Fitch Revises Criteria for Reviewing CDOs Backed by Bank & Insurance TruPS

Fitch Revises Criteria for Reviewing CDOs Backed by Bank & Insurance TruPSNEW YORKNY-FITCH-RATINGS/CDO

Credit deterioration amongst banks and thrifts that have issued trust preferred securities (TruPS) through collateralized debt obligations (CDOs) has been rapid and significant over recent periods. This performance has prompted Fitch Ratings to revise its criteria for reviewing the ratings of approximately $38 billion of CDOs backed by these assets.

In 2008, Fitch-rated Bank TruPS CDOs were exposed to defaults and deferrals representing approximately $3.4 billion. Through March 22, 2009, Fitch-rated bank TruPS CDOs have experienced defaults and deferrals of $780 million. This recent performance is in stark contrast to bank defaults and deferrals of $103.5 million observed in 2007. Fitch maintains a Negative Outlook for U.S. financial institutions in 2009. Increased bank failures and continued deferral activity are expected to curtail cash flows to bank TruPS CDOs, which may reduce their ability to meet payment obligations to noteholders.

The revised review criteria will affect CDOs backed by TruPS issued primarily by banks and thrifts (collectively banks) and, to a lesser extent, insurance companies, as well as real estate investment trusts and other structured finance assets. The review criteria addresses Fitch's analytical treatment of assets that are defaulted, deferring, or where Fitch sees default or deferral as a real possibility in the future. Other changes to the review criteria include the analysis of concentrated portfolios of insurance assets and the qualitative credit given to other structural features such as excess spread and cash flow redirection mechanisms.

Fitch's revised bank TruPS CDO review criteria begins with an updated analysis of the credit quality of the underlying assets from Fitch's financial institutions group. The credit enhancement measurement is adjusted for issuers that are currently defaulted, deferring on their TruPS obligations or scored in the lowest two sub-categories of Fitch's U.S. Bank Scoring Model scale of 1 to 5.

Specifically, the credit enhancement measurement assumes 100% loss on defaulted issuers, which is consistent with the deeply subordinated nature of trust preferred securities and Fitch's previously stated recovery estimates on these instruments. Credit enhancement is further adjusted for issuers that are currently deferring on their TruPS obligations. The analysis assumes that approximately 50% of deferring issuers may be unable to cure their deferral within the contractual five-year period and may migrate to default should the current environment persist. Finally, Fitch has observed that issuers with a Fitch bank score of 4.5 and 5 have generally exhibited high probability of deferral and default. As such, the revised review criteria assumes that 25% of these issuers will ultimately default on their obligations.

The review criteria translates the credit quality of the performing portfolio, as indicated by the average issuer score, to rating default rates for each rating level using the probability of default tables published in the 'Rating Criteria for U.S. Bank and Insurance Trust Preferred CDOs' (February 2005). Obligor and regional concentration penalties (in the form of higher cumulative gross default levels) are also applied to the calculation of the default rates for the performing portfolio. Rating loss rates are derived by applying tiered recovery rates as described in the aforementioned criteria report.

Fitch's Portfolio Credit Model ('PCM') will be used to determine default, recovery and loss rates for non-bank corporate issuers. As such, CDOs backed primarily by TruPS issued by insurance companies will be reviewed using PCM, Fitch's main analytical tool for analyzing portfolios of corporate debt. PCM correlation framework captures the risk of industry and sector concentrations, a prevalent risk in insurance TruPS CDOs, as well as regional and country concentrations.

The resulting rating loss rates for each rating level will be compared to the adjusted credit enhancement measurement for each rated CDO bond. Rating changes will be made to bonds where the current ratings are not adequately supported by the adjusted credit enhancement levels.

Fitch believes that the excess spread that was a meaningful component in previous rating analyses will not significantly benefit credit enhancement in the future as a result of the reduction in cash flow associated with increased bank default and payment deferral on bank TruPs. The revised review criteria does not use cash flow analysis in the evaluation of the credit enhancement to the rated bonds. Instead, Fitch will evaluate the effect of excess spread that is redirected through structural features such as over-collateralization and interest coverage tests, optional principal distribution amounts (OPDA) and other turbo features on a qualitative basis when applicable.

Fitch expects to conclude the rating review of its bank and insurance TruPS CDO portfolio using this review criteria within the next month. At that time, Fitch will also resolve the rating watch status that is currently outstanding on 75 bank TruPS CDOs.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.