Rating Model Arbitrage in CDO Markets: An Empirical Analysis

Stefan Morktter* / Simone Westerfeld** Swiss Institute of Banking and Finance, University of St. Gallen, Switzerland

Abstract We analyze whether information asymmetry between issuers and investors leads to rating model arbitrage in Collateralized Debt Obligation markets. Rating model arbitrage is defined as the issuer's deliberate capitalization of information asymmetry at the investor's cost on the basis of different rating processes. Using data from CDO transactions grouped by both rating agencies and underlying rating methodologies, we test for homogeneity of characteristic transaction features within the group and heterogeneity between the different groups. We find that the hypothesis stating nonexistence of rating model arbitrage on the basis of information asymmetry does not hold as individual patterns of transaction characteristics within each group could be identified.

Keywords: JEL Classification:

Rating Model Arbitrage, Collateralized Debt Obligations, Asymmetric Information D82, G14, G24

Corresponding Author: Stefan Morktter, Swiss Institute of Banking and Finance (s/bf), University of St. Gallen (HSG), Rosenbergstrasse 52, CH-9000 St. Gallen, phone: +41 71 224 7041, fax: +41 71 224 7088, stefan.morkoetter@unisg.ch. ** Dr. Simone Westerfeld, Swiss Institute of Banking and Finance (s/bf), University of St. Gallen (HSG), Rosenbergstrasse 52, CH-9000 St. Gallen, phone: +41 71 224 7039, fax: +41 71 224 7088, simone.westerfeld@unisg.ch.

1. Introduction
In this article we analyze whether information asymmetry between issuers and investors of Collateralized Debt Obligation (CDO) transactions leads to rating model arbitrage in CDO markets. Rating model arbitrage is based on the issuer's option to either publicize a solicited presale report and the underlying tranche ratings or to refrain from publication if the assigned presale report and/ or the rating deviates from expectations. Should the issuer choose to opt for a withholding of the results, rating model arbitrage in the applied definition occurs as specific transactions are rated by specific agencies and/or methodologies. We develop two hypotheses based on asymmetric information distribution between issuers and investors to find empirical evidence for rating model arbitrage (sometimes also referred to as rating shopping). Using a data sample of CDO transactions grouped both by rating agencies and underlying rating methodologies, we test for homogeneity of characteristic transaction features in the group and heterogeneity between the different groups. Apparently, such a test has never been performed before. We test the null hypothesis that rating model arbitrage on the basis of information asymmetry does not exist. The alternative interprets common patterns in the characteristics of CDOs rated by the same rating agency, or with the same underlying rating methodology as a manifestation of rating model arbitrage. We find that the null hypothesis can be rejected as individual patterns of transaction characteristics within each group could be identified. Furthermore, we show that transactions rated by Fitch and Standard & Poor's (S&P) incorporate a higher degree of consistency in terms of comparable characteristics (e.g. tranche structure) than transactions rated by Moody's. The results support the existence of rating model arbitrage in CDO markets and deliver useful insights for future rating commissioning and investors' behavior. CDOs have become increasingly important in today's financial markets, with issuance levels growing at an extraordinary rate in the past few years. Their development has been accompanied by debates involving market participants, regulators, politicians, and researchers alike (specifically during the 2008 subprime crisis) on the methodologies and processes by which credit rating agencies evaluate the creditworthiness of such securities. Rating risk in the CDO context arises from the fact that the structured nature of CDOs limits the usefulness of their ratings, since ratings only reflect certain aspects of a CDO's credit risk properties. Ratings reflect the average risk of a security and represent an opinion on the probability of default (PD) and expected loss (EL). They do neither factor in the dispersion of risk around its mean, nor can they convey the complexity of a structure or sensitivity of the structure to the embedded assumptions; for example, default correlations and recoveries post-default.1 Furthermore, information is distributed highly asymmetrically between investors and issuers with only limited possibilities to overcome these complexities. In cases where investors rely on ratings for their CDO investments (usually implying a high number of underlying loans), an additional specific model risk might arise from the respective agencys model used to assess CDO transactions and structures. Moody's Investors Service (2007a) analysed a database of 50,000 tranches of structured finance transactions rated by both Moody's on the one hand, and by S&P and/or Fitch on the other, containing all ratings outstanding on February 28, 2006. The report concluded that for jointly-rated CDOs the average rating gap vis--vis both S&P and Fitch is insignificantly different from zero. Differences in ratings are greater for ratings below Aaa than for Aaa ratings, while roughly
1

See Chan-Lau and Ong (2006).

98% of the Moody's/S&P and Moody's/Fitch ratings are the same when the Moody's rating is Aaa. The percentage of identical ratings drops to 60% and 55% vis--vis S&P and Fitch respectively, when Moody's is non-Aaa. Differences, while very large in many cases, are likely to understate the given options, because rating model arbitrage often causes large differences in rating opinions to be unobserved by the market. The reason is that rating model arbitrage in structured finance is interpreted to hide large systematic differences in rating opinions across agencies. However, differences in ratings of CDO tranches may be caused by a variety of reasons, e.g. methodological differences, adverse selection of collateral by the issuers, differences in criteria among the agencies, differences in monitoring practices, or an "unrepresentative" sample of securities rated by the respective agencies. It is assumed that rating model arbitrage in the context of CDOs exists and becomes evident in a sample selection bias. Cantor and Packer (1997) define a sample selection bias in connection with credit ratings. Not all firms receive a credit rating from each rating agency. Therefore, the published set of ratings is an incomplete sample. Accordingly, a sample selection bias arises in CDO markets since the sample of transaction ratings and especially the sample of presale reports is not complete: Particular agencies are chosen to rate a structure and publish a presale report. This suggests that the chosen agency's rating may be higher than the rating that would have been assigned by another agency. If an issuer requires only one or two ratings, but solicits proposed ratings and presale reports from multiple agencies, he has an incentive to choose the highest rating or the most favorable presale reports respectively.2 The paper is organized as follows. Based on a literature review in section 2, we develop two competing hypotheses based on information asymmetries within CDO markets in section 3. The data set, empirical test and interpretation of the results are contained in section 4. Section 5 concludes the paper.

2. Literature Review
CDO rating methodologies applied by the major three rating agencies differ substantially, which can result in clear differences in the ratings assigned by the agencies to certain tranche structures.3 Moody's has long relied on an EL criterion, as opposed to a criterion that focuses primarily on PD, as applied by its competitors S&P and Fitch. This, however, implies that senior instruments typically having thick tranche sizes not only show low probabilities of loss, but generally also suffer smaller proportionate losses in the event of default. (This does, albeit, depend partly on the transaction type: A small LGD would be more characteristic of structures backed by a well-diversified pool.). Other things being equal, an EL approach may therefore be more favorable to large senior tranches than a default probability approach, and less favorable towards more junior tranches that tend to be of thinner size. Fender and Kiff (2005) explore the impact of differences in methodologies across rating agencies for senior tranche rating outcomes. They conclude that because investors do not fully understand the possible implications of the effects analyzed for tranche ratings, rating model arbitrage is a theoretical possibility. In this context, rating model arbitrage arises, since investors do not distinguish between the methodologies based on EL and PD. Issuers would have an incentive to minimize their funding costs by tailoring deal struc-

2 3

See Moody's Investors Service (2006). See Peretyatkin and Perraudin (2002).

