Fitch c Do Rating

8/13/2019 Fitch c Do Rating

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13 September 2004

www.fitchratings.com

This report updates that of 1 August 2003

Analysts

Kenneth Gill, London+44 20 7417 [email protected]

Richard Gambel, London+44 20 7417 [email protected]

Richard V. Hrvatin, CFA, New York+1 212 908 [email protected]

Hedi Katz, New York+1 212 908 [email protected]

Gilbert Ong, CFA, Hong Kong+852 2263 [email protected]

David Carroll, Sydney+61 2 8256 [email protected]

Contents

Summary ............................................. 1Types of CDOs ...................................2

CDO Rating Process and RatingDefinition ............................................ 4

Default Probability in CDO Portfolios4

Loss Severity and Recovery Rate.......7

VECTOR.............................................9

Cash Flow Modelling .......................12

Structural Covenants and Waterfall .15

Relevant Parties and CounterpartyRisk ................................................... 19

Legal Issues.......................................23

Performance Analytics......................23

Related Research...............................24

Appendix 1........................................25

Appendix 2........................................26

Appendix 3........................................27

Summary

This report updates the Global Rating Criteria for CDOs publishedin August 2003. The core components of the methodology remainunchanged, namely:

multi-step Monte Carlo simulation;

incorporation of asset-specific correlation assumptions;

recovery assumptions tiered by rating stress;

empirically based Fitch CDO Default Matrix;

revised interest rate stresses;

explicit reinvestment assumptions; and

adjustment for Collateral Asset Manager (CAM) ratings.

Additional enhancements in 2004 include: increased granularity in ABS sector classifications;

revised default back-end timing stresses;

revised treatment of high-yield corporate collateral;

use of VECTOR as a portfolio trading tool; and

clarification of the use of CDO CAM ratings.

CDO performance is directly linked to three factors; the behaviourof the underlying assets, the CDOs structural features and theCDOs asset manager performance. All of these variables areaddressed in Fitchs rating criteria through Fitchs DefaultVECTOR Model 1 (VECTOR), policies regarding structuralfeatures and adjustments based on Fitchs CDO CAM Ratings.The criteria also factor in the 2000-2002 stressful credit

environment, which saw more bond defaults than the cumulativevolume of defaults occurring in the 20-year period beginning in1980 and ending in 1999.

The main quantitative tool implemented in the criteria is VECTORused in conjunction with the cash flow model. VECTOR allowsgreater precision and granularity in portfolio risk modelling whenevaluating and rating a CDO. It also addresses new structures inthe market, such as recent synthetic structures and basket trades.VECTOR uses an annual multi-step Monte Carlo simulation thatincorporates default probability, recovery rate assumptions andcorrelations to produce portfolio and loss distributions.

The criteria also draw on Fitchs comprehensive experience of the

performance impact of all types of structural features, capitalisingon its in-depth empirical research since the advent of the CDOmarket.

1The Fitch Default VECTOR Model was developed jointly with Gifford FongAssociates, Lafayette, CA

Credit ProductsCriteria Report

Global Rating Criteria for

Collateralised Debt

Obligations


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Global Rating Criteria for Collateralised Debt Obligations: September 2004

2

Asset manager decisions will affect the performanceof a CDO, and history has shown that performanceacross similar portfolios can vary markedly underdifferent managers. To appraise an asset managersperformance, Fitch utilises its CDO CAM ratings,the results of which will be integrated into thedefault and loss determination under the CDO

analysis.

This report focuses on the rating analysis behind alltypes of CDO transactions with the exception ofmarket value CDOs, trust preferred CDOs andprivate equity and hedge fund collateralised fundobligations. It outlines the theory behind Fitchsapproach to modelling the risk of defaults and lossesin a portfolio of debt obligations, describes themechanics and the application of VECTOR, andoutlines the stress tests and modelling assumptionsapplied to a structure and the cash flows of ratedCDO tranches. This criteria report is supplementedby other CDO research published by Fitch,

referenced at the end of this report.

Types of CDOs

CDOs can be categorised using three criteria: assettype, motivation and form of risk transfer. Thespecific combination of these criteria will dictate aCDO transactions name, although, despite thevariety of deal types, all CDOs have one thing incommon: they securitise the credit risk of debtobligations in one way or another.

CDO Deal Types

CDOs encompass collateralised loan obligations(CLOs), in which the assets being securitised areprimarily loans, and collateralised bond obligations(CBOs), in which the portfolio is primarily madeup of bonds. Both deal types can be classified asCDOs the term also used for portfolios combiningboth bonds and loans, portfolios of structuredfinance products, such as asset-backed securities(ABS), mortgage-backed securities (MBS) orother CDOs, and for transactions where theunderlying portfolio does not reference specific debt

obligations but rather entities, e.g. corporates orfinancial institutions.

Depending on the motivation behind a CDOtransaction, deals can be split into arbitrage andbalance sheet. Balance sheet CDOs are primarilyused by financial institutions to transfer credit risk

into the capital markets to manage their creditexposures and/or improve returns on economic orregulatory capital. This also implies an element ofarbitrage, which is less apparent in balance sheetCDOs than arbitrage CDOs. The motivation for anarbitrage CDO is to realise a profit on the marginbetween the weighted average return received on aportfolio of debt obligations and the cost of hedgingthe risk in the capital markets via the issuance of theCDO notes or swaps. Individual judgement of therisk embedded in the securitised portfolio and abilityto outperform the market are both the driver andimpact of the arbitrage CDO market.

A third criterion to differentiate CDOs is the way thecredit risk is transferred into the capital markets, i.e.a true sale, where the CDO issuer purchases thecredit risk debt obligations and becomes their legalowner, or a synthetic risk transfer, usually using acredit default or a total return swap (CDS or TRS,respectively).

In synthetic CDOs, debt obligations are referencedfor loss determination without being purchased bythe CDO issuer. Since it does not receive anypayments but rather the premium on the syntheticinstrument transferring the credit risk, the proceedsfrom the issuance of the CDOs are invested in low-risk collateral, which facilitates the coverage of the

credit risk borne by the issuer and the redemption ofthe issued notes upon maturity.

CDO Asset Types

CDOs are asset-backed securities where theunderlying portfolio can include either various typesof debt obligations or focus solely on one class ofdebt. An in-depth analysis of the debt obligations ina CDO portfolio is essential, since, depending on thedebt type, one can expect, inter alia, different

Characteristics of Various CDO Types

Criteria Characteristics CDO Type

Asset Type Bonds

Loans

Entities, Mixed Portfolios

Structured Finance Securities

Collateralised Bonds Obligation (CBO)

Collateralised Loan Obligation (CLO)

Collateralised Debt Obligation (CDO)

CDO of ABS/MBS, CDO of CDOMotivation Arbitrage

Risk ManagementFunding

Arbitrage CDOBalance Sheet CDOCash Flow CDO

Risk Transfer True SaleSynthetic

Cash Flow CDOSynthetic CDO

Source: Fitch


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recovery rates on the obligations upon their default,different characteristics in terms of recovery lag, ordifferent prepayment profiles.

Ultimately, all assets in a CDO portfolio can beclassified as bonds or loans, although both debt types

appear in various forms with unique characteristics.Bonds are fixed income, tradable and relativelyliquid debt obligations issued by an entity seekingexternal capital in the debt markets, be it a sovereign,corporate or financial institution. Debt is also oftenraised via specific funding entities, e.g. specialpurpose vehicles (SPVs), in structured financetransactions. Bonds are fungible instruments and,depending on the credit rating of the issuer, areclassified as either investment grade (IG) or highyield (HY). In addition to the specific structuredfinance instrument classifications, such as ABS,MBS and CDOs (together referred to as ABS), IGand HY can be used to describe the nature of the

underlying portfolio of bonds securitised in a CDOtransaction.

Bonds, whether IG or HY, very rarely benefit froman assignment of dedicated collateral or assetsecurity; rather, they are generally unsecuredobligations of the issuer. However, the structuralcharacteristics of individual bond issues can createsubordination and seniority between differentinstruments issued by a single borrower orborrowing group. While in ABS transactions this canbe expressed in the sequential allocation of incomingcash flows to pay down senior tranches ahead ofjunior tranches, for all other bonds with a senior-

junior relationship, the subordination becomesrelevant in the event of an issuer default andattempted recovery by the bondholders. Structuralsubordination is less of an issue in the IG bondsector as IG bonds will typically be structured on a

pari passubasis alongside other debt, including bankloans, taken on by an issuing entity.

Loans are less fungible instruments than bonds sincethey are generally less liquid and, therefore, lesstradable, and will usually be held by a smaller groupof investors (lenders) than bonds. Althoughinvestment in a loan may be sold via a primarysyndication or in the secondary market, the

relationship between debtor and creditor on a bankloan instrument is generally much stronger than isthe case with a bond. However, this distinction islikely to become increasingly blurred as bank lendersbecome more aware of the need to manage theircapital resources and credit risk exposure moreefficiently and to prepare for Basel II requirements,all of which should lead to greater liquidity andtrading activity in the global bank loan market.

