Standard & Poor's on Monday placed almost the entire universe of its rated US structured-finance collateralized debt obligations on CreditWatch Negative -- $63 billion worth -- as a result of a significant criteria tweak that it had begun to hint at several months ago. The move is likely to mean steep downgrades to an already distressed sector.
Yet the response from many in the market was: "Who cares?"
Even as risk appetite grows and trading picks up in the secondary market for products such as CDOs of asset-backed securities (ABS CDOs) and commercial real estate (CRE) CDOs -- and their values appreciate significantly -- investors are paying less attention than ever to the securities’ credit ratings, which are becoming increasingly uncorrelated to valuations, analysts say.
"From a pure trading vantage point, ratings are not important any more," said David Yan, global head of CDO strategy at Credit Suisse. "People nowadays care more about how much subordination is in an underlying bond, or what the recovery and loss levels are on the bonds underpinning the CDOs. People are ignoring the ratings."
Subordination refers to the credit cushion protecting investors in the senior portions of the CDO from losses. The losses are first absorbed by the lower-ranked, or subordinate, pieces of the security.
"The ratings are irrelevant," added Darrell Wheeler, head of CMBS strategy at Amherst Securities and an expert on CRE CDOs. "Most of these CDOs don't trade that often and are already written down."
S&P placed 517 bonds from 224 structured-finance CDOs on negative watch, in addition to many so called Re-Remics backed by commercial real estate. Re-Remics -- or re-securitizations of real estate mortgage investment conduits -- are structures used by dealers since the crisis to create new, investment grade securities out of severely downgraded mortgage bonds.
The disconnect between rating level and market value for these instruments is growing. For example, one slice of a CRE CDO called Hartford Mezzanine Investors I 2007-1 (HMEZZ 2007-1), rated only BBB/BBB+/Aa1 by Fitch/S&P/Moody's, was seen trading in the mid-90-cents on the dollar range last week, according to Richard Hill, a CMBS strategist at RBS.
"There are numerous examples of senior, first-pay CRE CDOs trading in the mid-to-high 80s and 90s, with investors assuming full return on principal. And these are certainly not Triple A rated CDOs. Ratings have become a secondary consideration in the analysis," Hill said.
As risky assets continue to perform well in the current environment, ratings have less meaning. Even other so-called "spread" products outside of S&P's recent ratings warning -- such as collateralized loan obligations (CLOs) -- have been valued higher in the secondary market than what their current credit ratings would suggest.
Credit Suisse's Yan gave an example of two slices from two different CLOs -- one rated Double B and one rated Triple C -- that have recently been trading at the same price. Despite the disparate ratings, the bonds' underlying subordination levels are the same. "Ratings don't necessarily reflect all the factors that investors need to look at," Yan said.
Different for banks
While investors interested in trading these securities are clearly no longer making decisions based on ratings, banks holding them on balance sheet may be in a different position. They face harsh regulatory capital charges if S&P pulls the trigger and downgrades the CDOs from investment-grade to junk.Luckily, roughly two thirds of the CDOs that S&P flagged are already non-investment-grade. But many European banks still hold high-grade CDOs, and such a move by the rating agency could force the banks to liquidate their distressed US assets ahead of the Basel III regulatory framework, sending a shock of supply into a fragile secondary market. The new capital adequacy rules will be gradually phased in starting in 2013.
"A substantial downgrade could motivate some of the European banks to expedite the process of selling off these assets," said Vishwanath Tirupattur, the head of securitized-product strategy at Morgan Stanley. "In this regard, ratings are important because they could trigger a sale that would destabilize the market."
The most pain will probably be felt by banks still holding CDOs at the Triple B, Double B, or Single A level.
"Regulatory capital charges increase significantly when the bonds are downgraded from Triple B to Double B," said Ratul Roy, head of structured credit strategy at Citigroup. "At Single B, the banks have to set aside dollar-for-dollar regulatory capital."
The degree of European bank liquidation of US SF assets has been difficult to gauge so far.
While there is surely significant exposure, securitization specialists say that the banks are fairly astute product managers and may have already found an exit for the assets.
"It's quite likely that they have managed by now to either trade up in quality, Re-Remic their positions, or exit entirely," said Chris Sullivan, the chief investment officer at the United Nations Federal Credit Union.
"But the raters are no longer a driver of market activity, or even valuation," Sullivan said.
By Adam Tempkin adam.tempkin@thomsonreuters.com
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