Although structured finance transactions that involve sovereigns have been around for many years, in 2005 Standard & Poor's has seen a flurry of such transactions in Europe and the Middle East. It is probably too early to tell whether this reflects a deep trend or is merely a coincidence.
However, this is an opportune time to look at the roles that sovereign entities play in structured finance transactions. Whichever the role, sovereigns bring with them a specific political risk not present when the sovereign's role is filled by a corporation, and the presence of this risk requires special analytical considerations.
He Who Makes The Law Can Break The Law
In the context of a structured finance transaction, if the sovereign is rated, why can it not simply be treated as a similarly rated corporation would be? Why not apply, unmodified, the traditional structured finance criteria to such transactions?
The simple answer to these questions is that sovereigns are different from corporates and so it follows that sovereign ratings are different from corporate ratings. The reality is that by definition a sovereign is not governed by laws. Rather, it makes the laws while corporates follow them.
Of course, this does not mean that sovereigns are lawless entities doing just as they please. Many sovereigns operate under the rule of law. This means that they accept that they will abide by certain legal rules and principles, often enshrined in a constitution.
Sovereigns also know that they cannot perform certain acts without a substantial political cost. If the acts that the sovereign proposes are clearly unconstitutional, the government may find that it cannot enforce its writ, as other organs of state, such as the civil service or the army, will simply refuse to comply.
Equally, sovereigns know that certain acts will have international consequences. For example, failure to pay debts owed to international investors or the nationalization without compensation of enterprises belonging to foreign investors may seriously damage the sovereign's access to international capital markets.
Depending on the circumstances, such acts may even result in the seizure of the sovereign's assets located abroad and trade sanctions. In theory at least, they may even result in war.
A sovereign's assets located within the control of another sovereign are subject to the laws of that other sovereign. When and how a sovereign entity can seize and control the assets of another sovereign entity is the subject of a doctrine of law known as "sovereign immunity." This doctrine is complex and variable across countries but only underlines the same basic truth: sovereigns make the law in their own territories, even with respect to the property of other sovereigns.
For these reasons, many sovereigns do respect legal rules. However, this always remains a choice on the sovereign's part. It therefore follows that the extent to which the sovereign follows legal rules, and when it elects to break them, is also a choice.
For this reason, Standard & Poor's rating on a sovereign generally reflects our opinion of the likelihood of the sovereign meeting its obligations under its international debt. Since compliance with obligations by a sovereign is always elective, one cannot derive from a sovereign rating the likelihood of it meeting any other type of obligation. Thus, the likelihood of a sovereign entity paying rent on a property lease or paying a trade receivable is not necessarily equivalent to that of it paying its internationally placed debt.
The right that sovereigns hold to create and amend laws comes with social, political, and economic checks and balances, and understanding this relationship is one of the subtleties of our analysis of structured transactions that involve a sovereign.
Sovereigns Play Various Roles In Structured Transactions
Sovereign entities have appeared recently in a number of guises in structured finance transactions, including as an obligor, as a key influence, and as the transaction's originator.
Sovereigns can act as obligors
Sovereigns appear as obligors most visibly in a number of Islamic financings (known as Islamic sukuk). Here, the sovereign wishes to issue debt, which, financially, is equivalent to its own internationally placed debt but is in a form that makes it suitable for Islamic investors.
In effect, the structured part of these transactions is not designed to isolate the risk of the originator's default, as in traditional structured finance transactions. It is designed to strip out of the transaction those aspects (e.g., the payment of interest) that are unacceptable to Islamic law. Qatar Global Sukuk QSC's issuance of rated trust certificates is an example.
The thrust of the sovereign analysis is to determine to what extent the payment obligations of the sovereign entity can be assimilated, in their credit risk, to that sovereign's international debt obligations. The purpose of the structured analysis is to determine to what extent the structure is transparent so that it does not impede the rights of investors vis-a-vis the sovereign entity. In other words, the structure here must provide a see-through to the sovereign.
Sovereigns can be a key influence in the transaction
The role of sovereigns as a key influence has been seen primarily in future flow transactions. These are securitizations where the assets securitized consist of rights that have yet to come into existence, e.g., rights over receivables due for future gasoline or petroleum exports, future credit card usage, or future fees for use of an essential service, such as telecommunication equipment.
The essence of the ratings in these transactions is the importance of the asset to both the corporation generating it and to the sovereign entity. Given this essentiality, the asset will continue to be generated and the value of that asset will continue to inure to the investors in the rated debt even if the corporation becomes insolvent and/or the sovereign defaults. For example, even if the national oil company goes bust and, as in some rated transactions, the sovereign is in default, the oil will continue to flow and the payment for that oil will continue to be paid to the investors.
In these transactions, the essentiality of the asset is both the opportunity and the risk. One of the key tasks of the sovereign analysis is therefore to understand how and in what circumstances the sovereign entity may interfere with the transaction. This is where the nature of the sovereign as maker of laws becomes a key component of the risk.
Will the government change the rules? What are the political and economic incentives driving for and against such a change?
For its part, the structured analysis tends to focus on whether the structure works under the existing regime. The reasoning is that whatever the sovereign's temptations to change the rules may be, they would be irrelevant if, structurally, the investors could lawfully be deprived of their expected entitlements anyway.
Sovereigns can take on role of originator
In a number of structured transactions, sovereigns have assumed the role of originator. In the first half of 2005 Germany accessed the securitization market as a traditional originator, following the example of Italy.
In the Aries Vermoegensverwaltungs GmbH and German Postal Pensions Securitization PLC transactions, the German government securitized receivables due from the Russian government under its Paris Club debt and arranged for the sale of pension fund contributions of various privatized companies, ultimately backed by the sovereign. These transactions are similar to the Italian transactions that relate to certain overdue tax receipts (e.g., Societ?di Cartolarizzazione dei Crediti INPS - S.C.C.I. SpA) or real estate properties (e.g., S.C.I.P. Societ?Cartolarizzazione Immobili Pubblici S.r.l.).
Here the interaction between the sovereign and the structured analyses is fairly subtle. The issues surrounding the sovereign analysis relate to compliance with various servicing covenants.
To the extent that the transactions rely on a promise by the sovereign to behave in a certain way, is the likelihood that the sovereign will comply with this promise equivalent to the likelihood that the sovereign will pay its international debt? For example, if the sovereign promises to enforce the sold receivables and the sovereign's own rating is 'AA', is the promise of enforcement also 'AA'?
The structured analysis requires an in-depth understanding of the meaning of "true sale" in the context of an entity that cannot be placed in traditional bankruptcy proceedings. What does it mean to sell the receivables to an SPE? Can the sovereign renege on such a sale? If it does, are there recourses to institutions such as the constitutional court or the European Court of Justice?
Whatever the answers to these questions, the increasing number of transactions drawing on our structured and sovereign expertise is another indication of the structured market's constant expansion into new areas. It is also a testimony to the way in which the analysis of the credit risk of any structured finance transaction always requires an in-depth understanding not only of the underlying assets but also of the surrounding circumstances that influence and are influenced by a particular sovereign.
[The article is an abstract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]
