Leaving to one side profound uncertainty about investors’ risk appetite for CDO product in the medium term, there is a strong possibility that the triple-A rating will become a rarity in structured credit.
First, Fitch raised the market’s ire by proposing to shift its methodology on synthetic corporate risk CDOs to a dramatically more conservative stance. The agency predicted, following the implementation of the new model, five-notch downgrades on average for deals rated under previous assumptions. Moody’s proposes doing away altogether with its well-known alpha numeric ratings scale for complex securities (in other words CDOs) and replacing it with one based purely on numbers or perhaps a special signifier to denote the asset class. Standard & Poor’s has also made some modest changes to its RMBS-backed CDO methodology.
Both Fitch’s and Moody’s proposals are a reaction to the fact that many ABS CDOs rated by all the rating agencies have not lived up to the rankings initially bestowed on them. What was called a triple A was not in fact a triple A, and in many cases not even of investment grade. Fitch’s approach is brave, although there is the possibility that it will lose a lot of business as a result of trying to match CDO ratings with standalone credit ratings. Moody’s risks confusing everyone with a scale that means nothing to anyone.
"Our main aim was to produce a corporate CDO rating methodology that results in ratings that are consistent with other asset classes," says Ken Gill, managing director, structured credit, at Fitch Ratings. "Effectively there are two questions you need to answer in order to do that. The first is: what is the appropriate quantitative approach? Secondly, when should the model’s results be challenged?"
Credit researchers from BNP Paribas welcomed the move, saying that as corporate defaults are likely to increase over their long-term average of 4.5% over the coming years, it is sensible that Fitch is planning to use a peak rate of 9.3% instead.
Adverse selection
"Concentration risk is something that we believed needed to be addressed," says Gill. "But in the first instance we looked to try the model out on a fundamental credit view. For example, single-A corporates should not default even in periods of peak defaults. Similarly, corporate CDOs rated single A and above also should not default even in periods of peak defaults. It’s easy to produce a model that results in that being true for large diverse portfolios but we wanted the framework to also test the risks posed by concentration and adverse selection," says Gill.
Fitch is acknowledging that there is a fundamental difference between structured credit and standalone credits. An A-rated credit tranche cannot go out and raise equity in the same way a bank or corporate can.
"A triple-A rated tranche in a static structure is at the mercy of the underlying default and recovery rates, a fact not yet being explicitly acknowledged by the rating agencies. Technically speaking, being a AAA-rated tranche is equivalent to selling out of the money default and recovery rate options (extreme tail risk), a concept few AAA investors realize even after the sub-prime debacle," says BNP Paribas researcher Mehernosh Engineer.
Most bankers complained about the dramatic scale of downgrades that will take place if Fitch does follow through with its planned changes. CDOs in corporate credit have performed fine, leaving aside any market value-type structures such as CPDOs that Fitch did not rate anyway. While the indices and CDS spreads are at record wides, defaults remain at record lows. They were also wary of qualitative interference that Fitch might make in the ratings process.
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Fitch looks to peak default rates |
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Ten-year rolling cohort triple-B default rate |
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Source: Fitch |
"Maybe it’s right in principle – but you want rating agency methodology to be transparent so you can create deals. Otherwise it is an inefficient process that is it too labour intensive," says one banker.
"What we’ve learnt is that concentration has crept in, as have other forms of adverse selection. It is those things we are trying to address by not only having a quantitative approach," says Gill.
CDO structurers are far from happy about the introduction of qualitative methodologies. But Fitch says that it will only be using such measures when the pool or structural characteristics warrant it. But the nature of banking, and structured credit specifically, is to seek out arbitrage opportunities. Fitch’s proposals threaten to cut the opportunities for ratings arbitrage – which is to take credits that are underperforming given their ratings and repackage them into CDOs. Fitch has also looked at changes in corporate governance and decided that recovery rates will probably be lower.
Rating agencies’ methodologies differ in default assumptions, recovery rate expectations and so on, so it is not unusual for there to be a meaningful gap in the actual ratings bestowed on standalone entities and for structured finance ratings. This also leads investment bankers to seek out the less conservative agencies for their clients. Given that there are only three or, at a push, four serious players in the international rating agency business, the implications are clear. The agency that is too out of step with its competitors will rate few transactions. Consequently Fitch’s move appears to be extremely foolish – or is it?
According to BNP Paribas, some $220 billion of synthetic CDOs will be affected. Fitch states that if this new methodology were applied to existing ratings of investment-grade synthetic CDOs, it would expect that on average there would be a five-notch downgrade. If this were applied in a uniform manner, triple As would be downgraded to perform in a manner consistent with single A. That would not please investors. There were a lot of rumours surrounding CDOs unwinding – whether these are pre-emptive moves ahead of Fitch’s possible shift is not known. But forced unwinds are a strong possibility if all goes ahead as planned.