Fitch Ratings yesterday answered criticisms of its capital model and ratings methodology, releasing a detailed report to give greater transparency to a market still trying to grapple with a raft of financial guarantor downgrades.
The report, which is in a question-and-answer format, addresses many of the questions that have been raised in the market about Fitch's capital model. Critics, including MBIA Inc., parent of bond insurer MBIA Insurance Corp., and Radian Group, parent of financial guarantor Radian Asset Assurance Inc., have raised concerns about the apparently conservative approach of the model.
Both companies have asked Fitch to withdraw its rating on their financial guarantors. They declined to comment for this story.
"There have been some recent questions that we received relating to our assessment of capital and how we go about its view, whether it is how we assess municipal finance risk or how we are assessing structured finance risk," said Tom Abruzzo, managing director at Fitch.
In January 2007, Fitch debuted a new capital model that it called Matrix. The model was created in consultation with Milliman Inc. and often demands higher capital levels for bond insurers than the models of the other rating agencies, or in some cases the models used by bond insurers' themselves.
Specifically, the Fitch model assumes a lower incidence of risk on municipal credits than other rating agencies and a higher risk of loss on complex structured-finance securities, such as collateralized debt obligations. This is due in part to a "regime shift," which assumes infrequent recessionary conditions, and in part due to a model that recognizes different loss expectations for different slices of a CDO.
This approach can mean more capital needs to be set aside for thinner, non-senior slices that could reach a default rate of 100%, which is apparently more severe than the models of the other two agencies, according to Fitch.
While Fitch is firm in its belief that the muni default rates are appropriate and that the Matrix model accurately addresses risks for most assets, Abruzzo said that the CDOs are proving to be more complex than the model envisioned.
"The existing model that we use was not necessarily built to address the level of deterioration within that asset class," he said.
Evidence suggests the other rating agencies did not foresee the degree of loss either. Both Standard & Poor's and Moody's Investors Service readjusted their calculations of default rates within CDOs tranches, which, like Fitch, led to changes in ratings for some of the financial guarantors.
"As the crisis progresses, investors have to assume that the rating agencies will update their models," said Matt Fabian, managing director at Municipal Market Advisors. "As people's opinion of risk is rewritten, they will have to similarly revise risk models."
In an effort to prevent further uncertainty, Fitch has made the choice to pull the CDO transactions out of each insurer's portfolio. Analysts will examine each transaction, calculate the capital needed to cover the worst-case losses, and then recombine the CDOs with the rest of the portfolio to arrive at the capital needed for each rating level.
Fitch also addressed criticism leveled at its low market share - as compared to its more established peers - in rating the underlying credits of issues. Its access to portfolio information and the robustness of its ratings methodology lead to comparative studies that show the ratings of all three agencies "align very closely," the report said.
While the report was intended to address the questions of investors and broader market participants, it is not likely to change the opinion of those who have been outspoken against Fitch's model.
"I think those folks have their own opinions of what is correct and, Q&A or not, those opinions aren't going to change," said Guy LeBas, fixed-income strategist at Janney Montgomery Scott LLC. "In a situation where there is no clear-cut answer, of course there are going to be differences of opinion."