Understanding the Risks in Credit Default Swaps AUTHOR: CONTENTS: Jeffrey S

STRUCTURED FINANCE Special Report

Understanding The Risks In Credit Default Swaps AUTHOR: CONTENTS: Jeffrey S. Tolk • Summary Opinion Vice President Senior Credit Officer • Credit Default Swaps (212) 553-4145 [email protected] • The Typical Structure • Isolating The Reference Portfolio's Credit Risk CONTACTS: • Moody's Definition Of Default And Loss Issac Efrat Managing Directior • ISDA Credit Events (212) 553-7856 [email protected] • The Problem Of “Soft” Credit Events: Synthetic Vs. Cash Gus Harris • Moral Hazard Managing Director (212) 553-1473 • Marking-To-Market/Calculation Of Losses [email protected] • Reference Credits Other Than Corporate Obligations Jeremy Gluck Managing Director • Good Faith Of The Sponsor (212) 553-3698 [email protected] • Conclusion

Investor Liaison SUMMARY OPINION Vernessa Poole Credit derivatives offer unique opportunities and risks to investors. They allow All Asset Backed and investors to have exposure to a firm without actually buying a security or loan Residential Mortgage issued by that firm. Because the exposure is synthetic, the transaction can be Backed Securities tailored to meet investors’ needs with respect to currency, cash flow, and tenor, (212) 553-4796 among other things. However, if the transaction is not structured carefully, it may [email protected] pass along unintended risks to investors. Significantly, it may expose investors to Sally Cornejo higher frequency and severity of losses than if they held an equivalent cash position. Collateralized Debt Obligations, Moody's has rated numerous structured transactions — mostly synthetic collateral- Commercial Mortgage ized debt obligations (CDOs) and credit-linked notes (CLNs) — whose key feature is Backed, and Fully a cash-settled credit default swap. Under the swap, losses to investors are deter- Supported Securities mined synthetically, based on “credit events” occurring in a reference portfolio. (212) 553-4806 Investors’ risk, thus, is driven largely by the definition of “credit events” in the swap. [email protected] The broader the definition, the broader the risk. The definitions published by the International Swaps and Derivatives Association WEBSITE: (ISDA) are, in many respects, broader than the common understanding of “default,” www.moodys.com and thus impose risk of loss from events that are not defaults. For example, Moody's — and much of the market — considers certain types of “restructuring” events to be “defaults.” However, the current ISDA definition of “restructuring” is broader than Moody's definition of “default,” and includes events that would not be captured by a Moody's rating.

March 16, 2001 Likewise, the ISDA definitions for other credit events — e.g., bankruptcy, obligation acceleration, and obligation default — are broader than Moody's definition of “default.” For the Moody's rating of a reference portfolio to capture the risks to investors, the “credit events“ should be narrowed such that they are consistent with “defaults” — the events captured by a Moody's rating. Many of the risks in these transactions are driven by moral hazard — the inherent conflict of interest that exists because the sponsoring financial institution (which is buying protection from investors) determines when a loss event has occurred as well as how much loss is imposed on investors. The sponsor's incentive, of course, is to construe “credit events” as expansively as possible and to calculate losses as generously as possible. Moody's considers these risks carefully when issuing its ratings. In addition to tightening the credit event and loss calculation provisions, these risks can be addressed by increasing transparency and providing mechanisms for objectively verifying loss determinations and calculations. Setting aside moral hazard, risks also arise based on the inherent difficulty in valuing a defaulted credit to determine the extent of loss to investors. Calculated losses may vary based on liquidity, market conditions, and the identity of the parties supplying bids. In analyzing a credit default swap, Moody's looks carefully at the methods and procedures for calculating loss given default, to ensure that all calculations are meaningful, realistic, and fair. The ISDA Credit Derivatives definitions, as currently drafted, do not effectively unbundle “credit risk” from other risks. If not structured carefully, a credit default swap using the ISDA definitions can pass along risks other than “credit risk.” For example, the swap may pass along the risk of loss following credit deterioration short of default. Such a risk is not necessarily captured by a Moody's rating of the reference portfolio, and, with some exceptions (e.g., when the loss event is a rating downgrade) is not readily capable of being measured. The capital markets have an enormous Table 1 capacity for absorbing credit risk, and this Example of a Cash-Settled Credit Default Swap capacity has only been partially tapped by the credit derivatives market. In Moody’s opinion, for capital markets investors to participate fully Premium in the credit derivatives market, the risks Seller Buyer inherent in credit default swaps must be more Credit Event Payment precisely defined, more transparently managed, (100%-market value) x notional and more readily quantifiable. This special report will describe the typical cash-settled credit default swap underlying a synthetic CDO or CLN,1 compare Moody’s definition of default with the credit event defi- Reference nitions currently used in the ISDA documen- Credit(s) tation, and discuss how different structural features and parameters of a credit default swap can affect risks to investors and impact Moody’s analysis and ratings.

CREDIT DEFAULT SWAPS Credit default swaps allow one party to “buy” protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits). The “buyer” of protection pays a premium for the protection, and the “seller” of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified “credit events.”

