Credit Issues in Rating Australian Margin Loan-Backed Securities

Structured FinanceStructured Finance

Credit Issues inRating AustralianMargin Loan-BackedSecuritiesMay 2000

Published by Standard & Poor’s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, New York, NY 10020. Editorial offices:55 Water Street, New York, NY 10041. Copyright 2000 by The McGraw-Hill Companies, Inc. Reproduction in whole or in part prohibited except by permission. All rightsreserved. Officers of The McGraw-Hill Companies, Inc.: Harold W. McGraw, III, Chairman, President, and Chief Executive Officer; Kenneth M. Vittor, Executive VicePresident and General Counsel; Frank Penglase, Senior Vice President, Treasury Operations. Information has been obtained by Standard & Poor’s from sources believedto be reliable. However, because of the possibility of human or mechanical error by our sources, Standard & Poor’s, or others, Standard & Poor’s does not guarantee theaccuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtained from the use of such information.

Standard & Poor’s Structured Finance ■ Australian Margin Loan-Backed Securities 3

Credit Issues inRating Australian MarginLoan-Backed SecuritiesCredit Issues in Rating Australian MarginLoan-Backed Securities ...................................................................... 5

Collateral Product and Market Overview ............................... 7

Growth of the Margin-Loan Market ................................................................ 7

Main Features and Terms and Conditions of Margin Loans ............................. 7

Borrower Profile Over Time ............................................................................. 9

Highlight of Rating Approach ......................................................11

The Australian Equities Market ...................................................13

Growth in the Australian Equities Market .......................................................13

Australian Total Share Ownership ...................................................................13

Major Indices ..................................................................................................14

Historical Performance ....................................................................................14

Standard & Poor’s Advance Rates forMargin-loan Transactions ...............................................................17

Advance Rates and Recovery Values ...............................................................17

Exposure Period ..............................................................................................18

Portfolio Concentration Adjustments ..............................................................18

Calculation of Portfolio Advance Rates ...........................................................18

Other Securities ...............................................................................................20

Determining Default and Loss Severity Drivers ...................21

Historical Performance ....................................................................................21

Capturing Increases In The Portfolio Risk Profile Over Time ...........................24

Total Credit Enhancement Calculation ............................................................27

4

Originator/Manager Review ..........................................................29

Legal Considerations ..........................................................................31

Other Rating Considerations .........................................................33


Credit Issues In RatingAustralian MarginLoan-Backed Securities

Standard & Poor’s has developed a framework for rating notes, backed by

pools of Australian margin loans as collateral, in anticipation of an

increasing interest in this asset class. Essentially, a margin-loan

securitisation is a cash flow transaction, like other asset-backed and mortgage-

backed transactions. Noteholder payments are serviced from loan repayments

made by a pool of underlying borrowers. There are key characteristics of margin-

loan pools that differentiate them from other asset-backed and mortgage-backed

transactions, including:■ The underlying value of the securities securing the borrower’s obligations is

highly variable. If the value of the securities falls significantly, this can reduce

the level of equity the borrower has at risk, which in turn can negatively impact

the borrower’s willingness and ability to pay.■ The credit composition of the margin-loan portfolio can change significantly

over time through borrower substitution, security substitution (either through

borrower preferences or additions, or deletions from the lenders approved

security list), and through changes to the lender’s maximum advance rate for

each security.■ The timing of cash flows under the margin loans is uncertain. Generally,

borrowers may capitalise interest as long as their loan balance remains below

the maximum advance rate set by the lender. In a bull market, where the

underlying value of the securities rises strongly, this lack of cash flow may be

significant. In addition to interest capitalisation, margin loans typically do not

have a set maturity date. The loans are usually callable with seven days notice,

and the lender usually reserves the right to liquidate the portfolio without

notice to the underlying borrowers in the event of a major market correction.

This can contribute to a significant reinvestment risk to rated noteholders,

particularly in a term deal. For these reasons, we expect that in most instances

issuers will use commercial paper fully supported by a liquidity facility to fund

margin-loan portfolios.

6

The credit enhancement for a margin-loan portfolio consists of two levels of

support. First, at the loan level, each loan is required to maintain a minimum

equity buffer. This support is available at the individual loan level only, and

cannot be cross-collateralised to support other loans in the portfolio. Second, at

the portfolio level, fungible credit enhancement such as overcollateralisation or

cash will be required.

Sizing of the fungible credit enhancement at each rating category will comprise

two components. The first loss component ‘first loss credit enhancement’ will

reflect the higher of historical losses multiplied by a rating stress factor and an

obligor concentration floor. This is the standard cash flow approach to sizing

credit enhancement. The second loss component ‘second loss credit enhancement’

will be driven by the composition of the lender’s approved security list, the

maximum advance rates set by the lender for each approved security, the lender’s

underwriting standards, and the lender’s management style and portfolio

parameters. The second loss credit enhancement uses market value criteria to

establish an advance rate for each pool so that together with the first loss credit

enhancement, the total loss coverage for the transaction is consistent with the

ratings desired. To the extent that the lender’s guidelines are more aggressive than

the advance rate established by Standard & Poor’s for that pool, further credit

enhancement will be required to support the rating on the notes. The second loss

credit enhancement encapsulates the dynamic nature of margin-loan pools and

possible deterioration in credit quality and/or increase in volatility after a

transaction closes.

Managers of margin-loan portfolios have direct influence over the credit quality

of their pool through their management strategy and capacity, and Standard &

Poor’s will visit the management onsite to gain further insights into each

originator/manager’s underwriting and servicing practices to assist in sizing the

appropriate levels of first and second loss credit enhancement.

This article will describe key features of margin loans that impact the cash flow

and credit quality of the collateral, the recent growth in the Australian margin-

loan market, and the highlights of the rating approach resulting from unique

credit risks associated with margin loans. As Australian equities are

predominantly the securities provided by the borrowers to secure their repayment

obligation, this article will provide a brief overview of the Australian equities

market and analyse the magnitude of recent share market corrections.

