Basel II capital requirements for structured credit products and economic capital: a comparative analysis

Luca Giaccherini, Giovanni Pepe rst draft August 2007, this version Febraury 2008

Abstract The huge development experienced by structured credit products has occurred under a banks capital adequacy regime inconsistent with the inherent complexity of these securities. The new prudential framework (Basel II) contains a specic section devoted to tranched products, which puts much store on public ratings. In this paper we try to evaluate the reliability of Basel II treatment for securitization exposures comparing the forthcoming charges for structured products with an estimate of their risk, a topic that deserves additional attention after the recent market turmoil. The results obtained cast some doubts about the actual degree of conservatism of the choice to map from ratings to prudential charges.

Keywords: Basel II, CDO, economic capital, regulatory capital, Value at Risk.

Contents
1 2 Introduction Collateralized debt obligation (CDO) 2.1 Single-Tranche CDOs . . . . . . . . . . . . . . . . . . . . . . . . Regulatory treatment 3.1 The rational behind the RBA and SFA approaches . . . . . . . . . A model for the conditional loss distribution 4.1 The pricing model . . . . . . . . . . . . . . . . . . . . . . . . . .

3 4 5 7 8 10 13

The view expressed in the study are those of the authors and do not involve the responsibility of the institution to which they belong. Banca dItalia, Banking Supervision Department. E-mail: luca.giaccherini@bancaditalia.it Banca dItalia, Banking Supervision Department. E-mail: giovanni.pepe@bancaditalia.it

5 6 7 8 9

Risk measures and economic capital Fitch model: VECTOR Comparative analysis Results Conclusion

14 16 18 19 20

Introduction

From a certain perspective, the great success obtained by tranched securities can be depicted as a remarkable example of capital arbitrage strategies played by banks under the previous version of the Basel Accord: a system of risk weights largely based on notional amount of investments has proven to be a strong incentive for banks to reduce the capital requirements without shedding a proportional deal of risk. To curb this incentive the new regulatory treatment of structured credit products (from now on the terms structured credit product and tranched security are used as synonyms) has been designed along the principles of: Capital neutrality Economic capital centrality Economic capital centrality implies prudential rules able to align closely regulatory charges and risks, while capital neutrality is obtained if these rules do not induce banks either to hold assets on balance sheet or to securitize them. The new regulatory treatment does not allow a big role for internal risk estimates, as in this case regulators choose to link capital charges to public ratings; this holds true even for banks judged suitable to determine on their own the risk components of traditional credit exposures, so-called Internal Rating Banks (IRB banks, a category that virtually includes all major banking groups). For these institutions two alternative approaches have been introduced, depending on the existence of a public rating for the structured product to which they are exposed: should a rating exist, the capital charge comes from a coefcient to be applied to the exposures notional amount (Rating Based Approach, RBA); for unrated products, instead, IRB banks must provide internal estimates of probability of default (PD) and recovery rate (1-LGD) for the underlying assets, as an input of a formula set by regulators (Supervisory Formula Approach, SFA). An analysis of the two prudential regime performed by Fitch over a range of structured credit products [4] appointed RBA as the most advantageous method, suggesting a race to rating. This issue gained additional relevance as the turmoil that recently affected the market for structured credit products highlighted the drawbacks of credit ratings when used beyond their intended meaning of opinions regarding the default risk associated with either an issuer or an issue. This paper deals with the coherence between the economic capital absorbed by structured products and their regulatory treatment, focusing on iTraxx tranches, a stylized and actively traded version of corporate CDOs, that in our opinion offers a useful boot camp for the forthcoming prudential regulation. Tranches ratings have been assigned using the Fitchs methodology for CDOs evaluation, Vector. The announcement of a proposal review of this approach allowed us to gets a sense of the prudential side-effects of the initiatives that rating agencies are now undertaking to improve the robustness of CDOs ratings.

The paper is organized as follows: section 2 introduces synthetic CDOs, section 3 provides an overview of the new prudential rules for tranched products, sections 4 and 5 describe the methodologies used to obtain an estimate of the tranches riskiness, section 6 contains a brief overview of the model used by Fitch for assessing CDOs credit worthiness, section 7 and 8 illustrate the results of the comparison between economic capital and prudential requirements; the nal section reports our conclusions.

Collateralized debt obligation (CDO)

Collateralised Debt Obligations could be dened as xed income securities originated by engineering the risk of a portfolio of credit instruments. Mixing securitisation and credit derivative techniques, these products are mainly used to transfer the risks arising from a portfolio of corporate exposures (so-called corporate CDOs), or a pool of securitized retail credits conveyed by a collection of Asset Backed Securities (CDO of ABS, at center stage of the recent nancial markets crisis)1 . In all CDOs a priority scheme governs the loss absorbtion with each tranche suffering a reduction of its notional amount when losses in the portfolio breach the tranches attachment point (Lb ), expressed as a percentage of the total pool notional. The investment will be wiped out should portfolio losses reach the tranches detachment point (Hb ). The thickness of each tranche is dened by the difference between Hb and Lb . The rst tranche to suffer losses is usually called the equity, as its risk-reward prole resembles that of equity investments. Next comes the mezzanine and then one or more senior tranches, where the one that sits at the top of the CDOs capital structure is usually termed as super-senior. The credit enhancement enjoyed by a tranche does not depend only on its position in the capital structure, as the contractual rules that govern the allocation of portfolios cash-ows (cash-ow waterfall) could make some partial changes to the strict prioritization scheme provided by the sequence of attachment and detachment points (i.e. Lb and Hb values). Basically, the waterfall rules aim to offer additional protection for senior tranches against the case of a prominent collateral pool deterioration; the rst source for this credit enhancement comes from the cash accumulated along the transaction life due to the so-called excess spread, which is the difference between cash generated by the collateral pool and that needed to pay the interests promised to bond holders. The diversion of cash-ows from the devised plan is usually triggered by the eventual breach of a certain threshold of a test aimed to monitor the collateral performance.
1 Although corporate exposures and ABS can be viewed as the most popular form of CDOs collateral, many other credit assets have been used as underlying of these transactions comprising project nancing loans, trust preferred securities, as well as other CDOs.