1 For purposes of this report, a CLN refers to a structure that references a single credit, and a synthetic CDO refers to a structure that references a portfolio of credits. 2 • Understanding The Risks In Credit Default Swaps A swap can be structured to provide for either physical settlement or cash settlement following a credit event. In a physically settled swap, the buyer of protection delivers to the seller an obligation of the reference entity that has experienced a credit event. The seller pays par for that asset, thus reimbursing the buyer for any default-related loss that it would otherwise suffer. In a cash-settled swap, the buyer of protection is not required to deliver the defaulted credit, but values the credit — for example, by marking it to Example of Cash-Settlement Under a Credit market or by using a final workout value — and is Default Swap Thirty days after a company defaults (e.g., it fails to reimbursed for the loss (measured by the differ- make a bond coupon payment), its bonds are valued ence between par and the value following default). at 30 cents on the dollar. If the notional of a cash- Because most of the synthetic CDOs and CLNs settled credit default swap referencing that entity’s that Moody’s rates are supported by cash-settled bonds is $10 million, the protection “seller“ would be swaps, this special comment will focus on cash- required to make a payment of $7 million to the settled credit default swaps. protection “buyer.“ THE TYPICAL STRUCTURE Through synthetic CDOs or CLNs, financial institutions utilize credit default swaps to “buy” credit protection — usually from the capital markets in the form of issued securities, but also directly from counterparties in the form of over-the-counter swap transactions. The structure allows financial institutions to remove credit exposure from their balance sheets while retaining ownership of the assets, and thus (1) manage risk more efficiently, and (2) obtain economic and/or regulatory capital relief. In the typical structure, the sponsoring financial institution (the entity seeking protection against credit losses) sets up a special purpose vehicle (SPV) to serve as counterparty to the credit default swap (making the SPV the provider of protection). The SPV is funded with the proceeds of notes issued to investors; it will use those proceeds to make credit event payments to the financial institution, and to return any remaining principal to investors at the deal’s maturity. The proceeds of the securities are typically invested in highly rated securities in such a way that the ratings of the notes can be “de-linked” from the rating of the sponsoring institution. Under the swap, the SPV is the “seller” of protection, and the financial institution is the “buyer.”The swap references a credit exposure, or portfolio of credit exposures, for which protection is being provided. The arrangement is similar to an insurance policy, in which the financial institution is buying insurance against losses due to default in its portfolio. The credit exposures can be assets physically owned by the sponsor (e.g., loans, Table 2 Typical Structure bonds, other securities), exposures to counterparties (e.g., by way of Credit currency or interest rate swaps), or Default Swap synthetic exposures (e.g., if the Notes Premium sponsor has sold protection on partic- Investors SPV Sponsor ular assets by way of credit default Credit Event 2 Proceeds swaps). Typically, in a synthetic CDO, Payments the financial institution retains the first- loss piece, and the mezzanine tranches are securitized and sold to investors. There is often a “super- Reference senior” piece that is either retained by Collateral the sponsor or passed off to a coun- Credit(s) terparty by way of a swap.

2 However, there is no requirement that the sponsoring institution actually have exposure to the credits being referenced; it may merely wish to take a short position on the credit of the reference entities. Understanding The Risks In Credit Default Swaps • 3 There are a number of key variations on the structure that can have a significant impact on the analysis of the transaction: • The reference pool can be static — remaining the same throughout the life of the transaction — or it can be dynamic, permitting removal and substitution of the individual reference credits pursuant to portfolio guidelines. • The swap can provide for ongoing cash settlement — as defaults happen and losses are incurred — or it can provide for cash settlement only at the maturity of the deal. • The procedure and timing for determining severity of loss on a defaulted credit reference can vary — from a bidding procedure that takes place shortly after a default, to reliance on a final “work-out“ value established after the formal workout process has been completed. • The swap can reference specific credits, or it can reference the general, unsecured debt of a reference entity. • If the swap references the general, unsecured debt of an entity, credit events under the swap can be triggered by defaults only on “bonds or loans”, on a broader class of “borrowed money,“ or on an even broader class of “payment obligations.“ • Perhaps most significantly, the definition of “credit event” can be tailored to meet the needs of the various parties to the transaction. While each of these variations is important, the most heavily negotiated component is most often the designation and characteristics of the “credit events” that will trigger a cash settlement under the swap.

ISOLATING THE REFERENCE PORTFOLIO’S CREDIT RISK Measurable “Credit Risk” “Credit risk” is generally viewed as the risk of loss following default. The risk of loss following other events — other than “default” — is not captured by “credit risk.” It is defined this way largely for practical reasons — because “default“ is an event that can be predicted based on historical data.

Rating Downgrade as a “Credit Event” A number of institutions have extensive data on While Moody’s does not have data concerning corpo- defaults. Moody’s, for example, has compiled data rate level events (e.g., covenant breaches, accelera- on corporate defaults spanning more than 80 tions) other than “default,” Moody’s does have data on years. This data permits Moody’s to assign a ratings transitions. With this data, it is possible to probability of default to each rating category over determine the likelihood of an entity transitioning from a given time period. For example, based on histor- one rating category to another. For example, based on ical data, Moody’s can estimate that a firm rated historical data, it is possible to determine the likelihood Baa3 has a 6.1% chance of defaulting over a 10- of a corporate obligor being downgraded from Baa3 to year period. Moody’s can also estimate the Ba1 over a certain period of time. Moreover, there is severity of loss given default for a given instrument data concerning (1) spreads at the various rating cate- using historical data. gories, and (2) the widening of spreads following The market does not have comparable data for downgrade. Thus, it may be possible to assign a corporate events other than “default.” For severity of loss, as well as a probability, to various example, Moody’s does not have data concerning downgrade events. Moody’s has not been asked to breaches of certain covenants, loan accelerations, rate a structure where the “credit event” is a rating or certain types of debt restructurings.3 Thus, downgrade, but it is theoretically possible to do so. Moody’s cannot assess the probability of these events occurring with the same accuracy that it can for “defaults.” “Credit risk” could be defined with respect to these events, but it would be very difficult to measure that risk without more data.

3 To date, requests made to other sources, such as banks and other financial institutions, have not yielded such data either.

4 • Understanding The Risks In Credit Default Swaps Isolating the Risk The basic assumptions underlying a synthetic CDO or CLN are that (1) only the credit risk — i.e., the risk of loss given “default” — of the reference portfolio is passed through to investors,4 and (2) the risk of loss on the reference portfolio can be measured by the rating of the portfolio. Thus, when analyzing a transaction, Moody’s must confirm that these assumptions are correct: • Credit risk must be truly isolated from other risks inherent in the reference portfolio. In its purest form, the swap should not transfer risks other than credit risk. Significantly, it should not pass through the risk of loss following credit deterioration short of default. • The definition of “credit event” under the swap — the event that requires valuing a reference credit and calculating a loss — should be consistent with a well understood and measurable definition of default. For a Moody’s rating of the portfolio to be used to assess the risk of the portfolio, the definition of “credit event” should be consistent with Moody’s definition of “default.“ In addition, the methods for calculating loss following default under the swap should be consistent with the market standard. If any of these assumptions are incorrect, a Moody’s rating of the reference portfolio will not capture the risk to investors. For example, if the loss trigger events under the swap are broader than the events Moody’s considers to be “defaults,” the actual expected loss posed to investors may be greater than the expected loss incorporated in the Moody’s rating of the reference portfolio. Synthetic CDO and CLN investors may be subject to greater risks than if they actually owned the reference portfolio and held each reference asset to maturity. MOODY’S DEFINITION OF DEFAULT AND LOSS In assigning ratings and compiling its historical default statistics, Moody’s considers the following events to be defaults: • Any missed or delayed disbursement of interest and/or principal; • Bankruptcy or receivership; and • Distressed exchange where (i) the borrower offers debtholders a new security or package of securities that amount to a diminished financial obligation (such as preferred or common stock, or debt with a lower coupon or par amount), or (ii) the exchange has the apparent purpose of helping the borrower avoid default. Severity of loss is defined as the difference between par and the recovery rate — measured as a percentage of par — following default. Moody’s uses the market value of defaulted instruments, approximately one month after default, as an estimate of recovery rate.5 These are the events that constitute “defaults“ in Moody’s historical studies, and these are the events that can be predicted by a Moody’s rating.

