Taiwan Ratings Corp.'s Structured Finance Default And Rating Transition Study 2003-2010: Credit Trends Improve In 2010

2011/05/04

Primary Credit Analyst: Aaron Lei, (886) 2 8722-5852
aaron_lei@taiwanratings.com.tw
Secondary Contact: Susan Chu, (886) 2 8722-5813
susan_chu@taiwanratings.com.tw

The credit quality of Taiwan-originated structured finance securities was stable or improved in 2010, following a period of deterioration over the past two years. Taiwan Ratings Corp. is providing this inaugural study to examine and document the historical default and transition rates for structured finance securities (also referred to as securitization notes) on which we have assigned ratings and to provide greater transparency over the behavior of such ratings.

This default and transition study covers 90 ratings (85 long-term ratings and five short-term ratings) from 30 Taiwan-originated structured finance transactions on which we assigned ratings from 2003 to 2010. The transition rates shown in the following tables are calculated on Taiwan Ratings' 85 long-term ratings only. An additional section provides the transition and default behavior of our five short-term ratings. In general, the transition and default studies do not include CreditWatch placements.

It should be noted that the findings of this study may have several limitations due to the relatively small number of securities covered in this study, the short time period involved, the concentration on certain asset types securitized, and the limited default events during this period of review. For this reason, they should not be generalized to understand the credit performance of other existing or new transactions; any comparison between this study and other similar studies may be inappropriate due to these limitations.

Key Findings

  • The credit quality of the majority of structured finance securities rated by Taiwan Ratings was stable or improved in 2010, and the number of upgrades outweighed that of downgrades, reversing the 2009 trend. This reflects the continued stabilization of asset performance and the macro economy. We expect such credit stability or improvement in rated securities to continue during 2011.
  • There have been four default events since 2003.
  • Securities rated 'twAAA', which is the most frequently referenced category in Taiwan's structured finance market, had relatively lower cumulative default rates in all time horizons.
  • The transition study shows that higher ratings are associated with higher credit stability or lower transition rates.
  • CDO Squared transactions, defined as CDOs (collateralized debt obligation) backed by other CDOs, had the highest number of downgrades, while many positive rating movements were related to corporate CLOs (collateralized loan obligations backed by corporate loans).

Credit Stability And Upgrades Dominate Taiwan Structured Finance Securities In 2010
In 2010, all rating categories had stable to positive transition behavior except the 'twCCC' rating category (see table 1). There were no downgrades in these rating categories in 2010, a sharp reversal from the 2008 and 2009 rating transitions where the number of downgrades of securitization notes in upper rating categories (mainly 'twAAA' through 'twBBB' categories) was relatively significant. In terms of rating actions, the number of downgrades dropped to four in 2010 from 29 in 2009, and upgrades reached 10 in 2010 from two in the previous year.

Credit stability and credit improvement occurred across all asset types (see table 2). In particular, asset backed securities (ABS) and prime residential mortgage-backed securities (RMBS) performed well despite the recent stressed environment. Such asset types accounted for the majority of upgrades in 2010, which was mainly due to improvement in the performance of underlying collateral and the structural elements of each transaction such as the fast accumulation of tranche credit enhancements in percentage terms.

Two rated structured finance securities defaulted in 2010. A default is defined as the failure to pay timely interests or principals by the legal final maturities according to the stated terms and conditions for that security. There were four defaults from 2003 through 2010, or 4.70% of the 85 long-term ratings we assigned.

The two defaults in 2010 came from the same transaction with previously defaulted tranches, and were rated 'twCCC' at the beginning of 2010 (see table 1). Also, these two defaulted securities came from a CDO Squared transaction (denoted as "CDO CF CDO of CDO" in table 2) as they weakened under the global corporate credit deterioration in recent years.

Economic Recovery And Sequential Payment Structures Result In Positive Rating Migration In 2010
The good performance of collateral underlying rated transactions in Taiwan in 2010 reflected the strong global and local economic recovery. Collateral delinquency rates decreased, which supported rating stability during the year. In addition, the sequential payment structures in most Taiwan transactions, which redeem issued notes in a sequential order, also help establish higher credit enhancements in percentage terms. This process, also known as deleveraging, made many upgrades possible. Taiwan Ratings provided a more detailed review on the island's macroeconomic evolution and deal performance in 2010 in the article "Ratings Roundup Report: Creditworthiness Has Stabilized But The Unsettled Economy Remains A Key Risk Factor In 2011," published on Dec. 30, 2010.