Furthermore, this article explains Standard & Poor’s rating methodology and

why we have chosen to use a combination of cash flow and market value

approaches. In addition, the main areas of the manager review will be outlined.

Legal and rating considerations that are commonly seen in other asset types will

not be discussed in detail in this article.


Collateral Productand Market Overview

A margin loan is a revolving personal debt obligation undertaken by a

retail investor ‘borrower’ to build an investment portfolio. The

borrower secures their repayment obligation under the margin loan with

a portfolio of marketable securities, predominantly shares. Increasingly, borrow-

ers are diversifying into other investments such as fixed-income securities, cash,

and units in managed funds.

Growth of the Margin-Loan MarketThe margin-loan market has experienced strong growth in recent years. The

Reserve Bank of Australia’s annual survey of major margin lenders indicates that

the margin lending business has grown to about A$6 billion at the end of 1999

from about A$2 billion in September 1996. Although the growth has been

phenomenal, margin lending as a proportion of the Australian equities market

(A$572 billion) remains small.

Margin loans are offered by a number of financial institutions and

stockbrokers. There are at least 15-20 market participants. Some of the major

participants include BT Securities Ltd. (a fully owned subsidiary of Principal

Financial Group Inc.), Leveraged Equities Ltd., (a fully owned subsidiary of

Adelaide Bank Ltd.), State Bank of New South Wales (trading as Colonial State

Bank), JB Were & Son, Australian and New Zealand Banking Group Ltd.,

Deutche Equity Lending, and Commonwealth Bank of Australia. Margin loans

are high yield products as they are perceived to be more risky. The interest rates

on margin loans are typically 1% to 2% higher than the interest rates charged on

residential housing loans.

Main Features and Terms and Conditions of MarginLoansMargin-loan borrowers are typically retail investors, in the legal form of

individuals, joint parties, companies, and trusts. The securities pledged can be

from borrowers themselves or third-party individuals and companies. Some

8

lenders perform credit assessments of borrowers, while others do not. Almost all

lenders will carry out identification checks and company searches. A lender’s

underwriting practice is one of the factors that will contribute to Standard &

Poor’s portfolio default frequency assumptions.

Margin loans are revolving credit facilities that provide borrowers with

maximum flexibility. Margin loans generally do not have a defined maturity,

however, a lender may declare a maturity by issuing a notice to borrowers. The

standard notification period is about seven days. Lenders usually require

borrowers to borrow a minimum amount for a minimum period. If these

requirements are not met, the lenders will continue to calculate interest on the

minimum amount for a minimum period. Although borrowers are not required to

make regular repayments, interest is capitalised if payments are not made, which

increases the outstanding balance of the loan. Repayments can be made any time

and interest can be prepaid, however, prepaid interest is usually not refundable.

In order to manage portfolio exposure, a lender generally establishes and

maintains their own approved list of securities and sets the minimum equity

requirement (or alternatively, the maximum advance rate against that security) on

each security on the approved list. The lender’s maximum advance rates typically

range between 30%-80%, depending on the composition of the underlying

securities collaterlising the loan. These maximum advance rates for each security

may change over time depending on the lender’s assessment of the risk of the

underlying security and the lender’s exposure to that particular security in its total

margin-loan portfolio, as well as reflecting the lenders broader business

objectives.

The lender usually monitors the equity level of each borrower daily. If the

market value of the borrower’s equity falls below the minium equity level

required due to interest capitalisation or market value deterioration of the

underlying securities, lenders will issue a margin call notice and request the

borrower to remedy the situation, usually within 24 hours. Lenders have the right

under the loan contracts to liquidate the borrowers portfolio upon borrower

default (failure to meet a margin call). Most lenders reserve the right to sell the

share portfolio without notification in the event of major market corrections (for

example, where the market declines 10% or more in one or two days). The

flexibility offered to borrowers with respect to repayment gives rise to cash flow

structuring considerations under margin-loan transactions. Consequently,

Standard & Poor’s expects that in most instances issuers will use commercial

paper to fund their margin-loan portfolios.

A margin-loan lender takes security of a borrower’s share portfolio by

becoming the borrower’s only Clearing House Electronic Subregister System

(CHESS) sponsor for shares included in the share portfolio. A borrower also will

grant the lender power of attorney to operate the borrower’s accounts and

transfer the share portfolio to itself or its nominee if necessary. Where securities

are not listed on the Australian Stock Exchange (ASX), they will be held in the


name of lender’s nominee company on behalf of the borrower, with the same legal

and operating rights to the securities. Lenders may assign their rights to securities

without notifying the borrowers. The lender’s rights to the underlying securities is

a key consideration in determining whether credit can be given to recovery from

liquidating the underlying securities.

Borrower Profile Over TimeDuring the early years of margin lending in Australia, margin loans were

extended mainly to high net-worth individuals. This has contributed to margin-

loan lenders experiencing minimal or no losses to date. With the rapid growth in

Australian share ownership across all income and age groups, the borrower

profile is expanding to include lower net-worth individuals. Consequently,

margin-loan portfolios may experience higher losses in the future. Standard &

Poor’s will require a minimum loss reserve in securitisation programs in

anticipation of increased future losses.

Collateral Product and Market Overview


Highlight ofRating Approach

Margin loans have a unique credit risk due to the market value

volatility of the underlying securities that collateralise each loan. A

deterioration in the market value of the underlying securities could,

if severe enough, change the nature of a margin loan from secured to unsecured.

In effect, each borrower’s equity holding improves or erodes with the rise and fall

in the market value of the underlying securities. This feature of margin loans is a

key consideration for Standard & Poor’s in the development of the rating

approach for margin loans.

