fitch global rating cdo criterias

8/8/2019 Fitch Global Rating CDO Criterias

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Structured Finance

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CDOs

GlobalCriteria Report

Global Rating Criteria forCollateralised Debt Obligationswith Emerging Market Exposure Summary This criteria report details Fitch Ratings methodology for analysing the credit riskof portfolios of corporate debt with limited diverse emerging market (EM) exposure.This criteria report applies to cashflow and synthetic CDOs with less than 50%exposure to EM assets. Fitchs approach towards portfolios that contain highershares of debt linked to EMs will deviate materially and these criteria will not apply.The quantitative aspect of the methodology for EM CDOs is similar to (and shouldtherefore be read in conjunction with) the Global Rating Criteria for CorporateCDOs, published on 30 April 2008.

The correlation structure of the EM CDO Portfolio Credit Model (PCM) was built toreflect the following credit views:

l EM corporate assets are considered to be more correlated than corporateassets from advanced economies, regardless of region and country. Therefore,the criteria apply a 10% uplift to the correlation of any two EM assets.

l Regional correlation is particularly important within EMs and, as a result, EMassets from the same region are subject to an additional 10% correlation uplift.Fitch has created four broad EM regions to implement this: EM Americas, EMAsia, EM Europe & Central Asia and EM Africa & Middle East. The EMframework described in this report is designed to distinguish betweenportfolios with significant geographical diversity and those distributed amonga small number of EM countries.

l Within EMs, there is a diverse range of countries both in terms of sovereignrating and geography. While EM assets represent additional risks to theportfolio, Fitchs view is that the higher the Sovereign Rating the lower therisks. Thus, the treatment of assets from A rated EM countries is different tothat of assets from B rated countries.

l In addition to the risks posed by the nature of EM assets, the portfolio will beexposed to the same sector and industry risk concentrations as portfolios ofdebt from advanced economies. Therefore, the same correlation addons areused for sector and industry concentrations.

Fitch believes that a small amount of EM exposure in a welldiversified portfolio ofdebt from advanced economies should add geographical diversity and reduce therating default rate. However, it is the agencys view that large EM exposuresincrease the risk to the portfolio, especially in high rating scenarios, and thisoutweighs any diversity benefits.

The diverse nature of the risks contained within CDOs with EM exposure means EMCDO transactions are likely to require additional analysis outside of a quantitativemodel. This is especially the case for portfolios with large exposures to EM assets.As a result, Fitch applies scenario overlays designed to protect holders of the higher

rated securities against the default of all assets within individual countries. Fitchmay also apply additional cash flow stresses, such as increasing the time betweendefaults and receiving any recovery proceeds.

AnalystsStructured Credit Olivier Vincens+44 20 7417 [email protected]

David Wong

+852 2263 [email protected]

Jeremy Carter+44 20 7682 [email protected]

Jackie Lee+886 2 8175 [email protected]

April Chen+886 2 8175 [email protected]

ContactsHong Kong Rachel Stringer+852 2263 [email protected]

Moscow Michael Hoelter+7 495 956 [email protected]

New York John Olert+1 212 908 [email protected]

Chicago Gregory Kabance+1 312 368 [email protected]

Related Research Global Rating Criteria for Corporate CDOs,

(April 2008) Global Criteria for Cash Flow Analysis in

Corporate CDOs, (April 2008)

The criteria described in this report can beapplied through the use of the Fitch PortfolioCredit Model (PCM). To use input dataconsistent with the criteria, the model can beused in conjunction with the Reference EntityFeed (REF). Both the Fitch PCM and the REFare freely available on the Fitch Ratings

website.
http://creditdesk/reports/report_frame.cfm?rpt_id=384564http://creditdesk/reports/report_frame.cfm?rpt_id=384542


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Analytical ApproachThe analytical approach is based on Fitchs criteria for advanced economycorporate debt, ie the Global Rating Criteria for Corporate CDOs. The mostsignificant difference is that the agency considers risks associated with thegeographical location of an entity to be of greater significance for assets from EMsthan for assets from advanced economies. As a result, Fitch has introduced anadditional step to the rating process that is designed to cover country risks.Sovereign interference could include interference in private contractualagreements up to expropriation initiated by local authorities reacting to economicpressure. These actions may result in economic restrictions, including forcedredenomination, interest rate caps or transfer and convertibility restrictions, beingimposed. To take these aspects into account, Fitch applies scenario overlaysdesigned to protect holders of the higher rated securities against the loss of allassets within individual countries.

