Andrew South, senior director at S&P, notes that market volatility led to varying ratings behaviour in European structured finance last year

In 2009 the severe economic recession and the ongoing rationing of credit to both corporate and household borrowers continued to place significant downward pressure on European structured finance ratings in some sectors. In addition, evolution in S&P's methodologies also caused some ratings migration. However, despite the extremes of the current economic and capital market environment, the effect of these developments was that 70.2% of ratings still remained unchanged or were raised over the year, compared with 82.2% in 2008.

Earlier pressures that focused on global financial institutions and parts of the US securitisation landscape gave way to a more widespread economic downturn, which in our opinion heightened credit risk in a broad array of European asset classes. Low rates of transaction amortisation offered little support for upgrades, while the sharp deterioration in economic fundamentals, such as GDP and unemployment, led to a decline in our view of creditworthiness - and consequent downgrades - for a large number of European structured finance securities.

More downgrades, while upgrades uncommon
The rate of downgrades for European structured finance securities accelerated in 2009 compared with historical averages. The number of ratings lowered exceeded the number raised for a second successive year and by a factor of almost 25.

Overall, 113 (1.2%) of S&P's outstanding European structured finance ratings ended the year higher than they began. Excluding triple-A ratings, which cannot be raised, the upgrade rate was 1.7%.

On the other hand, we lowered 2,765 (29.8%) of the outstanding ratings over the year. This year's downgrade rate is significantly higher than the 2008-equivalent figure of 17.8% and the upgrade rate of 1.2% is also lower than the 2008 figure of 1.7%.

Magnitude of transitions declines
Certainly, the relative number of ratings undergoing transition in one direction or the other is in our view one measure of credit performance. However, the magnitude of those transitions, measured in terms of the number of rating notches, we believe is also significant.

Analysis of this data reveals that, for those ratings lowered during 2009, the average net downward move over the period was 5.1 notches for European structured finance ratings, significantly lower than the average 8.1 notch downward move in 2008. The average magnitude of upward rating transitions was significantly less than that of downward transitions, at 2.3 notches (see chart below).

Of the upward and downward transitions, 43% were of three notches or fewer and about 15% of all transitions were only one notch. Highlights of the downward transitions were as follows:

• Of the 2,765 ratings lowered, 1,120 (41%) were lowered by between only one and three notches over the year.
• 822 (30%) ratings were lowered by between four and six notches.
• 823 (30%) ratings were lowered by more than six notches.

Highlights of the upwards transitions were:

• Of the 113 ratings raised, 107 (95%) were raised by between one and three notches.
• Four ratings (4%) were raised by between four and six notches.
• A further two ratings (2%) were raised by more than six notches.

Almost 90% of the downward transitions of more than six notches were among CDO ratings. This followed significant negative rating migration - including defaults - among certain investment grade corporate issuers, which were commonly referenced in CDOs. Combining this data with the number of ratings remaining stable leads us to an overall assessment of the average change in credit quality.

For this purpose, we define average change in credit quality as the average number of rating notches by which ratings changed over the year, where we take the average across all ratings in the universe under consideration. In this averaging, we count downgrades as a negative number of notches and upgrades as a positive number.

Stable ratings undergo a transition of zero notches. We believe this measure acts as a useful summary of credit performance, as it captures both the number and magnitude of transitions across the set of ratings under consideration, as well as accounting for those ratings that remained stable.

By this definition, 2009 saw what we view as a significant 1.5 notch decline in average credit quality for European structured finance securities - slightly worse than the average decrease in credit quality of 1.4 notches recorded in 2008.

Trend in default rate reverses
In 2009 we recorded 100 defaults across 81 transactions. By original notional amount, this resulted in an annual default rate of 0.15% - reversing the rising trend from previous years (see chart below), but still significantly higher than the one-year average default rate of 0.09%.

Of the 100 defaults in 2009, 42 were in the CDO asset class and generally followed breaches of certain thresholds related to the performance of underlying assets. There were also interest shortfalls recorded on 28 classes of notes in 25 RMBS transactions, 19 classes of notes in 18 ABS transactions and 10 classes in eight CMBS transactions. We consequently lowered these ratings to D.

Defaults were significantly more common among tranches rated speculative grade at the beginning of 2009 than among those rated investment grade, with default rates of 4.24% and 0.04% respectively. In fact, most of the defaults in ABS and RMBS were on deeply-subordinated tranches in Spanish transactions, which were originally rated triple-C minus.

