Thursday, July 17, 2008

S&P Requests Comments On Proposal To Explicitly Recognize Credit Stability As A Rating Factor

Standard & Poor's Ratings Services is requesting comments on a proposal to incorporate credit stability as an important factor in our rating opinions, given the volatility recently experienced in the markets.

Under the proposal, when assigning and monitoring ratings, we would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991 and the European recession of 1991 or appropriate sector-specific stress scenarios). In such cases, we would assign the issuer or security a lower rating than we would have otherwise.

The table shows the maximum projected deterioration under moderate stress conditions that we would associate with each rating level for time horizons of one year and three years. For example, we would not assign a rating of 'AA' where we believe the rating would fall below 'A' within one year under moderate stress conditions. The proposed change is an extension of our previously announced initiative to include a what-if scenario analysis in rating reports.

Maximum Projected Deterioration Associated With Rating Levels For One-Year And Three-Year Horizons Under Moderate Stress Conditions


AAA

AA

A

BBB

BB

B

One year

AA

A

BB

B

CCC

D

Three years

BBB

BB

B

CCC

D

D

These credit-quality transitions do not reflect our view of the expected degree of deterioration that rated issuers or securities could experience over the specified time horizons. Nor do they reflect the typical historical levels of deterioration among rated issuers and securities. In fact, instances of credit deterioration of this magnitude and speed have been uncommon. The proposal does not imply that we believe that issuers or securities should become—or are likely to become—less stable.

Rather, the values in the table express a theoretical outer bound for the projected credit deterioration of any given issuer or security under specific, hypothetical stress scenarios. Actual experience likely will vary from the hypothetical scenarios, so the universe of rated issuers and securities (as well as sub-populations of the full universe) likely will display actual degrees of deterioration greater than or less than those indicated in the table. For example, we would naturally expect relatively little credit deterioration during benign market conditions or during conditions of only mild or modest stress. Conversely, issuers and securities could suffer greater degrees of credit deterioration during periods of severe or extreme stress. In addition, specific business segments—such as housing, energy, retail, and transportation—could experience different degrees of stress over any given period.

We do not intend the proposed change to result in rating upgrades in sectors that have historically displayed above-average credit stability. Instead, we intend this proposal to function as a limiting factor on the ratings assigned to credits that we believe are vulnerable to exceptionally high instability.

The primary focus of the stability consideration is intended to be ordinary business risk rather than special types of risk, such as changes in laws, fraud, massive natural disasters, or corporate acquisitions.

The proposed change is asymmetric in that it focuses solely on credit deterioration rather than on credit improvement. There are two reasons for this approach. First, investors and creditors have expressed greater concern about deterioration than improvement. Second is the essential downside/upside asymmetry of the basic credit proposition.

The Possible Effects

We expect the proposed change would have very little, if any, effect on our ratings in the corporate and government segments of the capital markets. In those areas, it could affect issuers that have ratings-based trigger features in their obligations that accelerate the maturity of debt or that impose other onerous consequences under specified conditions. Likewise, the proposed change could affect companies engaged primarily in high-volatility business activities, such as energy trading.

We anticipate that the proposed change would have a more pronounced impact in certain areas of the structured finance segment, particularly on our ratings of derivative securities such as:

Collateralized debt obligations of asset-backed securities (ABS CDOs).

Constant-proportion debt obligations (CPDOs).

Leveraged super-senior (LSS) structures.

Transactions and structures that create more significant cliff risks would likely experience the largest impact. The proposed change could result in downgrades to significant numbers of the securities listed above when we first implement the proposal.

If we adopt the proposed change, we intend to implement it over a period of roughly 180 days from the date on which we announce it. It would apply to ratings on all types of issuers and securities and to both new and existing ratings. The change could require modifications to the rating criteria for certain types of issuers or securities. We will continue to strive for general comparability of ratings across the universe of ratings at each point in time, but the proposed change may somewhat affect comparability of ratings before and after the change.

As a general matter, our ratings express our opinion of the creditworthiness of issuers and specific securities. However, the notion of creditworthiness has sometimes been interpreted differently in various market segments. In particular, certain areas of the structured finance segment have favored a narrow interpretation, essentially meaning "likelihood of default" without regard to other factors. We are proposing to move beyond the narrow interpretation in favor of one that is more practical and useful for market participants. As a result, although our views on likelihood of default would remain a focus of our ratings, it would not be our only consideration.

We are proposing to incorporate credit stability in our ratings because of the high degree of credit volatility recently displayed by certain derivative securities. By explicitly recognizing stability as a factor in our ratings, we intend to align their meanings more closely with our perception of investors' desires and expectations.

Coordination With Other Proposed Initiatives

We previously announced that we would seek market comments on ways to highlight nondefault risk factors, such as volatility, and we have informally discussed a potential volatility indicator with some investors and other market participants. We are still exploring development of a separate volatility indicator that would complement our traditional credit ratings. However, under the current proposal, a volatility indicator would not be a substitute for explicitly incorporating the stability considerations outlined above into our ratings.

On May 29, we published "Request For Comment: Should An Identifier Be Added To Standard & Poor’s Structured Finance Ratings?" on RatingsDirect, the real-time, Web-based source for Standard & Poor's credit ratings, research, and risk analysis. The response deadline is July 31. We proposed adding an "s" identifier to ratings on securities issued from securitization transactions. The purpose of the identifier would be to provide greater transparency and insight to market participants by distinguishing ratings on structured finance instruments from ratings on corporate and government entities and obligations. The incorporation of credit stability in our ratings would not supplant an "s" identifier. We might implement one, both, or neither.

Response Deadline

Responses should be submitted on or before Aug. 6, 2008. Written responses should be sent to the following address: criteriacomments@standardandpoors.com.

Specific Question For Which A Response Is Requested

Do you support the proposal to explicitly recognize credit stability as an important factor in our ratings? Why or why not?

1 comment:

Doc Hoilday said...

Re: 'ikelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991"

>> This is what all the previous rating models were based on, obviously as well as all the failures associated with modeling outcomes, thus to return to the same models and retest the same stress is retarded! They proved beyond doubt that this model failed 100% -- no question about it!

IMHO, the reason this type of model is flawed, is because the model is built upon presumptions and correlations related to prior generational cash flow realities, i.e, people 40 years ago, 30 or 20 years ago, used to have 30 year fixed mortgages, which in large part, were paid off, because there were very few games played in regard to the long term fixed nature of a simple financial product -- versus the more modern approach of exploding a mortgage into a thousand different components that become linking mechanisms for cutting edge tax evasion derivatives that have odds less than a casino chip in Vegas.

This illusion to restore faith and confidence in a corrupt rating process is so dumb, that I'm sure these crooks will be back at the blackjack table in the blink of an eye!