Fitch Gets Technical with New U.S. Multiborrower CMBS Model

Business Wire, Feb 20, 2007

NEW YORK -- March 1 brings a sharper insight into the credit risk of a U.S. CMBS portfolio as Fitch Ratings' new multiborrower CMBS model goes into effect, according to the rating agency's Quantitative Financial Research (QFR) group in a technical paper that explains the new model analysis of quantifying both loan and pool dynamics.

The bedrock of Fitch's new CMBS model lies in decomposing the credit risk of a CMBS loan into three significant components and then aggregating them across loans with a simulation model for poolwide credit risk.

The three loan level components are probability of default (PD), probability of loss (PL), and loss severity (LS); the product of these three components equals the expected loss (EL) on the loan. Since default and probability of loss are both binary events, they cannot be modeled in the classical linear regression framework where the response variable is continuous; instead they are modeled via logistic regression. Loss severity, on the other hand, is a continuous variable referring to the amount on a percentage basis of loss experienced by the defaulted loan and is modeled by ordinary least squares regression.

QFR Director Krishnamoorthy Narasimhan said that it is crucial to capture default correlation among loans because of the empirically observed clustering of defaults. "If defaults are assumed to be uncorrelated, losses on the pool may be understated, especially in situations where systematic, shared risk factors are driving defaults," said Narasimhan.

"Due to empirical evidence that a loan's experience of default is dependent on the default experience of other loans, an aggregation step that captures effects of correlation is necessary to combine the three loan-level models into a description of credit risk on the entire pool," said Narasimhan.

The aggregation step simulates 500,000 scenarios of default and loss by a factor model of loan dynamics that captures correlation between loans through shared risk factors. The result is subordination levels deriving from a loss distribution that more accurately reflects the interdependence of loans in the pool.

'U.S. CMBS Multiborrower Rating Model Technical Report' is available on the Fitch Ratings web site at www.fitchratings.com.

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