Summary of Rating Methodologies. for Structured Finance Products. Rating and Investment Information, Inc.

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1 for Structured Finance Products Rating and Investment Information, Inc. April 1, 2014

2 Table of Contents Chapter 1: General... 5 Subchapter 1: Positioning of Rating Methodologies and approach to structured finance products.5 Subchapter 2: Basic of credit rating method for SF products Subchapter 3: Monitoring method of credit ratings Chapter 2: Particulars: Risks regarding structure Subchapter 1: Structure of asset transfer Subchapter 2: Structure of asset holding (SPV)...17 Subchapter 3: Structure of asset administration...22 Subchapter 4: Structure of external credit enhancement...35 Subchapter 5: Structure of external liquidity enhancement...37 Subchapter 6: Structure of cash flow distribution Subchapter 1: Installment receivables (excluding revolving payment receivables)...41 Subchapter 2: Lease receivables (finance lease)...47 Subchapter 3: Residential loan receivables...52 Subchapter 4: Japan Housing Finance Agency MBS Subchapter 5: Consumer loan receivables Subchapter 6: Corporate loan receivables Subchapter 7: Promissory note receivables...76 Subchapter 8: Accounts receivable Subchapter 9: Bonds...81 Subchapter 10: Derivative transactions (credit default swap, etc.)...86 Subchapter 11: Other monetary receivables (including trust beneficial interest) Subchapter 12: Real estate (real estate-backed trust beneficial interest)...94 Subchapter 13: Real estate non-recourse loans...98 Subchapter 14: Development-type real estate Subchapter 15: Security deposit receivables Subchapter 16: Guaranteed receivables Subchapter 17: Medical fee receivables/dispensing fee receivables Subchapter 18: Monthly clear (credit card) receivables Subchapter 19: Project assets (including PFI) Subchapter 20: Business cash flow, etc Subchapter 21: Sub-performing loans, etc /170

3 Chapter 4: Particulars: Cash flow risk Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) Subchapter 3: Analysis method for real estate Subchapter 4: Analysis method for project finance Subchapter 5: Analysis method for business cash flow, etc Subchapter 6: Analysis method using cash flow test Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products Subchapter 9: Deleted Subchapter 10: Analysis method of risk transfer transactions Chapter 5: Particular: Monitoring Subchapter 1: Monitoring of credit ratings of underlying assets and parties involved in the structure Subchapter 2: Monitoring for the large pool approach Subchapter 3: Monitoring for the small pool approach Subchapter 4: Monitoring of transactions backed by real estate Subchapter 5: Monitoring of short-term products backed by promissory note receivables, accounts receivable, etc Subchapter 6: Monitoring of transactions backed by project assets and business cash flow, etc.170 3/170

4 (Notes) Basic issues in Chapters 2 and 3 present facts. Risk factors in Chapters 2 and 3 describe major risk factors. Response to risk in Chapters 2 and 3 means responses to risk by originators, arrangers, etc. If there are multiple responses to one risk factor, any one response may be used either alone or in combination with another response. Perspective for evaluation in Chapters 2 and 3 means R&I s perspective for evaluating Response to risk. If any response other than Response to risk described is performed, R&I will perform an evaluation as to whether or not such a response is appropriate. The entities acceptable to R&I described in this Summary are those corporations to which R&I assigns undisclosed credit ratings and whose appropriateness R&I acknowledges in such a context. Structured finance products (SF Products) mean securitized products, derivative products, and other SF Products, but do not include J-REIT. Securitized products mean those products by which corporations seek to raise funds primarily by applying a structure of one sort or another with the backing of specified assets only. Derivative products primarily mean repackaged bond products with relatively high creditworthiness in which derivative transactions are embedded. Other SF Products mean those products for which creditworthiness is enhanced primarily by applying a structure of one sort or another to corporate finance. 4/170

5 Chapter 1: General Chapter 1: General Subchapter 1: Positioning of Rating Methodologies and approach to structured finance products R&I s rating methodologies are established in accordance with the Credit Rating Activities Basic Policy and the Rating Determination Policy. The rating methodologies prescribe the rating approach to be applied to credit ratings of structured finance products (hereinafter referred to as SF Products ) on the basis of qualitative and quantitative logical systems. The rating processes, procedures, specific calculation methods, etc., are prescribed in separate manuals in accordance with rating methodologies. R&I is pleased to publish the Summary of Rating Methodologies. This Summary consists of a general discussion of R&I s basic approach to rating methodologies and an item-by-item discussion describing risks associated with structure, risks associated with underlying assets, analysis methods by approach, and monitoring methods for credit ratings. The general discussion represents broader concepts covering topics under the item-by-item discussion. In a credit rating for an individual transaction, a credit rating is assigned on the basis of these rating methodologies. R&I performs credit ratings with the aim of rendering them trustworthy. This aim is achieved by: (i) clear-sighted ratings and (ii) ratings with features of stability and continuity. Performing clear-sighted ratings results in ratings featuring stability and continuity. To this end, it is critical to set out an accurate vision of the future. R&I achieves such an accurate vision of the future through the following analytical processes. First, R&I seeks to understand the actual conditions of transactions by identifying and analyzing factors that lie behind risks associated with structures and underlying assets, respectively. Then, after performing a cash flow analysis on the basis of the outcome of an analysis of these risk factors, R&I conducts a general evaluation and assigns a credit rating, taking into account the outcome of the analysis of those risk factors that are not worked into the cash flow analysis. The rating methodologies adopted in these processes must be selected in an appropriate manner according to the specific structure of the transaction involved and the attributes of the relevant underlying assets. The rating methodology to be adopted may be singular, partial, or multiple. In any event, a trustworthy credit rating must be assigned using expert knowledge and skills in accordance with the prescribed rating methodology. A case in which there is no rating methodology would mean a case in which there is no 5/170

