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Announcement:

Moody's comments on impact of back-up servicing for gray-zone ABS to ratings

27 Jul 2010

Tokyo, July 27, 2010 -- Moody's Investors Service has commented on the important topic of back-up servicing for securitizations backed by loan receivables, and which involve payments (both current and prior) of gray-zone interest, and where back-up servicing is delegated to regulated servicers.

Summary

Moody's sees uncertainty in back-up servicing operations, such as recalculation risk, in gray-zone interest asset ABS, when such servicing is delegated to regulated servicers.

This is because i) the operational guidelines for the inspection and supervision of servicer firms were revised on July 1, 2010; ii) the nature of regulated servicers' policies on back-up servicing operations; and iii) recent events surrounding regulated servicers, etc.

Moody's believes the rating levels for the associated securitizations may differ, depending on the availability of back-up servicers in each instance, and the current servicers' credit quality.

1. Revisions to operational guidelines for servicer firms

On January 25, 2010, the Ministry of Justice ("MOJ") called for comments on its proposed revision of operational guidelines for the inspection and supervision of servicer firms.

By "servicer firms," the MOJ is referring to all companies regulated under the Act on Special Measures Concerning the Business of Management and Collection of Claims -- the Servicer Law. (These firms are defined as "regulated servicers" in this report.)

On June 17, the MOJ published a summary of the public comments on its proposed revisions to the operational guidelines. These guidelines were then revised on July 1 ("the revised guidelines").

The revised guidelines include clauses on receivables with "gray-zone interest," and which are:

(i) Re-calculation of the principal amount -- based on the maximum interest rate under the IRRL -- should be carried out by returning to the loan agreement date, that is when the receivables were first generated.

(ii) The principal amount of the receivables will be re-calculated based on the above, even when the regulated servicers provide only notices on repayments -- but not demand for repayments -- to the obligors about repayment amounts.

(In Japan, interest rate caps are regulated by two statutes: the Interest Rate Restriction Law (IRRL) and the Capital Subscription Law, each of which stipulates a different cap. The difference in the interest rate charged between the two caps is called "gray-zone interest.")

Regarding these clauses, the MOJ's answers -- in summary -- to the public comments include the following:

- MOJ advises that it is better to dissolve, or decrease agreements on delegated payment notice operations, and this is the case with gray-zone interest receivables.

- The revisions are a clarification of MOJ's original view.

- The revised guidelines are applied to notifications to obligors of repayment amounts under the relevant agreements entered into after the revised guidelines become effective.

2. Moody's view on back-up servicing

Moody's considers that the main issues for assessing the back-up servicing of transactions are their actual policies for back-up servicing, based on the revised guidelines.

Moody's interviewed the regulated servicers, who are back-up servicers in existing securitizations, on their policies on back-up servicing operations and the recalculation of the underlying receivables.

The answers differed according to each regulated servicer, but we could not get definite answers -- such as those which said that they would not recalculate receivables -- on back-up servicing agreements entered into before the revised guidelines.

Regarding securitizations -- where back-up servicing agreements were entered into before the enforcement of the revised guidelines -- Moody's considers the possibility of the recalculation of the underlying receivables when this back-up servicing takes place.

This is a result of -- in addition to the regulated servicers' policies -- two factors: i) recently, some regulated servicers received administrative punishments because they deviated from the scope of payment notice operations, and ii) the difficulties in handling gray-zone interest assets in the scope of payment notice operations.

3. Risks and impact to ratings

Moody's has concerns about the uncertainty over back-up servicing for gray-zone interest asset ABS, and wherein the back-up servicer is the regulated servicer.

"Uncertainty over back-up servicing" means-- in our considerations:

i) The regulated servicers may recalculate the principal amounts of the underlying receivables when back-up servicing occurs (recalculation risk), and,

ii) The delegation of back-up servicing to a third party -- other than the regulated servicers -- may be difficult.

Recalculation risk will occur only when the following events materialize, although not for all transactions;

- A servicer replacement events occur and back-up servicing takes place, and,

- The back-up servicer determines that it needs to recalculate the underlying receivables principal amount, and,

- Back-up servicing cannot be delegated to those servicers which do not recalculate receivables.

However, should recalculation risk materialize, it is generally assumed that over half of the underlying receivables may be diluted.

Moreover, if the diluted amount cannot be sufficiently covered by the credit enhancement available, then the rated securities may suffer losses.

Moody's believes that the credit quality of current servicers and the availability of back-up servicers are key factors for making any risk assumptions.

If the relevant servicer's credit quality is low, or the availability of a back-up servicer seems low, then Moody's believes it may be difficult for the transaction to pass the stressed scenario under a high rating level.

This is because the scenario -- wherein servicer replacement occurs and back-up servicing takes place should -- be considered as one of the stressed scenarios when determining the ratings.