The characteristics of bank loans will varydepending on whether the borrower is an IG or asub-IG issuer, reflecting the differing credit riskprofiles of these issuers. IG bank loans will usuallybe unsecured debt obligations ranking pari passuwith all other obligations and indebtedness,including any bonds issued by the borrower. In thecase of a default by the issuer, the unsecured banklenders would claim against the borrower on a pari

passubasis with the bondholders.

Bank loans usually securitised in CDOs tend to begranted to sub-IG borrowers and will almost alwaysneed to provide the bank lenders with security oversome or, more usually, substantially all of theirassets. In this scenario, a borrower default can leadto the senior secured bank lenders taking action toenforce their security, either on an asset break-upbasis or via a sale of the company as a going concern.Theoretically, enforcement proceeds are used first to

pay all outstanding loan interest and principal to thesecured lenders, with any remainder being availablefor distribution to unsecured creditors. However,while this principle is practiced in the US and certainEuropean jurisdictions (most notably the UK), anumber of European insolvency regimes haveadopted an approach that allows junior creditors toachieve a certain level of recovery even if seniorsecured lenders are not repaid in full.

The capital structure of leveraged buy-out (LBO)transactions or other sub-IG issuers can comprise acombination of various debt instruments, issued by asingle borrower group with differing levels of

seniority as follows: senior secured loans; juniorsecured loans (mezzanine debt); senior unsecuredloans or bonds; subordinated loans or bonds.

IG Issuer

Assets Liabilities

Assets Senior Bonds/Loans(Unsecured)

Equity

Source: Fitch

Sub-IG Issuer

Assets Liabilities

Assets Senior Secured Loan

Subordinated Debt(Mezzanine or HY Bonds)

Equity

Source: Fitch

Highly leveraged issuers are, by nature, usually ofsub-IG quality. However, the qualitative andstructural considerations that form an integral part of


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Fitchs analysis of any issuer or debt issue mean thatdegree of financial leverage is only one factor to beconsidered when calculating whether an issuer fallsinto the IG or sub-IG arena. Fitch analysts alwayscarry out an in-depth analysis of the underlying debtinstruments in every CDO rated by the agency toidentify the seniority or subordination of theindividual assets and their respective expectedrecovery rates.

ABS assets, although fungible instruments, aregenerally less liquid than bonds. However, ABSbenefit from the fact they are issued by SPVs, theassets of which are ring-fenced for the holders of theABS. Hence, ABS investors have access to dedicatedcollateral in the case of a default of the ABSobligation, and the proceeds from the collateral areallocated sequentially from the senior notes to thejunior notes and the equity.

In synthetic CDOs, the analysis of the underlyingobligations in the portfolio is made more complex bythe fact that losses can be determined on a variety ofthe debt obligations of the referenced entity.Depending on the CDO structure, all of the above-mentioned debt types can qualify as referenceobligations. When modelling recovery rates insynthetic CDOs, Fitch assumes the instrument of areferenced obligor with the lowest expected recoveryrate will default. Please see Loss Severity and

Recovery Rates for Fitchs recovery rateassumptions.

CDO Rating Process and Rating

DefinitionThe rating process begins when Fitch receives arequest from an arranger or sponsoring institution ofa CDO. The first step is usually a review of the assetmanager, originator or servicer (see Asset Managerand Originator below) to determine the motivationbehind the transaction and their ability to manageand service the portfolio appropriately.

The rating process continues with the determinationof the portfolios quality and the probability ofdefaults in the portfolio. Depending on whether thetransactions portfolio is static or revolving andwhether it is already ramped up or not, Fitch will

assess default and recovery levels either on an actualbasis or based on the eligibility and portfolio criteriaset out in the indenture. Next, it will review theproposed structure and its impact on the transactioncash flows. Various cash flow scenariosincorporating interest rate and currency stressessimulate different default patterns to determinewhether subordination levels and priority of cashflows are sufficient to meet the desired ratings.

Legal documentation will also be reviewed to ensurethat the structure is clearly defined and the investorsinterests properly represented. After the transactionhas closed, Fitch will monitor the CDOsperformance and adherence to guidelines throughongoing surveillance.

Rating Definition

CDOs are typically rated with multiple tranches ofliabilities of varying credit quality and seniority. Anyrating assigned by Fitch to such liabilities addressesthe probability of a particular tranche performing inaccordance with the terms of the notes. In theinvestment grade categories, the rating givesparticular weight to the tranches ability to paytimely interest and ultimate principal. In the sub-investment grade categories, the terms of the notesmay allow for interest to be deferred and paid in kind(PIK), thus the rating addresses the ability of thenotes to repay principal and ultimate interest by final

maturity. Additionally in some other cases, the ratingmay address only the ultimate repayment of theinvestors investment or a minimum internal rate ofreturn (IRR), which may come from a combinationof principal and interest. Fitch will give a cleardescription of the type of rating assigned to aparticular tranche in its presale and new issue reports.

Default Probability in CDO

Portfolios

The centrepiece of Fitchs CDO rating methodologyis the Fitch Default VECTOR model, a portfolioanalytics tool that uses Monte Carlo simulationsincorporating default probability, recovery rateassumptions and asset correlation to calculatepotential portfolio default and loss distributions.

Using a multi-step process, at every step in thesimulation the asset portfolio is updated by removingdefaulted assets, updating asset histories andrecording default events and recoveries followingdefault. VECTOR also incorporates sector-specificcorrelations calibrated to the term of the MonteCarlo simulation, while intra-industry correlation isevaluated by a factor analysis of industry andidiosyncratic exposures.

The first step in the analysis of credit risk in a CDO

portfolio concentrates on the quality of both theindividual assets and the overall portfolio.

Determination of Asset Quality in CDO

Portfolios

Fitchs assessment of default probability for areference portfolio is based on the credit quality ofthe reference assets, usually measured by theirratings. Since underlying assets in a CDO aretypically rated by Fitch, this rating will be the


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primary reference for portfolio analysis. However, ifno Fitch rating is available, the agency will also lookat public ratings assigned by another NationallyRecognised Statistical Rating Organisation(NRSRO).

When Fitch looks at public ratings from anotherNRSRO, it accepts the fact that, for theoverwhelming majority of obligors rated by morethan one rating agency, the ratings will be within onesub-category. Therefore, rather than introducingformulaic, across-the-board treatments which

produce imprecise and costly results, Fitch applies acredit-focused approach combined with a fairtreatment of ratings assigned by other rating agencies.

For investment grade corporates and all structuredfinance assets not rated by Fitch but publicly ratedby two other NRSROs, Fitch will use the lower ofthe Fitch-equivalent ratings from the other agencies.For high yield bonds and leveraged loans not ratedby Fitch but publicly rated by two other NRSROs,Fitch will use the average of the Fitch-equivalentratings from the other agencies. However, shouldsuch a credit be publicly split-rated between IG andsub-IG, Fitch will use the lower of the two ratings.For all corporate ratings, the equivalent senior

unsecured issuer Long-term credit rating will be used.If an asset is publicly rated by only one otherNRSRO, Fitch will use this rating. However, toensure maximum diligence in the analysis of asecuritised portfolio, the agency may adjust therating used when there is an indication that Fitchscredit opinion may differ from that derived by theabove-mentioned rule.

To capture adverse selection and moral hazard risks,Fitch will check whether a particular name is onRating Watch Negative (or similar indicators byother NRSROs) and will reduce the rating, by onesub-category, for the purpose of a CDO evaluation.The agency may also take into account marketinformation, e.g. credit default spreads and bondprices.

For structured finance securities, Fitch hasestablished its Challenged Deal List. This listcomprises ABS transactions that Fitch assessed but

did not rate. Such ABS are reported in theChallenged Deal List with the estimated rating Fitchwould have assigned had it rated the transactionpublicly, which can be several sub-categories belowthe rating derived using the above-mentioned rule. Incertain instances, for Fitch to evaluate selectedstructured finance securities not rated by Fitch, theasset manager may be requested to provide theagency with the offering memoranda of therespective securities and, on an ongoing basis, withperformance reports.

For CDOs of small and medium-sized enterpriseswhere it is likely that not all the reference entities arepublicly rated, Fitch may assess portfolio quality

using a mapping to the originators internal ratingsystem (see European SME CDOs: An InvestorsGuide to Analysis and Performance dated 2October 2001, and Rating Criteria for US Middle

Market Collateralized Loan Obligations, dated 25June 2002 at www.fitchratings.com). Alternatively,the agency may apply corporate rating models likeFitch Risk Managements automated corporate ratingtool, CRS, which estimates Long-term credit ratings

Fitch CDO Default Matrix(Cumulative Default Probabilities in %)

Years

Rating 1 2 3 4 5 6 7 8 9 10

AAA 0.00 0.00 0.02 0.03 0.05 0.08 0.10 0.13 0.16 0.19

AA+ 0.00 0.02 0.05 0.13 0.19 0.26 0.33 0.40 0.48 0.57AA 0.01 0.02 0.07 0.16 0.26 0.38 0.49 0.62 0.75 0.89AA- 0.01 0.05 0.13 0.23 0.36 0.51 0.66 0.82 0.98 1.15A+ 0.03 0.11 0.22 0.37 0.56 0.76 0.98 1.20 1.43 1.65A 0.04 0.13 0.26 0.43 0.62 0.84 1.07 1.32 1.58 1.85A- 0.08 0.23 0.42 0.66 0.92 1.20 1.49 1.80 2.12 2.44BBB+ 0.12 0.32 0.57 0.87 1.20 1.55 1.93 2.32 2.72 3.13BBB 0.21 0.54 0.91 1.32 1.89 2.30 2.67 2.97 3.34 3.74BBB- 0.42 1.07 1.87 2.74 3.63 4.48 5.27 6.00 6.66 7.26BB+ 0.72 1.89 3.20 4.52 5.74 6.85 7.84 8.75 9.47 10.18BB 1.46 3.08 4.79 6.51 8.11 9.48 10.69 11.78 12.71 13.53BB- 2.80 5.19 7.48 10.63 12.50 14.06 15.36 16.44 17.46 18.46B+ 4.15 8.81 12.54 15.02 17.09 18.86 20.05 21.51 22.22 22.84B 5.71 11.75 16.29 19.12 21.36 23.36 24.51 26.26 26.98 27.67B- 10.55 16.81 20.89 24.60 27.08 29.20 29.99 32.12 33.50 34.98CCC+ 15.93 22.52 26.14 30.86 33.64 35.90 37.38 38.87 41.00 43.36CCC 17.83 25.20 29.25 34.53 37.64 40.16 41.82 43.50 45.87 48.52

Source: Fitch


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based on quantitative and qualitative information onthe obligor.

