The proceeds from the offering are typically used
to purchase a portfolio of assets, or may be held in
the SPE. Should some of the assets fall into default
or trigger some of the transaction covenants, excess
spread is first used to cover any losses. However,
there might not be sufficient assets to cover these
losses, and the lowest level, or more junior securi-
ties may take a loss. Payments to each of the liabili-
ty classes are dictated by a stipulated priority of
payments that reallocates the risk and rewards
associated with the assets. This allows the CDO
issuer to tailor the liabilities to meet the risk/return
profiles of a broad range of investors and to attract
additional groups of investors. These structures
appeal to different investors, collateral managers,
and sponsors for a variety of reasons, including
participating in new asset types, capitalizing on
arbitrage opportunities, or to transfer credit risk.
The specific steps of the CDO transaction rating
process leading to the rating of a transaction are
as follows:
■Reviewing the structural basics and the legal
structure,
■Sizing the default frequency of the proposed
asset pool,
■Reviewing the collateral manager,
■Sizing the loss severity,
■Reviewing of the transaction’s collateral and
structural features,
■Establishing the required level of credit support
for each rated tranche,
■Assigning preliminary ratings,
■Reviewing final documentation and legal opin-
ions, if required, and finally,
■Issuing the rating(s) of the transaction.
Municipal CDO ratings are a joint effort between
Standard & Poor’s Structured CDO group and
Standard & Poor’s Public Finance Department.
While public finance analysts will assist in review-
ing the pledged collateral and its relevance in deter-
mining credit support levels, structured analysts will
typically review the other rating aspects due to the
fluid and rapidly evolving nature of the CDO mar-
kets. While the treatment of municipal assets in a
CDO generally mirrors the assumptions set out in
this article in terms of default and recovery assump-
tions and coding for correlation purposes, general
CDO criteria is considerably more extensive.
Interested readers should consult Standard & Poor’s
Structured Finance Global Cash Flow and Synthetic
CDO Criteria.■Investment Guidelines ........................................................................................................
http://www.standardandpoors.com 49F
ormal rating requirements do not exist for
investing issuers’ operating funds because
finance officers tend to invest conservatively based
on internal policies or state-legislated restrictions
that emphasize the safety of principal and liquidity
over the desire for higher yields.
In the event that losses were to occur, most gov-
ernments and enterprises have the financial capaci-
ty to take budget balancing actions to reduce the
pressures derived from lost investment earnings.
Certain issuers, such as in the housing sector, have
limited revenue raising flexibility and therefore the
credit quality of investments takes on greater
importance. Standard & Poor’s Ratings Services
belief in the traditional conservatism of municipal
investment practices is grounded in experience and
has been confirmed in discussions with issuers on
investment policy as participation in exotic and
more volatile derivative securities has increased.
That is good news, because with the proliferation
of new investment structures, which can shift dra-
matically, it would be virtually impossible to regu-
late investment requirements to keep up with the
changing environment.
Standard & Poor’s rating analysis—particularly
for short-term notes and commercial paper—is
based on the presumption that funds are invested
with the preservation of capital as the issuer’s high-
est priority. The level of risk able to be tolerated is
also a function of the issuer’s level of liquidity and
overall financial strength. The following investment
guidelines are “common sense” investing policies
that Standard & Poor’s believes are followed by the
vast majority of rated public finance issuers; they
might be called “normal prudent practice.” If
Standard & Poor’s identifies issuers whose practices
diverge from these guidelines, it would not auto-
matically warrant a lower rating, but it would
prompt further questioning and analysis of that
issuer’s cash flow and liquidity needs.
Regular borrowers of short-term, seasonal cash
flow notes have greater needs for liquidity and safe-