ISDA CREDIT EVENTS The 1999 ISDA Credit Derivatives Definitions6 currently list six “credit events” that can be incorporated into credit swaps: • Bankruptcy; • Failure to pay; • Restructuring, • Repudiation/moratorium; • Obligation default; and • Obligation acceleration. 4 Transactions that are not “de-linked” from the sponsoring institution are also subject to credit risk associated with the sponsor. In assigning a rating to such transactions, Moody’s will include sponsor credit risk in its analysis. 5 See Moody’s Special Comment, Default and Recovery Rates of Corporate Bond Issuers: 2000, pp. 18, 24 by David Hamilton, Greg Gupton, and Alexandra Berthault (February 2001). 6 The ISDA Credit Derivatives Definitions have been revised once, and are currently in a state of flux. Thus, it is likely that they will be different two years from now. However, the 1999 definitions are currently the starting point for negotiations of most credit default swaps. Moreover, even though the definitions may change, it is fruitful to scrutinize them now to determine, as a general matter, what is and is not consistent with the Moody’s definitions. For purposes of this special comment, familiarity with the ISDA definitions is assumed, and thus the definitions will be described only generally.

Understanding The Risks In Credit Default Swaps • 5 While these are the so-called “standard” credit events, their inclusion and scope are always heavily negotiated in the context of Moody’s-rated synthetic CDOs and CLNs. The choice and characterization of these events is crucial, because they determine the probability of a loss occurring under the swap, as well as the extent of any such loss. Some of the ISDA credit events are consistent with Moody’s definition of “default,” and some are not. Bankruptcy The definition of “Bankruptcy” in the ISDA Credit Derivatives Definitions was copied wholesale from the ISDA Master Agreement. Thus, while most of the definition is consistent with a “default,“ there are some components that are not. The last clause of the definition, a catchall provi- The ISDA “Bankruptcy” Definition sion, is problematic because it makes a “credit The “in furtherance of” provision could be construed event” any action by the reference entity “in very broadly — for example, the act of planning for, or furtherance of, or indicating its consent to, even considering, a bankruptcy filing (such as hiring approval of, or acquiescence in” one of the listed bankruptcy advisors to discuss options) might be in bankruptcy events. This clause exposes investors furtherance of bankruptcy, but would not generally be to potentially greater risks, because it includes considered a bankruptcy event.8 If publicly reported, events that are vague, difficult to identify, and do such exploratory steps could trigger a loss payment not clearly indicate default.7 under the swap, even if the obligor does not ultimately Another potentially troublesome item in the ISDA enter bankruptcy. bankruptcy definition is “insolvency.” The ISDA definition does not specify what is intended by “insolvency.” However, there are different definitions — for example, by reference to balance sheet or income statement tests — and, depending on the definition used, the timing of an insolvency “credit event“ could vary. Under a very broad definition, it is conceivable that an “insolvency” could occur without being followed by an actual bankruptcy or failure to pay. Thus, a broad interpretation could lead to a “credit event“ being called under the swap when no “default“ has actually occurred. Failure to Pay The ISDA “failure to pay” definition is consistent with Moody’s definition of “default.” The key issue under this definition is materiality — i.e., the missed payment should be in an amount that is material, such that it would be captured by a Moody’s rating. To ensure that a credit event is not triggered by the failure to pay a trivial amount, a minimum amount — referred to as the “Payment Amount” in the ISDA definitions — should be specified under the swap. While there is a standard minimum amount, that amount may not be appropriate in all transactions, and it should be considered carefully for each swap. In some cases, the choice of a Payment Amount will depend on whether the swap is referencing (1) a specific obligation, (2) bonds or loans, (3) borrowed money, or (4) the more general “payment obligations” — all of which are options under the current ISDA documentation. A Moody’s rating will capture the risk of a “failure to pay” on the obligations rated by Moody’s — usually bonds and loans. However, it may not capture the risk of non-payment on all of an entity’s payment obligations — e.g., disputed trade obligations, certain fees, etc. An entity may choose not to make a payment on one of its “payment obligations” for reasons other than credit problems. To ensure that a Moody’s rating will capture the risk of payment default, the category of obligations being referenced should be carefully considered. In some circumstances, a higher minimum payment amount may be appropriate.

