a stress multiple). As shown in the following table, a basic stress multiple is established for each underlying asset type. For ratings equal to or lower than the BB rating, the stress multiple is established at levels lower than the level for the BBB rating.
Table: Stress multiple for default rate by underlying asset type and by targeted rating Underlying asset type Targeted Personal Corporate Residential loan rating receivables receivables receivables AAA 3 5 2.75 AA 2.5 4 2.29 A 2 3 1.83 BBB 1.75 2.5 1.6
149/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
The stress multiple is increased if exposures are concentrated, if the attribute distributions are concentrated, or if there is a possibility that variations of default rate may become relatively large. Or, an appropriate stress scenario is applied to the rated product by making a specific amount of large-lot exposures go into default. Conversely, the stress multiple is decreased and an appropriate stress scenario is applied to the rated product if exposures are diversified, if attribute distributions are diversified, if there is a factor that renders the level of default rate stable, or if variations of default rate become relatively small.
II. Establishing stress scenario based on standard deviation If exposures of the securitization pool are diversified and if the performance of default rate is assumed to remain stable, the stress scenario can be established on the basis of the standard deviation obtained from historical data on the reference pool. For the purpose of establishing such a stress scenario, R&I prescribes specific requirements for the degree of exposure dispersivity and stability of performance of the securitization pool. Of installment receivables, auto loan receivables and shopping receivables can be cited as underlying assets that fulfill such requirements. The basic configuration of the stress scenario is established by adding the standard deviation as multiplied by a stress coefficient corresponding to the targeted rating to the standard scenario. The configuration of the ultimate stress scenario is established by taking the past similar issues’ performance, characteristic features, and trends of data on underlying assets comprehensively into account.
III. Stress scenario for promissory note receivables/accounts receivable
A. Basic concept The terms of promissory note receivables and accounts receivable are typically as short as three months. If short-term funds are to be raised through such assets, a certain bias ordinarily arises in the exposure because the receivables pool created with the originator is assigned virtually on an as-is basis as a securitization pool without sorting the degree of diversification. At the same time, by virtue of the fact that the terms are short, the default rate as a percentage representing dishonored receivables during the securitization period is relatively low. For this reason, it is important to establish a stress scenario that takes large-lot obligors into account. The stress scenarios in this case are established basically by combining the following two amounts:
1. Default loss related to large-lot obligors
2. Default loss based on the stress multiple for the portion excluding large-lot obligors
150/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
B. Default loss related to large-lot obligors Default losses related to large-lot obligors are equivalent to the amounts of underlying receivables of obligors with a large obligation that need to be covered based on the characteristics and the targeted rating of the securitization pool. The number of obligors with a larger obligation that needs to be covered varies, depending on (1) the amount-weighted average term of the securitization pool, (2) the level of default rate deemed to arise from the securitization pool, and (3) the targeted rating of the product subject to rating. For example, if the credit rating of the senior portion is set at a-1+, basically one large-lot obligor is assumed to default each month, although it differs depending on the amount-weighted average term and the level of default rate. The level of homogeneity and diversity and concentration on corporate group are considered in setting the number of obligors that need to be covered. If, as of the initial time point, an obligor with a credit rating equal to or higher than the targeted rating for the senior portion is included among the obligors with a larger obligation, that obligor is basically considered to have creditworthiness comparable to or higher than that of the rated product, and is not included in the default loss related to large-lot obligors.
IV. Stress scenario using the small pool approach If the number of obligors is relatively small, in some cases the stress scenario of the small pool approach, which is discussed in the next Subchapter, using information on the creditworthiness of obligors (financial scores, probability of default (“PD”), etc.), is combined. Taking into account product attributes, the small pool approach could be set as a main scenario. Using the small pool approach as an analysis, PD rather than credit rating is used with respect to the obligors’ creditworthiness. In addition, if the small pool approach is set to be the main scenario, default losses related to large-lot obligors are considered according to the underlying assets or securitized products.
Section 6: Reminders on performance data other than default rate
I. Prepayment rate Any and all events whereby the principal to be collected is credited earlier than the due date as a result of obligors’ prepayments, early cancellations, etc., are referred to collectively as prepayments. Prepayment rate is defined, according to the originator’s data aggregation criteria or purpose of analysis, as the prepaid principal as a percentage of the aggregate principal to be collected during a specific period, the prepaid principal as a percentage of the beginning balance of a specific period, etc. As in the case of default rate, prepayment risk is analyzed by the large
151/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
pool approach if the securitization pool is broken into a large number of small-lot receivables and its performance can basically be estimated from that of the originator’s business.
A. Future interest If any prepayment occurs, whether or not an amount equivalent to future interest is paid varies depending on the nature of the underlying assets. With respect to future interest, receivables are classified broadly into receivables for which the full amount equivalent to future interest is paid at the time of prepayment (such as fully paid out lease receivables), receivables for which no future interest is paid (such as auto loan and other conventional installment receivables), and receivables without a contractual concept of future interest (such as installment receivables related to mobile phones).
B. Characteristic features of a receivables pool Principal factors having influences, as characteristic features of a receivables pool, on the level and fluctuations of prepayment rate include various items such as the obligors’ attributes (gender, age, income, resident area, and business industry), types of good attributable to the creation of receivables, time elapsed since the creation of receivables, outstanding balance of receivables, and interest rate environment.
C. Stress scenario Whether relatively high or relatively low, the prepayment rate can give rise to a stress scenario depending on credit risk factors associated with the structure of an SF Product. For example, for the purpose of analyzing a servicer’s commingling risk, the larger the amount retained with the servicer is, the greater the amount of loss at the time of the servicer’s bankruptcy is. Hence, estimating a higher prepayment rate gives rise to greater stress. For the purpose of analyzing default risk, the less often prepayments occur, the greater the aggregate amount of securitization pool is exposed to default risk. Hence, estimating a lower prepayment rate gives rise to greater stress. Therefore, for the purpose of analyzing prepayment risk, an appropriate stress scenario is established by giving due consideration to the frequency of occurrence of prepayments, magnitude of fluctuation of prepayment rate, latent risk factors, etc. A cash flow test is performed, as needed, by establishing a stress scenario that causes the prepayment rate to fluctuate within a specific range. In the cases of residential loan receivables, prepayments occur at a fairly high rate over the long-term. Hence, a stress multiple is established for each targeted rating after establishing the standard scenario for prepayment rate.
152/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Table: Stress scale multiple for prepayment rate on residential loan receivables by targeted rating Targeted rating Stress multiple AAA 0.5 AA 0.6 A 0.7 BBB 0.8
II. Dilution rate As in the case of default, the occurrence of dilution causes losses in underlying assets. Hence, as in the case of default rate, an analysis using the large pool approach may be performed. The large pool approach is applied to medical fee receivables, accounts receivable for which service provision has been completed, and other receivables with stable historical data. As dilution risk comes with a higher degree of severalty than does default risk, an appropriate configuration should be established by such means as taking the maximum value of historical data for the purpose of a stress scenario.
