Fitch Ratings said that credit events on Fannie Mae and Freddie Mac are unlikely to trigger large scale CDO downgrades even though both GSEs are referenced in approximately 30% of synthetic CDOs rated by the agency.

"The impact on CDO ratings is likely to be muted because high expected recovery rates will not pass significant losses onto the CDO," the rating agency said today in a release.

Both agencies are the seventh and 21st most popular reference entities in Fitch’s synthetic CDO index, which tracks Fitch-rated European synthetic CDO reference portfolios. Either Fannie Mae are Freddie Mac is close to 200 CDOs globally while around 150 CDOs reference both Fannie mae and Freddie Mac.

The CDO deals most likely to be affected are CDO squareds that reference the agencies in multiple portfolios, CDOs that reference the subordinated debt and CDOs with fixed recovery rates on the reference assets.

CDOs that reference the subordinated debt are likely to be more adversely affected than those that reference the senior debt due to lower market value, and therefore expected recovery rate, of the subordinated debt. Around a third of Fitch-rated CDOs with exposure to at least one of the GSEs reference the subordinated debt.

The rating agency reported that only a small number of Fitch rated synthetic CDOs apply a pre-determined fixed recovery rate to any asset in the portfolio that experiences a credit event. These deals are expected to have the biggest loss because recovery rates are usually set at 40%, which is significantly lower than the predicted market recovery rate.

The rating agency rates four CDO squared transactions that use fixed recovery rates for the reference assets. These are likely to be impacted by both the increased leverage of the CDO squared structure and the fixed recovery rate. It has already placed these four transactions on Rating Watch Negative upon application of Fitch’s new corporate criteria to outstanding transactions.

Fitch has already begun to receive credit event notices for both Fannie Mae and Freddie. The International Swaps and Derivatives Association (ISDA) credit event definitions state that the appointment of a conservator constitutes a Bankruptcy credit event.

To avoid doubt, Fitch’s definition of a default for a credit rating is not the same as ISDA’s definition of a credit event for credit-default swaps. The rating agency affirmed the 'AAA'/'F1+' long- and short-term ratings of Fannie Mae and Freddie Mac with a Stable Outlook earlier this week. It also downgraded the preferred stock ratings of both agenciess to ‘C'/'DR6’ and placed the subordinated debt of both GSEs on Rating Watch Evolving.

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