Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 7

Structured Finance Default and Recovery Rates

In the previous two chapters, we looked at the various types of structured finance collateral. In this chapter, we look at default and recovery rates on structured finance collateral. The first section describes some of the difficulties in calculating structured finance defaults and recoveries. We then detail the S&P and Moody's default-and-recovery methodologies and their results, including our methodology for combining their results. In the final section, we consider the best way to use this default and recovery information for high-grade structured finance-backed CDOs (SF CDOs). These are SF CDOs made up of AA and AAA assets where the constant annual default methodology does not always make complete sense.

To summarize—Exhibit 7.1 is our best estimate of historical defaults and recoveries based on studies by both S&P and Moody's. In the exhibit, we have turned the rating agencies' 5-year cumulative default rates into constant annual default rates that are more familiar to CDO investors. The exhibit also shows recovery rates on structured finance tranches. As with default rates, these are shown to vary with the tranche's original rating and its structured finance subsector. These historical results are useful as a starting point in estimating credit losses in a structured finance portfolio. They are also useful in evaluating default and recovery stress tests in the cash flow modeling of SF CDOs.

Exhibit 7.1 shows the superb ...