fitch ratcdo.pdf

7/27/2019 fitch ratcdo.pdf

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A Ratings Agencys Perspective

to Structured CreditGilbert Ong, CFA


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The Basics CDOs to CDOSquared


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3

TypesTypes of CDO

Cashflow> Portfolio of cash assets (loans, bonds, ABS) purchased by a special

purpose vehicle (SPV).

Synthetic> The SPV gains credit exposure by selling credit protection using a

portfolio of credit derivatives.

Market Value

> Risk in Market Value CDOs related to asset market price, not default.> Asset market price is a function of> Rating migration (credit driven)> Spread widening (market driven)> Liquidity (market driven)

Motivations

Balance Sheet> Risk management

> Regulatory requirements

Arbitrage> Exploit pricing inefficiencies

> Increase assets under management


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4

Synthetic CDO

Credit Default

Swap

Premium

Credit Protection

Payment

Protection

Seller

Protection

Buyer

Arranging Bank

Structure of a

Synthetic CDO

Protection Buyer

(Swap

Counterparty)

ProtectionSeller

(SPV)

Credit-Linked Notes

issued


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5

Correlation Impact on Credit Portfolios

> Mean remains unchanged

> Higher correlation leads to more extreme events at both ends of the

distribution

Corr=10%

STDev=5.27

Corr=30%

STDev=12.42

0%

1%

2%

3%

4%

5%

6%

7%

8%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49

Number of Defaulted Assets

Prob

ability

Portfolio Default Distribution ? (50 'B' rated assets)

Mean 12.41


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6

Common Synthetic Structures CDOs to CDO Squared

SCDO

Corporate

Reference

Pool

(100

names) Attachment

Point

Exhaustion

Point

> Single-Tranch CDO > Synthetic CDO2


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7

Portfolio Loss Distribution CDOs vs CDO Squared

> CDO Squared loss distribution has a fatter tail (max loss is higher)

> This is due to lower granularity (only a few inner CDOs in a CDO Squared),

higher correlation between CDOs and AP of tranches

0

5

10

1520

25

30

35

40

0 2 4 6 810

12

14

16

18

20

22

24

26

28

30

Portfolio Loss (%)

Pro

fita

bility

Portfolio Loss Distribution(100 IG Corporates)

(%)

Source: Fitch Ratings

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0 3 6 912

15

18

21

24

27

30

33

36

39

42

45

48

51

54

57

60

Portfolio Loss (%)

Pro

fita

bility

Portfolio Loss Distribution(CDO of 20 CDOs)

(%)

90.40%


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8

Impact of Correlation on Credit Enhancement(Rating Loss Rate) of CDO and CDO Squared

Rating Loss Rate Sensit ivi ty to Asset Correlation

CDO Squared

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24

PCL

RLR

'AAA' Credit

Enhancement

'BBB' Credit

Enhancement

Aver age Po rt fo lio Cor re lation Level (PCL)

Rating Loss Rate (RLR) Sensi tivity to Asset

Correlation

Single Layer CDO

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24

PCL

RLR

'AAA' CreditEnhancement

'BBB' Credit

Enhancement

Aver age Po rt fo lio Cor re lati on Level (PCL)


9/21

Fitch Rating Approach


10/21

10

VECTOR

Theory -

Structural

Form Model

> Default occurs if: Value of Assets < Value of Liabilities

> In a Monte Carlo Simulation

> The company defaults if

> a randomly drawn number representing the change in asset value

> Falls below the DEFAULT THRESHOLD

> Default threshold derived from Ratings and Historical Default Rates

> Cholesky decomposition used to incorporate asset correlations

> VECTOR runs multi-period Monte Carlo simulation

Book Liabilities

Asset Value

Time TNow


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11

FitchRatings

CDO Rating

Criteria

The Fitch default VECTOR model

> A multi-step Monte Carlo simulation model

> For Cash Flow CDOs: Used in conjunction with Cash Flow

model Sector specific correlation assumptions

> 25 industries and 34 countries

> 6 ABS sectors, 17 Sub Sectors, 22 countries/regions

Recovery rates tiered by ratings stress

An empirically based CDO default matrix

For Cash Flow CDOs: Revised interest rate and currency assumptionsfor CF Modeling

