The increase in the number and scope of CDO downgrades highlights the need for investors to understand how CDOs are evaluated in stressful environments. The purpose of this article is to describe Fitch Ratings' approach to evaluation of its ratings of CDOs in light of changing market conditions. The article will not address the reasons underlying the defaults and downgrades of corporates and sovereigns.
CDOs are primarily composed of high-yield and investment grade corporate bonds, loans and credit derivatives, with structured finance securities becoming a significant component in 2001 and 2002. With the exception of structured finance securities, all of these underlying assets suffered the highest default and downgrade rates in a decade in 2000 and 2001. Fallen Angels such as Enron and Railtrack have affected a large number of transactions. Higher default rates have created a glut of distressed securities driving down recovery rates across the spectrum of assets. The combination of high default rates, low recovery rates, and ratings migration of performing securities has created a substantial deterioration of par value and/or collateral credit quality in CDOs.
CDO Performance Analytics
For CDO monitoring purposes, Fitch Ratings has developed a proprietary, custom-designed Oracle database specifically dedicated to the surveillance of CDOs. The CDO Performance Analytics team tracks a number of historical portfolio level performance data points that pertain to its eligibility criteria and structural triggers. The database also tracks the amount outstanding and ratings of the liabilities/swap tranches, as well as compliance with overcollateralization ratios, interest coverage ratios, and other relevant structural triggers. The Performance Analytics Group also reviews the potential impact on any rated transactions of all Fitch Ratings ratings actions and any deterioration or improvement of the credit quality on any corporate names.
Rating Watch
When a troubled transaction or a transaction outperforming expectations has been identified Fitch Ratings conducts a review to determine whether the deal is performing poorly or outperforming enough to possibly warrant rating action. For potential downgrades Fitch Ratings focuses on those deals where there are multiple failures of tests and/or the amount of failure is material. The Rating Committee decides whether and which tranches to put on Rating Watch.
At the time a tranche is placed on Rating Watch, no decision has been made about whether to change its rating. The placement of the tranche on Rating Watch means that Fitch Ratings believes conditions have changed in a material way that might make the current rating inconsistent with the risk. Rating Watch is a signal that Fitch Ratings is immediately undertaking a full review of the CDO.
Understanding The Portfolio
For dynamic portfolios in situations where transaction triggers arrest substitution or ramp up is complete, Fitch Ratings is able to analyze the portfolio based on actual rather than implied collateral characteristics. As part of the review process Fitch Ratings updates the ratings of all assets within the portfolio including discussion with the relevant Fitch Ratings analyst for assets where the asset has migrated, defaulted or is currently on rating watch.
Distressed Assets
Recognizing that the market reacts quickly to adverse events, Fitch Ratings reviews assets in the portfolio that are trading significantly below par (this includes a review of credit-default swap spreads) or is otherwise deemed to be credit impaired. Particular attention is paid to structured finance securities whose definition of default may vary from standard corporate issues. Structured finance securities may not legally default for years after they have ceased to have economic value so this decline in value must be explicitly recognized in the cash flow model.
Defaulted Assets
Fitch Ratings analyzes expected recovery rates for the non-performing assets on a case-by-case basis with input from internal analysts specializing in the specific asset type, from the collateral manager and from discussions with market participants. The expected timing of the recovery is determined using Fitch Ratings criteria for cashflow transactions and in accordance with settlement procedures for synthetic deals. Where physical delivery is possible within synthetic transactions recovery timings will be significantly longer than for cash settled deals but may be offset by higher recovery levels for full workout.
Consistently Applied Criteria
Fitch Ratings goal in monitoring CDO ratings is to ensure that the CDO rating reflects the inherent risk and that those ratings are consistent with current criteria. For that reason, when re-evaluating any particular CDO, Fitch Ratings adheres as closely as possible to the published criteria for new CDO ratings. This means that the same stress runs in terms of timing and amount of defaults and recoveries, etc. are applied in the cash flow model runs when CDOs are re-evaluated. Effectively, the approach is the same as rating the deal again for the first time, given its current collateral portfolio, capital structure, hedging strategy, management and new time to maturity.
Large Obligor Concentration
Large obligor risk is magnified in CDOs that have either already experienced some performance problems, or highly levered transactions (such as CDOs that own or reference investment grade assets) where the actual percentage of credit enhancement protecting the rated notes against negative changes in the portfolio is smaller. Fitch Ratings's CDO criteria are designed to protect investment grade tranches from default due to event risk associated with individual names. This protection, provided through the Asset Concentration Matrix (also known as the Single Obligor Test), tests the ability of the structure to withstand the simultaneous default of the transaction's largest obligors at their current rating levels.
As a result of the default or significant downgrade of a particular name to which a CDO has a large exposure, the remaining credit enhancement could be materially less than was available previously. Therefore, negative rating volatility in investment grade/large obligor transactions this past year is a direct result of high degrees of leverage reflecting low historical defaults for highly rated assets, the unprecedented levels of investment grade defaults in 2001, credit downgrades of collateral and in certain circumstances, the severely depressed prices of those securities after default.
Ratings Committees
Each rating action made by Fitch Ratings is subject to a committee. A committee comprises senior members of Fitch Ratings's CDO team, members of the Performance Analytics team with up to date knowledge of deal performance and, where possible, analysts from various groups within Fitch Ratings with an in-depth understanding of the collateral assets. Each element of the review process is presented to the committee and discussed to the satisfaction of all members present. Where questions remain outstanding subsequent to a committee review, further analysis is performed and further committees convened. After a consensus has been reached the manager, trustee and banker are informed of the final decision and press releases go out.
Conclusion
The past two years have seen the highest level of credit deterioration in the high-yield corporate market in a decade and the highest level of credit deterioration in the investment grade corporate market ever. Since most cash flow arbitrage, balance sheet and synthetic CDOs are composed of assets drawn from these markets, and derive a large measure of their credit enhancement from par value subordination, the events of 2001 have led to widespread downgrades.
This week's Learning Curve was written by Andrew Jackson, director at Fitch Ratingsin London.
Review Process
The ratings review of a CDO by Fitch Ratings includes but is not limited to the following:
* Meeting with portfolio manager (where relevant)
* Full portfolio review
* Research on and analysis of distressed and defaulted assets
* Recalculating test compliance
* Recovery rates review
* Gross loss (actuarial and single obligor) modeling
* Cash flow modeling
* Ratings committee
* Publication of ratings decision
