Strategic Products Research First Union

Securities, Inc.
Member NYSE,
NASD and SIPC

The Default Cycle and Implications for CDO Valuation August 30, 2001

R. Russell Hurst
In this report, we offer a new approach to analyzing and valuing CDOs that blends rusty.hurst@funb.com
fundamentals with sophisticated analytics. We have identified default development (704) 374-6411
patterns that may be used to estimate expected aggregate default rates and to re-rate,
price and stress any CDO tranche. Identifying the drivers of high-yield defaults on a
macro and micro basis validates the approach. Meaningful results will occur when
solid credit work and analytics that correctly portray the cash flow of the transaction
back up the analysis. Specifically, we find that
• The default projections of Dr. Edward Altman, a professor of finance at the Stern Default development
School of Business, New York University, have been more accurate than those of patterns may be used
Moody’s Investors Service, Inc. to estimate expected
aggregate default
• The market recently has been a reliable predictor of defaults six months to a year
rates and to re-rate,
in advance but becomes less reliable when market liquidity is constrained.
price and stress any
• Rating changes are not predictive of the health of our economy, but forward- CDO tranche.
looking change in GDP projections can be used to predict defaults.
• Defaults will follow the same general pattern from the date of origination, peaking
in Years 2–4.
• Any CDO tranche should withstand a collateral loss derived from default devel-
opment curves and can be re-rated by comparing the change in confidence
intervals.

The study compares 20 years of rating changes with the change in GDP, issuer capital
structure and interest coverage relationships to the incidence of default over 13 years,
and concludes with the steps necessary to revalue a CDO tranche.

EXPERT OPINIONS
There is a difference of opinion in the credit markets regarding expected corporate Altman’s projections
default levels. As actual default levels converge toward or diverge from expected have been more
levels, the prices of credit-based fixed-income products adjust accordingly. In this accurate than those
regard, Altman’s projections have been more accurate than those of Moody’s. Altman of Moody’s.
uses percentage-of-par statistics, adjusting the universe for anomalies and small
issuers. Moody’s uses a percentage-of-issuers default calculation. We prefer the
percentage-of-issuers default calculation because most portfolios are diversified and
CDO portfolios are required to have minimum diversity levels by their indentures. It
is unlikely that most investors would experience a par default disproportionate to the
size of other issuers in their holdings. We also agree with Moody’s statement at
midyear 2001 that defaults are reaching their cyclical peak.
This report is available
on fusiresearch.com.
The Default Cycle and Implications for CDO Valuation
August 30, 2001
Altman believes there
will be an 8.0%–8.5%
default rate in 2001.
Moody’s believes
defaults will peak near
10.3% in February 2002.
Altman’s and Moody’s
projections suggest
that high-yield bonds
are rich and will
underperform.
The market may be
telling us defaults
have indeed peaked.
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FIRST UNION SECURITIES, INC.
Altman believes there will be an 8.0%–8.5% default rate in 2001 and calculates the year-
to-date annualized rate at 9.6% (on a percentage-of-par adjusted basis), implying a lower
default rate for the remainder of the year (to get to 9.6% for the year). Altman has been
in this business since the beginning and has been closer to the mark than others recently
as well as in the 1980s and 1990s. In early 2000, Altman predicted defaults would be
6.5%–7.0% on a percentage-of-par basis for year-end 2000. The average annual rate for
2000 was 6.8%, within his estimate.
Moody’s believes defaults will peak near 10.3% in February 2002, up from the current
8.3% (percentage of issues defaulting). Moody’s model has become sophisticated and
incorporates forward-looking elements similar to those of the KMV model or J.P. Morgan
& Co., Inc.’s Credit RiskMetrics. Unfortunately, Moody’s still incorporates its own ratings
as a predictive part of the model. Rating changes have lagged changes in the economy.
Nevertheless, Moody’s 6.0% projection for 2000 was lower than the actual 6.8% for
the year.
THE MARKET’S OPINION
Our data on market-implied default rates (the spread over 10-year Treasurys implies a
default level assuming a linear relationship) supports our theme of the divergence of
opinions in the credit markets regarding expected default levels. If you believe Altman’s
and Moody’s projections, the implication of Exhibit 1 is that high-yield bonds are rich
and will underperform because they will have a much higher level of defaults than the
market expects. Exhibit 1 plots speculative-grade high-yield spreads over 10-year Treasurys
against default levels over the past 13 years. The market implies a default rate of 8.5%,
which is at the top of Altman’s range (8.0%–8.5%) and significantly below Moody’s
(10.3%). The market has recently been more accurate than Altman’s or Moody’s projec-
tions and has reliably predicted defaults six months to a year in advance. At this time
last year, the then-current spread of the speculative high-yield index over 10-year
Treasurys implied a default rate of 7.7%, which is close to the current annualized level.
The market may be telling us defaults have indeed peaked. In times of severe stress, the
liquidity premium distorts the linear relationship that exists between high-yield defaults
and the spread of the high-yield index over 10-year Treasurys (see the 1991 datapoint
in Exhibit 1) and renders high-yield spreads useless as a predictor.
Exhibit 1: Speculative-Grade Default Rates and Corresponding Spreads over 10-Year Treasurys*
1,400
1990
1,200
1,000 Market Implied
Market Implied
7.7%, June 2000
8.5%, August 2001
STT (bps)
800
600
1991
400
Moody’s Projection
Altman’s Projection 10.3%, February 2002
200 8.0%–8.5%, 2001
0
0% 2% 4% 6% 8% 10% 12%
Default Rate Linear (Default Rate)
*Implied spreads of Moody’s Investors Service, Inc.’s and Dr. Edward Altman’s projections from 1987 to August 2001.
Source: First Union Securities, Inc.
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