The main feature of the rating approach for Australian margin-loan

transactions is the methodology for sizing credit enhancement. The credit

enhancement for a margin-loan portfolio consists of both equity collateral and

fungible credit enhancement. Sizing of the fungible credit enhancement at each

rating category will consist of two components.

While the methodology of sizing first loss credit enhancement is typical of most

cash flow transactions and is adjusted and applied to different asset classes such

as auto-loans, equipment leasing, consumer loans, and trade receivables, the

second loss component is unique to margin-loan transactions. The second loss

component is necessary to capture the very dynamic nature of margin-loan

portfolios. The risk in the portfolio can be significantly altered after origination

through borrower substitution, security substitution, and the manager’s ability to

change its advance rates on individual securities or alter its portfolio parameters.

This dynamic nature of the portfolio can reduce the effectiveness of historical

performance as a predictor of future performance, and, especially in a rising

market, may go undetected until a major market correction occurs. The second

loss component of the credit support calculation, together with the inclusion of

program wind-down triggers, complement the first loss credit enhancement and

help to encapsulate the underwriting and management standards of the manager

over time.

The second loss component assigns a default frequency based on such factors as

the experience of the lender in the market, track record, underwriting guidelines

(for example, whether or not a credit assessment on the borrower’s ability to pay

is completed), the historical data on the borrower’s ability to meet margin calls,

12

and the rating sought on the notes. To determine a loss severity to be applied

against the assumed default frequency, the actual advance rate of a lender’s

portfolio is compared with a reference pool advance rate. The reference pool

advance rate needs to be at a level that will result in a second loss credit

enhancement, which together with first loss credit enhancement will be sufficient

to cover estimated losses at a desired rating level. The higher the rating sought on

the notes, the lower the reference pool advance rate will be. To the extent that a

lender’s actual advance rates for individual loans in the portfolio exceed the

reference pool advance rate, additional credit support is required to cover the

increased risk. The loss severity assumed will be the lender’s advance rate less the

reference pool advance rate, subject to a minimum of zero. The amount of second

loss credit enhancement will be the derived default frequency multiplied by the

loss severity.

Each margin loan has embedded credit support provided by the minimum

equity level maintained by the borrower. This embedded credit support from

equity collateral is loan specific, however, and can not be used to cross subsidise

other defaulted loans. For example, liquidation proceeds of underlying securities

from one borrower may more than offset the loan amount owing by that

borrower, but any excess proceeds must be returned to the borrower and will not

be available to the lender to cover shortfalls from other loans. This is a key

feature that differentiates a margin-loan transaction from a pure market value

transaction. As each borrower’s risk appetite is different to another, each

borrower’s investment portfolio will look very different. This weakens the ability

to use the market value approach alone to size credit support for a margin-loan

portfolio as the application of one advance rate across all borrowers is not

entirely appropriate unless credit enhancement is fungible. The combined cash

flow and market value approach remedies this weakness, as the first loss credit

enhancement is fungible, represented by over-collateralisation or cash that is

available to cover any and all losses. Furthermore, credit support required in

addition to equity collateral under the second loss credit enhancement approach

also is fungible.

The combined cash flow and market value approach overcomes the weakness

in each approach when only applied to margin loans.


The AustralianEquities Market

As a large proportion of the investment portfolio securing the margin

loans are Australian equities, this section will provide an overview of

the Australian equities market, major price indices of the Australian

equities market, and Standard & Poor’s methodology of establishing a margin-

loan portfolio advance rate through market research and the analysis of the price

volatility of major price indices.

Growth in the Australian Equities MarketThe Australian equities market has experienced significant growth and

development in the last decade. The current capitalisation of the domestic equities

market is about A$572 billion, which is more than triple the capitalisation of a

decade ago. Trading activity has more than quadrupled in the same period, with

today’s trading volume at an average of over 30,000 trades per day. The recent

introduction of compulsory superannuation has created significant additional

liquidity in the market and the rapid development in technology has enabled the

recently demutualised national stock exchange, the ASX, to increase both trading

and settlement efficiency. The globalisation initiative has driven the ASX to

examine international opportunities, and it has become a member of a number of

other exchanges and is exploring new cooperative arrangements, such as an

alliance with the new European exchange. The globalisation strategy also allows

international investors to have real time access to the Australian share market,

which will create further liquidity.

Australian Total Share OwnershipWhile the size of the Australian equities market is relatively small compared with

the U.S., Japan, Canada, the U.K., and a number of other European countries—

ranked about eleventh in the world, Australian direct share ownership ranks first

among similar economies worldwide. A total of 54% of Australians own shares

either directly or indirectly, reflecting the increasing awareness and ease of access

to the share market and a wider range of broking choices becoming available at

14

much lower transaction costs. This increase in share ownership is consistently

observed in all Australian states and across all gender, age, and income groups.

While the level of diversification in retail investors’ portfolios is increasing with

an average of six companies held in each portfolio, a large number of retail

investors still have very concentrated portfolios, with more than 60% holding

three or less companies in their portfolio. The average dollar value directly

invested in shares by Australians is just under A$30,000. Retail investors are

moving toward more frequent trading in smaller sizes.

Major IndicesThe ASX share price and accumulation indices were first introduced in January

1980. Due to demand from the investor community, the share price indices have

recently undergone review, and new indices were introduced in April 2000. It is

possible that Standard & Poor’s Index Service will back calculate indicative

historical data for each new index, but until this exercise is completed, the old

indices will be used for the purpose of analysing stock market volatility for

margin-loan transactions.

Before the change, the ASX All Ordinaries Index (All Ords) was the best-

known and most followed index in Australia. Covering approximately 265

companies, the All Ords represented approximately 90% of the Australian

equities market. The All Ords comprised 24 industry sector indices and a number

of other indices by market capitalisation including the ASX 100 (top-100

companies), 20 Leaders (top-20 companies), 50 Leaders (top-50 companies),

MidCap50 (ASX 100 excluding 50 Leaders), and Small Ordinaries (SmlOrd, All

Ords excluding ASX 100). The ASX 100 represents approximately 90% of the

All Ords, and the SmlOrds represents the balance. 50 Leaders makes up

approximately 80% of the All Ords, of which 20 Leaders makes up 63% of All

Ords alone. The ASX published a number of other market statistics other than

the indices, and these statistics have been used for our research.

