Gas Week

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Rating agencies do double-take: In July Standard and Poor’s, Moody’s and Fitch downgrade hundreds of CDOs from A+ and BB to as low as CCC pushing them into junk status

Posted by gasweek on 21 September, 2007

But there are some curious default probabilities in S&P’s latest CDO model, released in mid-2006, which seem to suggest that historic or “idealised” defaults differ widely for corporate bonds, asset-backed securities and CDOs with the same rating, reported The Australian Financial Review (20/9/2007, p.68). Package as CDO and win higher rating: Its estimated default probability for a one-year AAA CDO is about the same as a one-year AA + corporate bond. A three-year A-rated CDO is the same as three-year BBB + rated asset-backed security. In fact in every rating category, from AAA to BBB-, the default probability for CDOs is at least three times that shown by equivalently rated asset-backed securities. This suggests that by repackaging securities as a CDO they can achieve a higher rating, says Adelson.

Big problem: Sophisticated investors know CDOs are different because they do their own analysis. There’s just no way that a AA or AAA CDO – is as safe as a AA or AAA corporate or government bond. “When people see a AA rating on a structured security, they may think it’s the same rise as the NAB,” says Jeffrey Brunton, head of global credit at QIC. “People who don’t have the resources and rely on that rating will have an issue.”

Sub-prime housing market troubles: The other problematic element of the CDO rating process is the assumed correlations — whether a default in one element of the CDO means that a default by another element of the CDO is also likely. “This is not guesswork, it is a sophisticated modelling process,” said a spokeswoman for S&P. Maybe so. But when it came to the sub-prime housing market, it was wrong. In July S&P, Moody’s and Fitch downgraded hundreds of CDOs from A+ and BB to as low as CCC, pushing them into junk status, and forcing many institutional investors to sell immediately.

New look at CDOs: The market values of thousands of other CDOs have plummeted. European CDOs are also being downgraded. And Moody’s will soon reveal the results of an internal review into whether it may have underestimated how much default rates of CDOs were correlated. If correlation risk was higher than Moody’s initially assumed, that could affect the ratings.

The Australian Financial Review, 20/9/2007, p. 68


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