Something pretty drastic would have to occur for a company’s credit rating to tumble from top-ranked AAA to junk in one move. Investors could find themselves reading about fraud, a hugely leveraged takeover or the discovery of a large and unexpected liability.
However, with some collateralised debt obligations – the pools of debt that are sliced up and resold to investors – such ratings collapses could be far from rare. This raises questions about whether ratings of CDOs are strictly comparable with those on corporate bonds.
The issue has been brought to the fore in recent months with the credit problems of the US auto industry and the knock-on effect on synthetic CDOs – those backed by pools of credit default swaps, a form of insurance against non-payment of debt.
Fitch warned this month that a senior tranche of one of Barclays Capital’s more esoteric CDOs could see its rating slashed from AAA to BB+ (a fall of 10 notches to the highest “junk” level) a few days after Dana followed its rival US car parts supplier Delphi into bankruptcy.
The Barclays deal, named Xelo III Series 2005 (Como II), was a form of CDO backed by other CDOs, known as a CDO². Experts say this kind of deal is often the most volatile because it has greater exposure to what is known as “cliff risk”.
Terri Duhon of B&B Structured Finance, an independent consultancy, says this describes how a CDO tranche can absorb a number of credit events, such as defaults and downgrades, and retain its level of subordination – or the size of the cushion that protects it from losses – until it reaches a point at which one further piece of bad news can push it over the edge.
“Several things can go wrong in a deal and it will still be triple-A,” she says. “But then you get one more event and boom!”
CDO² deals can suffer due to overlap in the underlying CDOs, with weaker names such as Dana or Delphi included a number of times over. This can multiply the effect of a default.
Ratings volatility in synthetic CDOs has surprised investors in the past and will do so in the future, but does it mean that applying such ratings is undesirable or even misleading for complex derivative instruments?
Ms Duhon says that ratings agencies are providing a comparable bottom line description of the expected loss of an investment at a given time, which is not the same as predicting its future behaviour.
When an AAA rating is given to a synthetic CDO tranche by Fitch or Standard & Poor’s – or an Aaa rating by Moody’s – it says the deal has a similar probability of default and similar levels of expected recovery as a corporate bond with the same rating. However, CDO ratings move down and up the scale more quickly and more often. Fitch, Moody’s and Standard & Poor’s, the three main ratings agencies, have been looking at the volatility problem, but none has found a solution to augment or change the current system that does not detract from its clarity.
There are moves under way to improve the transparency of the models used by the agencies in assessing ratings and their potential moves. Fitch on Monday published a report showing how its ratings model could assess the importance of factors that have a bearing on ratings stability.
Richard Gamble of Fitch says the agency will be looking for feedback from the market to see how banks and investors want to use the possibilities thrown up by the study, which could help to make transactions more stable in the future.
“The report discusses a number factors that have a part in stability, such as subordination and granularity [the number of instruments in the underlying portfolio], to give some insight into their effects and quantify their importance,” he says.
Moody’s last week released a product that investors can use to assess the performance of a CDO’s portfolio to help them see when Moody’s is likely to take action on a deal’s ratings.
Barclays Capital declined to comment on the Xelo deal, but Andrew Whittle, European head of credit derivatives, would discuss ratings volatility in general. He says the extra spread, or yield, investors receive on synthetic CDO tranches is not so much to compensate for a higher risk of losing money from within the tranche, but more for the ratings volatility.
“I think most investors are aware of that and know that they’re being paid for that volatility,” he says. “As a general rule of thumb, the higher the original spread for a given rating, the higher the likely volatility of that CDO tranche.”
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