Definition of Emerging MarketsFor the purposes of this criteria report only, the list of developed countries is basedon the list of Advanced Economies by the International Monetary Fund (IMF) (see

Appendix 1 ). The majority of these countries have Sovereign Ratings of AA orabove, with five being in the A rating category. Any country outside this list wouldbe defined as an EM country.

Corporate CDO Ratings Methodology Fitch published its updated Global Rating Criteria for Corporate CDOs in April2008 and many of the risks addressed in that criteria report are also relevant forCDOs with exposure to EM assets. The primary inputs to the quantitative componentof Fitchs rating methodology are default probabilities, recovery rates and

correlation.The default probabilities are based on data dating back to 1977 and have beenbased on information available from all three major rating agencies in order to usethe broadest set of default statistics available. Appendix 2 has an abbreviatedversion of the full default statistics table that is published in the PCM and availablefor download and installation at Fitchs website.

Obligor concentration and negative rating migration caused by adverse selectionare two of the credit risks that Fitch highlighted in its global corporate CDO criteriareport. These risks are equally applicable to CDOs with EM exposure. Appendices 3and 4 provide a summary of Fitchs methodology for analysing these risks.

Step 1 - EM Correlation Framework Using Correlation to Reflect Credit Views Correlation is difficult to measure on an empirical basis. This is also the case for EMassets due to the relative scarcity of historical default data from emergingcountries. Therefore, Fitch has used correlation as a calibration tool to achieve PCMoutputs that express the agencys credit views. Fitch has introduced a countrydefault coverage matrix outside of the simulationbased PCM to capture extremecases in which all of the assets within a country default.

Fitch applies a higher correlation between EM corporate debt obligations thanbetween corporate debt obligations from advanced economies. This view ismotivated to produce higher rating default rates for portfolios diversified among EMcountries than portfolios diversified among advanced economies. The assumption issupported by the weaker macroeconomic, political and legal stability of EMs.


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Global Rating Criteria for Collateralised Debt Obligations with Emerging Market ExposureMarch 2009 4

economies, with the highest rating default rates generated from the diversified EMportfolio.

14161820222426

0 5 10 15 20 25 30 35 40 45 50

Proportion of assets added in the portfolio (%)

Developed assets countries added Assets in one developed country

EM assets added in the same regionRDR (%)

Country Diversification Impact on theRDR

Source: Fitch Ratings

Fitch also distinguishes between the correlation of EM assets from countries in thesame region and the correlation of assets from countries in different EM regions.The chart below shows the rating default rate for two portfolios of assets of thesame credit quality. The AAA default rate for the portfolio that has 50% exposureto a multiregion EM pool is 21.75% whereas the portfolio that has 50% exposure toa single EM region is 24%.

16

18

20

22

24

26

0 5 10 15 20 25 30 35 40 45 50

Proportion of EM assets added in the portfolio (%)

EM assets added in the same region EM assets added in diversified regionRDR (%)

EM Regional Effect on An Initial Portfolio from a Developed Country BBB asset Portfolio

Source: Fitch Ratings

Industry Concentration EM portfolios may comprise assets concentrated in a few sectors and industries. Insome cases, the correlation framework in the PCM may not be deemed sufficient tocover the systemic risk in one particular industry. Since the risks in question arelikely to be portfoliospecific, Fitch will identify areas of systemic risk andimplement stress scenarios through a committee process on a casebycase basis.One possible stress scenario would be to aggregate all the assets from the sameindustry to create one large asset. This would have the same effect as increasingcorrelation to 100% for these assets.