For Fully Managed CDOs: An adjustment for asset manager ratings

Ability to analyze short positions in credits and in CDO tranches (within aCDO Squared)

Added new functionality to accommodate CDO Squared Transactions

> Look-through approach

> Cross-subordination

> Overlap Analysis


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Portfolio Inputs cont

Default

Probability

Recovery

Rate

Asset

Correlation

Term

Rating

Asset

Type

Country

Industry/

Sector

Asset Par

Value

Monte Carlo

Simulation

Default Distribution

(Rating Default

Rate or RDR)

Loss Distribution

(Rating Loss Rate

or RLR)

Recovery Rate Stress

(Rating Recovery Rate

or RRR)

Timing of Default


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Fitch Report: Comparative Empirical Study of AssetCorrelation (6 June 2005)

> Vector Model> Use of equity correlation data to derive asset correlation

> Can capture differences in di fferent regions, e.g. Europe, North America, Asia, and so for th

> Can yield name-specific pairwise correlations. Any possible (overestimation) bias can be adjusted by calibration> De Servigny and Renault:

> Averages the joint defaul t probabil ity by weighing i t by the number of obl igors in each cohor t.

> Frey and McNeal:> Joint default probabilities are aggregated using a simple average over all of the cohorts.

> RACM or Robust Average Correlation Measure:> Average of the Frey-McNei l and De Servigny-Renault .

> Gupton, Finger, and Bhatia

> Does not explicitly use timing o f the defaults.> Rating Transition Model

> measured directly using the co-movement of ratings. Cannot capture differences in regional dynamics (Asia vs. North America)


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14

Credit Default

Swaps

Referencing

ABS

> Developments

> Retention of bankruptcy / insolvency

> FTP Interest recognises concept of PiK> New Credit Events

> Permanent Loss

> Rating Downgrade

> Valuation> Extended valuation period

> Minimum Recovery Rates> Fixed Recovery Rates

> Challenges

> Corporate Credit Events not Applicable> Bankruptcy

> Failure to Pay> Insolvency

> Pass through/long dated maturity structure of ABS Assets

> Illiquidity / transparency

> ISDA has formed working groups towards developing

standards.


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15

Credit Event Definitions and Valuation Process


16/21

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Credit Event Study for 2004


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17

Factors to consider in determining recovery ratehaircuts due to valuation process

> the time period over which the bids are conducted and how soon

they begin after the occurrence of a credit event;> the source and number of bids: a low number of bids and bids that

include transaction participants in the valuation process have

tended to produce below-average recoveries;

> the number of valuation dates;

> how the final value is calculated (i.e. the highest bid, the average

of bids, etc.);

> the ability to include partial bids and WA quotations before

assuming a zero recovery value.


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18

Analysis of

Short Positions

0%

20%

40%

60%

80%

100%

-5.0

%

-4.0

%

-3.0

%

-2.0

%

-1.0

%

0.0

%

1.0

%

2.0

%

3.0

%

4.0

%

5.0

%

6.0

%

7.0

%

8.0

%

9.0

%

Cumulative Portfolio Loss

Cumula

tive

Pro

ba

bility

No Shorts 20 Shorts 40 shorts

# of Shorts

40200Confidence Level

6%7%8%99%

5%5%5%95%

Effect of Short Positions on RLR


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Synthetic

Index: A

surveillance

tool

> Definition

> Scope: 260 Fitch rated static synthetic corporate

CDOs 1160 underlying corporate names, comprising

the index

> Measure: WAR tracking CDO portfolio performance> Reporting frequency: Monthly

> Uses

> Tool to track CDO performance by vintage /

manager / type

> A proxy for CDS name liquidity> An indicator of negative name selection

> A tool to track macro credit trends

Chart above presents five vintage indices, which follow the same methodology as for the Synthetic Index calculation,except that the reference universe for the vintage indices comprises only those transactions which closed in the

respective period.


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CDO

S.M.A.R.T.

SurveillanceMetrics

Analytics

ResearchTools


21/21

www.fitchratings.com

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