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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; andrew_south@standardandpoors.com
Amit Sohal, London (44) 20-7176-3845; amit_sohal@standardandpoors.com

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
Number % of total*
Lehman Brothers Holdings Inc. Sept. 15, 2008 999 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 % of total
CIT Group, Inc. 1,053 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

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

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 % of total
CIT Group, Inc. 1,053 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

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European Synthetic CDO Portfolio Overlap Means Recent Corporate Credit Events Cause Widespread Rating
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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; StructuredFinanceEurope@standardandpoors.com

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