Surprise over "severe" Fitch CDO cuts

Fitch Ratings has outlined possible changes to its approach to rating collateralised debt obligations (CDOs), with downgrades potentially far deeper than the market expected.

Synthetic corporate CDOs would be the worst-affected under the new rules, outlined this week in a Fitch discussion paper. The rating agency predicts it would downgrade CDOs based on investment-grade corporate debt by around five notches; transactions with little or no credit enhancement could fall by up to ten notches. High-yield cashflow CDOs would be downgraded by up to three notches, with their AAA tranches generally confirmed.

The most significant change Fitch has made is to extend its historical data set back to the early 1980s, which includes two periods (2001-2002 and 1990-1991) of much higher default rates. The model now assumes higher default rates and lower recovery rates.

Fitch also admitted that its current model underestimates the degree of concentration in some CDOs, which has hurt the performance of subprime CDOs recently. It is stepping up its focus on concentration risk by increasing its assumed correlation rates by 50% for the largest risk contributors.

And to get around the problem of adverse selection - the tendency to pick atypical names from a given ratings band to maximise spread - the agency will also incorporate credit default swap pricing, which gives an independent implied rating, into its model.

Siobhan Pettit, a London-based structured credit analyst for RBS, commented in a strategy paper: "We weren't expecting anything this severe." If implemented, the new rules would have "serious implications", she added. Downgrades of tranches formerly rated AAA- would force selloffs by investors (such as pension funds) restricted to only AAA-rated assets; this in turn could cause more selloffs in senior mezzanine tranches, and increased demand for single-name credit default swaps as credit protection. "The danger then is of a snowball effect, where people exiting [synthetic CDOs] cause additional mark-to-market pain for those who decided to stay put, then causing further unwinds," Pettit concluded.

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