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Fitch releases refined CDO methodology

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Fitch releases refined CDO methodology

Fitch has released its much-anticipated revised criteria for rating corporate CDOs (see SCI issues 74 and 82), which now addresses concentration risk and the issue of adverse selection. The move follows a six-month review and sees the end of its self-imposed CDO ratings embargo - Fitch will recommence rating activity from tomorrow, 1 May.

The high-level aim of the review was to address the evolving risk in corporate CDOs, which has changed since CDO models were developed in general and in particular over the last 12 months, according to Ken Gill, md in structured credit at Fitch. "Our goal is to create more predictive and stable ratings, particularly at the AAA/AA/A levels, and restore investor confidence in ratings," he says.

Gill adds: "The review has resulted in no major changes to the framework proposed in February, but we've made some refinements to better capture nuances of risk and so the impact on individual deals will be variable."

For example, while sector and industry concentrations are generally modelled in a binary fashion, Fitch's new approach calls for the analysis of correlation at an intermediate level in order to be more discriminating of risk. "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," comments John Olert, md and head of global structured credit at Fitch.

And, in terms of the issue of adverse selection, the agency found it necessary to clarify what it means by CDS-implied ratings. "We don't mean using CDS spreads on their own as an indicator of default, but based on an individual relative to its peer group. We still believe that this is an effective way of predicting potential rating migration for ratings that are on negative watch or outlook," explains Gill.

Screening tools will also be 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," adds Philip McDuell, Fitch's md and head of structured credit for EMEA and Asia Pacific.

The new methodology will be applied immediately, with the priorities being all synthetic transactions exhibiting industry concentrations or a deterioration in asset quality. Fitch will also screen synthetic CDOs whose ratings are unlikely to be impacted by the changes.

But, because cash transactions have more moving parts, the agency will interact with individual managers to find out which actions they intend to take with their portfolios. The extent of manager flexibility and other relevant qualitative considerations will be factors in the rating review. A manager's willingness and ability to mitigate portfolio risk, for example, will be taken into account.

While Fitch expects many ratings to be affirmed, downgrades are also expected - in some cases by several rating notches. Downgrades are likely to be most severe in transactions with portfolio concentrations, or those with little or no cushion in their current level of credit support.

Fitch's review involved an extensive period of two-way consultation and dialogue with market participants, including over 200 one-on-one interviews. McDuell says that Fitch believes it has engaged with the market properly and that the fundamental re-examination of its methodology was necessary to reflect the evolutionary change in the CDO market.

"The best way to respond to the challenges of the last year is by having a robust and transparent methodology," he concludes.
I recall reading on Bloomberg a few weeks ago that Fitch has predicted more accurately the number of CDO defaults than either SP or Moody by a fair number. (In their defend, SP and Moody rate way more mortgage-backed deals than Fitch)
While the latter two dominates the market with 40ish % market share each, Fitch seems to make all the headlights and changes to reflect the market condition.