Criteria for Rating Synthetic CDO Transactions

Transcription

1 September 2003 Structured Finance Ratings Criteria for Rating Synthetic CDO Transactions

2 CONTENTS Introduction Section I: Description of a Synthetic CDO Transaction A. What is a Synthetic CDO? B. Types of Synthetic Transactions C. The Rating Process for Synthetic CDOs Section II: CDS Documentation A. Reference Entities and Reference Obligation Categories and Characteristics B. Reference Price C. Credit Events D. Conditions to Payment E. Deliverable Obligations and Deliverable Obligation Categories and Characteristics F. Settlement Mechanisms G. Loss Calculation Section III: Sizing of Defaults and Recoveries and Calculating the Credit Enhancement A. Sizing Expected Defaults Using the CDO Evaluator B. Recoveries C. Calculation of Credit Enhancement Section IV: Timely Payment of Interest and Ultimate Payment of Principal A. Interest B. Fees C. Termination Payments/Trading Gains and Losses D. Principal and Contingent Payments E. Liquidity Considerations F. Cash Flow Analysis G. Priority of Payments Section V: Counterparty Rating and Collateral Requirements A. Overview B. Rating Requirements for Liquidity Providers C. Rating Requirements for Reverse Repo and Put Agreement Counterparties D. Rating Requirements for the Cash Account Provider E. Rating Requirements for CDS Counterparties F. Rating Requirements for Currency and Interest Rate Swap Counterparties Section VI: Trading and Management A. Introduction B. Types of Management C. Assessing the Credit Quality of a Changing Portfolio D. Operational Review of the Manager E. Trading Limits F. Coverage Tests G. Structural Limitations H. Trading Gains and Losses I. When Can the Manager Trade? Section VII: Legal Analysis and Surveillance A. Legal Analysis B. Surveillance Section VIII: Other Synthetic Structures A. Synthetic CDO of ABS B. Short CDS Positions C. Hybrid Transactions D. Single-Tranche Synthetic CDOs E. Small Basket F. Total Return Swaps G. Synthetic Market-Value Structures H. Synthetic Indices Section IX: Concluding Remarks CONTENTS PAGE 1

3 ANALYTICAL CONTACTS London Monica Richter Katrien van Acoleyen Director (44) Juan-Carlos Martorell Director (44) Perry Inglis Managing Director (44) Stroma Finston Director (44) New York r Nik Khakee Director (1) nik_khakee@standardandpoors Michael Drexler Rating Analyst (1) michael_drexler@standardandpoors Henry Albulescu Managing Director (1) henry_albulescu@standardandpoors.com David Tesher Managing Director (1) david_tesher@standardandpoors Paris r Hervé-Pierre Flammier Director (33) herve-pierre_flammier@standardandpoors This report was reproduced from Standard & Poor s RatingsDirect, the premier source of realtime, Web-based credit ratings and research from an organization that has been a leader in objective credit analysis for more than 140 years. To preview this dynamic on-line product, visit our RatingsDirect Web site at Published by Standard & Poor s, a Division of The McGraw-Hill Companies, Inc. Executive offices: 1221 Avenue of the Americas, New York, NY Editorial offices: 55 Water Street, New York, NY Subscriber services: (1) Copyright 2003 by The McGraw- Hill Companies, Inc. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained by Standard & Poor s from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources, Standard & Poor s or others, Standard & Poor s does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtained from the use of such information. Ratings are statements of opinion, not statements of fact or recommendations to buy, hold, or sell any securities. CONTACTS PAGE 2

4 INTRODUCTION The use of credit default swaps (CDSs) and the volume of synthetic CDO transactions has expanded rapidly in recent years. This growth, which has been global in scope, is set to continue given the increased importance of risk management, better guidance from regulators, and the increased liquidity of and familiarity with credit derivatives. Standard & Poor's has analyzed synthetic CDOs and CDSs from their inception. In the early days, this technology was used as a risk-transfer mechanism to reduce balance-sheet capital requirements for financial institutions. The allure of synthetic technology then rested in its capability to avoid the intricate legal process required for the true sale of assets. Gradually, however, the goal of synthetic transactions moved from balance-sheet management to arbitrage. In arbitrage transactions, the assets in the reference portfolio are specifically selected for each transaction and are not on the balance sheet of the originator. Arbitrage synthetic CDOs are set up to take advantage of the difference between the yield received from the assets in the portfolio and the cost of issuing notes or entering into CDSs, with the aim to achieve trading profits. The reference portfolios of synthetic CDOs were initially mostly static and consisted of investment-grade corporate assets. Over time, though, they became increasingly managed and consisting of a wide variety of assets, such as ABS, leverage loans, project-finance loans, indices, options, etc. A further development is the mixing of cash assets and synthetic assets as seen in hybrid transactions. Synthetic CDO transactions, if not in unfunded form, typically issued various tranches of notes and/or CDSs of different ratings, thereby effectively covering the risk of the entire reference portfolio. More recent synthetic transactions are being done as single-tranche transactions issuing only one rated tranche in a much smaller amount than the total amount of risk of the reference portfolio. The purpose of this criteria book is to facilitate investors' and issuers' understanding of Standard & Poor's approach to rating synthetic CDO transactions and the rationale behind it. The rating approach described is applicable to all types of synthetic transactions from small-basket to hybrid CDO transactions. The criteria piece is global and therefore applicable to synthetic CDO transactions in the U.S., Europe, Asia, and elsewhere. In addition, Standard & Poor's general CDO criteria entitled "Global Cash Flow and Synthetic CDO Criteria" will provide readers with a thorough understanding of the broader CDO product of which synthetic CDO transactions are an increasingly important part. This criteria article was published on March 21, 2002 on RatingsDirect, Standard & Poor's Web-based credit analysis system and on Standard & Poor's Web site at INTRODUCTION PAGE 3

5 SECTION I: DESCRIPTION OF A SYNTHETIC CDO TRANSACTION A. What is a Synthetic CDO? While CDOs are structured, leveraged transactions backed by a variety of assets, synthetic CDOs combine the CDO securitization technique with credit derivative technology. In short, synthetic CDOs are CDOs that use credit derivatives, mainly CDSs. Credit derivatives, for their part, are tools that facilitate the isolation and management of credit risk from all other components of risk. CDSs are by far the most widely used type of credit derivatives. Other credit derivative products include credit-spread products, CLNs, and total return swaps. A CDS is a contract in which one party agrees to compensate the other party for the financial loss it may incur following a credit-related event (usually a default) with respect to an underlying obligation (see chart 1). A CDS can be compared to a default put option against credit erosion. The party who purchases protection on the underlying obligation is called the "protection buyer" or "fixed-rate payer" as he needs to make a pre-determined payment, either periodically or up front, called a "premium". The party who sells protection on the underlying obligation is called the "protection seller" or "floating-rate payer" as his payment obligation is contingent upon the occurrence of a defined credit event and satisfaction of the conditions to settlement. The underlying asset is defined by the reference obligation, which informs the scope of protection. The payment that needs to be made upon the occurrence of a credit event can be based on either a physical settlement process, in which case the defaulted asset will be delivered by the buyer in return for par value, or a cash settlement process, in which case the seller will pay the final price as determined through a bidding process (see chart 2 overleaf). A CDS is both an asset and a contingent liability. Selling protection via a CDS creates exposure to the credit risk of the underlying asset but also to counterparty risk as the counterparty periodically has to make premium payments on which the CDO transaction relies. In contrast, owning a cash bond or loan creates exposure to only credit risk. Buying protection via a CDS also creates exposure to the credit risk of the underlying asset and the CDS counterparty, as this party has to make the contingent payment after the occurrence of a credit event. Counterparty risk exposure can also be created by termination payments. Therefore, CDO transactions with a CDS involve an analysis of both credit and counterparty risk. Documentation for CDS contracts is standardized via the use of the International Swap and Derivatives Assoc. Inc. (ISDA) Credit Derivatives Definitions (the "ISDA Definitions"). The use of ISDA over-the-counter derivative documentation has provided liquidity to the CDS market. There are different applications of credit derivatives in synthetic CDOs. First, when using credit derivatives, transfer of risk with respect to a portfolio of assets is effected through the use of loss definitions rather than a true sale of assets. Second, synthetic technology permits tailor-made risk exposures, with regards to currency, cash flow, tenor, size of exposure, etc., which are not SECTION 1 PAGE 4

6 always available in the cash market. For example, a credit derivative can be constructed to transfer the risk equivalent to a fixed-rate security with a tenor of three years, even though this asset may not in fact be purchased in the cash market. Third, credit derivatives are used to create unfunded liabilities. Given that the sponsoring entity of the synthetic CDO does not always require funding, unfunded liabilities are attractive as they are cheaper, more flexible, and easier to execute. Therefore, the advantages of using CDSs are clear: there is no need to fund the purchase of the asset, there is no need to physically identify the asset, there is less legal analysis, they offer great flexibility, and the overall process is faster and cheaper. Synthetic CDOs are typically classified according to the following characteristics. Funded, partially funded, or unfunded. In a funded transaction, the CDO only issues notes; in a partially funded transaction, the CDO issues notes and enters into a CDS on the liability side; in an unfunded transaction, the CDO only enters into a CDS on the liability side. Managed/static. In a static transaction, the initial portfolio does not change over the life of the transaction. In a managed transaction, changes can be made to the reference portfolio by a thirdparty manager, the investor, or the dealer who is arranging the transaction. Arbitrage/balance sheet. If the purpose of the transaction is to achieve capital and/or economic relief from assets that are held on the sponsor's balance sheet, the CDO is classified as a balancesheet transaction; if the purpose is to achieve a gain from a selected reference portfolio that is not already owned by the sponsor, the CDO is classified as an arbitrage transaction. Portfolio CDO/CSO (collateralized swap obligation). In a portfolio CDO, the special-purpose entity (SPE, or issuer) enters into only one CDS with one CDS counterparty referencing a portfolio of assets. In a CSO, the issuer enters into many CDSs with many CDS counterparties and typically each CDS references only one asset. B. Types of Synthetic Transactions Although there are many types of synthetic CDO transactions, they fall into three broad categories: Unfunded portfolio CDS; Partially funded/funded portfolio CDO; and CSO and hybrid transactions. The above categorization is not exhaustive but covers the majority of synthetic transactions. As in any specialized area of finance, the vocabulary of synthetic products is unique. The source for much of this is the ISDA Definitions, which contain a helpful index of terms, but throughout this criteria piece the lexicon and the concepts behind it will be explained. To avoid confusion, the assets that represent the credit risk will be referred to as the "reference portfolio" or "reference entity" or "references obligations" and the assets in which the proceeds of the notes are invested are referred to as "collateral". 1. Unfunded Portfolio CDS In its most basic form, a synthetic CDO is structured as an unfunded CDS between two parties. SECTION 1 PAGE 5

7 The protection buyer or fixed-rate payer will transfer the risk of a single asset or portfolio of assets to the protection seller or floating-rate payer and will pay a fixed premium (see chart 3). The seller has to make a payment upon the occurrence of a credit event (usually a default). The reference portfolio can be either static or dynamic. The risks involved in this type of transaction are twofold: (i) the credit risk of the reference portfolio; and (ii) the counterparty risks of both the protection seller (as this party has to make a payment after the occurrence of a credit event) and the protection buyer (as this party has to pay the premium). For unfunded CDSs, Standard & Poor's will issue a credit assessment for the risk of loss above a certain threshold percentage or dollar amount, which is assumed by the counterparty to the CDS based upon a reference portfolio of a certain dollar amount. In the majority of cases, Standard & Poor's is asked to address only the credit risk of the underlying reference portfolio, not the counterparty risk, and therefore a credit assessment and not a rating is being issued. The contracting CDS counterparties are generally comfortable bearing each other's risk because each counterparty has a pre-approved credit limit. In instances where Standard & Poor's is asked to analyze both the credit risk of the underlying reference portfolio and the counterparty risk, it will issue a rating that reflects an analysis of each of the risks. When analyzing unfunded synthetic structures, Standard & Poor's will focus on determining the default probability of the underlying reference portfolio and assigning the appropriate recovery rates by reviewing the CDS confirmation, particularly the reference obligation and characteristics, the deliverable obligation and characteristics, the credit events, and the settlement mechanism. If the portfolio is dynamic, the trading limitations and manager also need to be reviewed. The main risks and issues considered in rating an unfunded portfolio CDS are summarized as follows. Credit risk. Standard & Poor's analyzes the default risk of the underlying reference portfolio (gross loss) and recoveries (net loss). Counterparty risk. This involves a consideration of the premium paid by the protection buyer and contingent payment paid by the protection seller (only if the credit assessment addresses the counterparty risk). Trading risk. For managed portfolios, this requires an analysis of the manager, the trading limitations, and the incorporation of trading gains and losses in the structure. 2. Partially Funded/Funded Portfolio CDO A funded or partially funded synthetic CDO is a more complex structure. It still involves a CDS where the buyer of protection (the sponsor) transfers the risk of a portfolio of assets to the seller of protection (typically an SPE; see chart 4 overleaf). However, in addition, the protection seller will itself transfer the risk, either by issuing creditlinked notes (CLNs) which are purchased by investors, and/or by entering into CDSs with a third party. The CLNs can be issued by a newly created SPE, an existing multi-issuing SPE, or a SECTION 1 PAGE 6

8 financial institution under its existing MTN debt program. In this section, it is assumed that the notes are issued by a newly created SPE. The portfolio can be static or dynamic; in the latter case, Standard & Poor's will review the manager and the trading restrictions and analyze how trading losses and gains, if any, are incorporated in the structure. The proceeds of the issuance of the CLNs or MTNs are typically invested in various types of collateral. The most common are cash or GIC accounts and securities typically acquired via a reverse repurchase (reverse repo) agreement or a put agreement. The collateral will be used to pay (i) the contingent payments triggered by the occurrence of a credit event, (ii) principal (minus losses) at maturity, and (iii) principal upon the occurrence of an early termination. The SPE will typically use the cash, sell the collateral, or return the collateral in return for cash in the event that a reverse repo or put agreement is used. If the collateral matures on the same day as the maturity of the notes, there is no need to sell the collateral as the cash will be available. However, if securities need to be sold, the market risk needs to be analyzed. In addition, if a reverse repo or put agreement is used, the counterparty risk will need to be analyzed as Standard & Poor's relies, in its rating analysis, on the counterparty to make a payment. The SPE will also periodically need to pay interest to the noteholders and fees to the various parties involved. The source of these payments is typically a combination of premium payments (usually fixed) received from the protection buyer and income received from the collateral (typically floating LIBOR or EURIBOR). Therefore, Standard & Poor's must consider whether the counterparties who make the payments are adequately rated. In this type of transaction there is no need to analyze the cash flow generated by the underlying assets in the reference portfolio. However, some structures can contain an excess spread feature, which can provide a reduction in the subordination, and for which a cash flow analysis may be needed. The main risks and issues considered in the rating of partially funded and funded portfolio CDOs are summarized as follows. Credit risk. Standard & Poor's considers the default risk of the underlying reference portfolio (gross loss) and recoveries (net loss). Counterparty risk. This involves the following: CDS counterparty. The rating on the CDS counterparty is relevant if the SPE relies on the premiums received from this party to pay interest on the notes and/or fees. The rating on the CDS counterparty is also relevant for termination payments. Account bank/gic account. If the proceeds of the notes are invested in cash, and if such proceeds are used to pay principal and contingent payments, the cash must be held with an appropriately rated counterparty. SECTION 1 PAGE 7

9 Reverse repo counterparty/put counterparty. If the proceeds of the notes are invested in collateral via a reverse repo or put agreement, these counterparties need to have the appropriate rating as they will provide the funds for the payment of principal and contingent payments. Rating on the collateral. Securities that provide support to the structure need to be adequately rated. Market risk.there should be no market risk when liquidating collateral to make payments or the market risk needs to be sized. Trading risk. For managed portfolios, Standard & Poor's requires ongoing monitoring of changing credit risk, analysis of the manager, analysis of trading limitations, and analysis of how trading gains and losses are incorporated in the structure. Cash flow analysis. This will be required if excess cash flow is generated, for example by the assets in the reference portfolio. This excess spread can be used to reduce the subordination required and/or to make interest, principal, fees, and contingent payments. Legal analysis. This involves consideration of the bankruptcy remoteness of the vehicle, security over collateral, legal opinions, timely access to collateral pledged by counterparties, and various legal issues specific to the particular structure under review. 3. CSO Transactions In CSO transactions, the assets in the underlying portfolio are CDSs. Therefore, both an asset and a contingent liability is acquired. At closing and/or over the life of the transaction, the SPE will enter into a series of CDSs referencing a single asset, either as protection seller or protection buyer (see chart 5). No funds are needed to enter into the CDSs. However, bivariate risk is introduced as CDSs expose the SPE not only to the risk of the underlying reference asset but also to the risk of the CDS counterparty, which either has to pay the premium (if the SPE sells protection) or make a contingent payment (if the SPE buys protection). The analysis will therefore include an assessment of the credit risk of the reference asset and a review of the counterparty risk. The proceeds of the notes are typically invested in collateral and used to make credit-protection payments after the occurrence of a credit event and to repay principal at maturity or upon early termination. The cash flow received from the CDS (i.e., the premiums) is used to make interest payments on the notes and to pay fees. A stressed cash flow model is prepared to evaluate whether the assets generate sufficient cash to make these payments. In the majority of cases, the portfolio of CDS is actively managed by a portfolio manager and the trading gains and losses are borne by the SPE. Corporate overview, trading limits, and/or coverage tests must curb the powers of the managers. The collateral manager can trade out of a CDS by terminating the CDS or by entering into another CDS to buy protection, thereby offsetting the SECTION 1 PAGE 8

10 CDS in which the manager had sold protection. The main risks and issues involved in the rating of CSOs are summarized as follows. Credit risk. Standard & Poor's will consider the default risk of the underlying reference portfolio (gross loss) and recoveries (net loss). Counterparty risk. This involves a consideration of the following: CDS counterparty. The rating on the CDS counterparty is relevant if the SPE relies on the premiums received from this party to pay interest on the notes and/or fees. The rating on the CDS counterparty is also relevant for termination payments. Account bank/gic account. If the proceeds of the notes are invested in cash and if the proceeds are used to pay principal and contingent payments, the cash must be held with an appropriately rated counterparty. Reverse repo counterparty/put counterparty. If the proceeds of the notes are invested in collateral via a reverse repo or put agreement, the repo or put counterparty needs to have the appropriate rating as it will provide the funds for the payment of principal and contingent payments. Rating on collateral. Securities that provide support to the structure need to be adequately rated. Market risk. There should be no market risk when liquidating collateral to make payments or else the market risk would need to be sized. Trading risk. For managed portfolios, Standard & Poor's requires ongoing monitoring of changing credit risk, analysis of the manager, analysis of trading limitations, and analysis of how trading gains and losses are being incorporated in the structure. Cash flow analysis. Analysis of the cash flow generated from the portfolio of assets is necessary as these funds will be used to pay interest, fees, trading losses, and termination payments. Legal analysis. This involves a review of the bankruptcy remoteness of the vehicle, security over collateral, legal opinions, timely access to collateral pledged by counterparties, and various legal issues specific to the particular structure under review. 4. Hybrid Transactions The main difference between a CSO transaction and a hybrid transaction is that the reference portfolio of a hybrid transaction contains both cash assets and unfunded assets (CDSs) whereas the assets of CSO transactions are only unfunded assets (CDSs). The proceeds of the notes are used to buy the cash assets; simultaneously, the SPE will enter into CDSs for which no funds are needed. As the proceeds of the notes are invested in cash assets, another source of funds needs be available to make payments after the occurrence of a credit event at maturity and upon early termination. This is typically provided by a liquidity facility. Alternatively, the transaction can also use only part of the proceeds to purchase cash assets, in which case the remainder of these funds can be used to make the contingent and principal payments (see chart 6). SECTION 1 PAGE 9

