The three largest global rating agencies are reconsidering their approach to rating structures exposed to fluctuations in market value, with potentially unpalatable results for holders and arrangers of various structured credit products.“We regularly review our ratings methodology for market value structures, but we are looking at it in the context of subprime,” remarked a London-based spokesperson for Standard and Poor’s (S&P). New York-based Moody’s Investors Service is also looking at its approach to rating these structures, which have been plagued by a continued wave of rating actions. They include – but are not limited to – market-value collateralised debt obligations (MV CDOs), structured investment vehicles (SIVs), leveraged super-senior (LSS) notes, and constant proportion debt obligations (CPDOs).
Moody’s recently downgraded €340 million of CPDO notes exposed to financial sector credits, on December 16. The deals, originated by ABN Amro and UBS, have suffered as a result of particular spread widening and volatility among financial names in the wake of market tumult.
Apart from causing immediate investor pain through downgrades, a more draconian approach to rating market value structures would make it harder to sell these products to investors. “I think the rating agencies are going to be a lot more conservative in their assumptions going forward and that’s not something that’s fully appreciated by everyone,” commented John Schofield, a structured credit strategist at Royal Bank of Scotland (RBS) in London.
London- and New York-based Fitch Ratings released a discussion paper mooting changes to its criteria for assessing such structures in December 2007. Roger Merritt, New York-based chief credit officer for the agency’s global structured credit group, said: “I think everybody in the market is reassessing their appetite for market value risk and for leverage we’re doing the same, as it relates to how we rate these structures.”
Fitch splits structures exposed to market value risk into two broad categories: traditional market value structures such as MV CDOs and SIVs, and structures that contain ‘out-of-the-money’ market value risk, in the form of a knock-out trigger. The latter includes CPDOs, which de-leverage and realise losses if their net asset value reaches a set level.
In its paper, the agency suggested that structural changes in the credit market, such as increased use of leverage, had made it more difficult to gauge the impact of a collective unwinding of credit structures. It proposes requiring greater credit enhancement for traditional market value structures, and placing more emphasis on the liquidity of underlying assets and the liquidity support provided to the vehicle.
Out-of-the-money or knock-out market value structures would find it almost impossible to achieve a rating above BBB from Fitch under the agency’s proposals. It attributed this to the lack of structural protections many of them contain, as well as their potential for low recoveries if a trigger is breached. It also accounts for the “challenges of modelling long-term market value risk with a high degree of precision,” according to the paper.
Fitch is accepting comments from market participants on the ideas until the end of January, and intends to give its updated ratings criteria for market value structures by the end of the first quarter.
The agency’s proposals do not affect its rating criteria for CDOs of commodities, foreign exchange or equity default swaps, which it said it would revisit separately. Schofield of RBS noted that, if it did implement updated criteria for other market value structures, it would seem inconsistent to leave these unchanged. “I don’t see how you can put a BBB ratings cap on a CPDO and then go on to give a single-A rating to any tranche of a CFXO,” he said.
Rating agencies have endured much recent criticism for assigning ratings to investment structures that hinge on market values as opposed to creditworthiness. This has been particularly acute in the case of CPDOs, which have garnered ratings as high as AAA or equivalent since the launch of the original deal in July 2006.
Many of the Moody’s, and all 29 of the S&P public CPDO ratings are currently under review.
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