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DOUGLAS J. LUCAS, LAURIE S. GOODMAN, AND FRANK J. FABOZZI

eceiu rating agency reports attack "material impairment" (either an uncured pay-

R

DOUGLAS J. LUCAS

is dirL'ctor <it t^DO :\ iong-held assumption ot partic- ment detanit or a dtjwngrading to C'a or C")

Research at UBS m ipants in the structured finance over tive years.

New York Cit\-,

market: that asset-backed securities Almost all market participants think tiie

d«uglas.lucas@ubs.com

(ABS), connnercial mortgage-backed securi- default rate tor BBB Resi B^"(~ has been much

LAURIE S . G O O D M A N ties (CMBS), .md residential mortgage- backed lower than 4.0%, let alone 13.4%. In fact, it is

IS a managing diRTtor and securities (RMBS) have lower historical default generally taken for granted that these assets

co-head of Global Fixed rates than equivalently rated corporate debt. default less frequendy than corporate bonds,

Intoinc Research at UBS

The implication ot this is important, not only which have 3.2% and 2.3% five-year default

ill Ncu- York City.

laurie.go(tdman@ubs.t'oni

for investors in these assets, but also tor investors rates according to SikP and Moody's. It is

in structured finance collateralized debt oblig- common, tor example, for SF C D O structurers

F R A N K J. FABOZZI ations (SF CDOs) backed by these assets. to use a base case of 0.36% defaults per year,

is the Frederick Fniiik For example, Cloodm.m and F.ibozzi or 1.80% defaults over five years, in their cash

adjunct professor of flow models of BBIi Resi B&C collateral.

[2002] argue that because the rating agencies

finance at the School of

Management of Yale Uni- ignore the historically low default rate ot struc- Investors care more about/iifKfc default

versity' in New Haven, C~T. tured finance collateral, they are more con- rates than pdst def'ault rates in SF CDOs and

fab«zzi32l@a()l.Ci)m servative in their ratings of SF CDOs than we are constantly reminded of the variability

CDOs backed by corporate bonds, and SF in credit quality of assets with the same rating.

CDOs thus otl^er investors relative value. It the But still. It would be nice if we could be a lot

rating agency reports are accepted at tace value, more certain of the past than is implied by a

it would appear that the Goodinan-Fabozzi range of five-year detault rates ranging from

conclusion lacks empirical support. 1.8% to 13.4%i.

Let s consider one important example tor We explore the discrepancy between the

investors in the CT^O market—BBB tranches default rates calculated by the rating agencies

from B and C credit qtiality first lien residen- and market intuition. We get into the nitty-

tial mortgages (Resi B&C, also known as sub- gritty of bow rating agency statistics are

prime home equities or home equities). SikP constructed betore we come to our own con-

published a statistic recently suggesting that an clusions. We find, to take one example, that a

average of 4.0% of BBB Resi B&C tranches more accurate historical default rate for BBB

are downgraded to D {S&l's default rating cat- Resi B ^ C over tive years is ].9% rather than

egory) over five years (see Hu, Pollsen, and the 4.0% to 13.4%. of the SixP and Moody's

Elengical |2OO3]). Hu, Cantor, Silver, Phillip, reports. Our estimate ot past pertormance is m

and Snailer [2()03| report a statistic suggesting line with the 1.8%, detault rate that SF C D O

that an average of 13.4% of these tranches suffer structurers commonly use to model the future.

We discuss six rating agency reports. We first focus EXHIBIT 1

on three S&F reports from January and February 2003 Moody's Material Impairment Rates in ABS

tliat show the rate at which different types ot structured

hnance tranches have been downgraded to D {tive-year Health Care Receivables 40.0%

Franchise Loans 22.8%

rating transitions). In discussing S&P's results, we explain Manufactured Housing 12-1%

the advantages of an alternative matrix multiplying approach Autos 1.4%

where we extrapolate five-year downgrade rates from HEL 1.3%

short-term average rating changes. We then apply this Leases 0.8%

matrix mtiltiplying technique to two other rating transi- Credif Cards 0.3%

Equipment 0.0%

tion studies—a July 2003 S&P rating transition study, and

Fioor Pians 0.0%

a January 2003 Moody's rating transition study—and we Smaii Business Loans 0.0%

examine the Moody's study that presents material impair- Student Loans 0,0%

ment rates tor structured fmance tranches. Other Receivables 0.0%

Other ABS 1.0%

All ABS 2.7%

I. PRELIMINARY CAUTIONS

Soma". Hii. Ciiiior, Silver. Pliillip. dml SiuiUcr j2()0Jj.

