CDOs: Fitch won’t add to crisis


Alex Chambers
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Rating agency considers wider implications of CDO methodology change.

Fitch’s new, more conservative corporate CDO criteria were due to be announced on March 31. However, it is likely that there will be some slippage on that deadline because of the amount of feedback the rating agency has received. The new criteria would entail lower ratings on future trades – or lower leverage.

But because of widespread fears that an unleashing of the changes on existing CDOs would cause havoc as investors and dealers unwound positions, it appears highly likely that Fitch will introduce its new corporate CDO methodology in a manner that does not dramatically exacerbate the credit crisis.

"The interest and amount of feedback was in excess of expectations," says John Olert, head of structured credit at Fitch. "It’s difficult for some people to understand what we are trying to do, as it is taking place right in the middle of various challenges."

Forced unwinds of structured credit structures have mostly been limited to market-value structures. Cashflow CDOs of corporate risk have generally not been affected by ratings because the underlying collateral has mostly performed – despite dramatic spread widening of credit default swaps, indices, bonds and loans. However, in the light of the poor performance of structured finance CDOs (or ABS CDOs) Fitch Ratings decided to revise its CDO methodology, starting with corporate risk. The aggression with which the agency decided to move led to widespread concerns that it would add fuel to the credit market fire, leading to forced unwinding of structures and fire sales by those investors that can only hold paper rated at a certain level. (See Yet more triple-A ratings are under threat Euromoney March, 2008).

According to JPMorgan, the size of the rated market is something between $450 billion and $700 billion. Fitch’s market share is relatively small at $75 billion but even so its methodology changes, in the present thin market conditions, could have a significant impact. JPMorgan’s analysts suggest that there could be as much as $250 billion of market risk arising from the possible $50 billion of triple-A tranches at risk of a (possible) average five-notch downgrade.

Olert points out that it is important to recognize what has occurred in the ABS CDO sector and reflect that greater understanding in other asset classes. "We need to learn from what we are currently experiencing," he says.

In markets where models have become so critical to the investment decision-making process, it is clear that Fitch officials believe that where gaps become apparent or there is obvious room to improve, it is better to act sooner rather than later. Getting ahead of the curve appears to be the main objective.

Olert says that there has been constructive feedback and that Fitch is intent on staying true to its objective; it does not want multiple approaches to any asset class. It will also try to take on board some of the concerns of market participants with regard to the possibility of further market turmoil.

It appears that Fitch officials are aware that the implementation of the new CDO criteria, if conducted carefully, could help resolve some of the issues.

Initially, Fitch had indicated an intention not to grandfather transactions that were already printed. Grandfathering would of course allow holders of existing deals rated by Fitch to avoid downgrades but would leave the agency vulnerable to accusations of being behind the curve if corporate credit does indeed deteriorate.

There are other mechanisms Fitch could use. For instance, the agency might choose to look at the deals only when they begin to underperform. The problem with that approach is that CDOs’ ratings would then be vulnerable to a dramatic decline because not only is the collateral deteriorating but the agency is applying new conservative criteria.

Observers say that Fitch could also re-evaluate deals according to the new criteria but look at a number of factors, such as maturity, performance and credit enhancement, before deciding the final rating – in essence take a qualitative approach of limiting the action.