Fortunately, there is currently plenty of liquidity in the high-yield market and more
liquidity than last year. The high-yield market has had a good year even at this default
level. This is the result of net inflows year to date into high-yield mutual funds that hold
70%–80% of the $700 billion of outstanding high-yield debt and the continuing bid for
high-yield paper from CBOs, which account for most if not all of the remaining high-yield
bond holdings.

HISTORICAL DEFAULT RATES AND THE ECONOMY

The data in Exhibit 2 suggest ratings are not predictive of changes in the health or our Ratings are not
economy as measured by the percentage change in GDP but do show the two are highly predictive of changes
correlated. Much attention has been given to predicting changes in GDP and many of in the health of our
these models have produced admirable results, particularly in the short term. Changes economy.
in GDP move with the changes in the percentage of upgrades to downgrades from year
to year and produced a positive correlation of 0.56. Lagging by one year, either set of
observations to the other resulted in a lower correlation coefficient. If there is a lag, we
can conclude it should be less than a year on average.

Exhibit 2: Moody’s Investment-Grade and High-Yield Upgrades to Downgrades

versus Change in GDP

0.8% 10%
0.6% 8%
Upgrades to Downgrades

0.4% 6%
0.2%
4%

%YoY
0.0%
2%
-0.2%
0%
-0.4%
-0.6% -2%

-0.8% -4%

-1.0% -6%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Investment Grade (left scale) . High Yield (left scale) . GDP (right scale)
Source: Moody’s Investment Service, Inc., and First Union Securities, Inc.

Exhibit 3 on page 4 is another way to show the relationship between GDP and defaults, The relationship
not just downgrades. In this case, the relationship is strongly inverse and produces a between GDP and
correlation coefficient of negative 0.78. We can see the default rate increase has slowed defaults is strongly
in 2000 and year to date in 2001 after a large increase in 1998. In our last period of stress, inverse and produces
the rate of increase accelerated for two years before slowing and peaking in 1991 at a a correlation coefficient
record speculative-grade rate of 10.6%. At this stage, we are not near that level and the of negative 0.78.
rate of increase has slowed, not accelerated.

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The Default Cycle and Implications for CDO Valuation
August 30, 2001
Default projections
using historical
ratings as a base
may be overstated
or underestimated.
Rating downgrades
should lag behind any
prolonged increase in
high-yield default rates.
Leverage and cash flow
multiples become worse
when the economy
expands.
4
FIRST UNION SECURITIES, INC.
Exhibit 3: Moody’s Investors Service, Inc., Default Rates (issuer based)
12% 12%
10.57%
10%
9.77%
10%
8%
7.70%
8%
6.82%
5.76% 5.75%
6% 5.15% 6%
4.18% 3.90%
3.53% 3.84% 3.64%
4% 4%
2.07% 1.92% 2.16%
2% 2%
0% 0%
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 6/01
Default Rates (issuer based) GDP % Change
Source: Moody’s Investors Service, Inc.
Moody’s, Standard & Poor’s Corp. (S&P) and, to some extent, Altman have relied on the
historical ratings pattern to predict default levels. Because of what we will call “the
rating effect,” default projections using historical ratings as a base may be overstated
when our economic health (as measured by increases in GDP) is on the way up and
underestimated on the way down—unless your view of the GDP is forward-looking, as
we suggest.
Rating agencies have long been criticized for lagging behind the current state of affairs
as it relates to the health of a company or the economy. Many of the credit models used
today by major corporations, such as J.P. Morgan’s Credit RiskMetrics and the KMV
model, incorporate current market information and options technology to validate fun-
damental analysis that shows a particular credit or company is weaker or stronger than
its rating implies. If this were the case, rating downgrades should lag behind any
prolonged increase in the high-yield default rates and upgrades should also trail
prolonged improvement in the level of defaults.
DRIVERS OF DEFAULTS:
AGGRESSIVE LEVERAGE AND LOW CASH FLOW MULTIPLES
In this section, we discuss the drivers of defaults, aggressive leverage and low cash flow
multiples, which we find become worse when the economy expands and improve when
the economy contracts. Our default data show bonds and loans originated in 1996, 1997,
1998 and the beginning of 1999 have had higher default rates than those originated
before 1996 or after the first half of 1999. We believe this was the result of the higher
leverage and lower cash flow multiples of loans originated in that period. Loans that
originated before 1996 are well seasoned and most likely have reached a steady state. The
steady rate of default may be stressed slightly upward in a contraction. Those originated
after the first part of 1999 have stronger leverage and cash flow characteristics than those
originated in 1996–1998 and should have a better default experience over time.
The default cycle follows this ebb and flow of leverage on average by two to four years
(Exhibits 4 and 5, page 5). The explanation is simple. Companies with lower leverage
multiples will be better able to cope with a downturn in the economy. Also, with lower
leverage these companies may be able to avoid default by accessing refinancing in the
market. During this period, investors will demand compensation via a higher risk-
adjusted return to account for the higher level of expected defaults. The market will only
fully recover once the default cycle has peaked. Our data cover two such cycles and, by
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