The sequential allocation of portfolio losses along the CDO concentrates much of the pool credit risk in the lower tranches. Offering a return many times higher than that rewarded by a direct investment in the collateral pool, these notes are often referenced as leveraged positions; at the opposite, senior tranches allow investors to get a deleveraged exposure as they embody a much lower amount of risk compared to that bore by an investment of corresponding notional in the underlying pool. The original scheme of CDOs has changed a lot from its appearance at the beginning of 90s; along this path of evolution the use of credit derivatives to transfer the risk of the underlying portfolio has been a structural break-trough, which gave life to a class of product on its own, the so-called synthetic CDOs. The rst version of synthetic CDOs required a stand-alone company (special-purpose entity, SPE) selling protection on an underlying pool by synthetically referencing a portfolio of single-name credit default swaps (CDS). The SPE then offsets the risk issuing a range of tranched notes, each one with a different risk prole. In case defaults hit the portfolio, the SPE will refund the swap counterparts for losses incurred on defaulted assets using the money gathered from investors when issuing the notes. As the use of single name CDS allowed to enlarge the supply of CDOs beyond the limit of existing loans or bonds, the appearance of CDS indexes (basically portfolios of single-name CDS) entitled investment banks to go even further, by providing them a standard collateral pool. It was then a small step to propose a CDO referenced to the contracts comprised into the index, where the issuer was able to sell just one tranche, hedging away the risks associated with unsold pieces by taking offsetting positions on the index: the Single-Tranche CDO.

2.1

Single-Tranche CDOs

The distinctive features of Single-Tranche CDOs is represented by the absence of a SPE, as the contract is a derivative agreement between two counterparts which mimics perfectly the payout of a CDO governed by a straightforward losses allocation rule. The success quickly achieved by this product induced a rapid standardization of the terms on which it was offered by different dealers. Nowadays many investment banks operate as licensed dealers of two standard contracts, quoting four tranches of the Dow Jones indexes that equally weight the 125 most liquid CDS referred to top European investment grade companies, (iTraxx), and their American counterparties, (CDX.NA.IG)2 In both cases most trades regard the index series that comprise CDS whose maturity is of 3, 5 and 7 years, with very tight bid-ask spreads for the on the run ones, which is the jargon name for the version of the indexes lastly revised.
A complete description of the rules governing the composition and the rolling process of both the iTraxx and CDX.NA.IG indexes can be found at www.indexco.com, while the templates of the documentation used for trading both indexes and their tranches are available at www.markit.com.
2

Figure 1: Single tranche CDOs. While in traditional CDOs there is a clear distinction between the arranger and the investor, in this case the difference is blurred, as it is possible to assume either short or long positions. Investment banks act as market makers being prepared to buy protection from protection sellers and sell it to protection buyers. Who enters into the deal as a protection seller is entitled to receive the agreed spread on a quarterly basis, while the protection buyer is to be paid should losses in the pool breach the tranches Lb ; in this case the contract doesnt terminate until the detachment point is reached, but the incurred losses are taken into account to determine the notional value on which the cost of protection is to be paid. If we look to the investor position, i.e. the seller of protection, we can isolate three different sources of risk: one arising from changes of credit spreads on the underlying portfolio (market risk); another linked to the eventual default of one or more rms in the pool (default risk); the last one emerging from changes in the level of expected default correlation between index constituents (correlation risk). The same risks are faced by the buyer of protection, unless she has been able to place the entire capital structure (i.e. all CDOs tranches). Both the seller and the buyer of protection can immunize themselves, by dynamically managing a hedge portfolio, which anyway will leave them exposed to model and liquidity risks. The easiest risk to hedge away is the market risk, which requires buying protection (for the protection seller) in CDS referenced to each company in the pool, or in the swap referenced to the index as a whole. In both cases, the amount of protection to be traded is a multiple (the delta) of the tranches notional value and is calculated using the CDOs pricing model. Delta represents the sensitivity of the tranche value to a shift of the reference portfolio credit spreads and therefore can be interpreted as a measure of the transactions

leverage / deleverage3 .

Regulatory treatment

By deviating from a general openness to the prudential use of internal risk measures, the Basel Committee preferred to link risk weights for securitization products to public ratings, appointing rating agencies as supervisors delegated monitors. The new prudential regulation [1] provide banks with different methods to determine the regulatory capital charges of structured credit products, depending on whether the bank will implement the Internal Rating Based approach or the standardized one for the underlying exposures4 . Under the standardized approach the capital charges are linked to the securitys external credit rating by a set of weights to be applied to notional exposures (table 2). For unrated positions banks must hold one unit of capital for each unit of exposure (known as a dollar-by-dollar capital charge), being a strong capital disincentive against this kind of exposures. Capital charges for IRB banks depend on whether the position held has a credit rating from a recognized credit rating agency. Should ratings exist banks must use what is known as the Rating Based Approach (RBA). Primarily targeted to banks that invest in a securitization they did not originate, RBA maps from the tranches external rating to its capital charge via a specic look-up table (table 3). The weights for tranches of a given rating vary according to the tranche seniority and the pool granularity5 . Further, if a tranche is the most senior in its structure and enjoys an investment grade rating, it attracts a lower risk weight than the base case, as long its underlying pool is perceived to be sufciently granular (N > 6). Moreover, the RBA allows unrated positions to be assimilated to the rst subordinated tranche which enjoys a rating (inferred rating), provided that its maturity is equal or longer than the unrated position. Where a rating couldnt be inferred IRB banks must use a bottom up approach, in which a set of parameters related to the pool credit quality and to the contractual terms governing the cash ow waterfall are plugged into the Supervisory Formula, SFA. The formula, conceived for banks that act as originators of a securitization,
These hedging positions are frequently reported to contribute materially to the booming growth experienced by credit derivatives volume. It is worth to notice that the actual performance of hedging strategies relies mainly on the stability of the parameters that govern the hedge ratio quantication. For this reason the extreme movements experienced by default correlation during market turmoils have been disruptive for these strategies. 4 Under the Internal Rating Based (IRB) approach, banks are allowed to calculate prudential charges for traditional credit exposures by providing internal estimates of probabilities of default (PD) and recovery rates (1-LGD) 5 A pool is said to be highly granular if it contains a large number of exposures, none of which contributes a large part of the total risk. As a measure of granularity it is used the statistic N = ( EADi )2 \ EADi where EAD denotes the exposure at default of the i-th exposure in the pool.
3

depends on ve inputs of which only one reects banks internal estimates (the Kirb, which is the capital charge that the bank would face if the exposures had been retained on balance sheet). In principle RBA and SFA risk weights have to be applied both to banking and trading book exposures; an exception is granted for banks able to model the credit risk of trading items not caught by standard VaR models, even if the prudential guidelines on this topic have not been realesed yet. However, when the rules will be issued banks should calibrate these additional charges (so-called Incremental Default Risk charges) to the banking book ones. In the meantime, the securitisation framework will also apply to structured credit products held with trading intent unless the existence of a liquid market for these exposures grants a clear opportunity to hedge away their default risk, like in the case of iTraxx tranches.