ture and strategically selecting rating agencies to obtain favorable ratings on particular tranches, due to differences in modeling pooled credit risk. In practice, however, the authors could only find limited evidence for this behavior. In a letter to the Securities and Exchange Commission Moody's Investors Service (2007b) comments on proposed rules regarding control of credit rating agencies. It terms rating model arbitrage as issuers' behavior prior to the transaction's finalization by asking different rating agencies for the possible rating outcome, but only requesting ratings from selected rating agencies. Moody's proves the existence of the defined rating model arbitrage habit by identifying 44 residential mortgage-backed securitizations, in which Moody's ratings were not accepted but, had they been chosen, would have resulted in significantly lower outcomes than the ratings of the actual chosen agencies. In contrast to Fender and Kiff (2005), we empirically test for the existence of rating model arbitrage in the context of CDOs. In addition to the above-mentioned study undertaken by Moody's Investors Service (2007b), this is the first empirical work to analyze the existence of rating model arbitrage based on an extensive data pool and analyzing the specific patterns of the transactions' characteristics. Looking closer into finance literature, various papers apply the theory of asymmetric information based on Jensen and Meckling (1976) in a credit and financing context. Flannery (1986) develops a theoretical concept to show the relationship between asymmetric information and risky debt maturity choice. He contends that if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders' information from the firm's financial structure. With positive transaction costs, high-quality firms can sometimes effectively signal their true quality to the market. The existence of a signaling equilibrium is shown to depend on the distribution of a firms' quality and the magnitude of underwriting costs for corporate debt (an originator's choice of rating agency may signal inside information on the quality of the underlying pool). Goswami et al. (1995) examine the impact of information asymmetries on the design of debt contracts, with a view to explaining features of debt financing. They show that, depending on the asymmetry of information concentrating around long-term or short-term cash flows, firms finance with coupon bearing long-term debt that either partially or does not restrict dividend payments. If asymmetry of information is uniformly distributed across dates, firms tend to finance with short-term debt. Other studies analyze the comparison of jointly-rated credit instruments. Generally, three reasons why investors gain additional rating for bonds are discussed. First, an additional rating may convey any incremental information to the markets that reduces the costs of borrowing for the firm. Several papers investigate the effect of split bond ratings. However, these papers fail to reach a consensus on how the market prices bonds with split ratings.4 Norden and Weber (2004) analyze whether prices react after a rating event, based on the assumption that credit ratings convey new information to the market. If credit ratings are only to reflect information that is already known by the market, prices should not react to the rating event at all. They conclude inter alia that both the credit default swap and the stock market not only anticipates rating downgrades, but also reviews for downgrade by all three rating agencies. Second, the main rating agencies might be biased or misjudge some bond issues. For these misjudged issues, an additional rating could provide useful information that is valued by investors. Third, issuers may hunt for rating agencies that provide inflated ratings. If the requested

See Jewell and Livingston (1999); Flannery (1986).

rating is favorable, the issuer publicizes it and if the requested rating is unfavorable, the rating is not released. Therefore, requesting an additional rating is similar to buying an option on a rating as it raises the costs of borrowing. This has the effect of ensuring that lower than expected ratings from the additional agency are rarely made public. Jewell and Livingston (1999) compare bond ratings of Fitch to those of Moody's and S&P in order to analyze the potential benefits of seeking out additional ratings from a smaller rating agency (Fitch), by comparing rating levels, rating changes, and the impact of ratings on bond yields. Inter alia, the authors test for the hypothesis that the average observed rating from Fitch is likely to be significantly higher than the true average rating from the two other agencies. Their analysis confirmed this hypothesis. In this context, Cantor and Packer (1995) analyze whether the reason for getting an additional rating may be regulatory in nature. Many financial institutions have limits, either self imposed or imposed by government regulators, on the amounts of debt they can hold of certain ratings. As most of these regulations only require that the highest or second highest rating be above the cutoff point, the firm's chances of meeting the standard increase if a third or fourth rating is obtained. Therefore, issuers could have a strong incentive to obtain multiple ratings to reach those investors. However, the authors find no evidence that firms obtaining Fitch IBCA ratings are doing so in order to meet rating regulation requirements. In a later paper, Cantor and Packer (1997) empirically test for the existence of rating model arbitrage in bonds. They find evidence that third ratings in bond markets on average assign higher ratings than the first two rating outcomes and that the policy of rating on request induces a sample selection bias. This sample selection bias is closely linked to our definition of rating model arbitrage.

3. Information asymmetries within CDO markets and the role of rating agencies
Ratings establish a form of due diligence delegation and provide guidance to investors in the course of capital allocation. This general assessment of ratings also holds for the CDO market. However, we have to take into account some specific features which differentiate the CDO rating market from traditional bond rating practices: First, the CDO rating market is an oligopolistic market, since only three different suppliers provide rating services: Fitch, Moody's and S&P. Each of the three rating agencies maintains a sophisticated rating process with each of them being widely accepted by investors. Thus, each rating agency is a viable choice for the investors in terms of due diligence delegation. Two of the three rating agencies (Fitch and S&P) rely on an expected loss (EL) based approach throughout the rating process whereas Moody's rating methodology is centered around a probability of default (PD) concept. Second, CDO ratings are solicited ones initiated by the issuer. In addition, the issuer also decides whether a rating is published or not. This implies that actually not all rating outcomes are made public as the issuer has a strong incentive to only publish rating outcomes in favor of the transaction. If this is not the case the issuer might withhold ratings and benefit from this behavior by paying lower risk premia to investors. Third, the rating outcome can be divided into publication of a presale report on the one hand and publication of individual tranche ratings on the other hand.. The presale report analyses the CDO transaction in detail including legal aspects and thereby establishes the most important source of information for potential investors. Typically, a presale report comes along with tranche ratings of the underlying transaction. Contrarily, it is common to only publish tranche ratings

but not a corresponding presale report illustrating the transaction details. In these cases a presale report might exist but the issuer has limited information sharing to transaction ratings as he has incentives to do so. Thus, published tranche ratings without accompanied presale report are not a sufficient indicator for the lacking existence of a presale report. However, in this paper we define a full CDO rating as the publication of a presale report including tranche ratings. Fourth, CDO rating processes involve a high degree of interaction between issuer and rating agency, thereby creating potential for conflicts of interest. The negotiation phase either leads to a presale report including rating assignment or cessation of negotiations when consensus cannot be found.5 These dialogs are time-consuming and bear significant costs for the issuer, amounting to approximately 4,25 bps of the transaction's par value.6 However, issuers willing to pay a rating fee gain the benefit of a solicited rating process, which allows them to put their best case before the agencies for the final evaluation.7 In CDO markets investors are kept out of the dialog between the issuer and the rating agency. They are not aware of the number of initiated rating processes, termination of negotiations or unpublished rating outcomes. From the investor's perspective the only visible outcome of the rating process is the published presale report and/or tranche ratings. The transactional setup of a CDO is primarily centered around the issuer, the investor and the rating agency. Based on the principals of information economics (e.g. Arrow, 1969; Jensen and Meckling, 1976; Leland and Pyle, 1976; Fama, 1980; Fazzari and Athey, 1987; Goswami et. al., 1995), we identify three principal agent relationships: The first between investor (principal) and issuer (agent) since the investor possesses the capital and decides upon its allocation. The issuer in turn serves as an agent by offering an attractive investment opportunity. A second relationship emerges from the interaction between the issuer (principal) and the rating agencies (agent). The issuer pays for the ratings, the rating agencies in turn deliver the asked services (rating) and thus behave like agents. Since the investor delegates his due diligence efforts to the rating agency, a third principal agent relationship can be identified between the rating agency (agent) and the investor (principal). For our empirical section we focus on the principal agent relationship between issuer and investor, which we assume to be the most important one for capital allocation and market efficiency. In the following, we test if this relationship is biased by information asymmetries. Specifically, we argue that the issuer obtains information during the rating process, which he only partially shares with investors, e.g. only favorable rating outcomes are made public. Investors do not control the due diligence process even though rating agencies perform it on their behalf. Control lies entirely with issuers having economic incentives to keep it, i.e. lower risk premia result if unfavorable ratings are not published. Rational investors could demand a full set of information which would imply full disclosure of all negotiations with rating agencies and its derived information throughout the rating process. However, current market standards are different. Accordingly, the issuer has a strong incentive to use the specific structure of the CDO rating market to limit information sharing to favorable ratings. We define this willingness to deliberately capitalize asymmetric information distribution between issuer and investor as rating model arbitrage and test the following hypothesis:

5 6

See Moody's Investors Service (2007b). See Standard & Poor's (2007). 7 See Cantor and Packer (1995).

Hypothesis H0 = Rating model arbitrage on the basis of information asymmetry does not exist. Hypothesis H1 = Rating model arbitrage on the basis of information asymmetry exists. If rating model arbitrage exists, we should be able to find patterns that are common for CDO transactions rated by a specific agency or by a specific rating model. Homogeneity between transactions rated by a specific rating agency and/or methodology would allow us to reject H0. If in turn rating model arbitrage does not exist, transactions with specific features (e.g. volume, number of tranches)should be distributed equally.