7 It was not appropriate to use the entire “bankruptcy” definition from the ISDA Master for the credit derivatives definition, because the definition has different purposes in the different contexts. In the context of the ISDA Master, “bankruptcy” is an event that permits early termination of a swap - whether it be an interest rate swap, a currency swap, or any other kind of swap - because of credit problems with a counterparty. Naturally, to mini- mize their potential losses, swap participants want the ability to terminate a swap before a counterparty default actually occurs - e.g., when a counterparty takes any action in furtherance of a bankruptcy filing. By contrast, in the credit derivatives context, the purpose of the “bankruptcy” definition is to transfer default risk of a reference portfolio - not of the counterparty - from one counterparty to another, and not to give a counterparty the opportunity to terminate a swap early, before a default occurs. 8 See Lowenstein, Roger, When Genius Failed: “The Rise and Fall of Long-Term Capital Management” (Random House 2000), pp. 179-80. 6 • Understanding The Risks In Credit Default Swaps Restructuring Moody’s considers certain types of “restructuring“ events — known as “distressed exchanges” — to be defaults, and captures those events in its ratings. Thus, Moody’s does not believe that “restructuring,” as a concept, needs to be excluded from the credit derivatives definitions. In many respects, however, the current ISDA definition of “restructuring” is broader than Moody’s definition of “distressed exchange,“ and includes events that are not captured by a Moody’s rating.9 Thus, for a Moody’s rating of the reference portfolio to capture the risk to investors, the definition of “restructuring“ should be tightened to make it consistent with “distressed exchange.” Under the current ISDA “restructuring” definition, Criteria for a “Distressed Exchange” Default five events can qualify as a “restructuring.” Each Whether a “distressed exchange” default has occurred event must meet the following requirements to can be a subjective, fact-specific determination. In qualify as a “credit event:” the restructuring (1) general, Moody’s looks to three factors: (1) the extent must not have been provided for in the original to which the restructured obligation is a “diminished terms of the obligation, and (2) must be the result financial obligation” — i.e., the degree of monetary of a deterioration in the obligor’s creditworthiness impairment suffered by investors, (2) the extent to or financial condition. While these requirements which the restructuring was involuntary for all investors, are helpful in restricting the events that could and (3) the extent to which the restructuring was done constitute “credit events,” they are not sufficient to to avoid an imminent payment default.10 prevent overbroad applications of the definition. The first three events under the definition — restructuring of an obligation that leads to (1) a reduction in interest payment amounts, (2) a reduction in principal repayment amounts, or (3) a postponement or deferral of interest or principal A Real Life Example payments — can constitute “distressed exchange” In August 2000, Conseco’s bank debt was restructured. defaults under Moody’s definition. Any one of While the restructuring included a deferral of the loan’s these events, by itself, would arguably lead to a maturity by three months, it also included an increased “diminished financial obligation.” However, if coupon, a new corporate guarantee, and additional combined with other changes to the obligation, covenants in favor of the lenders. Thus, because lenders they may not. For example, an obligation that has were compensated for the maturity extension, Moody’s been restructured to defer principal payments may did not consider the restructured debt to be a “dimin- not be considered a “diminished financial obliga- ished financial obligation,” and thus not a “distressed tion” — and thus not a “distressed exchange” — if exchange” default. (Indeed, the senior unsecured rating the lender has been compensated for the deferral. was downgraded only to B1). However, because of the Thus, any “restructuring” definition should look at maturity extension, the restructuring was considered a the totality of the circumstances — e.g., whether “credit event” under the ISDA “restructuring” definition the lenders/investors have been compensated for and triggered loss payments under the credit default the reduction or deferral — to determine whether swaps written on Conseco. This is a perfect example of the restructured obligation is truly a “diminished a loss event under the ISDA “restructuring” definition financial obligation.” that Moody’s did not consider to be a default. The fourth ISDA “restructuring” event — a restructuring that leads to a change in an obligation’s priority, causing it to be subordinated — can be overbroad. The subordination of a debt obligation to equity or preferred stock would clearly be a “default.” (It would probably lead to a failure to pay as well — thus, rendering this “restructuring” event unnecessary). However, a restructuring that merely lowers an obligation from a senior to a subordinated position in the capital structure (but not to equity) could also trigger a “credit event” under the current ISDA definition. In addition, the event could be triggered in a scenario where an entity takes on senior debt that effectively subordinates other debt in its capital structure. While these events may lead to a downgrade of the affected obligations, they would not necessarily render the obligations “diminished financial obligations” and thus not be a “default” in Moody’s view.11

9 The credit derivatives market is aware of the overbreadth of the current “restructuring” definition. The press has reported that swaps including this credit event often carry an additional premium to compensate protection sellers for the additional risk. 10 See Moody’s Special Comment, Moody’s Approach to Evaluating Distressed Exchanges, by David Hamilton and Sean Keenan (July 2000) 11 Other than removing it all together, bankers have addressed the potential overbreadth of this event by allowing it to be triggered only if the affected obligation is subordinated to equity status. There are undoubtedly other ways of addressing this problem as well. Understanding The Risks In Credit Default Swaps • 7 Finally, the fifth event in the ISDA definition — “any change in the currency or composition of any payment of interest or principal” — is also potentially overbroad. Apparently, the provision was intended to apply to scenarios where a restructuring leads to debt being repaid in a currency that is non-convertible or highly volatile — e.g., an emerging market currency — that ultimately leads to the lender receiving an amount that is lower than the promised interest or principle.12 Such a scenario might render the restructured obligation a “diminished financial obligation.” (Arguably, it would constitute a “failure to pay” as well). However, the definition would also include restructurings where the foreign exchange risk to the lender is hedged, or otherwise eliminated, such that the lender ultimately receives precisely what it was promised. Although such a scenario may not be a “default,” it would nonetheless trigger a “credit event” payment under the swap. Incorporating a notion of “diminished financial obligation” into the “restructuring” definition would address this problem as well. Any definition should also consider the extent to which the restructuring was “involuntary” to lenders/investors. Under the current ISDA definition, a “credit event” can be triggered if the lender voluntarily agreed to the restructuring (so long as it is the direct or indirect result of credit deterioration). However, Moody’s might not consider such an event to be a default, even if it results in a “diminished financial obligation.” Bank loans are restructured quite frequently — especially loans that are not syndicated — and not all such events would be considered defaults. “Credit risk” is risk imposed on lenders by an Voluntary Restructuring Not Necessarily a “Default” For example, at the request of a borrower whose credit obligor. It does not include, and a Moody’s rating has deteriorated somewhat, a bank might agree to less does not address, risks that lenders impose on favorable terms (e.g., a lower coupon) on an existing themselves — i.e., the possibility that lenders will loan. However, the primary motivation for the restruc- voluntarily take losses that are not forced on them turing may be something other than credit: for by obligors. example, the bank might want to preserve its business Unfortunately, it is not easy to define “involuntary,” relationship with a borrower — if the bank did not or to determine whether a restructuring was agree to the restructuring, the borrower might pay indeed “involuntary.” One possible means of down the loan immediately and take its business else- capturing “involuntariness“ — or at least where — because it believes the borrower’s credit will increasing the likelihood that a restructuring was ultimately improve. This type of restructuring might not indeed involuntary — is to limit restructuring credit constitute a default, but would trigger a credit event events to situations where there are a minimum under the current ISDA definitions. number of lenders. “Restructuring” thus would only be available for reference obligations that are bonds, or syndicated loans with a minimum number of syndicate members. With a larger number of lenders (as opposed to a bilateral loan), it is less likely that an obligation would be restructured for non-credit reasons.13 The third factor that Moody’s considers in assessing “distressed exchange” defaults — the extent to which the restructuring was done to avoid an imminent payment default — also provides some indication of “involuntariness.” If a lender is faced with the choice of taking a potentially smaller loss now, by way of a restructuring, or a larger loss later, due to an actual payment default or bankruptcy, it is a fairly good indication that the restructuring was “involuntary.” Unfortunately, in many cases it will not be easy to determine whether there would have been a default but for the restructuring. Moreover, this standard goes to the obligor’s motives in carrying out the restructuring — a subjective factor that may not always be evident.