Except for structured finance securities, the relevantrating indicating an assets credit risk is always theissuers Long-term rating. In most cases, this is equal

to the rating assigned to the debt instrument. Forinstruments such as leveraged loans or subordinatedbonds, however, the instrument rating may havebeen notched up or down in recognition of itsbenefiting from security or its subordinated positionrespectively. Such structural elements are reflectedin recovery assumptions made by Fitch.

Weighted Average Portfolio Quality and

Fitch CDO Default Matrix

Fitch has developed the Fitch CDO Default Matrix(Default Matrix) specifically for use in its CDOrating model. The Default Matrix is based on globalhistorical default rates modified to reflect the

diversity imposed by CDO collateral policies. TheCDO Default Matrix is utilised in the VECTORmodel to define default probability for eachcollateral asset, and secondly, to define thedistribution percentile corresponding to therespective CDO tranches rating.

Fitch will assign a default probability to each asset,depending on its term and rating, as per the DefaultMatrix. The Default Matrix can be used to calculatethe weighted average rating factor (WARF) of anyCDO portfolio. Although Fitch utilises asset by assetrating information in its default and recoveryanalysis, the WARF represents a useful indicator of

the portfolios average credit risk and may help incomparing performance across different portfolios.

A portfolios WARF is calculated by dividing thesum-product of the assets outstanding amountstimes their Fitch Rating Factors (see below) by thetotal notional portfolio amount. The factors representthe 10-year default probabilities for the respectiveweightings.

Servicer Limits

In addition to the portfolio default and recoveryanalysis done in VECTOR, Fitch has developedguidelines for limitations on a CDOs exposure toindividual servicers of the MBS and ABS purchasedby the collateral manager. In general, a CDO maynot have more than 7.5% of the collateral poolinvested in securities that are serviced by any oneservicer rated below S2 or with a Long-termfinancial rating lower than A. Fitchs servicerconcentration guidelines are shown below. Theagency will look to the servicer rating first, then tothe Long-term issuer rating.

In some cases, Fitch has been comfortable withexceptions to these guidelines, particularly insituations where the underlying loans are originatedby a third party or the loans are special serviced withan underlying primary servicer. This mitigates theexposure to the crash of a particular originationshop or vintage. This is frequently the case in CMBSconcentrated CDOs and some RMBS concentratedCDOs.

Fitch rates residential and commercial mortgageprimary, master, and special servicers on a scale ofS1 to S5, with S1 being the highest rating.

Fitch servicer ratings were established to provideinvestors and other market participants with a clearindication of servicers capabilities based on aquantitative benchmark assessment.

Servicer Concentration Limits

Long-Term FinancialRating/Servicer Rating Portfolio Limit (%)

Below A- or S2 7.50A- or S2 10.00AA- or S1 15.00

Source: Fitch

Default Probability Adjustments

Fitchs study of historical default rates, which hasbeen used to derive the CDO Default Matrix,captures instances of distressed bond exchanges,failure to pay and bankruptcy of corporate debtors.Fitch is aware that the application of hypotheticaldefault rates derived under such default definitionsmay not always be appropriate for all types of CDOtransactions, specifically synthetic CDOs and CDOsof ABS.

Fitch Rating Factors

Rating Factors

AAA 0.19AA+ 0.57AA 0.89AA- 1.15A+ 1.65A 1.85A- 2.44BBB+ 3.13BBB 3.74BBB- 7.26

BB+ 10.18BB 13.53BB- 18.46B+ 22.84B 27.67B- 34.98CCC+ 43.36CCC 48.52CC 77.00C 95.00DDD D 100.00

Source: Fitch


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In synthetic corporate CDOs, credit events usuallyconform to the 1999 International Swaps andDerivatives Association (ISDA) credit derivativedefinitions and supplemental amendments. NewCDOs will, however, begin to incorporate the new2003 definitions (see Fitch Examines Effect of 2003Credit Derivatives Definitions, dated 6 March 2003,available at www.fitchratings.com). Marketconvention generally defines credit events as:

Bankruptcy

Failure to Pay

Restructuring

Obligation Acceleration

Moratorium

Fitch is concerned that the ISDA restructuring andobligation acceleration credit events could betriggered on occasions where the relevant entitycontinues to perform, exposing the protection seller

to a loss that does not reflect loss upon default butrather market value loss on a still-performing asset.The risk of a soft credit event being triggered isconsidered greater for lower-rated assets, whose debtwill typically have more covenants that may bebreached, triggering a credit event. Therefore, Fitchreserves the right to apply an adjustment in itsdefault assumptions where such events are included.The lower the rating of the asset, the greater theadjustment factor may be.

While Fitch has not developed a default curve forABS and MBS due to the relatively short defaulthistory of these sectors, the agency expects such

transactions to have on average lower default ratesthan corporate issuers. With very few ABS or MBSdefaults reported, Fitchs structured finance andcorporate rating transition studies support the viewthat negative structured finance rating migration islower than that in corporate ratings (see GlobalStructured Finance Ratings Performance: First Half

2004 Review, dated 19 July 2004 and Fitch RatingsCorporate Finance 2003 Transition and DefaultStudy, dated 19 July 2004, both available atwww.fitchratings.com).

As a result, the default rates shown in the DefaultMatrix may be adjusted by the agency for certainstructured finance asset classes for which the

migration experience has been demonstrablysuperior to corporate ratings. Any default rateadjustment can be made directly in the VECTORmodel in the Default Rate Adjustment column onthe Portfolio Definition worksheet.

Loss Severity and Recovery Rate

Recovery rates for defaulted assets in a CDOprimarily depend on the characteristics of such assets,expressed by the position of the defaulted debt in the

debtors capital structure and the presence or not ofany security assigned to it as well as the jurisdictionof the defaulted debtor. However, analysis ofempirical data has shown that recovery rates are notonly a function of these idiosyncratic or debtor-related factors, but are also influenced by thesystemic effect whereby recovery rates decline asdefaults increase. This is intuitively sound and easyto understand, since, in a stressful economicenvironment there are fewer buyers willing to buy adefaulted debtors assets or acquire an entirecompany, including its debt, as a going concern. Inrecognition of this, Fitch has introduced the conceptof tiered recovery rate assumptions for increasedstress scenarios. While the B stress is roughlyanchored at base historical recovery levels, recoveryrates for all higher rating categories are adjusted by afactor of between net 20% and net 64% with anadjustment of up to 100%, setting the recovery rateat 0% for sub-investment grade ABS assets in a

AAA stress scenario. All current global recoveryrates are listed on the VECTOR Inputs worksheetof the VECTOR model.

Asset Type, Jurisdiction and Recovery

Rate

Fitchs Credit Products teams in Europe and the UShave conducted research on the performance ofdistressed debt using the agencys own empiricaldata and information provided by recognisedinstitutions like Altman/NYU and Loan PricingCorporation.

US Assets: For the US, comprehensive empirical

data was available for most of the debt typescommonly securitised in a CDO. Following the assettype classification explained in CDO Asset Types,Fitch found average historical recovery rates asshown in the table next page.

Average Empirical Recovery Rates for

the US (%)

Senior Secured Loans 65 75Senior Unsecured Debt 40 50Subordinated Debt 20 35

Note:these recovery rates are valid as of the publication date of thisreport. Recovery rate assumptions may change over time. Thecurrent recovery rate assumptions will always be available in thelatest VECTOR model, available at www.fitchresearch.com.

For senior secured bonds, Fitch will apply a senior unsecuredrecovery rate.Source: Fitch

Second Lien Loans: A relatively new addition tothe CLO world is that of second lien loans. In the US,a second lien loan is senior to all other subordinatedindebtedness of an obligor but is subordinated to atleast one other class of obligations with respect topriority of payment. With regard to the final


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payment of debt, it is due and payable only after allother senior andpari passuobligations of the relatedobligor are paid in full. As a result, US second lienloans should generally have recoveries in betweenthose of senior secured loans and senior unsecureddebt. Similarly, in Europe, second lien loans aresubordinated to senior secured debt but rank seniorto the traditional junior debt piece, which willnormally take the form of a mezzanine facility or ahigh yield bond. For CDO transactions investing inEuropean second lien instruments, Fitch will use thejunior secured recovery rate for the appropriatejurisdiction.

