Standard & Poor's debuts its much-ballyhooed new benchmark this week, after a year in pre-production. While other new performance metrics have also been created, market rumors singled out the ROC as replacing the S&P rating for CDOs.
The team behind S&P's new "ROC Reports" aimed to set the record straight as ASR got a first peek at the agency's first "ROC Report", a new S&P monthly publication.
ROC, short for "rated O/C" or "rated over collateralization" is a benchmark that scores individual tranches in recently issued and previously issued CDOs. Scores will be updated each month in the ROC Report and will be made available at no cost on the rating agency's Web site.
"This is a mature market that is clearly facing challenge - performance challenges, increasing liquidity challenges - and this is another tool that S&P is providing to the marketplace," said David Tesher, managing director at S&P. Debuting the scores to the investing public is an extension of the rating agency's initiatives set back in September 2001, which included increased transparency in the marketplace and better reaction time to CDO market conditions, Tesher said.
Beyond measures that focus on the portfolio, the ROC score "is also concerned with how well a tranche is supported by a pool of assets," said Sten Bergman, a managing director in S&P's CDO group. "It's similar to O/C, but that's just principal over collateralization and O/C tests only look at par," he said. The ROC benchmark factors in O/C while also taking other criteria into account, such as weighted average coupon, for example.
Expressed in percentages, ROC is weighed at 100. The score indicates how much of the tranche's collateral can be supported at the ratings level. A tranche with a ROC of 100% or more is a sign that it may have enough cash flow to support the tranche; conversely those below 100% may not.
"(When you) take into account the rating implied by the ROC you have to wonder why that isn't the real rating of the CDO," said another CDO market source.
"A hypothetical tranche with a ROC of 109% can have 9% eroded and, in an idealized waterfall, you still have a situation where the rating won't get impaired," said Bergman.
As a monthly benchmark, "it is an ongoing and continued measure of the amount of effective support that a CDO tranche enjoys," said S&P's analyst Yuri Chumak. ROC reflects not just the changes in the ratings of the overall portfolio, but the collateral manager's actions over time, he explained. The ROC is a forward-looking benchmark, and provides red flags for tranches in danger of downgrades, or conversely, upgrades. "It provides an answer as to why a particular tranche was downgraded because you can see the erosion over time," Chumak said.
Over the last six months, S&P analysts have tested and applied ROC internally to deals new and old. Releasing these results this week, S&P aims to demonstrate that ROC score accentuates a bond rating and does not replace it.
One hundred CDO transactions have been modeled to ROC, comprising 258 tranches to date. A bond deal from the 1996 vintage is the earliest CDO scored, and ROC scoring extends up to 2002 bond deals. Currently, of those 258 tranches, 61 have ROCs below 100% and 57 of these are on watch for downgrade; 197 of those tranches have ROCs equal to or greater than 100% and none of those are on S&P's watch list for upgrades.
Only four CDO tranches have ROCs below 100% but are not on watch for downgrade, perhaps best illustrating the differences between this new benchmark and S&P's traditional rating.
"The ROC does not replace the numerous stress tests that go into a credit rating," said Stephen Anderberg, associate director and head of S&P's cash flow CDO surveillance group. "What it boils down to is that it is unusual to see a tranche with a ROC below 100% that's not primed for a downgrade - but a tranche with a ROC above 100% may still, in some cases, be downgraded," he said. Eleven tranches with ROCs above 100% have ratings on CreditWatch Negative. "We don't rate to O/C tests, nor do we rate to ROC. Hopefully this will be used to demystify our surveillance process, as it provides significant transparency," said Anderberg.
The ROC can also provide a clearer snapshot as to what collateral managers are up to. While a bevy of conferences this year provided stories of seedy CM activity - par building trades for example - the more mundane reality for CMs is managing the many constituents built into a CDO.
"No one is looking to be a one-time manager. That said a manager can manipulate an O/C test," said Tesher. "A monthly ROC gives investors an additional tool which they can use to help them drill down to the trading patterns and scrutinize what managers are doing."
S&P's ROC Report is not the first new benchmark to enter the marketplace, and will have to muscle in against products already in use from Moody's Investors Service and Fitch Ratings.
"It is a pretty cleaver, sophisticated measure," remarked one CDO analyst who declined to be named. "However, it's S&P playing catch-up and how investors judge it remains to be seen."
Rival agency Moody's rolled out "Moody's Deal Scores" on March 4. These CDO-specific reports measure and compare Moody's rating performance on the deal and manager level using four parameters for each rated transaction including: average annual loss/gain of O/C and adjusted calculation of the annual average loss/gain of O/C.
"They are an independent objective criteria by which the market can measure an individual deal's performance," said Lisa Tibbitts, assistant vice president/communications strategist for Moody's.
And fellow rival Fitch actually launched the first new tool for CDO market last fall, dubbed "CDO Asset Manager Ratings." According to Fitch's Christopher Costello, director, operational risk group, this new standardized scorecard methodology measures collateral managers across nine different categories, including portfolio performance and credit underwriting. "The asset manager plays a strong role in deter the performance of CDO transaction. Fitch launched its CDO Asset Manager Ratings in response to investor requests for a more transparent and quantitative measure of asset manager's capabilities " Costello said.
Of course, rating agencies can churn out as many analytical products as they want. Ultimately it's how, or if, the market actually utilizes them.
"What will be interesting is how this affects secondary trading," said one structured finance professional. "More information is always good.
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