examining them closely, we can readily see the damage done by leverage during a
contraction.

Exhibit 4: Average Debt Multiples of Highly Leveraged Loans versus

Moody’s Speculative-Grade Defaults
10x 12%
In 1987, the market and
banks allowed leverage
8x
10% to increase to almost
9.0x and required cash
4.1x
6x 3.3x
8% interest coverage of
3.5x
6%
only 1.1x.
2.0x 2.3x 2.1x
1.9x 1.7x
4x 2.4x 2.5x 2.5x 1.2x
1.2x 1.3x 4%
1.5x
4.7x
2x 3.7x 3.4x 3.4x 3.5x
2.7x 2.8x 3.3x 3.3x 2.9x 2%
2.6x 3.5x 3.6x 2.6x 2.4x

0x 0%
1987 1988 1989 1990 1991* 1992 1993 1994 1995 1996 1997 1998 1999 2000 H1 Q2
2001 2001
Bank Debt/EBITDA (left scale) Non-Bank Debt/EBITDA (left scale)
Speculative-Grade Defaults (right scale)
*Insufficient data.
Source: First Union Securities, Inc.

Exhibit 5: Average Cash Flow Multiples of Highly Leveraged Loans

4.0x 12%
3.5x
10%
3.0x
8%
2.5x
2.0x 6%
1.5x
4%
1.0x
2%
0.5x
0.0x 0%
1987 1988 1989 1990 1991* 1992 1993 1994 1995 1996 1997 1998 1999 2000 H1 Q2
EBITDA – Capex/Cash Interest (left scale) EBITDA/Cash Interest (left scale)2001 2001
Speculative-Grade Defaults (right scale)
*Insufficient data.
Source: First Union Securities, Inc.

Our default data start during a severe economic downturn in the late 1980s, followed by
a period of recovery and growth and ends in the less severe downturn we are now
experiencing. Exhibit 4 shows the pattern of leverage over this period as measured by
debt/EBITDA for issuers with leveraged loans and high-yield bonds in their capital
structures. The exhibit also shows the mix of bonds and loans that constitute total debt
for those issuers. Exhibit 5 shows the corresponding cash flow interest coverage during
this period as measured by EBITDA minus capex and EBITDA to cash interest.