European Assets: In Europe there is a lack ofstatistical default and recovery rate data for thevarious debt instruments in each of the differentjurisdictions. The only European data comprehensiveenough to calculate empirically based recovery ratesrelates to UK secured loans, which, on average,

achieved a recovery rate of 76.5% (see SecuredLoan Recovery Rate Study The UK Experience,dated 29 February 2000). To address this lack ofinformation, Fitch completed studies of four of thekey European insolvency regimes (France, Germany,Spain and the UK) and compared them with the US(see Regimes, Recoveries and Loan ratings: The

Importance of Insolvency Legislation, dated 11October 1999 and Rating Spanish Loans, dated 1June 2000).

However, since the time of these studies, a numberof European jurisdictions have implemented changesto their insolvency regimes. Accordingly, Fitch is inthe process of a new review to assess the impact ofthese changes and to expand upon the number ofjurisdictions examined.

To conclude, while there have been a number ofdefaults in Europe over the last few years, availabledata does not allow statistically compelling recoverycalculations outside the debt types and jurisdictionsmentioned above. Therefore, Fitch has used thesestudies to determine conservative base case recoveryrate assumptions on various debt instruments across

European territories. The table below gives therecovery rate assumptions for France, Germany,Spain and the UK in AAA and B stress scenarios.

Structured Finance Assets: For structured finance,recovery rates for ABS obligations depend on a

securitys priority within the capital structure of theissuer, the credit rating of the respective tranche andthe tranche size relative to its own capital structure.Fitchs rating of an ABS instrument addresses itslikelihood of default but does not address loss in theevent of default. This is because, typically, thedefault of a lower-rated ABS tranche may notnecessarily lead to a default of a higher-rated tranche.Furthermore, a loss suffered by a lower-rated tranchemay alter over time, even while more senior tranchescontinue to perform. In general, the thinner atranche in relation to the total amount of thesecuritisation, the greater the risk of high lossseverity in the event of a default of that specific

tranche.

Fitch takes this into account by applying lowerrecovery rate assumptions to mezzanine and juniortranches of an ABS than senior tranches, and bydistinguishing recovery rate assumptions accordingto the size of a tranche. Tranches equating to lessthan 10% of their initial capital structure will receivea lower recovery rate assumption than those greaterthan 10%. In addition to the tranche factors outlinedabove, the asset class and characteristics of theunderlying portfolio may also be taken into account.Fitchs current recovery rate assumptions areoutlined in the VECTOR Inputs sheet in theVECTOR model. However, Fitch may adjust ABSrecovery rates higher or lower to recognise pool-specific characteristics. Higher adjustments maymost commonly be made for pools concentrated inAAA and AA collateral.

Loss Determination

In a cash flow CDO, recoveries are always achievedby either selling the defaulted asset or going throughthe work-out process. In a synthetic CDO, losses andrecoveries are determined by either cash or physical

Corporate Debt Recovery Rate Assumptions

IG Companies Sub-IG Companies

(%) Unsecured SubordinatedSeniorSecured

JuniorSecured

SeniorUnsecured Subordinated

Stress AAA B AAA B AAA B AAA B AAA B AAA B

US 44 55 24 30 56 70 24 30 36 45 24 30France 28 35 20 25 32 40 24 30 20 25 8 10Germany 28 35 20 25 44 55 32 40 17.5 22.5 4 5Spain 28 25 20 25 32 40 24 30 20 25 4 5UK 32 40 24 30 60 75 40 50 14.4 17.5 0 0

Note: These recovery rates are valid as of the publication date of this report. Recovery rate assumptions may change over time. The currentrecovery rate assumptions will always be available in the latest VECTOR model, available at www.fitchresearch.com.For senior secured bonds, Fitch will apply a senior unsecured recovery rate.Source: Fitch


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settlement. Under a cash settlement, a protectionpayment is based on the difference between the parvalue of an obligation selected for valuation and itspost-credit-event market value determined in abidding process, the equivalent of selling a defaultedasset in a cash flow CDO. A variation of this methodis used in synthetic balance sheet CDOs, where cashsettlement takes place after determination of thewrite-off amount by the originator. Under physicalsettlement, the protection buyer is paid the paramount of the defaulted obligation and must deliversuch an obligation to the CDO issuer. Depending onwhether the CDO then sells the obligation or holdson to it until the work-out process has been finalised,it too is economically equivalent to either selling theasset or going through the work-out process in a cashflow CDO.

Recovery Rate Adjustments

Fitchs standard recovery rate assumptions are set

out in VECTORs VECTOR inputs worksheet.However, due to the specific characteristics of everytransaction, a Fitch Rating Committee may decide togive credit or to haircut the standard recovery rateassumptions, which can be easily incorporated in theanalysis by using the Recovery Rate Adjustmentcolumn in the Portfolio Definition worksheet.

For instance, in synthetic CDOs, the sponsoringinstitution or protection buyer may haveconsiderable influence over the timing and amountof loss since they are often in a position to determinethe call of the credit event and to participate in thebidding process. Furthermore, following a credit

event it is the protection buyer who chooses whichparticular obligation of the failed reference entityshould be subject to the valuation process (i.e. thecheapest to deliver option). In empirical studies,Fitch has found that this may result in lower averagerecovery rates (see Credit Events in GlobalSynthetic CDOs: Year-End 2003 Update dated 11June 2004, available at www.fitchratings.com).Consequently, for these structures, Fitch reserves theright to adjust its recovery rate assumptions on a caseby case basis as necessary. Fitch also applies a 5%haircut to recovery rates of synthetic transactionswhere convertible bonds can be a deliverableobligation.

In cash flow CDOs, where the manager usually hasreasonable flexibility to decide whether to sell orhold on to a defaulted obligation, the option takenmay cause the recovery rate achieved to differ fromthe markets average recovery rate. Fitch may reflectthe managers recovery abilities as expressed in the

Fitch CDO CAM Rating (see CDO Collateral AssetManager Rating below).

VECTOR

VECTOR is Fitchs main quantitative tool toevaluate the default risk of credit portfolios in CDOtransactions. The model can be downloaded bysubscribers from the agencys website atwww.fitchresearch.com. The model will beaccompanied by an installation wizard as well as acomprehensive manual.

VECTOR Methodology

VECTOR is a multi-period Monte Carlo simulationmodel which simulates the default behaviour ofindividual assets for each year of the transactionslife. Monte Carlo simulation is widely used infinance and allows for the modelling of thedistribution of portfolio defaults and losses, takinginto account the default probability and recovery rateas well as the correlation between assets in aportfolio. The model can be used for portfolios ofcorporate assets as well as portfolios of ABS assets.

VECTOR is based on a structural form methodology(see Appendix 1 Structural Form Model and MonteCarlo Simulation), which holds that a firm defaultswhen the value of its assets falls below the value ofits liabilities (or its default threshold). The modelsimulates correlated asset values for each obligor andeach period, which are compared to the defaultthreshold derived from the rating and itscorresponding default probability in the DefaultMatrix (see Default Probabilities in CDO

Portfolios above).

VECTOR applies an annual multi-step process. Atevery annual step an asset portfolio is updated byremoving defaulted assets and recording amountsand recoveries upon default. VECTOR simulates theasset values for each year of a transaction, allowingthe modelling of time-varying inputs such ascorrelation and default rates, and incorporatingamortisation characteristics for every individualportfolio.

For a more detailed description of the mathematicalfunctions of VECTOR, please see The Fitch

Default VECTOR Model User Manual, available atwww.fitchresearch.com.

Correlation Between Assets

One of the key components of VECTOR is theexplicit incorporation of the correlation betweenindividual assets in a CDO. As mentioned above, the


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structural form methodology applied in VECTORmodels the asset value of individual obligors.Therefore the model requires asset correlation as aninput, which measures the degree by which the assetvalues between two obligors move together acrosstime. Asset correlation is different from defaultcorrelation, which measures the relationship betweenevents of default for any two assets (see DefaultCorrelation and its Effect on Portfolios of Credit

Risk, dated 17 February 2004, available atwww.fitchratings.com).

Correlation Between Corporates

Measuring asset correlation between corporatesdirectly is not possible since historical asset valuetime series are generally not readily available.Therefore, Fitch used equity return correlation as aproxy for asset correlation and conducted a factoranalysis (see Appendix 2: Empirically Derived

Asset Correlation by Industry). Fitch analysed allthe companies in the Dow Jones global universe of6,100 companies, and grouped them into the 25 Fitchindustry classes, as shown above, and the 34

countries in which the companies are based. For themost current Fitch correlation matrix, please see thelatest version of the VECTOR model on Fitchswebsite at www.fitchratings.com.

