S&P unveils new criteria for CDO collateral
In the midst of heightened market awareness regarding rating-agency notching policies (see ASR 6/18/01 and 6/25/01) Standard & Poor's has recently implemented new criteria for notching within CDOs, slated to be announced officially at IMN's German Securitization conference on Sept. 12 in Berlin. S&P also plans to unveil three brand new products to the CDO market, in addition to a new CLO performance index, which was announced to the public last week.
As a response to market inquiry regarding the transparency of rating-agency notching policies, Asset Securitization Report has compiled a general overview of each agency's guidelines for the notching of collateral in CDOs, ABCP and Structured Investment Vehicles (see chart on p. 9). While the agencies were able to provide general guidelines to ASR, detailed descriptions of specific notching procedures, broken down by each asset class, are not yet publicly available.
Arguably the most significant of S&P's recent revisions is the fact that the rating agency will now accept both Moody's Investors Service and Fitch ratings on equal footing for structured-product CDOs. Previously, S&P only notched off of Moody's.
"We have deemed that Fitch's track record for structured finance and their ratings are acceptable to us," said Richard Gugliada, managing director of CDOs, derivatives/SIVs and market-value products at S&P.
For corporate bonds going into CDOs, S&P has always allowed notching, though it continues to notch only Moody's-rated collateral, maintaining that Fitch does not have sufficient history for corporate-rating penetration. S&P accepts one notch for investment-grade and two notches for non-investment-grade.
For CDOs of ABS and MBS, S&P plans to present a detailed list of notching guidelines broken down into 25 asset classes, describing how many notches are taken off of ratings by its competitors. Generally, if only Fitch or Moody's appears on a security, S&P will subtract one additional notch beyond its "standard" notching guidelines, and will notch for up to 20% of the pool.
"The more rating agencies looking at it, the better; the transactions are likely better," Gugliada said.
Moody's Investors Service maintains that it has 95% market penetration for CDOs and 99% market share for ABS, so "notching is a small part of the CDO universe," says Noel Kirnon, group managing director at Moody's. Notching practices are very detailed and vary asset type by asset type, Kirnon said, and currently range from one to four notches. However, Moody's will take the lower of two ratings as a reference point, and will notch down "as appropriate."
Further, Moody's will notch off of S&P for single-rated CMBS and single-rated ABS going into CDOs; it will notch off of both S&P and Fitch for single-rated RMBS, which is "a more homogeneous asset class." There is a range of analytic and structural reasons for this, including the fact that Moody's uses an expected-loss methodology rather than relying on default frequency (see ASR 6/25/01).
However, the agency will not notch CDOs going into CDOs. "We have rated many CDOs of CDOs," Kirnon said. "As part of that, issuers and investment bankers ask us to do estimated ratings for non-Moody's-rated CDOs they want to put into CDOs. When we look at them, we see a wide divergence: for example, out of eight cases, there was one case where we were two notches apart, but some are five, six, seven, eight or nine notches apart."
Moody's, like the other agencies, also uses analyst estimates, model estimates (only available for corporates) and mapping exercises, though these are considered to be less precise than a rating.
Fitch's criteria for CDOs of structured product dictates that anywhere from half to two-thirds of a portfolio must have a Fitch rating; the agency, which has a CDO market share of between 70% and 80%, will take the lower of S&P or Moody's ratings, but notching only comes up if there is a single rating on this small percentage of non-Fitch-rated collateral. In this case, investment-grade securities get one notch, and non-investment-grade securities get two notches.
"The default rate for corporates has been 23 times higher than for structured," said Robert Grossman, chief credit officer at Fitch. "As a consequence, lowering by a notch is actually quite conservative. The default rate on the entire market is less than a basis point a year."
Notching for ABCP/SIVs
For the notching of ABCP and SIVs, the situation is a bit different. Unlike CDOs, CP conduits do not have the benefit of recoveries and there is no cross-collateralization, excess spread or collection of receivables. "In a CDO, if another rating is wrong it wouldn't cause a default on S&P-rated CDOs," said Thomas Fritz, managing director of ABCP and synthetics at S&P. "But in CP, credit tolerances are tighter. If another rating is wrong, it will cause a default. So we are sticking with our existing criteria."
According to Fritz, S&P limits non-S&P-rated collateral for conduits to 10% of the pool, and notches off of U.S. corporates only, giving one notch at the investment-grade.
The S&P rating is for timeliness of principal, whereas a Moody's rating is for ultimate recovery, Fritz noted. Therefore, even if collateral is notched, it could be difficult for the timeliness element to be there. "This policy is related to our discomfort with the fact that [a security] might not have enough credit enhancement to tolerate another agency's default," Fritz added.
While S&P only notches off of U.S. corporates for ABCP, both Fitch and Moody's also notch off of asset-backeds. In fact, Fitch's Grossman points out that structured ratings have actually been much more stable than corporates. Both Moody's and Fitch were intrigued by this aspect of S&P's ABCP notching methodology.
Additionally, some CDOs have been set up with a related single-seller CP program; for these programs, the same CDO notching policies apply.
As for Fitch, the agency notes that when a security is downgraded, there is an increase in credit enhancement to offset that risk. If it is downgraded below BBB', for instance, it is taken out of the pool or wrapped. If a manager does not do this, it is considered a stop-issuance' event and the program unwinds in 270 days.
"Therefore, the main risk from a credit perspective is whether a security goes from AA' to D' in 270 days," said Fitch's Grossman.
According to Moody's Sam Pilcer, most of the securities purchased by CP programs are rated by Moody's. "Arbitrage conduits do nothing but purchase rated securities," Pilcer said. "Most of these are going to be senior tranches, highly rated tranches of ABS transactions. Almost all the securities purchased by these programs are rated by Moody's."
For SIVs, Moody's has accepted requests for a small bucket of non-Moody's-rated assets of up to 5%.
Fitch's Grossman pointed out that unlike CDOs, CP and SIVs are large - usually more than $1 billion - and consist of diversified, highly rated assets, and SIVs have very dynamic structures with liquid securities. Fitch accepts the lower of an S&P or Moody's rating. "But the risk is deminimus," Grossman says. "Operational risk, hedging risk and liquidity risk are more significant."
In fact, S&P does not notch at all for SIVs. " There is no concept of notching," said S&P's Gugliada. "SIVs are different creatures than other types of transactions, and are rated based on their ability to liquidate the collateral in their portfolio."
Because of this, S&P demands that 95% of SIV collateral must be S&P-rated. The other 5% has to meet other high quality tests, but S&P still does not notch.