How appropriate are historical results in predicting

future credit performance? While rating transition and defaults are driven to a large extent by the idiosyncratic

detault studies are necessarily pictures taken of a rear-view problems of these corporate sponsors. For example, 17%

mirror, the nature ot structured finance makes it hard to of all ABS def^aults are traceable to problems at Con-

get an accurate picture of even the past. In a corporate seco/Greentree. Even more dramatic, 62% ot all RMBS

bond rating transition or default study, the unit of study defaults are traceable to Quality Mortgage. With past

is the corporate entity. But for structured fmance, the defatilts so much a tlinction of individtial corporate prob-

object of study is the specific tranche issued by a specit'ic lems, predicting future default rates is problematical. Are

special-purpose entity. we going to have more or fewer CA)nseco/()reentrees

The sheer number of these tranches, each with its and Quality Mortgages?

own unique credit characteristics, makes the creation of Finally, dcfatilt rates are only half of the credit loss

databases difficult. The fact of a default is often ambiguous; story. Default severity, or loss in the event of a default, is

a missed coupon may occur unseen, and the lapse may be the second part of the credit loss formula. l!)efauk severity

rectified later. It may also be certain /fi'ir, judging from the among structured finance tranches seems to vary by under-

state of the special-purpose entity's collateral portfolio, lying assets and by the seniority and size ot the tranche.

that a tranche will eventually default later m its lite. We do not touch on this important credit factor here.

The corporate entity moreover continues on as debt We thus approach the historical reports of S&P and

is issued and retired. Each structured finance tranche, Moody's with a healthy degree of skepticism about what

however, has a limiteci life, and in a database of structiu^d they can tell us about the future. But maybe they can at

fuiance defaults, withdrawn ratings abound. We shall sec least give us a clearer picture of the rear-view mirror.

that the treatment of withdrawn ratings is an important

consideration in assessing structured finance default studies. II. S&P'S FIVE-YEAR TRANSITION TO D

The heterogeneity of structured finance assets means

that broad categories are made up of assets with disparate In three reports issued in January and February 2003,

performance. For example, in Moody's ABS category, SikV published five-year transitions to D rates, or the his-

health care, tranchise loan, and manufactured housing toric rate at which structured finance tranches have been

securitizations have had the highest default rates, as shown downgraded to P. We take the 1) rates as a close proxy

ui Exhibit 1. When the individual types of deals are aggre- for default.

gated into a broad category we get a distorted picture of We show in Exhibit 2 S&P's results for ABS (Ertuk,

the performance of the whole and of the parts. Coyne, and Elengical |2()03|): CMBS (Hu and C:hun

The defaults ot structured finance tranches are often |2OO3|); and RMBS (Hu, Pollsen, and Elengical 12003]).

directly linked to the originators and servicers of the We also show S&:P's five-year corporate credit default rate

underlying assets. In fact, overall structured finance from Brady, Vazza, and Bos |2OO3j). Boxed in the exhibit

is the L'litry tor lUJB Resi B ^ C tranches. EXHIBIT 2

Keep in mind tliat Si^P's RMBS category iiicltides S&P Five-Year Transition to D Rates

transactions backed by prime and subprime first and

second residential liens, including home equity lines ot Corporate

Default

credit, home improvement loans, reverse mortgages, and ABS^ CMBS" RMBS'' Rate''

tax liens, so the nimibers in the exhibit merely suggest AAA 0.00% 0.00% 0.00% 0.10%

the actual downgrade rate of any specitic type of RMBS. AA 0.20% 1.93% 0.80% 0.27%

The same point holds tor the ditterent types of securiti- A 1.47% 1.97% 2.40% 0.62%

BBB 1.23% 0.93% 4.00% 3.20%

zations in the ABS and CMBS categories.

BB 4.62% 5.55% 9.90% 12.34%

Exhibit 2 contradicts two beliefs widely held by B 0.00% 13.68% 13.70% 26.59%

structured finance market participants. The first, as we

noted at the outset, is that detault rates tor structin"ed 'lliluk. Coyne, ami l-lci!i;iui! I2

hnance tiMns.tctions are lower than for corporate debt. '•Ilumii! CJuiu 1200}f.

The second is that CMBS and RMBS have lower default Ihi. l\'ll<n,. ,ui,! liU-Hiiical 120031.

r.ites than ABS. 'Bnuly, [;;;;.!, ami Bo^ 1200}j.

We see that many of the investment-grade structured

finance transitions to I) rates .ire higher than the corporate rating at a particular time) that cm enter the tive-year tran-

default rates for credits of the same rating. At the extreme, sition calculation is the one running from January I. I9'J8,

the AA CMBS rate is seven times the corporate AA rate. to January 1, 2(>()3. This means that any structured tinance

And the BBB RMBS, is 4.0% versus the corporate 3.2% securitization rated after January 1, 1998, is not part ot

rate. We also see that tor many rating categories, ABS tran- the five-year rating transition calculation.

sition rates ,ire lower than those for C^MBS and RMBS.