4. Empirical Tests
4.1. Data
The analysis is based on 231 international presale reports for 202 different CDOs published between August and December 2006 by Fitch, Moody's and S&P. We decided to use published presale reports as the basis of our analysis since a lot of CDO transactions receive two or even three ratings for their underlying tranches. Thus, multiple ratings are a rather difficult object of investigation to identify patterns. In turn, publication of presale reports is primarily limited to one rating agency per transaction. This fact makes us believe that information asymmetries are centered around publication of presale reports. In order to test our hypotheses, we apply both univariate and multivariate tests. Presale reports are prepared by rating agencies prior to the notes' issuance and typically published in parallel with the (preliminary) rating. Specifically, presale reports contain the specific characteristics of a CDO and the underlying tranches. According to the specific rating scale, each presale report contains a rating outcome for the underlying tranche. Each presale report was downloaded from the respective website of the three rating agencies and subsequently 15 different characteristics (e.g. volume of transaction, time to maturity) including the underlying tranche structure were analyzed. Nine out of the 15 characteristics were obtained for each of the 231 presale reports and therefore qualify for our test section. Including the size of the underlying tranches, our original data pool consists of 5,544 observations. Since our data sample represents all publicly released presale reports for the time period between August and December 2006, we consider it to be a consistent data pool. Sixtyfive presale reports were provided by Fitch, 59 by Moody's and 107 by S&P. For 28 out of the 202 transactions more than one rating agency published a presale report. In addition to rating agencies and rating methodologies, we use the following nine characteristics: transaction type size structure of the tranches (including equity portion) asset management involved parties maturity of tranches number of tranches total volume

currency cash flow structure.

Each characteristic is defined in detail as follows: The CDOs are classified along four different transaction types: Collateralized Bond Obligations (CBO), Collateralized Loan Obligation (CLO), Synthetic CDO and other transactions (e.g. Collateralized Fund Obligation). The difference between CBO and CLO can be explained by the divergent asset pool: bonds for CBOs and loans for CLOs. In contrast, synthetic CDOs primarily rely on Credit Default Swaps as underlying. Since rating agencies apply two different rating methodologies (PD and EL approach) this feature proves to be helpful for analyzing CDOs. As discussed, Fitch and S&P apply the PD approach, whereas Moody's uses the EL approach. The variable asset management refers to managed or static CDOs. In a static CDO, the asset pool remains the same during the lifetime of the transaction, whereas in a managed CDO, the asset pool's composition might be changed, based upon variance in market conditions. The number of involved parties in a CDO (e.g. trustee, servicer, etc.) can vary substantially between different transactions: The more complicated a CDO structure becomes, the more parties are involved. If one party (e.g. investment bank) is responsible for more than one function (e.g. trustee and servicer) we count the party only once. The maturity of the entire CDO transaction is defined as the mean of the different underlying tranches' legal maturities. The listing of tranches includes the equity portion. The total volume of the tranche is denominated in Euro. If the tranches are denominated in currencies other than Euro, values were converted on the basis of the exchange rates on October 4, 2006. In terms of the different cash flow structures, we differentiate between pass-through and pay-through transactions. In a pass-through CDO, the cash flow is transferred directly to the investors, whereas in a pay-through construction, the timing of cash flows is restructured. In order to incorporate the seniority structure in our analysis, we group the ninth characteristic size structure of the tranches into seven different tranche classifications, plus the equity share. We therefore classify the tranches on the basis of the seniority structure, according to the information revealed in the presale reports into Super Senior, Class A, Class B, Class C, Class D, Class E notes, other more subordinated notes and equity. Each tranche as well as the equity portion is displayed as a percentage of the entire transaction volume. Following the basic structure of seniority, Class E notes, for example, are subordinated to Class D notes and incorporate a lower rating than that obtained by Class D. Not all of the sample's CDOs have termed their structure of seniority in line with the aforementioned denomination. However, in order to compare the CDOs, we have adjusted the varying notations using our classification system as a guideline. In the case of more than one Class A-note (e.g. Class A1, Class A2) we have aggregated the different tranches into one Class A-note, since these notes often incorporate the very same rating and would otherwise dilute the CDO-specific structure of seniority.

4.2. Univariate Tests

As a starting point, sixteen variables (eight transactions characteristics and eight variables relating to the size structure of tranches, including equity portion) are included to perform univariate tests for the null and alternative hypothesis. The underlying data set is divided into two groups: The first dataset (Set I) is grouped along three data pools, corresponding to the three rating agencies Fitch Ratings, Moody's and S&P. In the second set of groups (Set II), the presale reports were

separated on the basis of the applied rating methodologies (EL vs. PD approach). The EL based sub-group therefore composes the transactions rated by Moody's and the PD based sub-group the transactions rated by Fitch Ratings and Standard & Poor's. 4.2.1. Set I (sorting by rating agencies) The first step for Set I focuses on a comparison of the mean, median and standard deviation of each group. In order to normalize standard deviation, the ratio of the group's standard deviation to the group's median was named as the decisive variable. Table 1 reveals the first signs of heterogeneity between the three rating agencies. The notes' denomination, for example, varies clearly between the three rating agencies and the same is true for the standard deviation of the variable volume.

Insert Table 1 about here

Following the comparison of means, medians and standard deviations, we now analyze the presale reports focusing on the univariate separation power of each characteristic. The tests of equality of group means for Set I in table 2 are based on a one-way ANOVA including the values for Wilks's Lambda. The results obtained provide us with the univariate separation power of each characteristic. If we analyze the results on the basis of a level of significance of equal to 5%, ten out of the sixteen features have univariate separation quality. The higher end of the structure of seniority (Super Senior and Class A notes) and the most subordinated tranches (others) incorporate group means, which differ significantly between the three sub-groups. In contrast, mezzanine tranches, equity portion and number of involved parties do not differ significantly and therefore incorporate no individual separation power.

Insert Table 2 about here

Since the test of equality of group means is only one part of the univariate comparison of groups, KolmogorovSmirnov-tests (KS-test) are run in order to assess the difference in the data points characteristics with respect to the subgroups. The KS-test is chosen due to its non-parametric and distribution-free qualities. By comparing each rating agency with the other two, we perform three different KS-tests to get the entire picture of this test section. The results of the KStest session as outlined in Fig. 4 provide additional insight concerning the univariate separation qualities of the different characteristics. It is only in the case of one variable (maturity), that the outcomes of the KS-tests show that the two datasets - and therefore all three groups - differ significantly for all three test sessions. With regards to currency and number of involved parties, Fitch and S&P differ significantly compared to Moody's, but in turn do not differ significantly between each other.

Since transactions analyzed by Moody's are dominated by Euro-denominated CDOs, we may link the observed heterogeneity to the variable currency. The number of tranches, portion of Class A and the portion of other tranches also prove to separate the presale reports on the basis of the rating agencies at least for two constellations. If the results of the KS-test are compared with the results of the ANOVA, it can be observed that maturity is identified in both test sessions as the variable with univariate separation power. With the exception of the variable rating methodology, this correspondence can be confirmed for all variables with one or two matches in the KS-test. Solely the variable equity proves to have univariate separation qualities only for the application of the KS-test. Furthermore, the majority of characteristics sorted by rating agency differ from each other. Only the outcomes of Fitch and S&P prove to have some degree of concordance. The results observed therefore document homogeneity within the sorted groups (rating agencies) and heterogeneity between the groups. The results can be interpreted as a first sign of rating model arbitrage in CDO markets, i.e. rejection of the null and non-rejection of the alternative hypothesis.

Insert Table 3 and 4 about here

4.2.2. Set II (sorting by rating methodologies) Sorting by different rating agencies already showed first signs of common patterns between the two rating agencies Fitch Ratings and S&P. The following sorting by rating methodology therefore seeks to confirm these patterns. The comparison of mean, median and standard deviation for each rating methodology (table 1) displays comparable features as observed for Set I. The means of currency for the two subgroups diverge again largely. The PD approach is more often used for CBOs. However, S CDOs are in turn primarily rated by the EL approach.

