Moody's Investors Service would like to hear from market participants regarding proposed changes to its modeling framework for cash-flow CLOs.
The rating agency is seeking feedback as part of a process that will include a review of its ratings. Moody's is requesting that market participants respond no later than April 8 to the proposals described in Moody’s Proposes to Change Its Global CLO Modeling Assumptions.
The proposed changes would apply globally to CLOs and CBOs that Moody’s models using the Binomial Expansion Technique (BET) modeling framework, the agency said. The request for comment does not include deals that were rated using other modeling frameworks.
However, Moody’s is now reviewing these other CDO modeling frameworks to make them more consistent with the proposed changes. It expects to finish the review in the coming months.
After implementing the proposed changes, the rating agency will place the affected ratings on review for upgrade.
These potential changes reflect the improved economic and credit environment. They also incorporate a thorough review of the findings from roughly 90 years of historical corporate default data and more than 20 years of recovery rate data.
These proposals are changing the credit enhancement levels for a given rating category to above those seen before the financial crisis but slightly below the levels during the crisis.
If the rating agency implements these changes, it expects upgrades on outstanding CLOs to average about a notch for senior and mezzanine tranches and between two and three notches for junior tranches.
The thrust of these proposed changes is removing a temporary 30% macroeconomic stress from the agency's default probability assumptions. In February 2009, Moody's added the stress in response to both the extraordinary potential depth of the global recession and the likelihood of a slow recovery.
The rating firm thinks it is now appropriate to remove this stress because credit conditions have greatly improved. But, after reviewing the historical corporate default and recovery rate data, it has decided to recalibrate a few key modeling parameters within its BET model as well as change different aspects of the methodology to reflect these experiences.
It specifically proposes to change its BET Model, which it uses for rating cash-flow CLOs by taking several steps.
The first is to remove the 30% default probability macro stress to reflect its improved outlook for global speculative-grade corporate entities. It also proposes to recalibrate key modeling parameters by increasing the BET liability stress factors as well as increasing recovery rate assumptions. This is going to be done to better reflect empirical evidence from corporate default and recovery data and to offer increased rating stability by using future credit cycles. Moody's also plans to change several modeling assumptions associated with defaults of reinvestments, asset amortizations, interest collection from defaulted assets, and the analysis of combination notes. It will also limit certain stresses for credit estimates to address time lags in credit estimate updates during the recent crisis.
"Perhaps the most significant changes, at least in terms of the likely impact on Moody’s CLO ratings, concern the 30% default probability macro stress, BET model stresses, and recovery rate assumptions," said Yvonne Fu, managing director responsible for rating new U.S. CLOs. "These proposed changes are the result of an extensive study and back testing of the CLO rating model using a large amount of historical corporate data available to us."
"In light of the historical data observations and corporate fundamental approaches to assessing recovery rates for European corporate assets, Moody"s has proposed not to tier recovery rates by legal jurisdictions," said Henry Charpentier, a managing director responsible for rating new European CLOs. "Furthermore, Moody"s is considering to adopt a fixed rate recovery rate modeling approach for European deals, much like the approach currently used in the U.S."
