The announcement ends months of uncertainty for structured credit market participants after Moody’s revisions to its CLO methodology in February sparked widespread downgrades.
Following the update, S&P has put the public ratings of 4,790 CDO tranches totalling about $578bn on CreditWatch negative. It expects mass downgrades in both cash and synthetic structures hitting even the most senior triple-A rated tranches.
It expects to downgrade super senior triple-A rated tranches of synthetic CDOs by two to three notches on average and most senior triple-A rated tranches of cash CDOs by one to two notches. Synthetic CDOs will be downgraded by about four notches on average while cash CDO downgrades will average three notches.
The actions are not good news for banks and other big holders of senior CDO tranches although many are likely to have already taken write-downs on their CDOs following the Moody’s review. The lower of two ratings is used to calculate capital requirements.
The rating agency has updated its default model to ensure that triple-A rated debt can withstand default rates on a par with those seen in times of "extreme macroeconomic stress," such as the Great Depression, and triple-B rated debt can withstand the highest levels of defaults seen over the past 28 years.
It will introduce quantitative and qualitative tests such as stress tests, concentration limits and minimum equity levels. It will also introduce tiering of recoveries for synthetic CDOs and reduce the expected level of recoveries based on expected stress levels for CDO tranches.
Stability and sensitivity
It will also now consider credit stability and sensitivity as modelling parameters in its CDO analysis.
The new criteria will apply to cash and synthetic CDOs backed by corporate debt.
The rating agency believes the addition of the qualitative and quantitative tests represents its most important change.
It will now test CDO tranches on their ability to withstand the default of a certain number of the largest obligors with a 5% recovery. For example, a triple-A rated tranche must be able to withstand defaults of the two largest obligors rated between AAA and CCC-, the three largest obligors rated between AA+ and CCC-, the four largest obligators rated between A+ and CCC-, the six largest obligors rated between BBB+ and CCC-, the eight largest obligors rated between BB+ and CCC-, the 10 largest obligors rated between B+ and CCC- and the 12 largest rated between CCC and CCC-.
It also will require CDO tranches rated between AAA and AA- to satisfy tests on the default of all the assets they are exposed to in the largest concentrated industry in the asset pool with a recovery of 17%.
If these tranches fail that test, they may still be rated AA or AAA if they pass a second test on industry concentration risk. This works like the largest obligor test with tranches having to withstand combinations of defaults of underlying assets within each industry assuming a 5% recovery.
For a triple-A rated tranche these combinations run from the four largest obligors rated between AAA and CCC- to the 24 largest obligors rated between CCC+ and CCC-.
The largest industry test will not apply to CDOs of hybrid trust preferred securities.
S&P has increased the correlation assumptions in its CDO Evaluator default model with correlation parameters at 0.2 for two firms in the same industry and 0.075 for two firms in different industries. Assets in different industries and in different regions will be assumed to have a correlation of 0.05. It has also increased the correlation assumed between assets in certain industries.
It has reduced recovery assumptions on assets held in CDO pools — for a AAA rated tranche senior secured first lien loans will be assumed to have a recovery of between 17% and 50% depending on the asset’s country; a recovery of between 17% and 41% for senior secured covenant lite loans or secured bonds; between 10% and 18% for senior unsecured bonds, mezzanine, second lien or senior unsecured loans; and for subordinated loans or bonds between 5% and 10%.
S&P may modify some modelling assumptions or applied stresses for portfolios that have heightened sensitivity to changes in correlation, changes in recoveries and CDOs with lumpy or skewed portfolios.
For CDOs squared, S&P will apply the supplemental tests on the inner CDOs if more than 20% of the underlying exposures are corporate CDOs. If the CDO squared’s inner CDOs don’t withstand the supplemental tests, the outer CDO will not be rated higher than A+ unless it has sufficient credit support to absorb the losses not absorbed by the inner CDOs.
If less than 20% of the underlying exposures are corporate CDOs all the corporate CDOs are considered to be one industry and S&P will apply the supplemental tests.
It will assume zero recoveries for CDO tranches that don’t have controlling voting rights.