3.1

The rational behind the RBA and SFA approaches

Decisions about the levels of structured credit product capital charges generated by the RBA and SFA approaches have been strongly inuenced by studies performed by analysts at the Federal Reserve Board and the Bank of England.

Rating based approach

Peretyatkin and Perraudin [14] examined the robustness of RBA weights on a portfolio of stylized tranched products, checking the impact of different maturities, granularity and correlation between the pool and the wider bank portfolio risk factors. For this purpose they developed a Monte Carlo model aimed to calculate the marginal Value at Risk of different tranches of stylized CDOs held into a well diversied portfolio; the model was used, along with two other simpler ones, to evaluate both the consistency of rating based charges with model based risk measurements, and the alignment of RBA weights with prudential capital that banks would have to hold in case they maintained the loans on balance sheet. They found the prudential requirements for investment quality tranches broadly consistent with the model based capital estimates, provided that the correlation between risk factors driving the structured exposures pool and the banks wider portfolio is set towards 60%. Moreover, they also detected non negligible effects played by pools granularity, asset correlation of the underlying exposures and maturity.

Supervisory formula approach

The supervisory formula has been designed in order to allocate the capital requirement of a given portfolio (Kirb ) along the capital structure of a structured credit product built upon this pool of assets. Given the difcult task to consider the myriad possible deal-specic features of each product, the formula was developed on

a limited set of information regarding the cash-ow waterfall. Pykthin and Dev [11], [12] tried to summarize the waterfall for a particular tranche in terms of its thickness T and credit enhancement level 6 . They assumed the allocation of the pools economic losses to be governed deterministically along tranches, according to a strict loss prioritization rule (SLP). Let denote the tranches credit enhancement level and T its thickness (both values easily observable for a market participant), under the SLP rule each tranche absorbs losses only in excess of , up to a maximum of T ; that is, if L denotes pool losses, then the loss for the tranche can be dened as min[L, + T ] min[L, ]. Notwithstanding its simplicity, the SLP approach brings an unsatisfactory knifeedge property when used to determine capital requirements: for an innitely grained pool, the capital requirement for a tranche is dollar by dollar if +T is less or equal to Kirb and zero thereafter7 . Gordy and Jones [8] generalized the SLP approach by adding a stochastic element to the distribution of losses across tranches in order to address the uncertainty about the true characteristics of the cash-ow waterfall. In doing this they assumed that the credit enhancement i represents the ex-ante expected protection against losses in the pool, while the actual protection provided by the waterfall is randomly determinated (they indicated with Z(i ) - where Z is a random variable - the unknown level of credit enhancement) and known only at the horizon. Based on this intuition they devised a model (Uncertainty in Loss Prioritization) Uncertainty in Loss Prioritisation (ULP) that smooths the step function for capital charges that comes out when one employs a strict prioritization rule to allocate the underlyings capital charge along the tranches of a structured credit product. The supervisory formula is based on an approximation of the ULP along with some supervisory overrides, like a dollar for dollar capital requirements for tranches whose credit enhancement fall short of Kirb , and an imposed oor level for most senior positions8 .
The thickness Ti is dened as the ratio between the i-th tranche notional Ci and that of the underlying portfolio, Ti = Ci /Ci ; the credit enhancement is dened as the sum of the notional values of all more-junior tranches. 7 To have an idea about the ows of this digital capital allocation, one can consider that subordinated tranches are entitled to get some payouts prior to more senior investors being paid out in full, hence not deserving such a harsh treatment. 8 To compute the capital charge via SFA we need to solve a function on the following seven parameters: Kirb n: number of names on the pool LGD: exposure-weighted loss given default of the pool : tranches credit enhancement T : tranches thickness : parameter that sets the level of uncertainty capital allocation between the tranches (xed by regulators );
6

A model for the conditional loss distribution

From the protection sellers perspective the value of a single tranche CDO is simply the difference between the discounted value at time t0 of the spread payments she expects to receive (fee leg), and the present value at time t0 of the sum due when defaults affect the tranche (contingent leg): V alue(t0 ) = M tM (t0 ) = f ee(t0 ) contingent(t0 ) (1)

The key input to evaluate both the fee and the contingent leg is the expected loss of the tranche to be computed of the probability distribution of losses in the pool. The market standard approach to generate the portfolios loss distribution relies on the so-called One Factor Gaussian Copula Model based upon Vasiceks model [16]9 . To derive the portfolio loss distribution the normal copula is typically implemented using either Monte Carlo simulation or quasi-analytical methods, as that described by Andersen, Sidenius and Basu [15], and Laurent and Gregory [7]. The appealing features of the copulas models is that they allow to decouple the specication of the individual stand-alone distributions from the identication of the correlation structure. While any valid correlation matrix could be used, it has become common practice to restrict the correlation structure to that described by a single common factor.

One-rm default probability

The main benet of the single-factor restriction is connected to the reduction in the number of parameters required by the model, which gave rise to effective techniques to obtain contracts values in closed-form. Most of the techniques rely on the observation that once the value of the common factor is xed, then the individual obligor defaults are conditionally independent. Based on the Merton approach for pricing corporate debt [13] a company defaults when the value of its assets decreases below the level of the rms liabilities (). In this framework the evolution of the rms assets (Ai ) is supposed to be driven by a systematic factor X, that can be interpreted as a proxy of the general state of economy, and a idiosyncratic component i . Ai = wi X +
2 1 wi i

(2)

where X and i are supposed to be uncorrelated standard normal variables (X N (0, 1), i N (0, 1) and E[X i ] = 0). The correlation between obligors i and j is wi wj , so the range of possible correlation matrices is quite limited. In fact, the most common application is to
: parameter that governs the LGD distribution.
9

The two articles by Li [9][10]are cited as the rst application of the model to pricing CDOs

10

set the weight parameters wi equal for all obligors so to consider just one pairwise correlation value for the entire portfolio, equal to the square of the factor loading10 : ij = E[Ai Aj ] = w2 (3)

Going backward to Mertons approach, starting from a default probability for the i-th obligor we get the default threshold Ai = wX + 1 w2
i

< (P Di (t))

(4)

and so the conditional default probability 1 (P Di (t)) qi (t|X = x) = 1 x (5)

A relevant choice regards the initial probability measure to use in (4): risk neutral or objective probabilities of default. If one is interested in pricing, modeling under the risk neutral measure is the natural choice; when estimating the capital absorbed by an investment, one could instead adopt an actuarial-like approach choosing historical probabilities.