Exhibits 4 and 5 show that in 1987, the market and banks allowed leverage (essentially
all debt to cash flow) to increase to almost 9.0x and required cash interest coverage of
only 1.1x. In fact, interest coverage minus capital expenditures was 0.8x, revealing a
negative cash flow on average for borrowers accessing the leveraged loan and high-yield
markets. This could be called an aggressive lending practice. This period represented the
tail end of a sustained growth cycle in the economy (Exhibit 3), followed by a severe
contraction. This was also the end of the Michael Milken era in high-yield bonds.
5
The Default Cycle and Implications for CDO Valuation
August 30, 2001
Despite improved credit
fundamentals, bank
and loan issuance was
almost nonexistent
in 1991.
Since 1990, we have
seen debt/EBITDA
multiples recede to
less than 4.0x by
2000 and stay there
so far in 2001.
Our review of Moody’s
speculative-grade
default data shows
average defaults for
any given year of bond
origination will peak
in Years 2–4 after
issuance.
6
FIRST UNION SECURITIES, INC.
The result was a decrease in the debt/EBITDA multiple to less than 5x in 1992 and an
increase in cash flow multiples to 2.5x in 1990. In 1991, the speculative-grade default rate
hit the current record level of 10.6%
Despite improved credit fundamentals, bank and loan issuance was almost nonexistent
in 1991 and, as a result, there are too few observations for a meaningful representation
in Exhibits 4 and 5. These events fundamentally changed the workings of the high-yield
market, which to date has not seen anywhere near the leverage levels allowed in the
1980s. The economy improved until the end of 1997, when growth decelerated. The 1990s
growth period saw a healthy stock market and a general exuberance around technology
and e-commerce (excessive per Alan Greenspan) as late as 1999. The 1990s also saw
the emergence of the institutional leveraged loan syndication market to compete directly
with the high-yield bond market for participation in the long-term capital financing of
high-yield issuers.
During this period, which ended with the Russian debt crisis in the fourth quarter of
1998, leverage in the loan and high-yield markets crept back up to around 6.0x in 1997
before receding to 5.0x in 1998, and EBITDA minus capex/cash interest decreased to a
low of 1.2x in 1996 from a high of 2.0x in 1990. Since then, we have seen debt/EBITDA
multiples recede to less than 4.0x by 2000 and stay there so far in 2001. EBITDA/cash
interest reached a record level of 3.4x in the second quarter, with the EBITDA minus
capex/cash interest measure moving up to a healthy level modestly above 2.0x for the
first half of 2001.
We expect this trend of improved leverage multiples to continue through the default
cycle.
CLASSIC ABS APPROACH: THE DEFAULT CURVE BY YEAR OF ORIGINATION
In this section, we introduce the application of the classic ABS underwriting approach
of creating a default curve by year of origination as a foundation for our default
projection and our CDO valuation models. Our review of Moody’s speculative-grade
default data shows average defaults for any given year of bond origination will peak in
Years 2–4 after issuance. As we move through this 2–4 year cycle for bonds originated
in 1996, 1997 and 1998, the overall speculative-grade rate of default will slow and begin
to recede. Exhibit 6 on page 7 shows the pattern of cumulative defaults by year of
origination and shows 1997–1999 originations starting off less steeply than the 1988–
1990 curves that led to the 10.6% peak in 1991, leading us to believe the peak of this
default cycle will be less severe than the one in 1991.
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

Exhibit 6: Speculative-Grade Cumulative Default Rate by Years from Origination

50%

40%

30%

20%

10%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994 1995
1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

We have charted all of Moody’s downgrades by speculative grade, Ba and B ratings and High-yield defaults
divided each group into origination cohorts in a similar fashion to HEL securitizations follow the same
for the purpose of identifying a pattern and comparing one year of origination with cumulative default
another. Exhibit 6, which groups all of Moody’s speculative-grade defaults in this pattern when compared
manner, shows high-yield defaults follow the same cumulative default pattern when with each other.
compared with each other.

Further examining the data in Exhibit 6, we see that after the first year, the annual default
rate accelerates, peaks (usually in Years 2–4) and then begins decelerating to a steady
state around Years 5–6. For the speculative-grade universe during the 10 years from
1988 to 1997, defaults peaked 2.7 years from origination. In three of the cohorts, defaults
peaked in the first year; in six of the cohorts, defaults peaked in Years 2–4; and in one
cohort, the default peaked in Year 5. The data also show that if the loss curve is steeper
in the early years, the cohort’s cumulative defaults will remain worse than cohorts with
less-steep curves. From the historical data, we know the average annual issuer default
rate peaked at 10.6% in 1991. From Exhibit 6, we see that bonds originated in 1991 and
1988–1990 contributed significantly to this record rate, however, 1991 now has experi-
enced a lower cumulative default than the other three years of origination.

Moving on, the year-to-year percentage change in GDP stopped decelerating in 1990 and
became positive in 1992. For the next 5–6 years, the economy exhibited fairly stable
growth and a healthy economic environment until the fourth quarter of 1998. The pattern
of growth followed by contraction is similar to what occurred in the late 1980s and early
1990s. For 2000, the 1997 cohort in Exhibit 6 had the highest annual default rate of all
the years of origination. For originations from 1996 and earlier, all annual default rates
for 2000 were less than 3.5%. For bonds originated in 1998–2000, the annual default rates
were 5%–6%. Annual default patterns for the speculative-grade cohorts are presented in
Exhibit 7 on page 8.

7
The Default Cycle and Implications for CDO Valuation FIRST UNION SECURITIES, INC.
August 30, 2001

Exhibit 7: Speculative-Grade Annual Default Rate by Years from Origination

The pattern of growth 12%
followed by contraction
is similar to what 10%

occurred in the late 8%

1980s and early 1990s.
6%

4%

2%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

Speculative-grade defaults represent a weighted average of Ba and B defaults. We

have presented the same data for the Ba and B groups of defaults in the Appendix
(Exhibits 12–17, pages 14–15). The Ba cumulative default rate and annual default rate
patterns are similar to the speculative-grade group. The B data show an earlier, higher
rate of default per origination year than the other two groups. The B default rates are
more volatile and respond quickly to any economic stress.

