Class A1-D fixed- and floating-rate notes

Disseminated from RatingsDirect
Publication date: 27-Dec-2001

Analysts: Kyson Ho, Hong Kong (852) 2533-3528; Diane Lam, CFA, Hong Kong (852) 2533-3522

Ratings Detail

Profile
New Ratings
Series 1
Classes A2, A2	AAA
Class B2	AA
Detail Class C	A
Class D	BBB
Series 1
Classes A1, A1	AAA
Class B1	AA
Closing date: Dec. 11, 2001

Profile
Closing date: December 21, 2001

Reference portfolio:
Portfolio of senior secured or unsecured corporate loan obligations originated by Development Bank of Singapore Ltd.

Collateral: Securities issued by the government of Singapore.

Credit default swap counterparty/Calculation agent: Development Bank of Singapore Ltd.

Interest rate swap counterparty: Development Bank of Singapore Ltd.

Put option provider/ Cross currency swap counterparty: JPMorganChase Bank

Account bank/Trustee: Bank of New York, London Branch

Custodian: Development Bank of Singapore Ltd.

Rationale
The ratings assigned to ALCO 1 Ltd.'s Singapore dollar (S$) and U.S. dollar fixed- and floating-rate notes classes A1 through D address the full and timely payment of quarterly interest and the ultimate repayment of principal by the transaction's legal final maturity date in June 2009.

The ratings are based on:

• The credit risk of the reference portfolio of senior secured or unsecured corporate loan obligations originated by Development Bank of Singapore Ltd. (DBS);
• The transaction's dependence on the credit quality of the initial collateral, which is comprised of securities issued by the government of Singapore, as well as on any replacement collateral acquired later, the quality of which is required to be commensurate with the ratings on the notes;
• The credit support provided by the subordinated classes of notes and a first-loss threshold amount of 4.5% of the notional amount for the initial reference portfolio;
• The dependence on DBS as the interest rate and credit default swap counterparty;
• The dependence on JPMorganChase Bank as the put option provider to hedge the market risk on liquidation of the collateral prior to its scheduled maturity, and as the cross currency swap counterparty;
• The sound nature of the mechanics of the credit default swap (CDS); and
  The sound nature of the transaction's legal structure.

Strengths.

• The restriction of credit events under the CDS to failure to pay and bankruptcy, which is consistent with Standard & Poor's definition of default;
• A loss valuation method under the CDS, which includes potential recoveries and workouts during the entire term of the CDS and monies still outstanding at the termination date as determined by the valuation agent. This method is likely to result in significantly higher recovery rates and lower net losses on the reference portfolio compared to standard CDS transactions, in which recoveries are based on the cash settlements obtained via market bids after only a short valuation period.
• The loss valuation method has made it relevant to consider the actual recovery experience of DBS in determining the recovery assumptions for this transaction;
• No interest rate risk. Any interest rate mismatch is hedged via the interest rate swap;
• No foreign exchange risk. Any potential currency mismatch between the currency of the reference obligations and the currency of the notes is structurally eliminated;
• Any currency mismatch between the U.S. dollar-denominated classes and the collateral is hedged via the cross currency swap;
  No market risk on the collateral. Any market risk is assumed by the put option provider;
• Appropriate downgrade provisions or structural features to address the dependence on the interest rate counterparty, credit swap counterparty, put option provider, and cross currency swap provider;
• Low sovereign risk as approximately 85% of the reference entities at closing are from countries rated 'AA' or above on a foreign currency basis. Entities from non-investment grade countries are not eligible for inclusion in the reference portfolio;
• First-loss risk of the reference portfolio is retained by DBS, thereby aligning its interests to the performance of the reference portfolio.
  

Concerns.

• Most of the reference entities are not rated;
• The concentration of the reference portfolio in building and development, surface transport, and conglomerates in Singapore;
• The revolving nature of the transaction;
• The exposure of note investors to possible prepayment risk as early redemption of the notes may take place in certain circumstances. However, Standard & Poor's ratings address the full repayment of the principal by, but not necessarily on, the notes' legal final maturity, and so do not address prepayment risk.

Mitigating factors.

• Standard & Poor's performed a correlation exercise (see Portfolio Analysis below) to determine the credit quality of the reference entities;
• Standard & Poor's has fully taken into account the effect of industry concentration in sizing credit support;
• Strict substitution criteria, including the use of the Standard & Poor's CDO Evaluator prior to each substitution.
  

