Fitch Ratings last week released for comment new interest rates stress criteria for structured finance transactions involving USD Libor. The key difference between the proposed methodology and the way Fitch currently applies interest rate stress criteria to ratings is a switch from historical data to the use of forward-looking swap market data - an information source widely employed across the structured finance market.
Subprime ABS and CDO transactions have the greatest possibility of feeling an impact from the move, but , according to Fitch managing director Ahmet Kocagil, head of the rating agency's quantitative financial research group, "the change is actually fairly moderate."
Investors have a 30-day window in which to provide comments to the rating agency prior to the new methodology's implementation; in the absence of "substantial comments," Fitch will implement the new guidelines after a 15- day time period. The criteria will not be used for deals that were initially rated using Fitch's current criteria. So far, investor inquiries have centered on technical details of the model, he said.
"Quite frankly the reaction was surprisingly extremely positive," Kocagil said. Using forward-looking market data for the model is similar or the same to models used in much of the market, he said.
Fitch's new model will use USD Libor swap prices in order to determine the term structure of interest rates, and it will predict rate volatility based on the pricing of swaptions. The rating agency will then map out potential rate paths based on the information, and then apply rising and falling interest rate stress scenarios accordingly.
The rating agency will also apply falling rate scenarios in order to capture the risk associated with accidental over-hedging of a portfolio of securities using derivatives. The use of both raising and falling rate scenarios - along with the new rate stress model - will limit arbitrage opportunities in Fitch-rated transactions, Kocagil said. For example, Fitch's current model could indicate that a home equity ABS deal using swaps to cover losses has more excess spread under a stressful interest rate scenario than a more moderate scenario.
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