Correlation Between Structured Finance

Products

Due to the lack of structured finance default data,correlation assumptions between structured financeproducts were established using Fitchs expertise andknowledge base across structured finance sectors.Structured finance securities are typically built ondiverse asset portfolios, which are much lessexposed to idiosyncratic or event risk. Portfolio

theory shows that the lower the idiosyncratic riskinherent in assets, the higher the correlation betweensuch assets. The level of diversity between structuredfinance products depends on the number of assets inthe portfolio, their regional and industry distributionand their level of cross holdings.

Fitch has identified 21 regions and six main assetsectors for the calculation of correlation betweenstructured finance products. For US assets,

Impact of Correlation on Portfolio

Defaults

The following chart shows the impact ofcorrelation on the portfolio default distribution.

0%

1%

2%

3%

4%

5%

6%

7%

8%

1 5 9 13 17 21 25 29 33 37 41 45 49

Number of Defaults

Portfolio of 50 B Rated Assets

Corr = 10%

STDev = 5.27

Corr = 30%

STDev = 12.42

Increasing the correlation changes the distributionpattern, leading to more frequent extremeobservations at either end of the distribution,although the mean of the distribution remainsunchanged. Both the standard deviation and upperpercentile increase significantly as a result ofgreater correlation. In the extreme case of 100%correlation (meaning that all assets are from thesame issuer) either all or none of the assets in aportfolio would be expected to default. As aresult, correlation can be both positive ornegative, depending on which part of the capitalstructure is concerned. For the holder of the firstloss piece, the higher the correlation the better.

Senior investors, on the other hand, prefer lowcorrelation to reduce the probability of largedefault numbers.

Fitch Industry Classes for Correlation

Aerospace & Defence

Automobiles

Banking & Finance

Broadcasting/Media/Cable Building & Materials

Business Services

Chemicals

Computers & Electronics

Consumer Products

Energy

Food, Beverage & Tobacco

Gaming, Leisure & Entertainment

Health Care & Pharmaceuticals

Industrial/Manufacturing

Lodging & Restaurants

Metals & Mining

Packaging & Containers

Paper & Forest Products

Real Estate

Retail (General)

Supermarkets & Drugstores

Telecommunications

Textiles & Furniture

Transportation

Utilities


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correlation is calculated between a further 45 assetsub-sectors. For non-US regions, which lack thedepth and breadth of the established structuredfinance markets of the US, asset sub-sectors mayvary.

The agency also recognises that, due to high regionalconcentration in structured finance products,

correlation between similar ABS in the same regionis higher than between ABS from different regions.Fitchs correlation assumptions for structuredfinance assets generally conform to the rules set outbelow. However, Fitch may adjust ABS correlationshigher or lower to recognise pool/asset-specificcharacteristics.

Correlation within ABS is higher compared tocorporates due to the increased systematic risk.

Correlation between ABS sectors is lower thanwithin the same ABS sector.

The correlation matrix for all corporate andstructured finance sectors is shown on theVECTOR Inputs worksheet in the VECTORmodel.

VECTOR Outputs

VECTOR is not a cash flow model and does not takeinto account structural features such as waterfalls orexcess spread. The VECTOR outputs reflect thecredit quality of the portfolio underlying eachindividual CDO.

The primary outputs of the VECTOR model are:

Portfolio Correlation Level

Rating Default Rate Rating Loss Rate

Rating Recovery Rate

Default Distribution over Term

Portfolio Correlation Level (PCL):The PCL is apre-simulation, average correlation statistic for thegiven portfolio in VECTOR, based on Fitchscorrelation assumptions. Each industry has a uniquecorrelation profile (see VECTOR Methodologyabove) with respect to every other industry, andevery portfolio will produce its unique PCL. ThePCL enables the user to view the impact of portfoliochanges on the portfolios correlation level. Since

correlation has a direct impact on the rating defaultrate of the portfolio, the purpose of the PCL is togive users an indication of the level of correlation ina portfolio. Changing the correlation, and hence thePCL, will change the default distribution.

Rating Default Rate (RDR):The RDR shows thepercentage of the initial portfolio that is assumed todefault in the respective rating scenario. It is derived

Fitch Structured Finance Regions for

Correlation

USA

Canada

Central America

South America

Germany, Austria, Switzerland

France, Belgium, Luxembourg

Netherlands

Italy

Greece

Spain

Portugal

Scandinavia

UK & Ireland

Eastern Europe

South Africa

Australia

New Zealand Japan

China

Hong Kong

Asia Other

0%

2%

4%

6%

8%

10%

12%

0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30% 33% 36% 39% 42% 45% 48% 51% 54% 57% 60% 63% 65% 68% 71%

Cumulative Default Distribution

96.5th percentile

=32.19%


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from the portfolio default distribution, applying thepercentile corresponding to the rating scenario andterm. The percentile applied for a particular targetrating incorporates the fact that the values in theDefault Matrix are assumed to be average defaultprobabilities. In the chart above, the 96.5thpercentile corresponds to a default rate of 32.19%.The RDR is a direct input into the cash flow model(discussed below).

Rating Loss Rate (RLR): This is the expectedportfolio loss for a particular credit portfolio in therespective rating scenario. The portfolio loss iscalculated using Fitchs recovery rate assumptionsfor each asset, taking into account the assetsjurisdiction, its ranking in the capital structure of theissuer and the rating stress level. The RLR is gross ofany structural mitigants such as excess spread. Likethe RDR, it is derived from the portfolio lossdistribution. In the absence of structural support,

static credit enhancement has to cover the RLR forthe respective rating.

Rating Recovery Rate (RRR):The RRR showsthe expected weighted average recovery rate for theparticular credit portfolio in the respective ratingscenario. In the past, this number was calculated on apre-simulation basis for all assets in a portfolio,regardless of whether any were likely to default ornot.

This simplistic analysis fails to capture twoimportant risk factors. The first is that recovery ratesare scenario sensitive. The second is the potential for

the bar-belling of recovery rates and ratings. Thisoccurs where ratings are distributed at the extremesaround a WARF. If the assets in a pool are nothomogeneous, the disparity in default rates couldproduce substantively different actual recovery rateson a portfolio basis. The extent of the differencedepends on the relative difference in default rates.

The VECTOR model captures this difference in theRRR. In the Monte Carlo simulation, each time anasset defaults, its recovery rate in each stressscenario is recorded. VECTOR computes theweighted average recovery rate of all defaultedassets in each simulation run. Those with highdefault rates will have their recovery rates recordedmore often than those with low default rates. As withthe RDR and the RLR, the resulting distribution ofportfolio recovery rates is used to derive the RRR.

Default Distribution over Term: The defaultdistribution shows the expected allocation ofportfolio defaults over the term of the simulation andwill be used as a default timing scenario in the cashflow model.

In addition to the above-mentioned outputs,VECTOR will produce various other valuableoutputs, all of which are explained in more detail inThe Fitch Default VECTOR Model User Manual,available at www.fitchresearch.com.

Default Risk in Revolving Transactions

Some CDOs are static, meaning their portfolio ofassets is set at closing and does not alter throughoutthe life of the transaction, bar amortisation orprepayments. In these deals, any principal proceedsare typically paid directly to the most senior class ofnotes then outstanding as a principal reduction.Other CDOs can be revolving or replenishing,meaning that they have a certain period after dealclose during which principal proceeds can be usedunder certain conditions to acquire new assets ratherthan pay down senior notes; during this time theoutstanding balance of the notes will remain constant,barring defaults. After this period, the transaction

begins amortising and effectively converts to a static,or quasi-static, portfolio and any principal proceedsreceived are used to repay senior notes.

In essence, there may be additional risk in arevolving versus a static transaction in that theportfolio may deteriorate not only by naturalmigration but also by substitution of assets duringthe revolving period. In fact, during this period, theportfolio turnover can be much higher than the initialportfolios weighted average life might indicate. Toaccount for this additional risk and to differentiaterevolving structures from static, Fitch will makeconservative assumptions regarding a portfolios

migration profile over the term of the transaction.The risk horizon of revolving portfolios, in both cashflow and synthetic transactions, will be modelled asthe greater of the initial portfolio weighted averagelife and that at the end of the revolving period plusthe revolving period.

Cash Flow Modelling

The VECTOR model focuses on creating uniquedefault patterns for each portfolio. The cash flowmodel focuses on how the various default andrecoveries generated by VECTOR affect thestructure of a CDO in different scenarios using theprincipal outputs of the model (specifically the RDR

and the RRR).

Cash flow models test the ability of the structure towithstand various stressful scenarios. Fitch hasdefined a number of scenarios based on acombination of inputs. These inputs include not onlythe RDR and the RRR from the VECTOR model butalso other inputs such as default timing, interest ratemovements and currency movements.


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The purpose of the cash flow model is to determine,based on the inputs of the VECTOR model and thedefined stress scenarios, whether various classes ofCDO liabilities pay in full, in accordance with theterms of the transaction.

Fitch has developed its own independent modellingcapability to analyse global CDOs that provides auniform platform for the analysis of a wide range oftransactions and compares their results in aconsistent way.

The Fitch cash flow model incorporates the capitalstructure of the CDO and the payment waterfall. Itreflects how the various timing and stress scenariosaffect principal and interest proceeds as they arereceived each period throughout the life of atransaction. The cash flow model then allocatesthose payments to the various classes of notes basedon the rules laid out in each transactions indenture.

