S&P Knocking Down Another $578 Billion in CDO Ratings

Standard & Poor’s Ratings Services is making a house-cleaning exercise which could have a broad impact on the ratings of thousands of already-troubled securities.  S&P is changing its ratings criteria for collateralized debt obligations backed by corporate debt, or CDO’s.  You know, those things that still can’t be properly valued by banks and that blew up the financial system….  As a result of this criteria recalibration, roughly 4,790 CDO tranches with an implied value of about $578 billion is now on watch for downgrade.

S&P noted that the changes are intended to make ratings for CDO classes and tranches more comparable to the ratings of other sectors and asset classes.   This change is titled “Update To Global Methodologies And Assumptions For Corporate Cash Flow And Synthetic CDOs.” S&P will be holding a conference call on Monday, September 21… This is going to be very difficult to go through without sarcasm and without harsh criticism based upon the ratings agencies’ poor grasp of the situation this decade, so our apologies for the rest.

Changes are being implemented in default-simulation mode outside of the Monte Carlo simulations, and more importantly S&P is adjusting models to target AAA default rates under ‘extreme macroeconomic stress’ events such as the Great Depression.  It is also adjusting BBB default rates consistent under the highest default rates over the last three decades.

S&P’s changes are probably going to feel like a ‘thanks for nothing’ research note that just adds insult to injury, but S&P warned (or noted) that these downgrades are likely to come in the form of multi-notch cuts in the coming months. This is expected as outstanding synthetic CDOs are probably going to see downgrades of four notches on average.  The super senior AAA tranches are likely less affected and will ‘only’ see downgrades of two or three notches…

This is going to be an interesting chapter in the public outcry over what the independent ratings agencies have for ratings policies.  It is no secret that all of these ‘AAA’ agency-rated CDO and derivative securities were not really triple-A… based upon the blow-up of the market, most were not even investment grade when you consider the performance versus the stress tests that used to be run for calculating risk.

It is hard to know if this will trigger another wave of valuation cuts because this is a policy change that is systematic in response to what has already been seen over the last two-year period.  As I have said before, in today’s world there is probably no such thing or very few ‘true triple-A’ rated securities.

Hopefully, this won’t cause another mudslide in the financial sector with another wave of valuation write-downs.  Frankly, this should just be a formality at this point.  It will be interesting to see what happens when portfolio managers who have bought and sold all of these thousands of instruments suddenly get the notice that so many more downgrades are now in their securities.

$578 billion??? What is the real value of those now?  Another outrage of the day…

Jon C. Ogg
September 17, 2009