III. Performance of revolving payment personal receivables (default rate, principal payment rate, yield) There are monetary receivables whose aggregate amount increases or decreases as individual obligors make principal repayments including partial prepayments or borrow additional funds and the contracted repayment amounts (linked to the balance of receivables) change. Consumer loan receivables held by moneylenders fall under the category of such receivables. Default rate, principal payment rate, and yield are the three principal indices intended to track cash flow fluctuations. Principal payment rate indicates the risk that the amount repaid by obligors decreases and the amount exposed to default risk increases as a result of changes in the obligors’ repayment table, increases in the number of delinquent obligors, etc. Yield indicates the risk that the yield in the pool of assigned receivables declines and the amount of interest collected decreases as a result of a downturn of interest rate applicable to receivables, increase in number of delinquent obligors, etc. An appropriate stress scenario is established for each of these three indicators by giving consideration to attribute information (the obligors’ gender, resident areas, applicable interest rates, outstanding balance, credit limits, annual income and LE) and performance triggers, etc.
153/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Table: Stress multiple for default rate by targeted rating(Revolving payment personal receivable) Targeted rating Stress multiple AAA 4 AA 3 A 2.5 BBB 2
IV. Rate of recovery from defaulted receivables With respect to the rated product for which recovery from defaulted receivables can be expected structurally, a scenario with a reasonable rate of recovery from the defaulted underlying assets is established primarily from the following perspectives:
Adequacy (absence or otherwise) of collateral assets Liquidity (whether or not disposal is possible) Liquidity period (whether or not liquidation is possible during the issue term)
The reasonableness of the scenario for the recovery rate is judged comprehensively from the aforementioned perspectives by taking into account the characteristic features of the underlying assets of the rated product and the structure for recovery. In the absence of any particularly advantageous or disadvantageous factor for recovery, R&I normally assumes that the degree of recovery at default ranges between 20% and 70%. If there is no liquidity or in the case of a rated product without a reasonable liquidity period, no recovery is basically expected from the defaulted receivables.
V. Expected cash flows from newly created receivables The contracted amount of repayment (expected cash flow) on the securitization pool may fluctuate during the term when monetary receivables as underlying assets are created or added during the remaining term of the rated product. In such a case, a reasonable expected cash flow scenario would be established by taking into account the characteristic features of the structure for creation/addition of monetary receivables for the rated product.
154/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach)
This Subchapter describes the credit rating of products whose underlying asset is a monetary receivables pool consisting of a relatively small number of obligors, among all SF Products backed by monetary receivables. The small pool approach refers to the analysis, in the process of credit rating these products, of the default loss the pool incurs based on the creditworthiness of an individual obligor. In the small pool approach, a default loss is analyzed from the perspectives of three factors: creditworthiness of obligors, correlations among them, and default recovery rate with a model. It is important to appropriately evaluate the creditworthiness of obligors. The major perspectives are fluctuation risk of loss amount caused by the creditworthiness of obligors and correlations among them.
Section 1: Creditworthiness of obligors If the obligor has a credit rating published by R&I, such a credit rating is used, in principle. Some alternative manner may be used for an obligor without credit rating published by R&I, including non-public unsolicited credit ratings, mapping internal ratings by financial institutions to the issuer ratings by R&I, mapping of default probability estimated from data of credit research companies or historical data on various models of database companies to credit ratings of R&I, mapping of credit ratings by other rating agencies to those by R&I, or estimations based on financial data using a rating estimation model. If there are any differences among definitions of default, appropriate adjustments are made. When mapping, the credit evaluation method used for mapping is reviewed and a response is taken in a conservative manner. If it is impossible to directly study the method in a due diligence meeting, etc., the upper limit may be set on the amount or the number of products for the product subject to mapping to fall within a certain range of the subject portfolio from the viewpoint of maintaining the reliability of the product subject to ratings.
Section 2: Correlation among creditworthiness of obligors The correlations among creditworthiness of obligors suggest there are some risk factors common to two obligors (Common Risk Factor). If the common risk factor is relatively large, a risk of concurrent default rises and dispersivity of receivables pool is substantially low. In the small pool approach, defining nationality factors and business-type factors as major common risk factors, an evaluation is made for each obligor based on these factors, in view of historical data and analyses of analysts of each business industry to decide correlations among creditworthiness of obligors.
155/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
If a receivables pool heavily consists of obligors that belong to some specific business industry and common risk factors are considered to be relatively large, a stronger correlation may be applied; on the contrary, if these factors are considered to be relatively small, a weaker correlation may be applied.
Section 3: Rate of recovery after default With respect to the rated product for which recovery from defaulted receivables can be expected structurally, a scenario with a reasonable rate of recovery from the defaulted underlying assets is established primarily from the following perspectives:
Adequacy (absence or otherwise) of collateral assets Liquidity (whether or not disposal is possible) Liquidity period (whether or not liquidation is possible during the issue term)
The reasonableness of the scenario for recovery rate is judged comprehensively from the aforementioned perspectives by taking into account the characteristic features of the underlying assets for the rated product and the structure for recovery. In the absence of any particularly advantageous or disadvantageous factors for recovery, R&I normally assumes that the degree of recovery at default ranges between 20% and 70%. If there is no liquidity or in the case of a rated product without a reasonable liquidity period, no recovery is basically expected from the defaulted receivable.
Section 4: Model Credit enhancement amount required for targeted ratings is decided using the Monte Carlo Simulation, while incorporating an evaluation of creditworthiness of obligors, correlations among them, and recovery rate after default. The Gaussian factor copula model is assumed to be the model used. The model simulates that the distribution of times when multiple obligors fall into default (“defaulting time”) is related through a multi-dimensional normal distribution. A correlation is found on the assumption that the default time for each obligor is affected by common risk factors. The concept of a weak link is partially incorporated in the model. As a multipurpose model, R&I has published R&I Tranche Pad Version 1.0 (Appendix), which implements the aforementioned simulation method, assuming a portfolio consisting of obligors from well-dispersed business industries. R&I only uses R&I Tranche Pad Version 1.0 and its amended versions in which parameters are amended in line with aforementioned concept.
156/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 3: Analysis method for real estate securitization
This Subchapter discusses credit ratings for real estate securitization. Real estate securitization can be broadly categorized into “single-borrower” that attract ratings for or are backed by a real estate non-recourse loan to a single borrower, and “multi-borrower” that are backed by real estate non-recourse loans to multiple borrowers. Note that most real estate securitizations originated after the Lehman crisis are single-borrower transactions. This Subchapter first describes the basic analysis method for real estate non-recourse loans. This is followed by descriptions regarding single-borrower, multi-borrower, and development-type real estate securitizations.
