Key Rating Issues in Synthetic CDO’s - Mayer BrownSynthetic CDO StructuresSynthetic CDO Structures...

Key Rating Issues in Synthetic CDO’s

Key Rating Issues in Synthetic CDO’s

Tania Cunningham, CFA - Associate Director July 16, 2003

Tania Cunningham, CFA - Associate Director July 16, 2003

Types of SyntheticsTypes of Synthetics

Synthetic Index Trades

Eg. HYDI Credit Linked Trust

Synthetic Index Trades

Eg. HYDI Credit Linked Trust

Single Name CreditLinked Notes

Eg. TIERS Trust

Single Name CreditLinked Notes

Eg. TIERS Trust

nth to DefaultBaskets

Eg. (private)

nth to DefaultBaskets

Eg. (private)

Static InvestmentGrade Synthetics

Eg. Julia CDO, Ltd.

Static InvestmentGrade Synthetics

Eg. Julia CDO, Ltd.

Managed Synthetics

Eg. Shoreline

Managed Synthetics

Eg. Shoreline

High Yield Arbitrage CLOs

Eg. SERVES

High Yield Arbitrage CLOs

Eg. SERVES

SyntheticStructures

SyntheticStructures

Single TrancheCDOs

Eg. Private

Single TrancheCDOs

Eg. Private

Typical Synthetic CDO StructureTypical Synthetic CDO Structure

InvestorSPV

(Protection Seller)Swap Counterparty(Protection Buyer)

Reference Entities Collateral

Proceeds

Proceeds

CouponCDS Premium

Protection Payment

Collateral Economics

Credit Default Swap

Credit Linked Note

Synthetic CDO StructuresSynthetic CDO Structuresä Characteristics of a Credit Default Swap:

— Protection buyer/ protection seller

— Reference entities

— Credit events

— Obligations on which a credit event can be called

— Obligations on which loss settlement can be determined

— Settlement method: cash or physical settlement

— Valuation process (if cash settled)

ä Characteristics of a Credit Default Swap:

— Protection buyer/ protection seller

— Reference entities

— Credit events

— Obligations on which a credit event can be called

— Obligations on which loss settlement can be determined

— Settlement method: cash or physical settlement

— Valuation process (if cash settled)

Summary of the Rating ProcessSummary of the Rating Processä Sponsor/ manager motivations and expertise

examined

ä Probability of credit events determined

ä Likely recoveries in the event of default assessed

ä Structure reviewed:— collateral arrangements

— counterparty risk

ä Performance Analytics

ä Sponsor/ manager motivations and expertise examined

ä Probability of credit events determined

ä Likely recoveries in the event of default assessed

ä Structure reviewed:— collateral arrangements

— counterparty risk

ä Performance Analytics

Portfolio Default ProbabilityPortfolio Default Probabilityä Name-by-name analysis of the portfolio

ä Publicly rated names:

— Fitch rating or lowest public rating

— Market information (CDS spreads), potential downgrades and corporate analyst’s opinion may lead to rating adjustment

ä Default probability

— New criteria effective August 1, 2003

ä Portfolio Diversification

— Correlation analysis

ä Name-by-name analysis of the portfolio

ä Publicly rated names:

— Fitch rating or lowest public rating

— Market information (CDS spreads), potential downgrades and corporate analyst’s opinion may lead to rating adjustment

ä Default probability


ä Portfolio Diversification

— Correlation analysis

Portfolio Default ProbabilityPortfolio Default ProbabilityTop Industry Concentrations

Insurance10.67%

Banking, Finance, and Real Estate10.67%

Building and Materials7.33%

Utilities6.67%

Broadcast and Media6.00%

Energy6.00%

Industrial/Manufacturing5.33%

Automobiles4.67%

Retail4.00%

13 Other Industries20.67%

Telecommunications8.67%

Computers and Electronics9.33%

Reference Entity RatingsRating Number % of Rating Category of Entities Portfolio Factor

‘AAA’ 2 1.33 1.3‘AA+’ — — 2.0‘AA’ 1 0.67 2.3‘AA–’ 5 3.33 3.3‘A+’ 15 10.00 4.0‘A’ 21 14.00 5.0‘A–’ 22 14.67 7.5‘BBB+’ 26 17.33 10.0‘BBB’ 35 23.33 14.0‘BBB–’ 15 10.00 20.0‘BB+’ 8 5.33 37.0‘BB’ — — 43.5‘BB–’ — — 46.5‘B+’ — — 50.0‘B’ — — 52.2‘B–’ — — 65.0‘CCC+’ — — 90.0‘CCC’ or Lower — — 100.0WA Rating Factor — — 11.32WA – Weighted average.

