Indeed, along with boutique banks (often backed by hedge fund investment), we believe hedge funds are now among the most active participants in the structured finance market. As a result, the hedge fund industry may be increasingly interested in the performance of structured finance ratings. There has been much debate about the performance of such ratings in the US and their role in the recent financial crisis, but it is worth looking more closely at the actual track record of ratings in the securitisation market.
Historical performance of S&P ratings
The performance of many ratings of securities linked to recent US subprime mortgages has been out of line with historic norms. However, the same is not the case with all securities. For example, S&P’s ratings of many European structured finance assets, particularly traditional securitisations such as residential mortgage-backed securities (RMBS) and consumer asset-backed securities (ABS) have been relatively stable to date, particularly at the higher rating levels.
Of Standard & Poor’s 9,640 ratings of European structured securities outstanding at the start of 2009, some 69% were left unchanged or raised while 29% were lowered by the year-end. This downgrade rate was lowest in the higher ratings categories, with 86% of ‘AAA’ ratings remaining stable, compared with 54% of ‘BB’ ratings. We believe it is important that market participants consider the performance of ratings across different areas of the structured finance market. For example, European collateralised debt obligations (CDOs) exhibited the highest downgrade rate during 2009 with 41.6% of ratings lowered, compared with only 15.0% for ABS. Furthermore, of the 750 ‘AAA’-rated European RMBS outstanding at the outset of the crisis in June 2007, over 98% remain ‘AAA’.
Significantly, ‘AAA’ rating downgrade rates in Europe remained low in most asset classes in 2009, at 4.0% for ABS, 4.1% for RMBS, 30.3% for commercial mortgage-backed securities (CMBS) and 25.0% for CDOs. However, it is important to note that a number of CMBS and CDO tranches are currently on CreditWatch with negative implications and may have their ratings lowered in coming months. Specifically, a number of CDO ratings could be affected by recent revisions to our assumptions and methodologies, while pressure on European CMBS ratings reflects the significant deterioration in commercial property values and constricted credit conditions, which we see leading to heightened refinance risk over the next few years.
Striving for comparability
While the majority of our ratings have performed broadly as anticipated during the crisis, we recognise that a number of the assumptions we used in our analysis of many recent US RMBS and CDO ratings did not hold up. Like many others, we did not fully anticipate the extent of the actual home price declines and the impact on US mortgage loans performance.
We have subsequently made a number of significant changes to our publicly available criteria for analysing several asset classes, including CDOs and US RMBS and CMBS. We believe these changes will contribute to continued rating comparability – across sectors, geographic regions and over time. In our view, this is a key part to restoring confidence in ratings.
For instance, as part of our effort to minimise ratings volatility in the future, we have introduced an assessment of stability into investment grade ratings. Under S&P’s new criteria we may surmise that two securities have a similar default risk, but if we believe one is more prone to a sharp downgrade in periods of economic stress it is likely to be rated lower.
A second initiative takes into account our perception that investors prefer ratings to behave as a consistent benchmark of credit risk – meaning that issuers or instruments with similar ratings perform in a broadly comparable way regardless of asset class, geography or point in time. Accordingly, S&P has published specific economic scenarios for each rating category that illustrate the level of stress that we believe issuers or obligations rated in that category should, based on our analysis, be able to survive without defaulting.
In the case of ‘AAA’ ratings, for example, we are applying a Great Depression-type scenario stating that the credit in our opinion should be able to withstand this level of economic downturn. Alongside other factors, these stress scenarios are being used to help calibrate ratings criteria and support the ongoing comparability of ratings. We understand that hedge funds and other investors also want to be better placed to analyse and evaluate ratings. We are therefore publishing more information about ratings assumptions, stress tests and “what if” scenarios so the market can see more clearly what we believe might cause ratings to change so they can take a deeper view of credit risk. If an institution, for example, has different macro assumptions than S&P’s, they should be able to determine how that could impact our – and their – view of creditworthiness. Underlying these and other improvements we are making is an important principle: our belief that transparency in what we do and how we do it builds confidence in ratings and helps investors make better informed decisions.
Where now for ratings?
Ratings have been, and we believe will continue to be, an important tool for investors and fund managers looking for a common and transparent language for evaluating and comparing creditworthiness across sectors and geographies. And we also believe they will become an increasingly important tool, among many, for hedge funds managing portfolios of structured assets.
Therefore, while important changes have been made to ratings transparency, including the measures mentioned above, as well as to governance of the ratings process and analytic quality, we continue to examine other areas for potential improvement. For instance, there may be further opportunities to continue incorporating the experience of the past two years, as well as enhancing the comparability of ratings across different sectors.
We hope that these changes will leave investors and hedge fund managers with a better understanding of our ratings and better equipped to analyse and evaluate them. We also hope it will lead to a more balanced and rational use of ratings by investors as one of many inputs in their decision making process. On that basis, we envisage a continued role for S&P in serving the market with ratings, research and data, in which we compete entirely on the quality and value of our product.
Simon Collingridge is Managing Director in Standard & Poor’s Structured Finance Ratings group. He is head of outreach to the structured finance market across all asset groups and has senior responsibility for structured finance research and publication.