Loss distribution
From (5) we see that once the value of the common factor is xed, starting with observed PD, we can obtain individual default probability conditionally independent. Then, the portfolio loss will be equal to the sum of the independent obligor losses and the conditional portfolio loss distribution will be the convolution of the individual obligor loss distributions. The simplest implementation of the single factor copula model, known as Large Homogeneous Pool (LHP), assumes the portfolio composed by innitely many small positions (perfect granularity) all sharing the same of probability of default (P Di = P D), recovery rate (Ri = R) and notional amount (Ai = A). A more realistic approach, known as Homogeneous pool is broadly used by market participants to get quick estimates of tranches prices (see [3] for a survey of the various implementation of the one factor copula model). The Homogenous pool diverges from the LHP with respect to the number of counterparties, assumed equal to the true number of companies in the portfolio, while shares the assumptions about the common value of default probability (equal to the one obtained by the quoted index spread), recovery rate and individual notional amount. Respect to the LHP the homogeneous approach allows to account for the fact that portfolio losses can only occur in discrete increments which introduces some idiosyncratic risk into the pricing framework. A structural difference between the two variants is that the exact model11 still allows some idiosyncratic risk: once
10

E[

i j 11

To get this result we must further assume uncorrelation between the idiosyncratic components = 0]) In this contest we use exact model as a synonym for the homogeneous one

11

we condition on the single factor there is still some variability in the portfolio which depends, among other things, on the number of obligors in the portfolio. In contrast, in the large pool model, the realization of the single factor uniquely determines the realization of portfolio loss. As a further step away from the large homogeneous paradigma we can remove the hypothesis of creditworthiness equality among obligors P Ds. Its common under the homogenous framework set the unique PD equal to the one derived from the average spread or from the index spread if there exists. Clearly this approximation could undermine the pricing accuracy in that it fails to consider the dispersion between the portfolio components. Further this approximation prevent us to distinguish between the different underlying names for hedging purposes: the simplied model can only produce a portfolio hedge consisting of equal weights on all the underlying names. On the other hand the unique PD is quite attractive in that it signicantly reduces the amount of information necessary to describe the structure. Having in mind the above considerations for our analysis we adopted a sort of Heterogenous Pool approach. We considered exactly 125 names each with its own P D (P Di ) derived from market data. We slightly deviate from the real heterogenous approach described in [2] in that we assume a constant recovery rate R (conventionally xed at 40%12 ) as well as the same invested amount for each company, A. The latter assumption doesnt represent a simplication in that the iTraxx index is made up by equally weighted exposures13 . The constancy of both recovery rates and exposures weights makes the computation of the loss distribution easier. Under this assumptions each credit either will take no loss or a loss of A(1 R), so that the distribution of losses on the reference portfolio will take on N + 1 discrete values corresponding to no defaults, one default, two defaults, and so on up to N defaults. Under this assumption, the distribution of losses and the distribution of the number of defaults become interchangeable: simply multiply the number of defaults by A(1 R) to get losses. An easy way to compute the entire default distribution p(l, t) is to implement the iterative algorithm proposed by Andersen, Basu and Sidenius [15]. Let pk (l, t|X) to denote the conditional probability to observe exactly l defaults at time t in a portfolio containing k credit exposures. If we know the entire distribution pk (l, t|X) (for l = 0, . . . , k), using the following iteration we get the default distribution for a k + 1 portfolio: pk+1 (0, t|X) = pk (0, t|X)(1 qk+1 (t|X)) pk+1 (l, t|X) = pk (l, t|X)(1 qk+1 (t|X)) + pk (l 1, t|X)qk+1 (t|X) pk+1 (k + 1, t|X) = pk (l, t|X)qk+1 (t|X)
12

(6)

The 40% recovery rate is thought to be coherent with the historical rate observed on the US unsecured bond market. 13 For lack of simplicity in the following we assume an invested total amount of 1 unit. Therefore N A = 1 and Ai indicates at the same time the amount invested on name i as well as the weight i=1 i on name i.

12

where qk+1 (t|X) is the default probability of the k+1 exposure added to the k-portfolio. Starting from the degenerate default distribution for k = 0, p0 (0, t|X) = 1, we can then use the recursion (6) to solve for the default distribution of the reference portfolio of N credits: pN (l, t|X)l = 0, ..., N (7) Once we have the conditional default distribution, the unconditional default distribution p(l, T ) can be solved as14 :

p(l, t) =

pN (l, t|X)g(X)dX

(8)

where g is the probability density of X. The integral is solved numerically. It is worth noting that the shape of the portfolio loss distribution depends largely on the strong assumption about defaults interdependence. In our framework the uniform pairwise correlation impacts on the individual conditional default probability (5) and, by (6), affects the entire distribution, inuencing the allocation of the risk along the capital structure (see section 7). As the risk of different tranches varies with asset correlation so does their fair values: asset correlation is indeed the most important parameter for Single-Tranche pricing, as highlighted by the market practice to quote the tranches implied correlation rather than its fair spread15 .

4.1

The pricing model

Let f L (c, t) be the density of the cumulative portfolio loss16 at time t. Given f L (.) we can compute the expected loss for a given tranche in a risk neutral world as:
Q Et [C L (t)] = Hb Lb

(c Lb )f L (c, t)dc

(9)

Provided that the index components share the same notional amount and hold for true the assumption of constant recovery rate across the pool, it is easy to see that the loss distribution will assume discrete values: let N denote the exposures comprised in the reference portfolio, the loss distribution will assume N + 1 values (from 0 to N defaults). The (9) will then reduce to17 :
N

Et [L] =
l=0
14

p(l, t){min(lA(1 R), Hb ) min(lA(1 R), Lb )}

(10)

To simplify the notation there on we omitted the sufx N In the market jargon the implied correlation is the number that makes the fair or theoretical value of a tranche equal to its market quote under the One Factor Gaussian Copula Model 16 With c we refer to the cumulative loss of the portfolio. 17 We omitted the Q since this quantity will be computed under both the risk neutral and real world measures
15

