Fitch’s recent discussions with market participants have revealed a broad understanding and support of our approach. However, the significant price falls and evaporation of liquidity seen over the summer in certain market sectors makes it even more important that market participants fully understand what credit ratings indicate, and, importantly, what they do not.
Our ratings provide an independent, timely and prospective opinion on the creditworthiness of an entity or transaction; they are used by investors as an indication of the likelihood of receiving their money back from an issuer or borrower in accordance with the terms on which they invested. They do not opine on the market value of the instrument during its life, the price at which the instrument may or may not be sold or the ease with which any instrument can even be price
As an example, there is a lot of debate about what a ‘AAA’ rating in particular means to the investor. Credit ratings have never explicitly spoken to the pricing of an instrument, nor to liquidity of the instrument, but the market has generally formed its own expectations regarding these factors, based on historical ‘AAA’ rated assets. The expectation that a ‘AAA’ rated security would always be highly liquid and priced at a very fine level – assumptions ‘beyond the rating’ worked well for treasury bills and very low risk institutions, but these will increasingly be challenged as the universe of very low-default instruments expands.
Credit ratings express risk in relative rank order, and should thus be seen as broadly consistent indicators of relative vulnerability. Given the profound effect that economic cycles may have on cardinal default experience, and the differing economic cycles that sectors and regions may face, entities or issues which carry the same rating will be of broadly comparable, but not necessarily identical, credit quality.
As a result, default rates often vary widely for a given rating category between any two given years. Pro-cyclical ratings that followed the cycle up and down, and tracked anticipated percentage default frequencies for each category, although they would produce results that are closer to cardinal default experience, would also display substantially more volatility than is the case for Fitch’s traditional ratings. In turn this would reduce the ability of ratings to communicate relative changes in creditworthiness between two issuers, beyond cyclical developments that affect all issuers.
Market observers have also commented on the broader role of agencies with regard to structured finance transactions in particular. Whilst the rating process in structured financial is an iterative one, Fitch does not structure transactions. Arrangers are able to combine and re-combine assets to achieve a target rating for the liability. Models published by Fitch to make its methodologies transparent are also sometimes used by arrangers and originators in their initial review of assets that they wish to include in a transaction. The decision on which assets to allocate, and which ratings to target, nonetheless remains entirely that of the arranger or originator. The rating committee will not propose alternative assets to include in a transaction, suggest alternative rating levels that may be targeted, or develop alternative legal structures that could be applied.
In the surveillance process, while transactions may incorporate a rating confirmation feature, this does not constitute an endorsement by the agency of any change that may occur in the transaction. As such, Fitch does not ‘require’, ‘approve’ or ‘endorse’ issuer behaviour. This reflects the nature of the particular role filled by rating agencies. Any rating review is simply an observation of relative creditworthiness, and Fitch is indifferent to the level of any rating assigned.
‘AAA’ ratings are defined as denoting “the lowest expectation of credit risk”, further defined as an “exceptionally strong capacity for payment of financial commitments.” As at 30 June 2007, ‘AAA’ obligors represented only1% of Fitch’s corporate and financial institution coverage. The absolute universe of ‘AAA’ ratings has however grown as structured finance issuance has grown. ‘AAA’ ratings are much more common for structured finance transactions (60% of outstanding ratings at June 30, 2007) due to the ability to ‘tranche’ securities into various layers. A target rating level can usually be achieved through the amount of subordination, or ‘credit enhancement’ created.
In a tranching structure, the so-called equity layer represents the first loss position, and typically only after it is exhausted will each successive tranche potentially be exposed to loss. Thus, even with a high risk pool of assets, a senior layer can be sized with sufficient credit enhancement below it to absorb losses (ie. equity, subordinated and/or mezzanine tranches) to create a security commensurate with a ‘AAA’ rating.
Crucially, for corporate and bank issuer ratings, and for structured finance instrument ratings, the ‘AAA’ rating refers to relative likelihood of default. It does not opine as to expected recovery given a default, or to relative market pricing or market liquidity. Investor assumptions regarding the characteristics of a ‘AAA’ rating other than relative default likelihood essentially derive from historical features associated with ‘AAA’ obligors and their obligations. While not included in Fitch’s rating analysis, ‘AAA’-rated debt is often assumed to have low loss severity rates and very high market liquidity – a logical assumption for highly-rated corporates, banks and sovereigns, as well as for many traditional structured finance instruments.
The fixed income market has, however, now expanded to include structured finance instruments which combine extremely low relative default likelihood, consistent with the ‘AAA’ rating, with the potential for either non-negligible levels of loss severity (eg. through multiple tranching at the ‘AAA’ level), or with only limited liquidity (eg. through bespoke construction).
Thus traditional investor assumptions ‘beyond the rating’ regarding the characteristics of a ‘AAA’ rated instrument may no longer be valid in all cases. Investors and other rating users should be aware of these developments when compiling and operating guidelines which incorporate ratings.
None of this is to say that rating agencies should not be using the lessons of current market conditions to improve the content and transparency of both methodologies and procedures. Over the coming months, Fitch will be conducting intensive discussions with major market participants, including investors, regulators, arrangers and others.
Richard Hunter is Managing Director of Fitch Ratings, London