brian d. gordon, director brian.gordon@fitchratings.com brian d. gordon, director...

Brian D. Gordon, Director

Brian.gordon@fitchratings.com

Brian D. Gordon, Director

Brian.gordon@fitchratings.com

Overview of PresentationOverview of Presentation Fitch is working on developing a completely new

methodology for evaluating and rating CDOs

The criteria is still a work in progress and subject to substantial change prior to release

This presentation will give a “sneak peak” of the underlying approach, logic and application

Fitch is working on developing a completely new methodology for evaluating and rating CDOs

The criteria is still a work in progress and subject to substantial change prior to release

This presentation will give a “sneak peak” of the underlying approach, logic and application

The World in 1997The World in 1997

1997 was the first year that saw a substantial issuance of CDOs

CDO rating methodologies created at about the same time by all three agencies

The core of all three methodologies is basically unchanged from that time

1997 was the first year that saw a substantial issuance of CDOs

CDO rating methodologies created at about the same time by all three agencies

The core of all three methodologies is basically unchanged from that time

But the world has changed substantially since then …But the world has changed substantially since then …

Asian crisis in 1997

Russian default plus Long Term Cap Mgmt 1998

Bubble Economy 1999-2000

Record High Yield Default Rates 2001-2002

CDO new issuance volume reaches $85 billion in 2002

Market volatility increases dramatically

Asian crisis in 1997

Russian default plus Long Term Cap Mgmt 1998

Bubble Economy 1999-2000

Record High Yield Default Rates 2001-2002

CDO new issuance volume reaches $85 billion in 2002

Market volatility increases dramatically

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U.S. High Yield Default Index1980 - 2002U.S. High Yield Default Index1980 - 2002

Default Volume Default Rate

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The 2001 default rate excluding fallen angels was 9.7%The 2002 default rate excluding fallen angels was 12.4%

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It’s Time for a Fresh Look at CDOs

It’s Time for a Fresh Look at CDOs

CDOs are among the most innovative and complex financial structures in existence

CDO types include cash, synthetic, market value, high yield, high grade, trust preferred, etc.

They are self-contained portfolios of credit risk

The same construct that is applied to CDOs can be applied to any portfolio of credit risk, including ABCP, SIVs, bank and insurance portfolios

CDOs are among the most innovative and complex financial structures in existence

CDO types include cash, synthetic, market value, high yield, high grade, trust preferred, etc.

They are self-contained portfolios of credit risk

The same construct that is applied to CDOs can be applied to any portfolio of credit risk, including ABCP, SIVs, bank and insurance portfolios

The Major Drivers of Risk in CDOsThe Major Drivers of Risk in CDOs Default rates of underlying assets

Recovery rates of underlying assets

Structural considerations

Interest rate risk, FX risk

Management Risk, Moral Hazard

Execution and ramp-up risk

Default rates of underlying assets

Recovery rates of underlying assets

Structural considerations

Interest rate risk, FX risk

Management Risk, Moral Hazard

Execution and ramp-up risk

Drivers of Asset Default RatesDrivers of Asset Default Rates

Rating of the underlying assets

Expected Life of the Assets

Correlation among the assets

Rating of the underlying assets

Expected Life of the Assets

Correlation among the assets

Measuring Asset Default RiskMeasuring Asset Default Risk

Fitch will introduce an entirely new Default Matrix

Based on empirical default rate evidence from all three agencies

30 year cohort analysis

Establishes “base case” default expectations by rating (AAA to B) and life (1 to 10 years)

Fitch will introduce an entirely new Default Matrix

Based on empirical default rate evidence from all three agencies

30 year cohort analysis

Establishes “base case” default expectations by rating (AAA to B) and life (1 to 10 years)

Cumulative Gross Default Rates

Cumulative Gross Default Rates

Cumulative Gross Default Rates

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45.00%

1 2 3 4 5 6 7 8 9 10

Years

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B BB BBB A AA

Marginal Gross Default RatesMarginal Gross Default RatesMarginal Default Rates

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Years

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B BB BBB A AA

2001 2002Total = $78.2bn Total = $109.8bn

Telecommunication36%

Banking & Finance

13%

Other11%

Metals & Mining

3%

Transportation2%

Food, Beverage & Tobacco

2%

Leisure & Entertainment

2%

Chemicals3%

Paper & Forest Products

2%

Automotive5%

Industrial/Manufacturing

2%

Utilities19%

Cable15%

Telecommunication54%

Others9%

Transportation3%

Insurance3%

Metals & Mining

3% Computers & Electronics

1%

Utilities6%

Paper & Forest Products

2%

Broadcasting & Media

2%Retail2%

Why Does Correlation Matter?Why Does Correlation Matter?

The degree to which two series of variables move in unison

What is Correlation?What is Correlation?

