Moody’s Updated Modeling Parameters for Rating Corporate Synthetic CDOs and Cash Flow CLOs
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In recent months, as the credit crisis that started in the summer of 2007 has spread across various sectors, and economies around the world are confronted with a deep and long recession, synthetic CDOs and cash flow CLOs—whose ratings have been relatively stable—have started seeing substantial downgrades.
During the past few months, Moody’s has revised and updated the key modeling parameter assumptions that it uses to rate and monitor CDOs and CLOs backed by corporate debt. These changes alone have led Moody’s to downgrade—in many cases by several notches—a large number of CDO and CLO tranches, and many remain on review for possible further downgrade.
Reasons for the changed assumptions include weak performance of the underlying collateral and Moody’s expectations for continued weak performance due to rising corporate default rates, limited near-term debt refinancing opportunities for corporations, and the increasingly negative credit outlook for the global economy.
Moody’s broad framework for rating CDOs uses a Gaussian copula model to generate a loss distribution for the portfolio, as incorporated in its public CDO rating model. The three key parameters in the model that Moody’s has been updating are: asset correlation, default probability, and recovery rate. For rating Cash Flow CLOs, in addition to the Gaussian copula based CDOROM model, Moody’s methodology also uses Binomial Expansion Technique (BET) and other methods such as Double Binomial for generating expected loss (EL) estimates within a CLO portfolio. BET relies on the use of Diversity Score (DS), which is a measure of diversity within a credit portfolio.
All of these changes are incorporated into Moody’s updated public CDO rating model, CDOROM v2.5, along with its user guide , which were released in February as well as in the other models used for rating Cash Flow CLOs. The CDOROMv2.5 user guide explains the new parameters in more detail than space allows here. Moody’s describes its approach to rating CDOs in detail in its published methodologies.
Here are the basics of the revised parameters:
Synthetic CDOs, CDOs backed by a pool of credit default swaps referencing corporate credits, and cash flow CLOs (collateralized loan obligations) share the important modeling parameter of probability of default. Historically, corporate default rates within a given rating category have varied greatly across the economic cycle. As in previous credit cycles, corporate default rates are likely to rise well above their historical long-term averages. Moody’s expects that the current negative cycle will last for at least the next two years and be worse than in previous cycles.
In response, Moody’s has increased its default probability assumptions for corporate credits in the collateral pools of synthetic CDOs and CLOs by a factor of 30% across all rating categories. This applies to all synthetic and cash-flow CDO transactions, which include those backed by corporate loans, bonds, or emerging market credits.
Moody’s has also made slight changes to its use of some its auxiliary rating signals. Given the highly volatile credit conditions, Moody’s has further extended its quantitative modeling practice of anticipating possible future corporate rating actions by treating ratings on “Review for Possible Downgrade” as if they were two notches lower than their current rating and credits with a “Negative Outlook” as if they were one notch lower. The prior practice was to adjust the rating down one notch for credit on negative review and no notches for those on outlook. As before, ratings on “Review for Possible Upgrade” will continue to be treated as if they are one notch higher.
Moody’s intends to follow closely any changes in future corporate default rate expectations and macroeconomic outlooks and make further necessary adjustments to the default probability stress factor as is appropriate.
Globalization and the increasing complexity and interdependence of credit markets have led to a substantial increase in the extent to which stress in one sector can impact another. In addition, the severe market environment at present is putting pressure on many regions and industries all at once. Both factors have led to a sharp increase in observed default correlation among corporate credits.
For synthetic CDOs, Moody’s derives its default correlation for its analysis through a combination of asset correlation and default rates. While increasing default probabilities generates higher default correlations across all rating categories, Moody’s has also raised asset correlation assumptions in the investment-grade rating categories and in the financial sector in order to generate default correlations consistent with its current observations. Accordingly, asset correlation assumptions have been updated as follows:
- Increased inter-industry asset correlations of investment-grade corporate credits. Moody's calculates overall asset correlations using a tree structure that adds component percentages according to risk or asset classification and assigns each asset into one of the branches on the tree. The intra-industry asset correlations have also been increased, and have eliminated the prior “low” and “high” categories. This is because a sector with a recent low correlation level can become a high correlation sector in future and vice versa.