11 Standard & Poor's analysis will therefore include elements of a cash CDO and elements of a synthetic CDO; for example, coverage tests that work for both cash and synthetic assets, portfolio limits for the cash assets, and restrictions to the unfunded exposure will be applied. The summary of risks and issues for CSOs applies in the case of hybrids also. C. The Rating Process for Synthetic CDOs Standard & Poor's ratings on notes issued in synthetic CDO transactions address, like in all other structured finance transactions, the likelihood of full payment of interest (either on a timely or ultimate basis) and ultimate payment of principal. The analysis focuses on how much credit enhancement is needed to achieve a given level of risk and arrives at the commensurate rating, taking into account the transaction's credit risk, structure, and legal analysis. The rating process for synthetic CDOs is similar to the rating process for cash CDOs. The main difference is that the use of CDSs introduces additional elements to the rating analysis, including ISDA documentation, issues surrounding termination, and bivariate risk (i.e., exposure to the underlying credit and the counterparty). The analysis can be short or long depending on the complexity of the structure. For example, an unfunded CDS typically can be executed in a much shorter time frame than a CSO transaction as only the credit risk will need to be analyzed. In addition, transactions that have pre-approved documentation (so-called synthetic programs) facilitate execution as template structures and standard documentation are used. In general, Standard & Poor's rating analysis follows a standard procedure, described as follows: The sponsor requests a rating. For programs, the request can be made by ; for complex, oneoff transactions, an initial meeting may be required. The sponsor must provide information with respect to the reference portfolio, along with a term sheet, pricing supplement, and the CDS confirmation or offering circular. Standard & Poor's sends an engagement letter and assigns an analyst to the transaction. An analysis of the information is presented by the sponsor to Standard & Poor's: structural basics, legal risks, credit risks, and collateral features. A review of the manager is conducted. The rating committee meets to review the transaction and any relevant issues. A review of the final documents and legal opinions is conducted. Standard & Poor's issues the rating letter or credit assessment letter. The sponsor provides surveillance data to Standard & Poor's on an ongoing basis. Standard & Poor's analysis of the data provided by the sponsor will involve a review of both credit and structural risk. With respect to credit risk, the analysis consists of: A review of the reference portfolio and CDS term sheet (credit events, reference obligation, etc.) to assess the default risk of the reference portfolio (see section II and section III); A review of the CDS term sheet (settlement mechanism, deliverable obligation, etc.) to assign recoveries (see section II and section III); If the portfolio is managed, an analysis of the changing credit risk of the portfolio, an analysis of the trading gains and losses, and a review of the manager and trading limits ; and A calculation of the credit enhancement based on credit risk and structure (see section III). A review of structural risk involves a consideration of the following: Timely payment of interest and ultimate payment of principal (see section IV); Counterparty risk (see section V) Priority of payments (see section IV); Specific structure types: synthetic CDO of ABS, hybrid CDOs, single-tranche transactions, smallbasket CDOs, synthetic market value transactions, synthetic indices, and transactions with short positions and total return swaps (see section VIII); Legal analysis (see section VII); and Surveillance (see section VII). SECTION 1 PAGE 10

12 SECTION II: CDS DOCUMENTATION Every CDS trade is typically documented in a contract called the "confirmation". Terms used in the confirmation are usually defined in the credit derivative definitions published by the ISDA. In addition to the confirmation, there should be a schedule and a master agreement (see chart 7). If the ISDA documentation is not used, Standard & Poor's will carefully analyze the template or documentation used in its place. Standard & Poor's recognizes that certain jurisdictions have their own ISDA equivalent. The ISDA has published the following documents relating to credit derivatives: The 1998 long-form confirmation; The 1999 ISDA credit derivatives definitions (the "1999 ISDA Definitions"); Three supplements to the 1999 definitions published in 2001: supplement relating to convertible, exchangeable, or accreting obligations; supplement relating to successor and credit events; and the restructuring supplement; and The 2003 ISDA credit derivatives definitions (the "2003 ISDA Definitions""): apart from incorporating the 2001 supplements, these also modify some of the definitions. Key changes have been made to the credit event definitions, guarantees, notice of physical settlement, alternative settlement procedure, physical settlement representations, dispute resolution, and novation provisions. There has also already been a supplement to the 2003 ISDA Definitions, relating to guarantees. Given the frequent revisions to the ISDA documents, Standard & Poor's will check which version of the documents is used and review the impact of the documentation on the structure and rating on the notes. Standard & Poor's closely follows the ongoing development and changes to the ISDA documentation and, when necessary, will adapt its criteria to accommodate such changes. A. Reference Entities and Reference Obligation Categories and Characteristics 1. Overview The reference entities and reference obligations in a CDS define the credit-risk exposure. They are the synthetic version of "assets" in cash CDOs. Therefore, the reference obligation category and characteristics in synthetic CDOs are comparable to the eligibility criteria of collateral debt securities in cash CDOs. The crucial difference is that while a cash CDO will actually purchase assets, a synthetic CDO does not it merely "references" them. The obligations can be direct obligations of the reference entity or obligations guaranteed by the reference entity on behalf of its downstream affiliate or other entities (as revised by the 2003 ISDA Definitions and the supplement to them). The "reference entity" refers to the debt-issuing entity (say, ABC Ltd.) and the "reference obligation" refers to the debt obligation issued by that reference entity (say, the senior unsecured debt of ABC Ltd. with a 10-year maturity). The CDS can reference a specific debt issue (typically indicated SECTION 2 PAGE 11

13 with a CUSIP or ISIN number) or can reference all or a portion of the reference entity's debt issues. This will be determined by the choice of reference obligation category. In addition, the reference obligation can be specified further by choosing one or more characteristics, thereby effectively narrowing the risk spectrum. The reference obligation category and characteristics need to mirror the obligations for which the protection buyer seeks protection. If, for example, the protection buyer seeks protection on a loan issued by company X but the CDS refers to a bond issued by company X as the reference category, then the protection buyer is not protected. For the same reason, it is vitally important that the names of the relevant parties are correctly spelled and that the correct entity is named in the documentation. Standard & Poor's reviews the choice of reference entity and reference obligation category and characteristics, as this will determine the credit risk of the portfolio and therefore the inputs in the CDO Evaluator. The latter is Standard & Poor's proprietary model and is used to calculate the probability of default of the assets (see section III). 2. Eligibility Criteria for Reference Entities In cash CDOs, extensive thought is given to the nature of the collateral debt securities and the characteristics of the pool. Cash flow CDOs involve the careful selection of assets as the transaction relies on cash flows received from these assets to make payments on the notes. Thus, for example, they will limit securities that include payment-in-kind (PIK) as this can potentially lead to a cash shortfall. In a synthetic CDO, on the other hand, the sources of credit risk are explicitly not acquired. Therefore, only the name of the issuing company is of concern; eligibility issues with regards to the cash flow characteristics of the assets are not an issue. The cash flow received by the synthetic CDO is the premium paid by the protection buyer. Managers in synthetic transactions are effectively selling a default put option whose payoff reflects the flexible obligations for which that option can be exercised. 3. Reference Obligation Categories The reference obligation is described by one obligation category, and one or more obligation characteristics. Standard & Poor's accepts the following reference obligation categories: "borrowed money", "bond or loan", "bond", "loan", and "reference obligation only" (see chart 8). In determining what should or should not be an acceptable category, Standard & Poor's has checked that the category would be covered by its historical corporate default study. If the obligation category would not be consistent with this study, then the default probabilities used in the CDO Evaluator will incorrectly represent the probability that a default will occur. SECTION 2 PAGE 12

14 The borrowed money category is most often selected and includes default of any bond, loan, deposit obligation, or reimbursement obligation. A credit event with respect to any of these will trigger a payment from the protection seller to the protection buyer. Standard & Poor's does not accept "payment" as an obligation category as this term is too wide. It could include any commercial contract, such as a utility bill, and thus does not constitute debt and is unlikely to be captured in Standard & Poor's default study. Commercial contracts are often the subject of commercial dispute, which is not necessarily material to a particular rating. 4. Reference Obligation Characteristics Reference obligation characteristics are less of an issue than deliverable obligation characteristics given that even the widest definition of borrowed money is acceptable without need for further specification (see section II.E). Nevertheless, when reference obligation characteristics are defined, Standard & Poor's reviews them for their applicability to the given transaction. Standard & Poor's accepts the following reference obligation characteristics: Not subordinated. If chosen, the defaulted obligation must be of equal ranking or senior to the reference obligation listed. If not chosen, the reference characteristic will be "senior unsecured". Specified currency. If no specific currencies are chosen, the following currencies will automatically apply: Canadian dollars, Japanese yen, Swiss francs, British pounds sterling, U.S. dollars, and euros. Standard & Poor's is comfortable with the exchange control risks posed by these currencies, given that such risks are already addressed by the foreign currency rating on the reference entity. Other currencies are assessed on a case-by-case basis; for example, Australian dollars are acceptable. Additionally, Standard & Poor's will determine whether the exchange risk is eliminated. This is typically done by setting the rate on the first day of the transaction. Not sovereign lender, not domestic currency, not domestic law, not domestic issuance. Standard & Poor's will check the applicability of these characteristics to the transaction, but the foreign currency ratings on the reference entity will capture the risk. Listed. If chosen as a characteristic, the reference obligations cannot be loans. Exposure to banks and insurance companies. Standard & Poor's needs to review the reference obligation language on a case-by-case basis; the defaulted obligation of the bank or insurance should be a valid claim. 5. Successor to Reference Entity and Obligations The 2003 ISDA Definitions elaborate on the situation that arises when a reference entity ceases to exist but there is a successor to that reference entity. The new definitions focus on the definition of a successor and succession event. The vague description of "all or substantially all of the obligations", which is used in the 1999 ISDA Definitions, has been removed in favor of numerical thresholds. The reference in the 2003 ISDA Definitions to successor entities is material to Standard & Poor's analysis only to the extent that an unrated successor would cause ratings volatility to the portfolio or if an attempt is made to define a succession event as a credit event despite the lack of bankruptcy or failure to pay. 6. Standard & Poor's CDO Evaluator and the Reference Obligation Categories and Characteristics The definition of the reference obligation category and characteristics will determine the inputs for Standard & Poor's CDO Evaluator. Key inputs to run the CDO Evaluator are: reference entity ID, rating, maturity, country, and industry category. Standard & Poor's will use the issuer credit rating on the reference entity to run the CDO Evaluator (see section III). The maturity used in the CDO Evaluator is typically the maturity of the CDS as this is the period during which the CDO is exposed to credit risk. Therefore, the maturity of the individual reference obligation is not relevant. However, if the reference category is "specific reference obligation only", the actual maturity of the underlying asset can be used as the input for the CDO Evaluator. In managed synthetic CDOs, the actual maturity of all individual CDSs entered into by the manager will be used as the maturity in the CDO Evaluator as the manager will use the CDO Monitor on an ongoing basis. Given the importance of using exact names, Standard & Poor's will require the sponsor to provide a spreadsheet with the exact name, CUSIP/ISIN number, industry codes, and country of incorporation of the reference entity. B. Reference Price In the vast majority of synthetic CDO transactions a reference price of 100% of par is selected. If a lower reference price is selected, the discount, which is represented by a cash payment to the SPE, must be retained in the structure. Standard & Poor's will seek an explanation as to why the SPE has entered into an off-market CDS. SECTION 2 PAGE 13

15 C. Credit Events A credit event in a synthetic CDO may be considered a proxy for the default of an asset as both a credit event and default represent the moment at which the investor becomes eligible to suffer a loss. Consequently, in a synthetic transaction Standard & Poor's seeks definitions of credit events that are consistent with the definition of default used in its corporate default study. If the definitions are not consistent, then the default probabilities used in the CDO Evaluator will incorrectly represent the probability that a credit event will occur with respect to a given reference obligation. Not all credit events are reflected in the definition of default for all asset types. As a result, the cross-referencing of the ISDA Definitions with Standard & Poor's default definitions becomes more challenging. 1. Credit Events With Respect to Corporate Reference Obligations For corporate debt, Standard & Poor's corporate default study registers the following events as defaults: Payment default; Bankruptcy of the reference entity; and Material cross-default with another debt instrument (selective default or 'SD'), downgrade to 'D', or, in certain circumstances, withdrawal of the Standard & Poor's rating. Thus, the ISDA-defined credit events that are currently accepted by Standard & Poor's in synthetic CDOs of corporate credits as proxies for default are: Failure to pay, with the standard payment thresholds; Bankruptcy; Obligation acceleration; and Restructuring, as defined in the 2003 ISDA Definitions (or in the May 2001 restructuring supplement). The "failure to pay" credit event is probably the clearest of the credit events and all parties generally agree that failure to receive a payment under the terms of a borrowing, after the applicable grace period has expired, constitutes default. Standard & Poor s request a minimum payment requirement of $1 million. The "bankruptcy" credit event in synthetic CDOs is a direct and clear counterpart of its equivalent in cash CDOs. The bankruptcy credit event definition was revised in the 2003 ISDA Definitions. The faults previously contained in the 1999 ISDA Definitions, which Standard & Poor's had requested be removed (i.e., clause i) for rated transactions, have been addressed in the new definition. The simplest credit derivative transaction is the one that contains only bankruptcy and failure to pay as credit events. Each of the other credit events creates greater ambiguity with respect to the definition of default. "Obligation acceleration" is accepted as a credit event definition on the basis that a trustee may declare an event of default for a myriad of reasons, but will initiate acceleration only if it is determined that fiduciary duty mandates an action of that severity. Once a declaration of acceleration is made, it qualifies as a credit event under the ISDA Definitions only if notice of this acceleration is available via publicly available information. Such knowledge, it is assumed, will lead to the acceleration of all liabilities of the reference entity in question by its creditors. Thus, under this credit event, all obligations will either be paid or defaulted upon. If default occurs, it is covered by the corporate default study definitions. If all obligations are paid, the credit event leads to settlement at par as long as there is either physical delivery or cash settlement outside of the window required for this to occur. "Restructuring", for its part, is accepted as a credit event in its modified form only (see section II.C.4). This is due to the fact that the five main components of modified restructuring reduction in interest, reduction in principal, postponement, change in seniority, and change in currency represent events that would also be deemed a default of a corporate credit by Standard & Poor's. This is not necessarily the case for restructuring in its unmodified form, however. Standard & Poor's is mainly concerned with changes in seniority (if such a change was due, for instance, to the provision of additional collateral), a change in currency (if it involved major world currencies), or a restructuring that occurs only between two consenting parties. None of these events would normally result in the lowering of the rating on a corporate entity to 'D'. If the old restructuring is chosen, Standard & Poor's will apply a "haircut" to the recoveries. The 2003 ISDA Definitions attempt to bridge the difference between the European and U.S. markets in their approaches to restructuring. Whereas modified restructuring was a standard credit event in the U.S. synthetic CDO market, this was not generally accepted in the European market. The 2003 ISDA Definitions therefore introduce the concept of the "modified modified" SECTION 2 PAGE 14

16 restructuring a slightly amended version of the modified restructuring credit event to account for the concerns of the dealers in the European market. Standard & Poor's accepts modified modified restructuring as a credit event. Standard & Poor s request a minimum default requirement of $10 million. There are two additional credit events that require comment. "Repudiation/moratorium" is an event that may be included as a credit event, although Standard & Poor's sovereign ratings capture the likelihood of moratorium. Since the rating on a corporate reference entity is typically constrained by the rating on the sovereign of the jurisdiction where the entity is based, the inclusion of this event is considered redundant and, indeed, is not as widespread as it once was. In addition, Standard & Poor's explicitly does not accept "obligation default" as a credit event, as this includes all technical defaults such as interest coverage ratio violations, which are decidedly not equal to default as defined by Standard & Poor's in the corporate default study. Finally, the list of credit events for synthetic CDOs of corporate credits is broader than the one for small baskets (small groups of obligations). This difference in treatment is based on how timing of a default affects CDOs, CLNs, and single-name credit derivatives. For instance, a company may accelerate its debt due to a covenant violation. If obligation acceleration were to be deemed a credit event in a small-basket CLN transaction, the investor would automatically lose money at that moment. In contrast, the synthetic CDO builds in the luxury of time, during which it can be determined whether the acceleration was rescinded or the debt paid in full. If the latter, the synthetic CDO investor suffers no loss. 2. Credit Events With Respect to Sovereign Reference Obligations Acceptable credit events for transactions that include sovereign reference obligations are slightly different due to the specific nature of sovereign debt. Failure to pay. As with corporate credits, failure to pay is the simplest and most direct credit event in the sovereign context. This may be included. Bankruptcy. This credit event has no meaning for a sovereign entity and should be eliminated. Repudiation/moratorium. This is a very important sovereign credit event, particularly the moratorium part of it. Standard & Poor's Sovereign group would always consider moratorium to be tantamount to a default. Restructuring. This credit event is a bit complicated in the sovereign context. There are some types of restructurings that Standard & Poor's Sovereign group does not track, such as those of the lending agreements between two sovereign countries. This type of lending is often a de facto foreign aid package and is consequently subject to renegotiation with considerable frequency. If restructuring is included as a credit event for sovereign reference obligations, then sovereign-to-sovereign restructuring should be explicitly carved out. In addition, this credit event should be restricted as closely as possible to the concept of "distressed exchange," which is the criterion that would cause Standard & Poor's Sovereign group to move the rating on a sovereign security to 'SD' or 'D'. 3. Credit Events With Respect to Structured Finance Reference Obligations For structured finance obligations in synthetic CDOs, Standard & Poor's limits the acceptable definition of default to the following. Failure to pay. As in the above obligation types, this is the standard credit event for synthetic CDOs that reference structured finance securities. The language for failure to pay, however, needs to be adjusted to specifically address the fact that a PIK security will not trigger a credit event by a typical missed interest payment. This carve out must go further than the "where and when due" language that is standard in the ISDA Definitions. The language should address: That a missed interest payment of a PIK credit will not constitute a credit event; and Any failures to pay that constitute a default or an event of default under the terms of the reference obligation will still be considered a credit event. Loss event/write-down. This credit event attempts to capture the incapacitation of an asset before its rating actually transitions to 'CC' or 'D'. This credit event is typically written in a variety of ways. In Standard & Poor's view, an acceptable definition will include the concept that a credit event may be called only when a principal reduction to the reference obligation is permanent. Transition to a low rating. This credit event is acceptable under certain circumstances. For some structured finance securities, a rating of 'CC' is a de facto default. In this case, Standard & Poor's would accept transition to 'CC' as an acceptable proxy for a default, and thus eligible to be a credit event. Acceleration/restructuring. This is a very uncommon credit event in structured finance synthetic CDO of CDSs. Standard & Poor's evaluates the SECTION 2 PAGE 15

17 appropriateness of this credit event depending, again, on the nature of the obligations referenced. (see section VIII.A). 4. Credit Events and the 2003 ISDA Definitions The 2003 ISDA Definitions make changes to the credit event definitions. The "bankruptcy" language in the 1999 ISDA Definitions was modeled on section 5(a)(vii) of the ISDA master agreement. However, "bankruptcy" in the definitions and in the master agreement serve different purposes. The 2003 definitions refine the bankruptcy language by removing clause (i) from the 1999 ISDA Definition and adding a clause stating that an admission of bankruptcy should be made in writing and in a judicial, regulatory, or administrative proceeding. The failure to pay credit event is not substantively amended. However, a payment requirement threshold must be met before this credit event is triggered. The repudiation/moratorium credit event has also been amended to address concerns that according to the 1999 ISDA Definitions the event could be triggered inadvertently or inappropriately. Now a declaration of repudiation or moratorium must be made by an authorized officer of the entity or by a governmental authority and there are additional provision when the event leading to a repudiation/moratorium must occur. With respect to restructuring, under the 2003 ISDA Definitions there are now four restructuring options available: (Old) restructuring; Modified restructuring. This incorporates the concept of a restructuring maturity limitation and fully transferable obligation: the buyer cannot deliver an obligation that has a final maturity date later than the earlier of 30 months following the restructuring and the latest maturity date of the obligation that has been restructured. However, one can never deliver an obligation that has a maturity date falling later than 30 months after the scheduled termination date. Bilateral loans can not trigger the credit event and a deliverable obligation must be fully transferable; Modified modified restructuring. This incorporates the concept of a modified restructuring limitation and conditional transferable obligation; the buyer cannot deliver an obligation that has a final maturity date later than the earlier of the scheduled maturity date and 60 months following the restructuring (for bonds or loans) or 30 months (for other obligations). Obligations must be conditionally transferable; and No restructuring. D. Conditions to Payment The occurrence of a credit event is the key event that causes the seller of CDS protection to make payments to the buyer. Determining that such an event has occurred is, of course, an important component of this. Standard & Poor's requests that both a credit event notice and a notice of publicly available information be delivered to the protection seller in transactions using either the cash settlement and physical settlement mechanisms. This notice is simply an attestation that a credit event has occurred and includes a description of the relevant details. The latter should further indicate the sources of the information that have led the calculation agent to conclude that a credit event has occurred. Standard & Poor's typically requests that the event leading to the credit event be reported in two internationally recognized public news sources, of which Standard & Poor's itself may be one. In some cases, local news sources may be more appropriate, depending on the nature of the reference obligations, and may be accepted as a public source. In addition, a "notice of intended physical settlement" is desirable if the transaction envisions physical settlement. The 2003 ISDA Definitions now require that the notice of physical settlement specify what the buyer will deliver to the seller. It is also more difficult to amend the notice. Finally, all notices must describe events that occur on or between the effective date of the transaction and the scheduled termination date (and grace period) under the relevant business day conventions. E. Deliverable Obligations and Deliverable Obligation Categories and Characteristics 1. Introduction The "deliverable obligation" in CDSs defines the defaulted asset that will be physically delivered to the protection seller if electing physical settlement or used to establish compensation to the protection buyer, if electing cash settlement, upon the occurrence of a credit event. The deliverable obligation category and characteristics further detail the exact nature of the asset that can be physically delivered or valued in cash. The deliverable obligation therefore influences the recovery value achievable by the CDO or CDS and is therefore paramount in Standard & Poor's credit risk analysis. In synthetic transactions, the reference obligation, which determines the credit risk, can be dif- SECTION 2 PAGE 16