Insert Table 5 about here

In accordance with the framework of the previously-implemented test design, we start testing equality of group means (ANOVA) for Set II. The ANOVA's results (table 5) provide us with an analysis of the individual ability of each variable in order to separate the two subgroups on a univariate basis. Eight of sixteen variables prove to have univariate separation power at a level of significance below 5%. In terms of identified separation variables, this result is slightly lower in comparison with the analysis of Set I (eleven out of sixteen). However, we have to point out that two variables (Class A and equity) are situated in the near range of the required level of significance of 5%. All identified variables with univariate separation power already proved univariate separation power in the test section of Set I. In contrast to the results of Set I, no univariate separation power was assigned to the variables asset management and Class A notes. Accord-

10

ing to the performed ANOVAs of Set I and II, the number of involved parties plays no significant role in both datasets for separating the underlying subgroups. In addition to the ANOVA, we also perform the KS-test for Data Set II and determine whether or not the selected characteristics account for the separation of the two subgroups. Table 4 summarizes the results of the performed KS-test for Set II. Five of the sixteen analyzed variables lead to univariate differentiation of the two subgroups. In comparison with Set I's results of the KS-test, only the number of involved parties is excluded from the selection of characteristics. Compared with the results of the ANOVA, the variables currency and maturity separate in both test architectures the subgroups on a significant level. These findings are similar to the test results of Set II. Also, when sorting for rating methodologies, additional support for a rejection of the null hypothesis is found.

4.3. Multivariate Tests

The results of the univariate test section verify homogeneity within the analyzed subgroups and heterogeneity between the different subgroups. Additionally, multivariate tests are applied in order to identify individual patterns in the characteristics of CDO transactions within each group. Common group-wide patterns in the characteristics are seen as evidence for rating model arbitrage, since this implies that specific CDO transactions are rated by the same rating agency or with the same rating methodology. Using the results of the univariate tests, we pick certain variables and perform a number of different discriminant analyses with the chosen variables. The aim is to identify the combination of factors delivering the best subgroups' classification of presale reports based on discriminant analyses. This optimization problem was not approached by performing all discriminant analyses that would be theoretically possible, but by presorting the variables relying both on the results of the univariate tests and on economic reasoning. By applying a classification based on Fishers linear discriminant function, the performance of each discriminant analysis in connection with its separation power is tested. 4.3.1. Set I (sorting by rating agencies) The results of the different discriminant analyses for the grouping variable rating agencies are shown in table 6. The composition of discriminant function coefficients of each analysis can be derived from Appendix I. For all performed discriminant analyses, the significance on the basis of Wilks-Lambda is equal to zero and therefore highly significant with regard to its separation qualities.

Insert Table 6 about here

The variables of Discriminant Analysis I are solely chosen on the basis of the outcomes of Set I's ANOVA. All variables that possess a level of significance below 5% are included. Only relying on the ANOVA's outcome already leads to a correct classification on the basis of Fisher's linear discriminant functions of 62.8%. More than 60% of the analyzed

11

presale reports are classified correctly. As outlined in Appendix I, the detected dominant drivers for classification function are to be seen in cash flow structure and the size structure of the tranches.. Adding different characteristics in relation to size structure (e.g. Class A) is of particular value. As outlined by Fender and Kiff (2005) the assigned rating of a specific tranche interacts both with the tranche's seniority and the applied rating methodology. Accordingly, senior tranches should be analyzed (and rated) on the basis of an expected loss approach. Since the expected loss approach is only applied by Moody's, we find an economic explanation why it is in the issuer's benefit to rely on Moody's analyzing transactions with high portions of senior tranches (e.g. since this will lead to higher ratings for large portions of the overall transactions). This argument is supported by the performed comparison of subgroups (table 1), which shows that transactions analyzed by Moody's have the highest portion of super senior tranches. Each variable that is identified by the KS-test as separating the two subgroups at least one time is integrated in Discriminant Analysis II. With a classification outcome of 60.6%, the results are slightly lower than those observed in Discriminant Analysis I. However, the preselection of variables on the basis of the univariate tests proves to be quite reasonable. In addition, we adjust the composition of discriminant analyses III to V in order to reduce the number of dependent variables. Following this approach, the function of discriminant analysis III only contains variables that proved to have separation power in each of the three KS-test sessions. The range of possible variables is reduced in this context to one single coefficient: maturity. However, even with only one dependent variable, the results of discriminant analysis III are also promising, with a classification level of 51.1%. A presorting relying on the results both of the KS-test and the ANOVA delivers the set for discriminant analysis IV. We take the separating variables found by the application of the ANOVA. We then only include those variables as factors for discriminant analysis IV that also indicate separation power at least in one section of the KS-test. On the basis of this presorting, we end up with six different variables, which in turn provide us with a classification of 59.3%. Moving along this pattern of presorting, we perform discriminant analysis V, including only those variables of the KS-test which have separation power in the sections for Fitch/ Moody's and Moody's/ S&P. The derived discriminant analysis consists of the variables currency and maturity and bears a classification level of 57.1%. If we add to this constellation the variable with the highest explanatory power in discriminant analysis IV, we receive the results to discriminant analysis VI or a slightly higher classification of level 61.9%. The discriminant analysis for Set I (rating agencies) provides us with a first assessment of the multivariate separation power of the transactions' characteristics. We find empirical support for the existence of individual patterns of characteristics within each subgroup (rating agency). Therefore, we can reject the null hypothesis. Even if the individual classification level of each discriminant analysis is rather high, we want to further improve the classification level between the different subgroups in the following section. A detailed analysis of the classification matrix for the different discriminant analyses provides us with some iterating patterns. As exemplarily outlined in table 7 for discriminant analysis V, we observe most allocation errors for the predicted subgroup Fitch in relation to S&P during the classification process. Presale reports originally prepared by S&P are falsely allocated to the Fitch subgroup. In the case of discriminant analysis V this is also reciprocally true for the predicted S&P subgroup classification. Trying to capture this error term, we perform a multivariate analysis by using the variable rating methodology in the following section. The subgroup of the PD approach consists of Fitch and S&P, while the EL approach only incorpo-

12

rates the ratings of Moody's. This allows us to neutralize the above-mentioned error term and increase the level of classification for our targeted separation of the presale reports.

Insert Table 7 about here

4.3.2. Set II (sorting by rating methodologies) The variable rating methodology is the grouping variable for the discriminant analyses of Set II. Similar to the sorting by rating agencies, we perform several discriminant analyses relying on the results of the univariate tests with the grouping variable rating methodology. In contrast to the sorting by rating agencies, the sorting by rating methodologies differentiates only between two subgroups. This reduction makes the application of a discriminant analysis less complex. Table 8 shows the results of the discriminant analyses for different coefficient combinations of the grouping variable rating methodology. The detailed outcomes are summarized in Appendix II. The significance on the basis of WilksLambda is equal to zero for all realized discriminant analyses. Therefore, they are all highly significant with regards to their separation qualities.

Insert Table 8 about here

The coefficients of discriminant analysis I are derived from the ANOVA's results of Set I. Each variable which proves to have univariate separation power under ANOVA was selected. The combination of the eight variables selected in this way seems to classify properly, according to the results of Fisher's linear discriminant function (77.1%). Excluding the standardized canonical discriminant function coefficients with the least explanatory power (discriminant analysis II) leads to a comparably high level with 77.1%. The selection process of function coefficients for discriminant analysis III solely relies on the KS-test of Set II. All variables, which proved to separate the groups EL approach and the PD approach, are included in the discriminant analysis III. The result in terms of the classification level (77.1%) is exactly the same as already observed for discriminant analyses I and II. In order to assemble the function coefficients for discriminant analysis IV, we use the results of both the ANOVA and the KS-test. We include these variables as function coefficients that have univariate separation power both in the ANOVA and in the KS-test. Following this selection process, we are able to identify the two variables of currency and maturity. With 74.9%, the relevant discriminant analysis has a slightly lower level of classification than observed in the preceding analyses. Since these two variables have the highest univariate separation power, we take them as a starting

