Banks face swaps threat after cut ratings Sovereigns, banks, deals - the whole financial system relies on ratings provided by Moody's, Standard & Poor's and Fitch. So when Moody's downgraded 15 of the world's biggest banks last month, many financial institutions and investors were focused on the wider impact a rating drop would have on the derivatives swaps agreements at the heart of many structured finance deals. The issue centres on the fact that banks often act as counterparties in interest rate or currency swaps that are put in place to hedge against risk in structured finance deals such as asset-backed securities, covered bonds, residential mortgage-backed securities and collateral loan obligations. The swaps themselves are not rated, but they are designed with trigger points that are set off when a counterparty falls below a minimum ratings threshold. The concern is that a downgrade of a bank counterparty will ultimately lead to a swath of downgrades of structured finance deals, potentially forcing up the cost of funding for banks as investors demand more for lower rated deals. So far there have been relatively few new structured finance bond issues to test the water. Transaction downgrades have also largely been avoidable. But some of the ways to dodge a downgrade of a transaction incur additional costs for the banks involved. Banks such as Citi, Morgan Stanley and RBS, whose ratings have fallen below single A or the A2 threshold, have already indicated they are likely to have to post millions or even billions of dollars of additional collateral to support transactions, including swaps, that breached ratings triggers. There are other ways to avoid transaction downgrades. Last month, for example, the Sorin Real Estate CDO [collateralised debt obligation] switched its counterparty bank on a swap transaction from Citi to Bank of New York Mellon. Alexander Batchvarov, international structured finance strategist at BofA Merrill Lynch Global Research, says: "Banks have known for some time that they would be downgraded and anybody who thought it would have no broader impact was clearly wrong. It is a function of the way deals operate that banks may act as swap counterparties, servicers, trust account holders. He says while structured finance transactions have been affected, many deals have been restructured to minimise the impact of a downgrade of one entity involved in a swap. Roberto Henriques, head of European financials credit research at JPMorgan, agrees that the immediate impact of the bank downgrades has so far "not been hugely disruptive as the market was braced for the new ratings landscape." Banks have managed to avoid unwinding transactions, mostly by increasing the amount of collateral posted in order to compensate for lower ratings. On structured credits, banks have explored options such as replacing the swap counterparty or finding a guarantor with a minimum rating. Matthew Jones of S&P says some counterparties have replaced themselves with subsidiaries located in a country where they have a higher rating. We've seen other situations where institutions have amended the minimum ratings requirement because ultimately nothing has really changed. There hasn't been a default of the structure," says Mr Henriques. But Ed Grebeck, chief executive of Tempus Advisors, worries that the shrinking number of highly rated counterparties poses a risk: it points to market concentration. It means less players than before. There were 10 you could go to and maybe there are five. Others argue that with the field of highly rated participants narrowing, banks will inevitably have to deal with lower rated counterparties. Andrew South of S&P says the market is getting used "to a new environment in which counterparties on swaps have lower ratings [than before] and the structured finance transactions they are contained within are not rated AAA." The change in the rating environment, he says, could even lead to a switch in the way structured finance deals are constructed. Issuing fixed rather than floating rate bonds, for example, would avoid the need for an interest rate hedge in some ABS deals. In May RCI Banque, the banking arm of carmaker Renault, went a step further and constructed an automotive ABS without any swap - an unusual move but one that analysts say could be repeated. S&P, Fitch and Moody's - which last week asked for comment on the debate - are clearly taking the counterparty issue on swaps deals seriously and have released a host of updates on the subject. But they are keen to point out that transaction downgrades are not a given. Moody's approach to counterparty risk on swaps is unlikely to have an impact on the rating of the majority of structured finance transactions, says Edward Manchester of Moody's, but there could be exceptions. The impact of bank downgrades has "not been catastrophic" and the market in most cases has moved ahead of the rating curve but Mr Henriques warns of other clouds on the horizon. He says regulatory pressures such as the European Commission crisis management directive, which will see the burden of a failed bank shift from taxpayers to senior unsecured bondholders, will lead rating agencies to further downgrade banks. In the long-run "funding costs are only going to go in one direction," says Mr Henriques, and that's up.