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Announcement:

Moody's Updates its Methodology for Surveillance of ABCP Credit Arbitrage Programmes

12 Jan 2010

Paris, January 12, 2010 -- Moody's Investors Service said today that it is supplementing its existing approach to monitoring credit arbitrage asset-backed commercial paper (ABCP) programmes by using the latest version of its public CDO rating model, CDOROM. This is a change to our current approach for determining the adequacy of credit enhancement, which mainly relies on a dynamic credit enhancement matrix as described in the Rating Methodology report "Moody's Approach to Evaluating Credit Arbitrage ABCP Programs", published in August 2002.

Credit arbitrage conduits, also called securities arbitrage programmes, fund portfolios of highly rated securities, most of which are structured finance securities with initial ratings in the Aaa or Aa range. They benefit from a liquidity facility that is equal to the face value of the outstanding ABCP. The liquidity facility funds the conduit's book value of non-defaulted assets. For structured finance securities default is defined by a rating standard, typically rated Caa1 or below. In order to cover non-defaulted assets, credit enhancement is provided at the programme level and is dynamic, meaning it increases as the credit quality of the assets migrates to Aa3 or lower.

Most credit arbitrage programmes rated by Moody's use the credit enhancement grid described in the August 2002 Rating Methodology referenced above to determine how much higher the credit enhancement should be when the securities are downgraded. For example, if a programme has a portfolio of Aaa-rated only securities and has ten securities downgraded to A1, it will have to post credit enhancement to cover the largest downgraded security. In addition, according to the credit enhancement grid, all non-investment grade securities have to be fully enhanced.

The primary risk to investors in credit arbitrage programmes is that a highly-rated security goes directly to default in a very short period of time, before a cure can be effected by increasing enhancement or selling assets. The cure period varies by programme. The strongest programmes have a cure period of ten days, while in others the risk horizon is driven by the maximum ABCP tenor. These programmes are only required to cease issuing ABCP if they do not comply with the required level of credit enhancement, so the risk is not removed until ABCP matures.

While Moody's still believes in the benefits of the dynamic credit enhancement adjusting to the migration of the securities' credit quality, it also sees some limitations in the current approach, which could be mitigated by the use of CDOROM as a surveillance tool. In particular, the methodology described in the August 2002 paper was based on corporate rating migrations, which did not differentiate rating transition by asset types or geography. It is also not easily updated for changes in correlation assumptions. The main advantage of CDOROM as a surveillance tool is that it allows the latest assumptions on correlations among asset types as regularly updated by Moody's to be taken into account (see press release "Moody's updates its key assumptions for rating structured finance CDOs" dated 11 December 2008).

The use of CDOROM to monitor credit arbitrage conduits requires some specific adjustments and assumptions to reflect the most common structure of such programmes:

i) Asset default probabilities need to be adjusted to bring them in line with an assumed probability of rating migration to Caa1 or below within a year. Moody's has derived stressed one-year migration assumptions from historical migration studies taking into account the past two years of Structured Finance rating migrations. These assumptions aim to differentiate between asset types and will be updated from time to time. Moody's will also be testing the sensitivity of the results to various levels of stresses. The re-securitisation stress factors used in CDOROM are not applied. Programmes showing very large concentrations in certain asset types would require additional adjustments if Moody's uses CDOROM to monitor them.

ii) The recovery rate assumption upon default of securities is set to zero as in almost all securities arbitrage programmes the liquidity facility does not front for recoveries on defaulted assets. No credit is given to recoveries on the asset due to the short tenor of the ABCP.

iii) The risk horizon is set to one year corresponding to the maximum CP tenor in most conduits and mirroring the horizon of the rating migration probability assumption in i). The goal is to model the securities portfolio in a maximum wind-down period of one year, which could be viewed as a conservative assumption for certain credit arbitrage programs.

As part of its ongoing surveillance process, Moody's will run CDOROM on all non-fully supported credit arbitrage portfolios, using the actual level of credit enhancement posted by the bank sponsor together with the assumptions described above. For hybrid programmes, which also fund a multi-seller portfolio in addition to a securities portfolio, Moody's will initially look at the two sub-portfolios separately and then on an aggregate basis. In most of these programmes, programme-wide credit enhancement is shared between the two legs.

The model will provide a benchmark with an equivalent long term rating on a one year horizon and will also give an indication of the probability of default for the senior tranche assuming a one year tenor. Both outputs will be deemed consistent with Prime-1 if at least equivalent to A2 level. However, Moody's intends to use the results of the CDOROM model as one of many factors to assess the adequacy of programme-wide credit enhancement in the surveillance of existing non-fully supported credit arbitrage programmes. In particular, the CDOROM modelling approach described above does not take into account certain positive structural features of securities arbitrage ABCP programmes such as: a shorter risk horizon (in certain programmes as little as ten days); lower threshold for liquidity funding, which would reduce the default probability assumptions; and the economic incentive of the conduit sponsor to cure the portfolio over time to maintain the utility of the programme as a funding source. Moody's could therefore be comfortable with lower model outputs in the Baa range if such structural mitigants exist.

It is expected that all of the partially supported credit arbitrage conduits currently rated by Moody's will pass the test with the current stressed migration assumptions on the basis of the actual amount of credit enhancement. However, in many cases, the required credit enhancement as per the August 2002 grid would not be sufficient. In addition, concentrated exposure on certain asset classes for certain programs could lead to pressure on the rating, should those asset classes show further rating volatility.

This press release is a supplement to the August 2002 Rating Methodology report "Moody's Approach to Evaluating Credit Arbitrage ABCP Programs". Moody's plans to publish a full report detailing the supplementary surveillance approach of Credit Arbitrage programmes in the coming weeks. In addition, Moody's publishes a weekly summary of structured finance credit, ratings and methodologies, available to all registered users of our website, at http://www.moodys.com/SFQuickCheck.

New York
Paolo Obias
Managing Director
Structured Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Paris
Sophie Berthelon
Senior Vice President
Structured Finance Group
Moody's France S.A.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's Updates its Methodology for Surveillance of ABCP Credit Arbitrage Programmes
No Related Data.
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