Fitch to introduce synthetic CDO market risk valuation service

Fitch Ratings is aiming to introduce a new service for evaluating market risk in synthetic collateralised debt obligations (CDOs) in the next three months, which it will announce tomorrow. The rating agency will offer a mark-to-model market risk service to market participants, which it is currently demonstrating to institutional investors.

"Market risk in synthetic CDOs is an acute problem for investors but has so far not received much attention," said Kim Slawek, a London-based group managing director with Fitch responsible for product development. "The tight yield environment that has driven the move to more complex products has highlighted the need for a solution."

Deutsche Bank’s dismissal of credit derivatives trader Anshul Rustagi in January for overstating his book by £30 million and the correlation crisis of May 2005, when the equity/mezzanine tranche correlation pricing dislocation caused traders many sleepless nights following the downgrading of General Motors and Ford, have put the spotlight on market risk issues in structured credit.

"The big challenge in pricing CDOs is where you're getting your correlation numbers from. All investment banks have numerous pricing models for CDOs and hold different views on what the best methodology should be," continued Slawek. For example, two banks that use different implied correlations but identical methodologies will obtain a very different price. Different sources for underlying CDS spreads can also result in significant discrepancies in pricing.

Slawek added that the service will give investors a 10 page analysis of the underlying market drivers of a price change, seeking to look in greater depth at how and why spreads and correlation figures have affected the price. "The aim is to create transparency behind price changes, which is not something that investors get today," she said.