12 It is unclear what scenarios a change in “composition” of payments was intended to cover. It is difficult to imagine scenarios that would not already be included in a “failure to pay” or the first three events of “restructuring.” 13 In all cases, analysis of the “Restructuring” definition depends on whether the swap references a specific obligation or the general unsecured obligations of a reference entity. If it is the latter, there is potentially a much broader range of instruments that could be restructured - e.g., both bilateral and multilateral loans - triggering a credit event under the swap. The “seller” of protection - the investor - will not necessarily be familiar with all of the entity’s outstanding obligations, and thus cannot assess the risk of a restructuring occurring with respect to each outstanding instrument. If the swap does not reference a specific obligation or class of obligations, the definition of the “Restructuring” credit event should be restricted considerably. For example, investors may wish to consider limiting the events within the “Restructuring” definition that can trigger a credit event. In addition, in all cases, to ensure that the restructuring is meaningful, a minimum restructured amount necessary to trigger a credit event - referred to as the “Default Amount” in the ISDA definitions - should be specified in the swap. 8 • Understanding The Risks In Credit Default Swaps With Restructuring more than any other credit event, the need for a precise, objective definition is often at odds with the need for accuracy and predictability. Any objective definition risks being over-inclusive (e.g., Conseco), because the determination of whether a “restructuring” constitutes a default is often fact-based and subjective. However, it is possible to refine the current ISDA definition based on the factors discussed above such that it more accurately reflects a true “default” event. Repudiation/Moratorium Repudiation/moratorium was included in the ISDA definitions mainly to address actions by sovereign lenders, and thus, is not included in many synthetic CDO’s, where the exposure is primarily to corporate credit. When applied to corporate credits, repudiation/moratorium is generally consistent with Moody’s views of default — although it is unclear how it would be different from “failure to pay.” However, there is concern with respect to the provision that includes as a credit event when a borrower “challenges the validity of . . . one or more Obligations.” This provision could be construed overbroadly to include situations where there is a legal dispute over a borrowing — in which, for example, the borrower unsuccessfully challenges some terms of the borrowing — that does not ultimately lead to a failure to pay interest or principal. Moody’s would not necessarily consider such an event to be a default. In addition, if this event is to be included, the “Default Amount,” or minimum amount that can be subject to a repudiation in order to trigger a credit event, should be material, so that the repudiation of a trivial amount will not trigger a credit event. Obligation Default ISDA defines “Obligation Default” as a non-payment default — i.e., a default other than a failure to pay — that renders an obligation capable of being accelerated. Moody’s has not been asked to rate a transaction that includes this credit event, and the market has moved away from including it. This is because the event is much broader than Moody’s — and most of the market’s — definition of “default.” Most bonds and loans contain representations, warranties, financial covenants, and non-financial covenants, the violation of which can give lenders the right to accelerate. While such violations can indicate credit deterioration (e.g., failure to maintain a minimum financial ratio, taking on additional debt, etc.), many such violations can be technical (e.g., failure to send a report). Of course, Moody’s ratings do not capture the probability of a technical violation occurring. Moreover, even a covenant violation that represents serious credit deterioration would not be captured if the obligation is still current on interest and principal, and has not carried out a “distressed exchange” or become bankrupt. Moody’s simply does not have data concerning such events that would allow it to assign a rating to them. Because inclusion of this event forces counterparties to mark-to-market an obligation before a payment default occurs, it will cause investors (i.e., “sellers” of credit protection) to take losses that they would not incur if they actually bought and held the obligation. For example, even though an obligation has suffered credit deterioration giving rise to a financial covenant violation, there is still a good chance that the obligation will pay both interest and principal in full. However, at the time of the violation, market bids will likely come in below par, because of concerns about the credit, or because of market sentiment, interest rate movements, or other systematic factors. Thus, while an investor that actually holds the obligation to maturity will get out whole, the investor “selling” protection will not.

Understanding The Risks In Credit Default Swaps • 9 Obligation Acceleration “Obligation acceleration” is similar to “obligation default.” However, to trigger a credit event, the non-payment default — i.e., default other than a failure to pay — must lead to a reference loan, bond, or other obligation actually being accelerated. Like obligation default, an acceleration, by itself, would not be captured by a Moody’s rating. A failure to pay, bankruptcy, or distressed exchange following acceleration would be captured, but the acceleration itself would not. Acceleration is simply a lender’s exercise of its contractual right, under certain circumstances, to declare a debt immediately due and payable.14 As with “obligation default,“ the events giving rise to a right to accelerate under “obligation acceleration” — defaults other than a failure to pay — are not considered by Moody’s to be “defaults” and would not be captured by a Moody’s rating. Consequently, a lender’s decision to exercise its acceleration right following such events is not captured either.15 There are three possible outcomes following an acceleration: (1) the borrower repays less than it owes (or becomes bankrupt), (2) the debt is renegotiated, or (3) the borrower repays everything that it owes. The first outcome is already captured by other credit events — failure to pay and bankruptcy. The second outcome, depending on the circumstances, may be a “distressed exchange” restructuring. The third outcome — the lender receives everything it is owed — is not a default. Because the first and second outcomes are already captured by other credit events, and the third outcome is not a default, it is unclear what additional scenarios this “credit event“ is intended to capture.16 It has been suggested that the purpose of this credit event is “timing” — i.e., because many accelerations are followed closely by either a payment default, bankruptcy, or restructuring,17 including this event allows credit protection payments to be made earlier than they otherwise would. However, if the acceleration precipitates a true default, the default is likely to occur, at most, two or three months later, and it is difficult to justify why a counterparty cannot wait until it has suffered a true credit event to be compensated. More fundamentally, an acceleration where the lender receives everything it is owed — clearly not a “default” — would trigger a credit event under the ISDA definition. While historically rare, there have been instances of bond accelerations where investors have been paid par, thus leaving them with no loss. Moody’s has not compiled its own data on such events, because they are not “defaults.” Moreover, while Moody’s is unaware of any data with respect to accelerations of loans and private placements, anecdotal evidence suggests that acceleration followed by total recovery — i.e., the lender gets all of its money back — is more common. Inclusion of “obligation acceleration” as a credit event would not be as problematic if the market value of an obligation is always par when the lender will be fully paid off following acceleration. If that were the case, there would never be any loss following such credit events. However, it is very possible that the market value would come in at less than par — even if the accelerated debt is fully repaid.