Historical PerformanceDespite the long-term upward trend in the Australian equities market, there has

experienced significant volatility and a number of major market corrections.

Chart 1 displays the price movement in the All Ords to April 2000 from

November 1981. During this period, the Australian equities market has

experienced two major market corrections. The October 1987 crash was one of

the most severe stock market crashes in history. Stock markets around the world

all experienced significant market declines, with small markets such as the

Australian equities market experiencing more severe declines than larger markets

such as the U.S. During the October 1987 crash, the All Ords experienced its

greatest one-day market fall of 25% and one-month fall of 47.4%. The largest


one-day market correction since October 1987 occurred on Oct. 28, 1997, when

the All Ords fell by 7.2%. As many margin lenders started their margin lending

activities after October 1987, the October 1997 decline was the first major

correction requiring a significant increase in margin calls within a short time

period. Margin lenders, however, experienced minimal or no losses in October

1997, as the market rebounded quickly with an increase of 6.3% in the All Ords

the next day. This market rebound negated many of the calls made on the

previous day.

The Australian Equities Market

Chart 1

Daily Close of All Ordinaries IndexNov. 12 1981-April 28, 2000

12-N

ov-1

981

21-J

un 1

982

20-J

an-1

983

26-A

ug-1

983

30-M

ar-1

984

6-N

ov-1

984

17-J

un-1

985

28-J

an-1

986

4-Se

p-19

8610

-Apr

-198

712

-Nov

-198

723

-Jun

-198

819

-Jan

-198

917

-Aug

-198

915

-Mar

-199

011

-Oct

-199

09-

May

-199

15-

Dec-

1991

2-Ju

l-199

228

-Jan

-199

330

-Aug

-199

35-

Apr-1

994

3-N

ov-1

994

13-J

un-1

995

12-J

an-1

996

16-A

ug-1

996

20-M

ar-1

997

22-O

ct-1

997

28-M

ay-1

998

29-D

ec-1

998

3-Au

g-19

997-

Mar

-200

0

Index

3500

3000

2500

2000

1500

1000

500

0


Standard & Poor’sAdvance Rates forMargin-loan Transactions

Advance Rates and Recovery ValuesAdvance rates are the maximum borrowing amounts as a percentage of the

collateral’s market value in structured market value transactions. In the context

of margin-loan transactions, the ‘borrowing’ refers to margin-loan balance and

the ‘collateral’ refers to the underlying securities. Although the market value

approach will be used to establish advance rates for margin-loan portfolios, it is

important to note that margin-loan transactions are not pure market value

transactions, as the assets in margin-loan transactions are revolving personal

credits and borrower defaults are the primary credit risk. The advance rates for

margin-loan pools will be used to estimate loss severity for the portfolio only.

Under the market value approach, quantitative methods are used to size the

total risk that affects the ultimate recovery value of the collateral. The total risk

can be broken down to market value risk, concentration risk, duration risk,

default risk, and liquidity risk. For equity investments, duration and default risk

do not apply, and the liquidity risk is embedded in the price return volatility

(price return volatility is a good proxy for market value risk in an efficient

market). Thus, the advance rates for equities only factor in the market value risk

including systematic and unsystematic risks, and any adjustments for portfolio

concentration. As the total risk at a given rating indicates the most a collateral

pool can lose in its market value, an advance is permitted on the remaining

collateral’s market value. For example, an advance rate of 60% means for every

dollar of collateral, the transaction’s liability cannot exceed A$0.60. In other

words, the A$0.40 represents the market-value risk of the collateral in a given

exposure period. In general, the more risky the collateral, the lower the advance

rate in a given exposure period.

18

Exposure PeriodThe exposure period is the period between the last collateral valuation date and

the liquidation date. Advance rates are exposure period sensitive as the asset price

movements can differ greatly for different exposure periods. Therefore, Standard

& Poor’s sets the maximum advance rate for a given exposure period, which

typically will be one month or 20 business days. The exposure period will be

assessed on a portfolio-by-portfolio basis.

Portfolio Concentration AdjustmentsStandard & Poor’s adjusts the portfolio advance rates for stock, industry, and

market capitalisation concentration. Stock and industry concentration

adjustments are made using variance-covariance equations. The market

capitalisation concentration risk is adjusted by adopting a weighted average

advance rate approach. Traditional portfolio theory suggests the greater the

portfolio diversification in uncorrelated assets, the lower the portfolio risk.

Likewise, the statistical model used by Standard & Poor’s to size advance rates

penalises high portfolio concentrations and requires lower advance rates for

portfolios with greater concentration. Diversification is required at stock and

industry levels to arrive at a higher advance rate. This is because while a portfolio

can be well-diversified by number of stocks. If these stocks are concentrated in

one industry, their prices will be highly correlated. Such a portfolio has a higher

risk compared with a portfolio with the same number of stocks, but diversified

across different industries.

Calculation of Portfolio Advance RatesIn general, the advance rate of a margin-loan portfolio will be calculated as the

weighted average of the stock and industry concentration adjusted advance rates

of 50 Leaders, MidCap50, and SmlOrds. These indices are selected on the basis

of their construction rules, and the fact that together they cover almost the entire

spectrum of the Australian stock market. Furthermore, the weighted average

advance rate of these indices will factor in the portfolio concentration by market

capitalisation. Consequently, a portfolio that is highly concentrated in 50 Leaders

will have a higher advance rate than one that is highly concentrated in the

SmlOrds, as the SmlOrds manifests a greater market risk. The dynamic

calculation of portfolio advance rate captures increasing portfolio risk, which can

be caused by portfolio composition migrating from high concentration in

companies with large market capitalisation to companies with small market

capitalisation. Usually, margin lenders implement portfolio parameters to prevent

rapid change in portfolio characteristics. The advance rates are portfolio specific,

and are dependant on the lender’s approved list securities and the portfolio

parameters that restrict stock, industry, and market capitalisation concentrations.


