Moody’s hits out at combined cash and synthetic CDOs

Moody’s Investors Service has warned investors that the International Swaps and Derivatives Association legal documentation underpinning combined cash and synthetic collateralised debt obligations (CDOs) is far from perfect.

In a new report, ‘Moody’s approach to measuring synthetic resecuritisations’, the credit rating agency added that measuring the risk in such products was “tricky”.

Synthetic resecuritisations, which reference pools of structured finance securities such as residential mortgage-backed securities synthetically, have proved popular with investors this year. Moody’s has rated eight such deals in North America this year with “many more” rated in Europe.

This is a result of arbitrage opportunities for corporate deals having proven scarce this year and ratings on asset-backed transactions having been more stable, Moody’s said.

But their structures do “not dovetail smoothly with Isda’s standard credit derivatives definitions”, according to Moody’s. The rating agency believes synthetic resecuritisations require unique definitions for what constitutes a credit event, along with the use of specialised recovery assumptions once an event has occurred.

“Isda’s definitions of credit events were not drafted with structured finance securities in mind,” said Yuri Yoshizawa, a senior credit officer at Moody’s. “The credit events affecting synthetic resecuritisations more closely resemble the losses experiences by individual structured finance tranches than they do defaults by corporate entities or issuers,” he added.

The most common credit events related to such deals are ‘failure to pay’ and ‘loss events’. Loss events are triggered when a write-down occurs on the asset referenced by the transaction and are unique to synthetic resecuritisations.

“To put it simply, the assumed recovery rates modelled by Moody’s for cash resecuritisations are not always applicable to synthetic resecuritisations,” Yoshizawa added.