S&P Proposal May Spur Downgrade of Some Derivatives

Certain structured finance derivatives such as collateralized debt obligations of asset-backed securities could see their ratings downgraded under a new proposal from Standard & Poor’s designed to take credit stability into account.

Under the proposal, when assigning and monitoring ratings, S&P “would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991 and the European recession of 1991 or appropriate sector-specific stress scenarios).”

In such cases, we would assign the issuer or security a lower rating than we would have otherwise.

S&P says the proposal “does not imply that we believe that issuers or securities should become—or are likely to become—less stable.” Rather, the proposal expresses a theoretical outer bound for the projected credit deterioration of any given issuer or security under specific, hypothetical stress scenarios. 

We do not intend the proposed change to result in rating upgrades in sectors that have historically displayed above-average credit stability. Instead, we intend this proposal to function as a limiting factor on the ratings assigned to credits that we believe are vulnerable to exceptionally high instability.

The primary focus of the stability consideration is intended to be ordinary business risk rather than special types of risk, such as changes in laws, fraud, massive natural disasters, or corporate acquisitions.

S&P expects the proposed change “would have very little, if any, effect on our ratings in the corporate and government segments of the capital markets.”

S&P anticipates that the proposed change would have a more pronounced impact in certain areas of the structured finance segment, particularly on ratings of derivative securities such as:

• Collateralized debt obligations of asset-backed securities (ABS CDOs).
• Constant-proportion debt obligations (CPDOs).
• Leveraged super-senior (LSS) structures.

Transactions and structures that create more significant cliff risks would likely experience the largest impact. The proposed change could result in downgrades to significant numbers of the securities listed above when we first implement the proposal.

If adopted, the proposed change would be it implemented over a period of roughly 180 days.

S&P is requesting comments to [e-mail]. by Aug 6 on the following questions: “Do you support the proposal to explicitly recognize credit stability as an important factor in our ratings? Why or why not”

Full details are available here.