Table 1 sets out the Standard & Poor’s estimated advance rates at different

rating levels for a number of major stock market indices after adjusting for

portfolio stock and industry concentrations.

Table 1 shows that the ‘AAA’ advance rate for the All Ords is 62.9%, indicating

a loss severity tolerance of 37.1% in a month. While this is less conservative than

the magnitude of the fall experienced in the October 1987 market correction

(47.4% over the same exposure period), a number of factors support this,

including:■ The primary credit risk in a margin-loan portfolio is borrower default risk,

which consists of the first level credit enhancement and the second level credit

enhancement. As the advance rates are used for estimating loss severity for the

second component only, the size of its impact on the total credit enhancement

requirement is not as great as in pure market value transactions.■ Our research indicates that the Australian equities market has evolved over

time, and that the probability of a market fall of the same magnitude as

October 1987 crash is small. The market has become more efficient and

significantly more liquid. Investors are better informed and the investment

community has become more sophisticated.■ The Australian equity market’s composition has changed significantly over

time. For example, the mining industry no longer carries the same weighting by

market capitalisation in the Australian equities market as it did in the mining

boom days.■ Recent data indicates that Australian equities no longer necessarily correct

more than other major markets. For example, the U.S. market declined by more

than 14% in August 1998, however, the Australian equities market declined by

6.6% in the same month.

Table 1Standard & Poor’s Advance Rates Adjusted For Portfolio Concentration*

Transaction All 20 50 Mid- Sml- All All

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

Rating Ords Leaders Leaders Cap50 Ord Industrial Mining

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AAA 62.9% 69.8% 65.5% 61.3% 51.7% 64.0% 52.2%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA+ 66.2% 72.5% 68.6% 64.7% 55.9% 67.2% 56.4%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA 69.5% 75.2% 71.7% 68.1% 60.2% 70.4% 60.6%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA- 71.7% 77.0% 73.8% 70.4% 63.0% 72.6% 63.4%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A+ 73.9% 78.8% 75.8% 72.6% 65.9% 74.7% 66.3%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A 76.1% 80.6% 77.9% 74.9% 68.7% 76.9% 69.1%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A- 78.3% 82.4% 79.9% 77.2% 71.6% 79.0% 71.9%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

BBB+ 80.5% 84.2% 82.0% 79.5% 74.4% 81.2% 74.7%

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

BBB 82.7% 86.0% 84.0% 81.7% 77.3% 83.3% 77.5%

BBB- 83.8% 86.9% 85.1% 82.9% 78.7% 84.4% 78.9%

*Assumptions: Issuer concentration = 2.5%; industry concentration = 10% and exposure period = 20 business days.

Standard & Poor’s Advance Rates for Margin-loan Transactions

20

■ The margin call process is usually shorter than 20 business days. Under normal

circumstances, the period between last valuation date and liquidation date of

the underlying securities should be no longer than five business days, and the

maximum market fall in that window of exposure period was 31.5% in the

1987 crash.■ A margin-loan portfolio can be managed so that stocks with extreme volatility

are excluded.

The recent price volatility in venture capital stocks demonstrated that irrational

behaviour does exist among investors. Standard & Poor’s is extremely

uncomfortable with venture capital stocks and initial public offerings that do not

have track records in profit generation or historical price data, and where their

prices are based purely on speculation of future market potential. These stocks

can experience a significant fall in value and market illiquidity. In the worst case,

some of these companies will go bankrupt. Standard & Poor’s advance rates on

these stocks will be zero until a performance track record is established. Our

advance rates on options also will be zero due to difficulties in analysing the price

volatility of these derivative products.

Other SecuritiesThe advance rates in Table 1 are for equity investments only. If a lender’s

approved list consists of unlisted managed funds, options, and other forms of

investments, we will require further information before a portfolio advance rate

can be established. Some lenders accept residential properties as securities for

margin loans. Standard & Poor’s will not give credit to recovery values of real

properties as they are highly illiquid and do not fit into the margin-lending

portfolio rating framework.


Determining Defaultand Loss Severity Drivers

Historical PerformanceA margin loan derives its cash flow from loan repayments made by the borrower.

Similar to other cash-flow transactions, the primary credit risk of this asset type is

borrower default risk. A review of historical portfolio performance forms the

basis for estimating potential losses for a pool, and hence the required credit

enhancement, which is the first loss credit enhancement mentioned previously.

Default frequency. Default frequency is the estimated proportion of loans in a

pool that will default. The lender’s gross-loss statistics through market cycles

provides an indication of default frequency for a portfolio under that lender’s

underwriting and management style. The gross loss statistics also are used to

estimate future losses before giving credit to the recovery value from the

underlying securities. As a break down of historical margin call statistics will

provide both gross and net loss information, Standard & Poor’s will request data

to facilitate the credit analysis and rating process for margin-loan transactions,

including number of margin calls made daily, how many margin calls have been

met, how many margin calls are no longer required due to market rebound, how

many loans have resulted in the liquidation of the underlying securities, and what

losses have been experienced on those loans.

Loss severity. Cash flows from recoveries provide an added source of credit

support to the extent the cash is available to offset a simultaneous loss. Because

of the secured nature of margin loans, recoveries can be substantial. The loss

severity is the difference between recovery value and the loan amount owed by a

defaulted borrower. The net-loss statistics of margin loans capture the default

frequency and recovery value of the underlying securities as the underlying

securities can be sold relatively quickly.

