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CDO defaults driven by rating downgrades

Do ratings merely constitute a journalistic opinion, or are matters a little more complicated than that?

The tricky part comes, of course, because ratings are taken as more than simply journalistic opinions by participants in the market, in spite of rating agency insistence to the contrary. There’s risk weighting under Basel II, investment guidelines for pension funds and, of course, default triggers in complex structured debt products themselves:

From Aaron Johnson at Total Securitization:

Very few if any of the nearly 200 collateralized debt obligations in default have done so because of missed payments. At least 180 CDOs totaling about $200 billion have defaulted due to ratings downgrades as a result of failing overcollateralization tests, according to various CDO officials. “Even though a deal has technically defaulted, there is money coming in to the deal and payments are being made,” one CDO trust official said. “[Involved parties] are continuing to administer the deal in the same way as before it defaulted.”

That may not be the case later in the year, however, said one CDO researcher. “[Defaults] are all driven by ratings [right now],” she said. “In six to 12 months we’ll start to see some actual cash flow problems.”

This entry was posted by Sam Jones on Friday, May 23rd, 2008 at 11:24 and is filed under Capital markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. May 23   12:23 Posted by TheWord [report]

    I’m still extremely skeptical that a great deal of risk has been transferred outside the banking sector, in any event. It seems much of the SIV-style risk, which deceived regulators, ratings agencies, analysts, etc. is returning to its spawning ground. Other portions which were supposedly securitized to third parties have resulted in litigation by those parties, who swear they were promised safe and secure investments.

    So, exactly how much of “securitized” risk should Basel II exclude? That question is far more open today, than it was a year ago.

  2. May 23   11:58 Posted by fugger [report]

    One of the maddest bits of Basel 2 is that the capital requirements for tranches of CDOs/ABSs etc are based on the ratings - even for advanced firms. Whereas Basel 1 gave banks an incentive to transfer risk outside the banking sector via securitisation, I thnk Basel 2 gives banks an incentive to transfer risk to each other via securitisation because the capital requirements on the rated tranches will be lower than those on the underlying assets on-balance-sheet. The Basel Committee are looking again at this. A requirement for banks to ‘look through’ to the underlying collateral on any structured produce would be a good thing.

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