Evaluating Structured Finance Credit Quality

Fitch Ratings has issued a lengthy new study detailing its criteria for evaluating the credit quality of securities backed by residential mortgages, commercial mortgages, credit cards, student loans and auto loans.

Evaluating the fundamental credit quality of underlying assets is a critical component of structured finance analysis and involves both qualitative and quantitative assessments of loan-level and portfolio level credit risk attributes, Fitch says.

On a loan-level, structured credit metrics include among others, measures of borrower credit quality, debt repayment capacity and collateral, and on a pool level, measures of portfolio risk such as borrower and sector concentrations.

While specific credit metrics are not always directly comparable or fungible across asset classes, the study seeks to identify and describe parallel analytical concepts across the different structured finance product types.

The study also contrasts the applicability of certain attributes across product types. For example, metrics pertaining to borrower leverage, such as loan-to-value ratios, are fundamental to the analysis of residential mortgage and commercial mortgage lending but largely irrelevant to unsecured lending in which the borrower does not have equity in an underlying asset, such as credit card receivables.

The analysis of borrower concentration risk is essential for less granular portfolios containing large individual exposures, such as commercial mortgages, but less so for more granular pools characterized by diversification of single-borrower risk, such as consumer loans.

The metrics and associated interpretations are synthesized from Fitch’s structured finance ratings criteria, published commentary, deal reports, surveillance process, and performance indices.

Fitch’s study Unstructuring Structured Finance is available for purchase.

 

In a related development, Fitch is seeking comments on proposed new rating scales and indicators to enhance the meaning and usefulness of existing structured finance ratings, as well as proposals for increased transparency. Any comments should be sent to [e-mail] by 1 August 2008.

The proposals focus on: the addition of new rating scales or indicators reflecting various risks in structured finance; and disclosure of key transaction parties’ retention of equity tranche risk within structured finance transactions.

Comments

[CharlieStromeyer Jr]

Gee, who woulda thunk that default risk increases with borrower leverage? Evidently, the morons on Wall Street never thought of this. Thanks for this great insight o you wizards at Fitch!

Disclosure: recommended shorting collateralized debt obligations (CDOs) in early June 2007, am still short U.S. home prices and have still not called a bottom in the U.S. credit markets.