- Created a new industry by merging banking, finance, insurance and real estate into one industry. This reflects much stronger connections between companies in these industries as demonstrated by the recent financial crisis. We have also reclassified corporate credits into 35 industries according to a new industry classification code. The new code incorporates Moody’s latest view on the industry characteristics of rated companies.
- Increased the number of global industries from three to twelve and reduced the number of local industries from fifteen to five. An industry that is global in nature tends to have higher correlation between companies in different regions.
- Portfolios with large concentration in a single industry are subject to an additive asset correlation penalty of up to 30%. This stress is effective on industry concentration greater than 8% and increases in geometric proportion until concentration reaches 50%. Concentrations of more than 50% will continue to be reviewed on a case-by- case basis. The prior triggers were at 20%, 35% and 50% concentration with an additional asset correlation penalty of 5%, 10% and 15% respectively.
Diversity Score (Cash Flow CLOs)
For cash flow CLOs Moody’s primary measurement for industry and issuer diversification is its Diversity Score. Many of the revised assumptions for the Diversity Score match the changes in the asset correlation assumptions for Synthetic CDOs:
- Four industries (banking, finance, insurance and real estate) are merged into one. This reflects much stronger connections between corporate credits in these industries in the current financial crisis. Corporate credits are reclassified according to a new industry classification code.
- The number of global industries has been increased from three to twelve with a corresponding reduction in the number of local industries from fifteen to five. Corporate credits from global industries are assigned higher correlation estimates than corporate credits across local industries. Larger number of global industries, therefore, translates into lower diversification benefit assumed in the CLO rating model.
Impact on Ratings
At the time of writing, Moody’s was in the process of reviewing all of its outstanding corporate synthetic CDO ratings across 900 transactions in the U.S., Europe and Asia (totaling approximately US$150 billion) using these updated assumptions. Rating actions are released as individual transaction’s analyses are completed. Based on initial data for the rating changes, ratings of a large majority of corporate synthetic CDO tranches have been lowered by three to ten notches on average. In addition to the effect of the changes in the modeling parameters, the magnitude of the downgrades also reflects transaction-specific characteristics such as tranche subordination, vintage, and portfolio composition.
Moody’s has also begun revaluating all outstanding mezzanine and junior tranche ratings from the approximately 1,000 CLO transactions that it rates (totaling approximately US$400 billion) across the U.S., Europe and Asia. The revised default probability and Diversity Score assumptions has had a significant impact on mezzanine and junior CLO tranches, resulting in a downgrade of their ratings by three to eight notches on average.
The senior CLO notes were scheduled to be reviewed on a case-by-case basis. It is important to note that the cash-flow diversion and delevering structural mechanisms in many CLOs are designed to provide significant credit protection to senior notes in a stressed credit environment. As such, the impact from the revised assumptions on most senior CLO tranches is expected to be small and to vary in accordance with a tranche’s credit enhancement level, its size relative to capital structure, and other structural features such as overcollateralization cushion, payments waterfall, as well as portfolio composition and vintage.
Moody’s is also further refining its CLO rating methodology. We intend to continue examining other elements of the methodology such as the use of Probability of Default Ratings (PDR) and Loss Given Default (LGD) in CLO rating analysis. In general, Moody’s expects such additional refinements to have rating implications that are less significant than those from the changes already made.
It is important to note that Moody’s ratings are determined by a committee process that considers both quantitative and qualitative factors. The rating outcome may, and sometimes does, differ from the model output.
Moody’s rating methodologies can be found at www.moodys.com in the Credit Policy & Methodologies directory, in the Ratings Methodologies subdirectory. Other methodologies and factors that may have been considered in the rating process can be found in the Credit Policy & Methodologies directory.
--Iftikhar U. Hyder, senior vice president and group credit officer in the Credit Policy Department at Moody’s
(This article was originally published in April 2009.)
“Moody’s Approach to Rating Synthetic Corporate Collateralized Debt Obligations,” published on December 31, 2008.
“The Binomial Expansion Method Applied to CBO/CLO Analysis,” published on December 13, 1996.
“The Double Binomial Method and Its Application to a Special Case of CBO Structures,” published on March 20, 1998.
Moody’s Special Report, “CDOROM v2.5 User Guide.”
“Corporate Default and Recovery Rates, 1920-2008,” published in February 2009.
“Moody's takes rating action on 361 notes issued by 122 CLO transactions,” press release dated March 13, 2009.