S&P methodology tweaks will lead to more CDO events of defaults, says Morgan Stanley

In its latest "CDO market insights" publication, Morgan Stanley says that the changes that Standard & Poor's made to its RMBS ratings methodology last week are very significant. S&P increased its cumulative loss assumption for 2006 vintage subprime from 14% to 19%. This suggests that A tranches on average are likely to experience complete impairment and that AA tranches are likely to come to be impaired. The report says the spectre of downgrades to AAA RMBS tranches, which have so far been limited, now looms large.

The report concludes that new S&P assumptions increase the prospects for events of default in ABS CDOs. This is because the par value ratios that can trigger an event of default are reduced by downgrades of the underlying collateral even when all the assets are still performing.