S&p Cit Cdo Exposure

December 4, 2008

European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating Actions Surveillance Credit Analysts: Andrew South, London (44) 20-7176-3712; [email protected] Amit Sohal, London (44) 20-7176-3845; [email protected]

Table Of Contents Recent Credit Events Have Contributed To Numerous Negative Rating Actions Ratings Do Not Comment On Correlation In Ratings Behavior Between Different Tranches Related Articles Appendix 1: 50 Most Widely Referenced Obligors In European Synthetic CDOs

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European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating Actions Three years ago, Standard & Poor's Ratings Services reported that, in its view, the dynamics of ratings in the European synthetic collateralized debt obligation (CDO) sector could be highly dependent on idiosyncratic events. Specifically, we noted that headline rating performance for the sector as a whole could be highly sensitive to downgrades or defaults among a few corporate obligors if these are referenced in a large number of CDO portfolios (see "Related Articles"). Recent bankruptcies and government-backed restructurings of seven entities in the financial services sector have triggered credit events in synthetic CDOs, providing a pertinent case study for this effect. While the number of corporate entities affected corresponds to around 0.4% of the number of investment-grade financial services issuers we rate, the effect on synthetic CDO ratings has been widespread because these entities were referenced in a large number of transactions (see table 1). Overall, about 75% of European synthetic CDOs–roughly 1,200 transactions–referenced at least one of these seven entities. The rating on a single CDO tranche may clearly be raised or lowered following a rating action in the reference portfolio. Therefore, if the corporate name in question is widely referenced in the CDO market, similar rating actions in a large number of CDO transactions are equally possible. This does not necessarily mean that individual CDO tranches have higher default risk than equivalently-rated securities in other asset classes, but it does mean that a portfolio of CDO securities may have different overall risk characteristics. In our view, an investor who holds multiple CDO tranches would be well advised to look through to the underlying portfolios to understand the extent of any diversification benefits. Table 1

Obligors Triggering Recent Credit Events Obligor

Date of credit event European synthetic CDOs referencing obligor

Lehman Brothers Holdings Inc.

Sept. 15, 2008

Number 999

% of total* 62

Washington Mutual, Inc.

Sept. 26, 2008

752

47

Fannie Mae

Sept. 7, 2008

750

47

Freddie Mac

Sept. 7, 2008

708

44

Kaupthing Bank¶

Oct. 8, 2008

412

26

Glitnir Bank

Oct. 7, 2008

287

18

Landsbanki Íslands¶

Oct. 7, 2008

286

18

*Based on a total of about 1,600 public European synthetic CDOs outstanding. ¶Not rated by Standard & Poor's.

Recent Credit Events Have Contributed To Numerous Negative Rating Actions Chart 1 shows the number of CreditWatch negative placements and downgrades among European synthetic CDOs since the beginning of 2007. In our view, the number of CDO downgrades in November 2008 was large because of

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European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating Actions

a combination of factors, namely: • • • •

Multiple financial institutions triggered credit events within a short space of time. Most of these institutions were referenced in a large number of CDOs. Recovery rates on some of these credit events were low. We made revisions to our asset correlation assumptions and industry classifications for certain financial services companies.

Chart 1

The large spike in negative CreditWatch placements during September 2008 followed a period of significant upheaval in the financial services sector. Fannie Mae and Freddie Mac–the two U.S. government-sponsored entities that provide funding for the housing market–were placed under regulatory conservatorship, triggering CDO credit events. Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection, also triggering credit events. Continued significant numbers of CreditWatch placements in October and November followed the collapse of three Icelandic banks and the eventual bankruptcy filing of Washington Mutual Inc. Other corporate entities were also undergoing negative rating migration at this time. Furthermore, in October and November we announced revisions to some of our rating assumptions for CDOs, which also contributed to negative ratings pressure on CDO tranches (see "Related Articles"). As an example, following recent consolidation and greater observed interdependence of institutions within the financial services sector over the past few months, in our rating analysis we no longer classify brokers, dealers, and investment houses