We expect credit stability or improvement in Taiwan's structured finance securities to continue in 2011. The underlying collateral performance of rated transactions, the basic sequential payment structures, and deleveraging are likely to remain the key reasons for any upgrades in 2011 despite the dependence of Taiwan's continuing economic recovery on the global macro economy.

Lower Default Rates Occurred In The 'twAAA' Rating Category
We focus on the first four rating categories--the 'twAAA' through 'twBBB'--in cumulative default analysis--as they dominate Taiwan's securitization issuance market and they are frequently referenced in the secondary market as well (see table 3). The 'twAAA' rating is singled out for its role as the anchor point in our assumptions of rating scenarios, and the benchmark for local investments.

The cumulative default rates of 'twAAA' rated securities are lower than those of other categories in all time horizons, and securities rated 'twAA', 'twA', and 'twBBB' had reduced cumulative default rates compared with lower ratings. The result echoes the general market perception that rating differences serve as indication of the relative likelihood of cumulative defaults.

Historical Transitions And Stability Rates Correlate With Ratings
The weighted average annual rating transitions show high ratios of upgrades and stability for each rating category from 'twAAA' to 'twBBB' (ratings with modifiers included) over an average 12-month period (see table 4).

The ratio of ratings stability, defined as ratings unchanged or securities fully repaid in the calendar year, indicates that higher ratings are associated with higher credit stability (see table 5). This finding is generally in line with the Standard & Poor's Ratings Services' global results and Taiwan Ratings' corporate default study.

The rating migration from the initial securities ratings to current ratings showed a similar pattern as the annual transition shown in table 5. From 2003 to 2010, among the 84 'twAAA', 'twAA', 'twA', and 'twBBB' ratings (with modifiers included) we initially assigned, we subsequently raised, withdrew after full redemption, or maintained about 90% of the ratings (see table 6), and we lowered about 10%. The differences between each rating category on this original-to-current rating movement are, however, not obvious on the default rates between the categories. This is mainly because of the low observation of default events.

In comparison with the global structured finance rating transitions tracked by Standard & Poor's (see tables 7 and 8), there were higher upgrade and stable rates and lower downgrade rates in both annual transition and original-to-current transition for Taiwan securitization transactions compared with Standard & Poor's. We however do not believe this observation should be generalized, due to the significant limitations of rating data in Taiwan's study. The local structured finance market began in 2003, and we have a much smaller rating universe and much shorter periods in structured finance than the global universe (ratings on 85 securities over the past seven years in Taiwan, compared with over 100,000 ratings assigned globally from1978 through 2010). As a result, the ratings migration in aggregate could be sensitive to even small number of rating actions, and the results would become not so meaningful.

CDO Squared Transactions Have The Most Negative Rating Migration And Corporate CLOs The Most Positive
Further review of initial ratings' transitions reveals that all the negative migration was from the CDO Squared sector, which had an 88.89% downgrade ratio and 44.44% default ratio (see table 9).

These CDO Squared transactions were collateralized by domestic corporate bonds and synthetic CDOs (the inner CDO) referencing global corporate obligors. During the recent period of global financial market dislocation, Standard & Poor's and Taiwan Ratings downgraded many reference entities in the inner CDOs or the reference entities went into bankruptcy. This deteriorated the inner CDO's performance and ultimately affected the ratings on the CDO Squared transactions.

In contrast, the ratings were raised on 78.13% of Corporate CLOs (denoted as "CDO Cash Flow CLO" in table 9). Transactions in this sector have domestic loans that origination banks extended to domestic corporate borrowers as collaterals. The ratings on Corporate CLO securities were subsequently raised due to quick credit enhancements accumulation, as these deals adopted sequential pay structures without reinvestment and most domestic corporate borrowers experienced less stress than their global peers did during the past few years.