The availability of a back-up servicer should be considered on a deal-by-deal basis.

Generally, Moody's currently considers that -- in cases of securitizations of major consumer credit (shinpan) and credit card companies -- the availability of back-up servicers is higher than in other instances.

This was concluded after interviewing each company and after considering the existence of transactions where back-up servicing is delegated to firms other than the regulated servicers. If the availability of back-up servicers seems high, then such a situation would mitigate the uncertainty over back-up servicing.

However, even when the availability of back-up servicers is high, any uncertainty over the issue would still not be resolved unless an agreement is entered into with another back-up servicer.

Therefore, if there remains uncertainty over back-up servicing, then the ratings on the relevant securitizations may be negatively affected, especially for deals where the servicer's credit quality is low.

On the other hand, if the availability of back-up servicers is assumed as low, then the possibility of actual recalculation risk is higher. Therefore, the ratings on such a securitization may be lower than when the availability of back-up servicers is high.

The guidelines for the rating ceilings for gray-zone interest asset ABS -- which meets certain conditions, including where the back-up servicer is a regulated servicer -- are listed below.

Each rating ceiling has a range because rating levels differ according to factors such as the level of back-up servicer availability, the level of servicer credit quality, etc.

Note that the availability of a back-up servicer is relative, and may change according to regulatory, or legal conditions, the policies of back-up servicer candidates, their capacity, etc. The guidelines below are just a guide, given current circumstances.

<Rating ceiling guidelines for gray-zone interest asset ABS which meets the conditions (**) including BUS is the regulated servicer>

- Availability of back-up servicer is assumed to be high (*1)

Servicer's rating is investment grade equivalent: Aaa

Servicer's rating is Ba1- B1 equivalent: Aaa- Aa

Servicer's rating is B2- B3 equivalent: Aa- A

Servicer's rating is Caa1 or lower equivalent: A- Baa

- Availability of back-up servicer is assumed to be low (*2)

Servicer's rating is investment grade equivalent: Aa- A

Servicer's rating is Ba1- B1 equivalent: Baa- Ba

Servicer's rating is B2- B3 equivalent: Ba

Servicer's rating is Caa1 or lower equivalent: Ba- B

(**) Conditions

1. The back-up servicer is a regulated servicer under the Servicer Law.

2. The back-up servicing agreement was entered into before the enforcement of the revised guidelines.

3. It is considered that dilution -- due to recalculation under the IRRL -- will not be sufficiently covered by the credit enhancement.

4. The liquidity reserve is sufficient to actually start back-up servicing.

5. There are no governance concerns for the servicer.

(*1) In this case, it is assumed that some candidates for back-up servicing exist in the market, and delegation to other back-up servicers may be possible.

(*2) In this case, candidates for back-up servicing are extremely limited, and delegation to other back-up servicer is difficult.

These are just guidelines and therefore actual ratings may be higher than the rating ceiling if the transactions include any positive factors. (see the following for example).

Positive factors to be considered (examples):

- Diluted amount -- due to recalculation -- is fully covered by the increased level of credit enhancement.

- The asset trustee has definitive and feasible policies, regarding delegation of back-up servicing, to prevent recalculation risk.

- The deal's remaining period is short, for example less than 6 months.

As for the servicer's credit quality, if the servicer or its parent has no ratings assigned by Moody's, then there will be reference to credit estimates. (See the Moody's rating methodology "Updated Approach to the Usage of Credit Estimates in Rated Transactions" October 2009)

4. Points of concern

- Even if the transaction is considered to have a high level of access to a back-up servicer, its ratings may be affected if any events -- which affect the availability of a back-up servicer -- occur.

- When delegating the back-up servicing operations to another back-up servicer, there may exist some issues, such as the nature of the asset trustee's decision; selecting the back-up servicer; investor approval, if needed; execution of back-up servicing agreement; amendment of the trust agreement, if needed; payment of fees; construction of a system for back-up servicing, etc. These issues should be carefully monitored.

Moody's Investors Service is a publisher of rating opinions and research. It is not involved in the offering or sale of any securities, nor is it acting on behalf of the offering party. This release is not a solicitation or a recommendation to buy, hold, or sell securities.

Tokyo
Yumiko Kitaoka
Asst Vice President - Analyst
Structured Finance Group
Moody's Japan K.K.
JOURNALISTS: (03) 5408-4110
SUBSCRIBERS: (03) 5408-4100

Tokyo
Koji Kumamaru
MD - Structured Finance
Structured Finance Group
Moody's Japan K.K.
JOURNALISTS: (03) 5408-4110
SUBSCRIBERS: (03) 5408-4100

Moody's comments on impact of back-up servicing for gray-zone ABS to ratings
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