Assessing the Credit Risk of CDOs Backed by Structured Finance Securities: Rating Analysts' Challenges and Solutions

Abstract

The CDO market grew strongly in the last several years thanks to a strong U.S. housing market, a low interest rate environment, abundant global excess liquidity, and a healthy U.S. economy. The growth slowed significantly in 2007 amidst an unprecedented housing market turnaround and the sudden performance deterioration of recent-vintage subprime residential mortgages-backed securities (RMBS). CDOs' large exposure to these subprime RMBS brought them under intense scrutiny. The illiquidity, novelty, and complexity of CDOs made them easy targets of criticism. This paper describes the evolution of CDOs backed by structured finance securities (SF CDOs) and the analytical approaches used by Moody's to rate SF CDOs. We show that SF CDOs have experienced substantial changes in the last eight years in terms of asset distribution and transaction structure. We find that this sector has been dominated by AAA-rated securities (about 85% by dollar volume of issuance), which did not experience any defaults and losses as of the end of 2006. Although recently issued SF CDOs are expected to perform poorly, not all SF CDOs are backed by subprime RMBS and CDO performance is expected to vary significantly across transactions. This paper also describes Moody's methods for the modeling of four basic components - default probability, recovery rate, asset correlation, and prepayment rate - and the differences and similarities across different rating models for transactions with and without complex waterfalls. Additionally, we analyze the rationale of a number of structural features such as par haircuts on lowly rated assets and assets purchased at deep discount in SF CDOs and additional stresses that are designed to protect SF CDO investors. Finally, we note that the changing distribution of CDO assets and the different credit cycles to which these assets have been subjected make it difficult to interpret the average statistics computed for the overall CDO sector during a short data sample period that covers only a part of the credit cycle for each asset type.