By Martin Hansen and Stuart Jennings, Fitch Ratings
Recent Basel II proposals in response to the financial crisis provide enhancements that will further strengthen the effectiveness and rigor of the Basel II capital framework. However, specific aspects could have unintended effects on the risk-sensitivity of capital requirements for structured finance exposures. In particular, there is potential overlap between Fitch's tightened SF CDO rating criteria and proposed increases in Basel II risk-weights on 're-securitization' exposures held by banks, which could result in the 'double-counting' of risks within SF CDO capital charges.
The Basel Committee, in seeking to address weaknesses revealed by the financial market crisis, has proposed several enhancements to the Basel II capital framework, including targeted changes to the calculation of Pillar 1 minimum capital ratios that primarily address various aspects of structured finance.
The primary objective of these Pillar 1 proposals is to tighten the regulatory capital treatment of those exposures and activities which performed adversely or posed heightened risks during the financial market stress. The proposals focus in particular on "re-securitizations," which notably encompass SF CDOs.
The regulatory rationale for imposing higher capital charges on SF CDOs is that potential risk concentrations, thin tranches of the underlying structured finance securities, and the contingent nature of SF CDO performance make SF CDOs inherently more volatile and complicated than stand-alone asset-backed securities, particularly under adverse market conditions.
A prudent, enterprise-wide capital framework addresses concentration risk within and across credit portfolios and is able to withstand potential losses on concentrated exposures in a stressed environment. Along similar conceptual lines, Fitch's efforts in developing its new SF CDO ratings criteria focused on: identifying and capturing the portfolio impact of risk concentrations; implementing conservative recovery assumptions to reflect the elevated risks associated with thinly-tranched collateral assets; and ensuring that enhancement levels, particularly at the higher investment grade rating levels, are calibrated to withstand collateral default rates well in excess of observed historical experience for poorly performing sectors of structured finance.
Fitch's SF CDO criteria redevelopment can be viewed as a microcosm of the broader and more complicated challenge for financial institutions to capture enterprise-wide risk concentrations and to establish an appropriate capital buffer for these risks at a portfolio level, which banks are expected to address under Pillar 2 of Basel II. For Basel II to provide a robust regulatory capital framework, banks will need to identify, manage, and hold capital against risk concentrations that potentially overlap securitization; consumer, commercial, and mortgage lending; and counterparty and credit exposure to other financial institutions.
"Re-securitization": The Basel II Perspective
The fundamental rationale behind the Basel II proposal to assign higher Pillar 1 charges on re-securitizations is to better capture unexpected loss (UL), which regulators treat as being intrinsically higher for SF CDOs relative to stand-alone SF assets. More specifically, the financial performance of SF CDOs is viewed as inherently more volatile or non-linear than that of other SF instruments, with SF CDOs experiencing below average losses during "normal" times but more extreme losses during market stress. By this account, the higher UL of SF CDOs is driven by elevated sensitivity to systematic risk. During a financial market or economic stress event, correlated defaults and losses amongst consumer or mortgage borrowers reach levels that breach the protection supporting the underlying SF CDO bond collateral (particularly if the structured finance bonds within the collateral pool have similar risk attributes, relatively limited credit enhancement, and thin tranches), in turn leading to credit deterioration across the SF CDO capital structure.
Recent SF CDO ratings volatility and impairments are explained in large part by thin tranches and sector risk concentrations (e.g. same asset classes, geographic exposure, and vintages or period of issuance) within the SF CDO collateral pool.
Adverse market or economic conditions drive correlated losses within the underlying, concentrated SF CDO collateral pool that are then magnified at the SF CDO level, particularly if enhancement levels for the more senior SF CDO bonds are not sufficiently robust to weather a severe systematic stress scenario or a peak in default rates on the collateral pool. It is this observed pattern of above-average credit performance during periods of relative stability punctuated by more extreme deterioration during recent market stress that would suggest that SF CDOs have a non-linear risk profile.
Prior to the release of Basel II's proposed enhancements, Fitch published revised SF CDO ratings criteria that provide a more comprehensive and conservative treatment of the risks of re-securitization transactions, in particular risk concentrations and the potential for correlated defaults on SF CDO collateral under stress.
Concentration Risk In SF CDOs: Fitch's Approach
Fitch has analyzed the performance of a broad range of assets and entities that performed adversely during recent financial market stress, with a view to identifying and building on lessons learned in order to enhance the assessment of credit risk. In evaluating the drivers of the extreme ratings volatility and impairment rates impacting SF CDOs originated in 2006 and 2007, Fitch has incorporated a number of findings and new insights about the risk profile and collateral performance of SF CDOs within ratings criteria.