Transaction Overview
At closing, ALCO 1 Ltd. entered into a credit default swap (CDS) with Development Bank of Singapore Ltd. (DBS) on a reference portfolio of loan obligations with an initial notional amount of S$2.8 billion. Under the CDS, DBS pays a premium to ALCO for taking on part of the credit risk of the reference portfolio up to the equivalent of a notional amount of approximately S$224 million, in excess of the first-loss threshold amount of S$126 million, which is retained by DBS. At the same time, the structure has enabled ALCO to transfer the credit risk from the CDS to the noteholders by issuing the six classes of notes. Proceeds from the notes will be used to purchase collateral commensurate with the ratings on the notes. The initial collateral consists of securities issued by the government of Singapore.

Interest payments for each class of notes are funded by a combination of the premium payable by DBS to ALCO under the CDS, and the interest received on the collateral. There is also an interest rate swap with DBS to hedge any interest rate mismatch on the transaction. Interest payments on the U.S. dollar-denominated classes are further swapped via the cross currency swap with JPMorganChase Bank. If the short-term rating on DBS falls below 'A-1', it will be required to find an appropriately rated replacement counterparty or guarantor to assume its role under the interest rate swap.

The repayment of note principal depends on the reference portfolio's level of cumulative net losses and on principal repayment of the collateral. If cumulative net losses on the reference portfolio do not exceed the threshold amount during the term of the CDS, proceeds from the maturity of the collateral will be used to redeem note principal. For the U.S. dollar-denominated classes, collateral proceeds are swapped via the cross currency swap with JPMorganChase Bank. However, if cumulative net losses on the reference portfolio exceed the threshold amount on the CDS, ALCO will be contractually obliged to make protection payments to DBS. At DBS' option, this can be achieved either by selling the necessary amount of collateral to the put option provider at a price of par plus the accrued interest and then transferring the sale proceeds, or alternatively by delivering an equivalent principal or face amount of the collateral to DBS. In either case, noteholders will not receive the full repayment of principal as the notes will be written down in reverse order of seniority beginning with class D, to the extent of the cumulative net losses exceeding the threshold amount.

The threshold amount for the CDS has been sized to take into account the credit quality of the reference portfolio and to provide credit support for the class D notes. Credit support for the class C notes is provided first by the threshold amount, and then by the subordination of the class D notes. Credit support for the B1 and B2 classes of notes, which rank pari passu with respect to each other, is provided by the threshold amount, and by the subordination of the D and C classes of notes. Credit support for the A1 and A2 classes of notes, which also rank pari passu with respect to each other is provided by the threshold amount, and by the subordination of the D, C, B1, and B2 classes of notes.

Notes terms.
The notes pay interest on a quarterly basis at the following rates:

• Class A1: US$ 3-month Libor + 0.50%;
• Class A2: S$ 3-month Swap Offered Rate + 0.45%;
• Class B1: US$ 3-month Libor + 0.85%;
• Class B2: S$ 3-month Swap Offered Rate + 0.80%;
• Class C: 5.20%;
• Class D: 6.70%.
  

Reduction of principal.
Principal repayment on the notes are dependent on the amount of cumulative net losses on the reference portfolio. If cumulative net losses on the reference portfolio exceed the threshold amount, part of the collateral will be sold or delivered to DBS to meet the protection payments due under the credit default swap. At the same time, the outstanding amount of the notes will be written down by an amount equal to the excess. The write-down will result in a principal shortfall on the relevant class that will be applied in the following order:

• To the outstanding amount of the class D notes until it has been reduced to zero;
• To the outstanding amount of the class C notes until it has been reduced to zero;
• To the outstanding amount of the B1 and B2 classes of notes (on a pari passu basis with respect to each other) until it has been reduced to zero; and
• To the outstanding amount of the A1 and A2 classes of notes (on a pari passu basis with respect to each other).
  

Scheduled or early redemption.
In the absence of an early redemption or a reduction in principal, principal on the notes will be redeemed in February 2009 in accordance with the terms and conditions of the notes.

Early redemption events for the notes include:

• An early termination of the credit default swap, including the exercise of the call option by DBS in December 2005 and June 2006;
• An event of default or termination event under the interest rate swap, the cross currency swap, or the put option;
• A default in relation to the collateral; or
• The occurrence of certain tax events.

Any scheduled or early redemption of the notes (other than an early redemption due to a default in relation to the collateral) will result in the noteholders receiving the principal in full plus accrued interest. Unless the collateral has already matured, such redemption will be funded by the put option provider, JPMorganChase Bank, acquiring the collateral at par plus accrued interest, thus minimizing market risk on the collateral to the noteholders, and by the interest rate swap counterparty, DBS, making the last interest payment on the notes. For the U.S. dollar-denominated classes, any interest and principal payments on the notes will be swapped via the cross currency swap established with JPMorganChase Bank. If the short-term rating on JPMorganChase Bank falls below 'A-1+', it will have to find an appropriately rated replacement or guarantor regarding its obligations under the put option and the cross currency swap.