S&P's methodology greatly reduces the number ot

We believe that both of these ettects are a result ot structured tmance transactions incorporated in the tive-

Si^'P's transition study niethodt>logy rather than a reflec- year transition calculation. For example, there are 282

tion ot true credit experience. BBB RMBS with five or more years of rating history

included in the tive-year transition rates, but there are 530

S&P's Transition to D Methodology BBB RMBS with tour or tewer years of rating history

that are cxdiidcd from the five-year transition rates. Fur-

S&P calculates tive-year transition to 1) rates in a thermore, it appears that a disproportionate number ot

way that excludes recent rating experience. This can some- pre-1998 RMBS transitioned to D.

times lead to strange results, such as when the transition We demonstrate the tact of declining transition rates

to 1) rate is higher over a shorter time interval th.m it is by comparing the 1978-2002 RMBS average one-year

over a longer time interval. For example, alnu)st all ABS transititm matrix with the earliest available RMBS transi-

transitions to 1.^ rates over ilircc years are higher than ABS tion matrix SikV published, the 1978-2000 average one-

transition rates over /Jre years. year transition matrix. In Exhibit 3 we show the 1978-2000

S&Ps transition methodology requires that, to enter transition matrix iiii)iiis the 1978-2002 transition matrix.

the five-year transition matrix, the rating must be tive years The positive numbers tor BBB transitions to BB, B, CCC!!,

old. So the l.ist rdtiiii^ coliort {group of credits with the same

EXHIBIT 3

S&P Average 1978-2000 RMBS Transition Matrix Minus 1978-2002 Transition Matrix

Rating at End of One Year

ing

c AAA -0.04% 0.03% 0.00% 0.01 % 0.00% 0.00% 0.00% 0.00% 0.00% 0.01%

en != AA -2.84% 2.48% 0.21 % 0.04% -0.01% -0.03% 0.05% 0.00% 0.00% 0.00%

01 (0

A -0.82% -2.73% 3.07% 0.25% 0.01% 0.03% 0.04% 0.00% 0.00% 0.03%

BBB -0.08% -1.59% -0.84% 1.33% 0.35% 0.62% 0.10% 0.00% 0.00% 0.01%

tin

BB 0.00% 0.00% -1.13% -4.13% 4.36% 0.21% 0.40% 0.13% 0.00% 0.06%

EC B 0.00% 0.00% 0.00% 0.04% -2.30% 3.86% -1.81% 0.23% 0.00% -0.12%

and I) mean that there were more BBB downgrades in Multiplying Transition Matrices

1978-20(11) tlian in 197S-2OO2. In other words, BBB down-

grades declined in 2(H)1 and 2002. We attempt to sidestep the methodological issues

This is consistent with our hypothesis that the small raised here by multiplyiini trcimitioti iiiatria's (which admit-

number of BBB credits before 1998 experienced more tedly stirs up its own methodological issues). Our pre-

downgrades than later BBB RMBS, and bias the five-year ferred way tt) calculate the five-year transition to D rates

transition to D statistic upward. The same result, declining from S&P data is to "multiply" transition matrices. By this

transition rates in recent ye.irs, holds true for the other we tiieati, for example, to look at a six-month average

RMBS rating categories too. transition matrix and see where BBB RMBS transition to

Another aspect ofS&l^'s methodology that affects its after six months. Most ratings will remain the same, but

five-year results is the treatment of ii'ithdnni'ii ratings. In some percentage of them will be upgraded or downgraded.

calculating five-year rating transitions, S&;I* excludes struc- Then, we put the vector of ratings and percentages back

tured finance credits whose ratings were withdrawn some- into the transition matrix to see where the originally rated

time over the five-year period (unless the credit was rated BBB RMBS migrate in one year. We continue this process

I) before its rating was withdrawn). An example shows until we have transitioned BBB RMBS ten times to arrive

the implication of this approach. at cumulative five-year transitions.

SLippose there are HH) BBB ratings at the beginning The advantage of this approach is that we use all

of a five-year period, and ISO of the ratings are withdrau'ii available data because the six-month transition matrix

sometime over the period. Further, suppose that one BBB incorporates data from recent periods, even January 1,

credit was downgraded to O, The five-year transiti(.)n to 2003. tojuly 1, 2003. It also prevents average transition

D rate would be 1 divided by 50, or 2%, because the 50 to I) rates from being higher over shorter periods than the\'

withdrawn ratings are excluded from the calculation of are over longer periods.

transition rates. The alternative treatment would be to Another advantage of this approach is that it uses

tre.it withdrawn ratings as stable ratings and calculate the S&P"s latest structured finance rating transition study

transition to I) rate as 1 over 100 or 1%. (Ertuk, Elengical, and Gillis |2003]). This study makes

I'liere are arguments for both approaches. Treating some improvements in S&Ps rating database and method-

a withdrawn rating as a stable rating makes sense in that ology in creating average six-month rating transition

.1 withdrawal is usually not a negative credit event. In fact, matrices. Eirst, structured finance credits are more care-

it is an unamhiguoLisly good thing that a credit pays off fully categorized by type of asset and domicile. Second,

its debt and has its rating witlidr.nvn. On the other hand, for ratings that are withdrawn at the end of the six-month

if a credit is not outstanding, it does not have an oppor- perie)d, but that transitioned to some intermediate rating

tunity to default. Why keep congratulating a one-year during the six-month period, the last rating before with-

bond for not defiUilting four years after its maturity? drawn is taken as tbe ending rating. Thus, if a credit started