13

point to optimize the classification level for the grouping variable rating methodology. In the following paragraph, we iteratively add one function coefficient to the existing combination of function coefficients and compute an individual discriminant analysis after each addition. If the inclusion of a new variable provides a higher or equally high level of classification, it is added to the set of coefficients. We start this optimization process by adding a third functional coefficient to the variables of discriminant analysis IV. For each of the remaining fourteen variables, an individual discriminant analysis is now computed. The highest level of classification (78.8%) is achieved by adding the variable Class D to the variables currency and maturity. The results of this analysis are documented in table 8 under discriminant analysis V. Trying to achieve an even higher level of classification, we add a fourth variable to the three variables currency, maturity and Class D. We again compute an individual discriminant analysis for each of the thirteen remaining variables. The accrued results all lead to lower levels of classification. Only the discriminant analysis including the variable Class E achieved an equally high level of classification with 78.8% (discriminant analysis VI). The inclusion of transaction type as a fifth variable during the next optimization step delivers a classification level of 78.8% for discriminant analysis VII that is as high as the optimal discriminant analysis of four variables. In the next step we add a sixth variable. Again, the individual inclusion of the variables Class C and equity increases the level of classification up to 79.2% (Discriminant Analysis VIII and IX). Concerning the inclusion of a seventh variable we compute the outcomes of the corresponding classification levels. With a classification level of 79.7% the additional inclusion of the variable other tranches leads to the highest classification level for seven function coefficients (discriminant analysis X). By adding the eighth coefficient number of tranches, we achieve a comparably high level of classification in discriminant analysis XI. In addition, the inclusion of a ninth coefficient does not provide a higher level of classification in any case. Following our optimization approach, the classification levels of discriminant analysis X and XI are the highest. Since the inclusion of a ninth coefficient does not lead to a higher classification level, we define our optimum in discriminant analysis X. This optimum is the result of the computation of over 90 discriminant analyses based on the results of the univariate tests. The discriminant analysis of Set II reveals high levels of classification. Therefore, we can state that presale reports of the same rating methodology show an identical pattern of characteristics, and that we can reject the null hypothesis. The results of the discriminant analyses of Set II show that the grouping variable rating methodology leads to higher classification levels than those obtained under the grouping variable rating agency in Set I. Based on a coefficient selection induced by the univariate test session, the results of discriminant analyses I to IV are only slightly lower than our optimum in discriminant analysis X.

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4.4. Interpretation
The variable maturity and currency have a great impact in separating the two groups of Set II. The discriminant analysis of Set I also confirms the impact of these two variables. Since we are not able to obtain the weighted average maturity of the CDO's asset pool for all analyzed transactions, we do not integrate this characteristic in our empirical analysis. However, assuming that the correlation between the detected weighted average maturities and the corresponding legal maturities is reasonably high, we can use the legal maturity as a proxy for the weighted average maturities. In addition, the weighted average maturity of the asset pool may influence the rating outcome due to different concepts of modeling default correlations. Only S&P calculates the recovery rates on the basis of so-called tired recovery rates, assuming not only default correlation but also a correlation in terms of recovery rates (e.g. a high number of defaults also triggers lower recovery rates than experienced otherwise). Therefore, the application of tired recovery rates corresponds to lower recovery rates resulting in lower expected losses since a long weighted average maturity corresponds to long maturities on the individual credit level. Together with the assumption that long weighted average maturities correspond to comparably long legal maturities, this supports our empirical results that the characteristic "maturity" acts as a variable with high discriminatory power in section IV 4a). Specifically transactions with long maturities should from an investors point of view - not be rated by S&P. Following this argument, we can identify a rationale why an issuer has an interest not to publish all solicited ratings and rather select the favorable ones. Additionally, currency contains high degrees of explanatory power in both sets. We can explain these findings in economic terms, since currency is generally linked to the geographical roots of the transaction's asset pool (e.g. the asset pool of notes denominated in Euro originates from European companies). The asset pool's geographical affiliation in turn determines its recovery rates. Since recovery rates not only vary between different regions but also between different rating agencies, we find an economic explanation for the high explanatory power of the variable currency. By comparing the medians of the characteristics for each rating agency (see table 1), we find additional support for this explanation, since the presale reports published by Moody's are primarily denominated in Euro, whereas presale reports of S&P mostly descend from the USD area. A third characteristic which significantly impacts the classification process is the transaction's tranche structure. To optimize the separation power of our discriminant analysis, we successively include the different tranches (in % of the overall transaction volume) as discriminant factors. Classifying on the basis of different rating agencies leads to high discriminatory power for the senior tranches of CDO transactions (see classification level of Set I). In turn, the inclusion of the more senior tranche portions (Super Senior, Class A and Class B) does not improve the classification results of Set II and are therefore excluded. However, the inclusion of mezzanine and junior debt (Class D notes and below) subsequently improves the classification level of Set II, since these notes add substantial separation power. Apparently, subordination and attachment points of levels of mezzanine and senior debt affect each rating methodology differently and contribute to diverse rating outcomes. These findings are in line with Fender and Kiff (2005), who argue that the higher the differences in tranche structure, the better the assignment of transactions to a specific rating methodology or rating agency. Since high subordination levels correspond to a high portion of junior tranches in the transaction structure the findings of Fender and Kiff (2005) deliver a second economic explanation for the high explanatory power of the tranche

15

structure: CDO transactions with high portions of very junior tranches (e.g. the equity portion) should be rated by Moody's. Cantor and Packer (1997) find evidence that on average, third ratings in bond markets assign higher ratings than the first two rating outcomes and that the policy of rating on request induces a sample selection bias. We find first signs of empirical evidence for a sample selection bias in the CDO market as defined by Cantor and Packer (1997) for corporate credit ratings. In line with our definition of rating model arbitrage and our empirical results, the findings of Cantor and Packor therefore support our view of rating model arbitrage (if applied to CDO markets): It is reasonable for an issuer to obtain two or more rating(s), but limit publication to the most favorable ones.

5. Conclusion
The main objective of this paper is to provide empirical evidence for rating model arbitrage in CDO markets. On the basis of information asymmetry it is argued that issuers of CDO transactions have economic incentives to take advantage of the uneven information distribution between issuers and investors and to perform rating model arbitrage. Sorted by rating agency and rating methodology, our empirical analysis provides evidence of homogeneity within the groups and heterogeneity between the groups, i.e. we are able to detect common patterns within the groups. The existence of these patterns shows that specific transactions are rated by specific agencies and/or methodologies. In detail, the variables currency and maturity incorporate the highest explanatory power in the discriminant analysis. Additionally, sorting the transactions by different rating agencies reveals consisting patterns between Fitch and S&P. The results allow us to classify the presale reports according to the used rating methodologies (EL and PD), because Fitch and S&P both rely on a PD approach. Eventually, we find strong classification power for variables referring to the seniority structure of the transactions. Since we looked at all assessable economic factors on CDO transaction level and follow the findings of Fender and Kiff (2005), we do interpret rating model arbitrage as the only possible explanation for the above detected patterns in transactions' characteristics. Thus, our empirical findings support the assumption that rating model arbitrage in CDO markets exists. Our results are closely linked to findings by Fender and Kiff (2005), who describe the related rating methodologies in their paper and theoretically argue that there are economic incentives for issuers to perform rating model arbitrage not only across rating agencies, but across rating methodologies. Thick senior tranches are likely to benefit from the EL rating approach by Moody's, whereas less senior tranches profit from a PD approach as incorporated in Fitch's and S&P's methodology. However, they did not find empirical evidence for rating model arbitrage in the CDO context. Our empirical results in turn show that transactions with large super senior tranches are more likely to receive ratings and according presale reports prepared by Moody's. To reduce information asymmetry and lower agency costs, investors need to combine their market power. With combined market power, investors could claim the publication of all assigned ratings or following our empirical analysis at least foster the publication of two presale reports issued by two rating agencies using different rating methodologies. In such an optimized market setting, an additional significant principal-agent relationship might develop, namely between

16

the investor (principal) and the rating agencies (agent). If the rating agencies become agents of the investors and the investor's influence on the rating process becomes more direct, higher risk premia might be enforced. Further research might focus on the impact of rating model arbitrage on the pricing of CDO notes in secondary markets, especially as variables referring to the structure of seniority have strong classification power. CDO notes usually trade at significantly higher spreads as comparable corporate bonds of the same rating category. Therefore, rating model arbitrage could be a driver for higher spread levels in CDO markets. Furthermore, the rating and pricing of individual tranches of CDO structures in the context of rating model arbitrage might be an interesting research topic. Additionally, potential arbitrage strategies for investors based on the different rating methodologies could be analyzed.

