09/27/2001 Moody's on the Financial Guarantors *

Global equity markets rallied sharply this week. In the U.S., the Dow and S&P500 surged almost 8%, with the Morgan Stanley Cyclical index jumping 9% and the Morgan Stanley Consumer index adding 7%. The Utilities suffered, dropping 5%. The broad market rallied strongly, with the small cap Russell 2000 and the S&P400 Mid-Cap indices both bouncing 7%. Technology stocks were mixed, with the NASDAQ100 and Morgan Stanley High Tech indices gaining 4%, while the Semiconductors declined 2%. The Street.com Internet index added 3% and the NASDAQ Telecommunications index jumped 5%. Biotechs surged 11%. Financial stocks performed exceptionally well, with the S&P Bank index jumping 11% and the AMEX Broker/Dealer index surging 12%. While bullion added better than $1, the HUI Gold index declined about 1%. Global currency markets remain erratic, although the dollar did muster a small gain for the week.

It was another extraordinary week throughout the over-liquefied credit market, with the long-bond and agency securities this week’s winners. With the 30-year Treasury yield sinking 16 basis points to 5.42%, while the 2-year yield declined 4 basis points to 2.82%, the unusually wide 2 to 30-year spread narrowed significantly this week. It remains, however, about 80 basis points wider than where it began September. For the week, 5-year Treasury yields declined 2 basis points to 3.80% and the 10-year 10 basis points to 4.59%. Mortgage-back yields generally declined 8 basis points, while agency yields sank 15 basis points, as the agency/Treasury spread continues to narrow. The benchmark 10-year dollar swap spread declined 4 basis points to 66. Bank, finance, and industrial spreads, however, did not participate, and despite extraordinary liquidity conditions remain indicative of heightened systemic risk. We tend to side with (quoted by Bloomberg) David Goldman, chief credit strategist at Credit Suisse First Boston: "Swaps have tightened as regulatory authorities ring-fence the banking system, but credit has suffered as stock markets have fallen."

Broad money supply surged an extraordinary (and record) $164.5 billion last week, fueled by a $111 billion increase in demand deposits and $47 billion increase in savings deposits. This increases 12-month broad money supply growth to an astonishing $937 billion, or 13.5%. And while the Fed release stated, "the increase is expected to be temporary," we see this as nothing less than the complete unhinging of the monetary "Pandora’s Box." For comparison, broad money supply added less than $300 billion during 1995, about $330 billion during 1996, and $450 billion during 1997. Since the beginning of 1998, broad money supply has surged an incredible $2.45 trillion, or 45%. According to the Investment Company Institute, money market fund assets surged $57 billion for the week ended September 18th, the second largest weekly gain ever (the record being the week of January 16th, 2001 – following the Fed’s surprise 50 basis point rate cut and Southern California Edison default). Money funds assets have jumped $82 billion during the past two weeks, and an unprecedented $458 billion (26%) during the past 12 months. Looking at today’s bank credit data, we see that bank security holdings increased $20 billion during the week ended September 19th (to $1.47 trillion).

The Mortgage Bankers Association reported applications to refinance surged 36% last week to the highest level since March. The refi index has now more than doubled since the early July lows. Yesterday, Freddie Mac reported that 30-year mortgage rates fell to 6.72%, the lowest level since late 1998. The average rate on 15-year mortgages dipped to 6.23%. From Freddie’s chief economist: "Continued uncertainty in the financial markets has helped to hold down mortgage rates, and the housing sector of the economy is bustling with activity." It now appears likely that total 2001 mortgage originations could approach $2 trillion.

The National Association of Realtors reported August home resales at a record annualized rate of 5.5 million units (compared to estimates of 5.2 million), as 2001 remains on track for the second-best year ever. If demand holds, estimates have this year’s sales at 5.19 million versus 1999’s record 5.21 million. Sales were approximately 30% above levels from pre-Bubble August 1997. The average (mean) price rose to a record $194,400, up $11,400 from a year ago, led by the West’s $251,600. In what has been nationwide real estate inflation, prices are up 20% in the West, Midwest and Northeast, while jumping 27% in the South since the beginning of 1999. Looking at the transaction value calculation (annualized sales multiplied by average prices), the dollar value of sales has jumped 11.5% from last August and 35% from 1998’s total sales. August new home sales were reported at an annualized rate of 898,000 units, up 7% from last August. It will be quite interesting to closely follow the housing and mortgage refi markets over the coming weeks.

