Friday, January 23, 2009

Moody's Corporate synthetic CDO assumptions updated

New York, January 15, 2009 -- Moody's Investors Service announced today that it has revised and updated certain key assumptions that it uses to rate and monitor corporate synthetic CDOs, a type of collateralized debt obligation backed by a pool of credit default swaps referencing corporate credits.

Moody's is revising its assumptions to reflect the expected stress of the global recession and tightened credit conditions on corporate default rates, which are likely to be more variable and extreme than those in other recent historical downturns. Specifically, the changes announced today include: (1) a 30% increase in the assumed likelihood of default for all corporate credits in synthetic CDOs, and (2) an increase in the degree to which ratings are adjusted according to other credit indicators such as rating Reviews and Outlooks. Moody's also announced an increase in the default correlation it applies to corporate portfolios as generated through a combination of higher default rates and an increase in investment grade and financial sector asset correlations.

Moody's will immediately start reassessing all of its outstanding corporate synthetic CDO ratings across 900 transactions in the U.S., Europe and Asia using these updated assumptions. Rating actions will be released continuously as individual analyses are completed. A summary of all rating actions will be published once all ratings in this sector have been reviewed.

Based on initial assessment, Moody's expects to lower the ratings of a large majority of corporate synthetic CDO tranches by three to seven notches on average. The actual magnitude of the downgrades will depend on transaction specific characteristics such as tranche subordination, vintage and portfolio composition.

Default Probability

Moody's is increasing its default probability assumptions for financial and non-financial corporate credits in the reference pools of synthetic CDOs by a factor of 30% across all rating categories. Historically, corporate default rates within a given rating category have varied greatly across the economic cycle. As in similar points in previous credit cycles, corporate default rates are likely to be elevated well above their historical long-term averages for at least the next two years; furthermore, Moody's expects that the current negative cycle will be worse than the previous cycles. Moody's will closely follow any changes in future corporate default rate expectations and macroeconomic outlooks and make necessary adjustments to this stress factor accordingly.

Given highly volatile credit conditions, Moody's will further extend its quantitative modeling practice of anticipating possible future corporate rating actions by treating ratings on "Review for Possible Downgrade" in the reference pool as if they are two notches lower and those with a "Negative Outlook" as if they are one notch lower. The prior practice was to adjust the rating down one notch for review and no notches for outlook. Ratings on "Review for Possible Upgrade" will continue to be treated as if they are one notch higher.

The revised default probability assumptions will also be incorporated into Moody's CLO rating methodology; those changes will be announced shortly.


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 together. Both factors have led to a sharp increase in observed default correlation among corporate credits.

Moody's explains that default correlation in its synthetic CDO rating analysis is derived through a combination of asset correlation and default rates. While increasing default probabilities generates higher default correlations across all rating categories, Moody's is also raising asset correlation assumptions in the investment-grade rating categories and in the financial sector in order to generate default correlations in line with its current observations. Accordingly, asset correlation assumptions have been updated as follows:

• Increased inter-industry asset correlations of investment-grade corporate credits from 3% to as high as 8%. 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.

• Reclassified corporate credits according to a new industry classification code. The new code incorporates Moody's latest view on the industry characteristics of rated companies.

• Merged four industries -- Banking, Finance, Insurance and Real Estate -- into one. This reflects much stronger connections between companies in these industries as demonstrated by the recent financial crisis.

• Increased the number of global industries from 3 to 12 and reduced the number of local industries from 15 to 5. An industry that is global tends to have higher correlation between companies in different regions.

• Increased intra-industry asset correlations. For instance, the asset correlation assumption for a pair of A2-rated corporate credits that are in different regions, but are in a global industry rose from 9% to 20%.

• Portfolios with more than 8% concentration in a single industry are subject to an additive asset correlation penalty of up to 30%. The prior trigger was at 20% concentration with an additional asset correlation penalty of up to 15%.

Moody's will release its updated synthetic CDO rating model, CDOROMv2.5, this month, along with an updated user guide, which will incorporate and explain in detail the new modeling parameters.

Moody's rates and monitors corporate synthetic CDOs using the methodology as summarized in Moody's Rating Methodology Report, "Moody's Approach to Rating Corporate Synthetic Obligations." This announcement updates some of the key parameters of the existing methodology as described in this report. Moody's emphasizes that in addition to the quantitative factors discussed in this announcement and in the methodology report, qualitative factors are part of rating committee considerations. The qualitative factors include the strength of the counterparty and collateral agreements, the legal environment, documentation features, and the potential for selection bias in the portfolio. All information available to rating committees, including macroeconomic forecasts, input from other Moody's analytical groups, market factors, and judgments regarding the nature and severity of credit stress on these transactions may be used to make a final rating decision.

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