14 There may be circumstances where acceleration is automatic, but those would typically involve much more serious events - such as a bankruptcy or insolvency. 15 “Obligation acceleration“ is the only ISDA credit event that can be fully at the discretion of the lender. (It is true that a firm’s lenders could force it into bankruptcy; however, a mere bankruptcy filing is not a credit event - the filing must remain undismissed for 30 days, or a final judgment of bankruptcy must be entered). This is contrary to the principle that “credit risk“ addresses loss events imposed by the borrower, and not a loss that the lender voluntarily assumes itself. 16 Forms of “obligation default“ and “obligation acceleration“ exist in the ISDA master agreement as early termination events, and it is possible that these provisions were merely copied from the ISDA master to the “credit event“ definitions. However, as already noted, early termination events in the ISDA master are not intended to be “defaults,“ but are intended to give a party the right to terminate the swap early if the counterparty has suffered serious credit deterioration but has not yet defaulted. 17 One theory behind acceleration, however, is that it is intended to permit the lender to get out whole. A lender can accelerate if, because of non- payment defaults, it is no longer comfortable with the borrower’s credit and wants to get all of its money back before there is an actual default. 10 • Understanding The Risks In Credit Default Swaps For example, if only some of the borrower’s outstanding debt is accelerated and the protection buyer is permitted to value the debt that remains outstanding, it is likely that the market value of the remaining debt will be valued at less than par. The acceleration is likely to have been triggered by some credit deterioration (though short of payment default), which would cause the remaining debt to trade at less than par. Even if the accelerated debt is valued, it is likely that a lender would agree to a grace period to allow the borrower to gather funds and make arrange- ments for paying down the debt, especially if the lender believed it could get par following acceleration. If bids on the accelerated debt come in during that grace period pursuant to the swap, it is possible that — because of market or interest rate movements or, more likely, because of uncertainty about the credit itself — the bids could come in below par, even if investors/lenders ultimately receive par following acceleration.18 Another concern with “obligation acceleration” is that its inclusion as a credit event may create additional incentives. A protection “buyer” that accelerates a reference obligation will be reimbursed regardless of the outcome. Indeed, the “buyer” could get all of its money back on the loan and get additional compensation if bids on the non-accelerated debt come in at less than par. Because occurrence of the “obligation accelera- Example of Increased Incentives tion” credit event is often within the protection A bank is considering whether to accelerate the loan of “buyer’s“ control, the additional incentive means a borrower that has suffered some credit deterioration that the event is more likely to occur in the pres- (and violated some covenants) but is not in imminent ence of a swap than under normal circumstances. danger of defaulting on any payments. Consequently, If the “buyer” has the right to accelerate, it is more the bank knows that it will get all of its money back if it likely to exercise that right if it can receive addi- accelerates. If the bank has bought protection on that tional compensation for doing so. Thus, any borrower through a cash-settled credit default swap that historical data regarding the likelihood of an accel- includes “obligation acceleration” as a credit event, after eration would probably understate the likelihood of it accelerates the loan, the bank could get bids on the 19 its occurring when it is covered by a swap. remaining outstanding debt and get additional compen- “Obligation Acceleration” and the sation. For example, if the remaining outstanding debt Problem of Basis Risk were bonds trading at 85¢ on the dollar, the bank will Sponsors of synthetic CDO and CLN transactions receive an additional 15% recovery. Without the swap, can fall under two different categories: (1) those the recovery is 100%; with the swap, the recovery is who are credit default swap “end users,” and (2) 115%. The incentive to accelerate is obviously greater in those who are not. The “end users” are buying the presence of the swap protection on cash exposure to the reference credits. In other words, they have actual exposure to the credits through loans or other business relationships with the obligors. Sponsors that are not “end users” are buying protection on synthetic exposure to the reference credits. They are exposed to the credits by way of credit default swaps — i.e., they are “selling” protection on the credits to other counterparties, and if there is a credit event on those swaps they will be required to make a credit event payment to the other counterparties. “End user” sponsors recognize that “obligation acceleration” is not necessary, and, unless required to do so by regulators, have typically not asked for its inclusion their transactions. However, institutions that are hedging, or buying protection on, synthetic exposure have argued that inclusion of this event is necessary, because most of the swaps giving rise to their exposure include “obligation acceleration.” If the synthetic CDO or CLN does not include this credit event, there are potential loss events for which they are not hedged. Believing this additional risk to be significant, these institutions are often unwilling to take the incremental basis risk and have asked Moody’s to rate the transactions with this event.

18 Obviously, if all of a borrower’s debt is accelerated and everything is paid down quickly, there will be nothing to bid on anyway. 19 The additional incentives are more likely to be present in situations involving bilateral loans, as opposed to bonds or widely syndicated loans. Understanding The Risks In Credit Default Swaps • 11 Moody’s is reluctant to rate a credit event that is not a default and is only present because of a quirk in the ISDA definitions that has become “standard.”20 The optimal solution is to remove “obligation acceleration” all together, or for it no longer to be “standard.” However, Moody’s has been able to rate transactions including this event with the following modifications to the ISDA definition: • Acceleration is only a “credit event“ if, after the later of a minimum time period and the time to the next payment date on the obligor’s obligations, the accelerated obligation has not been fully repaid. The rationale is that if the accelerated obligation is not fully repaid by the next payment date, it will likely never be fully repaid. • Following acceleration, instead of cash settlement, the protection buyer delivers to the SPV an obligation of the reference entity (1) that has been accelerated, or (2) if the delivered obligation has not been accelerated, that matures earlier than the transaction matures. The SPV would only be permitted to sell the delivered obligation if it actually defaults; otherwise, it must hold it until it matures or is paid down.21 This should remove the incremental market risk inherent in this event under a cash settled swap. Moody’s has considered numerous alternatives to these solutions, and additional solutions may be acceptable.22 However, the best solution would be to exclude this event all together.