6 Chapter 1: General description of any approach whatsoever in any of the chapters for rating methodologies. For example, the case of a product linked to equity indices would fall under this category. A rating method would be deemed to exist if there is an approach of one kind or another or even a partial description thereof in any of the chapters. Subchapter 2: Basic of credit rating method for SF products Section 1: Identifying products to be rated When assigning credit ratings, R&I first identifies SF Products that would be subject to a credit rating (products to be rated). The main attributes by which products to be rated are identified include issuer s name, issue number, issue date, redemption date, interest rate, issue amount, etc. These attributes are prescribed in transaction agreements. In addition to securities and loans, products subject to credit rating include purchase receivables that are prescribed in the so-called Basel II Supervisory Regulations, derivative contracts, programs, and other products. Types of credit ratings to be assigned to products subject to credit rating vary depending upon whether or not the period between issue date and redemption date is less than one year. If the period is less than one year, the product is deemed in principle to be a short-term financial obligation, and a Short-term Rating would be assigned to the product. Otherwise, a Long-term Issue Rating would be assigned. If, for the purpose of assigning a Short-term Rating, there exists no specific means of assigning a Short-term Rating to a product subject to a credit rating, R&I would first determine a Long-term Issue Rating in accordance with the applicable rating methodology, and thereafter determine a Short-term Rating by replacing the Long-term Issue Rating with a Short-term Rating. Therefore, the rating methodologies would basically be described with respect to Long-term Issue Ratings. It should be remembered that, for the purpose of the said replacement, creditworthiness under a Long-term Issue Rating would be judged from the possibility of default (default risk) and the possibility of loss in the event of default (recovery risk), whereas creditworthiness under a Short-term Rating would be judged only by default risk, and recovery risk would not be taken into account. Section 2: Putting contracts in order Because credit ratings are R&I s opinions on the certainty of an issuer fulfilling its obligations as contracted, it would, for the purpose of assigning ratings, be necessary to identify the relevant contracts. Generally, SF Products are designed in such a manner that they would not fall into default or 6/170

7 Chapter 1: General result in a legal arrangement as a result of default. Hence, R&I evaluates SF Products from the perspective of whether or not they are insolvent with respect to the initial principal redemption method and interest payment method. When performing credit ratings for SF Products, R&I typically puts contracts involving them in order based on the concept of default as laid out in the separately prescribed Rating Determination Policy. With respect to ordinary SF Products, R&I evaluates the certainty of principal repayment and interest payments up to the time of final redemption. R&I may evaluate the creditworthiness of products whose interest is linked to performance on the basis of only on-time principal redemption as a contract, because it is not possible to specify the amount of interest to be paid. R&I may also evaluate interest on interest-only debts. Generally, events falling outside the scope of rating SF Products are defined as changes in tax or legal systems that can be applied broadly and uniformly to market participants, irrespective of the design or transactions of such SF Products, delays or losses arising from the manifestation of systematic risks, or delays or losses arising from the fraudulent acts of parties involved in the structure. Section 3: Gathering data Information gathered for credit-rating purposes includes transaction-related agreements, data/material on underlying assets, data on performance, and monitoring data, etc. and is used for identifying credit risk factors. For purposes of identifying and analyzing credit risk factors (Section 4), such data are used for identifying risk factors from the perspectives of structure, underlying asset, and cash flow. In particular, performance-related data are used for analyzing cash flow risk (Section 5) among risk factors. In doing so, R&I uses the part or period that is most appropriate for underlying assets. Ultimately, R&I determines a credit rating by synthesizing all pieces of information used for an analysis (Section 6). Subsequent to issuance of the product subject to rating, R&I gathers monitoring data periodically or as needed, and performs monitoring services (Subchapter 3). Section 4: Identification and analysis of credit risk factors Based on the data gathered, R&I identifies important credit risk factors that are deemed to affect the products to be rated. To identify risk factors, it is important to verify the information gathered in line with the actual conditions of the products to be rated. Specifically, it is necessary to put credit risk factors in order by structure and underlying asset, and to verify the presence or otherwise of credit risk factors with respect to each of such items. 7/170