Section 1: Basic analysis method for real estate non-recourse loans
I. R&I evaluation amount
A. Basic approach In general, real estate non-recourse loans fund interest and scheduled principal payments during the term with cash flows generated from leasing operations of the underlying real estate, and final principal repayment with funds procured through the sale of the underlying real estate or refinancing. Many transactions do not make scheduled principal payments during the transaction period, and even if such payments are made, the amount would represent a very small proportion of the total principal amount. Hence, all or a large part of the principal amount is repaid at the end of the loan term. In this context, analysis regarding the probability of underlying real estate sale or refinancing is extremely important in evaluating the certainty of loan repayment. The analysis is centered on an assessment regarding the market value of the underlying real estate at the end of the loan term. In light of the fact that loans typically have a maturity of three to five years and the possibility of early principal repayment, the assessment regarding the market value of the underlying real estate focuses on achieving stability in the medium-term. R&I believes that the direct capitalization method is the appropriate method to achieve stability in the medium-term regarding the assessment of the underling real estate value. Under the direct capitalization method, real estate value is calculated by discounting the net cash flow (NCF) generated during a specific period with a capitalization yield (cap rate). R&I may adopt the DCF method when the revenue and expense structure of a real estate is likely to change in the near future. An example of such case would be a single-tenant building, where there is a high possibility of the contract rent being renewed or the building being converted into a multi-tenant building after a certain period.
157/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
B. Net cash flow (NCF) The NCF used for the purpose of the analysis using the direct capitalization method is determined based on historical track record, but future expectations are also taken into consideration. Considerations regarding the future would involve an assessment of the supply and demand situation in the relevant markets and stability of NCF, among other factors pertaining to the underlying real estate. R&I also takes appraisal values and the rationale behind such values into consideration. The stability of NCF is assessed based on the following key characteristics of the underlying real estate: Location: transportation access and surrounding environment Use of facilities: relevance to location Grade of building: size, quality of facilities, age, and seismic resistance Management conditions: management structure and quality Ownership rights: flexibility regarding management in case of partial ownership rights Tenant base: creditworthiness of tenant and continuity of lease agreement in the case where diversification of the tenant base is limited
C. Capitalization yield (cap rate) The cap rate used for the purpose of the analysis using the direct capitalization method is determined by adding a unique risk premium of the underlying real estate to the base yield determined by R&I, and by comparing this to examples of appraisals adopted by similar properties held by J-REITs and expected cap rates from various surveys. The base yield determined by R&I is the cap rate that is applied to properties that attract the lowest investment risk, which are A-Class buildings located in the Marunouchi/ Otemachi District. The risk premium is determined based on an assessment of the stability of NCF regarding the underlying real estate.
II. Credit enhancement The credit enhancement level of a loan subject to rating is confirmed by conducting LTV and DSCR tests.
A. LTV test LTV (loan-to-value) refers to the ratio of loan balance (margin of collateral) against the value of the underlying real estate. If the value of the underlying real estate exceeds the loan balance, the principal of the loan can be repaid by selling the real estate; therefore, the lower the LTV, the higher the probability of loan repayment. LTV is a measure of the size of cushion
158/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
against the risk of a decline in real estate price during the term. A LTV test is conducted to determine whether or not the size of cushion is sufficient against the rating level. Specifically, R&I confirms whether or not the LTV of the loan subject to rating is within the upper limit of LTV that R&I sets for a targeted rating (LTV requirement). The LTV requirement is determined for each product with a primary focus on the risk of decline in real estate price. When analyzing this risk, R&I considers the liquidity of the underlying real estate, as well as the risks that are common across the entire real estate market. The liquidity of an underlying real estate is determined based on the following key factors: Location Use of facilities Grade of building Status of maintenance and management Ownership rights Quality of tenants Furthermore, in R&I’s view, the overall cash flow stability is generally higher, when properties and tenants are more diversified, and the risk of a decline in real estate price would be reduced for transactions with shorter maturities. Therefore, an LTV requirement is determined by taking into consideration the number of properties and the maturity of the transaction, in addition to factors that are unique to the underlying real estate. The table below shows LTV requirements for transactions with a maturity of five years. When the maturity of a transaction is less than five years, R&I may ease (lower) the LTV requirement from those for five-year transactions, by taking market trends into consideration.
■ LTV range for each target rating (%)
Targeted LTV AAA AA A BBB BB LTV requirement 34-49 39-55 48-65 56-75 65-85
■ (Reference) Guideline for transactions backed by 1 property/ more than 10 properties
AAA AA A BBB BB 1 property Around Around Around Around Around 38 45 54 63 72 More than 10 Around Around Around Around Around properties 44 50 59 69 78
B. DSCR test DSCR (debt service coverage ratio) is a measure that represents the capacity to make
159/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
interest and scheduled principal payments during the term. It is calculated by dividing the cash flow generated during a certain period (the amount before interest and principal payments) by the amount of interest and principal payments during the same period. A higher DSCR means a higher capacity for interest and principal payments. On the other hand, DSCR of less than 1.0 indicates a shortfall in interest and principal payments. A DSCR test is conducted to determine whether or not the capacity to make interest and principal payments during the term is sufficient against the rating level. Specifically, R&I confirms whether or not the DSCR of the loan subject to rating exceeds the lower limit of DSCR that R&I sets for a targeted rating (DSCR requirement). The DSCR requirement is determined based on the same factors as the LTV requirement. However, R&I may adjust the calculated DSCR if the cash flow is particularly stable due to a structure of liquidity enhancement or a long-term lease contract. If the loan subject to rating has a variable interest rate, a certain level of a rise in the interest rate is assumed and incorporated into the DSCR calculation. The table below is a guideline for DSCR requirements by target rating level for transactions with a maturity of five years and backed by more than 10 properties.
■(Reference) Guideline for transactions backed by more than 10 properties
(X)
Targeted rating AAA AA A BBB BB DSCR Around Around Around Around Around requirement 2.3 2.0 1.7 1.5 1.3
III. Liquidity risk When there is a risk that events, such as the departure of a large tenant, may lead to a temporary decline in operating revenue of the underlying property, an analysis is conducted on whether or not the loan subject to rating can pay interest and principal and the expenses required to maintain the transaction scheme during the term. If there is a risk of a payment shortfall, and the risk of large tenant departure is high, R&I confirms whether a structure is in place to provide liquidity enhancement. The risk of large tenant departure is assessed from the perspective of i) the likelihood that the lease agreement will be maintained and ii) creditworthiness of the tenant, among other factors. The risk of large tenant departure is deemed high if the likelihood that the lease agreement would be maintained is low or the creditworthiness of the tenant is below the target rating level. In such case, R&I conducts a cash flow analysis taking into account a period following the exit of the tenant during which no revenue generation is expected, to ensure that sufficient liquidity reserves
160/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
are provisioned to make payments during that period. R&I sets the expected period during which no income is generated for each target rating level, by taking into consideration the probability of tenant replacement regarding the underlying real estate. Such period will not be required if the risk of large tenant departure is deemed low; that is, when the lease agreement is likely to be maintained given that the term of the lease agreement is long or the tenant is restricted from terminating the agreement, and the tenant’s creditworthiness is in line or above the target rating.