THE PROBLEM OF “SOFT” CREDIT EVENTS: SYNTHETIC VS. CASH Credit default swaps are intended to mimic the default performance of a reference obligation. Thus, for example, owning a CLN is often considered equivalent to having a cash position in the underlying reference obligation, except that the maturity, coupon, or other cash flow characteristics may be different. If an investor holds the CLN to its maturity, it should have the same risk of loss as if it held the reference obligation to its maturity.23 Put another way, the CLN should only default if the reference obligation defaults. However, if so-called “soft” credit events — events that are not truly “defaults” — are Example: Synthetic Exposure Riskier Than Cash Position included in the swap, that will not be the case. Two investors have exposure to the bonds of XYZ. The Selling protection through a cash-settled credit first investor actually owns the bonds. The second default swap — e.g., owning a CLN (or a synthetic investor owns a CLN that references XYZ. Because of CDO) — can actually be more risky than actually credit deterioration, XYZ violates some covenants on owning the reference obligation(s). its outstanding bank debt, which leads its bank to This is because cash-settled credit default swaps accelerate the loan. The bonds, however, are not essentially force investors to “cash out” of their posi- accelerated, but are trading at 85¢ on the dollar. The tion following a credit event.24 If the swap includes credit deterioration is not serious enough to lead to a credit events associated with credit deterioration default, and the bonds are ultimately paid off short of default — e.g., a broadly defined restruc- completely at maturity. Because the underlying swap turing or obligation acceleration — the CLN can includes “obligation acceleration” as a credit event default (the investor will receive less than the full par (swaps typically allow a credit event to be triggered if a of the CLN) when the reference obligation has not. bond or loan has been accelerated), the CLN investor Thus, if a cash-settled credit default swap includes receives 85% of its par back and the CLN terminates. “soft” credit events, the investor may suffer losses that By contrast, the cash investor receives the coupon for are not captured by a Moody’s rating of the reference the remaining term of the bonds and receives all of its obligation(s), subjecting it to greater risk of loss than if principal back at the bond’s maturity. it actually owned the reference obligation(s).

20 Fortunately, “obligation default” has not become a “standard” credit event. 21 An alternative to maturity matching, such as granting the SPV the right to “put” the delivered obligation at par, may have the equivalent effect of elimi- nating market risk. 22 When modeling the expected losses of a credit default swap containing “obligation acceleration,” it may also be appropriate to increase the probability of a loss occurring in the reference portfolio. However, because of the lack of historical data on this event (and the potential increased incentives for acceleration arising from the presence of swaps), the adjustment is likely to be fairly conservative. It would depend on a number of factors, including the nature of the reference obligations, the identity of the sponsor, the transparency of the transaction, and the motivations for doing the transaction. 23 Of course, if the investor chooses to sell the CLN prior to its maturity, it will be subject to market risk on that sale. 24 I.e., the seller must (1) mark the obligation to market, (2) make a cash payment equal to the difference between par and the market value, and (3) terminate the swap (or, in the case of a synthetic CDO, remove the affected reference obligation from the reference portfolio). 12 • Understanding The Risks In Credit Default Swaps MORAL HAZARD In virtually every synthetic CDO and CLN, the “buyer” of protection — the sponsoring financial institution — determines whether a credit event has occurred in the reference portfolio. More significantly, the “buyer” calculates the severity of its losses following a credit event, and how much the SPV will be required to pay under the swap (i.e., how much investors will lose under the transaction). Because of the moral hazard inherent in such an arrangement, credit swaps should be structured such that the occurrence and severity of losses can be objectively and independently identified, calculated, and verified. • Occurrence Of A Credit Event. Moody’s generally believes that, in order for a credit event payment to be triggered, the occurrence of the event should be published in (1) a well-known news source, (2) a corporate filing, or (3) a court document. This should deter protection “buyers” — acting either alone or in collusion with a reference obligor — from staging credit events for the sole purpose of being reimbursed under the swap. The rationale is that parties will be less likely to assert spurious credit events if the events have to be made public. There may be instances, however, where there is no published information available regarding a credit event. For example, the reference obligor may be a private, unrated company whose only outstanding debt is to a bank. There may be no press release, no public corporate filings, and no court documents to support the existence of the credit event. However, the sponsor should be able to get protection under the swap for that credit if there is a true default. Thus, in some limited circumstances, Moody’s-rated synthetic CDO’s provide that, for certain credit events, if there is no “publicly available information,” at least one senior officer who is part of the sponsor’s credit underwriting or monitoring depart- ment may provide written certification that the credit event has occurred and that the obligation has been treated internally as a defaulted asset. The certification may also contain contact information at the defaulted obligor so that the protection “seller” can verify the claim and, if necessary, dispute it. Here, too, the rationale is that a sponsor is less likely to assert a spurious credit event if a senior officer who is not directly involved with the transaction is required to sign a certification that the event occurred. • Loss Severity Following Credit Event. The amount of loss following default should be calculated either (1) by obtaining bids from third parties, or (2) by going through a formal workout process to arrive at a workout value. The former is the most common. Because it may not always be possible to obtain public bids, however, most transactions provide for contingency calculation methods. These methods are often a formal appraisal by an objective third party. The “buyer” should not be the sole source for determining its losses under the transaction. The existence of a meaningful dispute resolution mechanism will also help to elimi- nate the moral hazard inherent in these situations. In some cases, permitting investors to make firm bids — or designate other parties to make firm bids — for defaulted obligations can also be an effective solution. • The Case of Blind Pools. Occasionally, because of regulatory and/or legal restrictions, a bank may not be permitted to disclose certain names in a reference pool. Disclosure to Moody’s has usually been permitted, but the bank is not permitted to disclose to investors or others associated with the deal.25 This becomes a serious problem when a credit event occurs with respect to one of those names. It may be difficult to obtain a meaningful bid — and thus mark the defaulted name to market — without disclosing the name to potential bidders. The bank may also be unable to obtain an appraisal from an objective, unaffiliated third party. In these circumstances, it may be possible to get comfortable with an appraisal by the bank’s audi- tors, so long as the bank retains a portion of loss (e.g., 10%) on each such name.

