A positive credit trend occurred in European CDOs in 2003 compared to 2002, according to Standard & Poor's latest transition study. Despite a higher overall percentage of downgrades last year, analysts say the increased number of upgrades should be an indicator of an improving ratings environment for European CDOs.

By S&P's count, the percentage of stable triple-A rated CDOs increased to just under 93% in 2003 from 84% in 2002, said analysts during a teleconference last week. This stability was displayed at almost every rating level in 2003.

Analysts attributed the improvement to a number of factors, including amortization, an overall improvement in the underlying credits, the decline of default rates and improved portfolio quality. Also, many deals that were begun are approaching maturity, and that in itself reduces the probability of default of underlying assets.

"We saw a number of upgrades across sectors; these are ratings that are either upgraded from their initial position or those that experienced a prior downgrade but were actually upgraded on the back of this underlying improvement," said Simon Collingridge of the European structured finance group at S&P.

While the transition study highlights market improvements, analysts noted that the study does not take into account some of the more recent structural changes that have appeared in many deals over the last year, in order to reduce the level of portfolio volatility. Collingridge noted that 2003 has seen a significant increase in the number of transactions that have a managed component, compared to the pure static portfolios that comprised the bulk of the market prior to 2003.

He also highlighted the increase in the size of underlying portfolios. In prior years, when the portfolios were smaller, the impact of a single credit default was more significant. Portfolios have grown to include 126 assets from an average of 105 assets recorded for transactions in 2002. "In 2002, about 60% of rated CDO portfolios here in Europe had asset sizes of less than 100. In 2003, about 60% had asset sizes greater than 100," said Collingridge. "We have begun to see a shift towards more ABS assets, which people consider to be more stable assets."

Though S&P is hopeful the positive trend continues, downgrade activity still remained at significant levels in 2003 and continues to be a point of concern. The market is still assessing the impact of single-asset defaults in older CDOs transaction, and how this is changed by portfolio size. However, unless the universe of collateral increases, crossover exposure may not be better mitigated by the increase in the size of portfolios.

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