18 ferent from the deliverable obligation, which determines the recovery value. In addition, if the deliverable security is not pre-specified and thus the cheapest asset is typically delivered. This is referred to as the "cheapest-to-deliver" option. This differs from cash CDOs where the deliverable obligation equivalent is always the asset that has defaulted. Standard & Poor's determines the appropriate recovery value of the assets in synthetic CDOs based on the type of security (bond, loan, corporate, sovereign, ABS, etc.), the seniority of the asset (senior, secured, subordinated), the country of incorporation of the asset, the applicable legal enforceability considerations, the experience of the calculation agent or manager, the time available to establish the recovery, and the cheapest-todeliver option. Standard & Poor's will review the selection of the deliverable obligation category and characteristics and the settlement process as this will determine the recoveries for the transaction. The more precise the deliverable obligation definition, the more accurate the recoveries process. 2. Deliverable Obligation Categories and Characteristics Standard & Poor's accepts the following deliverable obligation categories: bond or loan, bond, loan, and reference obligation only. Standard & Poor's does not accept "borrowed money" and "payment" as categories, the reason being that it is difficult to establish a recovery value for payment obligations other than bonds and loans. As with the characteristics of the reference obligation itself, Standard & Poor's reviews the deliverable obligation characteristics to determine their applicability to a given transaction. The characteristics include: Not subordinated; Assignable loans and consent-required loans. Standard & Poor's requires language in the documentation to the effect that consent to assign or transfer the loan has been obtained; Transferable. The deliverable obligation must be transferable. Not a sovereign lender, not domestic currency, not domestic law, and not domestic issuance; Not bearer; Specified currencies. Standard & Poor's will check if deliverable currencies other than the currency of the vehicle can be delivered, in which case there needs to be a hedge and/or the risk has to be sized as part of the credit enhancement. In the case of physical settlement, the recovery assumption will need to be subjected to a haircut to reflect the potential loss due to the currencyconversion rate. The calculation is based on Standard & Poor's extreme-value tables method. The contingent ability of a manager to enter into a currency hedge upon physical delivery of a defaulted asset is not generally accepted, as it is hard to determine the cost in advance; Listed; Not contingent. If contingent obligations can be delivered, this needs to be sized, either by adapting the recovery rates and/or through credit enhancement; Direct loan participations; and Maximum maturity longer than the tenor of the transaction. F. Settlement Mechanisms 1. Introduction If a default has occurred in the reference portfolio, as defined by the credit event definitions, a process will be initiated to establish the recovery value. This process is referred to as the "settlement mechanism". CDSs can be structured to provide for either physical settlement or cash settlement. Both settlement mechanisms have inherent difficulties and will greatly influence the extent of loss to investors. Standard & Poor's will analyze the proposed settlement mechanism to determine the recoveries that can be assigned to the transaction. 2. Physical Settlement Mechanism In CDSs with physical settlement, the protection buyer will deliver an obligation of the defaulted reference entity to the protection seller. The protection seller will, in return, pay the full notional amount of the defaulted reference obligation to the protection buyer. As a result, the buyer is reimbursed for any default-related losses that it would otherwise suffer. Consequently, the protection seller will establish the recovery of the delivered obligation, either by selling the security or holding on to it for workout (see chart 9 overleaf). If physical settlement is chosen, a deliverable obligation category and characteristics need to be selected and the deliverable obligation must satisfy the deliverable obligation characteristics on the delivery date. Standard & Poor's also accepts partial delivery. With partial delivery, part of the obligation is settled on the settlement date and part at a later date. Standard & Poor's will check that this has no negative impact on the recoveries. Given that the protection buyer must deliver an obligation, he will either already own the obliga- SECTION 2 PAGE 17

19 tion or will have to purchase it in the market. The risk exists, therefore, that the protection buyer cannot find an obligation or that he does not have the funds to purchase one. If it is not possible to have physical settlement, there can be cash settlement or the valuation will be zero. The 2003 ISDA Definitions now include alternative delivery procedures. The cash flow impact on the SPE as a result of the physical settlement process needs to be examined since the protection seller must make a full payment with respect to the defaulted reference obligation after default. In CSO transactions it is therefore important that the cash flow analysis takes into account the full amount to be paid. The manager, calculation agent, or protection seller (as appropriate) plays an important role, as this party will be responsible for achieving recoveries after having received the defaulted security. The manager or other relevant party will either sell the security at a fixed time or hold the security for workout, in which case higher recoveries can be assigned. 3. Cash Settlement Mechanism In CDSs with cash settlement the defaulted obligations are valued and the protection buyer is reimbursed for the loss between par value and the value of the obligation following default. The value will typically be established by requesting bids from various market participants. Therefore, this process will directly influence recoveries achieved and needs to be closely examined. There are several important elements in the cash settlement process as follows. Size of the bids. The quotation amount is typically the reference obligation notional amount. Nevertheless, the bids obtained must be based on the standard trading size of the reference obligations. As it becomes very difficult to obtain meaningful bids on large amounts, Standard & Poor's requires a minimum quotation amount of $1 million and a maximum quotation amount of $15 million. In certain transactions, the quotation amount is determined by putting together various obligations of various sizes in a "valuation basket". Standard & Poor's will approve this on a case-by-case basis. Typically, the quotation amount excludes accrued interest, which is typically added when establishing the final price. The timing of valuation following default. There is some evidence that the longer the time between default and valuation, the higher the valuation. Immediately after default there will be a lack of information about the reference obligation and hence uncertainty about recoveries. Standard & Poor's considers that after 45 business days or 60 calendar days, the available information will have been priced into the market. Any period longer than 45 business days is acceptable and any period below 45 business days will lead to a haircut of the recoveries unless a certain amount of recoveries is guaranteed, which should be (at a minimum) the recovery level assigned to the transaction (see chart 10 overleaf). Identity of the bidders. The bidding entities must be actively involved in the market for the relevant reference obligation. Standard & Poor's will request that the names of the bidding entities be disclosed in the documentation. Number of bids. Standard & Poor's requires that a minimum of five bids be requested, of which three should be obtained. If three bids are not obtained, subsequent bidding rounds must be held until the required number is achieved or the bidding guidelines are exhausted. Selection of bids: Standard & Poor's requires that the highest or average highest of the bids be taken. Calculation agent or manager. The calculation agent or manager needs to be familiar with the settlement process used in CDSs. SECTION 2 PAGE 18

20 Transactions that have a cash settlement mechanism as described above will be able to achieve the base synthetic recovery rates. However, if the transaction has a less-solid settlement mechanism, typically a haircut of about 50% will be applied to the recoveries (see section II.C). 4. Disputes Over Settlement Mechanism Given the importance of the settlement process, disputes can arise. Most synthetic CDO transactions provide for a dispute mechanism as defined by the ISDA Definitions. 5. Settlement Mechanisms and Late Credit Events Standard & Poor's is concerned with the amount of time that is allowed to pass between the occurrence of a credit event and the valuation of a defaulted reference obligation, especially in the case of cash settlement. For different obligations, the optimal amount of time will vary. Still, there is always the possibility that credit events that occur very late in a transaction will face an accelerated valuation schedule in order to achieve a recovery value before termination. There are two solutions for this. First, the recovery rate may be haircut by the appropriate level to account for the potentially insufficient valuation period. This is likely an undesirable fix; since there is no way of determining what proportion of total expected credit events will occur at the end of the transaction, Standard & Poor's must conservatively assume that most, if not all, will occur at that time. The alternative is for the transaction to explicitly extend the valuation period a sufficient number of days past the termination of the CDS. This can be done via the legal maturity of the notes, if notes are issued, or by agreeing to an extension period in the confirmation. In either case, the goal is to ensure that a proper number of days passes before a defaulted reference obligation is valued, even if a credit event is called on the final day of the CDS contract. Another solution is that no credit event notice can be issued just before the maturity of the transaction. For example, if the settlement period is 45 days, no credit event can be issued 45 days before the maturity date. 6. Settlement Mechanism's Effect on Recovery Assumptions The settlement mechanism will directly affect recoveries. Either synthetic recovery assumptions or full workout recovery assumptions can be assigned to a synthetic transaction depending on the time available to establish the recovery value of the defaulted obligation. Typically, recovery assumptions will be lower for transactions that use cash settlement than for physical settlement transactions. Full workout recoveries are the same as the corporate recovery assumptions used in cash arbitrage deals when a manager has a minimum of one year to work out a bond and a minimum of two to three years to work out a loan. In a physical settlement scenario, the protection buyer will have received the defaulted reference obligation. If he holds on to it, either to work out or to sell at a time he considers appropriate, full workout recovery assumptions can be assigned. The minimum recovery period is one year for bonds and two to three years for loans (50% in each year). If, however, he needs to sell the obligation at a fixed point in time, for example, six months after the credit event notice, then although the recovery period is much longer than in a typical cash settlement, it is still a forced sale and therefore the recovery assumptions assigned will be closer to synthetic recoveries than full workout recoveries. In a cash settlement situation, the calculation agent will have to value the defaulted reference obligation at a specific point in time, typically 45 business days after a credit event has been issued and the conditions to payment have been satisfied. SECTION 2 PAGE 19

21 Due to this forced sale, only synthetic recovery assumptions can be assigned. Synthetic recovery assumptions are the base case synthetic recoveries (see section III.B) to which haircuts may be applied (see section III.B.2). G. Loss Calculation After the recovery value of the defaulted asset has been established through the cash or physical settlement process, the calculation agent will calculate the loss amount. The loss amount is the actual dollar amount of loss suffered by the protection seller. As this is the loss that will be suffered by the SPE and hence by the investors who purchased the notes, Standard & Poor's will need to review the calculation. The loss amount is typically calculated using a simple formula. Standard & Poor's will confirm that the loss calculation is not influenced by any elements other than the notional amount and the recovery value, which are already taken into consideration and sized for in its analysis. The formula used to calculate the loss amount is typically the following. The final price (expressed in a percentage) is the highest or average highest bid received and the accrued interest, which is typically excluded from this bid, is added to this price. Standard & Poor's will also review the party responsible for calculating the loss amount, usually the calculation agent or manager. In certain cases it may be necessary to have the loss amount reviewed by an independent party, such as an auditor. Once the loss amount has been calculated, Standard & Poor's will review when the notes are written down. The notes can be written down when a credit event notice is issued with the full notional amount of the reference obligation. In this case, the notes are subsequently restored to their original amount (minus losses) once the recovery value on the obligation has been established through the cash or physical settlement process. Alternatively, the notes can be written down after the loss amount has been established. Standard & Poor's also needs to review whether the notes are physically redeemed or only the outstanding notional amount is reduced. SECTION 2 PAGE 20

22 SECTION III: SIZING OF DEFAULTS AND RECOVERIES AND CALCULATING THE CREDIT ENHANCEMENT A. Sizing Expected Defaults Using the CDO Evaluator As in cash CDOs, Standard & Poor's relies on its CDO Evaluator to simulate defaults in synthetic CDOs. This model is now in its fourth incarnation (version 2.2). A description can be found beginning on page 40 of the "Global Cash Flow and Synthetic CDO Criteria". The CDO Evaluator uses Monte Carlo statistical methodology to evaluate the credit quality of a portfolio of obligations and to provide scenariodefault rates for the portfolio at each rating level. The user of the model merely inputs seven pieces of reference obligation information as shown in the image below, namely, the rating, the notional balance, the maturity, the asset type, the country of domicile, the sovereign rating of that domicile, and an identification number selects an "as of date", and clicks "run". The model produces a correlation-adjusted probability distribution of potential, aggregate default rates for the pool of reference obligations. This is not an idealized construction; rather, it is a simulation of the potential performance of the reference obligations and the correlation between them. As such, it is an efficient estimate of the distribution of defaults at different probability levels. From the distribution and other calculations, a variety of portfolio statistics and descriptions is produced, the most crucial of which are the scenario default rates for each rating level. These provide a first-blush indication of the likely subordination levels that Standard & Poor's will require for a run-of-the-mill, static, synthetic CDO transaction for which no credit has been given for recovery rates, excess spread, or other structural features. Consequently, in most synthetic transactions, and unlike the more complicated, cash-flowmodel-driven transactions, the CDO Evaluator provides an immediate sense of how much ultimate credit support will be required for a given rating before recovery assumptions are assigned. Once the gross default rate for each rated tranche has been established as shown in the image overleaf, the net loss rate can be calculated by subtracting the recovery rates. The net loss rate is the level of credit enhancement needed. The CDO Evaluator applies to both corporate and ABS obligations. For CDO of ABS transactions, which have a large portion of CDOs, and for CDO of CDOs it will also be necessary to look through the obligations at the underlying assets. However, CDO Evaluator methodology is applicable to only pooled reference obligations, meaning groups of more than 10. For smaller groups of obligations, Standard & Poor's employs a variety of modeling and analytical techniques to assess credit risk. For synthetic transactions that include excess spread, the gross loss rates can be further reduced by taking into account the excess spread using a cash flow model together with the CDO Evaluator (see section IV.F). SECTION 3 PAGE 21

23 B. Recoveries 1. The Base-Case Once the CDO Evaluator produces the basic scenario default rate for a pool of obligations, the impact of the other structural features of the transaction and recoveries on the credit enhancement required is considered. In synthetic CDOs, recovery assumptions are highly reliant on the 1999 and 2003 ISDA Definitions, which include numerous terms and conditions affecting ultimate recovery with respect to a defaulted obligation. The treatment of these is discussed in further detail in section III.B.2. First and foremost, however, likely recoveries for a reference obligation in a synthetic CDO are driven by the average recovery rate achieved for a similar cash asset, given the legal, regulatory, and market characteristics of the domicile of that asset. For example, secrecy provisions and uncertain disclosure or reporting standards may affect the flow of information that is vital for market participants to accurately gauge the risk inherent in a defaulted asset. Similarly, this uncertainty will hinder a participant in a synthetic CDO from correctly assessing the fair value of a reference obligation that has suffered a credit event. Secondly, the relative maturity of the distressed debt market in a given domicile can play an important role. Despite the lack of data on the point, Standard & Poor's assumes that domiciles where distressed debt market activity is low and where workout practices are not widespread will give rise to lower recoveries. Standard & Poor's has analyzed the laws, regulations, and state of the market of various domiciles to determine their impact on recovery assumptions for defaulted cash assets. From this analysis, Standard & Poor's takes the average level of actual and expected recoveries in each domicile. Not only the domicile of the assets but also the seniority and asset type play an important role in assigning recovery assumptions. In general, secured obligations will achieve higher recoveries than unsecured obligations and senior obligations will achieve higher recoveries than subordinated obligations. Empirical studies have also demonstrated that loans will achieve higher recoveries than bonds. Of course, given that in a synthetic transaction the "bond or loan" deliverable obligation category is often chosen, the bond recoveries will typically apply (see section II). Based on the above, the base-case recovery assumptions for reference obligations in synthetic and cash CDOs are determined. The base-case recovery assumptions for synthetic CDOs differ from those of cash CDOs because synthetic transactions typically incorporate a forced sale of assets. In addition, haircuts based on the specific details of the ISDA contract applicable to the particular synthetic CDO will apply to the synthetic base-case recovery assumptions, as in table 1. The base-case recovery assumptions are presented on a country-by-country basis. In addition, as the relative risks posed by countries' laws and SECTION 3 PAGE 22

24 Table 1 Base-Case Recovery Assumptions by Country of Domicile - Senior Unsecured Obligations Country Recovery assumption (%) Australia 27 Austria 31 Belgium 29 Canada 37 China 18 Denmark 31 Finland 31 France 29 Germany 34 Greece 29 Hong Kong 25 Indonesia 13 Ireland 36 Italy 29 Japan 15 Korea, Republic of 18 Luxembourg 29 Malaysia 18 The Netherlands 34 New Zealand 27 Norway 31 Philippines 13 Portugal 29 Singapore 25 Spain 29 Sweden 31 Switzerland 34 Taiwan 18 Thailand 18 U.K. 36 U.S. 37 Emerging markets These percentages do not include the haircuts for the general cheapest-to-deliver phenomenon, specified currencies, physical settlement, and convertibility or consentrequired loans. regulations becomes more sophisticated and more information is received with regards to the application of these laws, the assumptions are likely to change. Reassessment of recoveries is therefore an ongoing project. Table 2 Synthetic Base-Case Recoveries for Sovereigns and Emerging Markets Country Recovery assumption (%) Sovereigns 20 Emerging markets 10 Base-case recovery assumptions for subordinated obligations will be determined on a case-bycase basis and for sovereigns and emerging markets can be found in table 2. Note that the recovery rates applied to structured finance assets differ from the recovery rates assigned to corporate assets (see section VIII.A). If the corporate base-case recovery rates are not haircut to reflect the terms of the contract (see section II.F), the appropriate rate for each domicile can be used to calculate a notional amount, weighted-average recovery rate for the pool as a whole. This number is then simply subtracted from one, the result of which is multiplied by the scenario default rates produced by the CDO Evaluator. This product (again, if no other structural features are considered) results in the net attachment point required at each rating level. 2. Haircuts on the Base-Case a. Overview The haircuts that Standard & Poor's assigns to its recovery assumptions in synthetic CDOs are rooted in the understanding that the actual process of recovery in a synthetic structure may deviate significantly from that in the world of cash transactions. In addition, haircuts can be applied in order to compensate for perceived differences between the probability of default implied by Standard & Poor's corporate default study (used in the CDO Evaluator) and the probability of a credit event occurring under the terms of the ISDA contract. In addition, Standard & Poor's distinguishes between the base-case recoveries for synthetic CDOs that settle credit events via cash settlement and those that settle by physically delivering an obligation to the protection seller. In the latter case, the recovery assumptions assigned are likely to be quite close to the base-case recovery assumptions for cash transactions, if it can be established that the delivered obligation will be denominated in the same currency as the contracted exposure. SECTION 3 PAGE 23

25 There are six standard haircuts that Standard & Poor's will consider for a synthetic CDO. These are: The general cheapest-to-deliver haircut; The specified currencies haircut; The convertibility/exchangeability haircut; The consent-required loan haircut; The insufficient period before bidding haircut; and The old restructuring haircut. b. The General Cheapest-to-Deliver Haircut Generally speaking, this haircut addresses the broad ability of the calculation agent to find the worst-priced eligible obligation to be bid upon during the valuation process following a credit event. This penalty, the first that Standard & Poor's identified, has been expanded to incorporate new market developments and consequently does not include some of the other risks (as described further in this section) that could also fit under the rubric of cheapest-to-deliver. The current penalty applied for this phenomenon is 5% of the base-case recovery assumption. Standard & Poor's will subtract the product of the base case and the haircut from the base case. Thus, in the case of an obligation that is domiciled in the U.S., the recovery assumption will be lowered as follows. Base-case recovery assumption in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Net recovery assumption in U.S. = 37% % = 35.15% c. The Specified Currencies Haircut The other cheapest-to-deliver risk that needs to be addressed is the potential mismatch in pricing of an obligation in different specified currencies. In other words, this haircut attempts to capture the pricing discrepancy that arises when the obligations of a reference entity are priced differently in different markets. For example, there may be a difference in the price (as expressed as a percentage of par value) for a U.S. dollar-denominated bond issued by a U.S. corporate entity and the price of a yendenominated bond issued by the same entity. The yen-denominated bond will typically be priced lower and because either obligation may be delivered for valuation, the calculation agent is naturally inclined to choose the yen-denominated bond. The specified currency haircut is therefore driven by liquidity preferences for obligations denominated in one currency relative to another. Standard & Poor's acknowledges that it is challenging to calculate the severity of this haircut. The current penalty assigned for this phenomenon is 2.5% of the base-case recovery assumption. Again, Standard & Poor's will subtract the product of the base case and the haircut from the base case. Thus, in the case of an obligation domiciled in the U.S., the recovery assumption will be lowered as follows. Base-case recovery assumption in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Haircut for specified currencies = 2.5% x 37% = 0.93% Net recovery assumption in U.S. = 37% % % = 34.23% d. The Convertibility/Exchangeable Haircut This haircut addresses the lower valuation possible under the 2003 ISDA Definitions with respect to convertible, exchangeable, or accreting obligations after the occurrence of a restructuring credit event. By allowing convertible/exchangeable obligations to be valued after a credit event, the ISDA has raised the possibility that a "soft" credit event (i.e., the restructuring) may lead the market to incorrectly price the value of the convertible option; the option may still be in place, but the equity component of it would be worthless. This is not a problem when the credit event is bankruptcy or failure to pay because both situations are likely to result in the conversion option being deemed effectively rescinded and, consequently, the convertible option would no longer be an eligible deliverable obligation. In contrast, when the credit event is restructuring, the option still exists but could be worthless. In such a case, the option is not effectively rescinded but a pricing desk will nevertheless have little idea as to how it should be priced. Thus, Standard & Poor's assumes that the price will be low and a haircut is applied to the recovery assumption. It should be noted that this haircut is applied only in the circumstances described above when an obligation characteristic other than "loans only" is selected. Again, it is difficult to empirically quantify the risk that this phenomenon entails. Even so, the current penalty that Standard & Poor's assigns is 2.5% of the base-case recovery assumption, given the expectation that this risk is relatively modest. Thus, in the case of an obligation that is domiciled in the U.S., the recovery assumption will be further lowered as follows. SECTION 3 PAGE 24