25 For reference pools that are not disclosed to investors or Moody’s, the moral hazard concerns are magnified. Significant additional protections would be needed in order to become comfortable with such a structure. Understanding The Risks In Credit Default Swaps • 13 MARKING-TO-MARKET/CALCULATION OF LOSSES • Recovery assumptions. The sponsor must determine which position in the capital structure — senior secured, senior unsecured, subordinated, etc. — it will reference and, more impor- tantly, mark-to-market in order to calculate loss following default. Each priority position has different recoveries, and, in modeling loss scenarios, Moody’s applies recovery assumptions based on the level of debt that is specified in the covenants. In addition, obligations from different jurisdictions will carry different recoveries, and Moody’s will use assumptions based on the covenants pertaining to different jurisdictions in the transaction. • Obligation marked to market. If a specific obligation is referenced, that obligation, or an obligation that is pari passau in the capital structure (and has at least the same level of security), should be the one that is valued following a default. As mentioned above, this is necessary so that the actual recovery can be consistent with the assumptions used in modeling the transaction. In addition, many deals require that bids be obtained on the standard trading size of the reference obligation. This is important in transactions that reference very large amounts of reference obligations, where it is impossible to obtain meaningful bids on such large amounts. •Time to valuation following default. The timing of the mark-to-market following default may affect the calculation of losses. There is evidence that, in some cases, the longer the time between default and valuation, the higher the valuation will be. This is to be expected because, during the period immediately following default, there will be a relative lack of information about the credit and, therefore, uncertainty as to expected recoveries. Therefore, during this period we would expect higher volatility in pricing and, generally, lower valuations. In formulating recovery assumptions, Moody’s looks at market value thirty days following default. It is expected that available information will have been priced into the market by this point, and prices will be relatively stable. Investors should look very carefully at any swap that calls for valuations earlier than thirty days after default, as investors will likely be exposed to higher pricing volatility and, potentially, greater losses. • Nature and number of bids obtained. The pricing process must be structured such that it produces meaningful valuations following default. Thus, the potential bidders must be entities that are actively involved in the market for the relevant asset (e.g., loans, bonds, derivatives exposures, structured finance securities, etc.) and are capable of providing meaningful bids. It is also necessary that bidders have access to enough information to be able to make informed bids. In addition, most transactions call for a minimum number of bids. The highest bid is usually used for valuing the obligation. If the protection “buyer” is unable to obtain the minimum number of bids — due, for example, to some sort of temporary market disruption — it is usually required to repeat the bid solicitation process two or more times until it is able to get the minimum number.26 As mentioned above, there should be mechanisms for mean- ingfully pricing the defaulted obligation if the public bidding process is unsuccessful.

REFERENCE CREDITS OTHER THAN CORPORATE OBLIGATIONS Some financial institutions are seeking to buy protection on credits other than corporate obligations — e.g., structured finance obligations. This presents unique challenges for (1) classifying exactly what constitutes a credit event, and (2) applying recovery assumptions following a credit event. For example, “failure to pay” may not be an appropriate credit event for all reference obligations, because certain payment failures are not considered defaults. Some structured finance securities (e.g., mezzanine tranches of collateralized debt obligations, and most ABS and MBS) can defer and capitalize missed interest payments without going into default. Under these structures, capitalized interest can be paid back subsequently through the deal’s cash flow. However, interest can also continue to be deferred and capitalized, and the security is not considered defaulted until it reaches maturity and does not pay back original principal and all capitalized interest. A financial institution might like to buy protection against a CDO security 26 Different pricing processes may be appropriate depending on the market and expected liquidity of the reference obligations following default. 14 • Understanding The Risks In Credit Default Swaps deferring interest, or “paying in kind.” However, a Moody’s rating of the security does not capture the probability of that event occurring (it only captures the likelihood and extent to which it will not pay back principal and all capitalized interest by the final maturity date). Moreover, it is not clear that investors would want to sell protection for a simple “payment in kind,” because such events can vary in seriousness. As foreseen in these structures, a security could (1) defer interest for one or two periods and then pay it back (with interest) and be current for the rest of the transaction, or (2) defer interest until final maturity. While a mark to market following the first scenario would probably come in at less than par (and the credit default swap investor would suffer a loss), if an investor actually owned that security, it would ultimately get out whole. For a credit protection market to develop for these types of reference credits, market participants will have to determine what kinds of deferred interest scenarios should be considered “credit events” and how those scenarios can be modeled. Similar issues arise with respect to structured finance securities that can have their principal “written down” — and subsequently reinstated — without being in default. Market participants must consider very carefully what a rating on such a security addresses and how to model the various types of “credit events.” Finally, the use of structured finance securities as reference obligations raises issues concerning valuation following default. Recovery data for defaulted structured finance securities is extremely scant, as there have been very few defaults. Moreover, these securities — especially the lower-rated, mezzanine securities — can be highly illiquid when they are performing — rendering a mark-to-market very difficult. It can be reasonably assumed that liquidity following default would only be worse. Given the lack of data concerning market values following default, it is not clear what recovery assumptions should be used.27 Until there is sufficient data, recoveries assumed by Moody’s are likely to be very low.

GOOD FAITH OF THE SPONSOR In addition to reviewing the definitions of credit events, the methods for calculating severity of loss following default, and other structural aspects of a transaction, Moody’s looks very carefully at the sponsoring financial institution before assigning a rating. This is because, no matter how carefully the transaction is structured, an aggressive protection buyer can interpret credit events more broadly than the seller intended, or obtain pricing for defaulted obligations that is unrealistic or not meaningful. If the buyer/sponsoring financial institution does not approach the transaction in good faith, the structural protections can be rendered largely ineffective, and the risks to investors impossible to model. Moody’s examines — and investors should consider: • the sponsoring institution’s size • its reputation • its past history as a credit default swap counterparty • its commitment to the credit derivatives market — e.g., whether it intends to access the capital markets in the future to buy credit protection • its default and recovery history • its ability to manage and monitor the reference portfolio and abide by any portfolio guidelines • its motivation for carrying out the transaction • the separation between its credit underwriting/origination and portfolio management departments • the people and resources allocated to managing the portfolio and administering the transaction. If Moody’s has concerns specific to the sponsor, we will often ask that additional structural protections be included to address those concerns.

27 See Moody’s Special Comment, Moody’s Approach to Rating Multisector CDOs, by Jeremy Gluck and Helen Remeza (September 2000) (addressing ultimate workout value, but not market value shortly after default). Understanding The Risks In Credit Default Swaps • 15 CONCLUSION Securities backed by credit default swaps are a relatively new asset class. As the market matures, and market participants and Moody’s gain additional experience, it is likely that the standards for rating these transactions will be refined. In all cases, however, the risks to investors who buy CLNs and synthetic CDOs should be risks that are capable of being measured. For a Moody’s rating of the reference portfolio to capture the risks to investors, the credit default swap underlying the transaction should transfer only credit risk — the risk of loss following default — to investors. (The swap could theoretically transfer the risk of loss following rating downgrade, but as of yet, such a transaction has not been explicitly proposed). The “standard” ISDA credit derivative definitions, as currently drafted, do not effectively unbundle credit risk from other risks. Investors should carefully examine the means of determining frequency and severity of loss events under any credit default swap. The ISDA definitions were designed primarily as a template for private, bilateral contracts between two counterparties — usually large, sophisticated financial institutions. Thus, it should not be surprising that some of the “standard” provisions are highly complicated, unpalatable to a range of capital markets investors, and require significant scrutiny and incremental analysis by Moody’s. There is usually a price to pay for accessing the capital markets. In the case of credit default swaps, that price includes greater transparency, more precise loss event definitions, and tighter provisions to address moral hazard.

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© Copyright 2001 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. 16 • Understanding The Risks In Credit Default Swaps