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The degree to which the default probabilities of two firms move in unison

A “structural model” model of default, based on the Black-Scholes option pricing model

The degree to which the default probabilities of two firms move in unison

A “structural model” model of default, based on the Black-Scholes option pricing model

What is Default Correlation?What is Default Correlation?

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The Correlation MatrixThe Correlation Matrix 25 Fitch defined industries All companies within an industry similarly

correlated Inter-industry correlation is pair-wise correlation

among industries (e.g. Chemicals to Auto) Intra-industry correlation is the correlation within

an industry (e.g. Chemicals to Chemicals) Correlation for each company expressed as

“Sector Average Security” which is a multiple regression across all other industries plus epsilon, a random variable representing unsystematic risk

25 Fitch defined industries All companies within an industry similarly

correlated Inter-industry correlation is pair-wise correlation

among industries (e.g. Chemicals to Auto) Intra-industry correlation is the correlation within

an industry (e.g. Chemicals to Chemicals) Correlation for each company expressed as

“Sector Average Security” which is a multiple regression across all other industries plus epsilon, a random variable representing unsystematic risk

Recovery RatesRecovery Rates

Recovery rates are a function of four variables

1) Systematic risk, implying that recoveries are inversely correlated to default rates

2) Idiosyncratic risk, meaning the unique properties of that company

3) The position of the debt in the capital structure of the company

4) The industry of the company

Recovery rates are a function of four variables

1) Systematic risk, implying that recoveries are inversely correlated to default rates

2) Idiosyncratic risk, meaning the unique properties of that company

3) The position of the debt in the capital structure of the company

4) The industry of the company

Fitch CDO Recovery Rate Matrix

Fitch CDO Recovery Rate Matrix

Fitch introduces the concept of tiered recovery rates, where the recovery rate varies with the stress scenario

For example, US Senior secured bank loans

B BB BBB A AA AAA

Recovery 65% 63% 60% 55% 50% 45%

Recoveries will also be time lagged for cash deals, but not for synthetics because of immediate valuation procedures

Fitch introduces the concept of tiered recovery rates, where the recovery rate varies with the stress scenario

For example, US Senior secured bank loans

B BB BBB A AA AAA

Recovery 65% 63% 60% 55% 50% 45%

Recoveries will also be time lagged for cash deals, but not for synthetics because of immediate valuation procedures

CDO ModelingCDO Modeling The Monte Carlo Model

Generates a vector of defaults and recoveries that are required for each rating level

The Cash Flow Model

Generates payment streams to rated liabilities using the payment waterfall and liability structure

The Monte Carlo Model

Generates a vector of defaults and recoveries that are required for each rating level

The Cash Flow Model

Generates payment streams to rated liabilities using the payment waterfall and liability structure

Monte Carlo SimulationMonte Carlo Simulation Uses a very large number of trial values for

one or more random variables to produce a probability density function

The “brute force” method to solving differential equations

Used in the default generation model to produce inputs into the Cash Flow Model

May be applied to the Cash Flow Model in the future as well

Uses a very large number of trial values for one or more random variables to produce a probability density function

The “brute force” method to solving differential equations

Used in the default generation model to produce inputs into the Cash Flow Model

May be applied to the Cash Flow Model in the future as well

Monte Carlo SimulationMonte Carlo Simulation

Rating level default probability = Di

Random number generator = Vi

pi = Pr(Vi ≤ Di)

The degree in which two “random” variables are truly random, or conversely, move in unison, is dictated by the correlation assumption

The Impact of Correlation on Default Distribution

The Impact of Correlation on Default Distribution

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Default Rate

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Default DistributionDefault Distribution

99.5% C.I.C. G. D. R. = 40%

“AAA”

99.5% C.I.C. G. D. R. = 40%

“AAA”

96% C.I.C. G. D. R. = 23%

“BBB”

96% C.I.C. G. D. R. = 23%

“BBB”

N = 100P = 10%(i = I, …, N)

Number of Defaults

Summary of the New ApproachSummary of the New Approach

Draws upon empirical evidence for underlying assumptions about defaults, recoveries and correlation

Employs a rigorous mathematical approach

Uses state of the art modeling techniques, including Monte Carlo simulations

Widely applicable to all types of CDOs plus other credit dependent portfolios

Draws upon empirical evidence for underlying assumptions about defaults, recoveries and correlation

Employs a rigorous mathematical approach

Uses state of the art modeling techniques, including Monte Carlo simulations

Widely applicable to all types of CDOs plus other credit dependent portfolios

Roll Out and ImpactRoll Out and Impact

Expected release late Spring 2003

Immediate implementation after release

Likely to be more conservative than existing criteria

Fitch will release an article on the application of the new criteria to new and existing deals

Same methodology will be applied in Europe

Expected release late Spring 2003

Immediate implementation after release

Likely to be more conservative than existing criteria

Fitch will release an article on the application of the new criteria to new and existing deals

Same methodology will be applied in Europe

www.fitchratings.com