Maximum SingleCountry Exposure Fitch recognises the limitations of sole reliance on quantitative analysis, especiallywhen portfolio concentration rises above certain levels. Whilst concentratedexposure to any single EM country warrants additional scrutiny, at the same timeFitch acknowledges the differences in the relative credit strength of an A ratedsovereign, compared with a B rated sovereign, and its qualitative approachreflects this distinction. By means of guidelines, when analysing a portfolio, Fitchwill apply additional stresses if the portfolio contains single country exposures toEM countries that are above the exposure ceilings detailed in the table below. Theceiling level for each country is linked to the local currency ratings of its sovereign.


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As an example, if a portfolio presented to Fitch for analysis contains exposures of8% to one BBB rated country, the agency may aggregate some of the assets toincrease the correlation to 100%.

The single country exposure ceiling is linked to the sovereigns local currency ratingbecause this is perceived as the best indicator of the relative ability of a sovereignto withstand severe stress scenarios. These country ratings, in conjunction with theCountry Coverage matrix, are designed to address the risk that the default of asovereign could be a catalyst for the default of all the assets within that country.The correlation framework was calibrated for a diverse portfolio and the singlecountry exposure ceilings were set so that the rating default rate generated by thePCM would cover the default of all the assets within a set number of countries. Thenumber of countries defaulting that a rated note would be expected to withstandcan be seen in the table titled Minimum Country Default Coverage Test on page 6.The country default coverage should increase for lowrated sovereigns, thereforethe exposure ceiling per country decreases with the rating of the sovereign. In

addition, rating caps would be imposed on CDO portfolios with exceptionally highconcentrations to single countries.

Maximum Exposure per Single Country

Sovereign Local Currency Rating Maximum Exposure per CountryA 8% BBB 5% BB 3% B 3%Source: Fitch

Step 2 - Minimum Country Default Coverageand Country ConcentrationCountry Concentration Fitchs standard criteria rely on some minimum level of diversification in thetransaction. Excessive concentrations will be subject to additional scrutiny.

As part of its qualitative analysis, Fitch will use a country default coverage test toassess the impact on a transaction should the EM countries with the largestexposures no longer contribute to the future cash flow. Although the obligorconcentration uplift (OCU) is still applied to individual assets in the PCM, thecountry coverage test captures the risk of the sovereign intervening with privateagreements. Such action may range from forced redenomination to protect a

certain debtor client, to halting all cash flows supposed to leave the country. It alsoincludes politically motivated interference. Fitch recognises that these events areidiosyncratic in nature and cannot be built into a default distribution using thecorrelation framework applied in PCM. The agency therefore employs aconcentration test that uses the Country Ceiling of the sovereign. This level isconsistently used to measure the likelihood of transfer and convertibilityrestrictions to be enacted and can also be employed as a measure of the willingnessof the sovereign to interfere with private arrangements.

The test will compare the PCM model derived RDRs with the aggregate exposure ofthe relevant number of EM countries as prescribed by the Country Default CoverageMatrix (see table below). The matrix shows the minimum number of countries (andall the assets within those countries) whose default the transaction should be able

to withstand at a particular rating stress. This test will have more impact on smallportfolios, whereas the PCM simulation process will normally apply higher defaultsfor large portfolios. There is a considerable increase in the minimum defaultcoverage levels associated with AAA loss rates to reflect the likely increase in


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systemic defaults in AAA scenarios. For example, for a transaction to be ratedAAA it should be able to withstand the default of three of the largest EM countriesin its portfolio rated A or below, or five of the largest EM countries rated BBB or

below. In other words, the respective RDRs should be at least equal to the sum ofthe exposures to the relevant number of EM countries. The results are thencompared to the model output and the higher default rate at each rating stress willlikely be adopted by the rating committee.

The activity of obligors within the respective country and the nature of the debt tobe included in the portfolio can play a significant role in the assessment of thecountry risk. Further, intervention mechanisms are often closely linked to theeconomic fundamentals of a country. As an example, the budget of countries thatrely to a heavy degree on the export of crude resources may support and try toensure debt payments of companies that exploit and export these assets to protectthe ongoing operations of the entity. At the same time, they may interfere withother cash flows to prevent them from leaving the country. Additionally, politicalinstability can weigh heavily on such industries.

