The CDO community is the fastest growing customer base in line for a relatively new analytic system offered by Moody's Investors Service - so-called market-implied ratings. In short, the system tracks the gap between what the secondary market assesses as the chance of a security defaulting, versus the rating agency's own credit rating for the bond. And while the tool is only applicable to the cash and synthetic corporate bond sectors and it is not used by Moody's analysts as a precursor for ratings changes per se, the principle behind the system has "profound implications for the financial market," said Moody's Managing Director David Munves, who invented the system.

The system aims, in part, to tackle the long-held criticism of rating agencies that perhaps they don't move swiftly enough to warn investors of an imminent downturn in credit quality. By displaying the side-by-side comparison for investors of the market's value of a particular security versus its rating, an investor is able to decipher - both on a historical and real-time basis - whether that security is trading cheap or rich to its rating.

"If we changed the ratings all the time like the market frequently changes spread levels, we would really be doing a disservice," Munves said. "There is an inherent conflict between being stable and being accurate. The market moves first, Moody's moves second. That is what this is based on. If you overlay this product, you can do a better job."

Even though the system has been available for Moody's analysts for more than three years now, it has only recently been made available for the rating agency's subscribers. Certain components, such as combined ratings gap transitions and historical default data, have just become public in recent months, and in the last couple weeks matrices - similar to a scorecard indicating how Moody's and the market judged an issuer's actual probability of default or better-than-expected performance over time have - been showcased on the rating agency's website.

It is the use of this knowledge - how a five-year credit default swap on an issuer name or that issuer's bonds are trading relative to its rating - that Munves said is integral to judge the relative quality of collateral within CDOs more efficiently. The database includes about 1,700 credit default swaps and 3,000 bond entities, Munves said. The data for bonds stretches back to 1999, while the newer CDS market has historical data from 2001.

For example, a pool of high-yield bonds underlying a CDO could contain securities carrying "B1" "B2" and "B3" ratings. Looking only at the ratings, a potential investor under the guidance of rating agencies alone would assume default rates based on those ratings - for a "B2" rated security, for example, that would equal 5.80%. However, if the collateral manager were simply looking to ramp up with names trading cheaply in order to get more yield, those names, which could actually be showing an implied market rating at levels comparable with "C1" "C2" and "C3" rated securities, would be carrying a much higher chance of default.

By running the market-implied ratings system, an investor would be able to decipher the gap, or the difference between the actual rating and the market implied rating, of a particular collateral pool and bid accordingly. That gap under the Moody's system is quantified as a certain number either plus or minus the mean, being zero. Most securities are found to cluster around zero, trading at a plus or minus one versus its rating, Munves said.

"This is a classic problem with CDOs. Because typically CDOs are made up according to a number of parameters, one of them being that you have to have a certain rating composition within the portfolio. Collateral managers will often add names trading cheaply," added Munves. "But that tells you that if you do that, you have a higher risk of downgrade and default later down the road."

"And people who bought these tranches of CDOs knew that there is no free lunch. You get more spread, but the market is probably telling you this as well." Collateral managers as well, by monitoring movements in the gap between current and market-implied ratings, can trade out of bad situations in order to avoid what could be an impending downgrade or default.

For example, during a one-year period, "Baa3" rated securities trading flush with market pricing - a "zero" on the Moody's transition matrices - remained unchanged 82% of the time, were upgraded 8% of the time and downgraded 11% of the time. Meanwhile, securities rated negative two on the scale, meaning they were trading cheap to their ratings, were downgraded 25% of the time, upgraded only 1% of the time and remained the same 74% of the time.

The distribution of ratings changes on the matrices follow a predictable trend, with "Baa3" rated securities trading with a negative six gap to their ratings, experienced downgrades 63% of the time, while being upgraded 3% of the time. The results are more dramatic further down the rating scale. In another scenario, a "B2" rated security trading in-line with its rating defaulted 3.90% of the time over a one-year period, whereas securities with the same rating trading at a negative three gap to its rating defaulted more than 33% of the time. For that reason, the system works particularly well in the high-yield sector, Munves said.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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