Defaults accelerate
after an economic
downturn.
In summary, an examination of loss development by year of origination of the 1987–2000
Moody’s default data reveals loss development patterns are similar for each year and will
generally peak 2–4 years from the date of origination, defaults accelerate after an
economic downturn and the default level will depend on the length and severity of the
downturn.

PREDICTING DEFAULTS WITH GDP

If 2.5% year-over-year
growth is achieved in
2002, our model sug-
gests defaults will peak
at the end of 2001.
In this section, we discuss the methodology behind our default-forecasting model, which
uses GDP projections and default development patterns as predictors. Our model uses
simple linear forecasting and projects defaults for 2001 of 6.82%–8.58% and has an upper
band of 7.82% in 2002 using GDP growth assumptions of 1.7% in 2001 and 2.5% for
2002. If 2.5% year-over-year growth is achieved in 2002, then our model suggests defaults
will peak at the end of 2001. If GDP growth next year is 0.0%–2.0%, defaults will peak
in 2002 but at an only modestly higher level than our upper band projection of 8.58%.

A trusted GDP prediction and the average speculative-grade average default curve in
Exhibit 8 on page 9 will provide the basic information needed to predict a best and worst
case default rate range. Exhibit 8 shows the average default rate by years from origination
for the speculative-grade group along with the minimum, maximum and the 95%
confidence level observations.

8
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

Exhibit 8: Speculative-Grade Average Annual Defaults by Years from Origination (1998–2000)

12%

10%

8%

6%

4%

2%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
Maximum Minimum Average 95% Confidence
Source: First Union Securities, Inc.

Our best-case projection does not use GDP but takes the curves for each cohort by year Our best case estimated
of origination, fitting the curve exponentially. We then average the predictive result for default rate for 2001
the performance of each cohort in 2001, producing an estimated default rate of 6.76%. In is 6.76%.
other words, this would be the level of defaults in 2001 if defaults followed their
historical pattern. This result is lower than our experts’ projections and the implied rate
of the market (Exhibit 9).

Exhibit 9: Fitted Curve Projection of 2001 Issuer Default Rates

Avg. by Year of Origination 8.8 7.2 6.7 5.4 5 5.2 5.3 5.2 5.8 5.7 5.2 4.5 4.1 4.1
Years from Origination 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1988 3.47% 6.17% 8.35% 8.93% 3.40% 3.80% 0.88% 1.96% 0.73% 1.24% 2.33% 1.03% 2.19% 2.18%
1989 6.02% 9.83% 9.09% 3.58% 4.05% 1.01% 1.99% 0.96% 1.83% 2.52% 0.94% 2.47% 1.09%
1990 9.84% 9.81% 4.31% 3.77% 1.10% 2.02% 0.84% 1.89% 2.19% 1.23% 2.64% 0.92%
1991 10.50% 4.69% 3.92% 1.15% 2.35% 0.88% 1.98% 2.29% 1.73% 2.82% 3.05%
1992 4.85% 4.09% 1.37% 2.58% 1.15% 1.95% 2.23% 1.69% 3.21% 3.38%
1993 3.51% 1.63% 3.67% 1.35% 1.81% 1.79% 2.33% 3.27% 3.28%
1994 1.93% 3.40% 1.87% 1.24% 2.49% 3.33% 3.38% 3.68%
1995 3.32% 1.75% 1.83% 2.85% 3.42% 3.37% 3.73%
1996 1.66% 2.16% 3.57% 3.90% 3.52% 4.03%
1997 2.04% 3.98% 4.40% 9.21% 7.86%
1998 3.40% 5.62% 5.16% 5.62%
1999 5.51% 5.94% 5.94%
2000 5.71% 5.71%
2001 5.71%
Average Yearly Default Rates:
2000 6.82%
2001E 6.76%
Source: First Union Securities, Inc., including estimates.