IV. Considerations regarding transaction scheme The key features regarding a transaction scheme that could impact the interest and principal payment of the loan subject to rating that should be taken into consideration are as follows:
1. Assigning the right to control the real estate sale to the lender In light of the possibility that a certain event such as lapse of the scheduled repayment date occurs, R&I confirms that an effective structure is in place in advance to assign the lender the right to control the property sale.
2. Senior/ subordinated structure When subordinated loans or equity tranches are established, R&I confirms that an effective scheme is in place to ensure that the product subject to rating receives interest and principal payments on a priority basis.
3. Event of default stipulated in the loan agreement Such events generally affect the rating of the product to be rated. Hence, if events of default other than those pertaining to the creditworthiness of the borrower or the underlying real estate are stipulated, R&I confirms the probability of occurrence of such events.
Section 2: Single-borrower transactions Single-borrower real estate securitizations are transactions that attract ratings for or are backed by a real estate non-recourse loan to a single borrower. The analysis method described in Section 1 of this Subchapter is applied when the product subject to rating is a loan. In the case of products backed by loans, analyses regarding liquidity risk and the features of the transaction scheme at the product level are required, in addition to an analysis regarding the underlying loan.
Section 3: Multi-borrower transactions Multi-borrower real estate securitizations are transactions backed by non-recourse loans to multiple borrowers. Multi-borrower transactions are typically originated by the lender, who
161/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
transfers multiple loan receivables to an SPV. The SPV subsequently issues bonds backed by the loan receivables, and sells the bonds to investors. When the SPV is a trust, investors acquire the trust beneficial interest issued to the lender by the trustee of the loan receivables. Bonds and trust beneficial interest are often issued in multiple tranches under a senior/ subordinated structure. The cash flow risk analysis for multi-borrower transactions follows the process described below. I. Tranching of underlying loans II. Tranching of product subject to rating III. Identifying liquidity risk VI. Identifying key features of transaction scheme
I. Tranching of underlying loans The underlying loan is analyzed to determine the credit enhancement level for each rating level. The analysis method described in Section 1 of this Subchapter is generally applied.
II. Tranching of product subject to rating In the case of multi-borrower transactions, the credit limits for each rating level is determined based on the aggregate amount of credit limits at each rating level for the individual underlying loans, but also takes into account the impact of having multiple loans in the underlying portfolio. When the underlying loans of the product subject to rating are cross-collateralized, the LTV of product subject to rating is evaluated in the same way as a loan for a single borrower holding multiple properties. When the underlying loans of the product subject to rating are not cross-collateralized, the most subordinated tranche will face losses if any one of the underlying loans faces principal losses; in other words, the greater the number of underlying loans, the higher the probability of principal loss. Hence, depending on the number of underlying loans, the transaction level credit limit may be lower than the aggregate of the credit limits for the same tranche at the individual loan level. Tranches other than the most subordinated tranche generally benefit from the diversification effect achieved by the multiple underlying loans. Hence, depending on the number of underlying loans and the variety in loan size, transaction level credit limits for tranches other than the most subordinated tranche may be higher than the aggregate of the credit limits for the same tranche at the individual loan level.
162/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
III. Confirming liquidity risk The underlying loans in multi-borrower transactions usually have different terms and conditions, including redemption date and interest rate. Early repayment of principal is also considered on a loan-by-loan basis. Principal redemptions of multi-borrower transactions match the principal redemptions of underlying loans. In a typical multi-borrower transaction, the tranche attracting the lowest interest rate receives principal payments before the subordinated tranches (sequential payment). In this case, both the weighted average interest rate on the underlying loan pool and the interest rate on the product subject to rating will change when some, but not all, of the underlying loans are repaid. As a result, a transaction may face a situation where interest income from the underlying loan pool falls short of the amount required to cover interest payments. In the rating analysis, R&I establishes multiple scenarios regarding principal repayments on the underlying loans to confirm the impact of changes in cash flows on the product subject to rating. When liquidity enhancement, such as cash reserves and lines of cash advance, is provided, R&I determines the adequacy of such measures.
IV. Confirming key features of transaction scheme Cash flow risk analysis is focused on the effectiveness of the recovery structure regarding the underlying loans. The effectiveness of the recovery structure is particularly important in the case where the underlying loans are subject to default risk associated with factors other than the creditworthiness of borrowers or underling real estate. When a servicer conducts recovery operations, the track record and capability of the servicer must be confirmed.
Section 4: Development-type real estate securitization In this Section, development-type real estate securitization refers to transactions that aim to fund real estate development projects. A real estate development project typically involves the process of acquiring land, obtaining administrative permits and approvals required for construction, and completing the construction of the building. The key risk factors associated with development-type real estate is described below (please refer to Section 2 of Subchapter 14, Chapter 3 for details). Pre-development risk Construction project completion risk Fluctuation risk associated with cash flows from leasing operations Fluctuation risk associated with market value
163/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
In a typical development-type real estate securitization, the construction of the building is not completed as of the date of financing, and a certain period of time is required before the construction is completed. Therefore, analyses of development-type real estate securitizations involve more items of credit risk compared to securitizations backed by real estate that is already in operation. Also, credit risks subject to analysis will differ depending on the stage of the development project at which the financing is executed. The earlier the stage at which the financing is executed, the more risks the project will face during the period up to the completion of the building. For example, if the financing is executed for the purpose of acquiring land for development, risks associated with the process up to the launch of the construction project, such as acquiring the relevant permits and approvals, should be taken into consideration, in addition to risks during the construction period. The longer the period up to the completion of the building and the greater the items of credit risk involved, the higher the fluctuation risk associated with cash flows from real estate following the completion of the building. The analysis method for development-type real estate securitization conforms to the method described in Section 2 of this Subchapter (single-borrower transactions). R&I assesses the value of the underlying real estate based on the assumption that the building has been completed as planned. As for liquidity risk, R&I takes into consideration the fact that cash flows to pay interest and principal and expenses required to maintain the transaction scheme will not be generated until the building is completed as planned and the occupancy rate reaches a certain level. A rating is assigned based on an evaluation of various credit risk factors and countermeasures against each risk. The rating evaluation generally reflects the lowest credit quality suggested by the various credit risk factors.
164/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 4: Analysis method for project finance
This Subchapter discusses the cash flow analysis method for project finance.