One thing is certain. Compared to including with- tlie six-month period as a BBB, transitioned to BB over

drawn tranches in its calculations, SikVs exclusion of with- the six months, but was witbdrawn by the end of six

drawn ratings iiicrciiscs the percentage of credits deemed nuMiths. this wxitild be taken as a transition to BB in S&P's

downgraded to D. And eventually, over a long enough stiidy.-

period, all credits in a cohort will either mature, thereby

having then- ratings withdrawn (and be excltided from Results of Multiplying Transition Matrices

the cohort), or defatilt. When this happens, the transi-

tion to 1) rates must be 100%. As we noted earlier, with- In Exhibit 4, wv shtjw tlie results of multiplying the

drawn ratings are a bigger problem in studies of structured average six-month matrices and compare those results to

fmance defaults where the short maturities of specific S&P's previous calculated five-year transitions and to ftve-

issues, rather than the ongoing existence of a corporate year corporate defaults.

entity, are the object of study. Note that for RMBS and (^MBS. multiplying the

But the SikV methodology used in the three studies six-month matrix ten times almost always gives much

published in 2003 is not tbe only way to calculate transi- lower five-year transition to I) rates than S&P's five-year

tion statistics, and is probably not the best way. It is also not transition matrix number. F-or example, the multiplying

the way S&'P and Moody's calculate their default statistics.' method vields a BBB RMBS transition rate of 1.62%

EXHIBIT 4

S»§cP Five-Year Transition to D Rates

Corporate

ABS CMBS RMBS Default

Multiply 5-Year Multiply 5-Year Multiply 5-Year Rate

AAA 0.01% 0.00% 0.00% 0.00% 0.00% 0.00% 0.10%

AA 1.16% 0.20% 0.00% 1.93% 0.02% 0.80% 0.27%

A 2.09% 1.47% 0.08% 1.97% 0.47% 2.40% 0.62%

BBB 13.80% 1.23% 0.65% 0.93% 1.62% 4.00% 3.20%

BB 42.56% 4.62% 4.36% 5.55% 4.50% 9.90% 12.34%

B 82.53% 0.00% 12.28% 13.68% 14.14% 13.70% 26.59%

EXHIBIT 5

S&P ABS Defaults

1998 1999 2000 2001 2002 Total

Auto 1 - - - 1 2

Credit Card .- - 2 2 4

Franchise Loan - - - 9 22 31

Manufactured Housing - - - 1 32 33

Other - 9 - - 1 10

Total 1 9 0 12 58 80

Soiinv: Brink, j20()Jj.

while SikP\ five-year matrix shows 4.00%. Tbis, inci- finance transitioTi rates are similar, but usually a little lower

dentally, is consistent with the SF C D O structurer assump- than for the U.S. ABS. It would seem that S&P faced

tions of a 1.8% default rate over five years for BBB Resi more surprises from strange U.S. ABS asset categories

B&C. We also see that CMBS gain what we thmk is their than from international ABS asset categories. On average,

rightful place at the top of structured finance credit quality U.S. C O O transitions are worse than U.S. CMI5S and

with the lowest transition rates. RMBS. but not as bad as U.S. ABS. European C D O tran-

Yet for ABS, the effect is the opposite, as transition sitions win the booby prize, being worse than U.S. ABS.

rates calculated by the multiplying method are higher than Also interesting are the international categories we

the five-year rate. This is because ABS credit performance could not calculate transition to D rates for: European

since 199S has been much poorer than prior to I99H. C'MBS, European RMBS. Asian structured finance, and

Tbis recent poorer credit performance is captured only by Australia/New Zealand strnctured finance. These cate-

the multiplying method. As we mentioned before, the gories have never had a transition to D. Of course, there

poor performance of ABS in recent years has mainly come are not as many tranches making up their statistics, par-

from new and untested asset classes. ticularly low-rated tranches, as in the U.S. structured

Exhibit 5 shows S&Ps classification of recent ABS finance categories.

defiuilts.

S&P Study Conclusion

Five-Year Transitions of International

Structured Finance and CDOs We think our method ot multiplying six-month

transition matrices from S&P's report by Ertuk, Eleng-

S&P has also carefully calculated six-month transi- ical, and Gillis |2(K)3| is better at assessing tlie long-term

tion rates tor CDOs and structured finance transactions credit quality of structured finance tranches than the five-

backed by assets originated outside the United States. year transition matrices in S&P's three studies published

Exhibit 6 shows transition to D rates tor the geographies in January and February 2003. The multiplication method

and structured fmance categories that could be calculated. includes data h-om all years in arriving at long-term results

European ABS and emerging market structured and eliminates the problem that short-term transition rates

may be higher than loiig-rerm tiMiisition rates. It also EXHIBIT 6

makes use of S&.P's improved d.itab.ise and methods. S&P Other Five-Year Transition to D Rates