8 Chapter 1: General With respect to structure, R&I identifies risk factors related primarily to legal risk and strength of structure from transaction-related agreements. With respect to underlying assets, R&I identifies risk factors that could primarily cause cash flows to change from data/material on underlying assets. I. Risks regarding structure R&I analyzes risks regarding structure primarily from the three perspectives of transfer, holding, and management. This is for the purpose of confirming that the assets of an ordinary SF Product would, in the course of its formation, be transferred (assigned) to and managed by a legitimate special-purpose vehicle (hereinafter referred to as an SPV ). The three other perspectives of external credit enhancement, liquidity enhancement, and cash flow distribution relate to cash flows, and R&I verifies these structures if they are in place. Principal risk factors are listed below: Conflict of interest True sale Business risks regarding SPV Risks regarding SPV s capital relationships Risks regarding SPV s personal relationships SPV s ring fence Commingling risk attributable to servicer bankruptcy Liquidity risk attributable to servicer bankruptcy Risk regarding swap counterparty bankruptcy Risk regarding bankruptcy of financial institution where deposits are made Risk regarding custodian bankruptcy Risk regarding diminution in value of targets of excess cash management Risk regarding business framework of important parties involved in structure Risk regarding external credit enhancement provider/external liquidity enhancement provider Risk that external credit enhancement/external liquidity enhancement would not be provided Risk regarding timing of credit enhancement Risk regarding waterfall Risk regarding master trust II. Risks regarding underlying assets R&I analyzes risks regarding underlying assets primarily from the following perspectives: Verification of basic nature of underlying assets 8/170

9 Chapter 1: General Credit risk factors by underlying asset type In Chapter 3, R&I seeks to identify major risks by underlying asset type. If there is no asset type that can be adopted as the underlying asset of the product subject to rating, multiple asset types are adopted in combination or similar assets types are adopted. Section 5: Cash flow risk analysis R&I performs a cash flow risk analysis on the basis of its analysis of the aforementioned risk factors, the purpose of which is to analyze the impacts that servicer bankruptcy, structure of cash flow distribution, changes in cash flow of underlying assets, etc., may exert on the relevant SF Product s ability to repay principal and pay interest. If there are items that cannot be worked into the analysis of individual credit risks as certain facts, but which should be considered as being highly likely in the future, R&I incorporates their qualitative factors into the outcome of the analysis to assign a credit rating based upon clear-sighted prospects. Section 6: Comprehensive evaluation R&I takes into account those risk factors contained in the outcome of the cash flow analysis (Section 5) and the outcome of the credit risk analysis (Section 4) that were not worked into the cash flow risk analysis, and performs a comprehensive evaluation in the light of the definitions of rating symbols. Subchapter 3: Monitoring method of credit ratings Section 1: Basic approach The basic approach and the rating methodology that R&I adopts in determining credit ratings during the monitoring period are, in principle, the same as those it adopts when assigning fresh credit ratings. On that basis, R&I determines credit ratings by taking the position that, during the monitoring period, opinions with features of stability and continuity based on clear-sighted prospects are more important to investors. When determining credit ratings, R&I seeks to understand the actual conditions of products subject to rating, in the light of which it establishes an accurate vision of the future. 9/170

10 Chapter 1: General Section 2: Monitoring intended to capture changes occurring in and around the product subject to rating Essentially, credit ratings are R&I s opinions as of the time when information forming the basis of an analysis is gathered. However, the conditions and the surrounding environment of the product subject to rating do change. If information verified when assigning a credit rating or the assumptions used for a cash flow analysis change, a newly determined credit rating would be bound to vary from the existing rating, depending upon the degree of such a change. Therefore, R&I continuously monitors credit ratings unless it declares in advance it will not monitor specific credit ratings. Credit ratings do not change unless the information verified when assigning fresh credit ratings or the assumptions used for the cash flow risk analysis change materially. Therefore, the main focus of R&I s credit rating services during the monitoring period is on responding to changes in products subject to rating. R&I verifies those items subject to change that seem more important from the perspectives of the performance of underlying assets and changes that may arise among the parties involved in a structure. R&I analyzes credit ratings during the monitoring period within the limits of the information gathered. During the monitoring period, information becomes available such as actual performance of the underlying asset pool, which did not exist when initially assigning a credit rating, whereas information such as data on the attributes of obligors within the underlying asset pool cannot be obtained and the amount of usable information is limited during such a period. R&I may suspend a credit rating by temporarily replacing the credit rating with the term Suspended if it finds that maintaining a credit rating would be difficult due to insufficient data/information or other similarly compelling circumstances. R&I may withdraw a relevant credit rating if it finds there are prospects of the circumstances that make it difficult to continue the credit rating not being eliminated. Section 3: Placement and retention on, and removal from, the Rating Monitor R&I may place a product subject to rating on the Rating Monitor if it recognizes that the probability of a change in the credit rating is high as a result of a change in information on the relevant product, but an ample time would be required to determine the necessity or otherwise for the rating change, or if a totally unexpected circumstance comes into being and ample time would be required to determine the necessity or otherwise for the rating change. When a product subject to rating is placed on the Rating Monitor to indicate that an event that will affect the creditworthiness has occurred, the Rating Monitor with direction uncertain may be used, regardless of the 10/170