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European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating Actions

as a separate industry from other financial intermediaries. We have also increased to 25% from 15% our assumption for the asset correlation between different financial intermediaries in a CDO's reference portfolio. While it is therefore not possible to isolate the rating effect of the credit events described above, they were a significant contributor to negative ratings pressure over this period. As a result, by end-November there were around 800 tranches of corporate-backed synthetic CDOs on CreditWatch negative. During our monthly surveillance process for November, we resolved most of these CreditWatch placements, reflecting the full effect of the various credit events outlined above and causing an unprecedented spike in the number of downgrades seen in chart 1.

Future CDO performance depends on which corporates see rating actions Table 2 lists the corporate names that were most widely referenced in the European CDO sector as of the end of November 2008. (A longer list is given in "Appendix 1.") Needless to say, any positive or negative rating actions among these entities would potentially have widespread implications for synthetic CDO ratings. Table 2

10 Most Widely Referenced Obligors In European Synthetic CDOs—At End-November 2008 Obligor

European CDOs referencing obligor Number 1,053

% of total 66

Volkswagen AG

1,049

66

General Electric Capital Corp.

1,036

65

France Telecom S.A.

970

61

Deutsche Telekom AG

958

60

Hutchison Whampoa Ltd.

958

60

Telecom Italia SpA

946

59

Merrill Lynch & Co. Inc.

936

58

Morgan Stanley

929

58

Goldman Sachs Group Inc.

927

58

CIT Group, Inc.

Ratings Do Not Comment On Correlation In Ratings Behavior Between Different Tranches Although a pattern of "clustered" rating actions in a sector may have negative implications for a large number of noteholders, it is important to appreciate that it is not a risk that is addressed by the CDOs' ratings. This is because ratings are a measure of creditworthiness for individual CDO tranches, but do not comment on the joint behavior of these CDO tranches in an investor's portfolio, or, in this case, a whole sector. The joint behavior depends crucially on another factor—correlation—which describes to what extent different tranches behave similarly over time. It is important not to confuse the concept of correlation between different CDO tranches with the concept of correlation between the obligors in any individual CDO tranche's reference portfolio. Clearly, our rating on any individual CDO tranche does take into account the level of correlation among the obligors in its reference portfolio, which we might term "asset correlation." For example, if a CDO tranche's reference portfolio is concentrated in a particular industry, the asset correlation would be relatively high and the tranche would likely require more credit support to achieve a particular rating. Here, however, we are considering the degree of similarity in rating behavior

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European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating Actions

between different CDO tranches. We can think of this as "tranche correlation." As an example, consider a 'BBB' rated tranche from a securitization backed by tax liabilities owed to the Portuguese government, and a 'BBB' rated tranche in a U.S. CMBS transaction. We may believe they have a similar likelihood of default, as implied by their ratings, but they are unlikely to be strongly correlated. A collapse in U.S. commercial rents may mean the CMBS tranche ultimately defaults, but this would seem unlikely to affect the other tranche, which may ultimately make all payments due in a timely fashion. Their behaviors may therefore differ markedly, despite both being rated 'BBB' initially. As an opposing example, one could imagine numerous synthetic CDO tranches, each with identical structural features and backed by the same portfolio of reference obligors. If the credit quality of these reference obligors improved substantially, these tranches' ratings would likely all move upward in an identical way: Their rating behavior would be highly correlated. Rating movements and defaults in certain structured finance sectors can, in fact, be relatively correlated. As we have seen, many synthetic CDOs reference similar portfolios of investment-grade corporate credits, and certain corporate entities are referenced in well over 50% of synthetic CDO transactions. This leads to relatively high correlation in ratings behavior between different tranches in the sector. Recently we announced that we will soon incorporate credit stability as an important factor in our ratings. Where we believe a security is likely to experience a sharp drop in credit quality under conditions of only moderate stress, we may now assign a lower rating than we previously would have. However, this consideration of the likely severity—or "depth"—of any rating actions on individual securities should not be confused with how widespread any future rating actions might be—the "breadth" of impact—in a given sector. Finally, the degree of correlation between different tranches in a sector must also be considered when interpreting aggregate statistics of that sectors' rating performance. For a sector like synthetic CDOs, where different tranches' behavior can be highly correlated, the number of observed rating actions or defaults can vary significantly between periods. For a more diverse sector, aggregate statistics describing ratings performance will tend to be more stable.

