CDO Ratings to Fall as Losses Trigger Fitch Overhaul

CDO Ratings to Fall as Losses Trigger Fitch Overhaul

Feb. 5 (Bloomberg) -- Fitch Ratings may downgrade all of the $220 billion of collateralized debt obligations it assesses that are based on corporate securities because of rising losses.

The New York-based company may lower the notes by as much as five levels after failing to accurately assess the risk of debt that packages other assets, according to guidelines proposed by Fitch today. CDOs with AAA grades that are based on credit-default swaps and aren't actively managed may face the steepest reductions.

Ratings firms are responding to criticism that they failed to react quickly enough as increasing defaults on subprime mortgages in the U.S. caused a plunge in the value of CDOs. Fitch, a unit of Fimalac SA in Paris, lowered $67 billion of mortgage-linked CDOs in November, slashing some AAA debt to speculative grade, or junk.

``Fitch is acknowledging that it was overly optimistic in its default rate and other assumptions in its original CDO methodology,'' said Christian Stracke, an analyst at bond research firm CreditSights Inc. in London.

Moody's Investors Service last year downgraded $76 billion of CDOs and began this year with $185 billion of deals under review. The New York-based company said yesterday that it may overhaul its system for evaluating structured-finance securities, proposing options including a numerical scale and a designation of ``.sf'' to differentiate a structured-finance ranking from a corporate credit grade.

Ratings Challenge

Standard & Poor's, the New York-based unit of McGraw-Hill Cos., downgraded or placed under review $98.3 billion of CDOs last month, citing ``stress in the residential mortgage market and credit deterioration.''

Fitch's review of 600 CDOs referencing company debt and derivatives doesn't cover structured-finance notes, which package asset- and mortgage-backed securities. It plans to introduce the new criteria by the end of March after seeking feedback.

Fitch wants to ``challenge existing CDO rating assumptions,'' John Olert, head of global structured credit at the ratings firm in New York, said in a statement. The company wants to ``produce ratings that perform similarly in terms of default risk and ratings migration with the market's expectation for other asset classes,'' he said.

CDOs are securities that repackage pools of bonds, loans and credit-default swaps and slice their cash flow into notes of varying risk and returns that are sold to investors. Junk bonds are rated below Baa3 by Moody's and lower than BBB- by S&P.

Sales Decline

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

CDOs that package high-yield assets may be reduced as many as three levels for the portions first in line for losses, Fitch said.

Sales of CDOs to investors fell about 11 percent last year to $491.6 billion, and probably will slide 65 percent this year, according to JPMorgan Chase & Co. Citigroup Inc., Merrill Lynch & Co., Deutsche Bank AG, Wachovia Corp. and JPMorgan were the top CDO underwriters last year, according to Thomson Financial data.

``Any proactive action on Fitch's part which could result in substantial downgrades may be negative for credit markets,'' said Puneet Sharma, head of investment-grade credit research at Barclays Capital in London.

BLOOMBERG