Section 1: Perspectives for credit rating Debt in project finance is typically repaid over a long period, and the source of funds for repayment is, in principle, limited to cash flows generated by a specific project. Hence, it is important to determine the long-term stability and adequacy of the project’s cash flows. R&I places importance on DSCR as the quantitative measure of the cushion against debt repayment that is provided by cash flows. R&I sets DSCR requirements by target rating level based on the stability of cash flows generated by the project.
Section 2: Overview of contents of analysis R&I conducts an analysis on a project’s capacity to generate cash flows and identifies the associated risk factors by examining the project’s content, financing scheme and the capabilities of the related parties. Taking such analyses into consideration, R&I projects cash flows based on R&I’s standard scenario, and further establishes various stress scenarios to assess the tolerance level of debt repayment. The DSCR requirement to be applied to a product subject to rating is decided based on the stability of cash flows, which in turn is assessed based on the project’s content and financing scheme, among others. DSCR is calculated based on standard and stress scenarios. The DSCR based on the standard scenario is then compared against the DSCR requirement in order to check whether it meets the level required to achieve the targeted rating. An analysis based on stress scenarios is further conducted. The final rating symbol is decided based on a comprehensive assessment, including analyses on risk factors other than those pertaining to cash flows.
I. Analysis of standard and stress scenarios R&I establishes R&I’s standard scenario by projecting future trends regarding the factors that affect cash flows in light of the project’s content and business environment, among others. R&I further establishes various stress scenarios in light of the project’s content and business environment, among others, to assess the tolerance level of debt repayment.
II. Evaluation of cash flow stability The cash flow stability of a project will depend on its characteristics. The certainty of interest and principal payment on the product subject to rating should differ between a project with
165/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
highly stable cash flows and a project with low cash flow stability, even if their DSCR is the same under the standard scenario. Hence, R&I establishes a different set of DSCR requirements by target rating level for the different levels of cash flow stability. Cash flow stability is generally categorized as “high”, “medium”, and “ low”, based on a comprehensive assessment regarding the project’s content and financing scheme, among others. The key perspectives in determining cash flow stability are the following:
【Key perspectives to determine cash flow stability】 A) Revenue characteristics ・ Volatility in production volume, sales volume, unit sales price, etc. ・ Diversification of revenue sources B) Expense characteristics ・ Volatility of the procurable amounts and prices of raw material/ fuels ・ Volatility of operating costs (O&M fee, repairing, maintenance, replacement of parts, etc.) C) Facility characteristics ・ Difficulty of operation ・ Reliability, durability, and robustness of facilities ・ Technological maturity D) External factors ・ Probability and impact of accidents and natural disasters, etc. E) Track record of similar projects ・ Track record of similar projects operated by other sponsors ・ Track record of similar projects operated by the same sponsor ・ Historical track record, in case of projects already in operation F) Financing scheme ・ Structures that enhance the flexibility of the repayment schedule and tolerance level of repayment (e.g., availability of provisions for payment deferrals, availability of tail period, existence of dividend suspension trigger) ・ Interest rate type
III. DSCR requirement by target rating level DSCR requirements are established based on the stability of cash flows. Guidelines for DSCR requirements are shown in the table below. If the cash flow stability regarding a product subject to rating is deemed to fall somewhere between “high”, “medium” or “low”, or higher than “high” or lower than “low”, then the DSCR requirement by target rating level will be established by
166/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
interpolating the values in the table shown below.
＜Guidelines for DSCR requirements by target rating level＞ CF Stability AAA AA A BBB BB High － 1.80 1.50 1.30 1.20 Medium － － 1.80 1.50 1.30 Low － － － 2.00 1.80
IV. Analysis based on DSCR In order to calculate DSCR, R&I conducts a cash flow simulation based on a standard scenario that R&I considers reasonable. In principle, R&I confirms that i) the DSCR calculated based on the standard scenario meets the DSCR requirement for the targeted rating, and that ii) the results of the cash flow simulations based on stress scenarios for the targeted rating taking into consideration the waterfall and level of cash reserves indicate a high tolerance level against debt repayment.
V. Confirmation of level of cash reserves R&I confirms that liquidity enhancement and cash reserves necessary to ensure business continuity have been established. Cash reserves of an amount equivalent to interest and principal payment for a certain period (e.g. 6 months) and maintenance costs for the main facility, among other items, should be made available as necessary to pay expenses and ensure timely payment of interest and principal. The risk that costs may exceed initial expectations is taken into account when the facility adopts technology with limited track record, the maturity of the technology is low, or the replacement of parts is difficult.
VI. In case of PFIs In the case of PFIs, associated business risks differ by project depending on the content of the business such as the revenue payment type and importance of operation of the project. R&I identifies the business risks associated with a PFI and the situation regarding risk-bearing based on the application guidelines and the terms of the various contracts, among others. If an operator receives payments from the public sector for the public services that it provides in installments, and uses the funds received to make payments on the product subject to rating (service-providing project), it is the public sector which is obliged to make payments. Therefore, the credit rating is determined based on the off-taker’s creditworthiness and certainty of payments. R&I conducts an analysis on the terms of the agreement between the off-taker and the SPV, with a particular focus on (a) ability to cancel or amend the contract, (b) prescribed payment
167/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
amount and schedule, and (c) rules regarding the amendment of payment amount, among others. The ability of the public sector to meet its debt obligation in a PFI project can be considered to be equivalent to the creditworthiness of the public sector when the following conditions are met: 1) a PFI agreement duly concluded based on the decision by parliament exists, 2) monetary obligations under the relevant agreement have been passed by the parliament as an obligation, and 3) descriptions of debt, such as amount and payment schedule, are clearly defined. In the case where the operator provides services by conducting the operation and management of the project, and uses the cash flows from operating revenues to pay interest and principal on the product subject to rating (financially self-standing project), a specific off-taker does not exist. In such case, interest and principal payments will rely on the operating revenues of the PFI project. Hence, R&I also applies the analyses described in I. through V. above for such projects. In the case of combination-type PFIs that carry features of both service-providing and financially self-standing projects, R&I conducts an analysis by combining the approaches to service-providing and financially self-standing projects based on the weight of such features in a project.
168/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 5: Analysis method for business cash flow, etc.
This Subchapter describes credit rating of SF products that raise funds based on underlying assets of business cash flow, etc.
Section 1: Securitization of business Securitization of a business means “raising funds from bonds or loans, etc., backed by future cash flow generated by a specific business,” and is positioned midway between asset securitization (regular securitization transaction) and loans for business corporations or bonds. Approaches mentioned below are applied for issues satisfying all requirements A to C below.
