Feb. 5 (Bloomberg) -- Fitch Ratings may downgrade the $220 billion of collateralized debt obligations it assesses that are based on corporate securities to reflect higher risks of default than the firm initially assumed.

The New York-based company may lower the notes by as much as five levels after failing to accurately assess the risk of debt that packages other assets, according to guidelines proposed by Fitch today. CDOs with AAA grades that are based on credit- default swaps and aren't actively managed may face the steepest reductions.

Fitch, Moody's Investors Service and Standard & Poor's are slashing ratings amid criticism that they failed to react quickly enough as rising defaults on subprime mortgages in the U.S. caused a plunge in the value of CDOs linked to home loans. Fitch, a unit of Fimalac SA in Paris, cut $67 billion of mortgage-linked CDOs in November, lowering some AAA debt to below investment grade.

``Fitch is acknowledging that it was overly optimistic in its default rate and other assumptions in its original CDO methodology,'' said Christian Stracke, an analyst at bond research firm CreditSights Inc. in London.

Moody's last year reduced $76 billion of CDOs and began this year with $185 billion of deals under review. The New York-based company said yesterday it may overhaul its system for evaluating structured-finance securities, proposing options including a numerical scale and a designation of ``.sf'' to differentiate a structured-finance ranking from a corporate credit grade.

Ratings Challenge

S&P, the New York-based unit of McGraw-Hill Cos., downgraded or placed under review $98.3 billion of CDOs last month, citing ``stress in the residential mortgage market and credit deterioration.''

Fitch's review of 600 CDOs referencing company debt and derivatives doesn't cover structured-finance notes, which package asset- and mortgage-backed securities. It plans to introduce the new criteria by the end of March after seeking feedback.

CDOs are securities that package pools of bonds, loans and credit-default swaps and slice their cash flow into notes of varying risk and returns that are sold to investors. Junk bonds are rated below Baa3 by Moody's and lower than BBB- by S&P.

Fitch wants to ``produce ratings that perform similarly in terms of default risk and ratings migration with the market's expectation for other asset classes,'' John Olert, head of global structured credit at the firm in New York, said in a statement.

Sales Decline

The changes will penalize the concentration of risk in any one industry, Ken Gill, a managing director at Fitch in London, said in a telephone interview. The firm will also be tougher on CDO managers that pick the weaker of similarly graded securities to generate higher returns with the same ratings, known as adverse selection, Gill said.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

CDOs that package high-yield assets may be reduced as many as three levels for the portions first in line for losses, Fitch said.

Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry's largest conference this week.

`Dropping Precipitously'

``We're definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks,'' Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday during a panel discussion at the American Securitization Forum's annual conference in Las Vegas. ``It's a challenging time.''

Sales of CDOs to investors fell about 11 percent last year to $491.6 billion, and probably will slide 65 percent in 2008, according to JPMorgan. Citigroup Inc., Merrill Lynch & Co., Deutsche Bank AG, Wachovia Corp. and JPMorgan were the top CDO underwriters last year, according to Thomson Financial data.

``Any proactive action on Fitch's part which could result in substantial downgrades may be negative for credit markets,'' said Puneet Sharma, head of investment-grade credit research at Barclays Capital in London.

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

Last Updated: February 5, 2008 16:31 EST