26 Base-case recovery assumption in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Haircut for specified currencies = 2.5% x 37% = 0.93% Haircut for convertibility/exchangeable = 2.5% x 37% = 0.93% Net recovery assumption in the U.S. = 37% % % % = 33.30% e. The Consent-Required Loan Haircut Standard & Poor's will also lower assigned recoveries when consent-required loans are included in the deliverable obligation characteristics. The reason for this is that a consent-required loan can be more difficult to sell downstream because consent must first be acquired. This is a potentially timeconsuming and expensive process. Standard & Poor's will ignore this penalty if consent has been previously given. In addition, this haircut is applied only when the obligation characteristic "loans only" is selected. Thus, this haircut and the convertibility/exchangeable haircut above are mutually exclusive. The current penalty that Standard & Poor's assigns for this phenomenon is 2.5% of the basecase recovery assumption, given expectation that this risk is relatively modest. Again, this haircut and the convertibility haircut described above are mutually exclusive. Thus, in the case of an obligation that is domiciled in the U.S., the recovery assumption will be lowered as follows. Base-case recovery assumptions in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Haircut for specified currencies = 2.5% x 37% = 0.93% Haircut for convertibility/exchangeable or consent-required loans = 2.5% x 37% = 0.93% Net recovery assumption in the U.S. = 37% % % % = 33.30% f. The Insufficient Period Before Bidding Haircut For most obligation categories, Standard & Poor's requests that a period of 45 business days (or 60 calendar days) be allowed to elapse between the delivery of a credit event notice and the first bid period. Standard & Poor's view, after consulting market participants, is that the further the valuation date is from the event (in this case the credit event), the better the recovery prospects. While there are exceptions, the confusion and poor information that may still dominate the riskassessment process are more likely than not to lead to price destabilization after a credit event. A longer time period allows the market more time to assess the financial condition of the reference entity as part of the bidding evaluation process. Also, it potentially allows time for accelerations to result in an actual default upon acceleration, or for the acceleration to be rescinded. Consequently, Standard & Poor's looks for the longest possible valuation time period, with 45 business days being a minimum. Dealers, on the other hand, typically argue for shorter time periods because they must carry the basis risk for this time period. Standard & Poor's accepts valuation periods shorter than 45 business days but will apply a haircut to recoveries. Standard & Poor's can also accept a valuation period shorter than 45 business days without implementing the haircut if the definition of a successful bid is modified to include a price floor no lower than the recovery assumption made for the transaction when the bidding starts prior to the 45th business day. If the valuation period is shorter than 45 business days, acceleration can no longer be elected as a credit event. To the extent that the valuation period is shorter than 45 business days and no adjustment is made to the definition of a successful bid, Standard & Poor's will apply a 50% haircut to the base-case recovery assumption. Once again, in the case of an obligation that is domiciled in the U.S., the recovery assumption will be lowered as follows. Base-case recovery assumptions in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Haircut for specified currencies = 2.5% x 37% = 0.93% Haircut for convertibility/exchangeable or consent-required loans = 2.5% x 37% = 0.93% Haircut for insufficient period before bidding = 50% x 37% = 18.5% Net recovery assumption in the U.S. = 37% % % % % = 14.8% g. The Old Restructuring Haircut Other haircuts applied by Standard & Poor's are imposed to adjust for the increased likelihood that a credit event will occur compared with the probability of default indicated by Standard & Poor's corporate default study. The main haircut of this type is for the unmodified (old) restructuring credit event. The bilateral loan provision in the old version of the restructuring credit event sometimes led to simple restructurings of loans between a single bank and an obligor being deemed credit events, even if no economic value had been lost. This kind of restructuring would not normally be captured in the corporate default study; that is, Standard & Poor's would not consider such action as tantamount to default and therefore SECTION 3 PAGE 25

27 expects the frequency of this kind of restructuring to be greater than that of other types of default or selective default actions. Hence, Standard & Poor's increases the probability of a credit event occurring (indirectly, by lowering the recovery rate) when this credit event is used. The 2001 modification of the ISDA confirmation eliminates this problem by stipulating that bilateral restructuring does not constitute a credit event. The one exception is in Japan, where all publicly disclosed bilateral restructurings are considered to be captured in the default study. Thus, Japan is the one domicile in which transactions may be structured to include old restructuring as a credit event with no penalty. This issue is becoming moot, however, as the Japanese market is moving to a two-credit event environment. The haircut for old restructuring also incorporates a cheapest-to-deliver component through the maturity limitation. The maturity limitation stipulation in the modified restructuring definition of the ISDA supplement restricts the maturity of obligations eligible to be bid upon. This prevents the calculation agent from selecting the most long-dated obligation available, which a restructuring company would be more likely to ultimately default upon (in comparison with an obligation with a shorter maturity). Consequently, the bid on such an obligation is likely to be lower. Standard & Poor's will assign a 10% haircut to the base-case recovery assumption to address this risk when modified restructuring or modified modified restructuring are not included as credit events. In the case of an obligation that is domiciled in the U.S., the recovery assumption will be lowered as follows. Base-case recovery assumptions in the U.S. = 37% Haircut for general cheapest-to-deliver = 5% x 37% = 1.85% Haircut for specified currencies = 2.5% x 37% = 0.93% Haircut for convertibility/exchangeable or consent-required loans = 2.5% x 37.0% = 0.93% Haircut for insufficient period before bidding = 50% x 37% = 18.5% Haircut for old restructuring = 10% x 37% = 3.7% Net recovery assumption in the U.S. = 37% % % % % - 3.7% = 11.1% h. Additional Haircuts for Physical Settlement Standard & Poor's will apply a haircut to the base-case recovery assumption if the deliverable obligation could be denominated in a currency other than the floating payment currency, due to potential exchange rate movements that could occur between the moment the asset is delivered and the moment the recovery is established. Thus, there is one standard haircut that Standard & Poor's applies in transactions with physical settlement mechanisms, namely, the currency fluctuation haircut. In order to estimate the haircut that should be imposed due to currency fluctuations, Standard & Poor's utilizes an in-house model that estimates foreign exchange movements between specified currencies over a given exposure period. Currently, this model indicates that over a 45 business-day period the maximum change in two specified currencies is 21% at a 'AAA' level of probability. Thus, Standard & Poor's will assign a 21% haircut to the base-case recovery assumption for this risk. In the case of an obligation that is domiciled in the U.S., Standard & Poor's will lower the recovery assumption under physical settlement as follows. Base-case recovery assumption in the U.S. = 37% Haircut for currency fluctuations = 21% x 37% = 7.8% Net recovery assumption in the U.S. = 37% - 7.8% = 29.2% C. Calculation of Credit Enhancement 1. Introduction The determination of the credit enhancement needed to achieve the desired rating is key in CDO transactions. Credit enhancement is affected by both the underlying credit risk and certain structural features of the transaction. The assessment of credit enhancement levels typically begins with an evaluation of the default frequency of the proposed asset portfolio using the CDO Evaluator, as described above. Absent excess spread, a transaction would require a level of credit enhancement equal to the gross default rate (as determined by the CDO Evaluator) minus the recoveries (as assigned to each transaction) to achieve the required rating. This analysis is typically sufficient for most unfunded CDS and synthetic portfolio CDOs. In managed synthetic transactions and synthetic portfolio CDOs with a cash flow component, however, credit is given to excess spread from the assets. Therefore, the required credit enhancement can be reduced because this excess cash will be used to absorb losses before the noteholder bears any. Thus, the level of hard credit support for a note tranche is established by running cash flows to prove that, under the proposed transaction structure, the rated tranche can sustain the commensurate level of defaults and still pay out in accordance with its stated terms (see section IV.F). SECTION 3 PAGE 26

28 In addition to a transaction's structural basics, most transactions have additional features that must be factored into the rating analysis. These may include the manner in which the priority of payments is structured, the way in which the interest and/or foreign currency hedges work, liquidity considerations, and the way trading losses are dealt with. Once the necessary level of credit enhancement is calculated, the next step is to determine how that credit enhancement is provided. The credit enhancement is typically provided by subordination of lower and/or unrated tranches but there can be other forms of support, such as overcollateralization. 2. Subordination as Credit Enhancement One of the most common forms of credit enhancement in CDOs is the subordination of junior tranches. In multitranche or senior/subordinated CDOs, the subordinated or junior tranches support the senior tranches (see chart 11). In synthetic CDOs, the issuance proceeds from debt and equity are used to purchase collateral, which is used to make principal and contingent payments in an amount equal to the rated debt tranches plus the equity share. Since the equity is not typically rated, the value of the asset pool supporting the rated debt tranches is greater than the amount of these tranches. Thus, there is a loss amount that the assets can sustain without immediately affecting any of the debtholders. The waterfall in the transaction prioritizes the payments to each class of debtholders. In CDOs, payments are typically paid sequentially. Thus, holders of the senior debt tranche have priority of payment over the holders of any junior debt tranche. As a result of their subordinated status, the junior tranches are generally rated lower than the senior debt but they receive a higher level of compensation. A distinguishing feature of some synthetic CDOs is that they issue only one tranche as opposed to various tranches (see section VIII.D). In this case, subordination is not provided by junior tranches but by incorporating a threshold amount in the structure. The threshold amount will determine at which moment the investor will suffer a loss (see chart 12 overleaf). For example, the sponsor of a synthetic portfolio CDO issues one tranche and wants to achieve a 'AA' rating. After analyzing the default risk of the portfolio and assigning the appropriate recovery rates, Standard & Poor's confirms that the appropriate level of credit enhancement to achieve a 'AA' rating is 3%. In the documentation, the sponsor will set the threshold at 3%. Therefore, once the net losses in the portfolio exceed 3%, the investors will suffer a loss. The sponsor will bear the first 3% of losses or enter into separate hedges to cover this risk. Synthetic CDO transactions that issue various tranches can also use thresholds. Typically, the upper and lower thresholds need to be identified, thereby effectively defining the band of risk taken by the investor of a particular tranche. The credit enhancement can be set at a higher level than the minimum required according to Standard & Poor's analysis. Therefore, it is necessary to check the minimum required subordination based on the net loss and structure of the transaction and the subordination that is actually SECTION 3 PAGE 27

29 available in the transaction. Some transactions have more cushion than others. The threshold can be fixed for the entire life of the transaction or can also move depending on the available excess spread. 3. Overcollateralization as Credit Enhancement Instead of using subordination, the senior debt tranche can be supported by an excess of collateral or overcollateralization. The overcollateralization amount defines the ratio of available funded and unfunded resources of the synthetic CDO over its funded and unfunded liabilities. Depending on which particular debt tranche this is designed to protect, a ratio trigger will typically lead to early amortization or trapping of excess spread to build credit support. For partially funded or funded synthetic transactions the overcollateralization is similar to that encountered in traditional cash CDO structures. For unfunded CDSs, the trapping of excess spread can be put into a reserve account or the attachment credit enhancement for the unfunded tranche can be increased. 4. Other Forms of Credit Enhancement: Cash Collateral or Reserve Amounts Excess cash is held in highly rated and liquid investments that provide surety to the debtholders, generally in an account under the control of the trustee or custodian. Reserve accounts are less common in synthetic transactions as there are no cash proceeds from the sale of assets (except for a possible trading gain). However, some synthetic transactions establish a cash reserve account up front and use it for trading losses. Once the reserve fund is depleted, trading is no longer allowed. 5. Other Forms of Credit Enhancement: Excess Spread When the income earned on the assets is higher than the interest and fees that need to be paid to the noteholders, excess spread is generated. This excess spread can be used to provide additional subordination. The existence of excess spread in a transaction is established by running cash flows to prove that, under the proposed transaction structure, the rated tranche can sustain the commensurate level of defaults and still pay out in accordance with its stated terms. Standard & Poor's will therefore analyze the cash flow model presented by the transaction's sponsor and require that certain stresses are run, including amount of default, timing of defaults, default patterns, timing of recoveries, and interest rate stresses (see section IV.F). Excess spread can also be provided where the CDS counterparty pays a premium that is higher than the sum of all the payments that need to be paid to the noteholders. The rating on the counterparty who makes the excess payments is vital (see section V). Transactions can also only start to trap excess spread once a trigger is hit or losses exceed a certain amount. Therefore, if no trigger is hit or if there are no losses, no benefit can be given to the excess spread. Other transactions guarantee a fixed spread on a shrinking portfolio (even due to losses). Therefore, as the liabilities are reduced, there are more funds available to pay the remaining liabilities. There are many other ways to trap excess spread, such as spread trapping linked to trading in the portfolio (e.g., once there are a certain amount of losses due to trading, excess spread needs to be trapped). SECTION 3 PAGE 28

30 6. Credit Enhancement That is Built Up Over Time In some synthetic portfolio CDO transactions, a counterparty will add credit enhancement in the transaction over time. Standard & Poor's will assess the minimum level of credit enhancement needed at closing by imposing a certain number of defaults that the structure has to withstand in its first year based on Standard & Poor's synthetic cash flow default patterns. The build-up of credit enhancement needs to be cumulative and the frequency with which new credit enhancement is injected will be an important element of the analysis. Typically, the credit enhancement is provided by a threshold and therefore there is no actual cash injection in the transaction by a counterparty. If a counterparty has to make future payments, the counterparty risk must be carefully examined. 7. Credit Enhancement: Payment Allocations The manner in which collateral principal payments and losses are allocated among tranches has an impact on the level of credit support for each tranche over time. All payment structures represent different trade-offs between paydown and support of the senior class, versus return of cash to the junior debt and equity holders. There are several types of payment structures, of which the most commonly used are sequential pay, pro rata pay, and fast/slow pay. Synthetic CDO transactions typically are sequential pay structures, requiring payment in full of senior debt before the payment of junior debt. Different payment allocation structures can be considered on a case-by-case basis, such as pro rata paydown structures where available funds are allocated to pay down principal on the rated debt in proportion to the size of each tranche (i.e., pro rata). Thus, the degree of overcollateralization is maintained at the same percentage until retirement of the senior class. An added feature in most synthetic CDOs is that a large portion of the liabilities are in unfunded form, typically provided by a super senior swap counterparty who usually occupies a senior position. SECTION 3 PAGE 29

31 SECTION IV: TIMELY PAYMENT OF INTEREST AND ULTIMATE PAYMENT OF PRINCIPAL In a funded or partially funded CDO, Standard & Poor's rating on the issued notes addresses the likelihood of full payment of interest either on a timely or ultimate basis, and ultimate payment of principal. The source and timing of all the payments that need to be made according to the terms of the notes is therefore an important element in Standard & Poor's analysis. These payments can include interest, principal, fees, creditprotection payments, trading losses, and termination payments. Nonpayment of any of these amounts typically constitutes an event of default or termination event. This analysis is not relevant for the credit assessment of unfunded CDSs, given that in most cases the credit assessment addresses only the credit risk of the underlying reference portfolio and not any of the payments that need to be made by the counterparties. Standard & Poor's rating also addresses the terms of the issuance and the exact promise to pay that is made by the note issuer to the investors. The issuance should be viewed as a contract between the issuer and the investors, with the issuer making a promise to the investors to fulfill a financial obligation and the rating reflecting the terms of this contract. It is not acceptable for the rating to carve out certain elements and Standard & Poor's will therefore, at a minimum, rate the entire obligation to its explicitly stated terms. For example, Standard & Poor's can rate a note that pays a stated rate of interest that is less than the current market rate but is priced at par because this is the stated rate of interest according to the terms of the notes. Standard & Poor's can also rate a note only to the payment of principal, but only if all interest payments are residual, or a note that is issued with a zero coupon that may be optionally redeemed at accrued but less than par. However, Standard & Poor's cannot rate a note on a principal-only basis if it has a stated rate of interest. Similarly, it cannot rate a note to a lower coupon than the stated coupon in the note. A. Interest 1. Amount of Interest Payments Funded and partially funded synthetic CDOs typically pay a stated coupon, either fixed or floating (typically based on LIBOR or EURIBOR), on each interest payment date during the life of the transaction. The interest payment date can have any payment frequency but is most often quarterly or semi-annually. The coupon can also step up or step down at certain points in the transaction. If the step-up rate of interest is scheduled, Standard & Poor's will rate the notes based on the entire coupon, i.e., the increased or decreased rate. However, the note cannot be rated in this case based only on the coupon before the step-up, unless the step-up rate of interest is purely residual. Key for not including it in the rating analysis is that the interest must not be contractual but residual and based solely upon availability and not the promise to pay. Standard & Poor's does not prescribe what the coupon amount should be but will rate the notes according to the stated coupon. Another important element is the amount on which the interest is calculated. In synthetic CDOs, unlike cash CDOs, liabilities (i.e., the notes) can be temporarily decreased, after the occurrence of a credit event, by the full amount of the defaulted obligation. The liabilities are subsequently written up with the recovered amount, once recoveries have been established, by going through the settlement process. A relevant question is whether the interest should continue to be paid on the full notional amount of the liabilities before write-down or whether no interest should be paid during the settlement process. Standard & Poor's requests that any missed interest payments on the recovered amount during the settlement period have to be retroactively sized and paid to investors. In addition, the interest on this interest, representing the cost to the investor of a missed payment, should also be paid. In static portfolios, only the yield received on the collateral should be paid to the noteholders. Therefore, the premium portion will be lost if there is a credit event. The reason is that when a credit event on a reference obligation occurs, the premium payments from buyer to seller immediately cease. This needs to be clearly disclosed to investors. In synthetic transactions with modeled cash flows, the EURIBOR/LIBOR plus spread would be modeled in Standard & Poor's analysis. 2. Timing of Payment of Interest Standard & Poor's rating addresses full payment of interest either on a timely or ultimate basis. If Standard & Poor's rates on a timely basis, interest must be paid according to the terms and conditions of the notes and nonpayment of interest on the stated date will lead to an event of default. If the rating is given on an ultimate basis, nonpayment of interest on the stated date according to the terms and conditions of the notes will not trigger an event of default as long as all the outstanding and capitalized interest is paid at maturity. This can either be proven in the cash flows or be a payment obligation of a suitably rated coun- SECTION 4 PAGE 30

32 terparty. Standard & Poor's general CDO criteria ("Global Cash Flow and Synthetic CDO Criteria") apply to synthetic CDOs with regards to deferrable interest or PIK securities. In synthetic CDOs, interest may be deferred on tranches rated 'BBB+' or lower for the life of the transaction. Interest on tranches rated 'A-' may be deferred for a maximum period of three years, after which they must pay timely interest. No deferral is permitted on tranches rated higher than 'A-' unless they are defined as "deferrable interest tranches" in the documentation. Similarly, interest may be deferred on 'A-' rated tranches for more than three years as long as the tranche is defined as a deferrable interest tranche. 3. Source of Interest Payments In a synthetic portfolio CDO, interest is typically paid from a combination of (i) premium payments received from the protection buyer and (ii) income received from the collateral (see chart 13). Typically, the income on the collateral pays the floating part of the coupon and the premium will pay the fixed part. When the interest payments on the notes are funded by the premium payments made by the protection buyer, the analysis of the protection buyer's rating will be key. The required rating on the notes will determine the rating required for the protection buyer. Standard & Poor's considers the short-term rating on the CDS counterparty given that nonpayment of the premium will lead to termination of the transaction at no cost. If the counterparty no longer has the required short-term rating, it needs to be replaced with a suitably rated counterparty at no cost or a suitably rated guarantor must be found. If no replacement swap counterparty or guarantor can be found, the swap must be terminated at no cost to the SPE and the noteholders should not suffer any losses. In addition, it can also collateralize its obligations, typically by paying the premium in advance. If this advance premium payment is not made, the transaction must terminate early with no loss to the noteholders (see section V). Interest can also be paid from income received from the collateral. If the collateral is cash, the cash must be held in a suitably rated bank. If the collateral consists of debt securities, it must be adequately rated. Alternatively, a reverse repo agreement or put agreement can be entered into, in which case both the rating on the collateral and the rating on the repo counterparty or put counterparty become relevant (see section V). Standard & Poor's will check whether there is a mismatch between the LIBOR/EURIBOR rate payable on the notes and the LIBOR/EURIBOR rate received from the collateral, and how the currency risk is being dealt with in case the notes are issued in a different currency than the currency of the collateral. In CSO transactions, interest is paid from the income received from the portfolio of assets (see chart 14 overleaf). As these assets are typically CDSs, the cash flow will be generated from the premiums received from the various protection buyers. A unique feature of CDSs is that they entail bivariate risk, i.e., the risk of the underlying asset and the risk of the counterparty that has to make SECTION 4 PAGE 31