S&P's five-year RMBS transition rates are bigb

because S&P did not rate very many RMBS below AA Euro US Euro Corporate

ABS EMSF CDO CDO Default

until the last five years, and older RMBS have performed Multiply Multiply Multiply Multiply Rate

more poorly than more rccc-ntly issued RMBS. The mul- AAA 0,00% 0.00% 0,07% 0,54% 0,10%

tiplication methodolog\' leads to lower transition results AA 0,20% 0.00% 0,33% 1,32% 0,27%

for RMBS and CMBS that are in hne with our under- A 1,30% 1.26% 1,56% 4,02% 0,62%

standing of these products. It also calculates higher ABS BBB 7,22% 12.02% 2,20% 16,04% 3,20%

BB 39.35% 55.88% 4,41 % 41,18% 12,34%

transition rates by weighing in the recent poor perfor-

B 80.69% 80.03% 9.26% 90.24% 26.59%

mance of those tranches.

i from l-r G"i7fo IJ

Moody's Five-Year Transition to Ca and C

Moody's structured finance transition study calcu-

lates average one-year transition matrices by modified rating Corporate

categories, adding the 1 s. 2s, and 3s to the letter rating des- Default

ABS CMBS RMBS CDOs Rate

ignation (see Hu and Cantor [2(103]). Moody's does not Aaa 0.01% 0,17%

0,00% 0,00% 0,30%

calculate rating transitions over multiple years. Aal 0,27% 0,00% 0,01% 1,87% 0,17%

We follow the same multiplying technique we used Aa2 0,49% 0,09% 0,03% 1,92% 0,33%

on the S&P average transition matrices to create Exhibit Aa3 2,75% 0,01% 0.09% 4.99% 0.29%

7. It shows the rate at which Moody's structured finance Al 0,80% 0,02% 0,49% 6.00% 0,47%

A2 0.40% 0,01% 0,12% 2,95% 0,68%

ratings have migrated to Ca and C^ over five years. Bear

A3 1.88% 0,01% 1,12% 7,89% 0,62%

in mind that Moody s does not have a I) rating category, Baa1 6.51% 0,56% 2,41% 9,20% 1,80%

and Ca and C rating,s usually indicate default. Boxed in Baa2 5.47% 0,77% 1,31% 19,70% 2,24%

Exhibit 7 are the Moody's categories that include Baa Baa3 9.65% 0,07% 3,47% 22,09% 4.23%

Resi BikC tranches. Ba1 24,74% 0,62% 4,95% 40,27% 7.61%

Ba2 28,60% 0.06% 4.57% 47.49% 9.42%

The tmcness of the modified rating categories leads 47,58%

Ba3 0,60% 10.46% 38.24% 20,70%

to the unexpected result that in some cases higher ratings B1 53,28% 0,83% 4,85% 83,87% 27,56%

have transitioned to Ca and C more often than lower rat- B2 47.22% 1,07% 11,57% 56,19% 34,49%

ings have. But it one regroups ratings into letter rating B3 83.90% 3,23% 22,56% 82,09% 44,40%

categories, we can compare them with the S&'P multiplied Ciihihued tro)ii Hu and Cantor 1200^1.

fivc-ycar traii'^ition to D matrices, CMBS and RMBS

rating transitions, espc-cially in the mvt'Stment grades, are hve-year Baa ABS transition rates range from .S,47% to

roughly similar. For CDOs, Moody's transitions are a lot 9.65% and average 7.21%. This is four times the 1.62% rate

more frequent, which we attribute to the significantly we calculated for S&P's BBB RMBS transitions.

L^reater C D O market share Moody's had over S&P for But as we saw in Exhibit 1, Moody's reports that

much of the study period, especially of C D O tranches home equity loan defaults (including Resi B&'C and other

rated below Aa. home equities) are a little less than half of those of A_BS

For ABS, especially tranches rated helow Aa, Moody's in total. Using this percentage (arbitrarily, because we

transitions are much less frequent than S&P's multiplied don't really know how to apply it to specific ratings), we

transition results in Exhibit 4. We think this is partly arrive at average five-year Baa Resi B&C transition rates

because of a different mix of transactions designated as ranging from 2.63% to 4.65% and averaging 3.47%. We

ABS by tiie two rating agencies. For example, Moody's show these calculations in the last three rows of Exhibit

classifies Resi B&C and other home equities as ABS, while 8. These Moody s Resi B&C] transition rates are twice as

S&P classihes them as RMBS. Unfortunately, this does not high as the 1.62% S&P BBB RMBS transition rate, but

provide much clarity as we try to figure out the histor- lower and we teel much more accurate than Moody's all-

ical default rate of Resi B&C. ABS Baa transition rates.

