Fitch Ratings is analyzing the potential rating impact of recent court rulings in the English Court of Appeal and the U.S. Bankruptcy Court on existing structured finance (SF) ratings globally. The impact may be wide-ranging.

Any SF transaction with derivative exposure to a counterparty where that entity could be subject to the jurisdiction of the U.S. Bankruptcy courts, whether through itself alone or through a related party, may be impacted by these rulings. In instances where

1) U.S. laws could apply,

2) the ratings of the securitized notes exceed that of the counterparty and

3) Fitch believes the risk exposure to be material, the ratings of the securitized notes will be placed on Rating Watch Negative while additional analysis of any other structural mitigants is undertaken. Fitch is identifying all transactions potentially affected by these events and will provide additional information and its findings within the next few weeks.

European SF transactions may, in fact, be most impacted by this decision given the prevalence of derivatives to hedge interest rate and foreign exchange risk. Additionally, structured credit (SC) transactions that are currently rated higher than the counterparty with embedded credit default swaps are also believed to be at greater risk globally. Many cash flow structures also have significant interest rate hedges that may result in tranches being impacted.

In U.S. SF, the U.S. Bankruptcy Code, or similar statutes within FDIC regulations, will apply, but the potential rating impact will vary by asset class. Fitch anticipates that few U.S. CMBS transactions will have significant exposure to risks raised by the ruling as these structures did not widely contain derivative contracts that are likely to add material counterparty risk. In U.S. RMBS transactions interest rate hedges are present in some structures though the short terms of the hedges, combined with the amortization of balances are likely to make potential swap termination payments less material over time. Derivative contracts are also used in some U.S. ABS transactions including private student loans and credit cards. However, in Fitch's preliminary analysis these derivative exposures seem similar in materiality to those found in the CMBS and RMBS sectors.

Following the completion of analysis of any securities placed on RWN, the ratings of these securitized notes could become credit-linked and downgraded to the level of the counterparty. Specifically, if a downgrade is warranted, higher rated tranches would likely be downgraded to the counterparty rating, which is between 'AA' and 'A' in most SF transactions. This would be the case where Fitch believes this risk remains insufficiently mitigated - and where no restructuring of transactions has been proposed which could address the risk or where there have been no new legal developments which resolve the issues, including any conflict of law issues where applicable.

In Lehman Brothers Special Financing Inc. versus BNY Corporate Trustee Services Limited, the U.S. Bankruptcy Court recently decided that clauses which subordinated swap termination payments below payments due to rated noteholders upon an event of default triggered by the counterparty's bankruptcy (flip clause) were unenforceable. The Court ruled that these clauses violated the ipso facto provisions of the U.S. Bankruptcy Code. Since the transaction documents in question are governed by English law, a related case involving the same transactions was brought before and decided by the English High Court (Chancery Division) and subsequently affirmed by the English Court of Appeal with a decision contrary to that of the U.S. court, confirming that the flip clauses were enforceable. Although both U.S. and English courts have opined on the issue with respect to each jurisdiction's relevant law, notwithstanding any potential appeals in either court system which remain possible, the reconciliation of these fundamentally conflicting judgments remains outstanding.

Fitch believes that in transactions governed by U.S. law and with a U.S. counterparty such flip clauses will not be enforceable. Conversely, Fitch expects flip clauses to be enforceable in transactions governed by English Law and structured with an English counterparty that has no possibility of being subject to the jurisdiction of any other court than the courts of England and Wales. However, in transactions where counterparties could be subject to the jurisdiction of the U.S. Bankruptcy Courts, and/or the relevant transaction documents are governed by U.S. law, it remains uncertain whether flip clauses would be enforceable as a mitigant to counterparty default risk. Therefore, Fitch views the uncertainty surrounding conflict of laws issues to be of sufficient magnitude to include transactions of this type in its review. With respect to other jurisdictions, Fitch is not aware of any relevant court decisions at this time and therefore will not include such situations in Fitch's current review.

The flip clause has been widely used as a standard industry practice to mitigate potential counterparty risk in a transaction. Under the ISDA documentation, a counterparty's insolvency may trigger an early termination of the derivative contract and, depending on the market value of the derivative, a termination payment may be payable to the counterparty. Without the flip clause, this termination payment will remain senior in the transaction's priorities of payment in the next payment period. If the amount of the swap termination payment is material enough and no other mitigants are present, then insufficient funds may be available to service payments on the notes causing a note event of default.

In August 2009 Fitch said that ratings for global SF transactions with material derivative exposure to U.S. based counterparties may ultimately see their ratings capped at that of the counterparty, depending upon individual transaction circumstances. At that time, Fitch also noted that any potential rating action was neither imminent nor inevitable. Now that courts from both countries have issued decisions on enforceability within each jurisdiction's respective law, Fitch is providing further clarity on the potential impact on various SF ratings with such derivative counterparty exposure.

The full review of derivative exposure within Fitch rated SF transactions will be completed and subsequent rating actions communicated over the coming weeks.

Fitch will continue to monitor the ongoing litigation and provide additional comment once further information is available.

Related Research --'Counterparty Criteria for Structured Finance Transactions' (Oct. 22, 2009); --'Counterparty Criteria for Structured Finance Transactions: Derivative Addendum - Amended' (Oct. 23, 2009); --'Lehman Legal Challenge May Have Varying Impact on Global Structured Finance' (dated Aug. 14, 2009).