With a bit of lag time built into the moderately paced summer market, rating agencies have issued their own version of summer reading material. Though not exactly the page-turner that Harry Potter proves to be, recent rating agency methodology pieces - targeting synthetic CDOs and CFOs of private equity funds - can accompany any professional's poolside lounge chair.

Moody's Investors Service is set to release an in-depth report regarding synthetic CDOs, one of the fastest growing vehicles in the U.S.-based CDO market, and the agency's approach to rating them. Already a hit in Europe - synthetics comprised 85% of the Moody's-rated European CDO universe last year - the agency found some 30% of the U.S. market it rated last year was made up of synthetic transactions. That's up from a paltry 13% in 2001.

Obviously not all synthetics are created the same nor are ratings frameworks. In fact, Moody's traditional CDO-modeling methodology, aimed at capturing default risk for a pool of assets, harnesses the Binomial Expansion Method, compared to other modeling techniques such as simulation-based analyses. For example, Moody's Yuri Yoshizawa, senior credit officer and author of the new report, points out that with funded synthetic CDOs, the rating on each note represents the opinion of the expected loss on the note, whereas with unfunded synthetic CDOs, a rating essentially translates to the expected loss posed to the investor. Different CDO vehicles also means risk assessment is constructed differently; with a static CDO, the actual characteristics of the portfolio are used to create the model portfolio but with a managed CDO, constraints in the indenture documents are used to create the model portfolio.

Along with understanding the differences in ratings, investors need to understand inherent risks of the many synthetic CDO structures. Most synthetic CDOs are less sensitive than cash-flow CDOs to defaults; despite being highly leveraged synthetic deals, they may only need a small amount of subordination to support high ratings (due to short maturities and highly rated reference pools, on average). However, "it only takes a small miscalculation in the tail probability of the loss distribution to have significant effect on the ratings of one or more tranches," Yoshizawa noted.

Standard & Poor's last week issued a special report detailing its method of rating collateralized fund obligations, such as a CDO backed by private equity funds.

The cornerstone of S&P's rating for these vehicles begins with benchmark comparisons to determine if a manager, and thus the portfolio, has an adverse selection bias.

The private equity fund of a funds manager's cash flow performance record is compared with market cash flow benchmarks.

"Sizing the rated debt-to-equity ratio and a liquidity facility requires simulating different possible cash flow streams that can be ascribed to the asset pool," said Lily Cheung, a director in S&P's Structured Finance group and co-author of the article "Rating Private Equity CFOs: Stochastic Market Cash Flows."

"These simulated cash flow streams must exhibit three characteristics: empirical observation of a lag between cash inflows and outflows (J-curve); nondiversifiable market risks, i.e., the whole private equity market has uncertain upturns and downturns in cash flows; and diversifiable idiosyncratic risks, i.e., portfolio size and sector mix can reduce and alter portfolio risk-return," Cheung wrote.


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