Fitch announces new corporate CDO criteria

Fitch has published details of its new rating methodology for corporate CDOs. There are few surprises in the methodology, which has been finalised after wide consultation over the past couple of months. The more conservative methodology calibrated the model output to historical peak default rates rather than long-term historical averages. Higher correlations and lower recoveries apply.

Correlation assumptions were among the most hotly debated aspects of the methodology during the consultation period. Fitch says that the final correlation framework took into consideration the industry concentration observed in the early 1991 default peak. The peak periods of 1990 and 2001 were also examined.

Fitch has applied additional stresses to capture the risks posed by sector, industry and individual obligor concentrations. John Olert, head of structured credit at Fitch said the methodology brings portfolio concentrations into "much sharper focus".

The CDO modelling framework groups industries into five sectors, each containing one to eight industries. The methodology assumes that each asset is correlated to another by a base 2% level, and by an additional level of 2% if they are in the same sector. For assets that are also in the same industry, correlation is set at 20%.

To ensure the risks associated with industry concentration were captured in the model, hypothetical portfolios were created with an industry concentration of 30%. The outputs for concentrated and diversified portfolios were compared to observe the level of additional default protection implied by the concentration. Fitch says that for a 10-year portfolio of BBB assets, the model output for the diversified portfolio indicated that protection against defaults totalling 15.3% of the portfolio would be necessary to achieve a AAA rating on the CDO. For the industry concentrated portfolio, default protection totalling 20.7% of the portfolio would be required.

For obligor concentrations, stress is applied by increasing the pair-wise correlation of the five largest assets in the portfolio by 50%. In addition, the assumed recovery rate on the five assets is reduced by 25%.

Fitch has also sought to address the risk of adverse selection (or ratings arbitrage). To do that, implied ratings based on market spreads have been introduced to the methodology. If an asset is subject to negative rating action, the lower of Fitch’s CDS implied rating or the credit rating minus two notches (for negative rating watch) or one notch (for negative outlook) will apply.

Revised recovery rates include a 70% recovery rate for senior secured assets (in US and other ‘Group A’ jurisdictions), a 10% cut on the previous rate. There is a 40% senior unsecured recovery rate. Fitch previously applied a 50% recovery assumption to investment grade senior unsecured assets, and 40% to non-investment grade senior unsecured.

The methodology includes adjustments for managed CDOs. Beneficial default and loss rate haircuts apply for managers with the highest Fitch asset manager ratings.

Fitch says that the new corporate CDO criteria will be used to review existing transactions. However, it is still to elaborate on the precise approach. Reportedly it could include the use of an oversight committee to moderate the results off the model where appropriate. "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. Fitch said that it expects many ratings to be affirmed, but also that downgrades are 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.” Fitch is promising an “extensive communications plan” in the coming weeks, covering details of the criteria, as well as its plans regarding current ratings.

Olert said that the introduction of the methodology is an important step in restoring market confidence in CDO ratings.