NEW YORK - The controversial topic of "notching" ratings and investor bias in buying bonds rated by a particular agency has been debated among market participants in hushed tones for a long time, but last week, at the Commercial Mortgage Securities Association's Seventh Annual CMBS convention - at a session appropriately titled "CDOs: The Truth," - the thorny subject was finally tackled head-on.

Every rating agency puts restrictions on collateral not rated by itself, and often it will gauge its own rating by "notching" or adjusting the other agency's rating to estimate its own mark.

At the conference last week, analysts from Standard & Poor's and Fitch - a Moody's Investors Service representative was noticeably missing from the panel - as well as three other panelists discussed the "artificial arbitrage" that has been created in the market as a result of investors adhering to the requirement that any bond placed into a Moody's-rated CDO must be rated by Moody's.

Because of this, Moody's-rated paper has demanded a strong premium recently, especially for CMBS and ABS paper, the panelists said. Additionally, managers of multi-sector CDOs can arrange opportunistic trades if only S&P or Fitch has assessed the collateral, since those bonds will tend to trade cheaper. Overall, market sentiment is that this is a problem that needs to be addressed as soon as possible, since it is not healthy for the overall CDO market.

"On a recent floater, the certificates which had a Moody's rating first were golden," said a banker looking at a recent CMBS transaction. "Investors, especially European investors, prefer to see Moody's or S&P ratings."

However, other sources point out that those investors who "prefer" the Moody's paper are the managers of the CDOs themselves - so if they are asking Moody's to rate their deal, they have to live by the rating agency's demands.

"One rating agency wants the underlying assets definitively rated by them," said S&P's David Tesher, who was one of the panelists. "It will be to the benefit of the market that everybody gets to rate on a level playing field these liability structures."

According to panelist Jim Higgins of Bear Stearns, the whole notching process is fairly arbitrary and warrants more thoughtful and meaningful discussion from the constituencies involved. "The effects of this are not fully realized yet, but the current policies in place, in my opinion, are arbitrary and detrimental. Even outside of CDOs, this can affect the conduits, the loans, etc. It affects bonds upstream."

"As a result of this artificial arbitrage, spreads widen, and only Moody's bonds are going into CBOs," added John Malysa of Fitch, another panelist. "For this market to be a healthy market, this situation has to be rectified."

No analytical justification?

Moreover, Moody's has agreed to "notch" the ratings for S&P-rated CMBS bonds that bear no Moody's rating, but are not willing to do so for Fitch-rated paper. Market observers indicate that Moody's procedures are particularly stringent and considered conservative, and their bias has no analytical justification, many sources said.

"This is troubling to me in that it is really a game that Moody's is playing to get market share," said a large money manager who is irked by problem. "[Moody's] have very punitive notching if their securities aren't rated. Moreover, S&P is catching on and doing the same thing. I would have hoped they would have taken the higher ground. Moody's bonds do trade better - not because of the credit quality or because they understand the deal so well - it's just a game for fitting the bonds into the CBO buckets."

What is even more disturbing about this dilemma is that any banker thinking of issuing into a CDO must now first consider whether the bond is going to be rated by Moody's. "That is the first question that bankers ask for any sub deal," said Darius Grant, who is the head CDO structurer at Salomon Smith Barney. "In our view, this will have a significant impact on the way the sub market is traded...If you want to have agencies who rate down to the triple-B level, then you'd use Moody's or Fitch. If S&P rated the capital structure down to the triple-B level, then investors would have a choice, and they could buy S&P collateral. But there is a pricing differential right now; Moody's will trade at a tighter spread on subs."

To notch or not to notch

And Moody's sticks to its guns, regardless of the fact that for CDOs of structured product, Fitch has an exceptionally strong market share, rating 91% of such deals in 2001. "For CMBS, Fitch's ratings have proved to be as reliable as any of the others," said the money manager. "So what's going on is not justified in any way."

"Fitch requires a minimum percentage to be rated by Fitch, but will notch for the remaining portion from either or both of the other two agencies," said John Schiavetta, managing director at Fitch. "Moody's seems much less willing to do so...Analytically, Fitch can get comfortable with a certain percentage being non-Fitch rated. That is feasible from our point of view. Most investors will argue that that's feasible, and our ratings perform equally well if not better, particularly in the CMBS world."

But according to Moody's, analytics is indeed at the crux of its policies. "The easiest thing to do is to notch off of someone else, but we would not be accurate if we notched off of everything," said Isaac Efrat of Moody's CDO group. Noting that Moody's has notched off of Fitch RMBS ratings in the past, Efrat noted that for CMBS, "Analysis is inconclusive whether we can do it. That doesn't mean that in the future, what we are doing for RMBS can't be done for CMBS."

Efrat also noted that they do put aside a basket for notching for ordinary CDOs with corporate bonds, and their analysis to determine what the ratings would have been like justifies that level of notching. "For other asset classes it is too far away to make a rational determination. Each rating agency rates to different meanings."

More discussion needed

But despite the reasoning behind it, the reality is that investors simply must buy Moody's-rated paper for their CDO portfolios due to the rating agency's restrictions. But how about non-CDO portfolios? Some portfolio managers said that due to the technical bid caused by Moody's requirements, Fitch/S&P paper actually represents better value right now.

"If you're buying bonds..for their pure investment merits, there is often better relative value opportunities for non-Moody's rated paper, based on this artificial bid in the market, said Jeff Phlegar, a portfolio manager at Alliance Capital Management. "Moody's approach tends to be draconian compared to other rating agencies."

In the long run, do investors win or lose? On one hand, investors will now see more ratings on the deals.. On the other hand, why should a Moody's bond be at a tighter spread than a Fitch or S&P bond?

"The main way this could be addressed is if S&P looked closely at how they rate CDOs, and start rating down to the triple-B level," said SSB's Grant. "You'd see a righting in the supply-demand scenario...But we would welcome the agencies getting together to talk about this."

Ultimately, however, portfolio managers often have to go with the bond that fits in the buckets rather than the bonds they believe in. "A CBO investor is driven to buy ratings," said the money manager.

Market sources say that the brief discussion at the CMSA conference is just the tip of the iceberg: The agencies are going to have approach this situation rationally and address it effectively - before the sentiments which are harbored by the players involved send the CDO market too far out of whack.

"Investors now have the incentive to buy bonds with Moody's rating on it, and it has nothing to do with the risk-return profile on the bond. Moody's rates all the CDOs, and if you bring a bond into a CDO that does not have a Moody's rating, Moody's kills you on that bond." said a Street CDO banker. "It's borderline extortion."

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