11 Chapter 1: General possibility of a rating change. In principle, R&I may remove a product subject to a credit rating from the Rating Monitor if it becomes possible to incorporate the impacts of events into a credit rating. When a new event that makes R&I consider placement on the Rating Monitor has occurred regarding a product subject to rating that has already been on the Rating Monitor, R&I may take a rating action of retention on the Rating Monitor. 11/170

12 Chapter 1: General (Reference 1) Basic approach to credit ratings of SF Products Identifying products subject to rating Putting contracts in order Gathering data Chapter 2: Risk regarding structure Identification of risk factors Chapter 3: Risk regarding underlying assets Chapter 1: General Risk factor analysis Outcome of risk factor analysis (quantitative/qualitative) Chapter 2: Risk regarding structure Chapter 3: Risk regarding underlying assets (Perspective for evaluation of risk factor analysis) Outcome of analysis of factors other than cash flow risk factor Cash flow risk analysis Chapter 4: Cash flow risk (Perspective for cash flow risk analysis) Outcome of cash flow risk analysis Comprehensive evaluation => Credit rating Chapter 5: Monitoring 12/170

13 (Reference 2) Places of Reference for Summary of Rating Methodologies for Typical Products Summary of Rating Methodologies Chapter 1: General As these rating methodologies present descriptions by risk factor and analytical method for SF Products, if specific SF Products are subject of rating, it would be combination of these item-by-item topics. For this reason, principal places of reference with examples of typical products are shown below. P lease note that certain products do not neatly fall under the category of a typical product. Product name Chapter 1: Chapter 2: General Structure Chapter 3: Underlying assets Chapter 4: Cash flow risk analysis ABS (Installment) All As appropriate Subchapter 1: Installment receivables (excluding revolving payment receivables) Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test ABS (Lease) All As appropriate Subchapter 2: Lease receivables (finance lease) Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test RMBS All As appropriate Subchapter 3: Residential loan receivabl es Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test RMBS (Agency MBS) All As appropriate Subchapter 4: Japan Housing Finance Agency MBS Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test ABS (Loan) All As appropriate Subchapter 5: Consumer loan receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 6: Analysis method using cash flow test CLO, CBO All As appropriate Subchapter 6: Corporate loan receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 9: Bonds Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) ABS (Notes receivable) All As appropriate Subchapter 7: Promissory notes receivable Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) ABS (Accounts receivable) All As appropriate Subchapter 8: Accounts receivable Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Credit-linked products All As appropriate Subchapter 9: Bonds Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) (CLL, CLN, FTD, SCDO) Subchapter 10: Derivative transactions (credit default swap, etc.) Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products JGB repackage, CB repackage All As appropriate Subchapter 9: Bonds Subchapter 10: Derivative transactions ( credit default swap, Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure etc.) Subchapter 8: Analysis method for measures to reduce counterparty risk of derivative products Repackaged products All As appropriate Subchapter 11. Other monetary receivables (including trust Subchapter 7: Analysis method based on credit ratings of underlying assets and parties (Fund securitization, deposit receivables, beneficial interest) involved in the structure beneficial interest, etc.) CMBS All As appropriate Subchapter 12: Real estate (real estate-backed trust beneficial Subchapter 3: Analysis method for real estate interest) CMBS (Multi-borrower) All As appropriate Subchapter 13: Real estate non-recourse loans Subchapter 3: Analysis method for real estate CMBS (Development-type) All As ap propriate Subchapter 14: Development-type real estate Subchapter 3: Analysis method for real estate ABS (Occupancy security deposits) All As appropriate Subchapter 15: Security deposit receivables Subchapter 7: Analysis method based on credit ratings of underlying assets and parties involved in the structure CLO (Guaranteed loan receivables) All As appropriate Subchapter 6: Corporate loan receivables Subchapter 7: Analysis method based on credit ratings of underlying assets and parties Subchapter 16: Guaranteed receivables involved in the structure ABS (Medical fee) All As appropriate Subchapter 17: Medical fee receivables/ Dispensing fee Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) receivables ABS (Monthly clear) All As appropriate Subchapter 18: Monthly clear (credit card) receivables Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Project finance All As appropriate Subchapter 19: Project assets (including PFI) Subchapter 4: Analysis method for project finance Business securitization products & LBO All As appropriate Subchapter 20: Business cash flow, etc Subchapter 5: Analysis method for business cash flow, etc Real estate secured loan All As appropriate Subchapter 21: Sub-performing loans, etc. Subchapter 1: Analysis method for monetary receivables, etc. (Large pool approach) Subchapter 2: Analysis method for monetary receivables, etc. (Small pool approach) ABCP/ABL programs (full support-type) All As appropriate Subchapter 7: Analysis method based on credit ratings of underlying assets and parties - involved in the structure 13/170

