Latin American securitization structures featuring pro-rata amortization and/or maturity risk may amplify uncertainty in cash flow allocation, resulting in greater dependence on credit protection and structural mechanics, says Fitch Ratings. Ratings for these structures are more sensitive to model inputs because modeled scenarios’ outcomes significantly differ even with small changes in assumptions, such as default timing.
Structures that feature pro rata or controlled amortization periods of the notes allow for earlier repayment of the junior tranches or distributions to equity holders compared with standard sequential payment transactions. However, allocating cash flow pro rata may erode the senior tranches’ default buffer and affect their ultimate repayment because funds that would have been used to build credit enhancement (CE) are diverted to junior liabilities.
To address this issue, pro rata structures rely on performance triggers such as maximum default rate or minimum CE, in order to stop the release of funds to junior notes or equity holders when asset performance deteriorates beyond a predefined level. A structure that could easily repay the senior notes rated at the top of the rating scale in a front-loaded default distribution may not be able to do so if defaults are more skewed toward the tail, for example due to a benign period followed by a jump in the unemployment rate. Triggers are affected by a number of different variables and therefore the timing of breaches is difficult to predict, causing cash flow modeling outputs to be more volatile.
Additionally, prepayments, asset turnover and default timing are important considerations in Brazilian, Colombian and Mexican transactions, both pro rata and sequential, where the legal final maturity date is set close to, and occasionally even before, the maturity of the securitized portfolio. This is in contrast to most securitization markets worldwide where the legal maturity is set at the end of the total of the revolving period, if any; the longest-term securitized asset; and a final buffer of one or two years to allow for recoveries from late-defaulting assets.
If the legal maturity does not allow time for late recoveries, these are accordingly excluded from Fitch’s cash flow analysis, but even greater risk arises when the legal maturity date is set inside the maturity of the securitized assets. In this latter case, the documentation provides that only the installments that fall within the legal maturity date are considered for CE purposes, thereby ensuring that the contractually minimum ‘eligible’ CE is maintained. This, however, comes at the expense of increasing the reliance on the servicer’s calculations and oftentimes locking more assets in the transaction than would be needed without the legal maturity constraint.
Asset-liability mismatches partly derive from strong investor preferences in maturity terms. However, the overall risk increases for noteholders when the notes’ legal maturity is not commensurate with the maturities of the underlying assets, as the notes do not have benefit of full cash flow from performing assets. We employ various adjustments to our cash flow analysis to address this maturity risk, including modeling no prepayments and modifying the timing of assumed defaults.
Many structures that Fitch sees in Latin America offset these weaknesses through additional CE, as well as turbo amortization structures that do not leak excess cash, which is relatively rare elsewhere. These approaches sufficiently mitigate the credit risk for us to be able to rate the notes, oftentimes at the top of the relevant national rating scale. However, the timing of cash flow assumptions, such as defaults and prepayments, may affect model-implied ratings more than changes to absolute levels in certain structures, and early legal maturities leave less time to correct for unpredictable events.