The recovery levels of defaulted margin loans are influenced by the nature of

the underlying securities, the market liquidity of the underlying securities, and

borrower portfolio diversification. The recovery level of the entire margin-loan

portfolio is a function of the portfolio’s stock concentration, industry

concentration, and the exposure period to the underlying securities, which are

ultimately affected by the management strategy and operational capacity of the

manager. As margin-loan transactions will most likely be revolving in nature, the

22

underlying borrowers and the loan sizes may change frequently, and the

underlying securities may be substituted regularly. To give credit to recoveries,

Standard & Poor’s will review the manager’s management strategies, length of

experience in business, and operational capacity.

Net losses and first loss component. The expected cumulative losses estimation

by Standard & Poor’s serves as the foundation for the level of first loss credit

enhancement needed for a given rating level. While static pool data is preferred in

most asset-backed transactions, dynamic portfolio data is acceptable for margin-

loan transactions, as the factors that are not captured by dynamic portfolio data

are reflected in the second loss credit enhancement calculation. Factors such as

the impact of the originator/manager’s underwriting and collection policies on

portfolio performance that can be observed through the analysis of static pool

data, are captured through the estimation of second loss credit enhancement, the

dynamic approach in sizing credit support, and the documented amortisation

trigger events. The first loss credit enhancement requirement is calculated as

follows:

Highest Rolling Cumulative Historical Losses Over Average Life x Stress Factor

The historical losses refers to net losses. The average life refers to the maximum

exposure period to the underlying securities. The average life can vary from

transaction-to-transaction depending on the program trigger events and the form

of the lenders’ loan agreement, for example, the notification period required to

declare final maturity of margin loans. The rolling cumulative loss data needs to

be provided at least over a full market peak and trough cycle. Notwithstanding

this quantitative analysis, Standard & Poor’s qualitative judgement also will have

a bearing on the level of credit enhancement required, and based in part on this

analysis, Standard & Poor’s will assume a floor on cumulative losses. For

instance, we will assume a floor of 1% on cumulative losses for an experienced

lender with adequate underwriting and management processes and who provides

strong evidence of its track record.

Table 2 sets out the benchmark stress factors for different rating levels, these

stress factors serve as a benchmark only and may vary based on our transaction

specific analysis.

Table 2Benchmark Stress Factors For Requested Ratings

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

Transaction rating Stress factor (x)

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AAA 5

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA 4

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A 3

BBB 2


As the margin loans can be large in size in relation to the overall size of a

lender’s portfolio, it can expose a transaction to the risk of a certain number of

large borrowers defaulting at the same time. To address the issue of borrower

concentration, there needs to be a first lost credit enhancement concentration

floor.

Table 3 sets out a guideline for the minimum number of borrower defaults that

the first loss credit enhancement needs to cover at each rating level.

Given the secured nature of margin loans, credit may be given to potential

recoveries from defaulted borrowers in the concentration floor calculation. This

recovery level depends on each defaulted borrower’s portfolio diversification.

Minimal credit will be given to recoveries if the borrower is exposed to a single

stock. The greater the borrower portfolio diversification, the higher the recovery

value that will be assigned. The ultimate floor level depends on how the lender

manages the exposure to large obligors and controls borrower’s portfolio

distribution.

Example 1

The following example shows how the first loss credit enhancement is sized based

on certain assumptions, namely■ A margin-loan portfolio of A$150 million;■ The requested transaction rating is ‘A-1+’, which is equivalent to ‘AA’;■ The first loss credit enhancement estimated from historical performance is 4%

for ‘A-1+’ rating;■ The five-largest loans are A$10 million each;■ Each borrower’s loan-to-value ratio (LVR) is currently at 75% (hence each

borrower’s equity equals 25%);■ The large borrowers are required to invest in a diversified portfolio; and■ Estimated recovery from a diversified borrower portfolio is 60%.

Assume Standard & Poor’s advance rate is 60% at ‘A-1+’, hence the portfolio

should withstand a 40% market value decline under an ‘A-1+’ scenario. At the

‘A-1+’ rating level, we assume the five-largest borrowers will default in meeting

margin calls, and these borrowers’ entire share portfolios will be liquidated if the

market experiences a 40% market value decline. With the outstanding loan

Table 3Benchmark Borrower Concentration Coverage For Requested Ratings

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

Transaction rating Number of borrowers expected to default

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AAA 5

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA 5

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A 4

BBB 3

Determining Default and Loss Severity Drivers

24

balance equal to 75% of the market value of securities before market decline, we

expect the lender to experience a loss severity of 15% (equal to 75% less 60%, or

40% less 25%).

The first loss credit enhancement floor would be:

The loss severity x number of borrowers x exposure to each borrower.

Hence, in this example, the first loss credit enhancement floor would be:

15% x 5 x A$10 million = A$7.5 million

This equals 5% of the portfolio.

As the floor of 5% is higher than the 4% estimated from historical

performance, the first loss credit enhancement required is 5%.

For the purpose of sizing the concentration floor, Standard & Poor’s will

request detailed statistics of the five-largest borrowers in a margin-loan portfolio,

including loan statistics, borrower profile, and underlying securities portfolio for

each borrower including investment parameters. This information is required

before a rating is assigned, as well as for post-rating surveillance.

Capturing Increases In The Portfolio Risk ProfileOver TimeThe second loss of credit enhancement compliments the first loss credit

enhancement ,capturing increases in the portfolio risk profile over time and

encapsulating the underwriting and management standards of the manager.

The second loss credit enhancement level in a transaction will therefore reflect a

differentiation between conservative and aggressive management strategies, the

degrees of management expertise, and other issues arising from the originator/

manager review. As the management role is crucial for margin-loan transactions,

Standard & Poor’s will not rate transactions without significant levels of third-

party credit support where the manager does not have a strong servicing

platform.

