October 30, 2007 / 6:43 PM / 12 years ago

Fitch may tighten CDO rating methods

NEW YORK, Oct 30 (Reuters) - Fitch Ratings may revamp its entire methodology for rating collateralized debt obligations, including collateralized loan obligations, the ratings agency said on Tuesday, citing a previous failure to account for systemic risks.

The review comes a day after Fitch said it may lower ratings on $36.8 billion of subprime mortgage-related debt from collateralized debt obligations over the next few weeks. For details, see [ID:nN29401986].

The bulk of these securities now on watch for a downgrade, $23.9 billion, are top-rated “AAA” securities. Roughly $16 billion of these are from lower-quality subprime CDOs and CDOs linked to other CDOs, or so-called “CDO squareds.”

As part of the rating activity, Fitch is tightening some of its key assumptions in rating subprime CDOs, and will publish this new methodology next week.

“Especially at the triple-A level, the CDO criteria did not accurately consider the possibility of a broad systematic risk occurrence,” said John Schiavetta, head of structured credit at Fitch, during a conference call on Tuesday.

However, Fitch has also embarked on a broader review of its rating process for all CDOs, including collateralized loan obligations, which are backed by leveraged loans, and corporate synthetic CDOs, which are tied to derivatives on corporate bonds, Schiavetta said.

“We are reviewing our entire methodology,” he said.

Collateralized debt obligations are bonds backed by other types of debt products, such as subprime mortgage bonds, credit derivatives or junk bonds.

They’re sliced into different layers called “tranches” that carry varying levels of risk and reward, letting investors tailor their investments to their appetite for risk.

Over the last few years, the booming market for CDOs, especially those linked to subprime mortgages, has injected enormous amounts of capital into the U.S. mortgage market, helping even low-credit buyers into homes.

‘COV-LITE’ CONCERNS

Meanwhile, money managers selling another type of CDO, the collateralized loan obligation, or CLO, had emerged as a potent buyer of low-quality loans, providing easy money for the recent wave of private-equity-led buyouts.

“CLO performance has been strong, driven by low default rates in the underlying leveraged loans,” Schiavetta said on the call. “Having said that, there are concerns.”

Schiavetta pointed to the high prevalence of risky “cov-lite” loans, which lack investor safeguards, and the “overhang of loans on bank balance sheets” resulting from corporate buyout deals that were agreed upon this year, but have yet to find financing from debt investors.

Schiavetta did not offer a date for when the broader CDO rating method review would be completed.

Fitch, Standard & Poor’s and Moody’s are all slashing ratings on subprime mortgage-related debt securities and related CDOs to account for the deteriorating value of subprime loans, which have seen record defaults.

The rating industry is being scrutinized by federal regulators and has come under fire from U.S. lawmakers for failing to sufficiently highlight risks in financial securities linked to subprime mortgages.

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