KBRA Affirms Ratings for South Street Securities Funding, LLC and South Street Securities, LLC
17 Nov 2023 | New York
KBRA affirms the issuer and senior unsecured debt ratings of BBB- for South Street Securities Funding, LLC (“SSSF”) as well as the issuer rating of BBB and short-term issuer rating of K2 for South Street Securities, LLC (“SSS”). SSS is an SEC-registered broker-dealer domiciled in New York, NY that offers collateralized finance services to various mortgage REITs, hedge funds, and other financial institutions, in addition to interest rate risk hedging solutions for numerous U.S. residential mortgage companies. SSS is a wholly owned subsidiary of SSSF, an intermediate holding company whose principal assets consist of its equity investment in SSS. The Outlook for all long-term ratings is revised to Negative from Stable.
The Outlook revision at SSS is connected primarily to the emerging weakened trend in underlying profitability and increased balance sheet operating leverage within the core collateralized finance business, both of which are contrary to KBRA’s expectations. The ratings of SSSF are inextricably linked to SSS, as it effectively represents its sole source of earnings, a meaningful portion of which is needed to service the parent company’s debt burden. While revenue moderation was anticipated within the residential mortgage pipeline hedging business, given the rapid increase in mortgage rates the past year or so, the downturn in profitability within the core repo finance business was unexpected, particularly given the operating environment – marked by substantial interest rate volatility, which should, conversely, portend lending margin expansion in KBRA’s view. A portion of the weakened earnings YTD 2023 is tied to a prior hedging policy that resulted from accounting mismatch, where mark-to-market gains on futures hedges were recognized in 2022 but mark-to-market losses on forward reverse repurchased agreements were recognized in 2023. The accounting policy has since been revised and both forward agreements and futures hedges are now mark-to-market simultaneously. SSS assumes tenor risk within its repo lending business but “matches” the book from a funding perspective vis-à-vis interest rate futures and other hedging strategies.
Anticipated de-leveraging at the intermediate parent company, SSSF, has been prolonged beyond expectations, in part, because of the weakened profitability at SSS. KBRA’s expectation, as noted in the 2022 surveillance report, was that the double leverage ratio would trend to about 150% by YE 2023, or sufficient cash would be accumulated at the parent company to effectively achieve said ratio on a net basis.
The current ratings for SSS remain underpinned by the strength of the management team with noted expertise in developing and managing all aspects of its longstanding repo-oriented operation. Risk management policies and practices appear comprehensive, partly owing to the operating agreements that provide guidelines for risk measures. Counterparty credit risk has been managed well the past few years even during substantial market volatility.
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