Fitch Announces New Interest Rate Stress Criteria for U.S. Structured Finance.

NEW YORK -- Fitch Ratings has announced its new structured finance interest rate stress criteria for transactions involving USD LIBOR.

Fitch's current methodology for stressing interest rates involves applying a vector of rate changes to spot LIBOR. For each rating level, an increasingly more stressful vector is applied. The magnitude of these vectors was based on observation of historical interest rate movements. The new methodology takes advantage of information in the options market about term structure and volatility to determine scenarios based on the probability of future rate movements. As the methodology is based on forward rates and implied volatility, it therefore is more sensitive to market expectations than methodologies that apply fixed ramps to spot LIBOR.

'We sought to construct a methodology that reflected market expectations about the direction and magnitude of rate movements while incorporating sufficient conservatism to protect investors against larger, unexpected changes in interest rates,' said Managing Director and Quantitative Financial Research (QFR) group-head Ahmet E. Kocagil.

The new model utilizes forward-looking market data, i.e. USD LIBOR swap prices as inputs to determine the term structure of interest rates, and derives rate volatility based on swaption pricing. A lattice of potential rate paths is generated using the model. Rising and falling interest rate stress scenarios are defined based on the probability of rate changes encompassed by the lattice.

In terms of implications on ratings, Fitch expects the impact of the transition to be moderate.

'In terms of impact form the methodology change, CDOs and subprime mortgage bonds stand out because of the risk that arises from mismatches between asset and liability coupon rates,' said Kocagil. 'These securitizations also use an excess spread structure that uses the interest cash flow from assets in excess of the liability interest due to pay down bonds in an effort to offset collateral losses.'

In addition to capturing interest rate stresses, Fitch's criteria will also account for the increased use of derivatives within structures to mitigate rising rate risk as the effect can be quite noticeable, especially in structures where floating-rate liabilities are supported by largely fixed-rate assets. 'Fitch's utilization of rising and falling rate scenarios, together with the new rate stress methodology, will limit such arbitrage opportunities in Fitch-rated transactions,' said Kocagil.

For more details on Fitch's new criteria, see the report 'Interest Rate Risk In Structured Finance Transactions: USD LIBOR', which is available on the Fitch Ratings web site at 'www.fitchratings.com'

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, 'www.fitchratings.com'. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.