33 the payment. Therefore, Standard & Poor's must analyze not only whether the assets generate sufficient premiums but also whether the parties paying those premiums are adequately rated. First, to analyze if the cash flow generated from the reference portfolio of CDSs is sufficient to pay all the interest as stated in the terms and conditions of the notes, Standard & Poor's will analyze a transaction-specific cash flow model provided by the originator or sponsor. Alternatively, Standard & Poor's may conduct its analysis using an in-house proprietary model. The cash flow model must accurately reflect all cash inflows and outflows according to the terms and conditions of the notes, including payment priority, triggers, hedging structures, and the intrinsic cash flow characteristics of the assets. Standard & Poor's will impose various stresses on the model, including the expected level of gross defaults, the timing of defaults, the patterns of default, the timing of achievement of recoveries after default, the level of recoveries, and interest rate stresses (see section IV.F). Second, to analyze the risk of the CDS counterparties who make the premium payments, Standard & Poor's will verify the ratings on those counterparties (see section V). B. Fees An analysis of the fees payable in a synthetic CDO is important for two reasons. First, funds that would otherwise be available to pay interest and principal will no longer be available as they are used to pay fees. Second, if the counterparties do not pay the fees, they will no longer be inclined to fulfill their roles, which are vital for the continuation of the transaction. To ensure that key parties like the trustee perform their duties, Standard & Poor's checks that certain will fees be paid before any payments are made to the noteholders by verifying if these payments are first in the priority of payments. For the same reason, Standard & Poor's is concerned about the level of fees, particularly the collateral manager's fees. The initial or modeled amount of management fees needs to be sufficiently high to ensure that the transaction can withstand an increase in such fees in case the manager needs to be replaced at a higher cost. A minimum fee of 25 bps is usually modeled in Standard & Poor's analysis. To ensure that there are sufficient funds in the transaction to pay the fees, Standard & Poor's will analyze the size and source of the fee payments. The amount of fees is either precisely stipulated in the documents or left open, in which case it cannot be sized. Standard & Poor's will therefore require that the fee amount be either capped or clearly referenced in the various arrangements with the counterparties. The fees can be paid outside the transaction, in which case they do not form part of the rating analysis. Fees can also be paid by a counterparty, in most cases the CDS counterparty. The counterparty will therefore need to be suitably rated or it will need to collateralize its obligations (see section V). In CSO transactions, fees are paid from the cash flow generated by the CDSs in the reference portfolio. As described above, the fees need to be included as a cash outflow and subjected to various stresses in Standard & Poor's analysis. SECTION 4 PAGE 32

34 C. Termination Payments/Trading Gains and Losses Synthetic CDOs face the risk that the counterparty will chose to terminate the credit derivative contract. In addition, in managed transactions and CSOs, the manager can trade in and out of the CDSs that make up the underlying reference portfolio by terminating the CDSs. This leads to a risk of loss of premium and creates a need to make a termination payment because the mechanics of the CDS demand a mark-to-market on the CDS contract at the time of termination. Where the associated credit spread has widened in the traded market relative to the spread when the contract was initiated, the swap is "out-of-the-money" for the SPE and the SPE will have to make a payment. This payment is called the termination payment. The termination payment must therefore either be sized or subordinated to the rated noteholders in the priority of payments unless termination is caused due to default of the SPE, or in the case of a credit event where the SPE is the sole affected party. The alternative is to eliminate the responsibility to make such a payment by rendering section 6(e) of the ISDA master agreement (which deals with payments on early termination) not applicable. Although in the majority of synthetic transactions trading gains and losses are outside the transaction and therefore outside the scope of the rating analysis, in some managed synthetic transactions, the CDO bears the losses. Although trading gains do not affect the rating analysis, unless they provide additional credit enhancement, trading losses can have a negative impact on the CDO. Typically, the managers in these transactions use the CDO Monitor. Each time the CDO Monitor is run the breakeven default rate is adjusted to reflect any par gains or losses (see section VI). Alternatively, in structures that do not have a cash flow component, the trading loss will be deducted from the available subordination before the trade is made. There are also transactions that have a reserve fund for trading losses. This fund will have an initial amount and any trading gains will be deposited in this account. Once the account is depleted, the CDO cannot have a trading loss (hence not trade). In addition, all excess spread and recovered amounts can be retained in the transaction to pay for trading losses. D. Principal and Contingent Payments In any CDS, a credit-protection payment needs to be made by the protection seller upon the occurrence of a credit event. The CDS can have either a physical settlement or cash settlement mechanism. In the case of physical settlement, the protection seller must pay the full notional amount of the defaulted obligation to the protection buyer immediately after the occurrence of the credit event and the protection buyer will deliver the defaulted obligation to the protection seller. In the case of cash settlement, the protection seller will have to make a payment (notional amount minus recoveries) to the protection buyer after having gone through the cash settlement process. Therefore, from a funding perspective, the CDO must pay either the full notional amount of the defaulted obligation immediately after the occurrence of the credit event or the recovered amount after the cash settlement period. It must be shown that the CDO has sufficient funds to make these contingent payments, which can occur at any time during the life of the transaction. Contingent payments can be made when they occur or at the maturity date of the transaction. Synthetic CDOs are typically bullet structures and therefore principal payments are made either at maturity of the transaction or upon occurrence of an early termination event, a (regular) termination event, or an event of default. Standard & Poor's will check whether, following a default, the notes are written down without actually being reduced or whether the notes are effectively amortized. Standard & Poor's will also consider whether sufficient funds are available to repay the noteholders in full each time principal needs to be paid. Given that termination events can occur at any time, sufficient funds must always be available, unless the termination events are ratings remote. 1. Source of Principal and Contingent Payments In synthetic CDOs the proceeds of the notes are invested in collateral as, unlike cash CDOs, the proceeds are not needed to purchase assets. The collateral is typically used to pay principal and credit-protection payments. There can be different types of collateral, the most common being cash and securities acquired with or without the use of a repo or put agreement. If notes are issued out of the MTN program of a financial institution, the repayment of principal is typically the obligation of that financial institution and therefore the rating on the notes will be capped at the rating on the issuing financial institution. A liquidity facility can also be used to make contingent payments. The following is a brief description of the various options available with respect to the investment of proceeds. Cash account/gic account. The proceeds of the notes are kept in cash deposited in a bank SECTION 4 PAGE 33

35 account or with a GIC provider. The advantage of using a GIC account is that a guaranteed rate of income will be paid, rather than a variable amount. Nevertheless, Standard & Poor's requires that the GIC account be modeled at LIBOR or EURIBOR minus 100 bps in case it needs to be replaced. In addition, the bank account or GIC account provider must be appropriately rated (see section V.D). Reverse repo agreement. Where the proceeds of the notes are invested in collateral via the use of a reverse repo agreement, Standard & Poor's will review the repo agreement, confirm that the repo counterparty and underlying repo collateral is sufficiently rated, and determine how the repo rate is paid (see section V.C). Put agreement. If the proceeds of the notes are invested in collateral via the use of a put agreement, Standard & Poor's will review the put agreement and confirm that the put counterparty is sufficiently rated (see section V.C). Collateral. The proceeds of the notes can also be invested in collateral that matures before or at the maturity date of the notes. The collateral needs to have the appropriate rating. If the collateral is downgraded, the notes will also be downgraded. If substitution of collateral is permitted, strict eligibility guidelines must be in place. Interest rate and/or currency risk relating to the collateral needs to be addressed. Excess proceeds that are not put into cash will need to be invested in eligible investments. Collateral used for contingent payments and principal can also form part of the reference portfolio itself. 2. Principal and Contingent Payments: Hybrids In hybrid transactions, the proceeds of the notes are partially or fully used to purchase assets. Since not all the proceeds of the notes are available to make payments after credit events or to make principal payments, another source needs to be available to make these payments. Typically, a liquidity facility is in place for this purpose. The liquidity provider needs to have the appropriate rating (see section V.B). 3. Principal and Contingent Payments: Market-Value Risk Market-value risk arises when collateral needs to be liquidated to make credit-protection or principal payments. When liquidating collateral, the sale amount can be lower than the par value of the assets and therefore the noteholders may not be repaid in full. Standard & Poor's will analyze how this market risk is covered in the structure. The amount of collateral is usually greater than the par amount of the notes issued. This extra collateral will make up for the market loss when selling the collateral at less than par. Standard & Poor's will determine the required overcollateralization by reviewing the collateral and assigning advance rates or overcollateralization levels as appropriate. The rating on the collateral will also be an important element in Standard & Poor's analysis. When determining the overcollateralization levels, liquidity and the exposure period are of particular concern. Standard & Poor's will therefore typically request a detailed description of the transaction structure, the historical daily pricing data of a representative market index or the individual collateral for a sufficiently long time series, and a description of the exposure period (which typically comprises the mark-to market frequency, the cure period, and the liquidation period). In transactions with a physical delivery settlement mechanism the manager can hold on to the obligations until maturity or sell them. This must be clearly disclosed in the documentation. Standard & Poor's will also check that the denomination of the collateral allows for the physical delivery of collateral in the exact amount of the payment obligation. Alternatively, the market value risk can be mitigated by having an adequately rated counterparty pay the difference between sale price and par amount. In such a case, Standard & Poor's will check that the counterparty is adequately rated. E. Liquidity Considerations Given that timely payment is paramount in Standard & Poor's analysis, some transactions include a liquidity facility, which makes up for potential cash shortfalls. Standard & Poor's will check the rating on third-party liquidity providers and consider how the liquidity provider is to be repaid (see section V.B). F. Cash Flow Analysis Most synthetic CDO transactions have perfectly matching cash flow structures for all items in the priority of payments and therefore there is no need to analyze a cash flow model. Where there is reliance on cash flow matching, the rating on the supporting counterparty and/or the structural features of the transaction become key factors in Standard & Poor's analysis. It is very common to see synthetic transactions with structural features and minimum rating requirements that, once breached, will trigger an early termination of the notes (as long as the early termination of the notes is unlikely to cause any losses to investors). SECTION 4 PAGE 34

36 The only added risk for investors should be the prepayment risk. Nevertheless, in synthetic transactions where the cash generated from the assets is used to make payments on the rated notes, Standard & Poor's will analyze the cash flow model presented by the originator/arranger. 1. Synthetic CDOs in Which Cash Flows Are Not Matched Cash flow analysis becomes relevant in transactions where cash flows are not perfectly matched (see chart 15). Typically, the SPE enters into various single-name CDSs, either to buy or sell protection from one or more counterparties. The final capital structure for this type of synthetic CDO transaction is determined by assessing the credit risk by using the CDO Evaluator and by modeling cash flow simulations under different assumptions. The aim of this analysis is to determine whether each tranche can withstand portfolio defaults up to the default rates as determined by the CDO Evaluator and commensurate with the desired rating. The output of the cash flow model is the breakeven default rate for each tranche. 2. Parameters of the Cash Flow Analysis for Non-Matching Cash Flows The parameters incorporated in the cash flow analysis for synthetic transactions do not differ from the parameters for cash flow arbitrage transactions. They are: Transaction payment priority and triggers; Intrinsic premium characteristics of the individual CDS; Default rate: the expected level of gross defaults; Default timing: when defaults will occur during the life of the transaction; Default patterns: pattern of defaults that will occur once defaults start; Recovery timing or settlement process: when recoveries will be achieved after a credit event occurs; Recovery levels: the amount of the recoveries achieved; Interest rate curves: different interest rate paths; and Hedge structures. If a transaction has multiple tranches, cash flows will be run for each tranche to assess whether the level of credit support provided is consistent with the rating sought on each tranche. Cash flow analysis is also used for sizing the liquidity that needs to be present in order to fund the credit-protection payments. This is particularly relevant for synthetic CDOs in which the proceeds of the notes are used to purchase collateral that does not necessarily provide cash in a timely manner to fund the credit-protection payments. The cash flow analysis is based on the parameters specified by the transaction documents. At closing, the SPE may not have entered into all the CDSs, although it is very common to see the portfolio of CDSs fully ramped up at closing. The transactions are modeled based on the aggregate characteristics of the portfolio of CDSs. Thus, defaults are assumed pro rata across the SECTION 4 PAGE 35

37 portfolio. The cash flow modeling will determine the maximum breakeven default rate that the transaction can withstand at each tranche and with different sets of parameters. If the breakeven default rate is greater than the scenario default rate calculated by the CDO Evaluator, then that tranche can achieve the desired rating. In addition, cash flows must reflect the eligibility and reinvestment criteria based on minimum and maximum covenants specified in the transaction documents. 3. Default Rates The default rate is rating-scenario specific and is expressed as a percentage of the original assetpool balance. The asset-pool balance multiplied by the scenario default rate equals the total dollar amount of gross defaults that the transaction must be able to withstand at the given rating. The default rate provides no indication of how and when defaults will occur, when recoveries will be achieved, and what the level of recoveries will be, if any. All of these parameters must be modeled in the cash flow analysis and are discussed in the next sections. 4. Default Patterns The default patterns specify what percentage of the total default rate will occur in each year, once defaults start. The patterns are as follows. (%) Year 1 Year 2 Year 3 Year 4 Year 5* Scenario 1: Scenario 2: Scenario 3: Scenario 4: Scenario 5: ** 20 Scenario 6: *The same scenarios are then run for years 2-6, then 3-7, and so on. **Scenario 5 is run five times with the 50% moved between each of the five years. As is the case with traditional cash CDOs, Standard & Poor's subjects all transactions to both a no-default run and a set of runs where the default rate is spread out evenly over six to 10 years. However, particular to synthetic CDOs is that the tenor is typically short. 5. Default Timing Defaults may start soon after the transaction closes, or may occur after the transaction has been outstanding for a number of years. Since each individual CDS has a bullet maturity, the starting time for defaults can be pushed further back. This is not possible if the pool is amortizing, as in the case of traditional cash CDOs. Given that synthetic CDOs typically have a bullet maturity, defaults will need to be modeled until maturity. Accordingly, starting times for defaults are generally pushed back one year per rating category, starting with tranches rated 'A' and below. 6. Modeling Defaults Typically, defaults are assumed to start in year 1 on the last day of the last period of year 1 of the transaction. After the first year in which they occur, defaults should be modeled as occurring semi-annually on the last day of the period. Alternatively, defaults after first occurrence may also be modeled in one lump sum at the end of each subsequent year. 7. Recovery Rates Recovery rates specify the amount of money received by the SPE for transactions with a physical delivery settlement mechanism or the amount that reduces the credit-protection payment made in cash-settlement transactions with respect to a reference obligation after a credit event has occurred (see section III). Once specific recoveries are assigned to each class of reference obligations eligible for inclusion in the transaction, the cash flows for the transaction are modeled at the minimum weighted-average recovery rate. This assumes that the collateral manager will have the highest concentration of low-recovery assets permitted by the transaction. 8. Recovery Timing Recovery timing specifies the time it will take to achieve recoveries once a reference obligation defaults. Unlike transactions that employ physical delivery settlement, cash-settled transactions require a bidding process on specific dates after the credit event date (valuation dates). The cash flow models should lag recoveries in accordance with the specific requirements of the transaction. For transactions with physical delivery settlement Standard & Poor's assumes that the manager will work out the delivered obligation one year after the credit event date. Once recoveries are achieved, they are available to either pay down the rated notes or be reinvested. The use of recoveries is driven by the transaction specifics, and the cash flow modeling should reflect this. 9. Interest Rate Stresses It is necessary in synthetic CDOs to test the transaction under different interest rate paths. Transactions are stressed under the following index scenarios: index up, index down, index down/up, forward curve, at swap, and at cap. The interest curves are adjusted to match the length of the transaction and vary by rating level. SECTION 4 PAGE 36

38 10. Biased CDS Defaults The migration of ratings in CDOs, both traditional cash flow and synthetic, are modeled based on the general pool characteristics and on a pro rata default across the portfolio. Nevertheless, it is sometimes appropriate to test certain biases in default. For example, in synthetic CDOs, it is very common to not have an interest coverage ratio. If the distribution of premiums is very different, however, a credit event on the reference obligations that are paying the highest premium could lead to delayed payment or PIK of the lowest-rated obligations. As a result, Standard & Poor's needs to be satisfied that the minimum spread test can be achieved. In addition, if there is no interest coverage ratio and the portfolio is static, then Standard & Poor's will look at the distribution of premiums around the average. If the distribution looks normal, then the cash flow can be modeled based on the average. If the distribution is either bar-belled or skewed, the cash flow should bias defaults, starting with the highest premium assets and defaulting in order of premium until the entire amount of default is covered. For actively managed deals, it depends on how the premium reinvestment test is set and what pools the manager will invest in. To test for such interactions, Standard & Poor's will request certain cash flow runs where defaults are biased toward the highest-yield CDS. 11. Asset-Payment Characteristics, PIK, and Long-Dated Assets The cash flow model must accurately reflect the payment characteristics of the obligation pools. Asset eligibility criteria generally define the required payment frequency of the CDS and the limit on the number of reference obligations that may pay less frequently than the rated liabilities. It is also very common in hybrid CDOs that include ABS to run stresses on the ABS obligations, which include PIK or payment deferral features. Standard & Poor's typically requests stresses where the assets pay in kind for the life of the transaction. These are designed to size the liquidity needed to pay required timely interest on the rated senior liabilities. Long-dated assets are also very common in hybrid transactions. Typically, the rated liabilities have a maturity that is shorter than the legal final maturity of the ABS. Although some of the ABS may have call options, Standard & Poor's will assess whether credit can be given to the call option. 12. Premium of the CDS Standard & Poor's cash flow analysis will assume the minimum weighted-average premium. G. Priority of Payments 1. Waterfalls In cash CDOs, the principal and interest priority of payment waterfalls drive the transaction's allocation or distribution of cash flows down the capital structure. Synthetic CDOs also have cash waterfalls that dictate how premiums, interest, and cash from the collateral accounts will be distributed. However, these waterfalls are typically much simpler than in cash CDOs. The distributions may occur periodically, at the end of the transaction (typically in synthetic portfolio CDOs), or sooner (for example, if a transaction unwinds due to an event of default under the notes). Synthetic portfolio CDOs have a very simple waterfall due to the source of payments typically being one counterparty. These structures do not have combined interest and principal waterfalls but a simple priority of payments as follows (in order of priority): payment of fees to the various participants, payments to the CDS counterparty (except for termination payments), interest and principal payments to the noteholders, and termination payments. If the transaction is a partially funded synthetic portfolio CDO, the payments to the super senior swap counterparty (except termination payments) will also rank prior to the payments to the noteholders. The priority of payments becomes more complex in a CSO transaction. These transactions usually have separate waterfalls before and after enforcement and these are, in turn, split into interest and principal waterfalls. Standard & Poor's reviews the language of the principal receipts to check that they are not inadvertently passed down the interest waterfall to the noteholders. The inclusion of catch-all language in the principal proceeds definition to cover any unexpected items is preferred. Standard & Poor's will carefully scrutinize the definition of "principal distribution amount" to identify any potential leakages to equity. 2. Application of Principal Versus Interest Proceeds From the perspective of the investors, stronger transaction structures will include the trapping of trading gains in principal proceeds, allowing the manager to increase overcollateralization to support the notes. Following a breach of the coverage SECTION 4 PAGE 37

39 test, most CDOs use interest proceeds to pay down senior notes and use principal proceeds only to the extent of a shortfall. Nevertheless, some transactions use principal proceeds for both purposes right from the beginning. 3. Fees in the Priority of Payments Fees should be senior in the priority of payments because if they are not paid, the transaction participants such as the trustee, custodian, and paying agents will no longer be prepared to perform their duties and the transaction will therefore terminate. A cap on the payment of administrative expenses and fees to various participants should be implemented as it will otherwise be difficult to adequately model fees in the cash flow analysis. In addition, the senior collateral management fee should be sufficient to entice a replacement collateral manager should such substitution become necessary. If the fee is too low, Standard & Poor's will stress the cash flows to include an appropriate fee. 4. Termination Payments in the Priority of Payments Hedge termination payments may or may not be above the senior-most class in the priority of payments, but will rank after the capped transaction expenses. Future hedge termination payments are very difficult to accurately size. Any termination payment due from the SPE to any hedge counterparty must be subordinated to the rated notes, if such payment is due because the counterparty defaulted on its obligations. If the payment is due to the SPE defaulting, then it may be senior in the priority of payments. Alternatively, the termination payments can be removed completely from the priority of payments by deleting section 6(e) (payments on early termination) in the ISDA master agreement governing the swap. For ongoing hedge payments, the termination payments can be senior if they are received from the new counterparty (i.e., termination payments will come from the money received from the new counterparty). If no funds are received from the replacement counterparty, the payment will be zero. In addition, a legal analysis as to the enforceability of these mechanics in the proposed jurisdiction is necessary. SECTION 4 PAGE 38

