The Analysis of Short-Term Rating Migration in Synthetic CDOs

Abstract

The credit rating on a tranche of a synthetic CDO transaction addresses the probability that losses in the reference portfolio will not exceed that tranche's available credit enhancement (the attachment point) over the life of a transaction. This article introduces a model that allows comparison of near-term rating stability of different CDO tranches with the same initial rating. The question of whether the original rating will be maintained on a transaction over time will be determined by the pull of two factors: adverse rating migration in the reference portfolio exerts a negative influence on a CDO rating while, absent such migration, the passage of time exerts a positive influence. Other factors that influence ratings stability are surplus enhancement, the granularity of the portfolio (number of reference entities), bar-belling (range of ratings within the tranche), the weighted-average rating of the portfolio, and overlap of reference credits between tranches.