Expected Loss Covered Bond Model

These haircuts have been calculated by looking at what the percentage of the Collateral Score is required to
enhance the Cover Pool to its target rating. For example, if the Cover Pool rating that is required to achieve the
target covered bond rating is Aa1, then a 25-35% reduction in the Collateral Score may be applied in the Moody’s
EL Model.
The haircut to the Collateral Score is subject to a maximum of 60%. The reason for this is that a certain level of
losses might be expected to impact the Cover Pool following Issuer Default, and also this is approximately the
amount of equity that would be required to fund the Cover Pool if it were refinanced as a structured finance
transaction.
How the grids were prepared
There are two key inputs in the generation of the grid tables above.
• A minimum asset correlation for any pair of ratings. For the standard correlation table this minimum is
higher than for the low correlation table. 9
• The “theoretical asset correlation”. This is used where this is higher than the minimum asset correlation
inputs mentioned above. The theoretical asset correlation was calculated by considering the maximum
and minimum correlation levels which in turn were derived with the help of the following well-established
formula. 10 P(
A I B)
− P(
A)
P(
B)
Corr(
A,
B)
=
,
P(
A)(1
− P(
A))
P(
B)(1
− P(
B))
where P(X
) denotes the probability that entity X defaults during the horizon of interest, and
Corr( A,
B)
denotes the default correlation between entities A and B .
The theoretical maximum correlation between two entities based solely on ratings (hence default probabilities) is
obtained by setting the expression P( A I B)
in the above equation to the default probability of the higher rated
entity.
By contrast, the theoretical minimum is obtained by first observing that the lowest joint default probability for any
pair of entities is equal to the lowest historically observed default probability for any entity; that is, this quantity is
equal to the probability of default of a single Aaa-rated entity. In practice, for all pairs of entities, we therefore set
P( A I B) equal to P (A)
in the above equation, where A in this instance denotes a Aaa-rated entity.
The impact of taking the higher of the key inputs above is that the “average” asset correlation used when achieving
a Aaa rating using the standard correlation grid is over 50%, while the asset correlation using the low correlation
grid is in region of 40%.
9
To calculate these asset correlations, Moody’s has studied the historic observed correlations of rating movements between corporate and
financial institution issuers. For more information, see Moody’s Revisits Its Assumptions Regarding Corporate Default (and Asset) Correlations
for CDOs November 2004.
10
See Default Correlation and Credit Analysis, Douglas J. Lucas, March 1995.
12 • Moody’s Investors Service European Covered Bond Rating Methodology