40 SECTION V: COUNTERPARTY RATING AND COLLATERAL REQUIREMENTS A. Overview Counterparty risk arises each time the synthetic CDO relies on a counterparty to make a payment and/or is subject to the termination risk of the counterparty. Counterparties in synthetic CDOs can have many different roles: CDS counterparty, repo counterparty, interest rate swap counterparty, account bank, etc. The different counterparty roles can be executed by one entity or by many entities. Standard & Poor's risk assessment will depend on the role of the counterparty and the assessment of the exact exposure to that counterparty. The rating requirements for the counterparties will be driven by the rating on the highest-rated note in the transaction. If the counterparties do not have an adequate rating, additional collateral may be required. The counterparty risk can be "de-linked" from the transaction using rating triggers and replacement language. If there are no such triggers, the ratings on the notes will be linked to the rating on the counterparty. Chart 16 and the discussion illustrate the wide variety of counterparties in synthetic CDOs, using the example of a hybrid CDO. In a hybrid transaction, the issuer, through the manager, will enter into CDSs and purchase cash assets. The issuer will not keep the credit risk of the cash assets and CDSs but will transfer it to investors by issuing notes (funded portion) and entering into CDSs (super senior swap) on the liability side. The issuer, when selling protection, will typically use the premiums received from the CDS counterparties to pay interest on the notes. Therefore, the ratings on these counterparties are important. The issuer can also enter into a CDS to buy protection, in which case it relies on the CDS counterparty to make the contingent payments. Once again the rating on the CDS counterparty is important in this case. The proceeds of the funded notes are typically deposited in a cash account or invested in other forms of collateral. Additionally, a repo agreement or put agreement can be put in place. The collateral will be used to fund the purchase of the cash assets, pay the credit-protection payment after the occurrence of a credit event, and redeem the notes at maturity or upon early termination. As the CDO relies on the collateral to make principal and contingent payments, the rating on the collateral and the ratings on the counterparties (i.e., deposit bank, reverse repo, or put counterparty) involved is relevant. A liquidity facility can be used to fund the contingent payments or purchase the cash assets, and therefore the rating on the liquidity facility provider is important. There can also be currency risk and/or interest rate risk, which will need to be hedged with a swap. The interest rate swap and currency swap counterparties need to be adequately rated. Therefore, given the reliance in a hybrid CDO on the payments made by the CDS counterparties, the repo counterparty, put counterparty, liquidity SECTION 5 PAGE 39

41 provider, account provider, interest rate swap provider, and currency swap provider, the ratings on all of these entities are important. As the desired rating on the highest-rated note drives the rating required on the counterparty, the short-to-long-term ratings conversion table will apply (see chart 17). A counterparty, in its role as CDS counterparty (buyer or seller), reverse repo provider, put provider, deposit (cash account) provider, liquidity provider, and interest rate and currency swap provider, can be one and the same entity. Each of these counterparty roles is discussed in the next sections. B. Rating Requirements for Liquidity Providers For 'AAA' rated transactions the liquidity provider must be rated 'A-1+'. Upon downgrade the counterparty needs to be replaced or a guarantor needs to be found. C. Rating Requirements for Reverse Repo and Put Agreement Counterparties If the proceeds of the notes are invested in collateral via the use of a reverse repo or put agreement, the ratings on the reverse repo counterparty and/or put counterparty need to be reviewed. Reverse repo counterparties and put providers rated 'A-1+' are acceptable for 'AAA' rated transactions. If the rating on the repo or put counterparty falls below 'A-1+', then it must (within a 30-day grace period): Find a replacement reverse repo or put counterparty that has an 'A-1+' rating (subject to Standard & Poor's confirmation); Obtain a guarantee from an 'A-1+' rated bank or financial institution in respect of the obligations of the reverse repo or put provider (subject to Standard & Poor's confirmation); Pledge collateral to cover its obligations. The counterparty is required to mark-to-market (plus a volatility buffer) the collateral on a regular basis. The reverse repo or put counterparty will need to top up the collateral when needed to maintain the collateral value; or Employ any other strategy that may be acceptable to Standard & Poor's. The reverse repo and put counterparties need have a minimum rating of investment grade when entering into the transaction. The reverse repo counterparty needs to pledge collateral to ensure that if the collateral needs to be sold upon default of the reverse repo counter- SECTION 5 PAGE 40

42 parties on its obligation to repurchase the collateral, the proceeds of the sale are sufficient to pay off the notes. A put provider guarantees to pay the par value of the collateral and therefore the market risk with respect to early liquidation of the collateral is mitigated. Standard & Poor's will determine the level of overcollateralization, taking into account the exposure period which consists of the frequency of mark-to-market, the cure period, the liquidation period, and the tenor the characteristics of the asset, and the historical pricing data. The collateral eligible for 'AAA' transactions typically consists of eligible investments, government securities of Western European countries (minimum rating of these securities is 'AA-'), or the 'AAA' tranche of ABS transactions. However, any type of collateral is acceptable as long as the overcollateralization levels adequately reflect the market and credit risk. (For further details consult "Eligible Investment Criteria for 'AAA' Rated Structured Transactions", published June 25, 2001 on RatingsDirect and In addition to the rating requirements, there must be an analysis of the ability of the SPE to access the collateral in a timely manner. In some jurisdictions there may be preference risk related to the counterparty which has to top up collateral. Default of the reverse repo or put provider will typically lead to an early termination of the transaction. Therefore, the lower the rating on the reverse repo or put provider, the higher the early termination risk of the transaction. Of course it needs to be ensured that upon early termination of the transaction, the noteholders are still repaid par. D. Rating Requirements for the Cash Account Provider For 'AAA' rated transactions, cash should be held in a bank account or a GIC account provided by a counterparty that has an 'A-1+' rating. If the rating drops below 'A-1+', then the counterparty must, within a 30-day grace period, and subject to Standard & Poor's confirmation: Find a replacement bank or financial institution rated 'A-1+'; Obtain a guarantee from an 'A-1+' rated bank or financial institution; or Employ any other strategy that may be acceptable to Standard & Poor's. E. Rating Requirements for CDS Counterparties When analyzing the rating requirements for CDS counterparties, a distinction must be made between synthetic portfolio CDOs and CSO transactions. In synthetic portfolio CDOs, there is only one CDS counterparty and the transaction has structural features that trigger an early termination of the CDO. These early termination triggers are not present in CSO transactions because there are various CDS counterparties acting as protection buyers and/or protection sellers. Moreover, the termination payments due to the nondefaulting counterparty are senior in the priority of payments. 1. Synthetic Portfolio CDO: Rating Requirements for Single-Obligor CDSs Typically, the CDO sells protection on a portfolio of reference obligations. There is just one CDS and, therefore, the CDO as protection seller faces only one CDS counterparty. The transaction has early termination triggers in case the CDS counterparty fails to pay the premium. For 'AAA' transactions, if the counterparty is rated 'A-1+' the premium payments should be made on the interest payment dates. The reason is that these premiums, together with any income from the collateral, must cover the interest due on the rated notes for those dates. If the CDS counterparty is rated below 'A-1+', the premium payments must be made in advance, i.e., on each interest payment date (e.g., Interest Payment Date 1 in chart 18) for the following interest payment date (e.g., Interest Payment Date 2). SECTION 5 PAGE 41

43 Therefore, the rating requirements for counterparties that have bought protection under a CDS are as follows: If the counterparty is rated 'A-1+' no collateral posting is required. Counterparties rated below 'A-1+' must within 30 days find a replacement 'A-1+' counterparty (subject to Standard & Poor's confirmation), find an 'A-1+' guarantor (subject to Standard & Poor's confirmation), or prepay one premium and a one off payment must be made to cover the grace period for calling a default. The latter must remain in the account for the remainder of the transaction. CDS counterparties need to have an investmentgrade rating when entering into the transaction. 2. Rating Requirements for Multiple-Obligor CDSs In CSOs, the SPE typically enters into various CDSs with various CDS counterparties, either to buy or sell protection. Termination of the transaction upon nonpayment of a premium does not work in this case. If a counterparty defaults, the nondefaulting counterparties will not agree to the subordination of the termination payments in the priority of payments. However, if the termination payments are not subordinated, the SPE can incur nonsized losses. CDS counterparties rated 'A-1+' are acceptable for 'AAA' transactions. In this case, no collateral needs to be posted for either long positions (SPE sells protection) or short positions (SPE buys protection). However, if a CDS counterparty rated 'A-1' is buying protection (SPE is selling), it must post the greater of (i) the present value of the next premium payable by the counterparty (plus the grace period), and (ii) 100% of the ask side of the mark-to-market of the swap (this arises where the swap is out-of-the-money and the mark-to-market is used to find a replacement). If a CDS counterparty rated 'A-1' is selling protection (SPE is buying), it must post 100% of the ask side of the mark-to-market of the swap. CDS counterparties rated 'A-2' or 'A-3' that are buying protection must post the greater of (i) the present value of the next premium payable by the counterparty (plus the grace period), and (ii) 150% of the ask side of the mark-to-market of the swap (and cover the grace period in the CDS). CDS counterparties rated 'A-2' or 'A-3' that are selling protection must post 150% of the ask side of the mark-to-market of the swap (and cover the grace period in the CDS). CDS counterparties rated below 'A-3' must post an amount equal to the gross exposure equal to (i) the present value of all premiums payable under the swap over its life or the gross notional amount of the swap, for any long position, and/or (ii) the gross notional amount of the swap, for any short position but only if this is legally enforceable. When entering into the CDS (either to buy or sell protection), the CDS counterparties need to have a minimum investment-grade rating. When buying and selling protection on the same asset but from different counterparties, the SPE hedges the credit risk of the reference entity, but takes on the new risk of the counterparty's ability to perform. Therefore, the counterparty risk is removed only to the extent that the counterparty performs. The remaining counterparty credit risk should be addressed reflected in the available credit enhancement (see section VIII). In addition to the rating requirements, the legal aspects of providing collateral need to be addressed. F. Rating Requirements for Currency and Interest Rate Swap Counterparties The rating requirements outlined apply to both "plain vanilla" interest rate swaps and currency swaps. 1. Ratings Requirements for Interest Rate Swap Counterparties Counterparties rated 'A-1+' or 'A-1' can provide interest rate swaps without posting collateral as long as the documents specify that once a counterparty's rating is lowered to 'A-2', the counterparty is required to find a replacement. Alternatively, the counterparty can post collateral in an amount equal to Standard & Poor's collateral posting requirements (in jurisdictions where such a pledge is enforceable in a timely manner upon bankruptcy of the counterparty) or can deliver a guarantee from a suitably rated counterparty. If the counterparty chooses to post collateral, the collateral must be pledged and legal analysis must be completed within 30 days of the lowering of the rating to 'A-2'. In jurisdictions where the pledge of collateral is not enforceable in a timely manner upon bankruptcy of the counterparty, the counterparty must immediately find a replacement upon a downgrade to 'A- 2'. If the counterparty is not replaced, Standard & Poor's will review the rating on the notes issued for possible downgrade. If the pledge of collateral is enforceable in a timely manner under the laws of all relevant jurisdictions, the counterparty must continue to markto-market the swap and post additional collateral as necessary. SECTION 5 PAGE 42

44 Once a counterparty's rating is lowered to noninvestment-grade, the counterparty must immediately find a replacement. If a replacement cannot be found, a majority of investors can vote to allow the counterparty to remain in the transaction, or they can vote to terminate the swap, liquidate the collateral, and enter into a new swap, if possible. The new counterparty should meet Standard & Poor's rating requirements, including any posting requirements. If, after terminating the swap, the issuer is unable to find a replacement, investors can choose to liquidate the collateral and wind down the transaction. All breakage costs allocated to the swap counterparty must be subordinated to payments of interest and principal on the rated securities. 2. Ratings Requirements for Currency Swap Counterparties The ratings requirements for currency swaps are similar to those for interest rate swaps except that the requirement for replacing or posting collateral is triggered when the counterparty's rating is lowered to 'A-1' or below. Once a counterparty's rating is lowered to non-investment-grade, the counterparty must find a replacement immediately. These ratings requirements apply to the following currencies: U.S. dollars, euros, Japanese yen, British pounds sterling, Swiss francs, Canadian dollars, Australian dollars, Swedish kronor, Danish kroner, Hong Kong dollars, New Zealand dollars, and Singapore dollars. Application of the criteria to all other currencies is decided on a case-by-case basis depending on the liquidity of the market for that particular currency. SECTION 5 PAGE 43

45 SECTION VI: TRADING AND MANAGEMENT A. Introduction Unlike cash arbitrage CDOs, which are largely standardized, synthetic CDOs are much more tailor-made to meet the needs of investors and/or sponsors. One feature that is different in every synthetic transaction is the degree of management. Therefore, for managed synthetic CDOs, Standard & Poor's will examine the amount of substitutions and trading allowed, the party who makes decisions with respect to changes (for example, an external manager or the investor), and the trading strategy adopted by the manager (for example, defensive trading). The terms "replenishment" and "substitution" are commonly used in connection with a managed transaction. Replenishment applies when an asset is naturally removed from the initial portfolio (for example, an asset amortizes or prepays) and replaced with an asset from a pre-approved pool. Substitution can refer to one of two things: "changes to the portfolio", whereby a manager elects to remove and add assets while keeping the trading gains and losses outside the transaction, or "trading", whereby a manager can remove and add assets while the trading gains and losses are borne by the SPE. 1. Risk Assessment The presence of trading and management features affects the risk assessment of the transaction. As a result of trading, the risk profile of the portfolio can change and additional losses can be incurred, all of which can have an impact on the available credit enhancement. Standard & Poor's will therefore review the trading aspect of the transaction to ensure that the enhancement is adequately sized. The main risks are: Potential changes to the credit-risk profile of the transaction; Influence of the investment strategy, operational capability, and experience of the manager; Trading flexibility; and Trading losses. Standard & Poor's will therefore review the following elements in managed transactions: Assessment of the credit risk of a changing portfolio. Standard & Poor's will either model this on an ongoing basis or incorporate the trading in its initial assessment of the credit enhancement. Assessment of the manager. Standard & Poor's will assess the quality of the manager during an operational review. Assessment of the trading flexibility allowed. Standard & Poor's will review trading limits, coverage tests, stop-trading triggers, and other structural enhancements. Assessment of how trading losses and gains are being dealt with. It is difficult to give credit to potential trading gains but the impact of trading losses needs to be incorporated. Depending on the degree of management, type of transaction, and/or manager involved, Standard & Poor's will address all or some of the above elements in little or great detail. Standard & Poor's rating addresses the terms of the transaction. Therefore, if the transaction has a management feature, this will need to be addressed by the rating and cannot be carved out. 2. Point-in-Time Ratings Standard & Poor's is sometimes asked to assign only "point-in-time" ratings. A point-in-time rating is a rating that is valid only at the moment the rating is issued. Consequently, only the credit risk at the moment the rating is issued is addressed and there is no need to take into account that the transaction is managed. This type of rating is confidential and there is no ongoing surveillance. The rating is not suitable for investors who need an ongoing rating for regulatory or risk-management purposes. Point-in-time ratings are also not suitable when the synthetic CDO is repackaged using a multi-issuance vehicle, as these transactions also need ongoing ratings. B. Types of Management 1. Overview In cash flow arbitrage CDOs the trading aspect is fairly standard and comparable from transaction to transaction. An external manager will be allowed to trade credit-impaired and creditimproved assets and engage in discretionary trading of up to 20% (of the portfolio) per annum. There are additional limitations in the eligibility criteria, concentration limits, and coverage tests, and some transactions have additional structural features that further curb the powers of the manager. Trading losses are incorporated in the ongoing modeling of the credit risk of the transaction. Therefore, in most cases, the manager is the distinguishing factor. The same does not apply to managed synthetic CDOs. The degree of management, the way trading gains and losses are dealt with in the structure, and the trading limitations vary greatly from one synthetic CDO transaction to another. In addition, in managed synthetic CDOs, the manager is dependent on other parties (e.g., the CDS counterparty can decide to terminate the CDS) SECTION 6 PAGE 44

46 and coverage tests are not commonly used since it is not easy to de-lever synthetic transactions. 2. Managed Single-Tranche Transactions A new development is the managed single-tranche transactions involving "delta hedging". These tranches are typically lightly managed, which means that only a small degree of defensive trading is permitted. Management can be provided by a third-party manager, a dealer, or the investor in the single tranche. The aim of investor-managed transactions is to give investors greater input in the transactions they have purchased. Typically, trading is restricted and is done to protect the portfolio from deteriorating credit risk. Single-tranche trades can also be managed by the dealer or external manager. The incentive of dealers/external managers can be different to the incentives of investment managers (see section VIII.D). 3. Types of Managed Synthetic CDO Despite the great variation, it is possible to distinguish the following broad types of managed synthetic CDOs. a. Synthetic CDOs With Static Portfolios ("Static") In these transactions, the reference portfolio does not change during the life of the transaction, and management is not an issue. The initial pool analyzed at closing will determine the subordination needed in the transaction (see chart 19). b. Portfolio CDO With a Reference Portfolio Managed by an External Manager or the Investor ("Lightly Managed") In this case, the manager (being the CDS counterparty, external manager, or investor) manages the reference portfolio and therefore has the ability to make changes to it. The aim is largely to manage the credit risk of the portfolio and to remove assets that are considered to be close to default, thereby mitigating the risk to investors (see chart 20 overleaf). In some transactions, trading gains and losses are kept outside the transaction, i.e., they do not affect credit support. Depending on the specifics of the transaction, Standard & Poor's will analyze the need for a trading limit and/or corporate overview and determine how the subordination is being sized given that the portfolio will change over time. c. Managed Synthetic/Hybrid Transactions ("Managed") The first type of managed transaction is the synthetic CDO where an external manager has maximum trading flexibility. Trading gains and losses are borne by the CDO. CSO and hybrid transactions make up the second type of managed transaction (see chart 21 overleaf). These follow most closely the traditional managed cash flow arbitrage CDOs. An external manager will have maximum trading flexibility, and trading losses and gains are borne by the CDO. Given the large flexibility of the manager, Standard & Poor's will look for certain features in the transaction, such as due diligence, trading limits, and coverage tests, and other structural limitations. The three types of managed transactions described above are only a broad categorization and many variations are possible. Therefore, when analyzing the management aspect in synthetic CDOs, Standard & Poor's will include all or some of following elements: An assessment of the credit quality of a changing portfolio: worst case or CDO Monitor method; An operational review of the manager; SECTION 6 PAGE 45

47 An assessment of trading limits, coverage tests, and other structural limitations; and An analysis of trading gains and losses; C. Assessing the Credit Quality of a Changing Portfolio 1. Introduction As discussed in section III, Standard & Poor's uses a proprietary credit model, called the CDO Evaluator, to assess the credit risk of the reference portfolio in synthetic transactions. When analyzing transactions with static portfolios, the initial portfolio (i.e., the portfolio at closing) will be used to run the CDO Evaluator. As this portfolio will not change during the life of the transaction, the credit risk of the portfolio is correctly sized by looking only at the initial portfolio. However, this same method cannot be used for managed transactions, as the reference portfolio will continuously change over the life of the transaction. The initial portfolio is therefore not necessarily a reflection of the portfolio after the manager has made changes. There are two broad methodologies applied in determining the credit risk of a changing portfolio. The first method, the worst-case method, assesses the changing credit risk up front by looking at the trading limits and guidelines. The second method, the trading-model method, assesses the credit risk on an ongoing basis by running Standard & Poor's credit model each time a change is made to the portfolio. SECTION 6 PAGE 46

48 2. Assessing Credit Quality: the Worst-Case Method Under this method, credit enhancement is analyzed on a "stressed" eligible portfolio. Based on the transaction's investment parameters, an assumed portfolio will be constructed by filling the rating, concentration, and maturity buckets with the riskiest assets. The highest-risk, lowestrated assets are distributed in the buckets to maximize exposure, on the assumption that the manager exercises his full flexibility within the limits of the eligibility criteria. This "worst possible" constructed portfolio will be used to run the CDO Evaluator. For example, the reference portfolio of a synthetic CDO consists entirely of 'AAA' rated assets at closing. However, the eligibility criteria allow that the transaction can have up to 100% 'BB' rated assets. The substitution criteria stipulate that there is no limit on trading. Therefore, Standard & Poor's will use a portfolio that consists entirely of 'BB' rated assets to run the CDO Evaluator. If, for example, the substitution guidelines permit the replacement of an asset with an asset of only the same or better rating (and industry concentration is kept), then the portfolio cannot deteriorate because of substitutions alone, and therefore the initial portfolio will be used to run the CDO Evaluator. The advantage of this method is that credit enhancement is sized up front and the manager is not required to run any models on an ongoing basis. The disadvantage, however, is that the method is less flexible (the manager needs to trade according to the guidelines) and more onerous as the calculation typically leads to more credit enhancement being needed. 3. Assessing Credit Quality: Trading-Model Method Under this method, the credit enhancement may be analyzed based on the initial portfolio if regular ongoing tests are performed, including running Standard & Poor's CDO Monitor each time a change is made to the portfolio. The CDO Monitor is designed to monitor the total loss that the transaction has already or may incur in future, relative to the maximum amount of losses the transaction can support at each original rating level. Future trading gains and losses are not taken into account. The CDO Monitor is based on the CDO Evaluator but is specific to each transaction and each rated tranche. Once the transaction has closed, Standard & Poor's will provide the manager of the transaction with a customized CDO Monitor into which is hard coded the size of the asset pool and the original default rate that each tranche can withstand without violating the assigned ratings. If the current potential default amount on the portfolio exceeds the total losses at the time of a proposed change to the portfolio, then the CDO Monitor indicates a failure of the test. If the test shows a fail, the manager represents that he cannot make the change to the portfolio, unless it involves a credit-impaired asset, which can always be removed from the portfolio. It is the manager who decides whether it is a credit-impaired trade, but he must explain his decision in writing. There are two types of CDO Monitors for synthetic transactions. One is the CDO Monitor for synthetic CDO transactions, which does not take into account excess spread, and the second is the CDO Monitor for transactions that take into account excess spread from cash flow. 4. Using the CDO Monitor in Synthetic CDO Transactions Without Cash Flow The CDO Monitor in this case will simply reflect the changed credit quality of the portfolio based upon the deletion of one rated reference entity and the credit risk associated with the rating on the new (replacement) reference entity. In many cases, the manager will include a cushion on top of the subordination required based on the initial portfolio. Although this costs more up front, it will give the manager greater flexibility. The manager needs to run the CDO Monitor before and after any proposed trade. The manager will represent that he will execute the trade only if the credit quality of the portfolio is maintained or improved, unless it involves credit-risk assets, which can always be traded. The manager may also elect to run the CDO Monitor for credit-impaired assets, as long as he makes it clear to investors that he, as manager, has taken that decision. The CDO Monitor must be run both before and after a trade, rather then comparing with the CDO Monitor run at closing, to take into account the rating migration of the assets, as the manager should not be prevented from trading simply because the ratings on the assets have migrated. For example, assume the subordination required at closing is 5%. One month later the manager wants to remove an asset and replace it with a different asset. The manager runs the CDO Monitor on the portfolio before the proposed trade and the subordination required is determined to be 5%. The manager will then run the CDO Monitor on the portfolio as it would be constituted after having done the trade and the subordination required is determined to be 5.1%. The manager represents not to execute the trade SECTION 6 PAGE 47

