Fitch Ratings released its criteria for its structured finance loss severity (LS) rating scale last week. The rating agency said that the new scale was established to complement the existing Long-Term Credit (LTC) ratings for these securities.
"It's important to point out that the long-term credit ratings speak to the probability that a bond will default," said Glenn Costello, managing director and chief portfolio risk officer for U.S. structured finance at Fitch. "But it doesn't address the risk of major losses on that particular bond, assuming it has defaulted."
Costello also noted that there are some structural features that have appeared in structured transactions over the course of the last few years that have a direct bearing on loss severity.
One of these is the introduction of super senior classes. In a given deal, for example, some triple-A classes might experience a greater or lesser loss depending on the percentage that these tranches make up on a deal, arithmetically speaking.
As a Fitch report said, the LS ratings will be especially useful in examining thin deal tranches, particularly when there might be "hypertranching" of a capital structure or when there is a comparatively thin "support senior" triple-A tranche underneath a much thicker "super senior" triple-A portion.
"There has been a large degree of tranching that occurred among subordinate classes in deals in the various asset classes - there has been a significant amount of classes carrying a plus and minus rating in each category that were placed," Costello said. "As the credit asset classes increase, specifically in CDOs and RMBS deals, investors think it's valuable to know the loss severity, as these tranches could lose their principal balance given the high loss rates."
An important component of the loss severity scale, according to Costello, is that it applies calculations that take into consideration the size of the tranche or the tranche thickness. The size is taken against the base case expected loss that was determined for the asset portfolio that underlies a given structured finance deal, according to a report from Fitch.
Costello said that it is important to distinguish between Fitch's loss severity scale and the recovery ratings on distressed bonds. The new loss severity ratings, said the Fitch report, will only be assigned to structured finance securities where default is possible, but not to bonds that are considered distressed.
"The LS ratings Fitch assigns when a deal is initially rated and when the bonds are performing," Costello said, adding that the rating agency's recovery ratings scale represents its best estimate of the absolute recovery on the affected securities. "A security might have a poor loss severity rating, but the underlying bond might show the potential to recover most of its principal," he clarified.
The first asset classes to carry the LS ratings are all Dutch RMBS deals. According to Fitch, the ratings will be gradually applied by different regions and asset types over the course of 2009. "We review our credit rating for deals at least once in a year, so a year from now, all bonds should have an LS rating applied to them," Costello said.
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