14 Chapter 2: Particulars: Risks regarding structure Chapter 2: Particulars: Risks regarding structure In this Chapter, with respect to identifying and analyzing credit risks factors presented in Subchapter 2, Section 4 of the General Discussion, principal risk factors are enumerated from the aspect of risks regarding structure, and perspectives on their evaluation are presented. A Subchapter is set out for each type of structure. Basic issues of structure are discussed in Section 1 of each Subchapter, and an analysis of principal credit risk factors that are conceivable in the structure is discussed in Section 2. In the analysis of credit risk factors, the contents of risk factors are presented first, and then principal risk countermeasures and perspectives for the evaluation thereof are presented. Subchapter 1: Structure of asset transfer Section 1: Basic issues I. Purpose of structure The purpose of the structure of asset transfer is to ensure that ownership of underlying assets is transferred to the SPV as issuer of the SF Product, in order to distribute cash flows generated from underlying assets to investors without hindrance. II. Composition of structure Nominative claims are transferred basically in accordance with procedures for assigning nominative claims prescribed in the Civil Code. The underlying assets are transferred to the SPV after the positioning of claims to be transferred in the contractual relationship leading to monetary claims as underlying assets is clarified, and after other contractual rights/obligations are appropriately arranged. Underlying assets in the forms of promissory notes and bonds, for which rights are clearly defined and market practices for asset transfer procedures are firmly established, are transferred to the SPV in accordance with law and market practices. Underlying assets in the form of real estate are transferred to the SPV after complex rights are sorted out. 14/170

15 Chapter 2: Particulars: Risks regarding structure III. Principal parities involved in the structure Originator, arranger, SPV Section 2: Analysis of credit risk factors I. Conflict of interest with parties involved in the transfer The interests of originators, etc., normally conflict with those of investors. Hence originators, etc. (of which interests conflict with investors) may inflict a credit loss on investors to maximize their own interests. B. Principal risk countermeasures and perspectives for evaluation 1. Securing measures to prevent conflicts of interest Conflicts of interest are prevented by establishing appropriate selection criteria and clarifying assignment and risk transfer procedures that fit the characteristics of the underlying assets. 2. Partial holding of SF Products by originators, etc. Conflicts of interest are expected to be prevented because originators, etc., bear losses of SF Products by holding part of them. With respect to 1 or 2 above, an evaluation is made from the perspective of whether or not conflicts of interest are dealt with in an adequate manner. If the underlying assets are required to be similar to the reference pool, a credit rating is not, in principle, assigned unless 1 or 2 above is addressed. If the underlying assets are not required to be similar to the reference pool, an evaluation is made in the light of the characteristics of the underlying assets. II. Risks regarding true sale If the originator falls into bankruptcy, assignment of the underlying assets is denied, and funds for principal repayment and interest payment on SF Products run short. Even if assignment is not denied, transfer of the underlying assets may be viewed not as a sale/purchase but as the originator s secured transaction in the process of its legal bankruptcy procedures. 15/170

16 Chapter 2: Particulars: Risks regarding structure B. Principal risk countermeasures and perspectives for evaluation 1. Measures to assure true sale If R&I mainly considers the points listed below in the light of the characteristics of the underlying assets, and determines that the probability of risks associated with true sale becoming obvious is remote, it may assign a higher credit rating than the originator s creditworthiness. If measures to assure true sale are inadequate, R&I determines a credit rating on the basis of the originator s credit rating. The following are examples: (i) (ii) (iii) (iv) (v) Intentions of parties involved Validity of asset assignment, fulfillment of perfection requirements Transfer of legal control authority Transfer of economic risk Absence of secured claims An evaluation is performed from the perspective of whether or not measures for assuring true sale are adequate. 2. Originator s eligibility If the originator is in a state of insolvency upon transfer, there would be a risk that assignment per se is denied by the originator s bankruptcy trustee at the time of the originator s bankruptcy. If, as a countermeasure against such a risk, the originator subjects itself to an accounting audit and obtains unqualified clean opinions, R&I would not see any particular problem. If the originator does not subject itself to an accounting audit, R&I would verify its creditworthiness as it would not be possible to completely cast aside assignment denial risk on the basis of the originator s creditworthiness, etc. An evaluation is performed from the perspective of whether or not the probability of assignment denial risk becoming obvious is high. 16/170