49 as it does not maintain or improve the portfolio credit quality. Some transactions take into account trading losses by subtracting the trading loss from the available credit enhancement. 5. Use of the CDO Monitor in Synthetic CDO Transactions With Excess Spread and Cash Flow The use of the CDO Monitor in this case is comparable to the use of the CDO Monitor in cash flow arbitrage transactions. The credit enhancement is sized based on the initial portfolio and the credit risk is monitored on an ongoing basis using the CDO Monitor. Additionally, the CDO Monitor takes into account the breakeven default rate. The breakeven default rate, with respect to a particular tranche, is the maximum percentage of defaults a collateral pool can sustain and still pay ultimate principal and all due interest to that tranche. This rate is initially set by the issuer based on the various cash flow runs performed. Each time the CDO Monitor is run, the breakeven default rate is adjusted to reflect any par gains or losses in order to confirm that there are sufficient funds to meet timely or capitalized payment of interest and ultimate payment of principal or interest. Thus, as losses occur, the breakeven default rate for the rating changes. The scenario default rate is the level of defaults the collateral pool is expected to experience. The CDO Monitor result for a particular tranche is a pass if the breakeven default rate is higher than the scenario default rate; otherwise, the test is a fail. The objective, once again, is for the manager to maintain or improve the credit quality of the portfolio when undertaking discretionary or credit-improved trades. If undertaking a credit-risk sale, then the "maintain or improve rule" does not apply; rather, the manager must buy what he deems to be the best possible credit and par amount, regardless of whether the CDO Monitor results show that the credit quality is maintained or improved. Once again, in this case the manager must justify in writing why he deems an asset to be a credit-impaired asset. D. Operational Review of the Manager 1. Application of the Operational Review Requirement For transactions involving some degree of management, Standard & Poor's will require that an operational review of the manager be conducted. Different degrees of management call for different degrees of detail in the operational review, from a short conference call to a full-day, detailed, on-site visit. Transactions with static portfolios do not require an operational review as there is no manager. However, Standard & Poor's will still conduct a review of the calculation agent. The calculation agent is the party responsible for establishing the recoveries and loss amount, a duty which is normally undertaken by the collateral manager in managed transactions. As recoveries are a vital part of Standard & Poor's analysis, comfort is required that the calculation agent has the necessary infrastructure and experience to fulfill his role. The calculation agent is typically one of the large credit derivative houses. A full operational review will not be needed if Standard & Poor's is familiar with the agent's processes and takes comfort from the agent's experience and market presence. Similarly, the operational review can be relaxed for synthetic portfolio CDOs with managed portfolios if the manager is regularly involved in this type of transaction and Standard & Poor's is familiar with the manager's experience and operations. The transaction should not take into account trading gains or losses or have an excess spread feature and will typically be part of the sponsor's synthetic program. Operational review requirements can also be less detailed if trading is limited and defensive, for example, if the manager can replace assets only with assets that have the same or better rating, or if the manager can change only a very small percentage of the portfolio per year. If the transaction requires the manager to monitor the credit risk on an ongoing basis using the CDO Monitor, Standard & Poor's will need comfort that the manager understands the operational aspects involved in using the CDO Monitor. Transactions where the manager is the only investor and private transactions can also require a less detailed operational review. Of course, if the transaction is sold to another investor, the situation needs to be re-assessed. 2. Conducting an Operational Review The goal of any operational review is to determine how well equipped the manager is to meet the diverse needs of a variety of constituents and to further assess his trading strategy. Major elements in the operational review are the team and organization (experience, stability, decision-making, etc.), the performance of existing transactions, the research and credit selection process, the compliance infrastructure, the workout experience, and the familiarity with credit derivatives and the CDO Monitor (if required by the transaction). In addition to the manager review, which is part of the rating analysis, Standard & Poor's SECTION 6 PAGE 48

50 may conduct further corporate overview visits to assess collateral managers in more detail. The result of these visits is the publication of an extensive report, called the "CDO manager focus report". These reports cover managers of both cash flow arbitrage and synthetic transactions. Their aim is to provide investors with a comprehensive analysis of the manager and a tool to better compare managers. E. Trading Limits As CDOs are not operating companies, unlimited trading is not allowed. Trading limits, together with operational review, coverage tests, and structural limitations, are the main elements that control the power of the manager. To minimize credit volatility, Standard & Poor's will assign a high rating only in transactions that specify trading limits. A five-year CDS is modeled by looking at the five-year default probabilities of an underlying portfolio. If the risk is exacerbated by trading losses, then the calculation of the default risk of the portfolio was incorrect. When asked to consider broader trading probabilities, Standard & Poor's key consideration is whether the risk can be appropriately modeled. For portfolios that turn over multiple times in a transaction's lifetime, risk is not appropriately measured by looking at the initial portfolio assumptions; instead, Standard & Poor's considers the net asset value or mark on the portfolio as affected by trading gains or losses once this becomes the dominant risk. Thus, a market-value framework is more appropriate for this type of risk exposure. Typically, the manager may engage in a maximum 20% per annum discretionary trading and unlimited credit-impaired and credit-improved trading. The 20% rule exists because this effectively allows the portfolio to be turned around once during the term of the transaction (most transactions are typically five-year revolving transactions or five-year bullet transactions). Although the manager is free to define creditimpaired and credit-improved trades, Standard & Poor's will look for that the definition includes a concept of significant change in credit standing and that it reflect the manager's responsibility to determine whether an asset fits within the applicable definition. The manager's judgment is paramount in making these decisions, and Standard & Poor's therefore does not impose price or other hurdles, but the manager is required to justify credit-impaired trades in writing. Some transactions stipulate that trading is no longer allowed once trading losses have reached a certain level or once a certain amount of equity is lost due to losses. Although Standard & Poor's fully recognizes the benefit of these structural enhancements, they are put into the transaction at the discretion of the manager. Other transactions limit trading to a certain percentage per year or to a certain number of names per year. The manager is free to determine these limits as long as they are not broader than the maximum trading limit. The flexibility of the manager will be further curbed by the presence of eligibility and substitution criteria, such as minimum rating requirements, geographical concentration requirements, maximum single-obligor limits, etc. Standard & Poor's does not impose specific eligibility or substitution criteria because overly restrictive limits may impede a manager's ability to maximize portfolio performance. In addition, the CDO Evaluator and CDO Monitor provides the manager with the ability to maintain the credit risk of the portfolio. Standard & Poor's will review the eligibility and substitution criteria when it needs to build a worst-case portfolio as described before. Other trading limitations consist of subtracting realized losses out of par coverage ratios, subtracting offsetting trade spreads from the weighted-average spread test, and limits on aggregate losses that can be observed purely as the result of trading. F. Coverage Tests Synthetic CDOs can also have coverage tests similar to those in cash CDOs, namely the overcollateralization ratio and the interest coverage ratio. plus: plus: divided by: The undrawn amount of funded note proceeds Cash Defaulted securities, at the lower of market or expected recovery rate The total amount of the senior tranche presently outstanding. There is much discussion about eliminating the interest coverage test in synthetic CDOs as the total spread income coming into the portfolio, due to leverage, usually dwarfs the interest that needs to be paid. Standard & Poor's does not require an interest coverage test if enough comfort can be drawn from a minimum-spread test and if the loss of a couple of the highest-spread obligations does not lead to nonpayment of any of the rated tranches. Because a large portion of a synthetic CDO is typically supported by an unfunded liability (usually a "super senior swap"), these coverage ratios are primarily used to trap cash and not to pay down noteholders. In hybrid transactions and in SECTION 6 PAGE 49

51 SECTION 6 PAGE 50 some of the CSOs, there are instances where the minus: divided by: plus: plus: minus: The total amount of CDSs written, defaulted, or with respect to which a credit event has occurred Hedged CDSs The undrawn super senior swap Cash Funded note proceeds in the collateral account triggering of overcollateralization and interest coverage tests leads to amortization from super senior swap down to the different classes. 1. The Overcollateralization Test How the overcollateralization test is defined in a synthetic structure is driven by whom the test is aiming to protect. If the funded noteholders are to be protected, the ratio is likely to be defined as the par value of the funded note proceeds to the par value of the tranche. plus: plus: plus: divided by: plus: Net undelivered defaulted CDS The undrawn amount of funded note proceeds Cash Defaulted securities, at the lower of market or expected recovery rate The super senior swap The total amount of the senior tranche presently outstanding The super senior swap The typical overcollateralization ratio for senior obligations is calculated as follows. Most transactions have a collective overcollater- The premium received from the CDS plus: Interest income from funded note proceeds in a given period divided by: The insurance premium payable to an unfunded tranche or tranches plus: Interest payable to a funded tranche or tranches of the CDO in that period. alization test for their senior and junior tranches. Each of the tests below the senior-most tranche test would also include all the senior tranches in the denominator. 2. The Synthetic Exposure to Synthetic Coverage Ratio Since cash trapped in synthetic structures is often re-levered by the synthetic CDO entering into more CDSs, the amount of credit exposure is ultimately governed by a synthetic exposure-to-synthetic coverage ratio. This ratio is aimed at protecting the unfunded and funded investors as well as CDS counterparties. It is calculated as follows. The ratio has to be less than or equal to 1, so that synthetic coverage is always enough to cover synthetic exposure. 3. The Senior Overcollateralization Ratio In structures where the protection of the super senior swap provider takes priority, the super senior swap is likely to be notional in both the numerator and denominator. The senior overcollateralization ratio is calculated as follows. 4. The Interest Coverage Ratio The interest coverage ratio is calculated as follows. The interest coverage test is set higher than the minimum needed to pay interest and insurance on the tranches. If the test fails, trapped cash will go into the collateral account to build subordination but the notes will not be amortized. As in the case of cash CDOs, on top of regular monthly and due period measurement dates, any trading, hedging, or changes in the existing portfolio, such as downgrade, default, or maturity, should trigger recalculation of the coverage tests. G. Structural Limitations Specific structural requirements are aimed at capturing and enhancing the performance of the transaction in light of a manager's actions that cannot be quantified and modeled. Standard & Poor's expects to see a number of these structural improvements incorporated in the transaction. Not all of the structural limitations are applicable to all types of synthetic transactions; some are applicable only to synthetic CDOs that have excess spread and coverage tests. 1. CreditWatch Adjustment If the rating on an obligation is on CreditWatch with negative implications, the rating for purposes of running the CDO Evaluator should be one notch lower than the current rating. This is implemented to properly reflect the increased risk of credit migration of the asset. 2. Haircut to Lower-Rated Collateral The aim of this feature is to start building credit support as the 'CCC' bucket increases. This provision is applicable only if collateral rated 'CCC' or lower is more than 5% above the initial concentration in the transaction. One possible solution is to adjust the value of the low-rated collateral in the overcollateralization test.

52 3. Value of Defaulted Securities Defaulted securities should be carried at the lower of market price or assigned recovery. This is applicable in synthetic transactions that use the defaulted security price in an overcollateralization test or any other measurement or valuation test. 4. Additional Defaults of Reinvested Recoveries If recoveries are used to take on new risk instead of paying down debt, the manager exposes the transaction to the risk of additional default. Therefore, if recoveries can be reinvested, additional defaults will be modeled on the reinvested recovery amount. 5. All Payments Received From Defaulted Securities are Deemed Principal The definition of principal proceeds should state that all payments received from a defaulted obligor are principal proceeds until 100% of the par value has been received. However, in most synthetic transactions this is not an issue since they hold collateral and pay only the loss to the protection buyer. Nevertheless, if the transaction employs a physical settlement mechanism and consequently there is workout/sale by the manager, then it is applicable. 6. Modeling Transactions at Minimum Coupon/Spread Since most transactions are not fully ramped-up at closing and allow reinvestments, it is assumed that the manager will only acquire assets that meet the requirements of the eligibility criteria. Therefore, when modeling the cash flows, the minimums are assumed. For static, fully rampedup pools, the actual figures can be used. This is not applicable in synthetic transactions that do not have an excess spread component providing additional credit support. 7. Limit Pass-Through of Gains The aim of this test is to avoid the situation where it is possible to have had par losses, and yet gains on the sale of obligations are still passed through the interest priority of payments to the equity holders. If the transaction has an initial amount of par value and is meeting the weightedaverage recovery, minimum coupon/spread, and weighted-average life tests, then gains may be classified as interest proceeds. If this is not the case, gains should be classified as principal proceeds and reinvested. The proper definition of gain is any amount received over par value. This applies to a synthetic transaction if it incorporates a concept of gain. 8. Limit Pass-Through of Unused Principal Proceeds This is an issue in transactions that allow release of unused principal proceeds through the interest priority of payments. 9. Modeling Defaults After an Overcollateralization Trigger In the situation where the manager trades to avoid losses and decrease par value, but the quality of the pool of obligations still deteriorates, the breakeven rates will be adjusted. This adjustment will apply to transactions with paydown or overcollateralization trigger and will adjust the break even default rates. 10. Overcollateralization Reinvestment/Interest Diversion Trigger These tests should be robust and should be triggered before the paydown and overcollateralization tests are triggered. A substantial amount of the excess spread should be trapped and reinvested in synthetic transactions that have excess spread to reinvest. 11. Credit-Risk Disclosure If a manager purchases or enters into secondarymarket obligations for below 60% of par and primary first-issuance obligations at below 85% of par, then the manager must provide an explana- SECTION 6 PAGE 51

53 tion as to why such credits are considered noncredit-risk assets. This rarely applies to synthetic transactions as most transactions are executed at 100% of par. However, even in synthetic transactions that are executed at 100% of par, the spread of the CDS is important. CDS spreads behave differently from the spreads on cash assets. CDS spreads, together with the rating, give a good indication of the credit quality of the portfolio. Therefore, when analyzing synthetic CDO transactions Standard & Poor's will also look at the CDS spread of the reference obligations. Standard & Poor's may ask the managers to provide information on the CDS spreads and will seek an explanation as to why some of the obligations in the reference portfolio have a much wider spread than the average CDS spread for an obligation with that rating. H. Trading Gains and Losses 1. The Meaning of "Trading" Trading in cash CDOs means that the manager will sell an obligation to possibly replace it with another obligation. If the manager sells the obligation for a lower price than he initially paid for it, a trading loss will be incurred. In contrast, if the manager can sell the obligation at a higher price, a gain will be achieved. Although trading gains do not affect the rating analysis unless they provide additional credit enhancement, trading losses can have a negative impact on the CDO as it needs to make an additional payment. Trading in synthetic CDOs, on the other hand, is more complex. In synthetic portfolio CDOs, trading means that a reference obligation will be taken out of the reference portfolio to be replaced by another reference obligation. In a CSO transaction, trading can either be done by terminating a CDS or by entering into a new CDS to buy protection. Going short (buying protection) against a long position (where protection is sold) will offset the risk position and therefore results in the same position as selling an obligation. The difficulty with terminating a CDS is that it requires the consent of both counterparties. Terminating a CDS and entering into a new CDS will create a trading gain or loss depending on whether the CDS is out-of-the-money or in-the-money. 2. Accounting for Trading Losses Trading losses in synthetic CDOs are not as straightforward as in cash flow arbitrage CDOs. For example, in a cash flow arbitrage CDO the manager may purchase an obligation for $10 and later sell it for $8. Therefore, there is a trading loss of $2. In synthetic transactions, determination of trading losses is more complex as one needs to look at the old spread, the new spread, the duration period, and an adjustment factor. Trading losses can either be dealt with on a present-value basis (i.e., take the loss today), and are likely to affect the overcollateralization trigger, or can be booked on an ongoing basis, in which case they will affect the spread test. The way the manager deals with trading losses provides a useful insight into his trading strategy. 3. Trading Gains and Losses in Managed Synthetic Portfolio CDOs and CSOs In most synthetic transactions, trading losses and trading gains are outside the transaction. Therefore, Standard & Poor's does not take the trading losses and gains into account when determining the necessary credit enhancement as it will not be affected. Nevertheless, managed synthetic portfolio CDOs and CSOs can be structured to take into account the trading gains and losses. In this case, Standard & Poor's will analyze their potential SECTION 6 PAGE 52

54 impact on the credit enhancement. Trading losses can be accounted for in various ways. First, one can use the CDO Monitor. Each time the CDO Monitor is run, the breakeven default rate is adjusted to reflect any par gains or losses in order to confirm that there are sufficient funds to meet timely or capitalized payment of interest and ultimate payment of principal or interest. A second method is to set up a reserve fund. The funds are used to pay the trading losses and, once the fund is depleted, no more trading is allowed. Thirdly, in synthetic portfolio CDOs before executing the trade, the loss is deducted from the threshold amount. Lastly, all excess spread and recoveries are retained in the transaction and are used to pay for the trading losses. I. When Can the Manager Trade? CDO transactions may involve an initial period of time after closing during which the manager acquires the underlying collateral using the proceeds of the notes. This is known as the ramp-up period. Synthetic portfolios usually have a very short or no ramp-up period as it is relatively easy to fully identify the portfolio at closing given the liquidity of the credit derivatives market. Therefore, synthetic transactions do not have the risks associated with long ramp-up periods, such as negative carry (synthetic CDOs do not require funds to enter into CDSs), liquidity risks (not being able to pay interest), origination risks, interest rate movements (collateral typically provides the floating element), and concentration risk. Most transactions have an effective date, which occurs after the last day of the ramp-up period or earlier if the required amount of collateral has been acquired or entered into. This is also the date on which the CDO Monitor is delivered to the manager. The ramp-up period and effective date normally exist only in managed synthetic and hybrid transactions. For most synthetic CDOs, the closing date will be the effective date. SECTION 6 PAGE 53

