Standard & Poor's is reviewing its rating methodology for first-to-default baskets and may adopt a new system more in line with the other agencies. S&P currently uses a weakest-link approach to rating baskets and is examining changing this to reflect the diversity of portfolios, according to Nik Khakee, director in the structured finance group in New York. Within three weeks it will likely be decided whether, and how, to change its rating, he added.
Standard & Poor's methodology is seen by many market participants to be too lenient and could be abused to get a higher rating than deserved. A first-to-default basket is automatically awarded the lowest rating of the underlying names, for example a diversified first-to-default basket of five single A corporates will get a single A rating, even though the risk is more in line with a BBB or BBB minus rating, said Tony Morris, structured credit derivatives trader at UBS Warburg in London.
Officials speculated that S&P has not changed its methodology before because first-to-default baskets have traditionally been a small proportion of the structured finance market and it was likely making most of its money from CDOs. However, the volume of basket products has rocketed in the last year and this is now a mainstream area.
Mark Stainton, director in the integrated credit trading group at Deutsche Bank in London, said S&P changing its methodology will have an impact, but it will not be huge as investors examine the risk of the underlying names and spreads, rather than just the rating, when buying first-to-default baskets.