If the cash flow model shows that a particular classof notes has received payment in full in the stressscenario for a particular rating, then it is deemed tohave passed that stress scenario. Ultimately, whileratings are assigned by a Fitch Credit Committee,which also considers other qualitative factors,passing the cash flow model runs is key to receivingthe desired rating.

Modelling Differences Between Synthetic and

Cash Flow Transactions: From a modellingperspective, the main difference between the typicalcash flow CDO and the typical synthetic deal is thereliance of cash flow CDOs on proceeds from the

underlying assets, whereas in a synthetic CDO,investor payments are usually fed by proceeds fromthe collateral and the protection buyer. In bothtransaction types, excess spread may be available(see Excess Spread below), which, depending onthe waterfall and structural covenants in thetransaction, is either passed through to equity holdersor trapped by the structure to fund a reserveaccount and increase credit enhancement. Thus, itcan be used to cushion the impact of defaults on therated notes. Excess spread can replace part of thesubordination to achieve the same economics as therated notes. The key to measuring the degree ofreliance on excess spread in a given scenario is the

cash flow model.

Many synthetic CDOs either have no excess spreador no excess spread trapping mechanisms and hencethere is no need to measure any impact on availablecredit enhancement via the cash flow model. In thiscase, credit enhancement levels in a CDO measuredby subordination will equal the RLR, which can bedetermined more directly from the VECTOR outputs

also see VECTOR as a Portfolio ManagementTool, page 22.

Timing of Defaults and Recoveries

Defaults

Fitch employs several default timing stresses in thecash flow model. The timing of defaults can have amaterial impact on the ability of the structure to copewith a given amount of defaults. To see how timingaffects excess spread, consider the differencebetween a front end and back end timing scenario. Ina front end scenario, defaults occur shortly afterclosing and will generally cause overcollateralisation(OC) tests to fail, triggering the trapping of excessspread, which is then paid as a principal reduction tothe senior notes. Thus, a front end scenario capturesthe maximum amount of excess spread.

In a back end scenario, even though the same

amount of defaults occur, they do not peak until laterin the life of the transaction. Thus significant levelsof excess spread can be paid to the equity holdersbefore the loss of collateral is such that it causes theOC tests to fail and excess spread to be trapped. Bythe time the excess spread begins to be trapped, thereis less of it remaining to be captured because thereare fewer periods left in the life of the transaction.

Conversely, a structure that experiences back enddefaults may have been able to use earlier periods tobuild up par value, pay down expensive notes orbuild up reserve accounts or other structuralenhancements that may provide protection against

such a scenario.

Given these differences, it is important to test thevalidity of a structure in multiple timing scenarios.Fitch has four different timing scenarios: base case,front end for IG and sub-IG tranches, and back end.Note that the total amount of defaults will always bethe same, regardless of the scenario. The front endtiming scenario for an investment grade stress is asfollows:

Front-end Timing Default Scenario

Year Share of RDR (%)

1 33

2 253 164 135 13

Source: Fitch

The sub-IG front-loaded timing scenario applies100% of the RDR evenly over the first six years ofthe transaction, equating to 16.67% of the RDR ineach of the first six years.


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The back end timing scenario back-loads half of thedefaults toward the maximum possible weightedaverage life of the assets. Thus, the peak of thedefault rate will occur further into a transaction thathas long-dated assets and will shorten as the dealseasons. The peak of the defaults is assumed tooccur evenly in the three years prior to the averagelife of the underlying collateral. During this peak,50% of the RDR is applied; the remaining 50% ofthe RDR is spread evenly over the prior years of thetransaction. In the event that the weighted averagelife of the collateral is less than six years, 100% ofthe RDR is spread evenly over the years leading upto the weighted average life.

In order to address the potential defaults ofadditional collateral purchased during thereinvestment period in revolving deals, Fitch modelsportfolios with a weighted average life equal to themaximum weighted average life allowed in the deal's

governing documents. For example, if a transactionhas a maximum weighted average life test of fiveyears and a revolving period of three years, Fitchwill model a portfolio with a weighted average lifeof eight years. To the extent that the dealsgoverning documents contain a step-downschedule (decreasing the maximum allowableweighted average life as the deal progresses throughthe revolving period), Fitch will calculate themaximum weighted average life that can occur overthe revolving period while incorporating all of thestep-down rules.

For example, assume a collateral pool has a

maximum WAL of seven years and an RDR of 20%for the stress scenario in question. The distribution ofdefaults for the back-end timing scenario is asfollows:

Back-end Timing Default Scenario

Seven-Year Maximum WAL

Year Allocation (%) Amount (%)

1 12.50 2.502 12.50 2.503 12.50 2.504 12.50 2.505 16.67 3.336 16.67 3.337 16.67 3.338 0.00 0.009 0.00 0.0010 0.00 0.00Total 100.00 20.00

Source: Fitch

Another example shows a collateral pool with a 10-year maximum WAL and a 10% RDR. Thedistribution of defaults for the back end timingscenario is as follows:

Back-end Timing Default Scenario

10-year Maximum WAL

Year Allocation (%) Amount (%)

1 7.14 0.712 7.14 0.71

3 7.14 0.714 7.14 0.715 7.14 0.716 7.14 0.717 7.14 0.718 16.67 1.679 16.67 1.6710 16.67 1.67

Total 100.00 10.00

Source: Fitch

Additionally, the output of the VECTOR modelgives the expected default pattern over the term ofthe simulation. Fitch will use these results as thebase case default timing scenario. For portfolios

where the above-described default patterns are notapplicable, e.g. because a portfolio is of very short-term nature, or has a very steep amortisation profileafter the revolving period, Fitch may adjust theapplied default patterns to account for the specificsof the analysed portfolio.

Recoveries

As discussed earlier, in a cash flow CDO, recoveriesare realised by either selling the defaulted asset inthe market or going through the work-out process. Inthe interim, the CDO may experience a period ofnegative carry in that it must continue to pay intereston its liabilities but is not receiving income on that

portion of the defaulted portfolio. To capture thisrisk, Fitch will assume a timing lag in the cash flowmodel. For US bonds this is six months. For loans,there may be a longer recovery period; therefore, therecovery lag assumptions for US loans is one year.Due to the relative lack of data on defaultedEuropean bonds and loans, the recovery lag for theseasset types is assumed to be 18 months and 30months, respectively.

Amortising Portfolios

While most bonds and loans have bullet maturitydates, some securities, particularly those of ABS andMBS, may have amortising principal schedules. An

accurate term for each asset and a simulation horizonfor the whole portfolio is a key determinant of theRDR in the VECTOR model output. While bulletassets and amortising assets may share the sameaverage life, it would be nave to assume that theyhave the same default profile. It is less accurate tomodel the default probability of an amortising assetbased on its average life, since this approach doesnot capture what the principal balance of the assetwould be at the time of default. This would


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overestimate the effect of defaults that occurredduring the weighted average life and ignore defaultsthat could conceivably occur after the end of theweighted average life.

To precisely capture the principal balance at the time

of default, the VECTOR model can incorporate anamortisation schedule for every asset in a portfolio.Since the VECTOR model simulates individual assetdefaults rather than average portfolio defaults, theprincipal balance at the time of default and aggregatedefaults for each simulation iteration can becalculated at every step of the simulation.

Prepayment Stresses

Any CDO, but particularly those collateralised bystructured finance products such as residentialmortgages, may receive unscheduled repayment ofprincipal when the underlying borrower refinancesall or part of its obligations early to take advantage

of lower financing rates. When a bond prepays fasterthan expected, the notional value of the principal isreduced, thus decreasing the expected future cashflow stream. When a bond prepays slower thanexpected, its average life extends, causing cash flowsto be received later than initially expected. Therefore,when evaluating a transaction, Fitch tests thecollaterals cash flows under three differentprepayment assumptions. The first is the base casewhere prepayments are consistent with currentexpectations. For seasoned securities, the base caserate of prepayments should be an average of theprevious six months. For newly issued securities, theprepayment rate base case should be that used to

price the securities at issuance. The second case isthe extension scenario, where Fitch calculatesprepayments to be half current expectations. Finally,the agency examines cash flows in the shorteningscenario, where prepayments are double currentexpectations. Prepayment scenarios are conducted inconjunction with interest rate up and down scenariosHowever, Fitch does not conduct analysis of non-intuitive scenarios such as fast prepay/interest ratesup or slow prepay/interest rates down. For collateralthat is not prepayment sensitive, such as CMBS andREIT securities, it is unnecessary to modelprepayment stresses.

Treatment of IOs and PIKable SecuritiesInterest-Only Securities: To increase the spreadarbitrage between the coupons on a CDOsunderlying assets and outstanding debt, many CDOcollateral managers purchase interest-only (IO)securities. These provide additional interest cashflows that increase excess spread within the CDOstructure. To date, collateral managers haveprimarily purchased IOs exhibiting relativelypredictable cash flow characteristics such as CMBS

IOs and franchise loan ABS IOs where prepaymentlockout periods and yield maintenance provisionsare included in the issuing trusts.

