Moody's Investors Service is currently implementing changes to its asset correlation model within cashflow structured finance CDOs backed by ABS, RMBS, CMBS, and other CDO tranches, said Yvonne Fu, a senior vice president in the rating agency's derivatives group. Moody's changed its approach for modeling correlations in synthetic transactions in the latter part of last year, she added.
The rating agency will now be using an approach called the Directional Ratings Transition Matrix' which is based on some 20 years of structured finance ratings transitions. The model is meant to provide more clarity to investors for understanding asset correlations among re-securitized portfolios, according to Moody's. The new matrix simultaneously identifies pairs of credits, both within and across different asset types that have been upgraded or downgraded.
The agency's earlier approach for analyzing asset correlation within re-securitized portfolios used model-based simulations, equity market data in the case of real estate investment trusts, and analysts. The approach was more subjective, and limited by the lack of available structured finance default data available at the time, according to Moody's. The new asset correlations are based on at least 1,000 rating actions within each major sector.
"Correlations themselves are quite elusive, because there is no market agreed-upon way on how to derive them," Fu said. "It is very interesting that we were able to take the ratings transition to analytically predict the correlation numbers."
Indeed, Fitch Ratings last month said in research that market-based approaches to defining levels of asset correlation within CDOs provided the most accurate outcome. The agency warned against relying solely on historical credit default or ratings data to decipher the level of risk within a given tranche, and instead said that equity-based correlation analysis, along with other methods, could result in a more precise correlation outlook.
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