As we show in the first two rows of Exhibit 8, Moody's

EXHIBIT 8 expect that the treatment of withdrawn ratings makes a

Moody's Baa Resi B&C Five-Year Transitions to D bigger diflerence in the cumulative rating transitions like

tln>se ot S&P sliown in Exhibit 2. This is because over

Baa1 Baa2 Baa3

time, as cumulative cohorts age, withdrawn ratings make

ABS Transitions 6,51% 5,47% 9.65%

Averaqe ABS Transition 7,21%

up an increasingly greater proportion.

Relative Default Frequency

48,15%

of Resi B&C versus All ABS Moody's Material Impairment

Resi B&C Transitions 3.13% 2.63% 4,65% and Downgrade Study

Average Resi B&C 3.47%

Hu, Cantor, Silver. Phillip, and Snailer [2003]

cd fivin daiii in l:xhihiti t iiiitl 7.

examine "material impairments" of structured finance

securities. Moody's defhies a material impairment as a

EXHIBIT 9

payment default that has gone uncured or a ciowngrading

Moody's Five-Year Transition to Ca and C to the Ca or C rating categories. A rating of Ca or C in

Eliminating Withdrawn Ratings the absence of a payment det^ault may indicate that the

1

Default the condition of the underlyiiitf collateral augurs an

ABS CMBS RMBS CDOs Rate

almost-certain eventual default on interest or principal.

Aaa 0,02% 0.00% 0,00% 0,35% 0,17%

Aa1 0,32% 0.00% 0,01% 2,14% 0,17%

Alternatively, the presence of an uncured payment default

Aa2 0,53% 0,12% 0,03% 2,14% 0,33% in the absence of a Ca or C' rating may indicate that the

Aa3 2,93% 0,01% 0,09% 5.38% 0,29% payment default is slight or expected to be cured.

Al 0,93% 0,02% 0,52% 7.01% 0,47% About half of all material impairments so defined are

A2 0,47% 0,01% 0,13% 3,45% 0,68%

payment defaults of tranches rated above Ca or C".

A3 2,19% 0,02% 1,16% 8,48% 0.62%

Baai 7.15% 0,75% 2.47% 10,58% 1.80%

Moody's has not taken a public stand that the payment

Baa2 5.92% 0,79% 1.36% 20,95% 2,24% default IS severe or is going to continue. In fact, a high

Baa3 10.83% 0,08% 3.59% 23,38% 4,23% percentage of structured finance payment defaults later

Ba1 26.02% 0.78% 5,14% 41,67% 7,61% become cured, maybe about 20% to 3O'X). Thus, we view

Ba2 30,51% 0.08% 4,72% 48,78% 9,42% Moody's material impairment category as an expansive

Ba3 52,90% 0.72% 10,80% 39.76% 20,70%

definition of default.

B1 57,60% 1,06% 5,04% 85.25% 27,56%

B2 49,66% 1,39% 12,14% 58,00% 34,49% Another step in Moody's methodology" is to deduct

B3

UO 86,32%

OU,Oil /o 3,57%

0.01 lO 23,54%

jCJ,iJt 84,37% 44,40% halt of all withdrawn ratings in the calculation of default

Calailalcd from Hii iiiid (.'.iiiilor j200.ij. rates. So, if two ratings in a cohort ot 100 ratings were

withdrawn over the year, those defaulting over the year

would be compared to a denominator of 99 rather than

Effect of Withdrawn Ratings 100 or 98, But if next year two more ratings are with-

drawn, defaults are compared to a denominator of 97,

The Moodys data also allow us to explore the meth-

This splits the difference between counting withdrawn

odological question mvolving the treatment o{ with drawn

ratings as non-defaults and eliminatinu; them completely

ratings. In arriving M the downgrade rates m Exhibit 7.

from the defluilt statistics and tliereby biasing the default

we multiplied Moody's one-year transition matrix with

statistics. But again, one has to e.xpect that many struc-

withdrawn ratings treated as stable ratings. In Exhibit 9,

tured finance tranches mature every year and have with-

we sliow the result ot rcnuiving withdrawn ratings.

drawn ratings. To the extent this is so. this treatment will

As we expected, eliminating \\ ithdrawn ratings raises exaggerate the calculated structured finance def'aults. and

the transition rates, particularly tor ABS and C^DOs rat- the efTect is componnded as tranches season.

ings and particularly for speculative-grade ratings, but the

Exhibit 10 shows Moody's material impairment rates

difference is not great. We think the multiplying method

for structured finance tranches along with the agency's

eliminates a lot of the difference between the two with-

calculation of five-year corporate defiiult rates. Moody's

drawn rating methodologies, because over six months or

BBB Resi B&C are categorized as ABS (the hoxed

one year there are not very many withdrawn ratings. We

number).