9
The Default Cycle and Implications for CDO Valuation FIRST UNION SECURITIES, INC.
August 30, 2001

Exhibit 10: GDP Regression and Projection of 2001 Issuer Default Rates
GDP (%YoY) 4.27 2.64 1.26 2.29 3.03 3.44 3.59 2.51 4.43 4.74 4.02 4.23 2.55 1.70 2.50
Years from Origination 1 2 3 4 5 6 7 8 9 10 11 12 13 14 14
1988 3.47% 6.17% 8.35% 8.93% 3.40% 3.80% 0.88% 1.96% 0.73% 1.24% 2.33% 1.03% 2.19% 6.62% 5.03%
1989 6.02% 9.83% 9.09% 3.58% 4.05% 1.01% 1.99% 0.96% 1.83% 2.52% 0.94% 2.47% 5.38% 5.12%
1990 9.84% 9.81% 4.31% 3.77% 1.10% 2.02% 0.84% 1.89% 2.19% 1.23% 2.64% 7.35% 5.45%
1991 10.50% 4.69% 3.92% 1.15% 2.35% 0.88% 1.98% 2.29% 1.73% 2.82% 6.85% 5.23%
1992 4.85% 4.09% 1.37% 2.58% 1.15% 1.95% 2.23% 1.69% 3.21% 4.34% 3.60%
1993 3.51% 1.63% 3.67% 1.35% 1.81% 1.79% 2.33% 3.27% 4.21% 3.49%
1994 1.93% 3.40% 1.87% 1.24% 2.49% 3.33% 3.38% 3.95% 3.39%
1995 3.32% 1.75% 1.83% 2.85% 3.42% 3.37% 3.92% 3.47%
1996 1.66% 2.16% 3.57% 3.90% 3.52% 4.34% 3.86%
1997 2.04% 3.98% 4.40% 9.21% 11.91% 9.35%
1998 3.40% 5.62% 5.16% 5.24% 5.02%
1999 5.51% 5.94% 6.16% 5.95%
2000 5.71% 5.71% 5.71%
2001 5.71% 5.71%
2002 5.71%
Average Yearly Default Rates:
2000 6.82%
2001E 8.58%
2002E 7.82%
Source: First Union Securities, Inc., including estimates.

Our worst case projects
a default rate of 8.58%.
Our model projects a
7.82% default rate for
2002.
Our worst case, or upper-band projection, will use a GDP projection. David Orr, chief
economist for First Union Securities, Inc., projects a year-over-year change in GDP of 1.7%
for 2001. Fitting the curve for each of the origination year cohorts and averaging the
predicted 2001 result for each results in a 2001 default projection of 8.58% (Exhibit 10).
This is the upper band of our default projection for 2001. It is modestly higher than
Altman’s prediction and significantly lower than Moody’s projection and is also mod-
estly higher than the current implied market default rate. Using Orr’s 2002 projection of
a 2.5% year-over-year change in GDP, our model projects a 7.82% default rate for 2002.
If 2.5% year-over-year growth is achieved in 2002, then our model suggests defaults will
peak at the end of 2001. The fundamental anecdotal evidence of our default drivers,
leverage and cash flow coverage, also support this conclusion. If GDP growth next year
is 0.0%–2.0%, defaults will peak in 2002 but at only a only modestly higher level than
our upper band projection of 8.58%.

IMPLICATIONS FOR CDO VALUATIONS

Our result is a re-rating, In this section, we discuss how to value any particular CDO tranche addressing
up or down, that will important fundamentals and a new process that incorporates default development curves
allow more accurate as a foundation to re-rate and ultimately re-price the security. It is an understatement to
pricing of CDO say CDO analysis is complex, but the following approach is superior to other approaches
investments. in the market, including the practice of increasing constant default rates (CDRs) to find
a breakeven. The result does not easily translate into information that can be used to
re-rate or value a CDO tranche. Our result is a re-rating, up or down, that will allow
meaningful comparisons between like-rated tranches of CDOs and allow more accurate
pricing of CDO investments. The process incorporates eight steps as follows:
• Review the collateral manager and motivation for the transaction and summary
statistics on the pool of collateral to be securitized.
• Detailed credit-by-credit review of the collateral pool.
• Recalculate the diversity scores and weighted average rating scores.
• Develop or purchase analytics that correctly portray the cash flows of the
transaction.
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FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

• Divide the collateral pool into origination cohorts and develop a weighted average Our model develops
annual default rate pattern that incorporates the remaining life of each cohort’s a weighted average
default pattern. Use this vector of defaults as a base case assumption to run expected annual default rate
case cash flows for the CDO tranche to be analyzed. pattern from origina-
tion cohorts.
• Stress the CDO tranche using the default development vector calculated in Step 5 in
combination with probabilities of downgrade over a five-year period from Moody’s
corporate ratings migration study. The default level should be increased by the
number of standard deviations needed to produce a confidence level consistent with Our model stresses the
the corporate rating probability of a downgrade over a five-year period equal to the CDO tranche using the
rating of the CDO tranche being analyzed (e.g., a 95% confidence level for Aaa bonds default development
or 75% for Baa bonds). Revise the CDO tranche rating downward if it fails the stress vector in combination
test, to a rating consistent with the lower, but passing, confidence level. A breakeven with probabilities of
confidence level can also be higher and becomes a meaningful measure of relative downgrade.
value among like-rated tranches such that the results can always be cast as an
increase or decrease in the rating of the CDO tranche.
• Validate the results by running the transaction through Moody’s Binomial Expan-
sion Model.
• Value the CDO tranche to achieve a discounted margin consistent with the current
spreads of the revised rating

Many of the steps are self-explanatory, but we have provided further comments on each
step where we feel the information may enhance the understanding of the process.

