Standard and Poor’s released a request for comment on a proposal to change its ratings methodology for fixed-rate conduit and fusion deals. The agency stated that it expected to downgrade 25%, 60% and 90% of super-senior 'AAA' bonds issued in 2005, 2006 and 2007, respectively.

JPMorgan Securities said that the propasals' impact on ratings has caught most investors off guard.

"We view S&P’s release as an extreme example of a pro-cyclical overreaction, one that may reinforce investors’ skepticism and could ultimately result in the effective disintermediation of the rating agencies from the investment process," JPMorgan analysts wrote in a special report released yesterday.

In the release, S&P is soliciting investor feedback to determine if its proposed subordination levels are satisfactory. Among other criteria, the authors explained their plan to anchor future conduit/fusion pools to a credit enhancement level of 20% at the 'AAA' rating level, with some exceptional quality and new-issue pools requiring half that level.

The agency, however, recently released a report in which it said that the majority of the 20% credit-enhanced 'AAA' classes (AM classes) are likely not at risk for downgrade, although some of these classes within what the worst performing 2007 vintage deals appeared to be potentially vulnerable over their 10-year lives.

"While some portions of the ratings process may clearly need to be subjective, this strikes us as too arbitrary and too much of a sudden departure from the company’s previous stance," JPMorgan analysts said. "Given the amount of subjectivity and latitude the rating agencies have when assigning and monitoring bond ratings, and the differences that currently exist among agencies for a given bond, it raises questions such as “what is a 'AAA' anyway, and is it really any better than a 'AA' rating?”

Meanwhile, Merrill Lynch analysts noted in a report that if S&P's new methodology is implemented it will likely prompt a significant number of downgrades in recently issued — 2005-2008 vintage — CMBS conduits.

This includes the super-senior classes of these transactions.Such downgrades, if they happen, places a considerable part of the CMBS universe in danger of no longer being TALF-eligible under the current Legacy program's guidelines.

The current triple-A rating on the senior bonds is a key determinant of value under the Legacy TALF guidelines. Considering the high percentage of deals S&P rates, and the firm's projection for heavy downgrades, this jeopardizes the effectiveness of Legacy TALF for CMBS, according to Merrill.

What happens from here is difficult to project, according to analysts, but there are a few possibilities. They think there is a good chance the Federal Reserve revisits their inclusion criteria for the TALF Legacy program. Merrill analysts think that S&P is very interested in industry participants' feedback on this proposal.

While it is impossible to say if S&P will make changes to their proposed criteria, institutions are encouraged to voice their opinion with the rating agency, Merrill analysts noted.

To give meaningful feedback, Merrill analysts would like to see more data on S&P's methodology and its implications, and not just forward looking but backward looking as well.

A question that Merrill analysts believe would be constructive to have answered is "what would the performance, the ratings and the rating migration of transactions that were brought over the past 10 years look under the new methodology?"

Meanwhile, a corollary to this question is: "What probability is S&P targeting, at each rating category, for a bond to default?"

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