We see in Exhibit 10 tli.it CMliS inip.urnieiits are EXHIBIT 10

about ill line witii corporates. but that ABS and l^MHS Moody's Five-Year Material Impairment Rates—

arc liigher than corporates. Moody's structured finance Rolling Cohorts

results are generally a lot higher than those we achieved

from multiplying S&Fs six-month transitit^i matrix. P:irt Corporate

ABS CMBS RMBS Default Rate

of the relatively high structured fuiance default rate is 0.97% 0.12%

Aaa 0.06% 0.00%

attributable to the expansive definition ot tnaterial impair- Aa 3.13% 0.00% 0.61 % 0.26%

ments versus default and the elimination of withdrawn A 1.61 % 1.03% 1.42% 0,51%

ratings. Baa 13.44% I 2.23% 7.25% 2.25%

Ba 53.08% 5.17% 9,65% 11.36%

B 49.38% 19.43% 17.17% 32.31%

Rolling Cohort versus Original Issue Cohorts

Soiinr: Hu, Cuiiior, Sihvr, Phillip, and Siiaiter 120031.

impairment rates, calctilated in a slightly different manner, tranches tend to increase over time after issuance. Exhibit

that sheds further light on these default rates. Instead of 12 illustrates tbe pattern of marginal defaults yc-ar-by-year

the rolling cohort methodology, where a BBB Resi B&C- after initial issuance.

tranche issued on |aiiLiary 1. 2000, its part of tiie 2000, It shows that marginal detanks increase until three

2001, and 2002 cohorts, Moodys alternative original issue years after original issuance and then decline. This pat-

cohort methodology forms cohorts only from imi'ly Issued tern of defaults insures that the rolling cohort method

tranches. The tranche issued on January 1, 2000 would will produce higher default rates than the original issue

be part of only that one single cohort, and would coLint cohort method. This is because under the rolling coliort

only as a three-year default at its original issue rating. method, defaults in later years in tbe life of a tranche are

Structured finance defaults calculated by both weighted into the default rate of earlier years. Under these

riK'thodologies differ greatly, as shown in Exhibit I I. With circumstances, we feel the original cohort method pro-

the same exact data, detank rates for structured finance vides a better estimate of future structured finance default

tranches are about twice as high under tbe rolling cohort rates.'

niL'tbod as under tbe original issue metbod. In Exhibit 13. we show Moodys material impair-

Moody's points out that the reason for the different ment rates tor structured hnance tranches, using the orig-

restilts is that marginal defaults among structured finance inal cohort methodology, along with the rating agency's

EXHIBIT 11

All Structured Finance Cumulative Impairment Rates

5%

B Rolling Cohort Method

Years

EXHIBIT 12

Marginal Material Impairments

0.8%

0.6%

0.4%

0.2%

0.0%

EXHIBIT 13

those we achieve by multiplying S&Ps six-month tran-

Moody's Five-Year Material Impairment Rates-

Original Issue Cohorts sition matri.x shows Moody's defiult results are still gen-

erally higher. Again, part ot the relatively high structured

Corporate fmance deflmlt rate is attributable to the expansive defi-

Default

ABS CMBS RMBS Rate nition ot material impairment versus default, and part is

Aaa 0.05% 0,00% 0,58% 0,12% due to the partial elimination of withdrawn ratings.

Aa 2.83% 0,00% 1,01% 0.26% Using the ratio of HEL defaults to total ABS defaults

A 1,10% 0,23% 0,63% 0.51 % from Exhibit 1 {again blindly, since we still don't know

Baa 1 4,38% 0,83% 6,00% 2,25%

how to apply it to specific ratings), we arrive at an average

Ba 19,70% 1,77% 4,98% 11,36%

B 39,53% 5,66% 13,66% 32,31%

five-year Baa Resi B&:C. transition rate of 2.11%. We show

these calculations in Exhibit 14. This Moody's Resi B&C

Soitra-: Hii. Cmnor, Silver, Phillip, tiiid Siiailcr [2

transition rate is higher than the 1.62% S&P BBB RMBS

EXHIBIT 14 transition rate, but it is lower, and we feel much more

Moody's Baa Resi B&C Five-Year Material Impairments accurate, than Moody's all-ABS Baa default rate.

Baa

All ABS Material IV. CONCLUSION

Impairments 4,38%

Relative Frequency of Resi

In determining default rates for structured finance

B&C and All ABS Material 48.15% tranches, we think the most reliable sources are the S&P

Impairments multiplied five-year transition to ][) rates presented in

Resi B&C Transitions 2.11% Exhibit 4 and the Moody s original issue material impair-

Bxhihits I tvid

ment rates presented in Exhibit 13. We thus average the

two to produce the five-year default rates shown in Exhibit

calculation of five-year corporate default rates. Boxed in 15, We also take Moody's ABS rate and multiply it by

the exhibit is the Moody's category that includes BBB 0.4K to arrive specifically at Resi B&C default rates.

Resi B&C. The origin:il cohort methodology produces Obviously, there is a lot ot Kentucky windage in

lower material impairment rates than the rolling cohort our historical default estimates. Yet historical results, what-

methodology; especially for ABS and especially for the ever their exact number, are pictures of a rear-view mirror.