13

where p(l, t) is the probability to get l defaults by time t computed by (8) and N is the number of single name CDS composing the underlying portfolio. The settlement convention to pay the contingent at the payment dates following the default further simplies the pricing, as it allows us to determine the expected loss only on a quarterly basis. From (10) the expected value of the payments due in case of defaults will be equal to
n

contingent =
t=1

Dt (Et [L] Et1 [L])

(11)

while the fee leg could be expressed as

n

F ee = s
t=1

Dt t {(Hb Lb ) Et [L]}

(12)

where t = t (t 1), s is the yearly spread due by the protection buyer and Dt is the risk-free discount factor for payment date t. In (12) the amount (Hb Lb ) Et [L] indicates the notional reduction caused by defaults and reects the right of the investor (protection seller) to get payments only on the residual amount of the tranche. Like interest rate swaps, at inception synthetic CDO tranches will have their spreads set to constrain the mark-to-market value to zero; setting M tM = 0 in (1) and using (11) and (12) to solve for s, the par spread can be obtained as spar =
n t=1 Dt t {(Hb

contingent Lb ) Et [L]}

(13)

Risk measures and economic capital

The risk of a tranched product can be evaluated by different metrics. From now on we describe those we believe could be eligible as proxies of the economic capital absorbed by a corporate CDO, adopting the one-year time horizon chosen by Basel II for all credit exposures. We are aware that this time horizon is far too extended for index tranches that, mostly held in the trading book, need a shorter period to be closed or hedged. In this regard, the adoption of the 1-year regulatory constrained embodies the idea of using these contracts as a proxy of corporate CDOs, whose scarce liquidity can well justify the regulators choice, as showed by the recent upheavals in the market for these products. In line with the Value at Risk baseline methodologies on which Basel II relies to assign capital charges on both credit and market exposures, we computed a rst measure of the economic capital absorbed by tranches using a VaR measure derived from the Gaussian Copula model, taking the expected loss at the one year time

14

horizon conditioned at the 99.9 th percentile of the systematic factor18 . In our framework that is equivalent to solve (10) considering the probability distribution conditioned to X = x99.9 (7):
N

Et1 [L|X = x99.9 ] =

l=0

p(l, t|X = x99.9 ){min(lA(1 R), Hb ) min(lA(1 R), Lb )} (14)

Et1 [.] can be considered as a measure for the Unexpected Loss computed over the disposed one-year time horizon. This method, while based on a widely used methodology for computing Credit VaR measures, fails to consider the additional risk encapsulated on the maturity of these instruments being longer than the VaR time horizon. To be clear just consider two different tenor but otherwise identical tranches, one with one-year maturity (t1 ) and the other with ve-years maturity (t5 ): if we compute (14) at t1 we end up with the same unexpected loss for both tranches. This additional risk, which encompasses the losses that could hurt the tranches until the maturity (downgrade risk) has been take into account also by regulators which impose to adjust the capital charge for all the credit exposures by the socalled maturity adjustment. Further, independently from regulatory prescriptions, the liquidity squeeze stemmed from the recent turmoil on the mortgage related assets, strongly suggests to consider a longer time horizon - may be the nal maturity - when assessing the risk embedded on structured credit products. All things considered, we dened a more comprehensive risk measure based on the loss suffered at t1 by an hypothetical investor which bought the tranches in t0 . Such an investment is vulnerable to the losses occurring from t0 to t1 as well as to the potential loss faced in case she decided to close the position at time t1 . Accordingly, an effective risk measure should account for both losses. Being a seller of protection, the investor is mainly concerned about an increase on credit spreads which could make the quarterly premium xed at time t0 inadequate to cover the risk he brings. This of course will cause a drop on the value of the cash ow she expects to receive during the holding period (t0 t1 ). However, the loss suffered during the holding period dont allow for the potential loss the investor could face as the effect of tranches evaluation at time t1 . The tranches value at time t1 clearly depends on the default observed from t0 to t1 on the time to maturity as well as on the future evolution of credit spreads. In order to consider both the sources of risks we computed the following measure of risk, that we called Modied Unexpected Loss: U Lmod = E[CashF low(t0 , t1 )|X = x99.9 ] + |M tM (t1 , t5 )|
18

(15)

Gordy[6] shows that when dependence across exposures is driven by a single systematic risk factor, and no exposure accounts for more than an arbitrarily small share of total portfolio (perfect granularity), the loss distribution is completely described by the systematic factor distribution: this allows to compute the VaR without generating the entire loss distribution.

15

The rst term largely resembles the unexpected loss as dened in (14) but it provides a more precise estimate for the loss suffered during the holding period in that it considers the spreads cashed in by the investor. Moreover it is equivalent to the mark to market of a contract with maturity of 1 year, having observed a negative state of the economy during this time horizon (X = x99.9 ). The second one mainly accounts for the mismatch between the time horizon of the VaR measure and the product maturity. Since its evaluation is equivalent to that of a 4-year CDO written on the original pool of names starting at t1 and with maturity at t5 , it resembles the pricing of a forward starting CDO, an issue recently studied by Hull & White [18]. Forward starting CDOs represent contracts that compel two counterparties to enter into a CDO transaction at a specied future time on a given portfolio at an agreed spread; the contract is canceled out if during the period between the deal date and the start date the portfolio experiences an amount of losses exceeding the tranche detachment point. In line with standard CDOs, we dene the forward CDO spread as the specic spread value that determines a zero Mark to Market at the deal date. Market participants distinguish the case where the underlying portfolio currently exists (specic forward start CDOs), and may have suffered defaults before the start date occurs, from the de novo portfolio which will come into existence at the start date (general forward start CDOs). Hull & White have showed that specic forward CDOs can be priced in a consistent way by the One Factor Gaussian Copula Model, as it produces coherent results with those obtained by a more general dynamic model [17]. Accordingly, to compute the M tM (t1 ) in (15) we used the One Factor Gaussian Copula Model, considering the reduction of the notional portfolio caused by losses incurred from t0 to t1 . In this respect we need to calculate the number of defaults (l) associated to the losses incurred during the 1 year time horizon. To get l we compute the portfolio unexpected loss at time t1 by (14); hence, considering the equivalence E1 [L|X = x99.9 ] = l A(1 R) E1 (16) A(1 R) Once we known l from (16) we can easily compute M tM (t1 , t5 ) just evaluating (14) starting from l = l . l = we obtain