We continue to closely monitor simply unprecedented developments throughout the U.S. credit system. On the one hand, some types of bank credit are apparently easily available, and we have the GSE-led mortgage sector in overdrive. On the other hand, there is acute stress in some key sectors of the financial system, with unsettled conditions permeating throughout the asset-backed and CDO markets. Generally, "over liquefied" and mortgage Bubble meets risk aversion, faltering "structured finance," and acute global financial fragility, with the short-term outcome of this free-for-all very much in doubt. While it is tedious, I would like to highlight a few of this week’s ratings downgrades to illuminate the broadening scope of this financial and economic crisis. I think it is important today to better appreciate the types of securities that were created during the halcyon days of the protracted boom and the institutions and structures involved, while in the process working to assess the points of acute systemic vulnerability.

At $1.9 billion, Lloyd’s of London is estimating that it will suffer its single worst loss in its 300-year history. From the Financial Times: "Lloyd’s admitted its forecast could be revised upwards…Lloyd’s also conceded that some of its 108 underwriting syndicates would need to make cash calls on their individual investors, know as Names, as well as corporate backers which now provide 80 per cent of the market’s capital…" From the Wall Street Journal: "With the total insurance bill from the attacks now generally expected to approach or even top $40 billion, analysts at some U.S. credit ratings agencies are less sanguine. Fitch Inc., which downgraded Lloyd’s this week, said Wednesday that Lloyd’s ultimate loss related to the attacks was likely to be at least 1.7 billion pounds ($2.4 billion) and noted that initial estimates on catastrophes are almost always understated. Keith Buckley, a Fitch managing director, said that the worst-case scenario for U.S. insurers is that Lloyd’s wouldn’t be able to fully pay its claims stemming from the terrorist attacks, including reinsurance payments due to U.S. insurers." Lloyds and other property and casualty insurers’ financial positions were already weakened by poor operating results during 1998, 1999 and 2000. This time around, casualty losses are compounded by stock market losses.

"Standard & Poor’s--Sept. 26, 2001-- Standard & Poor’s today lowered its rating on Sovereign Credit Corp. (1)’s collateralized notes following a recent rating action concerning Lloyd’s. At the same time, the rating is placed on Credit Watch with negative implications. The rating action and Credit Watch placement reflect the fact that the asset-backed security is weak-linked to the underlying credit support provided by Lloyd’s, which acts as insurance provider/guarantor. Lloyd’s financial strength rating was lowered to single- ‘A’ from single-‘A’-plus on Sept. 20, 2001 following the terrorist attacks in New York and Washington D.C. Its rating was simultaneously placed on Credit Watch negative."

9/27 - "MOODY’S PLACES CITIBANK MUTUAL FUND FEE DEAL ON WATCH FOR POSSIBLE DOWNGRADE - Approximately $125 Million of Debt Securities Affected - Moody’s Investors Service announced today that it is placing under review for possible downgrade Series 2000-R4 and 2000-4 Notes issued by Mutual Fund Fee Trust XIV. The cash flows supporting these notes are various future fees generated by equity and debt mutual funds. The credit quality of a security backed by those mutual fund fees depends on the likely fees to be generated by the funds during the life of the security and the potential variability of the actual collections. Expected future fees are highly dependent on the likely future values of the funds, which, in turn, are strongly linked to current values. In the expected case, funds increase in value over time, so that credit quality also generally improves with time. However, severe declines in asset values can erode credit quality. Each class of notes requires a certain level of market underperformance to result in a default. The overall fund values have performed far below historical norms since issuance of Mutual Fund Fee Trust XIV, due mostly to the sharp and sustained declines in stock prices. Since changes in the current value of a fund alter the likely course of the fund's future values, the declines in market values have lowered the fees expected to be generated by those funds."

9/27 – "MOODY’S PLACES SIX CONSTELLATION MUTUAL FUND FEE DEALS ON WATCH FOR POSSIBLE DOWNGRADE - Approximately $540 Million of Debt Securities Affected. The cash flows supporting these notes are various future fees generated by equity and debt mutual funds…Each class of notes requires a certain level of market underperformance to result in a default. The overall fund values have performed far below historical norms since issuance of FEP I-VI, due mostly to the sharp and sustained declines in stock prices."

9/27 "MOODY'S PLACES THE NOTES ISSUED BY MUZINICH CBO II ON REVIEW FOR POSSIBLE DOWNGRADE - Approximately $372 million in debt securities affected – Moody’s Investors Service announced today that it is placing on review for possible downgrade all classes of Notes issued by Muzinich CBO II Limited. Muzinich CBO II, a ‘market value’ collateralized bond obligation, is violating both the Class A and B overcollateralization tests. As of the end of the requisite period, those violations have not been cured. Moody’s noted that the primary reason for the violation is a large, negative mark-to-market - due to declining interest rates - of the interest rate hedge that was put in place at closing."