The different rating migrations in asset sectors also affected the transition rates in issuance year (the vintage, see table 10). Most CDO Squared transactions were originated between 2005 and 2006, while CLO issuance spanned from 2003 to 2007. This vintage distribution partly explains the fluctuation of cumulative rating transitions in related years.

Transition Of Short-Term Ratings
Taiwan Ratings has assigned five short-term ratings to securities issued in commercial papers. Among these, two related to account receivables transactions, two related to CDO transactions collateralized by RMBS, and one related to the CDOs of corporate bonds.

The two short-term ratings on the CDO of RMBS transactions had mildly negative rating transition over the past two years, as we lowered the rating from 'twA-2' to 'twA-3', before the securities were fully redeemed. In contrast, the other three short-term ratings remained unchanged or were withdrawn on full redemption. There were no defaults among Taiwan Ratings' short-term rated securities between 2003 through 2010.

Credit Trends On Global Structured Finance Securities Began Improving In 2010
We noticed a similar improving trend on global structured finance ratings in 2010, which is discussed as follows. It should again be noted that the comparison of rating transition and default rates in Taiwan's structured finance securities to Standard & Poor's global results may not be so meaningful due to data limitations. There are many differences in assumptions and data between Taiwan and the global studies, particularly the different rating scales used, which prevent meaningful comparison. Other limitations include the small number of ratings and short time frame, as well as the concentration of issuance on particular asset types, and the limited default events in Taiwan Ratings' study.

According to a study by Standard & Poor's Ratings Services (see Related Criteria And Research), the credit quality of global structured finance securities rose in the second half of 2010, and although downgrades were still significantly higher than the historical level, the degree of deterioration declined. Standard & Poor's expects the improvement of collateral performance for certain asset types and the generally improving global economy will likely reduce overall credit downgrades and defaults in 2011.

In 2010, 83.24% of global structured securities rated 'AAA' by Standard & Poor's remained at 'AAA' or paid off in full, and only 0.33% of securities originally rated 'AAA' defaulted. ABS sector has performed particularly well, with a 93.37% stability rate (where there was no rating change or securities were paid in full) for 'AAA' rated securities in 2010, compared with 56.61% for CDOs, 87.97% for commercial mortgages backed securities (CMBS), and 87.35% for RMBS rated 'AAA' at the beginning of the year.

Overall, about 4.3% of the cumulative original issuance amount of global structured finance defaulted in 1978-2010. During the same period, 75.51% of global structured finance securities originally rated 'AAA' remained stable or paid in full, and 4.19% defaulted.

Related Criteria And Research

APPENDIX: Methodology And Terminology

This section provides a detailed discussion of Taiwan Ratings' rating transition and default methodology. It also explains the study's terminology, including definitions of transition windows, rating modifiers versus full-rating categories, and the treatment of rating withdrawals.

Rating transition
The rating transition of a single static pool (cohort approach) is based on the rating of each security at the beginning and end of the observed transition window. For instance, we calculated the transition rates by determining the ratings of each security at the beginning and end of the period. We then tabulated these ratings in a two-dimensional table to calculate the percentage of ratings that stayed the same and the percentage of ratings that changed. During this process, we count every security only once, even if it had more than one rating change during the period. In other words, we use a security's rating on the first day of the period and the last day of the period to calculate the transition rates, while disregarding the interim rating changes.

Weighted average transition
For weighted average transition rates, we calculate the individual transition rates of static pools as described earlier. We then create a single averaged matrix weighted by the number of ratings in each static pool.

Transition window
A transition window refers to a defined period in which we observe a security's rating transition. For example, the 2010 performance transition window starts on Jan. 1, 2010 and ends on Dec. 31, 2010. Transition windows for historical data also follow annual windows, running from January 1 to December 31 of the same year.

Rating modifiers
We use rating modifiers ("+" and "-") to calculate the upgrade and downgrade percentages, as well as the magnitude of rating changes throughout this study. However, some transition tables may use full rating categories for practical reasons. In other words, the use of a full rating category suggests that transitions from, for example, 'twAA' to 'twAA-' or from 'twBBB+' to 'twBBB-' are not considered as rating transitions because the rating remained within the full rating category.

Rating withdrawal
A security with a withdrawn rating at the beginning of a transition window is not included in the transition and default rate calculations for that period.