Fitch model: VECTOR

While a detailed analysis of the process performed by rating agencies when evaluating structured credit products is well beyond the goal of this paper, in this paragraph we provide a general outline of the Fitch methodology we used to obtain the tranches rating used under RBA (par. 3). 16

Fitch assesses CDOs creditworthiness performing a two-stage process. In the rst stage, an analytical model is used to assess the pool credit risk, while the second stage is devoted to conduct a structural analysis of the transaction, which crucially depends on deal specics as laid out in the CDOs documentation19 . Due to the interactions between the two stages, ratings cannot be simply viewed as the model outputs since they are the results of a formal committee process. In the case of iTraxx tranches, their straightforward nature allows us to focus only on model outputs and dismiss the effect of the evaluation regarding the qualitative aspects of the transaction. Fitch itself used to provide model based credit assessments for iTraxx tranches, even if they dont assure that an actual credit rating will be the same as the assessment, or that the assessment will not materially change over time. The proprietary model used by Fitch to perform the rst stage of CDOs rating (Vector) is a multi-period one, based on a structural form approach according to which a company defaults when the value of its assets falls below the value of its liabilities (default threshold). The full loss distribution is obtaneid using Monte Carlo simulations: for each year correlated asset values are generated and compared with the related default thresholds. When a default occurs, the recovery amount is registered and the obligor is removed from the portfolio. The multi-step feature of the simulation allows the incorporation of time-vary parameters such as default probabilities. The default threshold assigned to each obligor is derived from the Fitch CDO Cumulative Default Matrix which contains for each rating the cumulative default rates for different horizons. Vector requires the pools asset correlation as an input. For pools that comprises corporate exposures Fitch has developed a factor model that derives equity return correlations between different countries and industries as a proxy of asset correlation. Vector is used to perform a credit risk analysis based on the following strategy: rst, the model estimates a default rate distribution of the collateral portfolio. Next, asset specic recovery rates are used to obtain a loss distribution out of the default distribution; the portfolio loss distribution is then employed to establish representative stress scenarios, assigning to each scenario a realization probability. Finally, the severest stress scenarios sustained by a tranche without monetary losses determines the rating of that tranche. For instance, a tranche will enjoy a AAA rating only if the probability of realization of the scenario that produces losses in the reference portfolio exceeding the tranches attachment point has been estimated to be lower or equal to the historical frequency of default of a AAA credit exposure on a time horizon xed to the tranches maturity. After the recent nancial market turbulence a widespread criticism have been
19 This step usually comprises a detailed cash-ow modeling as well as legal assessments and evaluations of any third parties involved in the agreement, such as servicers and asset managers.

17

addressed to the main rating agencies, regarding the crucial role they have been playing in the structured nance space.An effect of this debate has been the decision of the three major agencies to perform a thorough review of both their rating models and processes. A the beginning of 2008 Fitch posted to the nancial industry a proposal for a major review of its model for CDOs evaluation. While the overall models architecture has been conrmed, material changes have been introduced for default probabilities and recovery rates, in order to strengthen consistency with empirical long-term observations. Default rate time series have been also updated to consider the now prevailingly tighten credit market conditions and calibrating also the model on historical peaks. The agency claims that these changes will have a relevant impact on Fitchs corporate CDO ratings currently outstanding. The rating on synthetic CDOs referencing investment-grade corporate exposures are expected to be the most severely impacted, with model-implied downgrades on average of around ve notches; for some senior tranches the downgrades can be as severe as from AAA to BB. When performing our comparative analysis we used rating obtained using both the Old and New methodologies so to compare the impact of these changes on prudential charges.

Comparative analysis

We performed our analysis with respect to the standard tranches quoted on the fth series of the iTraxx index, using the market data as of September 15, 2006 for the ve year maturity. For each tranche the economic capital absorbed has been computed under the two proposed measures, using both risk neutral and real world PDs; the results have been compared with the capital charges calculated under both the regulatory approaches: RBA and SFA. As rst we checked the soundness of the pricing methodology by calibrating the model (5-13) to tranches correlation values quoted by dealers (see table 4) to obtain exactly the market spread of each tranche. Risk neutral PDs have been derived from CDS spreads. We assumed a Poisson process for default, implying P Di = 1 exp(t). The annual default intensity has been obtained from the 5-year CDS spread quoted at September 1520 ; to keep the computation simple we assumed a at term structure for the default intensity and a constant recovery rate of 40%. Actual PDs have been computed using the assigned by Fitch to the 125 companies listed in the fth series of the iTraxx index. As a proxy for the PD we considered the 5-year cumulative default rate (CRD) computed over a portfolio encompassing all the corporate nance long-term debt issuer ratings assigned by
has been computed using the pricing formula of credit default swap, going backward from the quoted CDS spreads to the default intensity, .
20

18

Fitch from 1990 to 2006 [5]. From these gures we derived the constant intensity of default as = log(1 CRD)/5. It is widely known that actual PDs are, on average, lower that those resulting from from CDS spreads, mainly due to scarcity of defaults occurred in the best rating classes (see table (1) ). In our case moving from the risk neutral world to the real world reduces the average default probability of Itraxx constituents on the ve year time horizon by half a percentage point (from 2.45% to 1.91%). In order to evaluate the sensitivity of the two proposed risk measures to the value of asset correlation in the collateral pool we considered values of ranging from 5% to 30%. We chose to use the same correlation measure for all tranches (we refer to the implied or compound correlation), as the same idea of multiple correlation for the same pool lacks logical background and should be viewed as a signal of the limited adequacy of the standard pricing model to explain the quoted tranche prices. RBA charges are based on model implied ratings obtained using the Fitch proprietary model (Vector 3.2): Old Ratings; we also used assessments produced by the latest release of the same model recently proposed by the agency: New Ratings. In implementing the Supervisory Formula we obtained the Kirb parameter using default probabilities derived by ratings assigned by Fitch to each rm in the pool and assuming a common LGD value of 60%. The one year PD has been calculated on the basis of the historical default rate observed in one year time for each rating class along the seventeen years spanning from 1990 to 2006.