Default Frequency. Among others, the LVR of a margin loan is one of the most

important factors affecting the default probability of a borrower. The LVR of a

margin loan can change as a result of lender changing their lending policy, or as a

result of the market value fluctuation of the underlying securities. Therefore, the

default frequency assumption at each rating level is a function of each originator’s

underwriting standards, borrower credit requirements, management strategy,

operational capacity, length of time in business, and experience during a bear

market. For example, a manager who sets strict portfolio parameters and requires

borrowers to have a minimum number of stocks in their portfolio, is viewed to be

more conservative compared with a manager who has less strict portfolio

parameter and no borrower portfolio distribution control. The default frequency

assumption would be lower for a portfolio that is under the management of a

conservative manager. The anecdotal information provided by some lenders on


borrower profile and performance suggests that the default frequency is relatively

low. Due to lack of quality industry wide historical data, however, Standard &

Poor’s will take a conservative view of the default frequency levels until the

market develops more of a documented track record. Table 4 sets out a wide

range of default frequency assumptions at each rating level. It is provided as a

guide only, as the assumptions may be higher or lower depending on the outcome

of Standard & Poor’s originator/manager review. The outcome may well be

outside the range. The quantity and quality of historical default and margin call

data the lender is able to provide will account for much of this differential.

‘Strong’ in Table 4 represents conservative underwriting and portfolio

management strategy and experienced management, and ‘average’ represents

more aggressive underwriting and portfolio management strategy and less

experienced management.

The default frequency ranges are relatively conservative compared with other

asset types and what may happen in reality. Comprehensive quantitative data to

support lower assumptions, however, is not available at this time. The

information we have seen so far reflects lower default frequency levels due to a

number of reasons, including:■ The borrower profile consists of high net-worth individuals, although it has

expanded to include other borrowers from other income levels.■ The borrowers are informed by the lenders of how the margin loans operate

and associated risks. Hence, most borrowers have a good understanding of the

market risk and how to mitigate the possibility of a margin call being served

and default upon a margin call.■ The borrowers have a large equity stake in their investment, which they are

interested in protecting.■ Lenders have the right of recourse to borrowers’ other assets and can file

borrowers into bankruptcy if the borrowers fails to repay the margin loan.

Table 4Default Frequency Assumptions At Requested Rating Levels

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

Rating Strong* Average*

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AAA 12.5 25

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

AA 11.25 22.5

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

A 10 20

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

BBB 8.75 17.5

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

BB 7.5 15

B 5 10

*Where: Strong represents conservative underwriting and portfolio management strategy and experienced management, andAverage represents more aggressive underwriting and portfolio management strategy and less experienced management.


26

■ For some borrowers, investment portfolios built from margin loans form one

part of their aggregate investment. Their net worth may include other

investments, such as residential and commercial properties, which they are not

interested in placing at risk by failing to meet margin calls.■ Lenders who follow their margin call policy strictly usually are able to liquidate

the underlying securities before the market value decline by a greater magnitude

than the minimum equity buffer, hence resulting in a loss on the loan.

Loss severity. Standard & Poor’s portfolio advance rates reflect our expected

loss severity at each rating level. Margin loans have embedded credit support

from the minimum equity level maintained by the borrowers. As the actual LVR

of margin loans can be higher than Standard & Poor’s advance rate at a rating

level, we expect the difference between them will be lost at that rating level if a

borrower defaults. Therefore, the loss severity of a loan is the difference between

actual LVR and Standard & Poor’s advance rate. The loss severity of a portfolio

is the sum of loss severity of each individual loan.

For example, if a portfolio has a Standard & Poor’s advance rate of 60%, and

each loan has a 75% LVR, the estimated loss severity would be 15% per loan.

The portfolio loss severity is the sum of loss severity estimation of each loan.

Where a borrower’s LVR is less than Standard & Poor’s advance rate, a zero loss

severity is assumed.

The calculation of loss severity under the second loss credit enhancement

consists of two major components. The first component is calculating the

portfolio advance rate, which is the weighted average of the stock and industry

concentration adjusted advance rates of 50 Leaders, MidCap50, and SmlOrds.

Standard & Poor’s will supply the adjusted advance rates for each major index

depending on the manager’s portfolio parameters as shown in Table 1. The

manager is then required to monitor the market segment distribution of the

underlying securities of the margin-loan portfolio, and obtain the weighting of

each market segment on a daily basis. For each example, the portfolio

composition is 80% in 50 Leaders, 10% in MidCap50, and 10% in SmlOrds.

The Standard & Poor’s portfolio advance rate would be the weighted average of

the Standard & Poor’s advance rates of these major indices (see Table 1), where

the weightings are 80% for 50 Leaders, 10% for MidCap50, and 10% for

SmlOrds. The second component of the calculation involves the manager

identifying all margin loans in the portfolio with an LVR greater than the

Standard & Poor’s portfolio advance rate and calculate the difference. The

portfolio loss severity is the aggregate of differences on each margin loan. Before

assigning ratings to a transaction, Standard & Poor’s will review the manager’s

system capacity for reporting and the model to size the credit support on a

dynamic basis. We also will require a point in time portfolio statistics by LVR, by

market segment break-down, by size and by borrower profile as well as historical

margin call statistics.


As part of surveillance after the initial rating process is completed, Standard &

Poor’s will require reports on a regular basis on the required level of credit

support, the actual credit support available, and current portfolio performance

against the trigger events. Further surveillance information will be specified on a

transaction-by-transaction basis.

Net losses. The second component net losses is the product of the estimated

default frequency and loss severity. Given the revolving nature of margin-loan

portfolios, the second loss credit enhancement needs to be sized on a dynamic

basis.

For example, if a transaction with a requested rating of ‘A-1+’ has an estimated

loss severity of 10% and estimated default frequency of 20%, the second loss

credit enhancement required would be 2% (equal to 10% multiplied by 20%).