Baa category including Resi B&C. CMBS defaults are And in this case, they reflect the difficulty of conducting

now lower than corporate defaults, hut ABS and RMBS an investigation of structured finance det'aults and the

defaults are still higher than corporates. almost random etYect of corporate credit events on struc-

Comparison of these original issue results against tured finance.

EXHIBIT 15 REFERENCES

Estimated Historical Five-Year Default Rates for

Brady, Brook, Diane Vazza, and Roger J. Bos. "Corporate Detanks

Structured Finance Tranches and Corporate Bonds

Peak in 20(12 Amid Record Amounts of Detaults and DecliniTig

AB5 CMBS RMBS Rest B&C Corporates Credit Quality." l^atiiii><: Perforiiuvicc 2002: DeJauU Transition.

AAA 0.0% 0.0% 0.3% 0.0% 0.1% Recovery, and Spreads. Standard ik Poor's. February 2003.

AA 2.0% 0,0% 0.5% 0.7% 0,3%

A 1.6% 0.2% 0.6% 0.5% 0.6% Ertuk, Erkan, Patrick Coyne, and Jay Elengical. "Ratings Tran-

BBB 9.1% 0.7% 3.8% 1.9% 2.7% sitions 2002: U.S. ABS Weather a Turbulent Year." Standard &

BB 31.1% 3.1% 4.7% 7.0% 11.9% Poor's, January 31,2003.

B 61.0% 9.0% 13.9% 16.6% 29.5%

Ertuk, Erkan, Jay Elengical, and Thomas G. Gillis. "Rating

Transitions in Eirst-Half 2003: Global Structured Securities

ENDNOTES

Semiannual Review. " Standard Ik Poor's. July 29, 2003.

This article draws on material to be published in Lucas.

Goodman, Laurie S,. and Frank J. Eabozzi. CoUaterahrrcd Debt

Goodman, and Fabozzi, CoUatcraHzcd Debt C)bl{i;iitioiis: Swicfurcs

Obli_^alions: Stniaiircs and Analysis. Hoboken, NJ: John Wiley

and Analysis, 2nd ed. (Hobokcii. NJ:John Wiley & Sons. 2005).

& Sons, 2002,

'In short, marginal default rates (defaults within the tlrst

year, within the second year, and so on) are calculated tor each

rating cohort. Yearly marginal default rates are then averaged Hii, Jian, and Richard Cantor. "Structured Einance Rating

across all rating cohorts with the requisite iiunihcr of years oi Transitions: 19S3-2OO2: CoinparisoTis with Corporate l^atings

history. The one-year cuniularivc default rate is merely the average and Across Sectors." Moody's Investors Service, January 2003.

of every rating cohort's tlrst-year marginal default rate. Buc the

two-year cumulative default rate is the sum of the one-year cumu- Hu, Jian, Richard Cantor. Andrew Silver. Tad Phillip, and Joe

lative default rate and the average sccoiul-ycar marginal detault Snailer, "Payment Defaults and Material Impairments of U.S.

rate. The three-year cumulative dehiult rate is the sum of die Structured Einance Securities: 1993-2002," Moody's Investors

two-year cumulative detault rate and the aveniiie f/dnV-year mar- Service. December 2003.

ginal delault rate. And so it goes, adding average iiuiri;iiial default

rates to previously calculated ttiiiiuLilii'c default rates. I hi, losepb, and Roy Cbun. "Rating Transitions 2002: Respect-

able Credit Performance of U,S. CMBS." Standard & Poors,

This approach uses as much ot the availahle data as pos-

January 16, 2003.

sible. Last year's rating cohort, with only one year of data, con-

tributes something to the ten-year average cumulative default rate.

Hu,Joseph, Robert B, Pollsen, and Jay Elengical. "RatingTran-

The other suboptimal way to calculate a five-year default

sitions 2002: A Quarter Century of Outstanding Credit Per-

rate would be to average the cumulative default rates of every

ct)hort with five years of history. (This is what S&:V did with torniance of U.S. RMBS." Standard & Poor's, February 6, 2003.

structured finance rating transitions in its three studies pub-

lished in 2(103.) In this case, the last four annual cohorts would

To order reprints oj this artidc, plduc Lontiict Ajcuii MaHk at

contribute nothing to the average five-year cumulative detault

statistic. The marginal method also makes sure that cumulative imiaiik@iijomniili.coni or 212-224-3205.

default rates never decline over time.

-S&.P and Moody's point out that the multiplication

method implicitly assumes that rating downgrades are not seri-

ally correlated, i.e., that a tranche that has been downgraded is

not more likely to be downgraded tigaiii. relative to other

tranches that have not been downgraded. We know tbat down-

gracies ot corporate bonds are serially correlated, but we are

not sure bow serially correlated downgrades of structured

finance trancbes would atTect the overall results of tbe multi-

plication metbod.

^The original cohort method stilJ takes advantage of recent

detauit history troni tranches issued within the last tive years.

These detaults go into the calculation of average marginal def.uilr

in the particular year after issuance.

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