When evaluating the use of these instruments inCDOs, the following criteria will apply. First, since

IOs do not have outstanding principal balances and,hence, no principal cash flows, these securities donot receive any credit in the OC tests, although asthey provide interest cash flows, they will beaccounted for in the interest coverage (IC) tests.Second, even though CMBS and franchise loan IOshave a degree of cash flow predictability, it is stillprudent to limit a CDOs overall exposure to thesesecurities by restricting the aggregate amortised costof these investments to a maximum of 5% ofcollateral assets to reflect the substantial losses thatan IO could incur in the event of defaults in theunderlying CMBS or franchise loan pool.

CDO Notes and Other PIKable Investments: Dueto the attractive spreads that mezzanine CDOtranches offer compared to other subordinated ABSnotes, some CDO collateral managers have begunpurchasing these securities. As mentioned, manyCDO tranches have the ability to pay in kind (PIK).The risk of interest deferral may pose a problemsince the CDO is relying on the interest receivedfrom investments to make interest payments on theissuers notes. A cash flow mismatch could force aCDO issuer to miss an interest payment on its notesand, therefore, cause it either to default on its seniornotes or defer interest on its subordinate notes. Tocapture the risk of interest deferral in portfolio

investments, Fitch assumes that the PIKableinvestments defer interest when stress testing aCDOs expected cash flows. After the deferralperiod, Fitch models the remaining PIKable assets tocommence paying interest, including the one-offgain of interest previously deferred. Liquidity swapshave been implemented by some issuers to reducethe risk of interest deferral on PIKable assets. Fitchincorporates the benefit of liquidity swaps in itsstress testing of PIKable investments.

Structural Covenants and WaterfallStructural covenants and their impact on atransactions cash flow have a significant impact on

a transactions performance, in particular duringperiods of increased default rates. In addition,structural covenants can give some guidance as towhether a portfolio manager follows a balancedapproach or rather acts for the benefit of a particularclass of investor. Structural covenants have beendiscussed in great detail in Enhancing theStructural Foundation of Cash Flow CDOs: What

Investors Should Ask, dated May 19, 2003,


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available on Fitchs web site atwww.fitchratings.com.

Priority of Payments

Generally, CDO structures include interest andprincipal waterfalls that dictate the distribution of all

proceeds collected, measured on each date on whichinterest payments on the debt are due. The priority ofdistributions typically changes as the transactionseasons, i.e. ramp-up period, reinvestment periodand amortisation period. Most cash flow structuresuse interest proceeds generated by the assets to paytransaction expenses such as portfolio managementand administrative fees and net hedging costs (ifapplicable), as well as the interest payments due onthe CDO debt. Principal proceeds are typicallyapplied to cover any shortfalls in the interestwaterfall and then to either reinvest in additionalcollateral assets during the reinvestment period or toredeem notes in order of priority during the

amortisation period. Fitchs cash flow modellinganalyses the impact of a transactions interest andprincipal waterfalls on the ability of the rated notesto withstand their respective default levels and cashflow scenarios.

Overcollateralisation and Interest

Coverage Tests

Cash flow CDOs generally incorporate OC and ICtests at all rated debt levels. OC tests are designed toensure that a cushion of OC is maintainedthroughout the life of the CDO to protect the rateddebt from losses on collateral.

Coverage tests, an important component of Fitchscash flow modelling of each CDO transaction, areperformed as frequently as interest payments aremade to the debt-holders and whenever assets aredeleted from or added to the portfolio. If coveragetests are failing, cash flows are redirected to redeemnotes in order of priority until the failing coveragetest is cured.

Fitch looks at the assumptions behind the OC levels.Overly tight test levels relative to the initial OCratios can lead to easily breached OC tests. When atrigger is tripped, interest that would normally bepayable to subordinate classes is redirected toredeem notes in order of priority until compliance

with the breached OC test is restored. Principalproceeds may also be used to redeem notes to curethe failing OC test if interest proceeds areinsufficient.

Cash flows that would otherwise pay interest tojunior rated notes should only be redirected whenthere is real doubt as to the adequacy of protectionavailable for rated notes over the life of thetransaction. For this reason, Fitch welcomes

reinvestment diversion tests that, if breached,redirect excess spread towards the purchase ofadditional collateral securities, and thereby helpmitigate any erosion of par value.

Performing assets are typically valued at par for the

OC tests, while defaulted assets are valued at thelower of market value or assumed recovery value. Attimes, Fitch may value the defaulted asset at a pricethat the portfolio manager believes reflects theassets ultimate value. Fitch reviews the prices atwhich assets are purchased for a CDO, and willreview the credit quality of any assets purchased at asubstantial discount to par. In certain circumstances,it may be appropriate to value discounted assets at aprice other than par when calculating the OC tests.For further discussion see Treatment of DiscountSecurities in Cash flow CDO Tests, dated 11 March2003, available at www.fitchratings.com.

A portfolio manager may sell credit-impaired assetsat a discount and should be allowed to do so if hebelieves the optimal price is being offered. A credit-impaired asset can generally be defined as one thatthe portfolio manager believes is at risk of decliningin credit quality and, with the passage of time, willhave a high probability of default. However, since acredit-impaired asset is carried at par until sold, theOC level will fall immediately upon its sale unless itis exchanged for another asset purchased at adiscount. Alternatively, the portfolio manager maymake up for the reduction in OC by selling assetstrading at a premium to par.

IC tests validate the arbitrage between the yield on

the portfolio assets and the cost of the CDO debt.Maintenance of the IC tests ensures that there aresufficient interest proceeds to cover funding costs fora particular period.

Excess Spread

Excess spread can be defined as interest proceeds netof transaction fees, expenses and interest due onrated notes. It can form an important component ofcredit enhancement for the rated notes, but can onlybe determined through detailed cash flow modelling.Structural features within a CDO, such as priority ofpayments, coverage tests and the amount andposition of fees and expenses in the payment

waterfall, can have a dramatic impact on the level ofexcess spread available either to redeem notes orreinvest in additional collateral. Despite somedifferences, the two uses of excess spread both bringabout a deleveraging of the structure by enhancingOC and boosting the ratio of income to expenditure.Fitch conducts comprehensive cash flow modellingin order to understand the impact of excess spread ina particular CDO and its influence on the creditenhancement of each tranche of rated debt.


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Available Cash Investments

Many cash flow CDOs will hold some cash fromprincipal or interest payments either until the nextpayment date or until the available amounts arereinvested in other collateral. In particular, in caseswhere significant amounts of cash are held, theinterest earned thereon over time can have an impacton the overall performance of the transaction.

Fitch makes an assumption about the amount of cashon the balance sheet of the CDO in each period andassumes that interest on this amount is earned atEURIBOR/LIBOR minus 1%. Principal repaymentson the underlying obligations in the portfolio arepresumed to be received by the CDO midwaythrough a period. That cash is presumed to earninterest at the coupon rate of the underlyingcollateral for half of the period andEURIBOR/LIBOR minus 1% for the remainder.

Fees and ExpensesThe fees and expenses associated with issuing andmanaging a CDO structure have a bearing on thelevel of credit enhancement available to the rateddebt. Structuring fees, legal fees and upfrontexpenses are typically paid out of the structure atclose. The aggregate amount of initial fees andexpenses influences the net proceeds of the debtissuance that may be available to invest in portfoliocollateral; excessive initial fees and expenses maygive the portfolio manager the incentive to purchasecollateral at a discount to par to make up for anyshortfall. Fitch monitors the amount of initial feesand expenses closely to ensure that they are in line

with market practice. Furthermore, the agencybelieves that it is a benefit to the structure to have aportion of the initial fees and expenses deferred so asto allow the portfolio manager to invest as much ofthe issuance proceeds as possible.

Ongoing fees and expenses of the CDO, such asportfolio management fees, should be balanced asequitably as possible in the interest waterfall. Bydistributing portfolio management fees evenlybetween senior and subordinate positions in thewaterfall, the portfolio manager is more aligned withall of the noteholders interests. Furthermore, theamount and position of ongoing fees and expensesmay also affect the amount of excess spread

available to the rated notes as credit enhancement.The more ongoing fees and expenses are senior inthe interest waterfall, the less excess spread isavailable. Fitch incorporates all the upfront andongoing fees and expenses in its cash flow model toensure that there is sufficient credit enhancement forthe rated notes throughout the tenure of thetransaction.

Treatment of Distressed and Defaulted

Securities

This section covers the inclusion in a CDO ofdistressed and defaulted assets. The VECTOR modelproduces a distribution of defaults using inputs such

as the rating and life of a portfolio of securities. Assuch, it is a forward-looking tool used to predictthe level of defaults in the future for a givenportfolio of assets. The analysis that VECTORperforms does not apply to assets that have alreadydefaulted or are distressed to a point where theirdefault is highly likely or imminent. The inclusion ofa distressed obligation in a CDO portfolio is fairlyuncommon, but for the few transactions where this isthe case, they are handled on a case-by-case basis(see Fitchs Approach to CDO Rating Actions,dated 6 February 2002, available atwww.fitchratings.com).

Distressed and defaulted assets are treated differently

in the cash flow model. Defaulted assets are includedat the lower of assumed recovery rate and marketvalue. The latter is discussed with the asset manager,together with the managers view on the expectedholding period for the defaulted asset. Defaultedassets are typically in a non-accrual state during theirworkout, which produces negative carry for the CDO.

