UPDATE 2-Fitch plans CDO overhaul, sees 5-notch downgrades

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By Jane Baird

LONDON, Feb 5 (Reuters) - Fitch Ratings announced plans to toughen the way it rates $220 billion worth of corporate collateralised debt obligations (CDOs) following criticism that debt ratings played a role in creating the credit crisis.

Fitch said the change in methodology would probably hit synthetic CDOs the hardest, leading to an average downgrade of five notches for the $75 billion worth it rates. Synthetic CDOs are created from portfolios of credit derivatives, typically on investment-grade corporate borrowers.

These sharp ratings downgrades could force some investors to sell their CDO holdings, which could lead to declines in valuations and writedowns on investor portfolios.

European credit spreads widened sharply on Tuesday after the announcement.

Fitch's analysts said they aimed to ensure that its CDO ratings perform in a similar way to its company ratings, which have an established history and are well understood.

"Our philosophy is that we're trying to be extremely transparent. We are trying to explain to everybody exactly what our thinking processes have been," Philip McDuell, Fitch head of structured credit for Europe and Asia, said in an interview.

"There are no black boxes here. We've opened ourselves up, and we're actively looking for feedback on it," he added.

A CDO is a portfolio of debt divided into tranches, or slices, by degrees of risk.

The riskiest and highest-yielding tranche is exposed to the first few percent of default losses from any credit in the pool. After it has been wiped out, losses then move to the next tranche. The tranches at the top of the ladder are typically rated triple-A.

INVESTMENT GRADE VULNERABILITY

Fitch's announcement comes a day after rival Moody's Investors Service said it might change how it rates thousands of structured credit products.

Synthetic CDOs are based on portfolios of credit default swaps, which are bets on whether a company will default. Ratings of these CDOs, including many of their triple-A rated tranches, will be most affected by the new criteria, Fitch said.

Ken Gill, Fitch managing director for structured credit, gave two main reasons.