17

References
Arrow, K. J., 1969. The Organization of Economic Activity: Issues Pertinent to the Choice of Market Versus Nonmarket Allocation, in: The Analysis and Evaluation of Public Expenditure: The PPB System, 1, U.S. Joint Economic Committee, 91st Congress.1st Session, Washington, DC., pp. 59-73. Cantor, R., Packer, F., 1995. The Credit Rating Industry. Journal of Fixed Income 5, pp. 10-34. Cantor, R., Packer, F., 1997. Differences of Opinion and Selection Bias in the Credit Rating Industry. Journal of Banking and Finance 21, pp. 1395-1417. Chan-Lau, J., Ong, L., 2006. The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions. IMF, Working Paper. Fama, E. F., 1980. Agency Problems and the Theory of the Firm. Journal of Political Economy 88, pp. 288-307. Fazzari, S. M., Athey, M., 1987. Asymmetric Information, Financing Constraints, and Investment. Review of Economics and Statistics 69, pp. 481-487. Fender, I., Kiff, J., 2005. CDO Rating Methodology: Some Thoughts on Model Risk and its Implications. Journal of Credit Risk 1, pp. 37-58. Flannery, M., 1986. Asymmetric Information and Risky Debt Maturity Choice. Journal of Finance 49, pp. 19-37. Goswami, G., Noe, T., Rebello, M., 1995. Debt Financing under Asymmetric Information. Journal of Finance 50, pp. 633-659. Jensen, M. C., Meckling, W. H., 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownerships Structure. Journal of Financial Economics 3, pp. 305-360. Jewell, J., Livingston, M., 1999. A Comparison of Bond Ratings from Moody's, S&P and Fitch IBCA. Financial Markets, Institutions and Instruments 8, pp. 1-45. Leland, H. E., Pyle, D. H., 1976. Informational Asymmetries, Financial structure, and Financial Intermediation. Journal of Finance 32, pp. 371-387. Moody's Investors Service, 2007a. Comparing Ratings on Jointly-Rated U.S. Structured Finance Securities: 2007 Update. Moody's Structured Finance Special Report. Moody's Investors Service, 2007b. Comment Letter on Proposed Rules regarding Oversight of Credit Rating Agencies registered as Nationally Recognized Statistical Rating Organizations. Securities and Exchange Commission. www. sec.com. Norden, L., Weber, M., 2004. Informational Efficiency of Credit Default Swap and Stock Markets. Journal of Banking & Finance 28, pp. 2813-2843. Peretyatkin, V., Perraudin, W., 2002. EL and DP Approaches to Rating CDOs an the Scope for Ratings Shopping, in: Ong, M. K. (Eds.), Credit Ratings Methodologies, Rationale and Default Risk, London, UK, Risk Books. Standard & Poor's, 2007. Das Geschftsmodell einer internationalen Ratingagentur. Presentation at the University of St. Gallen by Torsten Hinrichs.

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Tables
Table 1: Comparison of subgroups (Set I & II)
Comparison of Subgroups (Set I & II)
Variable (numeric & alphanumeric) Asset Management Cash Flow Structure Currency Managed Static Pay Through Pass Through Euro USD Others Transaction Type CBO CLO S CDO Others Tranche Structure Super Senior* Class A Class B Class C Class D Class E Others Equity Variable (numeric) Maturity** (in years) Number of involved Parties Number of Tranches Volume (in Mio. Euro) Median Std. dev.* Median Std. dev.* Median Std. dev.* Median Std. dev.* Fitch (in %) 66.15 33.85 81.54 18.46 49.23 49.23 1.54 23.08 49.23 18.46 9.23 10.85 59.43 7.24 5.58 3.65 2.74 4.36 6.14 Fitch 32.50 0.58 5.00 0.42 7.00 0.47 501.62 1.12 Moody's (in %) 83.05 16.95 100.00 0.00 76.27 16.95 6.78 5.08 54.24 30.51 10.17 14.75 58.42 7.98 4.51 3.20 2.52 0.41 8.26 Moody's 10.00 1.17 5.00 0.22 6.00 0.31 400.00 5.49 S&P (in %) 87.85 12.15 99.07 0.93 34.58 64.49 0.93 16.82 63.55 12.15 7.48 3.42 69.99 7.37 5.08 4.24 2.28 1.16 6.52 S&P 14.00 0.91 4.00 0.44 7.00 0.24 394.86 2.96 EL (in %) 83.05 16.95 100.00 0.00 76.27 16.95 6.78 5.08 54.24 30.51 10.17 14.75 58.42 7.98 4.51 3.20 2.52 0.41 8.26 EL 10.00 1.17 5.00 0.24 6.00 0.31 400.00 5.49 PD (in %) 77.00 23.00 90.30 9.70 41.91 56.86 1.24 19.95 56.39 15.31 8.35 6.23 66.00 7.32 5.27 4.02 2.45 2.37 6.38 PD 16.00 1.02 4.00 0.47 7.00 0.35 405.55 2.42 total (in %) 79.02 20.98 93.53 6.47 53.36 43.56 3.08 14.99 55.67 20.37 8.96 8.41 64.06 7.49 5.08 3.81 2.47 1.87 6.86 total 14.83 1.07 5.00 0.35 7.00 0.34 402.00 3.52

* For reasons of transparency we incorporate the Super Senior tranche, which contains comparable rating scales as observered in Class A notes. ** legal maturity *** ratio of computed std. dev. and median

19

Table 2: Test of equality of group means (Set I)

Tests of Equality of Group Means (Set I) Wilks' Lambda 0.9461 0.8783 0.9296 0.8288 0.9990 0.9296 0.9654 0.9640 0.9596 0.9540 0.9983 0.9923 0.9842 0.9961 0.9004 0.9828 F 6.4991 15.7970 8.6363 23.5484 0.1193 8.6359 4.0855 4.2540 4.8015 5.4933 0.1947 0.8846 1.8341 0.4490 12.6132 1.9975 df1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 df2 228 228 228 228 228 228 228 228 228 228 228 228 228 228 228 228 Sig. 0.0018* 0.0000* 0.0002* 0.0000* 0.8876 0.0002* 0.0181* 0.0154* 0.0091* 0.0047* 0.8232 0.4143 0.1621 0.6388 0.0000* 0.1380

Asset Management Cash Flow Structure Currency Maturity Number of involved Parties Number of Tranches Transaction Type Volume Super Senior Class A Class B Class C Class D Class E Others Equity * level of significance ( = 5%)

20

Test Statistics: Kolmogorov-Smirnov Test (Set I)

Asset Management Currency Volume Class A Class B Class C Class D Class E Others Equity Maturity Transaction Type Super Senior Cash Flow Structure Number of involved Parties 0.1565 0.1565 -0.1046 0.8701 0.4353 0.0194* 0.2694 0.1517 0.8860 0.3980 0.3224 0.0699 0.4767 0.7721 1.5226 1.0006 1.1355 0.5830 0.8962 0.9542 1.2950 0.8425 0.6627 -0.2738 0.0000 -0.2042 0.0000 -0.1611 -0.1604 -0.2329 -0.1515 -0.0615 0.0138 0.1799 0.1557 0.1048 0.1119 0.1716 0.1515 0.1098 0.1192 0.0000 -0.2907 1.6169 0.2738 0.1799 0.2042 0.1048 0.1611 0.1716 0.2329 0.1515 0.1192 0.2907 0.2947 0.2947 0.0000 1.6386 0.0107* 0.0093* Number of Tranches

Grouping Variable: Rating Agencies (Fitch Rating vs. Moody's) 0.1690 0.0000 -0.1690 0.9397 0.3403 0.2425 0.0217* 0.0000* 1.0267 1.5038 3.3019 -0.1846 -0.2704 -0.5937 0.0000 0.0524 0.0016 0.1846 0.2704 0.5937

Most Extreme Differences

Absolute

Positive

Negative

Kolmogorov-Smirnov Z

Asymp. Sig. (2-tailed)