Total Credit Enhancement CalculationThe total credit enhancement required is the sum of the first and second loss

credit enhancement. In the examples used in this report, the total credit

enhancement required for an ‘A-1+’ rated transaction would be 7% (equal to 5%

plus 2%).

The first loss credit enhancement needs to be resized at least monthly, the

second loss credit enhancement needs to be revalued on a daily basis to capture

potential market volatility. Should the total credit enhancement provided in the

transaction fall below the required level sized dynamically, such shortfalls needs

to replenished, otherwise program wind-down triggers will occur.



Originator/ManagerReview

In margin-loan transactions, the manager’s strategy and capacity to actively

manage the portfolio can impact the portfolio performance and the level of

credit enhancement required. Important considerations with respect to a

manager can be categorised into company overview, underwriting, and

investment strategy and objectives, servicing, and credit monitoring capabilities.

More specific areas of interest during a onsite meeting with management include:■ The company’s background, its competitive position in the market and

organisational structure;■ The style of management and strategic objectives of the company. How the

investment securities approved and how are the advance rates are arrived at;■ The skills and experience of the staff and their compensation arrangements;■ The policy of segregation of duties and independence of reporting lines between

the risk management team, lending department, and servicing department;■ The underwriting and investment strategy, credit and approval policy,

underwriting guidelines, and portfolio management policies and procedures;■ The hedging strategy for interest rate risk, currency risk, and market risk of the

portfolio;■ The efficiency of the computer system with respect to tracking the investment

securities against each borrower in the portfolio, the system capacity in

producing reports and in serving margin calls, the degree of automation and

security of the system, back-up facilities, and disaster recovery plans;■ The source of market prices, timeliness of the prices and policies, procedures

regarding securities valuation, and the frequency of valuation;■ The mechanisms implemented to prevent human errors, particularly during

peak periods;■ Contingency plans in the event of major market correction, including additional

staff requirements, additional computer terminal availability, etc;■ The level of internal control and frequency of compliance checks;■ The frequency of external and internal audits;■ The security of mortgage management;■ The handling of collections and disbursements;■ The management of revolving credit facilities;

30

■ The handling of margin calls, delinquencies and liquidation of investment

securities, and historical portfolio management performance;■ The handing of problem credits; and■ Contingency plans for handing over to a replacement manager in the event of

manager default or insolvency.

The outcome of Standard & Poor’s onsite meeting will be factored into the

sizing of credit enhancement. Depending on the review outcome, Standard &

Poor’s may request a back-up servicer to be in place before a rating can be

assigned.


Legal Considerations

Margin-loan transactions are subject to similar legal considerations

seen in other asset-backed transactions, such as the creation of a

special purpose entity (SPE), the nature of charge, and the transfer

of assets and related rights and interests from a legal and a practical perspective.

The rating analysts will review loan documents, security documents, and transac-

tion documents to see if they are consistent with the requested rating level.

For margin loans, we would need the standard opinions from an experienced

legal counsel of the issuer, they include:■ Corporate and enforceability opinions for the transaction participants;■ The true sale opinion to the effect that if the correct procedures are followed,

title to the margin loans will pass to the SPE notwithstanding the seller

retaining custody of the security and loan documents and the assets will not

constitute assets of the seller if the seller is wound up;■ Security interest opinion to address the effectiveness of the charge granted to

the security trustee;■ Insolvency opinion to the effect that the insolvency of the issuer or the security

trustee will not affect the rated securities; and■ Tax and withholding tax opinion addressing whether the transaction is tax

neutral, and if not, to what extent is the transaction exposed to tax.

In addition to the above opinions, an additional opinion is required in relation

to the margin-loan documentation and related securities. The issues that this

opinion will need to address include:■ That the operative margin-loan documentation and security create binding and

enforceable obligations of the borrower.■ Any registration or stamping requirements for the margin loan or security on

each of originations, equitable assignment, and perfection of title.■ The security structure gives the lender total control over each borrower’s

securities portfolio (to the exclusion of the borrower), both before and after

default. For example:

—That the security structure is effective to allow the lender/servicer to liquidate

the securities within “x” days of a default or margin call;

—The terms upon which any nominee or custodian holds any securities will be

effective to require the nominee/custodian to comply with the instructions of

the lender/servicer to the exclusion of the borrower;

32

—That third-party security providers are bound in the same way as the bor-

rower; and

—The security is effective to survive the insolvency/bankruptcy of the borrower

or any third-party security provider.■ That the lender can liquidate the underlying securities if a borrower becomes

insolvent. Where the insolvent borrower is a company, whether an

administrator of that company can prevent the liquidation of the underlying

securities.■ That the issuer will have the benefit of all the rights of the seller to sell

mortgaged securities in accordance with the margin-loan documentation, both

before and after insolvency of a seller and/or custodian, and that right will be

recognised by CHESS and any other registrar of securities. In particular, that

the issuer can rely on any power of attorney granted in favour of the seller or

custodian in the margin-loan documents before and after the insolvency of the

grantor.■ The method of funding of further advances (there can be no liability for the SPE

to fund).■ Interest rates may be effectively changed (at any time on notice).■ Set-off rights.■ Loan products with special characteristics.■ The capital gains tax on sale of underlying securities.


Other RatingConsiderations

This report does not address rating considerations that are similar to other

asset-back transactions or transaction structural features that are unique

to certain transactions. Some of these rating considerations include

maturity risk, liquidity risk, commingling risk, lender’s liability risk, set-off risk,

reinvestment risk, interest rate mismatch risk, and currency risk. The rating

analysts are available to discuss these issues should an issuer or investor wish to

take these topics further. Asset and structure specific features will be reviewed on

a transaction-by-transaction basis.

Credit Issues in Rating Australian Margin Loan-Backed Securities

Documents

Transcript of Credit Issues in Rating Australian Margin Loan-Backed Securities