brian d. gordon, director [email protected] brian d. gordon, director...
TRANSCRIPT
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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18%
U.S. High Yield Default Index1980 - 2002U.S. High Yield Default Index1980 - 2002
Default Volume Default Rate
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20
40
60
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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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5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
40.00%
45.00%
1 2 3 4 5 6 7 8 9 10
Years
Def
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B BB BBB A AA
Marginal Gross Default RatesMarginal Gross Default RatesMarginal Default Rates
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
1 2 3 4 5 6 7 8 9 10
Years
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ate
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?
(1)
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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?
(2)
(3)
(4)
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jiijji
pppp
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)Pr( jjiiij DVDVp
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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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5%
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35%
Default Rate
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0% correlation 40% Correlation
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Pro
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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