Tuesday, December 16, 2008

Fitch Announces Updated Criteria for SF CDOs

The Fitch Ratings Press release:

Fitch Ratings has today published its updated approach for rating collateralized debt obligations backed by structured finance assets (SF CDOs). The updated criteria follow an eight-week consultation period. Fitch initially announced the new proposals on October 14, 2008, and further clarified its treatment of commercial real estate assets on November 14, 2008.

The criteria contain updated default probabilities (based on rating and term of asset), increased correlation assumptions, and recovery rate assumptions that are based on tranche thickness.

The correlation framework has been calibrated so that CDO notes rated in the high investment-grade categories would be protected against estimated peak default potential for portfolios of SF assets concentrated in terms of geography, sector, and vintage.

Much of the feedback received during the consultation period focused on the correlation calibration. Some market participants thought that treating RMBS as a single sector did not give enough benefit to the different risk drivers of the conforming and non-conforming sectors.

'While we agree that differences in RMBS risk drivers may lead to distinction in observed default correlation during mild or even moderate stress scenarios, we continue to believe that in high stress scenarios, correlation will prove to be high,' says John Olert, Managing Director and head of global structured credit at Fitch in New York.

Another common element of feedback related to the application of US based performance statistics to non-US portfolios. The approach focuses on the potential for a peak default rate for a portfolio of concentrated assets. It does not represent an expected portfolio default rate, but rather recognizes that there is a higher potential for portfolio default rate variability in concentrated portfolios.

'The data we used to influence our thinking were skewed toward poorly performing US SF sectors, but we believe that any concentrated portfolio can pose the same risk,' says Ken Gill, Managing Director at Fitch.

The more recent clarifications focused on treatment of real estate investment trust (REIT) and commercial real estate loan (CREL) assets. The correlation assumptions for REIT assets recognize a higher intra-industry correlation compared to other corporate industries, but still provide a small amount of diversification credit when adding REIT debt to a portfolio of commercial mortgage-backed securities (CMBS). The CREL correlation assumptions recognize the potential for high correlation in high stress scenarios, while still recognizing that idiosyncratic factors such as property type, quality, and location, may reduce default correlation between CREL and CMBS.

The criteria will be applied to review the current ratings assigned to all SF CDOs. Ratings of SF CDOs are currently under analysis or in some instances on Rating Watch, and rating actions are expected beginning in January. For SF CDOs already exposed to distressed US RMBS securities, the application of the revised criteria is not expected to result in any meaningful rating changes.

For European SF CDOs with no or limited exposure to US RMBS securities, the application of the new criteria is expected to produce some affirmations of 'AAA' ratings; however, many 'AAA' rated securities are expected to be downgraded an average of three categories, to the 'BBB' category. For US CRE CDOs, some senior 'AAA' rated tranches may also be affirmed, but many are expected to be downgraded by three or four categories (to 'BBB' or 'BB'). Details of model-implied impact on existing ratings in various transaction categories are expected to be published separately this week.

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