These additional stresses reduce the risk of over -reliance on model assumptions andtest the ability of a rating to withstand different scenarios. These stresses willdepend upon the specific portfolio characteristics, but are likely to include countrywide default and migration scenarios, and may be supplemented with caps on theratings below AA and AAA. Wherever such stresses are applied, they will becommunicated in the rationale for the individual rating.

Recovery RatesFitch updated its recovery rate assumptions with the publication of its GlobalRating Criteria for Corporate CDOs in April 2008 and these assumptions apply to

EMs as well as advanced economies. Recovery rate expectations are based on thejurisdiction of the asset, the type of debt instrument and the rating stress.

The corporate CDO recovery framework recognises the procyclical nature ofdefaults and recoveries, with lower recoveries expected to occur during periods ofhigher defaults. As such, the assumed asset recovery rate is reduced when assigningCDO ratings in the AAA, AA and A categories. The AAA recovery rateassumption is 80% of the base recovery rate assumption used for CDO ratings ofBBB and below. The AA and A recovery rate assumptions are 85% and 95%,respectively, of the base assumption.

The debt type is also critical in determining recovery rate expectations. Fitchdistinguishes between four different debt types. They are senior secured; seniorunsecured; second lien/junior secured; and subordinated debt. The table belowshows the recovery rate assumptions for each category.

Minimum Country Default Coverage TestRating Stress

Country Ceiling AAA AA A BBB BBAA 1 0 0 0 0 A 3 2 0 0 0 BBB 5 3 2 0 0 BB+ 8 5 4 2 0 BB 10 6 5 3 0 BB 12 7 6 4 1 B+ 14 8 7 5 2 B 16 9 8 6 4 B 17 10 9 7 5 CCC 18 12 10 9 7Source: Fitch


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Recovery Rates Country Groupings Fitch examined creditor friendliness and insolvency regimes across countries todetermine recovery rate expectations for corporate obligors from different

jurisdictions. This research determined countries into four broad groups based oncomparable levels of expected recoveries.

Obligors from Group A countries are expected to exhibit recovery prospectsconsistent with those for US obligors, while Group B, C and D obligors are expectedto exhibit decreasing levels of recovery. Currently, the majority of EM countriesbelong to either Group C (eg Bulgaria, Malaysia, Mexico and Morocco) or Group D(eg China, Brazil, Russia and Turkey). For more information on this research, seethe report entitled CountrySpecific Treatment of Recovery Ratings Revised ,dated 21 August 2006. A full list of Fitchs recovery rate country groupings can befound in Appendix 5 .

Base Corporate Recovery Rate Assumptions

Recovery Rates (%) SovereignSenior

secured

Mezz,Secondlien,

Jr securedSenior

unsecured Subordinate Group A Jurisdictions that generallysupport the priority of claims onbankruptcy and display other featuresthat are deemed to be creditorfriendly, including generally reliableenforceability

30 70 25 a 40 25

Group B Jurisdictions whereinsolvency and bankruptcy proceduresplace less emphasis on the priority of claims, and display other features thatare deemed to be generally moredebtorfriendly

30 50 5 35 15

Group C Jurisdictions where theletter of the law is balanced againstgovernance indicators, suggesting thatenforceability of claims may bevariable, for example, whereenforceability has yet to develop ademonstrable track record

3040

5 35 10

Group D Jurisdictions where the lawis not supportive of creditor rights,and/or where significant volatility inthe application of law and legalenforceability of any claim materiallylimits the practical chances of recovery, or greatly increases thevolatility of recovery prospects

30 30 5 25 10

a Fitch studies of European mezzanine debt indicate that recovery prospects may be lower than 25%. The standard

recovery rate assumption may therefore be reduced for mezzanine debt from European countries in Group ASource: Fitch