9/25 – "Moody’s Investors Service has revised its outlook on the lodging REITs sector to negative, from stable, but cautious, following the September 11, 2001 attacks on the World Trade Center in New York City and the United States Pentagon. At the same time, Moody’s placed under review for possible downgrade the ratings of 5 lodging REITs… These rating actions reflect the increasing business and financial risks facing these companies in the aftermath of the terrorist attacks in the United States. According to Moody’s, the negative outlook for the lodging REIT sector and these rating actions are based on the expectation that the lodging industry will remain under intense operating pressure for the remainder of 2001 and likely well into 2002. Moody’s anticipates a significant decline in intermediate-term business and leisure travel. These factors should result in material erosion in the lodging industry’s operating environment, and will further depress already weakened financial performance for many lodging REITs. The lodging sector was already experiencing substantial deterioration in revenues per available room (RevPAR) and occupancy rates due to an increasingly weakened economy. The September 11th acts of terrorism will further exacerbate negative lodging industry RevPAR growth. Moody’s anticipates that all hotel segments will be adversely affected, with upscale, luxury hotels, convention and resort properties, being particularly vulnerable."

"Fitch-NY-September 24, 2001: Fitch downgrades Northwest Airlines ‘European Enhanced Equipment Trust Certificates’ (E-EETC), Series 2001-2 as follows: class A securities from ‘AAA’ to ‘AA-’ and class B securities from ‘A’ to ‘BBB’. The rating actions reflect Fitch’s downgrade of Northwest Airline’s unsecured corporate debt from ‘BB+’ to ‘B+’. All E-EETC classes remain on Ratings Watch Negative."

"Fitch-NY-September 27, 2001: Fitch places the ratings of Team Fleet Financing Corporation (a wholly owned subsidiary of Budget Group, Inc.) and National Car Rental Financing Limited Partnership (a wholly owned subsidiary of ANC Rental Corporation) rental car ABS transactions on Rating Watch Negative. Fitch expects rental car demand to decline over the next several months as the industry experiences a slowdown in business and leisure travel related to the tragic events of Sept. 11. As a result, Fitch anticipates fleet reductions and weaker operating results among the rental car companies. The uncertainty and potential for a prolonged decline in demand, coupled with softening used car prices and continued aggressive rental pricing competition, have created instability within the rental car industry, which could have a negative impact on certain rental car ABS transactions rated by Fitch."

9/24 - "Standard & Poor’s today lowered its ratings on two synthetic asset-backed securities following the recent rating action concerning Royal Caribbean Cruises Ltd. The lowered ratings on the two synthetic deals reflect the credit quality of the underlying securities issued by Royal Caribbean Cruises Ltd. The two transactions are swap-independent synthetic transactions that are weak-linked to the underlying collateral, Royal Caribbean Ltd. debt. This rating action follows the Sept. 19, 2001 downgrade of Royal Caribbean Cruises Ltd. as a result of weakening credit measures, particularly in light of the Sept. 11 terrorist attack on the World Trade Center in New York."

"Sept. 24, 2001--Fitch has reviewed the potential short and long term impacts that the events of Sept. 11 are likely to have on the collateralized debt obligation (CDO) market and has identified several areas of concern that asset-backed CDOs, cash flow and synthetic CDOs, and market value CDOs…. Asset Backed CDOs: CDOs with exposure to WTC related commercial real estate securitizations or structured aircraft bonds may be impacted due to changes in collateral quality of the underlying assets… Fitch put all structured aircraft bonds on Rating Watch Negative on Sept. 20… If the credit quality of the WTC or aircraft securities deteriorates, either by downgrade or default, the bearing on the credit quality of the CDO will be assessed and ratings will be adjusted as warranted. Cash Flow CDOs: The erosion of credit quality in the aircraft, gaming, lodging, and tourism industries may result in Rating Watch or downgrade of CDOs with large exposures to these industries. The CDOs of most concern are those that have suffered higher than expected credit losses prior to these events and CDOs of investment grade assets with higher degrees of leverage.

Market Value CDOs: Market value CDOs have suffered a period of extreme price volatility over the last week. Especially impacted are transactions that have suffered large erosions of asset values in the past and have been struggling to maintain compliance with overcollateralization and minimum net worth (MNW) covenants. There are a few market value CDOs that passed their last quarter MNW tests with limited margin for safety. These transactions may be facing a difficult time complying with the upcoming Sept. 30 tests. It is expected that the asset managers of these transactions will take every measure possible to try to pass, including waiving management fees, seeking additional equity

capital, or amending the transaction documents. In the event that no remedies are put into place, deeply subordinated tranche ratings may be impacted if liquidation is commenced. Fitch has contacted all of the market value asset managers, and is staying in close contact with those who are facing difficulty. It should become clear over the next few weeks the status of all funds’ compliance with the quarterly tests and the progress of any plans for remedy. Finally, all CDOs will be influenced by recessionary pressures accelerated by the terrorist events. Both high yield and investment grade CDOs have been suffering with high corporate default rates for the last two years and are less well equipped to weather economic recession than when they were originated. Fitch will continue to monitor these intermediate and long term issues and will take rating actions on CDOs as a result of rating migration in underlying portfolios and/or erosion of par value."

