Downgrades Likely Based on New Corporate CDO Criteria
Fitch Ratings has revised its criteria for rating corporate collateralized debt obligations and as a result is likely to downgrade many such CDOs.
Fitch’s move follows a six-month review of its approach, which included a fundamental re-assessment of Fitch’s approach to corporate portfolio risk where each component of the rating approach was challenged and re-tested, leading to a number of important revisions.
These revisions are intended to create more stable, predictive ratings, especially for the ‘AAA’, ‘AA’ and ‘A’ categories. Importantly, additional stresses are applied to capture risks posed by concentrations in sector, industry, or individual obligors.
“CDO modelling to date has relied upon some expected minimum level of diversification. In recent times we have observed an increase in portfolio concentrations, and our updated framework brings this risk into much sharper focus,” said John Olert, Managing Director and head of Global Structured Credit at Fitch. Screening tools are also applied to identify portfolio assets that may have an above-average likelihood of downgrade.
“The early, and sometimes severe, downgrade of corporate CDO notes has been a vexing issue for the market. By identifying adversely selected assets, CDO holders can benefit from additional protection against credit deterioration in the underlying portfolio,” said Philip McDuell, Managing Director in London.
Fitch had ceased new rating activity in the sector during the criteria review period, and with the publication of the methodology, lifts this self-imposed embargo.
The new approach will also be used to review existing transactions with exposure to corporate debt and all such transactions remain under analysis whilst the criteria is implemented.
“Applying the updated criteria to existing ratings is important for market transparency and consistency,” said Roger Merritt, Fitch’s Chief Credit Officer for Global Structured Credit.
While Fitch expects many ratings to be affirmed, downgrades are also expected, in some cases by several rating notches.
“We expect the downgrades to be most severe in those transactions with portfolio concentrations, or those with little or no cushion in their current level of credit support,” said Merritt. “The extent of manager flexibility and other relevant qualitative considerations are also expected to be factors in the rating review. If a manager shows willingness and ability to mitigate portfolio risk, we will take this into account.”
Fitch plans an extensive communications plan in the coming weeks, covering details of the criteria, as well as plans regarding its application to current ratings.
A full description of Fitch’s rating criteria for corporate CDOs can be found in the following reports: Global Rating Criteria for Corporate CDOs; and Global Criteria for Cash Flow Analysis in Corporate CDOs.
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