Credit EventsCredit Events

ä Failure to Pay

ä Bankruptcy

ä Restructuring

ä Repudiation/Moratorium

ä Obligation Acceleration

ä Obligation Default

ä Failure to Pay

ä Bankruptcy

ä Restructuring

ä Repudiation/Moratorium

ä Obligation Acceleration

ä Obligation Default

Credit EventsCredit Eventsä Market Practice

— For developed markets– Failure to Pay

– Bankruptcy

– Some form of Restructuring

— For emerging markets and sovereigns– Failure to Pay


– Repudiation/Moratorium

ä Market Practice

— For developed markets– Failure to Pay

– Bankruptcy


— For emerging markets and sovereigns– Failure to Pay


– Repudiation/Moratorium


ä Restructuring

— Old Restructuring

— Mod Restructuring

— Mod-Mod Restructuring

— No Restructuring

ä Restructuring

— Old Restructuring

— Mod Restructuring

— Mod-Mod Restructuring

— No Restructuring


ä Obligation Acceleration or Obligation Default

— Alternative Credit Events

— Used Primarily in “one off” trades for which the events may be relevant

ä Obligation Acceleration or Obligation Default

— Alternative Credit Events

— Used Primarily in “one off” trades for which the events may be relevant

Restructuring and/or Obligation AccelerationRestructuring and/or Obligation Acceleration

Examples: Both the Xerox restructuring (June 2002) and the Conseco restructuring (Oct. 2002)highlighted ‘soft credit event’ risk and ‘cheapest to deliver’ risk

Examples: Both the Xerox restructuring (June 2002) and the Conseco restructuring (Oct. 2002)highlighted ‘soft credit event’ risk and ‘cheapest to deliver’ risk

Since the inclusion of Restructuring and/or Obligation acceleration as a Credit Event increases the probability of loss to investors, Fitch increases Its base probability when rating a synthetic CDO.

Since the inclusion of Restructuring and/or Obligation acceleration as a Credit Event increases the probability of loss to investors, Fitch increases Its base probability when rating a synthetic CDO.

Fitch applies a default adjustment factor to ReferenceEntities whether old-R, mod-R or mod-mod R is included asa Credit Event.

Fitch applies a default adjustment factor to ReferenceEntities whether old-R, mod-R or mod-mod R is included asa Credit Event.

Fitch Rating ImplicationsFitch Rating Implications

Fitch pays close attention to the choice of Credit Events, thescope of protection based Obligation selection and ObligationCharacteristics included in the terms of the CDS.

Fitch pays close attention to the choice of Credit Events, thescope of protection based Obligation selection and ObligationCharacteristics included in the terms of the CDS.

When analyzing the default risk of synthetic CDOs, Fitchwill, when applicable, take account of the Credit Eventsdefined and Obligations specified in the underlying CDS.

When analyzing the default risk of synthetic CDOs, Fitchwill, when applicable, take account of the Credit Eventsdefined and Obligations specified in the underlying CDS.

Loss DeterminationLoss Determination

ä Recovery Rate assumptions


— Loss settlement method (cash versus physical)

— Valuation process (cash settlement)

ä Recovery Rate assumptions


— Loss settlement method (cash versus physical)

— Valuation process (cash settlement)

Convertible, Exchangeable and Accreting ObligationsConvertible, Exchangeable and Accreting Obligations

ä The 2003 Definitions essentially roll in the Convertible, Exchangeable and Accreting Obligations Supplement

ä The 2003 Definitions essentially roll in the Convertible, Exchangeable and Accreting Obligations Supplement

Example: CSFB had refused to accept delivery of Railtrack exchangeable bonds from protection buyer Nomura.

Fitch may apply a haircut to its normal recoveryRate assumption when either convertible bondsand/or consent required loans constitutedeliverable obligations

Fitch may apply a haircut to its normal recoveryRate assumption when either convertible bondsand/or consent required loans constitutedeliverable obligations

Structural FeaturesStructural Featuresä Counterparty exposure

— Achieve structural delinkage (reserve accounts and downgrade triggers)

— Immunize “breakage costs”

ä Collateral arrangements

— Overcollateralization and marking-to-market

— Put option/repurchase agreement

ä Counterparty exposure

— Achieve structural delinkage (reserve accounts and downgrade triggers)

— Immunize “breakage costs”

ä Collateral arrangements

— Overcollateralization and marking-to-market

— Put option/repurchase agreement

SummarySummary

ä Area of growth and development

ä New rating issues raised with innovative structures

ä New data used to refine assumptions

ä New criteria report: ‘Global Rating Criteria for CDOs’

ä Area of growth and development

ä New rating issues raised with innovative structures

ä New data used to refine assumptions

ä New criteria report: ‘Global Rating Criteria for CDOs’

www.fitchratings.com

Rating nth-to-Default Basket CreditLinked Notes

Rating nth-to-Default Basket CreditLinked Notes

Tania Cunningham, CFA - Associate Director

July 16, 2003

Tania Cunningham, CFA - Associate Director

July 16, 2003

Defining the characteristics of an nth-to-default contractDefining the characteristics of an nth-to-default contract