Grouping Variable: Rating Agencies (Fitch Ratings vs. Standard & Poor's) 0.2170 0.2170 0.0000 1.3797 0.0444* 0.1667 0.3505 0.0000* 0.9866 0.0427* 0.9551 0.1523 0.6430 0.0068* 0.6800 1.1145 0.9317 2.7209 0.4526 1.3870 0.5129 1.1346 0.7406 1.6869 0.7186 0.7150 0.6862 0.0000 -0.1465 -0.0643 -0.0510 -0.0785 -0.0625 -0.0187 0.0000 -0.2653 -0.1130 -0.1124 0.1753 0.0060 0.4279 0.0712 0.2181 0.0807 0.1784 0.1165 0.0840 0.0774 0.0966 0.1753 0.1465 0.4279 0.0712 0.2181 0.0807 0.1784 0.1165 0.2653 0.1130 0.1124 0.1586 0.0296 -0.1586 1.0085 0.2610 0.0932 0.0932 -0.0881 0.5925 0.8741 0.2329 0.2329 1.4812 0.0249* 0.1448 0.0730 0.0000 -0.1448 0.9207 0.3648

Most Extreme Differences

Absolute

Positive

Negative

Kolmogorov-Smirnov Z

Asymp. Sig. (2-tailed)

Grouping Variable: Rating Agencies (Moody's vs. Standard & Poor's) 0.0480 0.0480 0.0000 0.2960 1.0000 1.0000 0.0000* 0.0000* 0.0389* 0.3616 0.0687 0.2956 0.4479 0.0576 2.5711 2.3073 1.4037 0.9231 1.2982 0.9769 0.8616 -0.0093 -0.4169 -0.3741 -0.0783 -0.1497 0.0000 -0.1286 0.0000 -0.3719 2.2936 0.0001* 0.0000 0.0585 0.0169 0.2276 0.0111 0.2105 0.1584 0.1397 0.0100 0.0093 0.4169 0.3741 0.2276 0.1497 0.2105 0.1584 0.1397 0.3719 0.1925 0.1925 -0.1532 1.1869 0.1195 0.1842 0.0878 -0.1842 1.1361 0.1513 0.2170 0.0504 -0.2170 1.3383 0.0556 0.1218 0.1218 -0.0374 0.7512 0.6252 0.0748 0.0000 0.4611 0.2450 0.2450 -0.0748 -0.0108 1.5112 0.9836 0.0208*

Most Extreme Differences

Absolute

Positive

Negative

Kolmogorov-Smirnov Z

Asymp. Sig. (2-tailed)

* level of significance ( = 5%)

21
Test Statistics: Kolmogorov-Smirnov Test (Set II)
Asset Management Currency Maturity Cash Flow Structure Number of involved Parties Transaction Type 0.2007 0.2007 -0.0882 1.3304 0.0580 -0.1688 1.1188 0.1635 0.0121 0.1688 0.1800 0.1800 0.0000 1.1933 0.1159 Number of Tranches Volume 0.0340 0.0000 -0.0340 0.2253 1.0000 0.9633 0.0000* 0.0000* 0.5010 2.3964 2.4773 -0.0756 -0.3615 -0.3738 0.0000 0.0562 0.0111 0.0756 0.3615 0.3738 0.1574 0.1574 -0.1336 1.0431 0.2267

Table 3: Test statistics: Kolmogorov-Smirnov-Test (Set I)

Super Senior

Class A Class B

Class C

Class D Class E

Equity

Others

Grouping Variable: Rating Methodologies (EL vs. PD approach) 0.1123 0.1123 0.0000 0.7446 0.6363 0.2923 0.0208 -0.2923 1.9372 0.0011* 0.1824 0.1824 -0.1559 1.2090 0.1075 0.1994 0.1088 -0.1994 1.3219 0.0607 0.1781 0.0604 -0.1781 1.1802 0.1233 0.1121 0.1121 -0.0465 0.7433 0.6385 0.2638 0.2638 1.7484 0.0044* 0.1512 0.0000 -0.0058 -0.1512 1.0019 0.2680

Most Extreme Differences

Absolute

Positive

Negative

Kolmogorov-Smirnov Z

Asymp. Sig. (2-tailed)

* level of significance ( = 5%)

Table 4: Test statistics: Kolmogorov-Smirnov-Test (Set II)

Table 5: Tests of equality of group means (Set II)

Tests of Equality of Group Means (Set II) Wilks' Lambda 0.9986 0.9795 0.9411 0.9231 1.0000 0.9609 0.9657 0.9641 0.9762 0.9835 0.9984 0.9945 0.9894 0.9999 0.9710 0.9834 F 0.3213 4.7821 14.3431 19.0672 0.0001 9.3242 8.1223 8.5310 5.5775 3.8391 0.3772 1.2653 2.4636 0.0214 6.8301 3.8623 df1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 df2 229 229 229 229 229 229 229 229 229 229 229 229 229 229 229 229 Sig. 0.5714 0.0298* 0.0002* 0.0000* 0.9913 0.0025* 0.0048* 0.0038* 0.0190* 0.0513 0.5397 0.2618 0.1179 0.8839 0.0096* 0.0506

Asset Management Cash Flow Structure Currency Maturity Number of involved Parties Number of Tranches Transaction Type Volume Super Senior Class A Class B Class C Class D Class E Others Equity * level of significance ( = 5%)

Table 6: Discriminant analysis and classification of Set I

Discriminant Analysis and Classification of Set I
Discriminant Analysis I II III IV V VI Eigenvalues % of Variance 78.5 21.5 71.9 28.1 100.0 73.4 26.6 76.5 23.5 81.0 19.0 Canonical Correlation 0.587 0.355 0.514 0.351 0.414 0.514 0.339 0.420 0.249 0.484 0.259 Test of Functions 1 through 2 2 1 through 2 2 1 through 2 2 0.359 0.130 0.215 0.066 0.307 0.072 1 through 2 2 1 through 2 2 1 through 2 2 0.651 0.885 0.772 0.938 0.714 0.933 96.822 27.608 58.724 14.504 76.532 15.802 0.000 0.000 0.000 0.000 0.000 0.000 Wilks' Lambda WilksChiLambda square 0.572 0.874 0.645 0.877 0.829 124.772 30.182 98.418 29.456 42.813 Classification (in %) 62.8 60.6 51.1 59.3 57.1 61.9

Function 1 2 1 2 1 2 1 2 1 2 1 2

Eigenvalue

Significance 0.000 0.000 0.000 0.000 0.000

0.527 0.145 0.360 0.140 0.207

Table 7: Classification results of Discriminant Analysis V

Classification Results of Discriminant Analysis V Rating Agency Predicted Group Membership Fitch Ratings Original Count Fitch Ratings Moody's S&P % Fitch Ratings Moody's S&P 30 3 20 46.2 5.1 18.7 Moody's 13 40 25 20.0 67.8 23.4 S&P 22 16 62 33.8 27.1 57.9 Total Fitch Ratings 65 59 107 100.0 100.0 100.0

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Table 8: Discriminant Analysis and Classification of Set II

Discriminant Analysis and Classification of Set II
Discriminant Analysis I II III IV V VI VII VIII IX X XI Eigenvalues Function 1 1 1 1 1 1 1 1 1 1 1 Eigenvalue 0.225 0.225 0.162 0.147 0.161 0.161 0.174 0.181 0.189 0.198 0.198 Canonical Correlation 0.429 0.429 0.373 0.358 0.373 0.373 0.385 0.391 0.399 0.406 0.406 Test of Function 1 1 1 1 1 1 1 1 1 1 1 Wilks' Lambda WilksChiLambda square 0.816 0.816 0.861 0.872 0.861 0.861 0.852 0.847 0.841 0.835 0.835 45.736 45.806 34.001 31.324 33.986 33.914 36.331 37.596 39.133 40.713 40.624 Classification (in %) 77.1 77.1 77.1 74.9 78.8 78.8 78.8 79.2 79.2 79.7 79.7

Significance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

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Appendix

Appendix 1: Discriminant Analysis of Set I (sorting by rating agencies)

