Standard & Poor's is changing the way it accounts for underlying defaults in collateralized debt obligations, in a move that could introduce some ratings volatility in outstanding CDOs, says Simon Collingridge, head of European surveillance and research in London. S&P now plans to take into account the defaults of underlying credits when they occur. Previously, S&P had not discounted an underlying credit until the collateral manager informed it of a credit event, and given they were not under any obligation to do so, collateral managers "could delay a week, they could delay a month or they could delay forever if they liked," according to Collingridge. The change applies to synthetic CDOs on a global basis, but mainly affects the European market where 75% of deals are synthetics, he says.
One analyst is concerned the change adds ratings volatility to CDOs, given the rating agency could downgrade a tranche based on an underlying default only to upgrade the tranche at a later date if the rating agency's recovery expectations are exceeded. Collingridge acknowledges this, but says it should only occur in rare cases. "That's more than offset by the greater clarity and transparency in this approach," he adds.