Results

For the most senior tranches we found RBA and SFA charges being closely aligned; likewise, at the lowest end of credit spectrum the equity tranche faces comparably stringent charges under both approaches (gure 2). Rather than the result of a sensible calibration of regulatory approaches, this is mainly due to the cap and oor that Basel II applies to the ULP model, which bounds the resulting capital charges. The alignment relaxes moving to the center of capital structure, as SFA charges become signicantly higher than the RBA ones, at least as long as Old Ratings are used (3.5 times in the case of the tranche 3-6). The opposite happens when we deal with the RBA charges stemming from New Ratings, providing clear evidence of the additional degree of prudence adopted by Fitch when developing the latest Vector release. Our most relevant nding, however, is that RBA charges, expected to be the preferred criteria for measuring the regulatory capital for CDOs held into the banking book, do not fully cover the economic risk of tranches. Using risk neutral PDs and a correlation value of 15% or greater, our estimates of economic capital absorption (U Lmod ) exceed the RBA charges for all tranches 19

but the equity 21 (table 6). The gap is sizable for the mezzanine investments, with the regulatory capital being 15 times lower than the EC (for the 3 6% tranche, see gure 3). Regulatory and economic capital are more aligned using New Ratings. In this case the ratio between EC and RBA CC plummets from 15 to about 1 for the junior mezzanine tranche with a correlation of 15%, but widens again as we let the correlation to increase. This pattern emphasizes the key role played by default correlation in explaining the differences between CC and EC. From a regulators perspective this nding is quite relevant: asset correlation tend to increase during economic downturns, which is precisely the situation regulatory capital has to cope with. Part of the gap depends on the use of risk neutral probabilities of default when computing risk metrics. In this regard we argue that it seems inadvisable computing economic capital measures without considering market information; the attention paid by rating agencies to CDS spread as leading indicators for implied ratings seems to conrm our point. Finally, our results are inuenced by the Basel II time horizon for banking exposures. In this respect we are aware that one year is clearly too extended for iTraxx tranches, that need a shorter time period to be closed or hedged. This regulatory horizon become acceptable as we think to index tranches as a proxy of plain corporate CDOs held in the banking book; the scarce liquidity of these products, that the recent upheavals in the market has just conrmed, can well justify the regulators choice implemented in our excercise.

Conclusion

Like polo shirts, that come only in small, medium and large sizes, ratings are discrete in nature and address just one dimension of structured products risk, the probability of default. For this reason they are not the right tool for capital allocation, that should be based on tailor made metrics linked to extreme values of the loss distribution. We think that it would be useful to explore the robustness of rating based prudential charges with respect to less stylized corporate CDOs or other structured credit products, like CDOs of ABS. In the event the same ndings emerge it should be questioned whether the Basel II mapping from ratings to capital is the right choice or it is encouraging new forms of arbitrage.

21

Being unrated, the equity tranche is entitled of a dollar by dollar (100%) capital charge.

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References
[1] The capital requirements directive 2006/48/ec. European Parlament. [2] P. Allen E. Beinstein. Enhancing our framework for index tranche analysis. Credit derivative research, JP Morgan, 2005. [3] C.C. Finger. Issues in the pricing of synthetic cdos. Working Paper 04-01, RiskMetrics Group, 2004. [4] FitchRatings. Basel 2: Bottom-line impact on securitization markets. Special report, FitchRatings, 2005. [5] FitchRatings. Fitch ratings global corporate nance 2006 transition and default study. Special report, FitchRatings, 2007. [6] M. Gordy. A risk-factor model foundation for rating-based bank capital rules. Journal of nancial intermediation, 12:199232, 2003. [7] J.P. Laurent J. Gregory. Basket default swaps, cdos and factor copulas. Working paper, BNP Paribas, 2003. [8] M. Gordy D. Jones. Random tranches. Risk, march:7883, 2003. [9] D. Li. The valuation of basket credit derivatives. CreditMetrics Monitor, april:3450, 1999. [10] D. Li. On default correlation: a copula function approach. Journal of xed income, 9(4):4354, 2000. [11] A. Dev M. Pykhtin. Credit risk in asset securitizations: an analytical model. Risk, may:s16s20, 2002. [12] A. Dev M. Pykhtin. Coarse-grained cdos. Risk, january:113116, 2003. [13] R.C. Merton. On the pricing of corporate debt: the risk structure of interest rates. Journal of nance, 29:449470, 1974. [14] V. Peretyatkin W. Perraudin. Capital for structured products. Mimeo 4-2, RiskContrl, 2004. [15] L. Andersen L. S. Basu J. Sidenius. All your hedge in one basket. Risk, November, 2003. [16] O. Vasicek. Probability of loss on loan portfolio. White papers, KMV, 1987. [17] J. Hull A. White. Dynamic models of portfolio credit risk: A simplied approach. Working paper, University of Toronto, 2006. [18] J. Hull A. White. Forwards and european options on cdo tranches. Working paper, University of Toronto, 2007.

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Figure 2: SFA vs RBA CC)

Figure 3: EC vs RBA (Old rating)

22

Figure 4: EC vs RBA (New rating)

Figure 5:

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Names Abn Amro Accor Adecco S.A. Aegon N.V. Akzo Allianz Altadis Arcelor Auchan Aviva AXA BAA BAE system Banca BPI Banca Intesa Banca MPS Banco Bilbao Banco Comercial Portugues Banco Espirito Santo Banco Santander Barclays Bayer Aktiengesellschaft Bayerische Motoren Werke Bertelsmann Boots British American Tobacco British Telecommunications Cadbury Schweppes Capitalia Carrefour Centrica Ciba Specialty Chemicals Commerzbank Compagnie de Saint-Gobain Compagnie Financiere Michelin Compass Continental DaimlerChrysler Degussa Deutsche Lufthansa Deutsche Telekom Deutshe bank Diageo

Rating (Fitch) AABBB BBBAA AA+ BBB+ BBB A A+ AAABBB BBB AAA+ AAA+ A+ AA AA+ BBB+ A+ BBB+ BBB ABBB+ BBB AA A BBB A ABBB+ BBB+ BBB+ BBB+ BBBBBBAAAA+ 24

Real PD (%) 0.03 3.74 4.76 0.15 1.42 0.37 2.24 3.74 0.5 0.37 0.03 1.42 3.74 3.74 0.03 0.37 0.03 0.37 0.37 0.15 0.03 2.24 0.37 2.24 3.74 1.42 2.24 3.74 1.42 0.5 0.5 3.74 0.5 1.42 2.24 2.24 2.24 2.24 4.76 4.76 1.42 0.03 0.37

Risk Neutral PD (%) 0.93 3.15 3.58 1.21 2.00 0.91 2.56 3.31 1.15 1.19 1.24 4.09 2.36 2.32 1.09 1.32 1.07 1.14 1.24 1.28 0.79 2.56 1.11 2.76 2.64 2.16 3.39 2.84 1.40 1.13 1.96 3.89 1.72 2.24 3.04 3.08 2.92 4.39 7.26 3.93 3.47 1.11 1.24