17 Chapter 2: Particulars: Risks regarding structure Subchapter 2: Structure of asset holding (SPV) Section 1: Basic issues I. Purpose of structure To have an SPV play the roles of holding underlying assets and distributing cash flows generated from the underlying assets to investors in a stable and continuous manner, it is generally necessary to make such an SPV a box (or conduit) equipped with a high degree of bankruptcy remoteness. If cash flows generated from underlying assets are blocked due to a factor other than the underlying assets, it is not possible to fulfill the needs of the originator or the investors. To fulfill such needs, the SPV as issuer of the SF Products is required to hold the underlying assets and distribute cash flows generated from the underlying assets to the investors in a stable and continuous manner. II. Composition of structure An SPV can take the form of a trust or a corporation (joint-stock corporation, special-purpose company, general incorporated association, limited liability company, Cayman SPC, etc.). For the purposes of SF Products formed in Japan, SPVs of trust type are often used for their bankruptcy remoteness features, and are assured under the Trust Act. III. Principal parties involved in the structure SPV, holder of voting shares, creditor (investor in SF Products, entity to which managerial business agents are dispatched, etc.), securitization service agent (director, employee, etc.), trustor, trustee, beneficiary Section 2: Analysis of credit risk factors This Section sets out measures for enhancing the bankruptcy remoteness features of an SPV of co rporation type. The structure for bankruptcy remoteness features is evaluated from the following four perspectives: Business risks Risks regarding capital relationship Risks regarding personal relationship Ring fence 17/170

18 Chapter 2: Particulars: Risks regarding structure With respect to SPVs of trust and other types that are not dealt with in this Section, R&I verifies whether or not they are highly bankruptcy remote from these four perspectives in the same manner. In the case of a trust unlike the case of an SPV of corporation type an SPV of trust type basically does not have risks regarding capital relationship or risks regarding personal relationships, among these four perspectives. The absence of capital relationship risks is due to the fact that there are no shareholders. The absence of personal relationship risks is due to the fact that there are no directors, and the trustee, who is a third party, performs operations as a good manager. Hence, in the case of an SPV of trust type, perspectives as to whether or not business risks are limited and a ring fence is in place are important. R&I verifies the restrictions inherent in business risks on the basis of the purpose of a trust, and evaluates the ring fence from the perspective of whether or not the underlying assets are distinguished and segregated from the trustee s own assets. I. Business risks An SPV as an issuer of SF Products is established for the specific purpose of conducting securitization business (business related to services for issuance, maintenance, and management of SF Products). Generally, however, a corporation is allowed to conduct business activities freely within the limits of laws and regulations, therefore, it is allowed to conduct business activities other than securitization business. Principal risk factors associated with business risks include: Risk that money earmarked for securitization business is diverted to another business Risk of creditors of another business filing a bankruptcy petition B. Principal risk countermeasures and perspectives for evaluation 1. Taking necessary measures In the section setting out the purpose of establishing a company in the articles of incorporation or in the section for the parties representations and warranties in a related contract, the risk that business risks may become obvious or an incentive for taking an action that causes such a risk is eliminated by prescribing items such as those listed below. The following are examples: Not conduct another business (excluding ancillary business indispensable for securitization business) Not bear any debt obligations other than those for securitization business An evaluation is performed from the perspective of whether or not business risks are properly confined. 18/170

19 Chapter 2: Particulars: Risks regarding structure II. Risks regarding capital relationship An SPV is allowed to raise funds for conducting business activities by issuing shares. The shareholders who hold voting shares (hereinafter referred to as Shareholders ) can influence the securitization business by exercising their voting rights. If an SPV issues new shares, the number of Shareholders may increase. The presence of voting shares gives rise to the following principal risks regarding capital relationships: Shareholders can exert a material adverse influence on the securitization business. For the benefit of parties related to Shareholders, Shareholders can submit and pass a resolution to dissolve an SPV. Additional voting shares can be issued. If the Shareholders of additional shares are not positive about the securitization business, they can exert a materially adverse influence on the securitization business by exercising their voting rights. B. Principal risk countermeasures and perspectives for evaluation 1. Taking necessary measures In the section covering voting shares in the articles of incorporation or in the contract covering assignment of voting shares, the risk that the relevant risks may become obvious or an incentive for taking an action to cause such a risk is eliminated by prescribing items such as those listed below. The following are examples: Shareholders to be third parties who are independent of interested parties Shareholders to be made to waive their rights to file a bankruptcy petition Exercise of voting rights by holders of voting rights to be restricted (for example by creating a charitable trust to prevent voting rights attached to the shares from being exercised) Condition for consent by creditors (bond administrator, investors, etc.) to issue any additional voting shares to be imposed An evaluation is performed from the perspective of the relationship between the SPV and Shareholders. III. Risks regarding personal relationship Directors, etc., are allowed to exert an influence on business activities through resolutions of the board of directors. The principal risk factors regarding personal relationship include: Risk that directors, etc., can perform an act that may have a material adverse influence 19/170

