Simon Collingridge, md, structured finance, at S&P explores the record of credit ratings in structured finance markets and some of the new measures the rating agency is adopting

At the start of the global financial crisis, credit deterioration was generally limited to certain US structured finance assets and global financial institutions. However, the onset of a broader economic recession has meant rising credit risk across most financial asset classes - for example, European residential and commercial mortgages, consumer finance and corporate credit. In certain cases, this deterioration has led S&P to take negative rating actions in the related structured finance sectors.

However, not all structured finance assets have been equally affected. For example, ratings of many European structured finance assets - particularly traditional securitisations, such as RMBS and consumer ABS - have been relatively stable to date, especially at the higher rating levels.

Indeed, S&P's report 'Credit deterioration continued to pressure European structured finance ratings in H1 2009' found that of the 9,293 ratings of European structured securities outstanding at the start of the year, we left unchanged or raised 83% and lowered 17% in the first half of 2009. Importantly, the downgrade rate was lowest in the higher rating categories, with more than 95% of triple-A ratings remaining stable, compared with 73% of double-B ratings.

We believe that it is important that market participants look at the performance of ratings in different areas of the structured finance market, rather than viewing the market as a whole. For example, European CDOs exhibited the highest downgrade rate over this same period with 26.6% of ratings lowered, compared with only 7.3% for ABS.

Furthermore, of the 750 triple-A rated European RMBS outstanding at the outset of the crisis in June 2007, over 98% remain triple-A today and the remainder at double-A or single-A.

Importantly, triple-A rating downgrade rates in Europe remained low in most asset classes, at 0.7% for ABS, 1.9% for RMBS, 2.5% for CMBS and 8.7% for CDOs.

However, it is important to note that a large proportion of CMBS and CDO tranches are currently on credit watch with negative implications and may have their ratings lowered in coming months. Specifically, a number of CDO ratings could be affected by recent revisions to our assumptions and methodologies, while pressure on European CMBS ratings reflects the dramatic deterioration in commercial property values and constricted credit conditions, which we see leading to heightened refinance risk over next few years.

Striving for comparability
While the vast majority of our ratings have performed broadly as anticipated during the crisis, we have acknowledged that the performance of our ratings in certain areas - including US mortgage-related securities - has been out of line with historic norms.

We recognise that a number of the assumptions we used in our analysis of many recent US RMBS and CDO ratings did not hold up. Like many others, we did not fully anticipate the impact of actual home price declines on mortgage loans performance.

We have subsequently made a number of significant changes to our criteria for analysing several asset classes, including CDOs and US RMBS and CMBS. We believe these changes will lead to enhanced rating comparability - across sectors, geographic regions and over time. This, in our view, is key to restoring confidence in ratings

As part of our effort to minimise ratings volatility in the future, we have introduced a measure of stability into investment grade ratings. Under S&P's new criteria, for instance, we may feel that two securities have a similar default risk, but if we believe one is more prone to a sharp downgrade in periods of economic stress, it is likely to be rated lower.

A second initiative concerns our perception that investors prefer ratings to behave as a consistent benchmark of credit risk - meaning that issuers or instruments with similar ratings perform in a broadly comparable way, regardless of asset class, geography or point in time. Accordingly, S&P has published specific economic scenarios for each ratings category that illustrate the level of stress that issuers or obligations rated in that category should, based on our analysis, be able to survive without defaulting.

In the case of triple-A ratings, for example, we are applying a Great Depression-type scenario. Alongside other factors, these stress scenarios are being used to help calibrate ratings criteria and support the ongoing comparability of ratings.

We understand that investors also want to be better placed to analyse and evaluate ratings. We are therefore publishing more information about ratings assumptions, stress tests and 'what if' scenarios, so the market can see more clearly what might cause ratings to change and can take a deeper view of credit risk. If an institution, for example, has different macro assumptions than S&P's, they should be able to determine how that could impact our - and their - view of creditworthiness.

Underlying these and other improvements we are making is an important principle: transparency in what we do and how we do it builds confidence in ratings and helps investors make better informed decisions.

Where now for ratings?
Ratings have been, and we believe will continue to be, an important tool for investors looking for a common and transparent language for evaluating and comparing creditworthiness, across sectors and geographies.

While important changes have been made to governance of the ratings process, ratings transparency and analytic quality, we continue to examine other areas for potential improvement. For instance, there may be further opportunities to continue incorporating experiences over the past two years, as well as enhancing the comparability of ratings across sectors.

We hope that these changes - as well as our ongoing education programme - will leave investors with a better understanding of our ratings, and better equipped to analyse and evaluate them. We also hope it will lead to a healthier and more rational use of ratings by investors, as one of many inputs in their decision-making process. On that basis, we envisage a continued role for S&P in serving the market with ratings, research and data, in which we compete entirely on the quality and value of our product.