Related Articles • "CDO Spotlight: Overlap Between Reference Portfolios Sets Synthetic CDOs Apart" (published on Sept. 26, 2005). • "Criteria:Revised Correlation Assumptions For Rtng CDO/CDS Exposed To Financial Intermediaries" (published on Oct. 3, 2008). • "Criteria: Correlation Assumptions Revised For Rating Global CDOs/CDS Exposed To Insurance Cos." (published on Nov. 6, 2008) • "Criteria: Prob Of Default, Correlation Assumps Revise For Glbl CDOs/CDS Exposed To REITs/REOCs" (published on Nov. 6, 2008) All criteria and related articles are available on RatingsDirect, the real-time Web-based source for our credit ratings, research, and risk analysis, at www.ratingsdirect.com. The criteria can also be found on our Web site at www.standardandpoors.com.

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Appendix 1: 50 Most Widely Referenced Obligors In European Synthetic CDOs 50 Most Widely Referenced Obligors In European Synthetic CDOs—At End-November 2008 Obligor

European CDOs referencing obligor Number 1,053

% of total 66

Volkswagen AG

1,049

66

General Electric Capital Corp.

1,036

65

France Telecom S.A.

970

61

Deutsche Telekom AG

958

60

Hutchison Whampoa Ltd.

958

60

Telecom Italia SpA

946

59

Merrill Lynch & Co. Inc.

936

58

Morgan Stanley

929

58

Goldman Sachs Group Inc.

927

58

Daimler AG

885

55

International Lease Finance Corp.

869

54

Southwest Airlines Co.

860

54

Munich Reinsurance Co.

855

53

PMI Group Inc.

846

53

British Telecommunications PLC

839

52

Hannover Rueckversicherung AG

826

52

Countrywide Home Loans, Inc.

818

51

Swiss Reinsurance Co.

817

51

Vodafone Group PLC

814

51

Koninklijke KPN N.V.

811

51

Telefonica S.A.

801

50

AT&T Inc.

795

50

Siemens AG

790

49

Carnival Corp.

787

49

Financial Security Assurance Inc.

774

48

Radian Group Inc.

773

48

British American Tobacco PLC

762

48

Altria Group Inc.

753

47

The Bear Stearns Cos. LLC

744

47

American International Group Inc.

739

46

Allianz SE

727

45

Zurich Insurance Co.

711

44

GDF SUEZ S.A.

703

44

Verizon Communications Inc.

701

44

AXA

682

43

Compagnie de Saint-Gobain

682

43

Enel SpA

675

42

CIT Group, Inc.

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50 Most Widely Referenced Obligors In European Synthetic CDOs—At End-November 2008 (cont.) XL Capital Ltd.

672

42

Centex Corp.

669

42

MBIA Insurance Corp.

669

42

MGIC Investment Corp.

664

42

CenturyTel Inc.

657

41

Lehman Brothers Holdings Inc.

656

41

Electricite de France S.A.

652

41

Bayer AG

649

41

Deutsche Lufthansa AG

648

41

Ambac Assurance Corp.

646

40

Petroleos Mexicanos (PEMEX)

645

40

Wolters Kluwer N.V.

641

40

Additional Contact: Structured Finance Europe; [email protected]

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