CDO Performance AnalyticsMonitoring the performance of a CDO is critical for maintaining the ratings on atransaction over its life. The outstanding ratings on the CDOs are formally reviewed,on average, annually, but may be reviewed more frequently, as warranted byevents, to maintain the timeliness of such ratings. Fitch, therefore, expects issuersto supply the agency with timely, accurate and complete information relevant toevaluating the ratings on the securities. Whilst the criteria set out the standardassumptions and guidelines for assessing portfolio risk, the ultimate rating decisionrests with the credit committee. CDO committees may make adjustments to

standard assumptions, or call for bespoke analysis.In addition, the general economic outlooks for certain sectors or industries orregulatory developments may be taken into account. Fitch recognises the need to


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balance independence and prudent credit judgement with consistency. Therationale for any public rating action, including any deviation from standard criteria,will be communicated in a public rating action commentary. Subscribers can find

commentary and further information on the rating action analysis atwww.fitchresearch.com.


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Appendix 1: Advanced EconomiesFor the purposes of the CDO criteria only, Fitch has based its list of emergingmarket (EM) sovereigns on the International Monetary Funds definitions. Theagency considers the countries listed below to be advanced economies, all othersare considered to be EMs. The treatment of sovereign economies as EM or advancedeconomies is solely at Fitchs discretion. The agency may add or remove sovereignsfrom this list if its opinion on the risks of those economies changes.

The International Monetary Funds Categorisation of AdvancedEconomies Australia Finland Israel Netherlands SpainAustria France Italy New Zealand SwedenBelgium Germany Japan Norway SwitzerlandCanada Greece Korea Portugal TaiwanCyprus Hong Kong SAR Luxembourg Singapore UKDenmark Ireland Malta Slovenia US

Source: IMF, Fitch


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Appendix 3: Obligor ConcentrationsPortfolios with a small number of assets or those where individual asset balancesrepresent a disproportionate exposure within the portfolio, carry the risk thatportfolio performance may be adversely affected by a few assets that may underperform relative to the statistics suggested by their ratings. Fitchs methodologyapplies additional stresses to certain inputs to mitigate the risk to CDO portfolioperformance posed by outsize assets.

The basic model framework is already sensitive to obligor concentrations in that asportfolios contain fewer assets, all else being equal, the portfolio default rateincreases. This is because the variability of defaults inherently increases with areducing number of assets, in the same way that the variability of the return on aportfolio increases with fewer assets.

Above and beyond this, the methodology includes additional scenario stresses suchthat the model produces the default of a minimum number of assets given aportfolio credit quality and target CDO rating. This approach creates what can bethought of as a floor in the assumed default rate, such that CDO investors areprotected in the event that the larger assets default. This is particularly importantwhere the portfolio credit quality is relatively high, and individual assets canrepresent a large proportion of the support available to a particular class of ratednotes. For example, as shown in the table below, a AAA CDO rating would beprotected against the default of a minimum of the five largest BBB exposures and10 of the largest B exposures.

Minimum Default CoverageCDO liability rating

BB BBB A AA AAA AAA 1AA 1 2A 2 3BBB 1 3 5BB 2 5 6 7

Asset rating

B 1 5 6 8 10Source: Fitch

The stress is applied by increasing the pairwise correlation of the five largest riskcontributors by 50%. This addition is applied irrespective of any correlation upliftsapplied for sector and industry. The largest risk contributors are determined on apresimulation basis, and are based on size of exposure, default probability impliedby the rating and recovery rate. It is important to take into account the defaultprobability and recovery rate when determining the assets to which the stress is

applied, as applying the stress to assets with high ratings, or high recovery ratesrelative to other assets in the portfolio, would have a negligible effect on theoutput.

The second element of the stress is to reduce by 25% the assumed recovery rate onthe same five assets. This stress is applied within the model framework, and has animpact on the portfolio loss distribution. This stress to recovery rates acts to reducethe risk posed by individual assets experiencing recoveries upon default at lowerrates than historical average rates. Individual assets experiencing low recoverieswill cause them to erode a disproportionate amount of support available to ratednoteholders. The stress to recovery rates is applied only where standard recoveryrates are applied, and not where assetspecific recovery rates have been assignedby Fitch.