Discriminant Analysis of Set I (sorting by rating agencies)
Discriminant Analysis Independent Variables Canonical Discriminant Function Coefficients Function 1 I Asset Management Cash Flow Structure Currency Maturity Number of Tranches Transaction Type Volume Super Senior Class A Others (Constant) II Asset Management Currency Maturity Number of involved Parties Number of Tranches Class A Others Equity (Constant) III Maturity (Constant) IV Asset Management Currency Maturity Number of Tranches Class A Others (Constant) V Currency Maturity (Constant) VI Currency Maturity Others (Constant) *Fisher's linear discriminant functions 0.8263 2.6647 0.3275 0.0335 0.0094 0.0479 -0.0003 1.2610 -0.7225 9.7578 -4.7781 1.0686 0.2588 0.0517 0.0156 -0.0174 -0.9005 9.8033 -0.2851 -2.2989 0.0690 -1.4370 1.0874 0.2412 0.0519 -0.0188 -0.9028 9.8233 -2.2316 0.4354 0.0665 -2.0563 0.2269 0.0546 11.5647 -1.7054 -0.8467 1.1576 0.0053 0.1272 2.5951 -0.9934 -3.3749 1.8281 -0.0178 -2.4300 1.8395 -0.0015 -4.7813 -2.6992 0.1208 0.7942 0.5561 0.9792 -0.0211 -0.2299 0.2318 0.9664 0.9732 -0.2585 0.4216 0.1284 0.7544 -0.0432 -0.2284 0.4724 -0.3283 0.6162 0.0765 0.2924 0.6565 -0.0478 Function 2 -0.6777 -0.3270 1.1477 0.0059 0.0943 -0.2673 -0.0001 -0.8992 1.1154 -2.0501 -1.2830 -0.9651 1.1799 0.0019 0.0987 0.1362 2.4020 -1.3215 -3.4622 -3.3733 1.0000 0.4143 0.1378 0.7511 0.0272 -0.0399 -0.2278 0.4714 -0.0181 -0.3742 0.6281 0.0269 0.1725 0.3130 0.6076 -0.0635 -0.2202 Standardised Canonical Discriminant Function Coefficients Function 1 0.3204 0.5793 0.1743 0.4874 0.0216 0.0381 -0.3659 0.2997 -0.1828 0.4692 Function 2 -0.2628 -0.0711 0.6110 0.0856 0.2168 -0.2126 -0.1523 -0.2137 0.2822 -0.0986 Classification Function Coefficients* Fitch 9.5815 26.7527 5.6319 0.0873 3.3844 9.6927 -0.0010 21.3446 31.2010 -25.2148 -61.9988 10.4377 7.6197 0.0840 1.9784 1.9403 6.6181 -40.4508 31.1677 -29.7352 0.1454 -3.5000 10.4438 5.6057 0.0657 2.1535 6.0823 -46.3057 -22.5661 5.2694 0.1401 -7.4314 5.2351 0.1379 15.6571 -7.7142 Moody's 8.4253 22.1822 4.5320 0.0252 3.3251 9.7289 -0.0005 19.5190 31.9750 -41.5651 -52.7562 9.2435 6.7491 0.0063 1.9146 1.9101 6.9712 -54.5048 33.0159 -24.8760 0.0633 -1.7887 9.1723 4.7811 -0.0134 2.1301 6.3748 -60.4750 -17.8340 4.5612 0.0587 -4.7343 4.5618 0.0588 -0.2602 -4.7344 S&P 8.0455 22.6639 5.6819 0.0405 3.4144 9.4975 -0.0006 19.0634 32.7872 -40.5840 -54.5121 8.6946 7.8854 0.0233 2.0079 2.0272 8.8601 -52.7769 29.8228 -27.7973 0.0902 -1.6298 8.7495 5.8534 0.0060 2.2350 8.3658 -58.5262 -20.6150 5.8069 0.0844 -6.4041 5.8018 0.0841 2.3421 -6.4105

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Appendix 2: Discriminant Analysis of Set II (sorting by rating methodologies)

Discriminant Analysis of Set II (sorting by rating methodologies)
Discriminant Analysis Independent Variables Canonical Discriminant Function Coefficients Standardised Canonical Discriminant Function Coefficients 0.3402 0.5737 0.3959 0.1625 -0.1499 -0.3270 -0.0418 0.2150 Classification Function Coefficients* EL Approach I Cash Flow Structure Currency Maturity Number of Tranches Transaction Type Volume Super Senior Others (Constant) II Cash Flow Structure Currency Maturity Number of Tranches Transaction Type Volume Others (Constant) III Currency Maturity Class A Equity (Constant) IV Currency Maturity (Constant) V Currency Maturity Class D (Constant) VI Currency Maturity Class D Class E (Constant) VII Currency Maturity Class D Class E Transaction Type (Constant) VIII Currency Maturity Transaction Type Class C Class D Class E (Constant) IX Currency Maturity Transaction Type Class D Class E Equity (Constant) X Currency Maturity Transaction Type Class C Class D Class E Others (Constant) XI Currency Number of Tranches Maturity Transaction Type Class C Class D Class E Others (Constant) *Fisher's linear discriminant functions 1.4850 1.0734 0.0259 0.0697 -0.1888 -0.0002 -0.1749 4.3142 -3.6763 1.5077 1.0762 0.0253 0.0665 -0.2095 -0.0003 4.4891 -3.6291 1.1208 0.0457 0.8443 -2.6976 -3.0280 1.2336 0.0495 -2.9251 1.2161 0.0472 8.5304 -3.1736 1.2130 0.0471 8.7283 -0.3645 -3.1655 1.1832 0.0395 8.5231 0.4134 -0.3628 -2.1728 1.1863 0.0398 -0.3605 5.0639 5.6998 -0.3377 -2.3200 1.1330 0.0351 -0.3658 9.9097 1.1494 -4.6483 -1.7514 1.0953 0.0345 -0.3480 4.8601 6.1630 -4.4796 6.3310 -2.1214 1.0942 0.0033 0.0344 -0.3466 4.8421 6.1702 -4.4920 6.2405 -2.1405 0.5848 0.0076 0.5266 -0.2751 0.2162 0.2126 -0.1394 0.3110 0.5854 0.5278 -0.2763 0.2170 0.2124 -0.1390 0.3155 0.6055 0.5378 -0.2904 0.3414 0.0357 -0.2951 0.6340 0.6085 -0.2862 0.2261 0.1964 -0.0105 0.6323 0.6040 0.2937 0.0128 -0.2880 0.6483 0.7204 0.3007 -0.0113 0.6500 0.7217 0.2939 0.6593 0.7581 0.5990 0.6994 0.2164 -0.1713 0.3454 0.5752 0.3872 0.1551 -0.1663 -0.3511 0.2237 24.1763 5.9523 0.0158 2.6382 7.1640 0.0009 -10.8782 -74.4865 -33.7175 25.5479 6.1004 -0.0205 2.4410 5.8811 -0.0002 -63.7180 -32.2254 4.1934 0.0744 9.3099 31.0467 -8.6010 4.5849 0.0586 -4.7490 4.7211 0.0579 31.5857 -5.3384 5.0501 0.0668 10.5522 38.6646 -5.7637 4.8516 0.1400 9.0078 29.0813 4.5502 -11.5698 4.9614 0.1445 4.5304 21.1449 -2.0854 25.9789 -11.9072 4.8616 0.1534 4.6372 0.4838 25.3793 22.8583 -12.5336 5.0360 0.1512 4.5365 21.1125 -3.4364 33.8690 -12.0174 -12.0609 4.3350 2.0148 0.1017 5.4081 10.0953 1.0217 26.2330 -67.5935 -17.9498 PD Approach 25.7860 7.1158 0.0438 2.7138 6.9594 0.0006 -11.0678 -69.8100 -36.3451 27.1815 7.2664 0.0069 2.5131 5.6541 -0.0004 -58.8539 -34.8005 5.2220 0.1163 10.0848 28.5709 -10.1040 5.6658 0.1020 -6.0541 5.8357 0.1011 39.4035 -6.9715 6.1618 0.1100 18.5517 38.3306 -7.3895 5.9784 0.1776 17.1246 29.4749 4.2047 -12.3472 6.1137 0.1831 4.1803 26.0635 3.4510 25.6509 -12.8600 5.9864 0.1883 4.2741 10.3213 26.5203 18.2439 -12.9612 6.1484 0.1862 4.1831 26.0485 2.8228 29.3195 -5.5877 -12.8932 5.4462 2.0181 0.1366 5.0561 15.0130 7.2882 21.6709 -61.2556 -18.8015

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