One of the main variables or factors driving negative credit performance for SF CDOs has been the presence of risk concentrations within the underlying collateral pools of structured finance assets. The onset of stressed market conditions exacerbated the portfolio impact of these risk concentrations, increasing the sensitivity of collateral performance, and hence of SF CDO performance, to negative market conditions. Correlated performance of collateral assets under stress was more pronounced within portfolios containing significant risk concentrations.
The most influential sources of risk concentration were asset class and vintage. In other words, SF CDOs referencing the same types of assets originated at the same point in time were particularly vulnerable to credit deterioration under stress. SF CDO enhancement levels were not commensurate with the higher observed correlations in the performance of collateral assets during stressed market conditions, particularly for portfolios with elevated risk concentrations or exposure to a narrow, common set of risk factors.
By applying a new approach to estimating and incorporating asset correlations (and, in turn, default correlations) amongst collateral assets, Fitch's revised SF CDO ratings methodology provides more rigorous treatment of risk concentrations and establishes more conservative overall credit enhancement levels. More specifically, Fitch's ratings methodology uses correlation as a "top-down" calibration parameter to generate appropriately conservative enhancement levels for SF CDOs generally that are consistent with Fitch's fundamental view of the credit risk associated with the asset class.
Correlation values are calibrated such that, for SF CDOs concentrated in a single sector and single vintage, investors at the 'A' and above rating stresses would be protected against the historically-observed peak default rate for a concentrated portfolio of structured finance assets. The historically-observed peaks reflect the extent to which risk concentrations can increase the variability of a portfolio's default rate relative to the long-term average default rate. Structured finance default rate data for select poorly performing sectors historically illustrate the greater variability in credit performance of sector-concentrated structured finance portfolios under stress conditions. The greater observed volatility and clustering of defaults is indicative of the high correlation inherent in concentrated portfolios of structured finance assets. Fitch's SF CDO calibration therefore reflects this experience. At the 'A' rating level, the SF CDO enhancement levels for single-vintage, single-sector portfolios are set to be at or above the historical observed peak default rate for poorly performing structured finance sectors.
The correlation parameter within Fitch's SF CDO ratings methodology is designed to be sensitive to risk concentrations within the underlying collateral pool of SF assets, with concentrations to specific sectors or asset classes, vintages and countries requiring higher correlation inputs.
The outcome of Fitch's revised SF CDO criteria is that the resulting enhancement levels are considerably higher than under the prior methodology, particularly for collateral pools characterized by risk concentrations and thinner tranches. One way of quantifying the increased rigor and conservatism of Fitch's SF CDO enhancement levels is by comparing the Basel II capital charges on sample SF CDO transactions under the prior versus the revised Fitch ratings criteria. In evaluating three sample SF CDO transactions, it is evident that the prior "arbitrage" (i.e. where the total Basel II charges on the SF CDO structure were less than the total Basel II charges on the underlying collateral pool of structured finance assets) has been dramatically reversed solely by the application of Fitch's revised ratings criteria.
It is noteworthy that the recent Basel II proposal to increase the Pillar 1 re-securitization charges exacerbates this difference. The combined impact of Fitch's revised, more conservative criteria and the increase in the Basel II SF CDO capital calibration is that the Basel II capital charge on the entire SF CDO structure is potentially several multiples higher than the Basel II capital charge on the underlying portfolio of structured finance collateral (a more detailed analysis of the potential Basel II capital impact on SF CDOs can be found in Annex 2 of Fitch's recent special report 'Basel II's Proposed Enhancements: Focus on Concentration Risk'). This disparity in Basel II charges would result even though the total credit risk on the two exposures (i.e. the entire SF CDO capital structure and the entire underlying collateral pool of structured finance assets) is essentially the same; it is only the form of the risk exposure that differs.
The potential 'double-counting' of risks within the Basel II capital charges on SF CDOs is in part a reflection of Fitch's tightened ratings criteria; it therefore depends on a rating agency having revised its ratings methodology to reflect the unique risk attributes of SF CDOs.
Martin Hansen is a senior director in Fitch Ratings' U.S. credit market research group. Stuart Jennings is the structured finance risk officer for EMEA and Asia-Pacific at Fitch Ratings.