Basel rules may exaggerate charges for CDOs

20.04.2009 18:25 -Fitch LONDON, April 20 (Reuters) - Proposed changes to Basel II capital rules coupled with tougher rating criteria for collateralised debt obligations (CDOs) could end up exaggerating the charges banks must set aside, Fitch Ratings said. 'Potential overlap ... could result in the 'double-counting' of risks within SF (structured finance) CDO capital charges,' Fitch said in a report released on Monday. Earlier this year, the Basel Committee proposed an increase in capital charges for re-securitisations -- deals that involve two layers of packaging debt. In the first layer of packaging to create asset-backed securities (ABS), a number of mortgages or other loans are pooled together, and then the pool is divided into tranches by degree of risk. In the second layer of packaging to create a CDO, tranches of asset-backed securities are pooled together, and the pool is then divided into tranches. The riskiest tranche of a CDO is exposed to the first few percent of defaults from anything in the portfolio. When it is wiped out, default losses move to the next tranche. The higher up the structure, the greater the cushion against losses and the higher the tranche's credit rating, up to triple-A at the top. These structures are meant to provide diversification of risk across the market. But widespread defaults of subprime mortgages, which kicked off the financial crisis, revealed that diversification was illusory for many deals. RISKIER THAN EXPECTED Portfolios proved to be concentrated by type of asset, industry, geographic area, vintage of underlying loans or other aspects. CDOs created from the mezzanine, or lower-middle-level, tranches of subprime ABS, for example, ended up by concentrating risk, because default losses hit mezzanine levels of many ABS deals at about the same time. Even their triple-A tranches are forecast to go under. Some CDO tranches were riskier because the tranche slices were very thin, such as from 5 percent to 6 percent of a portfolio, which meant that they could quickly be wiped out. 'The regulatory rationale for imposing higher capital charges on SF CDOs is that ... (they are) inherently more volatile and complicated than stand-alone asset-backed securities,' Fitch said in its report. But Fitch and other credit rating agencies also have been changing their methdologies and downgrading ratings of CDO tranches to better account for these risks. Fitch said it had focused on many of the issues that concerned regulators, which could lead to an overlap. 'Similar risk exposures should face similar capital charges, irrespective of the form that the exposure takes,' said Ian Linnell, Fitch group managing director. 'Our analysis indicates that the Basel II capital charges on the full SF CDO capital structure could be several multiples higher than the Basel II charges on the entire underlying pool of structured finance collateral, even though the risk exposure is essentially the same,' he said. In other words, the proposed capital charges for banks on all the tranches of a CDO added together would be several times the capital charges on all the asset-backed securities in its portfolio. But if all the ABS were to default, the total loss would be the same whether or not they were packaged in a CDO.