ä Correlation trade

ä Type of OTC credit derivative

ä Payoffs depend on the occurrence of the nth credit event in an underlying basket of bonds

ä Correlation trade

ä Type of OTC credit derivative

ä Payoffs depend on the occurrence of the nth credit event in an underlying basket of bonds

Cash Flows of nth to Default Basket SwapsCash Flows of nth to Default Basket Swaps

Credit Event on nth Asset No Credit Event on nth Asset

TRUST INVESTOR

Proceeds

Notes/Certificates

1 Initial Exchange

TRUST INVESTOR

PAR

2 Early TerminationRecovery amountor physical security

TRUST INVESTOR

Proceeds

Notes/Certificates

1 Initial Exchange

TRUST INVESTOR

Note

2 At Maturity

PAR

Maturity

Closing

Time Line

Types of nth-to-defaultsTypes of nth-to-defaults

First loss pieces in traditional CDOs

First loss pieces in traditional CDOs

First-to-defaultFirst-to-default

Third-to-defaultThird-to-default

Linear basketsLinear baskets

Fifth-to-defaultFifth-to-default

TYPESTYPES

The rating is ultimately based onThe rating is ultimately based on

ä Creditworthiness of individual reference entities

ä Number of reference entities

ä Default correlation between reference entities

ä Number of defaults to trigger payment

ä Term of the deal

ä Credit event language, legal opinions, etc.

ä Creditworthiness of individual reference entities

ä Number of reference entities

ä Default correlation between reference entities

ä Number of defaults to trigger payment

ä Term of the deal

ä Credit event language, legal opinions, etc.

Rating nth to Default Basket SwapsRating nth to Default Basket SwapsRating of 1st to Default Basket

Ratings of the reference entities form the boundaries for the rating of the basket.

§ Upper boundary – weakest credit

§ Lower boundary – sum of the default probabilities of each credit

§ Lower boundary assumes no creditsdefaults at exactly the same time

0 10020 40 60 80

Def

ault

Pro

babi

lity

Correlation %

Ratings (reference entities, swap counterparty and collateral)

Associated default probabilities

Default correlation (reference entities, swapcounterparty and collateral)

Number of reference entities

Term of the deal

Credit event language, legal options, etc.

Number of defaults to trigger payment

Lower Boundary

Upper Boundary

Advantages of Monte CarloAdvantages of Monte Carlo

ä The number of assets— Typically ranges from 2 to 25

ä The number of assets— Typically ranges from 2 to 25

Distorts the results if we use a scenario model based on historical averages.Distorts the results if we use a scenario model based on historical averages.


ä Correlation between the assets— Plays a crucial role in this type of deal

ä Correlation between the assets— Plays a crucial role in this type of deal

The MC approach provides a fairly simple way to factor in correlation.The MC approach provides a fairly simple way to factor in correlation.


ä Dynamics of transaction— Captured using MC simulation better than any other method

ä Dynamics of transaction— Captured using MC simulation better than any other method

In particular MC is the only way to model the tail end of the distribution: It is possible to compute the mean and the variance without using a MC approach but not the 99th percentile unless you assume a specific statistical distribution.

In particular MC is the only way to model the tail end of the distribution: It is possible to compute the mean and the variance without using a MC approach but not the 99th percentile unless you assume a specific statistical distribution.

Effect of Correlation: three name first-to-default basket Credit Default SwapsEffect of Correlation: three name first-to-default basket Credit Default Swaps

A B

C

A B

C

A B C

Negative Correlation Low Correlation High Correlation

Effect of CorrelationEffect of Correlation

ä First-to-default transactions benefit from it because it reduces the likelihood of one or more defaults

ä The effect of correlation for all other nth to default transactions is more variable

ä First-to-default transactions benefit from it because it reduces the likelihood of one or more defaults

ä The effect of correlation for all other nth to default transactions is more variable

Effect of CorrelationEffect of Correlation

0%5%

10%20%

30%40%

50%60%

70%80%

90%99%

First-to-DefaultSecond-to-Default

Third-to-DefaultFourth-to-Default

Fifth-to-Default

Sixth-to-Default

Seventh-to-Default

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Def

ault

Pro

bab

iliti

es

Correlation levels

Correlation Chart

First-to-Default

Second-to-Default

Third-to-Default

Fourth-to-Default

Fifth-to-Default

Sixth-to-Default

Seventh-to-Default

The CommitteeThe Committee

ä Results based on a number of correlation assumptions presented

ä Where necessary input sought on individual bi-variate correlations from Fitch corporate analysts

ä Consistency checks by reference to comparable deals

ä US and European attendance on committees is normal

ä Results based on a number of correlation assumptions presented

ä Where necessary input sought on individual bi-variate correlations from Fitch corporate analysts

ä Consistency checks by reference to comparable deals

ä US and European attendance on committees is normal

www.fitchratings.com

Key Rating Issues in Synthetic CDO’s - Mayer BrownSynthetic CDO StructuresSynthetic CDO Structures...

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