Distressed assets have not yet defaulted but theirvalue and/or their performance has deteriorated tothe point where default is likely in the near term. Inmany cases, default is imminent but in some cases(particularly ABS), it may not occur for some time,even though, ultimately, it is virtually inevitable.

Distressed assets where default is imminent are moretypically corporate bonds and loans. In these cases,prices are usually quoted in the secondary market asa percentage of par rather than on a yield basis. If theexpected default is less than a year away, Fitch willtypically treat the asset as if it is already in default inthe cash flow model. The discussion with themanager will also include some expectation of thetiming of workout to ensure that the cash flow modelwill contain the most realistic view of the portfolio.The model will reflect the imminent default of thedistressed asset, the time lag to recovery andexpected recoveries on a case by case basis.

Distressed ABS are a special case because they do

not default in the same manner as corporates.Distressed ABS can follow a number of differentpayment patterns. These include:

current pay on interest to maturity but no returnof principal (it turns into an IO);

the security defers interest (PIKs) until maturity,then pays a portion of the accrued interest andprincipal (it turns into a PO);


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pays interest intermittently until maturity withsome principal at that time;

any combination of the above.

Fitchs CDO and ABS teams together construct themost likely payment structure for each distressedABS, which the cash flow model is updated toreflect. This gives the Fitch analysis a more nuancedview of the performance of the CDO than simplymodelling the assets as performing or non-performing.

Interest Rate and Currency Risks

Interest rate or currency risk arising from a mismatchbetween the assets that constitute the CDO collateraland the liabilities may leave the issuer exposed toadverse movements in interest or exchange rates.This is typically hedged to a large extent eitherthrough matching both assets and liabilities in theircomposition of different currencies/interest rates

(natural hedge) or through derivatives, primarilyswaps, but also caps, floors, forwards and options.

Nevertheless, despite the hedge, the CDO mayremain exposed to interest rate and currency risk dueto un- or over-hedged positions following defaults,prepayments and substitutions in the underlyingportfolio. As a result, derivative hedge positions mayhave to be terminated, which may lead to the issuerpaying breakage costs to the swap counterparty(unless the swap allows for early termination with nopenalty). The amount of breakage costs owed istypically the difference in net present value (NPV)of the future payments between the two legs of the

hedge.Fitch stresses interest and currency exchange rates toreflect the required rating category of the notes basedon historical movements in the relevant index (seemethodology box) to ensure that investors areadequately protected.

Interest Rate Risk

Fitch developed interest rate stresses for cash flowtransactions for USD LIBOR, GBP LIBOR and theEuropean Interbank Offered Rate (EURIBOR).Interest rate stress scenarios are naturally moresevere for investment grade stress runs. In the caseof EURIBOR, the structure is subjected to an

additional absolute rate increase of 4.3% at AAAduring year one. This is applied periodically(according to the payment frequency on a CDO) tothe rate at closing. Further increases of 2.2% and1.0% are then applied in year two and three,respectively. As interest rates are assumed to bemean reverting and to take account of the particularoverall stress scenario, Fitch reduces the rate in yearfour by 1.4%, which is applied for the remainder ofthe transactions life. The methodology is the same

for the other rating levels and interest rates. Therespective stress levels for each of the three indicesand rating levels are outlined in the tables below.

3 Month USD LIBOR

(%) Year 1 Year 2 Year 3 Year 4 TotalAAA +3.8 +0.4 0 0 +4.2

AA +2.8 +0.5 0 0 +3.3A +2.3 +0.6 -0.4 0 +2.5

BBB +1.8 +0.8 -0.2 0 +2.4BB +1.4 +0.7 -0.2 0 +1.9

Source: Fitch

3 Month EURIBOR

(%) Year 1 Year 2 Year 3 Year 4 Total

AAA +4.3 +2.2 +1.0 -1.4 +6.1

AA +3.7 +1.9 +0.8 -1.1 +5.3A +3.1 +1.7 +0.7 -1.1 +4.4BBB +2.6 +1.2 +0.5 -0.9 +3.4

BB +1.9 +1.0 +0.5 -0.6 +2.8

Source: Fitch

3 Month GBP LIBOR

(%) Year 1 Year 2 Year 3 Year 4 Total

AAA +4.9 +2.5 +1.1 -1.6 +6.9AA +4.2 +2.2 +0.9 -1.3 +6.0A +3.5 +1.9 +0.8 -1.2 +5.0BBB +2.9 +1.4 +0.6 -1.0 +3.9BB +2.2 +1.1 +0.6 -0.7 +3.2

Source: Fitch

Fitch also runs interest rate down scenarios, relevantin the event of over-hedging, which could be theresult of defaults in an underlying portfolio (see The

Effect of Interest Rate Swaps on Arbitrage Cash

Flow CDOs, dated 6 May 2002 and available atwww.fitchratings.com). Given the assumption ofmean reversion, the applied interest rate downstresses mirror the interest rate up stresses, subject toa floor of 25bps.

Currency Risk

Fitch analysed historical USD, EUR, JPY and GBPprice movements. The table overleaf shows the logscale stress factors for the EUR/USD exchange rateover a 10-year period. These are continuous time logscale stress factors denoted as St in the followingformula:

Et= Eclosing * eSt

As in the case of interest rates, Fitch runs bothappreciation and depreciation scenarios. In the aboveexample, the agency assumes the EUR willappreciate over the first year by 39.9% on a log scale.Over two years, the assumed appreciation is 49.2%on a log scale, which would result in an exchangerate of 0.6115 assuming an original rate of 1. The


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next table shows the exchange rate path for theEUR/USD rate in a AAA scenario, assuming therate is 1 at closing.

EUR/USD Log Scale Stress Factors

Variation EUR/USD (%)Year AAA Depreciation AAA Appreciation

1 42.9 -39.92 55.0 -49.23 65.0 -55.34 74.1 -62.25 87.4 -71.46 96.1 -78.67 96.1 -78.68 96.1 -78.69 96.1 -78.610 96.1 -78.6

Source: Fitch

EUR/USD AAA Stress Actual

Exchange Rate ChangeVariation EUR/USD (%)

Year AAA Depreciation AAA Appreciation

1 1.5351 0.67132 1.7329 0.61153 1.9165 0.57554 2.0984 0.53665 2.3959 0.48986 2.6142 0.45587 2.6142 0.45588 2.6142 0.45589 2.6142 0.455810 2.6142 0.4558

Source: Fitch

For a more detailed description of the application ofcurrency stresses, see Fitch Ratings Approach to

Foreign Exchange Risk in Collateralised DebtObligations, dated 26 March 2003 and available atwww.fitchratings.com. Fitchs detailed currencyassumptions for GBP, USD, EUR and JPY areavailable at the same address as an excel file FXStresses (Excel Spreadsheet) at www.fitch-ratings.com.

Relevant Parties and Counterparty

Risk

Asset Manager and Originator

Originator Review

An important pillar of Fitchs rating process for aCDO is an assessment of the capabilities of theoriginator, servicer or portfolio manager(manager) to service or manage the CDO. Theagency recognises that the managers performance isvital to the performance of all rated tranches of theCDO, particularly the most subordinate. Therefore, itwill undertake this assessment in the context of thetype of CDO under review for example, a managedsynthetic CDO, a balance sheet CDO with limitedsubstitution rights or a managed cash flow arbitrage

CDO as each type of CDO requires differentmanager capabilities to successfully service ormanage a CDO.

Fitch's information requirements for a managerreview are supplemented and tailored according tothe characteristics of the CDO and the motivations ofeach deal. The agency will assess the managerscapabilities by conducting an on-site review, thestarting point for which will be gaining an insight

Methodology behind Fitchs Currency

and IR Stresses

Fitchs currency and interest rate stresses werederived using historical data as opposed to using

market expectations implied by the forwardcurves. The analysis was based on the standarddeviation (STDEV) of changes in the respectiveinterest and currency rates as well as actualdistribution of movements in each rate over thesample period. The individual stresses weredetermined as the minimum of the multiple of theSTDEV and the worst-case changescorresponding to a particular confidence level foreach rating scenario.

Currency Stress

Fitch analysed the historical price movements of theUSD, EUR, JPY and GBP over a period starting in1988 for USD, EUR and GBP and 1980 for JPY.Prior to 1988, the USD, EUR and GBP displayed

greater volatility associated with the high inflationexperienced by many countries during that period, atrend Fitch believes is unlikely to be repeated. Italso believes the JPY to be more volatile than theother major currencies and, therefore, included themore volatile pre-1988 period.

Interest Rate Stress

Fitch analysed the absolute rate changes in 3 monthEURIBOR, 3 month USD LIBOR and 3 monthGBP LIBOR. For the period prior to theintroduction of EURIBOR, the agency used theECU LIBOR computed by the British BankersAssociation as a proxy. The final data sample

included daily rates starting in 1984 in the case ofUSD LIBOR, 1989 for EURIBOR/ECU LIBORand 1987 for GBP LIBOR. As in the case ofcurrency rates, the volatile period of the early 1980swas excluded. While the EURIBOR/ECU LIBORrate was the least volatile of the three, the agencyincreased the stress factors due to the lack of a trackrecord at the European Central Bank and the limiteddata history of EURIBOR.


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into how the CDO fits within the overall businessstrategy of the company. When evaluating ma

Fitch c Do Rating

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