In Step 1, investors should evaluate the collateral manager and particularly their
experience and performance in managing the securitized asset class. The initial collateral
review should include a market valuation of the bonds or loans, the mix of ratings, the
CCC basket, the historical pattern of defaults and whether the manager has done a good
job of industry and issuer selection. The strategy must be defensible.

In Step 2, our approach is forward-looking, however, meaningful results for each CDO Meaningful results for
issue analyzed will depend on the integrity of the data describing the current condition each CDO issue anal-
of the collateral pool. Ideally, each issuer in the pool should be reviewed or analyzed yzed depend on the
with a view toward validating or changing the rating to reflect the investor’s view of the initial integrity of
credit. Our approach has been to mark portfolios to market and look at whether the rating the data.
seems consistent with the price. We look in detail at bonds priced in the stressed
$40–$70 price range and stressed loans in the $70–$90 price range. Changes in the credit
outlook in this subset can affect the price significantly. Bond and loan trading at stressed
levels requires less credit work than the distressed group. Our end result is a re-rating
of the collateral pool to reflect our view. The credit work becomes more intense the further
down the CDO capital structure we are.

In Step 3, diversity scores and weighted average rating scores should be recalculated
giving effect to any revision of ratings that took place in Step 2. These calculations are
all important inputs for our analytical model. In addition, a realistic recovery assumption
must be used.

In Step 4, analytics that correctly portray the cash flows of the transaction analyzed Analytics that correctly
cannot be overemphasized. The misdirection of the cash flow by the model used can portray the cash flows
cause inappropriate investment decisions to be made and CDO tranches to be mispriced. of the transaction
Alternatives for the investor are to build a proprietary model or buy analytics from one analyzed are crucial.
of the many vendors that now offer CDO products. The most widely used are Intex, Wall
Street Analytics and Conquest.

11
The Default Cycle and Implications for CDO Valuation FIRST UNION SECURITIES, INC.
August 30, 2001

Any change in equity
returns will be an
indication of whether
a particular tranche of
the deal has strength-
ened or weakened.
In Step 5, using the data we have presented, the portfolio should be divided into
origination cohorts using that part of the average default development curve for the year
and rating group (Ba or B) that corresponds with the remaining life of that origination
year’s default development pattern. For example, B rated bonds originated in 1999 would
initially use the B average default pattern without the first two years of the default cycle.
This would be done for each year using each year’s origination default pattern to
produce a set of base case scenarios of expected collateral cash flows and deal cash
flows. Any change in equity returns from previously run cash flows will be an indication
of whether a particular tranche of the deal has strengthened or weakened since the last
review.

If the Baa 2 tranche
survives the test, it
should have a 98.8%
probability of main-
taining its rating over
the next five years.
In Step 6, this methodology can be used in a meaningful way to stress differently rated
tranches’ informative results. For example, if your projected holding period is five years
and the Moody’s rating migration study (Exhibit 11) shows a 95% probability that any
corporate Aaa will be still rated Aaa in five years, use the same 95% confidence interval
around the default development patterns constructed for the base case to stress the Aaa
tranche. Given a normal distribution, plus or minus 1.98 standard deviations produces
a 95% confidence level. If there is no loss of interest or principal, you are ensured to that
level of confidence that the deal will perform as expected. Measuring the total loss of
collateral value in this scenario against another Aaa is a good way to determine whether
one deal is stronger than another.

Exhibit 11: Comparison of Probability of Maintaining Rating*

Rating Corporates CDO Notes Difference
Aaa 92% 100% 8%
Aa1 88% 90% 3%
Aa2 84% 93% 9%
Aa3 85% 93% 9%
A1 78% 92% 14%
A2 82% 96% 14%
A3 76% 98% 22%
Baa1 78% 95% 17%
Baa2 75% 99% 24%
Baa3 75% 91% 16%
Ba1 66% 87% 21%
Ba2 64% 86% 22%
Ba3 60% 97% 37%
B1 64% 81% 17%
B2 65% 100% 36%
B3 64% 97% 33%
*1996–2000.
Source: Moody’s Investors Service, Inc.