20 Chapter 2: Particulars: Risks regarding structure on the securitization business (business operation for the benefit of interested parties) Risk that directors, etc., may file a bankruptcy petition at the request of interested parties Risk that persons who might have conflicts of interest with the securitization business may become directors, etc. Risk that retirement of SPV s officers and employees may have a material adverse influence on the securitization business B. Principal risk countermeasures and perspectives for evaluation 1. Taking necessary measures Directors, etc., are to be appointed from among attorneys at law, CPAs, etc., who are not officers or employees of any interested party, and who are to be dispatched under a dispatch contract, and the risk that relevant risks may become obvious or an incentive for taking an action to cause such a risk is eliminated by prescribing items such as those listed below in the relevant dispatch contract, service contract, etc. The following are examples: Take measures to prevent any adverse influence from being exerted on the securitization business by appointing attorneys at law, CPAs, etc., who are not influenced by any capital relationship as directors, etc. Directors, etc., to be made to waive their rights to file a bankruptcy petition An evaluation is performed from the perspective of whether or not the SPV is subject to personal influences. IV. Ring fence In cases where multiple SF Products are issued by the same SPV against differing underlying assets, a measure fulfilling the function of a partition (fence) to prevent losses incurred on respective SF Products from mutually affecting one another is referred to as a ring fence. In case a business corporation issues multiple debt securities, and if any problem occurs for one reason or another with the recovery of claims of a creditor holding specific debt securities, the creditor may expect to recover the claims by seizing the assets of the business corporation in question. By virtue of their product design, principal repayment and interest payment on SF Products are made from the cash flows of specific underlying assets that are assigned. If an SPV issues multiple SF Products against different underlying assets (Product A and Product B) to investors who are subject to differing interests, and if an event occurs that for the purpose of the recovery of claims on a specific SF Product (Product A), other assets of the SPV (underlying assets for Product B) are seized, principal repayment and interest 20/170

21 Chapter 2: Particulars: Risks regarding structure payment on one SF Product (Product B) would be affected by the bankruptcy of another SF Product (Product A). B. Principal risk countermeasures and perspectives for evaluation 1. Only one SF Product to be issued by one SPV The creditor would not be subject to any differing interests as two or more SF Products are not issued. Hence, a ring fence is assured. 2. Ring fence to be assured while multiple SF Products are issued by one SPV The arranger specifies the assets that creditors (Creditor A and Creditor B) may claim, respectively, by clarifying the underlying assets (Underlying Asset A and Underlying Asset B) for the respective SF Products (Product A and Product B). Having done that, the arranger takes the following measures to inhibit creditors bankruptcy filings or incentives therefor by applying the same measure to all SF Products: To create a security interest in each of the underlying assets for SF Products (fulfillment of perfect requirements) To prescribe segregated administration of underlying assets by SF Product in the relevant contract To prescribe limited recourse and non-petition provisions pertaining to investors and parties involved in the structure, in the relevant contract With respect to SF Products to be issued in the future, measures will be taken to ensure that the abovementioned measures are taken. When it is not possible to create a security interest in underlying assets, a ring fence is assured by implementing measures to enhance the ring fence features that would fit the characteristics of the relevant issues. An evaluation is performed from the perspective of whether or not an SPV is properly ring-fenced. If the ring face is found to be inadequate, credit ratings for all SF Products issued against differing underlying assets are in principle be set at the same level. 21/170

22 Chapter 2: Particulars: Risks regarding structure Subchapter 3: Structure of asset administration Section 1: Basic issues I. Purpose of structure The purpose of the structure of asset administration is to properly administer and dispose of the underlying assets held by an SPV and to properly administer money received by the SPV and pay out in the manner prescribed in the relevant contract. II. Composition of structure Generally, an SPV as an issuer of SF Products, as a formality, does not have a framework to hire employees and perform administrative services on its own. Therefore, an SPV finds it necessary to outsource the services needed to administer and dispose of underlying assets to a third party. Depending upon the types of underlying assets, principal services that an SPV may outsource include servicing of monetary claims, property management of real estate, and the custody of securities. Appropriate structures are set up, as needed, for assuring the continuity of these administrative services. The structures for administering and paying money received by an SPV include placement of deposits and other forms of funds management, swap transactions to hedge cash flow mismatches, and payment of necessary expenses. III. Principal parties involved in the structure Servicer, swap counterparty, financial institutions where deposits are placed, custodian, surplus fund investment vehicle Section 2: Analysis of credit risk factors I. Commingling risk arising from bankruptcy of servicer Normally, an SPV outsources the servicing of underlying assets to a servicer. The servicer sets a specific collection period, and hands the funds collected from obligors during the collection period over to the SPV on the delivery date. If the servicer falls into bankruptcy before handing the funds collected over to the SPV, and if the servicer s own assets and the collected funds are not segregated, the funds collected may be treated as part of the servicer s own assets and the SPV may be treated in the same manner as other creditors in the course of 22/170

