The world has changed. Traditional approaches used to set the level of program wide credit enhancement (PWCE) for ABCP programs fall short of quantifying the true default risk associated with such portfolios. These approaches such as the fixed percentage approach for multiseller ABCP programs or the obligor or security coverage approach for securities-backed programs, do not take into account many important portfolio characteristics that affect the portfolio default risk. Specifically, they do not fully account for the subtle portfolio characteristics such as asset type, correlaton, and rating distribution among other factors when determining the PWCE level. To address these factors, Fitch employs a VECTOR CP analysis for the securities backed and multi-seller ABCP programs it rates on a monthly basis and when evaluating new transactions to be included in the program to determine the default risk for a given ABCP portfolio.
When Fitch reviews a transaction being funded in a conduit, less focus is given to whether or not the individual transaction is "commensurate" with the rating of CP. Analyzing CP risk based on the merits of the individual transaction on a standalone basis does not fully account for the true risk. On the one end, even if each additional transaction is structured to be commensurate with the CP rating, first to default risk increases as more assets are combined into a portfolio, and the credit risk of the portfolio may not be commensurate with the CP rating. On the other end, even if a transaction is not structured to a credit quality commensurate with the CP rating, the level of PWCE may be sufficient to support the CP rating when the whole portfolio is analyzed. Because VECTOR CP is able to quantify the risk at the portfolio level, Fitch determines standalone ratings for each individual security or transaction and incorporates them into the simulation. The simulation results determine whether the ABCP rating can be confirmed or not.
Correlation is a key factor that affects the benefits of diversification and default risk of a portfolio. With a low correlation, default of one asset will less likely lead to a default of other assets, so there will be lower portfolio loss volatility and less likelihood of extreme loss on the right tail of the portfolio loss distribution. However, lower correlation will result in a greater probability of at least one asset defaulting. With a higher correlation, on the other hand, there is a greater chance of higher loss severity, but it is more likely that none of the assets will default. Whether high or low correlation is a desirable characteristic depends on the structure of the program. For example, low correlation is desirable for CP investors of ABCP programs equipped with PWCE like a typical multiseller program, because lower loss volatility increases the likelihood that the losses, if any, do not exceed the PWCE. Conversely, for PWCE provider (ingnoring any possible FIN 46 subordinate notes) or programs that do not have any PWCE, as with most securities-backed programs, high correlation level can be beneficial because the first to default probability is lower.
Correlation distribution is another important factor in determining the portfolio default risk. Not only does VECTOR CP account for correlation, it estimates correlation for each asset pair and runs simulation accounting for the correlation level of each asset pair. This is significant because, even if two portfolios have the same portfolio correlation level, the effect of correlation on portfolio credit risk could be quite different due to different portfolio correlation distributions.
Similar to correlation distribution, rating distribution also has a significant impact on portfolio default risk. Riskiness of an asset portfolio is strongly influenced by the rating distribution of the assets, more so than by the weighted average rating (WAR). For example, two portfolios may have the same WAR, but if one has a barbell distribution with higher exposure to lower rated assets while the other portfolio is more concentrated around the mean, the portfolio with the barbell distribution would result in higher VECTOR CP outputs. Fitch views a WAR to be an inadequate measure of portfolio risk.
Fitch believes VECTOR CP provides numerous benefits to end users including investors, issuers, originators and other market participants. Unlike other outdated methodologies, Fitch's analytical model provides an easy to use quantitative tool to measure credit support. Given the popular demand of the original VECTOR CP, Fitch expects to introduce the next generation of this widely used model - VECTOR CP 3.0 - in the next week. The new version contains many features and applications specifically tailored to the intricacies of ABCP conduits. It also features a user friendly interface that minimizes the number of inputs needed to calculate appropriate PWCE. End users simply use information commonly found in monthly servicer reports and with a few clicks, VECTOR CP does the rest.
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