26 Mar 2009, Mark Pengelly, Risk magazine
Since the outbreak of the US subprime mortgage crisis, rating agencies have been placed under intense pressure by regulators. In particular, they have homed in on the so-called "cliff risk" posed by structured finance ratings, which make them more prone to sudden and multiple-notch downgrades than ratings for plain vanilla bonds.
As a result, rating agencies are drastically increasing requirements for attaining the highest ratings. "There's a feeling rating agencies need to become more conservative, or their hands will be forced by regulators," said Michael Hampden-Turner, head of European collateralised debt obligation (CDO) strategy at Citi in London.
On March 16, S&P issued a paper outlining proposed changes to the methodology and assumptions it uses for rating synthetic CDOs and cash flow collateralised loan obligations (CLOs).
The modifications would have a "significant negative effect", the agency said. In a test of selected transactions using the criteria, 90.9% of AAA rated synthetic CDO tranches fell to between A and BBB level. Meanwhile, 72.5% of AAA rated cash flow CLO tranches went down to A.
Banks are large holders of AAA rated tranches, noted Citi's Hampden-Turner. As a result, any downgrades could significantly increase the amount of capital they would have to hold against them under Basel II. "The main implication is that holders of AAA rated tranches are looking at, on average, two-notch downgrades. That means banks will have to hold far more capital against them," he said.
The rating movements could lead to funding difficulties if they affect the eligibility of assets for central bank deposit schemes, he added.
Elsewhere, the bulk of S&P-rated affected CDO and CLO tranches are expected to receive downgrades of between one and two notches, causing further pain for battered structured credit investors.
Lying behind the expected downgrades is an update to the agency's CDO Evaluator default model, as well as new additional tests for each CDO and CLO tranche.
The updated CDO Evaluator model will require tranches to withstand more defaults to attain a given rating and include higher correlation assumptions between credits. CDO Evaluator will be adjusted to target AAA default levels that "far exceed the highest observed levels in the post-World War period", the agency said, and BBB default levels consistent with the highest that have occurred since 1981.
S&P will also put tranches through various "outside-of-the-default-model" tests once their ratings have been determined by CDO Evaluator. These include making sure a given number of credits can be defaulted without recoveries at each rating level and that the largest industry in AAA and AA tranches can be defaulted without recoveries.
The S&P changes do not include market-value CLOs or CDOs of ABSs, which are being reviewed separately, the agency said.
In recent months, Moody's has announced it is modifying the way it rates various structured credit deals, including CLOs, synthetic CDOs and CDOs of ABSs. In all cases, this has involved upping the level of defaults tranches should withstand and increasing correlation assumptions. For corporate synthetic CDOs, this encompasses a 30% blanket increase in the likelihood of defaults - contributing to an expected average downgrade of three to seven notches among the 900 transactions it rates.
On March 4, the agency placed nearly all Moody's-rated European and US CLO tranches on review for a possible downgrade, amounting to approximately $100 billion in CLO notes.
A report from Fitch in mid-November 2008 suggested the alterations made by the agency for rating CDOs last year had helped them weather the multiple credit events that took place during September and October. These included the conservatorship of US government sponsored mortgage lenders Fannie Mae and Freddie Mac and the bankruptcy of Lehman Brothers, among others.
The changes saw just 37% of AAA ratings affirmed, while one in ten of the remaining tranches dropped to below investment grade. Just 15% of AA rated tranches were affirmed, with around two-fifths of the remaining tranches falling to below investment grade.
However, in a survey of the Fitch-rated synthetic CDOs that had seen their ratings revised, 97% of AAA tranches had retained their ratings after the market tumult of September and October, the report highlighted.