Fitch says it may cap ratings of CSOs to that of the counterparty

This last comment is poignant and is the reason that Fitch has made the statement. Lehman is "trying this on" in the US courts right now and Fitch is saying exactly this, that unless the US courts find in favour of the docs and that these deals do not come under Chapter 11, then they will have to downgrade all deals which are rated higher than the hedge provider

The more interesting question is, if provisions of trust deeds which subordinate the claims of insolvent swap counterparties don't work under US bankruptcy law, why haven't the rating agencies downgraded the senior tranches of all securitisations which have a US bank as a hedge provider?

I am familiar with the Dante CSO program !! The issue is not that there is a flaw in the docs. The docs are market standard, crystal clear, upheld by the courts and not even disputed by BNY. The issue is that BNY as Trustee is refusing to perform its role under the docs! BNY has a problem in that if it operates the docs and releases collateral to investors and is subsequently sued by Lehman, it bears the costs and risks of defending itself as the collateral is long gone. Perversely by dithering for so long they have made themselves a target and this is exactly what has happened. (Other trustees who acted quicker in distributing the collateral are not under attack from Lehman). BNY is relying on a clause in the docs that say it is entitled to be “indemnified to its satisfaction” before it takes any action. BNY interprets this as a holdback of the swap mark to market out of the collateral for 6 years, the statute of limitations. Breakdowns in negotiations have led to investors suing BNY. Clearly if this approach by BNY was known when the deals were originally rated by the agencies, then they wouldn’t have got ratings above the swap counterparty. The bigger question now is why don’t the rating agencies downgrade every CSO where BNY is Trustee to the level of the swap counterparty? Do the agencies do the right thing by investors and warn them that if BNY is their Trustee, then they’ll likely end up in the same situation as Dante investors, or do they try to maintain a relationship with BNY and not destabilise the market? S&P has ducked the issue by withdrawing its ratings. Fitch is honourably showing more backbone.

I'm not familiar with the structure of the Dante CSO but you have to wonder who was acting for investors during the structuring of the CSO agreements. Either way, the lawyers / investors spectacularly failed to adequately ring-fence the collateral in the event of a counterparty default. The trustee can only work with what's contained in the agreements.

Valid methodology or not, another nail in the coffin of structured credit... Will only increase the costs and complications of new issuance even further...

It is great to see a rating agency actually acknowledging what is going on here (Lehman running spurious lawsuits to try and take advantage of a weak trustee) and expressing their views and concerns. Obviously a standard premise of all the rating agencies is a weakest link approach that if the swap counterparty goes down and it affects investors in a material way the rating can't be higher that the swap counterparty. However, this is the first time to my knowledge, that the a rating agency has actually acknowledged and supported the premises of their own methodologies in this case! The approach by S&P has been much weaker. They withdrew their ratings on all Lehman affected deals several months ago and are hiding behind the issue that they are no longer following Lehman deals and therefore won't take into account anything that happens on them in regard to other transactions. I have not seen any statements from Moody's on the issue