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Appendix 4: Risk of Adverse Selection & Negative RatingMigration

BackTested Effectiveness of Adverse Selection Criteria

Original ratingAssets downgraded

1 notch or more (%)Assets downgraded

3 notches or more (%)

Implied downgrade underproposed methodology

(rating notches) CDO1 AAA 34 10 1CDO2 AAA 39 12 0CDO3 AAA 37 8 0CDO4 AAA 26 5 0CDO5 AAA 30 6 0CDO6 AA 37 12 0CDO7 AA 23 4 0CDO8 AA 24 7 0Source: Fitch

The Portfolio Credit Model (PCM) output provides an indication of supportcorresponding to each rating category. If managers or arrangers choose to issuetransactions with little or no cushion relative to the relevant model output, theremay be an increased risk of negative migration to the rated notes. The risk isespecially acute if underlying portfolio assets are subject to downgrade soon afterthe rating of a CDO.To address the risk of an early CDO downgrade due to excessive underlying portfoliomigration, Fitch incorporates the use of Rating Watch and Outlooks, in conjunctionwith the Fitch CDS Implied Ratings (Fitch CDSIRs) into the methodology. The FitchCDSIR will be used to supplement the asset rating information in determining thedefault probability input in certain instances. For all assets subject to Rating Watch

Negative placement, the lower of the Fitch CDSIR or the credit rating minus twonotches will be applied. For assets subject to Negative Outlook, the lower of theFitch CDSIR or the credit rating minus one notch will be applied.

If no Fitch CDSIR is available, and the asset is subject to a Rating Watch Negativeindication, the credit rating will be reduced by an assumed two notches for thepurpose of determining the appropriate input default probability. In the case ofassets subject to a Negative Outlook, and where no Fitch CDSIR is available, thereduction will be assumed to be a single notch.

The approach calls for the use of a Fitch rating, where available. Where aparticular asset is not rated by Fitch, the lower of the rating assigned by either S&Por Moodys will be applied. Should the rating be subject to a Negative Watch status,it will be reduced by two notches before the comparison is made and, if it issubject to Negative Outlook, it will be reduced by one notch before the comparisonis made. The approach still calls for use of the Fitch CDSIR for assets subject toNegative Watch or Negative Outlook status. So if the rating applied was subject to aNegative Watch or a Negative Outlook (before adjustment), it will be compared tothe Fitch CDSIR (where available), and the lower of the two applied.

Fitch believes that Fitch CDSIRs can act as effective screening tools to generate acushion to protect investors in rated CDO notes against downgrades caused byadverse portfolio selection. Both the Rating Watch Negative and Negative Outlookstatus have proven to be good indicators of rating momentum. But the magnitude ofultimate downgrade has varied considerably. For assets subject to Rating WatchNegative and Negative Outlook, the Fitch CDSIRs are being used to supplement arulebased notching to discourage the systematic inclusion of assets that are atrisk of being subject to an aboveaverage downgrade.


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In addition to using the Fitch CDSIR in the systematic fashion described,committees will be provided with a comparison of the Fitch CDSIR and the creditrating for all assets, regardless of Rating Watch or Outlook status. If there is an

indication that the portfolio has been subject to significant adverse selection,additional adjustments may apply. Any additional adjustments will be described inthe rating rationale.


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Global Rating Criteria for Collateralised Debt Obligations with Emerging Market Exposure

Copyright 2009 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 18007534824,(212) 9080500. Fax: (212) 4804435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rightsreserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and othersources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, theinformation in this report is provided "as is" without any representation or warranty of any kind. A Fitch rating is an opinion as to thecreditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specificallymentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor asubstitute for the information assemb led, verified and presented to investors by the issuer and its agents in connection with the s ale of thesecurities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does notprovide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment onthe adequacy of market price, the suitability of any security for a particular investor, or the taxexempt nature or taxability of paymentsmade in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for ratingsecurities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitchwill rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a singleannual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment,publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection withany registration statement filed u nder the United States securities laws, the Financial Services and Markets Act of 2000 of G reat Britain, orthe securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch researchmay be available to e lectronic subscribers up to three days earlier than to print subscribers.

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