Names Dsg International E.ON EADS Edison EDP - Energias de Portugal Electrcite de France Electrolux EnBW Energie Baden-Wuerttemberg Endesa Enel Finmeccanica Fortum France Telecom Gallaher Group Gas Natural Generali GKN Holdings Glencore International GUS Hannover Rueckversicherung Hellenic Telecommunications Henkel HVP Iberdrola Imperial Chemical Industries Imperial Tobacco ITV Kingsher Koninklijke Koninklijke Philips Electronics Lafarge Linde Aktiengesellschaft Louis Vuitton Marks and Spencer Metro mmO2 Muenchener Ruck National Grid Nestle Nokia Pearson Peugeot

Rating (Fitch) BBB+ AAA BBB A AABBB+ AAA+ BBB A+ ABBB A+ AABBBBBBBBB+ A+ BBB AA A+ BBB BBB BBBBBB ABBB+ BBB BBBBBB BBB+ BBB BBB+ AABBB+ AAA A+ BBB+ A-

Real PD (%) 2.24 0.03 0.5 3.74 0.5 0.03 2.24 1.42 1.42 0.37 3.74 0.37 1.42 3.74 0.37 0.03 4.76 4.76 2.24 0.37 3.74 1.42 0.5 0.37 3.74 3.74 4.76 3.74 1.42 2.24 3.74 4.76 3.74 2.24 3.74 2.24 0.03 2.24 0.03 0.37 2.24 1.42

Risk Neutral PD (%) 2.96 0.99 1.76 1.44 1.09 0.66 3.08 0.99 1.17 0.99 1.72 1.07 2.88 2.52 1.44 0.95 4.59 7.15 3.06 2.08 3.35 1.36 1.07 1.42 3.11 3.15 2.41 3.78 10.17 1.64 2.92 3.94 1.88 2.60 2.52 2.08 1.58 2.12 0.33 0.91 3.11 2.30

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Names Portugal Telecom Internat. Finance PPR Reed Elsevier Renault Rentokil Initial 1972 Repsol Reuters RWE Safeway Sano Aventis Sanpaolo Imi Siemens Sodexho Alliance Stora Enso Suez Svenska Cellulosa Aktiebolaget Swiss Reinsurance Company Tate & Lyle Technip Telecom Italia Telefonica TeliaSonera Tesco The Royal Bank o Scotland Thomsom Unicredir Unilever Union Fenosa United Utilities UPM-Kymmene Valleo Vattenfall Aktiebolag Veolia Environnement Vivendi Universal Vodafone Group Volkswagen Volvo Wolters Kluwer WPP 2005 Zurich Insurance Company

Rating (Fitch) BBB BBBABBB+ BBB BBB+ AA+ BBB AAAAAABBB BBB A BBB+ AABBB BBB BBB+ BBB+ AA+ AA+ BBB A+ A+ BBB+ BBB+ BBB BBB A+ ABBB AAABBB BBB+ A

Real PD (%) 3.74 4.76 1.42 2.24 3.74 2.24 1.42 0.37 3.74 0.03 0.03 0.03 3.74 3.74 0.5 2.24 0.03 3.74 3.74 2.24 2.24 1.42 0.37 0.03 3.74 0.37 0.37 2.24 2.24 3.74 3.74 0.37 1.42 3.74 1.42 1.42 1.42 3.74 2.24 0.5

Risk Neutral PD (%) 3.94 3.78 1.80 3.00 1.88 2.32 1.80 1.01 3.55 1.60 1.09 0.91 2.12 3.19 0.99 2.12 1.64 2.44 2.00 5.64 3.47 3.55 1.07 0.75 5.23 1.30 1.24 2.28 1.56 3.11 7.80 1.07 2.12 3.51 2.56 1.96 2.82 3.78 2.44 1.68

Table 1: Risk neutral vs Real world 5-years probabilities for the 125 names.

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Counterpart Sovereign Banks (options 1) Banks (options 2) Corporates Securitisation products

AAA to AA0% 20% 20% 20% 20%

A+ to A20 % 50 % 50 % 50 % 50 %

BBB+ to BBB50% 100% 50% 100% 100%

Rating classes BB+ B+ to BBto B100% 100% 100% 100% 100% 100% 100% 150% 350% Capital deduction

below B150% 150% 150% 150% Capital deduction

unrated 100% 100% 100% 100% Capital deduction

Table 2: Standard approach. Risk weights.

Long Term Rating Aaa/AAA Aa/AA A1/A+ A2/A A3/A Baa1/BBB+ Baa2/BBB Baa3/BBBBa1/BB+ Ba2/BB Ba3/BBBa3/BB-Unrated

Senior 7% 8% 10% 12% 20% 35% 60%

Base case 12% 15% 18% 20% 35%

Tranche type Backed by non granular pools 20% 25% 35% 50% 50% 100% 250% 425% 650% Deduction

Table 3: RBA risk weights.

5Y Tranches 03 36 69 9 12 12 22

Mid Spread 500+15.65% 49.5 14.5 6.5 3

Index spread 27 Base Corr Comp Corr 12.7% 12.7% 22.5% 6.4% 29.7% 13.4% 35.4% 17.5% 51.3% 25%

Delta 26x 5x 1.5x 0.75x 0.3x

Table 4: iTraxx trading screen

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Tranche 03 36 69 9 12 12 22 22 100

Ratings (Old) NA AAAA AAA AAA NA

RBA (Old) 100.00 2.80 0.56 0.56 0.56 0.56

Ratings (New) NA BB AAAAA AAA NA

RBA (New) 100 36.00 1.44 0.56 0.56 0.56

FSA 92.00 10.00 0.56 0.56 0.56 0.56

Table 5: RBA and SFA Capital Charges

Tranche 03 36 69 9 12 12 22 22 100 5% 48.7 6 0 0 0 0 15% 100 43.5 4.4 0.6 0 0 25% 100 78.4 29 4 0.5 0 30% 100 100 55 9 1.2 0

Table 6: U Lmod - Risk neutral PDs

Tranche 03 36 69 9 12 12 22 22 100 5% 31 6 0 0 0 0 15% 76.6 20 0.8 0 0 0 25% 100 60 8.4 1.3 0 0 30% 100 78 20.4 2.6 0.3 0

Table 7: U Lmod - Real World PDs

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