23 Chapter 2: Particulars: Risks regarding structure handling the servicer s bankruptcy. As a result, the commingling risk that the collected principal of and interest on the relevant underlying assets may be lost becomes obvious. B. Principal risk countermeasures and perspectives for evaluation 1. Senior/subordinate structure (addition of amount equal to commingling loss to subordinate portion) It is possible to enhance the certainty of principal repayment and interest payments on the senior portion by adding an amount equal to the commingling loss to the subordinate portion. An evaluation is performed from the perspective of whether or not enhancement by means of the subordinate portion is adequate. If the servicer is highly creditworthy and the underlying assets are also reasonably creditworthy, R&I may opt not to assume the possibility of bankruptcy for a specific period from the beginning of an issue. 2. Cash reserve for the amount equal to commingling loss An amount equal to commingling loss is set aside as a cash reserve to provide for the relevant risk. An evaluation is performed from the perspective of whether or not the amount of the cash reserve is adequate. 3. Advance payment The servicer pays in advance a specific amount to the SPV prior to the date of delivery of collected funds. If the relevant risk becomes obvious, the advance payment retained beforehand by the SPV is offset by an amount equal to the commingling loss. An evaluation is performed from the perspective of whether or not the amount of advance payment is adequate. 4. Countermeasure by means of cash reserve or advance payment based on rating trigger If the servicer s creditworthiness deteriorates, a countermeasure is taken in the form of 2. Cash reserve for the amount equal to commingling loss or 3. Advance payment. An evaluation is performed from the perspective of whether or not the measure for a rating trigger is valid and adequate. 5. Replacement of servicer based on rating trigger As the relevant risk is one that is not obvious unless the servicer falls into bankruptcy, the occurrence of commingling risk is avoided by replacing the servicer as of the time the servicer s creditworthiness deteriorates. 23/170

24 Chapter 2: Particulars: Risks regarding structure An evaluation is performed from the perspective of whether or not the measure for a rating trigger is valid and adequate. 6. Setoff with seller interest Seller interest corresponding to an amount equal to the commingling loss is established. If the relevant risk becomes obvious, seller interest is offset by an amount equal to the commingling loss. An evaluation is performed from the perspective of whether or not the countermeasure against the relevant risk is adequate. 7. Changing the redemption method of seller interest Seller interest corresponding to an amount equal to the commingling loss is established. If the relevant risk becomes obvious, it is possible to enhance the certainty of principal repayment and interest payment on the senior portion by subordinating the redemption order of seller interest to that of the senior portion. An evaluation is performed from the perspective of whether or not the countermeasure against the relevant risk is adequate. 8. Servicer being a financial institution participating in the deposit insurance system If account in which the collected funds are processed falls under the category of a deposit for settlement or the delivery obligation of collected money falls under the category of a specific settlement obligation, and the collected funds are treated as separate deposits or suspense receipt, the full amount is likely to be protected under the deposit insurance system. An evaluation is performed from the perspective of whether or not commingling risk occurs after verifying that the full amount is protected under the deposit insurance system, and that measures are taken to limit the length of time during which the funds collected are retained by the servicer. 9. Case of direct remittance of funds from obligor to SPV Commingling risk does not occur if funds are remitted directly from the obligor to the SPV, without passing through the servicer. 10. Case in which there is no risk countermeasure The relevant risk is one that it is not obvious insofar as the servicer does not fall into bankruptcy. An evaluation is performed on the basis of the servicer s creditworthiness. 24/170

25 Chapter 2: Particulars: Risks regarding structure II. Liquidity risk arising from servicer bankruptcy If the servicer to whom servicing of underlying assets is outsourced by the SPV falls into bankruptcy, servicing may not be continued. Even if servicing is continued, it may be suspended for a specific period. Under such circumstances, payment of interest on rated products or payment of expenses necessary for maintaining the schemes may be temporarily delayed. Amounts for liquidity countermeasures necessary to respond to the relevant risk vary depending upon underlying assets, schemes, timing of notices to obligors, periods required until servicing by the backup servicer can be resumed in a normal manner, etc. B. Principal risk countermeasures and perspectives for evaluation 1. Cash reserve for the amount of liquidity enhancement The amount necessary for liquidity enhancement is secured as a cash reserve to provide for the relevant risk. Normally, a cash reserve is secured from the beginning of the issue to provide for servicer bankruptcy. However, with respect to a highly creditworthy servicer, a cash reserve is not accumulated from the outset, and a specific moratorium may be placed on the accumulation period. An evaluation is performed from the perspective of whether or not cash reserve and other risk countermeasures are adequate. 2. Backup lines from liquidity enhancement providers including financial institutions To respond to the relevant risk, backup lines are accorded by liquidity enhancement providers including financial institutions. When performing an evaluation, the validity and adequacy of the backup lines are verified. 3. Expenses having been paid Liquidity risk does not occur if interest and expenses are paid at the beginning of the issue. 4. Servicer being a financial institution participating in the deposit insurance system Under the deposit insurance system, there are two ways by which to process the bankruptcy of a financial institution: funding support method and insurance payment method. Depending on which method is adopted, the timeliness of payments may vary. The funding support method assumes that the bankruptcy of a financial institution will be dealt with over a weekend and processing is performed smoothly so that the financial 25/170

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