Fitch to Add Loss Severity Metric to Structured Finance Ratings
Fitch Ratings intends to add a measure of the severity of potential losses to its ratings of structured finance instruments. Fitch also is adding a measure of collateral quality and a “Rating Outlook” for all such instruments, in an effort to add greater clarity to its ratings.
In a new report Fitch “examines the case for potential separate complementary indicators and ratings that may be offered in three areas to enhance the meaning and usefulness of existing structured finance ratings.” The proposals build on earlier ideas announced in April.
The key elements of the proposals, on which Fitch is seeking comment, are as follows:
Loss Given Default/Loss Severity — Fitch’s ratings traditionally address the probability that a security will default prior to its legal final maturity. They do not address the extent of loss that might occur if a security defaults (loss given default or loss severity).
Fitch proposes a complementary Loss Severity Rating scale at the security level to accompany traditional ratings. Fitch believes additional disclosure in this area would offer most value‐added given the inherent difference in loss given default between traditional corporate debt and most structured finance debt. In structured finance, given different priorities of payment and the relative ‘thickness’ of tranches, the extent of loss given default can vary significantly. It is an important consideration for investors that Fitch’s structured finance ratings do not traditionally address.
Collateral Quality Assessment — Fitch generally conducts a periodic originator review visit as part of the rating process in order to assess the quality of origination and underwriting processes for the underlying assets. The portfolio profile in terms of borrower and product types, for example, will also be examined to form a view on the collateral. Historical performance data will be analysed to assess collateral performance. The result of this analysis is considered by the rating committee when determining transaction ratings. No separate opinion on collateral quality is generally published, however. Fitch proposes that an opinion scale be adopted for individual asset classes and sub‐sectors. At the time of rating a new transaction, the agency would assign the underlying collateral an opinion grade alongside the rating of the transaction securities.
Rating Transition Probability and Volatility — Fitch believes that meaningful scales giving indications of the potential for a particular security to suffer rating transition or volatility would be difficult to develop in isolation from factors captured by traditional debt ratings. However, the agency agrees that additional transparency regarding the likely medium‐term path of a credit rating would be useful information for investors to have.
To address this, Fitch has recently committed to an extension of “Rating Outlooks” to all structured finance areas globally.
Rating Outlooks are intended to give a forward‐looking opinion about the medium term prospective direction of a tranche rating, generally over the next 12–24 months. Fitch believes this will give the market greater information about prospective future individual tranche performance than an explicit rating volatility indicator.
Full details of Fitch’s proposals are available for purchase.
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