Although assumptions vary by rating agency and by deal, to some extent SF CDOs benefit from conservative structures versus CDOs that source like-rated corporate collateral. Like all other CDOs, defaults, recovery rates, and correlation are key determinants in the credit enhancement processbelow we provide a brief overview.
Due to the relative youth of the ABS market and the lack of a sufficient default history, Moodys bases its expected loss assumptions on similarly-rated corporates.
Moodys does acknowledges that to date, ABS performance has been superior, and that their recovery rate assumptions may be somewhat conservative17(as follows, if you back out default rates holding expected loss constant, implied defaults are somewhat lower than corporates). Table 22 below illustrates Moodys current recovery assumptions. Excessively thin tranches are penalized, as are CDOs with low Diversity Scores (reasonable, we think).
Turning to S&P, less stringent default assumptions are used, but this is at least partially offset by more onerous ABS default correlation assumptions. Additionally, S&P uses a 7 year weighted average maturity for the purposes of determining subordination levels for SF CDO liabilities. This is particularly conservative for junior SF CDO Defaults and Recoveries
17. Moodys Approach to Rating Multisector CDOs, Moodys Investors Service.
Table 22
Moodys Recovery Values for Structured Finance collateral Structured Finance Sector % of deal Tranche Rating
Aaa Aa A Baa Ba B
Diversified Securities1 > 70% 85% 80% 70% 60% 50% 40%
10 - 70% 75 70 60 50 40 30
< = 10% 70 65 55 45 35 25
Residential Securities2 >70% 85 80 65 55 45 30
10 - 70% 75 70 55 45 35 25
5 - 10% 65 55 45 40 30 20
2 - 5% 55 45 40 35 25 15
< = 2% 45 35 30 25 15 10
Undiversified Securities3 > 70% 85 80 65 55 45 30
10 - 70% 75 70 55 45 35 25
5 - 10% 65 55 45 35 25 15
2 - 5% 55 45 35 30 20 10
< = 2% 45 35 25 20 10 5
Low Diversity CDOs4 > 70% 80 75 60 50 45 30
10 - 70% 70 60 55 45 35 25
5 - 10% 60 50 45 35 25 15
2 - 5% 50 40 35 30 20 10
< = 2% 30 25 20 15 7 4
High Diversity CDOs5 > 70% 85 80 65 55 45 30
10 - 70% 75 70 60 50 40 25
5 - 10% 65 55 50 40 30 20
2 - 5% 55 45 40 35 25 10
< = 2% 45 35 30 25 10 5
Source: Moodys Investors Service.
1. Autos, Car Rental Receivables, Credit Cards, Student Loans.
2. Home Equity Loans, Manufactured Housing, Residential A/B/C.
3. CMBS Conduit, CTL, and Large Loan. Others not included in Diversified Securities.
4. CDOs with a Moodys Diversity Score < = 20.
5. CDOs with a Moodys Diversity Score >= 20.
tranches, which tend to have longer average lives than 7 years (say 10 years). These tranches are effectively penalized as they must withstand a higher scenario default rate than if their actual expected life were used to calculate subordination.
Finally, Fitch also uses historical default rates of corporates as the basis for ABS
again given the performance of ABS (excluding CDOs) they reduce rates by as much as 20%. The agency also takes into account tranche size and seniority level to determine recovery ratei.e. more senior (and/or larger) tranches would receive a higher rate.
Turning to default correlation, the rating agencies acknowledge that the lack of a default history poses a problem in accurately estimating joint-default probabilities of ABS sectors and issuers. S&Ps CDO Evaluator18assumes a correlation of 30% for the same ABS sector within the same country, 20% for the same sector within the same region (i.e. UK RMBS vs Italian RMBS), and no correlation only in cases with the same sector but within different regions (i.e. US RMBS vs Australian RMBS).
In contrast, S&P assumes no correlation between corporate sectors for other CDOs.
For Moodys, its more difficult to make an explicit comparison, but we describe their Alternative Diversity Score methodology (adapted from the original
framework for corporates). The calculation groups a portfolio into a matrix of ABS sectors and adjusts for par amount, default probability, and correlation. In the final analysis an actual, correlated portfolio is reduced to an idealized, uncorrelated one.
Moodys assumes lower joint-default probability for investment grade ABS than for sub-investment grade ABS and also makes specific adjustmentsi.e. consumer sectors (such as Cards and Autos) might be highly correlated with each another, but as a group, largely uncorrelated with real estate sectors (such as CMBS and RMBS).
Somewhat similar to S&P, Fitch uses a rule based approach that captures both regional and sector diversitybut all things equal, correlation between ABS is assumed to be higher than correlation between corporates. Correlation is assumed to be around 45% between ABS assets within the same sector and the same region.
This assumption is reduced for assets from different sub sectors and/or different regions, and for CDO tranches the agency applies a look through methodology that derives the correlation between CDO tranches, from the correlation between the underlying corporates. See Appendix B for an overview of rating agency classifications for structured securities.
Finally, ABS collateral prepaying or extending at speeds different from whats been originally modeled can be problematic, as it can impact the stability of the expected cash flows from the portfolio, affecting the credit quality of the CDO tranches. For example, a significantly higher prepayment rate than what was expected would lead to more asset cash flows than expected. If this is occurring in a declining interest rate environment, and/or during a slowdown in ABS issuance, the deals manager might have difficulty reinvesting this excess cash. As a result, Moodys halves and
18. Global Cash Flow and Synthetic CDO Criteria, Standard and Poors.
Correlation
Prepayment Stress
then doubles prepayment speeds of ABS collateral. The other agencies perform something similarfor example S&P stresses the base case prepayment speed by 0.5 times and 1.5 times the base case to come up with slow (and fast) prepayment scenarios. Wearing our ABS hat, we think all of this is potentially more stressful than what has happened to ABS during different periods in the markets history
but again highlight the benefit of this conservatism to CDO investors.