Significant number of ratings on credit watch negative
We believe the 2009 rating transitions should be viewed in the context that an unusually large number of ratings - 20.8% - remained on credit watch negative at the end of 2009. These widespread credit watch placements were generally due to the pending application of recently updated rating methodologies to the analysis of certain transactions.

In particular, this affected the covered bond and CDO asset classes, where 68% and 32% respectively of the ratings included in this study were on credit watch negative at the end of 2009. In addition, 31% of CMBS ratings were on credit watch negative at the end of 2009, due to performance reviews.

However, we also note that in each of these three asset classes, we placed between 45% and 68% of the ratings that remained stable during 2009 on credit watch negative by year-end for the reasons mentioned and therefore have a heightened likelihood of experiencing a downward rating migration in early 2010.

CDO transitions dominate downgrades
The severe economic recession has had a widespread influence across numerous countries and asset classes in 2009, making this difference less pronounced - although CDOs in any case still dominate our headline statistics, given their large number. The distinction in rating performance between CDOs and all other structured finance asset classes lessened in 2009, in our view in part given the weaker performance of CMBS.

Overall, CDOs saw a downgrade rate of 41.6%. Excluding CDOs, structured finance securities saw a much lower downgrade rate of 19.3%. CDOs saw a lower upgrade rate of 0.2%, compared with 2.1% for the rest of European structured finance.

Some aspects of aggregate CDO rating statistics are in our view due to the relative homogeneity of the asset class, which in our sample is dominated by synthetic CDOs of global investment grade corporate credits. Unlike in most traditional securitisation asset classes, many different CDO transactions of this type can be backed by the same underlying credits.

Indeed, we have found that the 15 most common corporate names, for example, are referenced in more than 50% of all the synthetic CDOs we have under surveillance. One effect of this feature is that rating performance of the CDO tranches themselves is in our view relatively highly correlated. As a result, our analysis suggests that aggregate observed transition rates among a group of CDOs can be relatively volatile.

In 2009, European CMBS has experienced a similar effect. While, in contrast to CDOs, different CMBS transactions do not contain the same loans as one another, they may be exposed to similar property and/or tenant dynamics, and typically share exposure to a systemic downturn in the European commercial real estate market, as has occurred over the course of the current recession. As such, their rating behaviour has in our view also been highly correlated, leading to a high downgrade rate.

ABS downgrades driven by SME transactions
Overall, the ABS asset class exhibited a downgrade rate of 15% in 2009 and an upgrade rate of 1.9%. This represents a relative deterioration in performance compared with 2008, when the downgrade and upgrade rates were 4.6% and 3.4% respectively.

Of the 157 ABS ratings we lowered over the year, 50 were in Spanish and 46 in German transactions backed by loans to SMEs, giving downgrade rates of 27.3% and 44.2% respectively for these subsectors. SME transactions account for around 42% of the ABS ratings under consideration in this study. Credit card ABS was the subsector with the next highest downgrade rate of 22.9%.

Indeed, economic pressure on European consumers and companies has in our view resulted in significant collateral deterioration for some ABS transactions. Spanish transactions have experienced the greatest rise in arrears, in line with a more pronounced economic slowdown and increase in unemployment. For Spanish SME ABS in particular, a concentration of underlying corporate borrowers in the real estate and construction sectors has led to higher arrears, since these sectors have been most adversely affected by the economic downturn.

RMBS performance differs between countries
In 2009 downgrades gathered pace in the RMBS asset class, as there was continued house price weakness and rising unemployment in many European countries. While the upgrade rate increased to 3.1% in 2009 from 2.3% in 2008, the downgrade rate increased to 17.3% from only 6.1% in 2008 (see chart below).

While a few of the downgrades continued to be due to counterparty rating actions or unhedged interest rate risk, the majority were due to our assessment of rising risk in the underlying mortgage loan collateral, as captured by rising delinquency rates and indexed loan-to-value (LTV) ratios. Realised losses also increased throughout the year as house prices remained weak in many countries, especially Spain and Ireland. The net effect was an average decrease in our opinion of credit quality of 0.46 notches in 2009, following a decrease of 0.18 notches in 2008.

However, we believe it is important to distinguish 2009 performance between subsectors within European RMBS. In fact, more than half the downgrades in all of European RMBS were in the UK non-conforming subsector, with Spanish and Irish RMBS also contributing significantly, although in absolute terms there are relatively few Irish RMBS ratings outstanding.