55 SECTION VII: LEGAL ANALYSIS AND SURVEILLANCE A. Legal Analysis Standard & Poor's reviews the proposed legal structure in every synthetic CDO transaction in order to identify the legal issues that may affect the ability of the rated noteholders to receive full and timely payments. Legal issues are addressed by reviewing the transaction documents and, where appropriate, the legal opinions provided by counsel. For a more detailed analysis of the legal issues see "Legal Criteria for Structured Finance Transactions", published April 2002 on RatingsDirect. Although synthetic CDOs follow the general legal CDO criteria, the legal considerations can be easier to address as synthetic CDOs do not involve the purchase of assets, and therefore avoid the true sale issue. Specific legal considerations include the ISDA documentation, netting, and issues regarding collateralization. 1. General Considerations Depending on the type of transaction and the jurisdictions involved, all or some of the following issues need to be addressed in the legal analysis: The bankruptcy remoteness of the SPE or review of the MTN program used to issue the notes; True sale issue. This is relevant only in hybrid transactions and with respect to the collateral; Segregation of funds. This is relevant for collateral and cash accounts; Creation of security over documents, collateral, assets, and the enforceability of such security, etc.; Enforceability; Tax issues. The issuance should be free of taxes (addressed in legal opinions) or Standard & Poor's needs to size for taxes; Preference risk. This is relevant for collateral; Netting. This is important if the SPE buys and sells protection; Guarantees. This is important if a counterparty guarantees the obligation of another counterparty; Segregation; and Opinions on domicile of the counterparty, swap, and collateral. 2. Transaction Documents The documents that need to be reviewed will vary depending on the type of transaction. For unfunded CDSs, Standard & Poor's reviews the CDS confirmation, the ISDA schedule, and the ISDA master agreement. For partially funded and funded portfolio CDSs or managed synthetic transactions, the following is a non-exhaustive list of the documents reviewed by Standard & Poor's: CDS confirmation; ISDA schedule; ISDA master agreement; Collateral support agreement; Pricing supplement/term sheet or offering circular; Trust deed; Management agreement; Administration agreement; Account bank agreement; Custodian agreement; Paying agent agreement; Repo agreement or put agreement; and Legal opinions (bankruptcy remoteness, valid creation of security, tax issues, etc.). 3. ISDA Credit Support Annexe A credit-support annexe (CSA) outlines the terms and conditions of the posting of collateral. Standard & Poor's typically checks the following elements, in most cases for the purpose of ensuring that there is no loss to the noteholder if the SPE receives less collateral then it had counted on: Base currency of the collateral. If different than the currency of the notes, there can be currency risk; Definition of eligible collateral. This is relevant in determining overcollateralization levels; That the independent amount is zero; That the threshold amount with respect to the SPE is infinite and, with respect to the counterparty, zero; That the minimum transfer amount with respect to the counterparty is as low as possible; That the SPE is obliged to return collateral only to the extent it has actually received the collateral and only in the form the counterparty has posted it to the SPE; That the delivery amount is rounded up and the return amount rounded down; That the SPE is obliged to transfer interest only to the extent that it has actually earned and received such interest; That the counterparty is obliged to transfer the collateral upon demand; Default and early termination provisions; That transfer costs are borne by the counterparty; Substitutions of collateral; and The party who holds the collateral. Not all collateral arrangements use a CSA. 4. Netting Netting must be analyzed under relevant jurisdictions and across different products. It is relevant when the CDO wants to offset transactions, i.e., in transactions where the CDO both buys and sells protection on the same reference obligations with the aim to be in the same position as a CDO that sells a cash asset. SECTION 7 PAGE 54

56 B. Surveillance Standard & Poor's will monitor the ratings assigned to every rated synthetic CDO tranche throughout the life of the rated notes. It will raise, lower, and place ratings on CreditWatch to ensure that the ratings assigned to the notes continue to reflect the transaction's performance, the credit enhancement available, and the likelihood of receipt of timely interest and ultimate principal payments by the noteholders. Deterioration of the credit quality of the assets, trading, and changes to the rating of supporting counterparties are the most important influences on the performance of a transaction. Credit assessments on unfunded CDSs are also monitored over the life of the transaction. Transactions with point-in-time ratings are not monitored as these ratings are valid only on the day of issue. 1. Information Required for Ongoing Surveillance Standard & Poor's needs the following information to monitor the performance of transactions: Closing portfolio (the rating, the notional balance, the maturity, the asset type, the country of domicile, the sovereign rating of that domicile, identification number, etc.); Changes to the portfolio (for managed transactions), including defaulted assets; Confirmation of compliance with triggers (e.g., overcollateralization, interest coverage, etc.); Confirmation of actual performance against triggers; Confirmation of compliance with eligibility criteria, substitution criteria, etc.; Credit event notices (name and which credit event is being called) and recovery values after the settlement process (including the different bids that were obtained); If necessary, cash flow runs; Results of running the CDO Monitor; and Trading gains and losses. For static synthetic transactions, the sponsor needs to provide only credit event notices and recovery values. Standard & Poor's will monitor the ratings on the underlying assets and on the various counterparties. For managed synthetic transactions, pool and trigger information must be provided on a regular basis, typically monthly or quarterly and on each measurement date (e.g., when a trade is done or a payment made). For static synthetic transactions, it is sufficient to run the CDO Evaluator to check the effect of rating migration, shortening of the tenor of the transaction, and losses on the available credit enhancement. If an obligation has defaulted, but a credit event notice has not yet been issued, the obligation is kept in the portfolio with a 'D' rating. If an obligation has defaulted and the credit event notice has been issued, but the settlement process has not yet been finalized, the obligation is removed from the portfolio and a recovery value equal to the recovery set at closing is used. In addition, the current market value is checked in case there is a large discrepancy. If the obligation has defaulted, the credit event notice has been issued, and the settlement process has been finalized, the obligation is removed from the portfolio and a recovery equal to the recovery achieved in the settlement process is assigned. For synthetic portfolio CDOs with substitution, the substitutions that have been made also need to be monitored. In synthetic CDO transactions that have a cash flow component, it may be necessary (for example, when there have been losses or downward rating migration) to re-run the cash flows to check whether the available credit enhancement is still sufficient. When the CDO Evaluator run shows that there is insufficient enhancement but the cash flows have not yet been re-run, Standard & Poor's will usually place the ratings on the transaction on CreditWatch with negative implications. Even if a transaction is downgraded, the counterparty rating requirements and other triggers and threshold that were initially approved for the transaction will continue to apply. 2. Rated Overcollateralization (ROC) as a Performance Indicator Standard & Poor's recently approved another performance indicator called the "rated overcollateralization" (ROC; see "Standard & Poor's Rated Overcollateralization Benchmark: A New Tool for Primary and Secondary Market CDOs", published on Oct. 2, 2002 on RatingsDirect). ROC is a key performance indicator in the surveillance of all CDOs including synthetic transactions. A ROC of 100 or greater is necessary for ratings to be maintained; it does not automatically follow, however, that a ROC of less than 100 will result in either the lowering or placement on CreditWatch of the rating as other factors will be taken into account. ROC is a point-in-time measure of the potential total support available to a rated CDO tranche. It takes into account the par amount of non-defaulted assets, recoveries of defaulted assets, expected net losses from future defaults commensurate with the tranche rating, and additional support from expected total excess spread available. SECTION 7 PAGE 55

57 SECTION VIII: OTHER SYNTHETIC STRUCTURES A. Synthetic CDO of ABS Increasingly, synthetic CDOs reference not only corporate obligations but also other obligation types, the most common being structured finance securities. In a synthetic CDO of ABS or CDO of CDOs, the risk transfer of the structured finance securities is achieved synthetically through loss definitions rather than by the sale of obligations. Most of the requirements discussed throughout in this criteria piece also apply to synthetic CDO of ABS/CDOs, but there are some additional considerations. The most important of these are: Credit events; Settlement mechanism; Recoveries; and Structural features of the underlying assets. 1. Credit Events For structured finance obligations in synthetic CDOs, Standard & Poor's limits the acceptable definitions of default to the following: Failure to pay. Standard & Poor's accepts failure to pay but the language needs to be adjusted to specifically address the fact that, where obligations include PIK securities, a missed interest payment will not trigger a credit event. This carve out must go further than the "where and when due" language in the ISDA Definitions. The language should address that a missed interest payment of a PIK security will not constitute an event of default and that any other failure to pay that constitutes a default or event of default under the terms of the reference obligation will be considered a credit event. Loss event/write down. This credit event attempts to capture the incapacitation of an asset before the rating on it is lowered to 'CC' or 'D'. This credit event is typically defined in a variety of ways. In Standard & Poor's view, an acceptable definition will include the concept that a credit event may be called only when a principal reduction to a reference obligation is permanent. Migration to a lower rating. This credit event is acceptable under certain circumstances. For some structured finance securities a rating of 'C' or 'CC' is de facto default. In this case Standard & Poor's accepts the lowering of the rating to 'C' or 'CC' as an acceptable proxy for default, and thus eligible as a credit event. Acceleration/restructuring. These are not very common credit events in synthetic CDO of ABS. Standard & Poor's evaluates the appropriateness of this credit event depending on the nature of the obligations referenced. 2. Settlement Mechanism The majority of synthetic CDO of ABS incorporate physical settlement with a long workout period or cash settlement after a sufficiently long period. Standard & Poor's does not consider a short cash settlement period for structured finance securities to be appropriate. The reason is that the valuation in such a case is expected to be low due to the large liquidity premium that market participants impose on ABS, and the timevalue of money effect, which will cause market participants to discount the expected recovery on such assets. 3. Recovery Rates Recovery rates are taken from the ABS matrix based on the original rating on the liability and its rating at closing (see table 3 overleaf). Covenants with respect to recovery assumptions for each class of notes should be included in the documentation. For synthetic transactions, a haircut is applied depending on the size of the tranche and the nature of the tranche obligation. In addition, there should be a minimum workout period. The manager who is not forced to sell an asset under any particular time frame will be assigned 100% of a recovery assumption if he agrees not to sell an obligation at a price lower than that assumption. If a manager is forced to sell under a given time frame, then a haircut is necessary, regardless of the transaction type (synthetic or cash) (see table 4 overleaf). 4. Structural Features of the Underlying Assets If the synthetic CDO has a cash flow component, the structural features of the assets in the underlying reference portfolio are very relevant. The structural features of the transaction determine whether the CDO can rely on the cash flow generated by those assets. Three clear examples where this can be a problem are PIK securities, pre-paying obligations, and long-dated obligations. "Pikable" obligations pose the problem that interest will not be received without causing a default of the asset. Therefore, the PIK feature should be modeled in the cash flows. An obligation that pre-pays no longer generates cash flows and therefore pre-payment stresses based on the type of obligation and the country of incorporation of the issuer of the obligation need to be applied. Long-dated obligations pose the problem that they mature after the legal final maturity date of the transaction. SECTION 8 PAGE 56

58 Table 3 Recovery Rates for ABS Assets (%) Liability AAA AA A BBB BB B CCC Senior asset class AAA AA A BBB Junior asset class AA A BBB BB B CCC Haircuts for Cash-Settled ABS Number of days between default/credit event and forced sale Percentage of ultimate recovery assumption assigned > At maturity 100 Table 4 B. Short CDS Positions 1. Introduction In CSO transactions with an underlying portfolio of CDSs, the SPE will enter into CDSs to sell protection, in which case it will receive a premium but has to make payments upon the occurrence of a credit event. The SPE will also enter into CDSs to buy protection, in which case it has to make premium payments but will receive payments upon the occurrence of a credit event. The latter is referred to as having "short" positions in synthetic CDOs. The synthetic CDO faces three types of risk with respect to short positions. First, the CDO, which in this case is the protection buyer, must have sufficient funds to make the ongoing premium payments. The transaction will therefore have to include a forward-looking spread test. Second, the CDO will have to rely on the credit-protection payments that need to be made by the protection seller upon the occurrence of a credit event. The transaction will therefore have to include strict counterparty rating requirements. Third, if the CDO relies on the short CDS to offset a long CDS written on the same reference obligation, it is necessary to ensure that the credit risk of the reference obligation is completely removed. There is also the additional risk that in the case where the SPE does not already own the bond, it will have to purchase one to physically settle the transaction. 2. Shorts and Offsetting CDSs The primary use of short CDS positions is to buy protection to cover an existing credit exposure. The existing exposure can be a credit exposure via cash assets or CDS long positions. This primary use of short CDS positions is therefore very similar to selling a cash asset. Short CDS positions against long CDS positions or cash positions are referred to as offsetting CDSs. The offsetting trade could be assumed to render the position "flat" from a credit perspective, and thus the gain or loss is the difference between the two spreads. However, the credit risk is not always flat. Although the credit risk of the reference enti- SECTION 8 PAGE 57

59 ty is hedged, the CDO has taken on the new risk of the counterparty's ability to perform. There are two types of offsetting CDSs. In the first type, both the long and short CDSs have identical CDS documentation and are entered into with the same counterparty (for example, the SPE sells protection to CDS counterparty X and buys protection from CDS counterparty X). The CDS also typically allows for physical settlement, in which case the obligation will be passed on from the buyer to the seller. In cash-settled transactions, Standard & Poor's will check that the calculation agent uses the same bid for the long and short position (i.e., the same dealers must be solicited only once by the calculation agent). The only difference allowed between the two CDSs is the premium payments. Where all of these requirements are met, Standard & Poor's considers that the two CDSs completely offset each other and therefore the SPE no longer has to recognize the exposure. This effectively means that the exposure can be excluded when calculating the credit risk of the portfolio using the CDO Evaluator. Standard & Poor's does not impose a limit on this type of offsetting CDS. In the second type of offsetting CDS, the SPE has exposure to credit risk via a CDS and enters into a CDS to buy protection. However, the documentation of the short and long CDSs are not identical and/or the counterparty to whom the SPE has sold protection and from whom it has bought protection are different. Alternatively, the SPE has a credit risk exposure via a cash asset or total return swap and enters into a CDS to buy protection. In all these cases, Standard & Poor's considers that elements of risk still remain. For instance, basis risk exists when the documentation is not identical. If the counterparties are different, there is a risk that it will become necessary to find a replacement CDS counterparty upon default of the CDS counterparty. These trades are referred to as "partially offsetting CDSs". Standard & Poor's does not consider the exposure to the reference entity to be completely eliminated and therefore the remaining exposure will need to be addressed. Standard & Poor's will check the limit on partially offsetting CDS to make sure there is no unlimited leverage. The remaining credit risk is accounted for either through modeling or structurally. Additionally, in both offsetting and partially offsetting CDSs, the SPE has to demonstrate that it has sufficient funds to make the premium payments (which also need to be included in the weighted-average spread test if any) and the protection must be bought from counterparties with a sufficient rating. In addition, short CDSs should be included in the discretionary trading bucket and credit-impaired and credit-improved limit (see section V). 3. Open ("Naked") Shorts The secondary use of short CDS positions is to buy protection on a reference entity without having exposure to that reference entity. These trades are referred to as "naked shorts". In this case, the SPE will receive a cash inflow upon the occurrence of a credit event. First, the SPE has to demonstrate that it has sufficient funds to make the premium payments over the life of the transaction. Second, the question whether credit can be given to the potential cash inflows needs to be carefully considered. Clearly, calculating the probability of default and hence the probability that the SPE has to make a payment is quite different from calculating the probability of having a cash inflow that will directly reduce the credit enhancement needed. Standard & Poor's will review proposals that give credit to naked shorts on a case-by-case basis in the context of the manager's portfolio approach and will look for the following in determining what rating to assign to a particular transaction: A limitation on naked shorts (i.e., either on the naked shorts entered into, the overall credit given, or a combination of the two); Conservative modeling (at a minimum, the assumption used in the CDO Evaluator method will need to be revised); An overall limit on the reduction in capital due to shorts; Strict eligibility criteria; Sufficient diversification; and Any other elements it considers relevant. C. Hybrid Transactions CDOs are increasingly being used as instruments to manage credit in whatever form presented. Initially, CDOs were only exposed to the credit risk of bonds and/or loans. Gradually, they encompassed a wider selection of obligations, including bonds, loans, leveraged loans, structured finance securities, convertible securities, etc. Synthetic CDOs are broader in scope as they typically refer to the general category of borrowed money, which includes a wide spectrum of credit obligations. Hybrid transactions go a step further as they are exposed to both cash assets and synthetic assets. Hybrid transactions are managed arbitrage CDOs in which the asset side combines elements of a cash CDO (purchase of cash assets) and a synthetic CDO (entering into CDSs). The liability side combines a funded and unfunded portion. SECTION 8 PAGE 58

60 The challenge of these transactions, therefore, relates to the simultaneous use of synthetic and cash assets, the proportion of each of which can change over time. Hybrid transactions employ the following structural elements normally found in synthetic CDOs: The assets are CDSs (hence there is bivariate risk). Defaults are defined by credit events. Risk positions are eliminated by entering into offsetting CDSs and naked short CDSs. Collateral/liquidity needs to be available to make contingent payments. There is a large proportion of unfunded liabilities. The transaction includes an unfunded coverage test/minimum weighted spread test. Synthetic exposure should not be larger than synthetic coverage. Similarly, hybrid transactions employ the following structural elements normally found in arbitrage CDOs: The assets are cash bonds and loans. The assets are in default once rated 'D' by Standard & Poor's (i.e., default is not defined by a credit event). Risk positions are eliminated by selling the assets. A cash flow model is used. Liabilities are funded. Overcollateralization and interest coverage tests are employed. Eligibility criteria and trading limits are in place. Hybrid transactions are analyzed as traditional cash flow arbitrage CDOs. A hybrid transaction typically includes the ability to: Buy and sell cash assets; Trade and hedge protection sold; Buy protection (short CDS) subject to counterparty risk being addressed and there being adequate funds available to pay for protection; and Buy cash securities and buy protection referencing the same entity. Trading restrictions also follow cash arbitrage CDOs. Specifically: These transactions use the CDO Monitor to analyze the changing portfolio, including buying and selling cash assets and CDSs, offsetting trades, and shorting. They are consistent with cash flow transactions in that there is a 20% per annum discretionary trading bucket, and credit-improved and credit-risk trades are permitted. Interest and overcollateralization coverage must be considered for both funded and unfunded elements. A liquidity facility or collateral account is needed to cover CDS losses and to change the mix of funded/unfunded assets. The CDO Evaluator can be run on both the cash and synthetic portfolio together and separately. The manager must have experience and a performance record in managing both cash and synthetic assets. Standard & Poor's conducts an overview to assess the manager's ability to use multiple asset types in long and short strategies. D. Single-Tranche Synthetic CDOs Increasingly, sponsors no longer conduct one-off transactions in which they divide the entire risk of the reference portfolio over a number of rated tranches, which are then sold to investors. Instead, they offer tailor-made products that respond to specific investor needs. The sponsor will typically select a reference portfolio, with or without the input of the investor, and offer only one tranche with the rating required by the investor. Therefore, although the reference portfolio is, for example, $1 billion, the issued tranche may be only $10 million (see chart 22 overleaf). The growth in single-tranche transactions has been driven by the following: Investors want bespoke transactions to meet their individual needs. Therefore, they demand greater input in determining the characteristics of the transaction, such as the rating, the size of the issued tranche, the portfolio composition, the note return, and the ongoing management of the portfolio. The negative publicity surrounding the alignment of interests in CDO transactions has spurred investors to take greater control of their transactions. Single-tranche transactions avoid the conflict of interest issue. Sponsors are finding it difficult to place all tranches of the capital structures. With singletranche transactions sponsors only issue a tranche that has already been committed to by an investor. The development of dynamic hedging techniques allows sponsors to hedge the credit risk when issuing single-tranche transactions. Single-tranche transactions are less costly and can be executed very quickly. SECTION 8 PAGE 59

61 Investors in single-tranche transactions typically achieve a better return in an environment with wide spreads. Single-tranche technology can be used to transfer the risk of any type of underlying asset, but in the majority of transactions the risk of small portfolios (between 100 and 200 names) of European, U.S., and Asian investment-grade corporate names are being transferred. Standard & Poor's is seeing more pools of highly rated ABS and tailor-made synthetic CDOs. The choice between the different asset types will depend on the available arbitrage. These trades typically use multi-issuing SPEs rather then setting up new SPEs each time a new tranche is issued. The structure of a single-tranche transaction is similar to that of a traditional synthetic CDO, the main difference being that only a portion of the risk of the reference portfolio is being transferred. Sponsors are willing to accept this as they have developed techniques to dynamically hedge the remaining risk (referred to as delta hedging). When a sponsor uses delta hedging, it will purchase protection on a limited number of underlying obligations. The hedged obligations will change over the life of the transaction and it is therefore referred to as being dynamic. However, it is clear that hedging is not perfect. The sponsor will add the trades into a correlation model in order to determine the arbitrage and the amount of premiums payable to the investor. Their positions will be frequently rebalanced to maintain the economic arbitrage of the transaction. In an environment with very wide spreads, investors are typically offered attractive premiums compared with other similar structures (see chart 23 overleaf). Standard & Poor's will analyze these transactions in the same manner as any other synthetic portfolio CDO. The only difference is that these trades are often part of a program and therefore can be executed in a very short time frame. E. Small Basket For smaller groups of credits, i.e., typically less than 10, Standard & Poor's employs a variety of modeling and analytical techniques to assess credit risk. Standard & Poor's will review the transactions on a case-by-case basis to determine the most appropriate methodology and model approach. F. Total Return Swaps Managed synthetic transactions and hybrid transactions can also enter into total return swaps. As with CDSs, total return swaps create exposure to both the risk of the underlying obligation and the risk of the counterparty who has to make payments upon which the CDO relies. The main difference between a CDS and a total return swap is that with a total return swap both credit risk and market risk, i.e., depreciation or appreciation in the value of the underlying obligation, are hedged. In a CDS, on the other hand, only the credit risk is hedged. Although the total return swap removes all economic exposure to the reference obligation, the risk transfer does not require a cash sale (see chart 24 overleaf). A total return swap is another way to create a SECTION 8 PAGE 60

62 risk exposure without actually purchasing the obligation. It consists of a contract in which counterparty A agrees to pay all cash flows received from the obligation (i.e., interest, prepayments, principal payments, recovery) and counterparty B agrees to pay up front the notional amount of the obligation. At maturity or upon default, counterparty A will deliver the obligation to counterparty B. Funding is needed to enter into a total return swap. Therefore, total return swaps are typically used in hybrid transactions or can be used in managed synthetics as long as the funded amount does not need to be paid up front. Given the reliance on the total return swap counterparty to repay the whole principal, Standard & Poor's applies counterparty rating requirements similar to those imposed on CDS counterparties where the SPE buys protection. SECTION 8 PAGE 61