If early redemption occurs as a result of a default of the collateral, the collateral will be liquidated at market prices. The proceeds of such liquidation will be used to redeem the note principal. Noteholders are likely to suffer a write-down in the principal in this scenario.

Credit Default Swap
At closing, ALCO entered into a CDS with DBS on the reference portfolio with an initial notional amount of S$2.8 billion. Under the CDS, DBS pays a premium to ALCO for taking on part of the credit risk of the reference portfolio up to the equivalent of a notional amount of approximately S$224 million, in excess of the first-loss threshold amount of S$126million which is retained by DBS.

Under the CDS, premium is paid by DBS in advance on a quarterly basis. Should DBS fail to make a premium payment, the CDS will be terminated early without any termination costs being incurred. The collateral will then be sold to the put option provider at a price of par plus accrued interest, and the proceeds will be used for the full redemption of the notes. This structure ensures that noteholders will not suffer any shortfall as a result of a failure by the CDS counterparty in making ongoing premium payments.

Reference obligations.
The initial reference portfolio has been fully disclosed to Standard & Poor's and consists of the specific reference obligations listed in the portfolio schedule attached to the CDS. The reference obligations all come under the obligation category of loans, which, for the purposes of this transaction, has been defined in broader terms than the standard ISDA definition to include bank guarantee reimbursements or indemnification agreements.

All reference obligations must satisfy the obligation characteristics of pari passu ranking, specified currency, not contingent, not sovereign, and have a maximum maturity of 15 years. Specified currency has been defined as including the currencies of Singapore, the U.S., Japan, the United Kingdom, Hong Kong, Malaysia, South Korea, Taiwan, Australia, and the Euro. Foreign exchange risk between reference obligations denominated in a currency other than the Singaporean dollar and the notes is structurally eliminated by applying a fixed exchange rate determined at the transaction's closing to all calculations of notional amount, recovery, and net loss. This structural feature thus shields ALCO from any foreign exchange risks.

Reference obligations that meet the above requirements will be used to determine both credit events and cash settlement amounts under the credit default swap.

Credit events.
Only two credit events are defined under the credit default swap, namely, a failure to pay, and bankruptcy. These two credit events are consistent with Standard & Poor's definition of default.

Conditions to payment.
Once a credit event has occurred in relation to a reference obligation, ALCO will be under an obligation to make protection payments, provided the following conditions are met:

• The issue of a credit event notice setting out the details of the credit event;
• The delivery of a notice of publicly available information, involving the citing of two public sources, or the issue of a certificate by the auditor which details or confirms the occurrence of a credit event;
• Cumulative net losses exceed the threshold amount; and
• The delivery of a notice of loss amount that has been verified by the auditor.
  

Determination of net losses.
Net losses in relation to reference obligations are determined on the valuation date, which is the earlier of:

• The date on which final monies representing all recoveries have been received in respect of that reference obligation; and
• The termination date of the credit default swap.

Net loss means the notional amount in relation to a reference obligation less any recovery. In determining the recovery, all monies received as final settlement of the reference obligation by the valuation date will be applied as principal repayment, in priority to any outstanding interest payments or fees relating to the reference obligation. In the event that a reference obligation is restructured after a credit event of failure to pay or bankruptcy, recovery will take into account all monies received plus the outstanding principal amount of the restructured reference obligation.

To the extent that all monies representing final settlement of the reference obligation are not received by the termination date of the CDS, recovery will be calculated as the sum of all monies received up to that date, plus an amount determined by the valuation agent in accordance with the valuation guidelines set out in the CDS.

Portfolio Analysis
The reference portfolio consists of senior secured or unsecured corporate loan obligations originated by DBS in accordance with its usual lending policy of the corporate loan portfolio of DBS. As a revolving pool, DBS may substitute reference obligations prior to December 2005 provided certain conditions are met (see below).

Approximately 80% of the initial reference portfolio comprised of loan obligations originated by DBS to reference entities in Singapore. The remaining 20% reflected exposure to reference entities in Hong Kong, Malaysia, Japan, Taiwan, Korea, and Australia. Sovereign risk in relation to the reference entities is low as over 80% of the initial reference portfolio originated from countries with foreign currency ratings of 'AA' or higher by Standard & Poor's.

The initial reference portfolio was concentrated in the building and development, surface transport, and conglomerates industries in Singapore. In sizing credit support, Standard & Poor's took into account the correlation effect of industry concentration.