A. Bankruptcy remoteness is secured through a true transfer by the originator of the subject business or assets.
B. The continuity and stability of the subject business is high.
C. The subject business is expected to continue after the originator falls into bankruptcy.
The source of payments against products subject to rating (loan, bond, beneficial interest, etc.) is basically cash flow from the subject business. In the rating analysis, risk or ability to create cash flow of the relevant business is analyzed first and then the amount of the source of payments generated is predicted. The stress scenario assumes a deterioration of the business environment or a decrease in competitiveness or influence of originator’s bankruptcy. Possibility of repayment of the rated product is evaluated in line with Debt Service Coverage Ratio (DSCR), etc., obtained from the estimated amount of the source of payments generated and amount required for principal and interest payments. If the originator’s bankruptcy affects the possibility of repayment, when the creditworthiness of the originator declines, the credit rating of the product subject to rating may be lowered. Based on an evaluation of the possibility of repayment, a credit rating is assigned in view of the degree of bankruptcy remoteness or descriptions of covenants.
Section 2: LBO, in which a financial buyer is an investing body The LBO scheme assumed in this section is a scheme under which a financial buyer including a buy-out fund establishes a SPV, which obtains shares of a company, the target of the acquisition, using equity funds or senior loans or mezzanine finance (subordinated loan or preferred stock) from financial institutions. When a financial institution provides a loan to a SPV, it typically i) requires
169/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
joint and several guarantees from the subject company, ii) takes the entire assets of the subject company as security, iii) takes shares of the subject company held by the SPV as security, and iv) sets up covenants for the subject company and the SPV. Once acquisition is completed, the SPV and the subject company typically merge after a certain period. However, they may not merge if the merger causes disadvantages such as approval becomes invalid or a huge amount of goodwill is generated. The basic approach of a credit rating for senior loans or mezzanine finance is explained below. If the subject company and the SPV have merged, the credit rating of an individual loan is decided based on the issuer rating of the company after the merger, taking into consideration payment priority, security priority, possibility of recovery in the event of bankruptcy, covenants or governance, or governance and business support of funds. Due attention is paid to whether the payment method is that promised in the contract or lump-sum payment after a certain period, whether covenants are set up so that if the fund exits during the term the product to be rated is repaid at the same time, what achievements the fund has made, what attitude the fund takes on this issue, what exit strategy is set, etc. If the subject company and the SPV have not merged, the issuer rating of the company after merger, if they merge, is estimated and used as a base, on the condition that the aforementioned requirements i) to iv) are all satisfied. The approach to credit rating is basically the same as that mentioned above.
Section 3: Asset Finance In the rating analysis of asset finance (as specified in Section 23, Chapter 3), R&I focuses on the value of underlying assets and related expected business cash flows. When analyzing the risks, R&I analyzes first the price stability/ liquidity at the time of sale of underlying assets, and ability to generate business cash flows from the assets, among other things. Then, R&I conducts an analysis on business environment, market trends and competitiveness of underlying assets, as well as policies, operating structures, and track record, etc. of the companies involved in business operations and management of underlying assets. Taking such analysis into consideration, R&I predicts the amount of repayments generated, based on establishing a reasonable standard scenario and various stress scenarios to assess the tolerance level of the debt. In addition, if a structural measure is available to enhance the probability of principal and interest payment of product subject to rating, R&I takes such factors into account comprehensively.
170/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 6: Analysis method using cash flow test
This Subchapter discusses credit ratings of SF products for which cash flow changes in a complex manner due to a combination of multiple risk factors. A cash flow test is a test for examining the certainty of payments of principal and interest on products to be rated through simulations of installment receivables, lease receivables, and residential loan receivables using a complex scenario consisting of multiple factors in a credit rating of these products. Risk factors subject to the cash flow test are default, prepayment, recovery after default, interest rate fluctuations, and servicer bankruptcy.
Section 1: Underlying assets The basic approach of Section 1: Large pool approach is applied to scenario of default, prepayment, or recovery after default, etc. A complex stress scenario is created by combining scenarios within a certain scope with the limits of the stress scenario for each risk factor, if any.
Section 2: Interest rate fluctuation If either the interest rate on underlying assets or rated products is a variable interest rate, or both rates are variable, there exists a risk that an excess spread may decrease or a negative carry may arise depending on the difference with the index interest rate or the difference with the time the rate is decided (interest rate fluctuation risk). Interest rate fluctuation risk is evaluated with a rate-declining scenario for the case in which the interest rate on underlying assets is variable, with a rate-increasing scenario for the case in which the interest rate on rated products is variable, and with a combination of both scenarios for the case in which both rates are variable. If interest rate fluctuation risk is hedged by a swap contract, etc., it is to be confirmed whether interest rate fluctuation risk can be sufficiently hedged by the contract concluded. For swap counterparty default risk, refer to Chapter 2, Subchapter 3 Structure of asset administration.
Section 3: Servicer bankruptcy If the servicer falls into bankruptcy, commingling loss risk that money collected from underlying assets may be lost, or liquidity risk due to stagnant collection operations may arise. The extent of a commingling loss depends on the amount of funds retained at the servicer when the servicer falls into bankruptcy. Liquidity risk depends on expenses and amount of interest concerning rated products when the servicer falls into bankruptcy. As either amount is influenced by cash flow from underlying assets, the timing of the servicer’s bankruptcy and other risk factors will be simulated.
171/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Section 4: Waterfall Cash flow generated from underlying assets is distributed in accordance with the distribution priority under the contract. Even if the principal amount collected from cash flow generated from underlying assets exceeds the principle amount of the rated product, the principal of the rated product does not always have higher priority unless the money collected is distributed to the rated product. A simulation is performed based on the waterfall described in the written contract.
172/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure
This Subchapter describes the credit ratings of products subject to rating for which an evaluation is based on credit ratings of underlying assets and parties involved in the structure.
Section 1: Link of credit ratings
I. Link If there is one underlying asset and a party associated with the structure (party to whom creditworthiness belongs), which is to be evaluated based on credit rating, the credit rating of the party to whom creditworthiness belongs becomes the credit rating of the product subject to rating. If there are several parties to whom creditworthiness is associated, the judgment is made as described below.
II. Weak link If the default of any one of the parties to whom creditworthiness is associated causes the default of the product subject to rating, the lowest credit rating of all the parties to whom creditworthiness is associated becomes the credit rating of the product subject to rating. However, the number of parties to whom creditworthiness is associated, which can be considered by this method, is limited to nine.
III. Strong link If the product subject to rating does not default unless all of the parties to whom creditworthiness is associated default, the highest credit rating of all the parties to whom creditworthiness is associated becomes the credit rating of the product subject to rating.
