Fitch Says Will Toughen the Way it Rates CDOs


Fitch Ratings announced plans to toughen the way it rates $220 billion worth of corporate collateralised debt obligations (CDOs) following criticism that debt ratings played a role in creating the credit crisis.

Fitch said the change in methodology would probably hit synthetic CDOs the hardest, leading to an average downgrade of five notches for the $75 billion worth it rates. Synthetic CDOs are created from portfolios of credit derivatives, typically on investment-grade corporate borrowers.

These sharp ratings downgrades could force some investors to sell their CDO holdings, which could lead to declines in valuations and writedowns on investor portfolios.

European credit spreads widened sharply on Tuesday after the announcement.

Fitch's analysts said they aimed to ensure that its CDO ratings perform in a similar way to its company ratings, which have an established history and are well understood.

"Our philosophy is that we're trying to be extremely transparent. We are trying to explain to everybody exactly what our thinking processes have been," Philip McDuell, Fitch head of structured credit for Europe and Asia, said in an interview.

"There are no black boxes here. We've opened ourselves up, and we're actively looking for feedback on it," he added. A CDO is a portfolio of debt divided into tranches, or slices, by degrees of risk.

The riskiest and highest-yielding tranche is exposed to the first few percent of default losses from any credit in the pool.

After it has been wiped out, losses then move to the next tranche. The tranches at the top of the ladder are typically rated triple-A.

Investment Grade Vulnerability

Fitch's announcement comes a day after rival Moody's Investors Service said it might change how it rates thousands of structured credit products.

Synthetic CDOs are based on portfolios of credit default swaps, which are bets on whether a company will default. Ratings of these CDOs, including many of their triple-A rated tranches, will be most affected by the new criteria, Fitch said. Ken Gill, Fitch managing director for structured credit, gave two main reasons.

Many investment-grade CDOs have large concentrations, 25 to 30 percent, of credits in the banking and finance industry, which included some of the most liquid names in the derivatives market, he said.

"We are taking a harsher view of that industry concentration in our new approach," he said.

Fitch also is looking to change its default risk assessment to take better account of peak default rates from its 30 years worth of data, Gill said.

The agency also is considering taking into account market pricing of credit default swaps of underlying credits when evaluating a CDO.

It will use a formula to calculate the increased risk of a CDO portfolio that includes, for example, a AAA-rated bond insurer that has credit default swap spreads of over 1000 basis points.

Lower Recovery Rate?

Fitch is also re-examining its assumptions on recovery rates if companies do default, McDuell said. "Given the significant amount of debt (in CDOs) with low ratings, the average recovery rate might be lower," he said.

For CDOs based on portfolios of high-yield assets such as leveraged loans, the agency expects downgrades to be less severe.

Most of the top tranches of these are likely to be affirmed, but their lower, riskier tranches may be downgraded by one to three notches, Fitch said in a statement. "Ratings are not expected to be lowered below B- in the absence of actual portfolio deterioration."

Fitch said it would not rely solely on the new model, which would not eclipse its analysts' fundamental credit views.

The agency said it was seeking feedback from the market on the proposed revisions and would publish the final criteria by March 31. It will then take three months to review all CDOs based on the new criteria.