The reference entities in the initial reference portfolio were mostly unrated. Standard & Poor's performed a correlation analysis to map the internal risk ratings of DBS to Standard & Poor's credit ratings, using a sample of reference entities. In addition, Standard & Poor's performed a due diligence review of the credit approval process applied by DBS in assigning its internal credit ratings. Standard & Poor's then used the adjusted results of the correlation analysis as inputs in Standard & Poor's CDO Evaluator to calculate the stressed default rates (gross default).

Under the credit default swap, DBS may remove reference obligations from the reference portfolio as follows:

• Any reference obligation which has been repaid or cancelled; or
• Any reference obligation on a discretionary basis, up to 10% of the initial reference portfolio on a cumulative basis.

Reference obligations that have been removed may be substituted with new reference obligations provided that no credit event has occurred in relation to any reference obligation since the transaction's closing in December 2001 and that the replacement eligibility criteria are met.

The replacement eligibility criteria include:

• Standard & Poor's CDO Evaluator must be run prior to each substitution;
• No more than 20% of the reference portfolio may be from countries rated below 'AA' on a foreign currency basis by Standard & Poor's;
• Reference entities from Singapore must make up at least 78% of the reference portfolio;
• The aggregate notional amounts for all reference entities from Singapore, Hong Kong, Australia, the U.K., and the U.S. must be no less than 87% of the reference portfolio;
• Secured reference obligations must be no less than 55% of the reference portfolio.
  

Credit Enhancement
Credit enhancement for the class D notes is provided by the threshold amount under the credit default swap. Credit enhancement for the class C notes is provided by the threshold amount and the subordination of the class D notes. Credit enhancement for the B1 and B2 classes of notes is provided by the threshold amount as well as the subordination of the D and C classes of notes. Credit enhancement for the A1 and A2 classes of notes is provided by the threshold amount, and by the subordination of the D, C, B1, and B2 classes of notes.

Credit enhancement for each class is determined by the stressed default rate and recovery assumptions appropriate for the relevant rating.

Taking into account the transaction's definition of credit events (failure to pay and bankruptcy), Standard & Poor's determined the stressed default rate of the initial reference portfolio by using its CDO Evaluator, the latest version of the former CBO/CLO Default Model. Using Monte-Carlo methodology, the CDO Evaluator assesses the credit quality of a portfolio, taking into account the credit rating, size, maturity of each reference obligation, and the correlation among obligors from the same industry. The credit quality of the portfolio is presented in terms of a probability distribution for potential default rates. From this distribution, a set of stressed default rates (called gross default rates in the CBO/CLO Default Model) is derived. The stressed default rates identify the maximum level of portfolio defaults a CDO class should be able to withstand at a given rating level. The default probabilities used in the CDO Evaluator are based on Standard & Poor's corporate default studies over the past 20 years.

In determining the recovery assumption for the portfolio, Standard & Poor's has considered the following factors:

• The use of a loss valuation method under the CDS which includes potential recoveries and work-outs during the entire term of the CDS, and the monies still outstanding at the termination date as determined by the valuation agent. This has enabled Standard & Poor's to use higher recovery assumptions than would be employed for typical CDS transactions, which usually rely on the market bids of defaulted reference obligations after a short valuation period of 30 to 180 days.
• DBS' recovery experience for the past seven to eight years;
• Bankruptcy legislation in the relevant jurisdictions. Standard & Poor's has used higher recovery assumptions for reference entities from jurisdictions such as Singapore, Hong Kong, and Australia, where the bankruptcy legislation is in general creditor-friendly;
  Credit has been given to the fact that the entire portfolio consists of senior obligations. Standard & Poor's has also considered the security available for those reference obligations that have security attached.
• Under the credit default swap, loans have a broader definition than the standard ISDA definition and include bank guarantee reimbursement or indemnification agreements. However, the risk of low liquidity having an adverse effect on the market sales of such a broadly defined category of loans is not a concern as the loss valuation method does not rely on market sales of defaulted reference obligations.
• Replacement eligibility criteria include certain provisions that are designed to ensure that recovery assumptions for the reference portfolio will not be adversely affected by substitutions.
  

Structural & Legal Analysis
Issuer
ALCO is a newly incorporated special-purpose company, established in the Cayman Islands solely for entering into this transaction, and will not issue any notes other than the six classes issued at closing. Its shares are held on trust for charitable purposes.

Standard & Poor's has reviewed the transaction documents and is expected to receive legal opinions to ensure that ALCO complies with its bankruptcy remoteness criteria. Standard & Poor's expects to receive legal opinions to the effect that:

• ALCO will not be consolidated with the assets of any other entity upon the bankruptcy of such other entities; and
• Creditors of other entities will not have recourse to the assets of ALCO.