IV. Exceptional application of strong link (Joint support) A strong link would be applied to a structure under which several parties jointly owe one obligation (joint support). Unless there is strong dependence between parties owing the debt, it can be estimated that no loss is incurred unless either obligor defaults. Hence, a higher credit rating than that of the issuer rating of both parties may be assigned to the product subject to rating. The effect of joint support depends on the structure of debt burden, creditworthiness of obligors, and strength of correlations among obligors. The strength of correlations is decided by the extent to which risk factors are common such as descriptions of businesses of obligors,
173/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
capital relationships, and transaction relationships. The following is an example of a table in which the issuer’s ratings of each obligor corresponds to and is related to the creditworthiness of joint obligations.
Table: Correlation is relatively strong:
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- AAA AAA AA+ AAA AAA AA AAA AAA AA+ AA- AAA AAA AA+ AA A+ AAA AAA AA+ AA AA- A AAA AAA AA+ AA AA- AA- A- AAA AA+ AA AA- AA- AA- A+ BBB+ AAA AA+ AA AA- AA- AA- A+ A BBB AAA AA+ AA AA- AA- AA- A+ A A- BBB- AAA AA+ AA AA- AA- AA- A+ A A- BBB+ BB+ AAA AA+ AA AA- AA- A+ A A- BBB+ BBB BBB- BB AAA AA+ AA AA- AA- A+ A A- BBB+ BBB BBB- BB+ BB- AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BBB- BB+ BB
Table: Correlation is relatively weak:
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- AAA AAA AA+ AAA AAA AA AAA AAA AAA AA- AAA AAA AAA AAA A+ AAA AAA AAA AAA AA+ A AAA AAA AAA AAA AA+ AA A- AAA AAA AAA AA+ AA+ AA AA- BBB+ AAA AAA AAA AA+ AA+ AA AA- A+ BBB AAA AAA AAA AA+ AA+ AA AA- A+ A BBB- AAA AAA AA+ AA AA- AA- AA- A+ A A- BB+ AAA AAA AA+ AA AA- AA- A+ A A- BBB+ BBB BB AAA AAA AA+ AA AA- AA- A+ A A- BBB+ BBB BBB- BB- AAA AA+ AA AA- AA- AA- A+ A A- BBB+ BBB BBB- BB+
Section 2: Notching up and notching down in credit ratings If events that are deemed to be risk factors are broader than default events for the party to whom creditworthiness is associated because of the structure of the product subject to rating, the credit rating of the party to whom creditworthiness associated, may be evaluated lower than that of the issuer rating of that party. On the contrary, if events that are deemed to be risk factors are narrower, the credit rating of the party to whom creditworthiness is associated may be evaluated higher than that of the issuer rating. In the event a default occurs at the party to whom creditworthiness is associated and the degree of loss is extremely large, the credit rating of that party may be lowered, and if extremely small, raised. Such an evaluation is referred to as notching up or notching down. These are both based on a comprehensive judgment of the magnitude of events that are deemed to be risk factors and the degree of loss incurred after occurrence of the event.
174/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products
This Subchapter describes the credit rating of products for which some measures to reduce counterparty risk of derivative products are taken. Derivative products are referred to as bonds, etc., that are structured with the objective of providing investors with investment opportunities by taking interest risk, exchange risk, credit risk, etc., through derivatives transactions combining repackaged products consisting of bonds (secured bonds) with relatively high level of creditworthiness and relevant derivatives transactions. If a counterparty defaults, derivative products are generally redeemed early with settlement money from early termination and proceeds of the collateral bond. For this reason, the credit rating of the counterparty is generally the upper limit of credit ratings of these products. However, if some measures to reduce counterparty risk by pledging additional collateral or other means are appropriate, a higher rating may be assigned to the product subject to rating than that of the counterparty. The adequacy of the measure to reduce counterparty risk is evaluated, considering the sufficiency of collateral, validity, and effectiveness of the contract.
Section 1: Price fluctuation risk of collateral bonds At early redemption, it is checked whether price fluctuation risk of the collateral bond is hedged. Typically, price fluctuation risk becomes apparent at the same time as the counterparty defaults. Therefore, the adequacy of collateral pledged for the subject derivative transaction is evaluated based on liquidity, creditworthiness, duration, frequency of mark-to-market and sale period of the collateral bond, and creditworthiness of counterparty. Adequacy of collateral is evaluated on the assumption that the issuer rating of the counterparty is BBB- or above at the time of the evaluation. If the issuer rating of the counterparty is lowered to BB+ or below, the rating of the counterparty as well as that of derivative products may be lowered.
Table: Counterparty’s issuer rating and rating assigned to derivatives products Upper limits of rating assigned to derivative Counterparty’s issuer rating products AAA, AA, A, BBB zone AAA to AA+ (note) BB zone and below AA- to BBB+ (Note) If a custodian of collateral bonds is a counterparty or its affiliated company or if no collateral is provided from the time when the rated product is issued, it is impossible to assign AAA to derivative products.
175/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Section 2: Priority of repayment by SPV If a counterparty has a claim on settlement money of derivative transactions against a SPV at early redemption, investors and counterparty will compete with each other. As swap settlement money typically changes, an evaluation is made from the perspectives of the validity and effectiveness of the contract on whether senior priority to receive repayment is given to investors rather than the counterparty.
176/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 9: Deleted
177/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 10: Analysis method of risk transfer transactions
This Subchapter discusses credit ratings of SF products with the objective of transferring some or all economic risk taken by a third party holding underlying assets to investors (risk transfer transactions) without transferring the underlying asset itself. As for risk transfer transactions that identify an underlying asset (excluding credit default swap), basically, after referring to Chapter 3 Underlying assets and identifying risk, a cash flow analysis that is appropriate for the underlying asset is conducted as described in Chapter 4. However, in risk transfer transactions, the definition of the default of an underlying asset is not always the same as the definition of the default of a risk transfer transaction. If they differ, some adjustment is made appropriately to the definition of default, etc., and the issue is analyzed. If other matters affect a credit rating in risk transfer transactions, these are analyzed and the results are reflected on the credit rating of the rated product.
178/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
Subchapter 11: Analysis method for aircraft finance This Subchapter describes the credit ratings of structured finance products backed by monetary receivables from airline companies (lease receivables and loan receivables) and aircraft (including engines).
Section 1: Creditworthiness of airline companies
Possibility of repayment of the rated product basically depends on the possibility of repayment of the monetary receivables from airline companies. An evaluation is therefore performed based on the airline companies’ creditworthiness.
Section 2: Discrepancy between definitions of events of default for monetary receivables from airline companies and rated product
I. Case where definitions of events of default match
In cases where the definitions of events of default for the monetary receivables from airline companies and the rated product basically match, the credit rating is notched up or down depending on the recovery rate, which is derived from the expected recovery amount following an airline company’s bankruptcy based on factors such as the possibility of collateral execution and the price stability/ liquidity of the aircraft.