For example, to stress the Baa2 tranche of a CDO, the corporate Baa2 probability for
corporates (the corporate migration probability is used because the collateral is corporate)
of 75% would be used as the confidence interval and would require adjusting each of
the loan origination cohorts up 1.15 standard deviations. If the tranche survives the test,
the Baa2 corporate rating on the tranche should have a 98.8% probability (the five-year
migration probability for Baa2 CDO tranches) of maintaining its Baa2 rating over the next
five years. As nonintuitive as this may seem, the Baa2 tranche was originally designed
to withstand a Baa2 level of cumulative defaults on the collateral pool. If the Baa2 fails
our default development stress test, moving the confidence interval down until the
tranche passes the test with no missed payments will allow us to approximate what the
new rating would be if Moody’s were to re-rate the transaction. We can also test
confidence levels upward, which would result in a higher revised rating. Using the
12
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

information in Exhibit 11, this is accomplished by looking up the passing or breakeven We recommend
confidence interval in the corporate probability table and finding the corresponding Moody’s model for
rating. For example, if the passing confidence level were 66.1%, we would expect this validation of our
tranche to be downgraded to Ba1 in the near future. This is particularly useful for approach.
tranches on negative watch that have not yet been downgraded to determine how many
notches the rating downgrade may be.

In Step 7, it is easy to validate our results in Step 6 by running the Baa2 tranche cash
flows through Moody’s Binomial Expansion Model to see if it passes all of the tests. The
Moody’s tests are pass/fail, and a much more complicated trial-and-error approach is
needed to determine a new rating for any particular CDO tranche than is needed in our
approach. As a result, we recommend Moody’s model for validation of our approach.

Step 8 is self-explanatory.

Additional information is available on request.

13
The Default Cycle and Implications for CDO Valuation FIRST UNION SECURITIES, INC.
August 30, 2001

APPENDIX
Exhibit 12: Ba Cumulative Default Rates by Years from Origination
40%

30%

20%

10%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

Exhibit 13: Ba Annual Default Rate by Years from Origination

9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

Exhibit 14: Average Ba Defaults versus 95% Confidence by Years from Origination
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
Maximum Minimum Average 95% Confidence
Source: First Union Securities, Inc.

14
FIRST UNION SECURITIES, INC. The Default Cycle and Implications for CDO Valuation
August 30, 2001

Exhibit 15: B Cumulative Default Rate by Years from Origination

70%

60%

50%

40%

30%

20%

10%

0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

Exhibit 16: B Annual Default Rates by Years from Origination

18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
1988 1989 1990 1991 1992 1993 1994
1995 1996 1997 1998 1999 2000
Source: First Union Securities, Inc.

Exhibit 17: Average B Defaults versus 95% Confidence by Years from Origination
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13
Year
Average 95% Confidence Maximum Minimum
Source: First Union Securities, Inc.

15
 First Union Securities, Inc.
Structured Products Research (800) 691-7758
Richard Gordon Managing Director Head of Structured Products Research (704) 383-8758 rich.gordon@funb.com
James S. Anderson Managing Director ABS Product Management (704) 383-7589 james.anderson@funb.com
Brian M. Doyle Managing Director CDO Research (704) 383-6381 brian.doyle@funb.com
Leo Budin Director Quantitative Research (704) 383-0628 leo.budin@funb.com
R. Russell Hurst Director CDO Research (704) 374-6411 rusty.hurst@funb.com
Inna Koren Director ABS Research (212) 909-0082
(704) 383-1908 inna.koren@funb.com
Rubin Bahar, CFA Vice President Quantitative Research (704) 383-8688 rubin.bahar@funb.com
Mark Heberle Vice President ABS Research (704) 383-1936 mark.heberle@funb.com
Tom Lofton, CFA Vice President Real Estate Investment Trusts (704) 374-6198 tom.lofton@funb.com
Bruce Miller Vice President Database Management (704) 374-6440 bruce.miller@funb.com
Shawn Mallon Assistant Vice President Database Management (704) 383-5094 shawn.mallon@funb.com

Mike Palavido Director Application Development (704) 374-4727 mike.palavido@funb.com

Greg Kelly Vice President Application Development (704) 383-6815 greg.kelly@funb.com
Scott Shukes Vice President Application Development (704) 383-6212 scott.shukes@funb.com
Jean Philippe Cabrol Associate Application Development (704) 374-2675 philippe.cabrol@funb.com

Fixed-Income Sales
Chris Huff Director Charlotte, NC (704) 715-1203 chris.huff@funb.com
Robert Teller Managing Director Charlotte, NC (704) 383-5037 robert.teller@funb.com
Tommy Lawson Managing Director Charlotte, NC (704) 715-1202 tommy.lawson@funb.com

Editorial Group
Michael D. Evans Senior Editor Fixed-Income Research (704) 374-6545 michael.evans@funb.com
Dawn M. Dixon-Cotter Editor Fixed-Income Research (704) 383-6788 dawn.cotter@funb.com
Jennifer Yount Editor Fixed-Income Research (704) 383-6479 jennifer.yount@funb.com
Greg Hendricks Editor Fixed-Income Research (704) 383-8192 greg.hendricks@funb.com
Jeanne M. Deitz Graphic Design Fixed-Income Research (704) 715-1557 jeanne.deitz@funb.com

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