(The following statement was released by the rating agency)
Jan 07 - In its updated rating criteria for derivative product companies (DPCs) published today, Fitch Ratings clarified that it will look to the DPC’s stand-alone credit strength, as well as the sponsor‘s, when rating DPCs engaging in standardized, liquid derivatives.
A DPC’s ratings may be de-linked from the rating of the sponsor at a certain level, termed a ‘ratings floor.’ A ratings floor of ‘A’ will apply for continuation DPCs that are well-capitalized and appropriately structured, whereas a ratings floor of ‘AA’ may assigned to termination DPCs. Fitch’s new criteria applies to DPCs that are separate legal and operating entities and benefit from capital and structural protections that seek to make them legally, financially, and operationally distinct from their sponsor. DPCs are typically wholly owned subsidiaries of financial services companies who serve as a DPC’s sponsor. The criteria addresses DPCs that intermediate or guarantee ‘plain vanilla’ derivative transactions on behalf of the sponsor.
The DPC’s final rating will also reflect the credit strength of the sponsor, if the sponsor is a higher rated entity. The DPC’s final rating is expected to be the higher of the DPC’s stand-alone rating floor or one notch above the sponsor’s long-term issuer default rating. The rating is expected to migrate with the sponsor’s rating until the rating floor is reached in most cases. Ratings linkage to the sponsor may continue at rating levels below the proposed rating floors where a DPC shows weakness in capital level, structure or operational separateness.
DPCs face counterparty, market and liquidity risk as the main financial risk factors. These risk factors are addressed via the DPCs capitalization, collateral posting arrangements, and hedging/unwind mechanisms. Well-defined counterparty and portfolio diversification limits help serve to identify and control these risks. Distinct and well-defined governance standards and operating procedures also play an important role in achieving legal and operational separateness from the sponsor.
Fitch’s rating criteria also addresses considerations for DPCs acting act as a counterparty or guarantor for structured finance (SF) transactions. Derivatives associated with SF transactions, even liquid derivatives with standardized terms, raise certain unique issues when analyzing DPCs. Likewise, a DPC’s particular structure and trigger events should not negatively impact the SF transaction, relative to Fitch’s SF counterparty criteria.
This criteria does not apply to more bespoke derivatives, including those that may be associated with SF transactions such as balance guaranteed swaps or swaps with highly customized reference rates. Fitch will continue to dialogue with the market to assess various proposals that are designed to intermediate more bespoke derivatives.
The criteria report, titled ‘Derivative Product Company Rating Criteria’ (Jan. 7, 2012), is available at ‘www.fitchratings.com’ or by clicking on the link.
Link to Fitch Ratings’ Report: Derivative Product Company Rating Criteria