II. Case where events of default for rated product is narrower in definition If the events of default for the rated product is narrower in definition compared with those for the monetary receivables from airline companies, the credit rating is notched up based on an evaluation of the possibility of continued repayment of monetary receivables in the event of an airline company’s bankruptcy, and the possibility of repayment of the rated product by maturity from the funds recovered by selling the aircraft, taking into account the difference in the events of default and the resilience of the rated product’s structure (establishing tail period, liquidity enhancement of the period, and PIK (note), etc.) . (Note) PIK is an abbreviation for Payment in Kind, which is a structure that defers interest payments and incorporates the amount equivalent to the interest into the principal. Possibility of continued repayment of monetary receivables from airline companies in the event of an airline company’s bankruptcy is evaluated based on the business continuity in the event of bankruptcy, the importance of the aircraft to the airline company, the negotiation powers
179/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 4: Particulars: Cash flow risk
of the obligors of the rated product (possibility of collateral execution, collateral value, cross-default/ cross-collateral clauses, etc.), and other factors. Notching up (of up to 3 notches) is determined based on the above evaluation. Possibility of repayment of the rated product by maturity from funds recovered by selling the aircraft is evaluated based on the expected recovery amount, which takes into consideration the possibility of collateral execution and price stability/ liquidity of the aircraft in the event of repossession and sale of the aircraft. Notching up (of up to 6 notches) is determined based on the above evaluation. The credit rating is notched up by up to the total of the above (9 notches).
As for the collateral value of the aircraft, a reasonable value is initially assumed based on multiple appraisals and other information, and a recovery value is estimated by taking into consideration the decline in value with age.
180/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 5: Particular: Monitoring
Chapter 5: Particular: Monitoring
In this chapter, the method of monitoring credit ratings specified in “Subchapter 3” in “Chapter 1: General,” which shows an outline of these methods, classified by main analysis approach, is discussed. When monitoring SF Products, changes that occur during the monitoring period are analyzed in line with the characteristics of individual rated products mainly from the following perspectives and the credit rating is reviewed, as needed.
Subchapter 1: Monitoring of credit ratings of underlying assets and parties involved in the structure
In credit ratings of underlying assets and parties involved in the structures of SF products to be monitored, impacts on the credit ratings of SF products are analyzed each time a change occurs and, as needed, the credit ratings of SF products are reviewed.
Subchapter 2: Monitoring for the large pool approach
With respect to monitoring of rated products for which the large pool approach is used to analyze cash flow, performance data on the underlying asset pool, respective balance information, etc. on rated products , credit enhancement and underlying assets, and other monitoring materials are collected, while the impacts of the changes confirmed with the monitoring materials on the nature of the underlying asset pool and on the credit rating of rated products are analyzed. After considering analysis results mainly from the following perspectives, a credit rating is reviewed, as needed. Extent of gap between performance results of underlying asset pool and standard scenario used for analysis If a gap exists, whether or not the gap is caused by a change in the nature of the underlying asset pool and whether the standard scenario should be reviewed Change in balance of rated products and credit enhancement balance and extent of accompanying changes to creditworthiness of rated products
In actual monitoring, an analysis is conducted in line with the characteristics of rated products . Therefore, monitoring may be performed from the perspective of the number of large obligors covered if the degree of concentration on obligors with a large obligation becomes higher.
181/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 5: Particular: Monitoring
Subchapter 3: Monitoring for the small pool approach
When monitoring rated products for which the small pool approach is applied to an analysis of the creditworthiness of the portfolio as an underlying asset and tranches extracted from the portfolio, the default probability, allocated based on credit ratings, etc., of portfolio constituents, are input and analyzed along with other parameters within the evaluation model, R&I Tranche Pad. The creditworthiness of tranches is then measured. Based on the measurement results, a credit rating is reviewed, if needed.
Subchapter 4: Monitoring of rated products backed by real estate
When monitoring rated products backed by real estate, impacts of fluctuations in LTV of the ratedproducts on credit ratings are mainly analyzed. Based on the analysis results, the credit ratings are reviewed, as needed. A decline (or increase) in R&I evaluation amount causes an increase (or decrease) in LTV of the rated products. Therefore, changes in the net cash flow (NCF) and the capitalization yield (cap rate) used for an assessment regarding an R&I evaluation amount are confirmed based on operating results of the underlying real estate and the real estate market trend. Any principal repayment of a rated product during the term is reflected in LTV calculation. If LTV of a rated product fluctuates beyond a specified range, the credit rating is reviewed in principle. As for rated products whose remaining period up to the scheduled repayment date is short and rated products whose scheduled repayment date has passed, the progress of activity for the underlying real estate sale and refinancing is also taken into account.
Subchapter 5: Monitoring of short-term products backed by promissory note receivables, accounts receivable, etc.
When monitoring short-term products backed by promissory note receivables, accounts receivable, etc., materials on events such as bankruptcy of obligors are either collected during the term or after redemption of the rated products. As the term of rated products is short, the results of analyzing the materials obtained during the term and after redemption are taken into consideration in next initial rating assignment. If it is found that events such as bankruptcy of large obligors during the term have occurred, the impacts are analyzed and credit rating is reviewed, as needed.
182/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 5: Particular: Monitoring
Subchapter 6: Monitoring of rated products backed by project and business cash flow, etc.
As regards rated products backed by project and business cash flow, etc. and for which credit ratings are determined based on DSCR, etc., R&I mainly analyzes impacts on the credit ratings resulting from the review of future cash flow and associated changes in DSCR, etc. Based on the analysis results, the credit ratings are reviewed, as needed.
Subchapter 7: Monitoring of rated products backed by monetary receivables from airline companies and aircraft
When monitoring rated products backed by monetary receivables from airline companies and aircraft, the impacts of changes in the airline company’s creditworthiness, the possibility of continued repayment of monetary receivables from airline companies in the event of an airline company’s bankruptcy, and the possibility of repayment of the rated product by maturity with funds recovered by selling the aircraft on the credit rating are analyzed. Based on the analysis results, the credit rating is reviewed, as needed.
Subchapter 8: Monitoring of credit ratings for programs
There is an approach for enabling flexible financing of agreeing on legal and other documents regarding the outline of financial instrument issuance are agreed upon in advance (i.e. program) and terms of issuance (e.g. currency, issue amount, maturity date, interest rate) are determined when an individual financial instrument is issued. In structured finance, R&I may assign a credit rating to such a program only if the program has certain terms that will prevent the individual financial instruments issued under the program form differing in their creditworthiness. A credit rating for a program of SF Product represents the creditworthiness of individual financial instruments issued under the program. When monitoring a credit rating of a program, the impact of the observance status of conditions set for the program on the credit rating is analyzed. Based on the analysis results, the credit rating is reviewed, as needed.
183/184
©Rating and Investment Information, Inc. Summary of Rating Methodologies Chapter 5: Particular: Monitoring
The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese, the information written in Japanese will take precedence.
184/184
©Rating and Investment Information, Inc.