"Standard & Poor’s--Sept. 21, 2001--Standard & Poor's today placed its ratings on various synthetic asset-backed securities on CreditWatch with negative implications."

"PRNewswire/September 27 – Selected debt securities in eight aircraft-backed securitizations were today placed on CreditWatch with negative implications. This action follows Standard & Poor’s review of aircraft lease portfolios and other aircraft-backed transactions…"

9/26 - "Standard & Poor’s today stated that the recent terrorist attacks at the World Trade Center in New York may negatively affect the ratings of a number of outstanding CDO transactions in the near-term future if obligors within certain industry categories, particularly the airline industry and the lodging industry, experience significant downward credit migration or defaults due to the impact on their businesses. A number of arbitrage CBO and CLO transactions have collateral pools with significant exposure to debt issued by obligors within the airline and lodging categories, which means they may be negatively affected if obligors within those industries see significant downward ratings migrations or defaults as a result of recent events."

"A failure by Northwest Airlines to make certain payments to the operator of Minneapolis-St. Paul International Airport raises ‘troubling’ questions for airport bonds if other carriers follow suit, Fitch Inc. said." Bloomberg, September 28th.

"Business losses caused by this month’s terrorist attacks will reduce tax and other income collected by New York state by more than $1 billion in this fiscal year…" Bloomberg, September 28th.

I have listened to several conference calls addressing the myriad issues associated with the financial guarantors (credit insurers). By far the most informative was provided by Laura Levenstein and her team from Moody’s. I have pulled excerpts from this presentation – including Q&A – that I hope will be of value in shedding some light on difficult subject matter that is sure to garner considerable attention over the coming weeks and months. (The audio was at times difficult, so I can only say I did my best at transcribing the comments.)

Laura Levenstein, Managing Director Moody’s Investor Service: "…I would like to take a few moments to discuss Moody’s approach to analyzing the (financial) guarantors (Moody’s rates MBIA, Ambac, FGIC, and FSA) and the methodology we utilize to measure an insurer’s capital adequacy and claims paying ability. Moody’s takes a portfolio risk approach to analyzing the insurers portfolios and measuring potential credit losses. The financial guarantors team has developed a portfolio risk model which measures among other things the probability distribution of credit losses for an insurer’s insured portfolio on a present value basis. The financial strength rating of a particular company is driven both by the output of our portfolio risk model and by a number of other more fundamental factors such as management quality, the robustness of the earnings stream, financial flexibility, liquidity, underwriting and risk management practices, competitive dynamics, the regulatory environment, the ownership structure, and franchise value.

The benchmark for the output of the model is not the margin of capital over potential credit losses in low probability scenarios, but rather the adequacy of the company’s capital resources to cover losses at different confidence intervals. For instance, the default probability of a "Triple-A" company is consistent with a 99.99 confidence interval. So any company rated "Triple-A" by Moody’s must have sufficient capital to cover losses at that confidence interval. That is not to say that any company with sufficient capital to cover this level of losses will be rated "Triple-A." Also, how much capital a company must have beyond one times the credit losses at the target confidence interval will be driven by a number of other factors including the composition of the company’s earnings stream, the company’s exposure to large single-risk or correlated risk, transition risk associated with the company’s insured portfolio, and the company’s financial flexibility. Nonetheless, every company must have sufficient claims paying resources to cover losses at the confidence interval consistent with the default probabilities associated with the rating assigned to that company. But the key inputs into Moody’s portfolio risk model for financial guarantors is the default probabilities in the expected case for each of the insured exposures. The default probability is derived from the rating assigned to each exposure. Another key input is the expected loss severity. For each insured sector, Moody’s has derived an expected loss severity based upon historical performance. For each exposure, the product of the default probability and the loss severity is the expected loss for that exposure.

The aggregate expected loss for the insured’s portfolio, or more simply the sum of expected loss for each insured exposure, is the primary driver of portfolio risk in the tail of the distribution. The extent that the underlying ratings of a large number of insured exposures are under pressure and, subsequently, a large number of downgrades takes place, that could change the aggregate expected loss of the insured portfolios and increase the tail risk and the credit losses associated with different confidence intervals. Additionally, given the unprecedented nature of recent events, expected loss severity for any particular sector may be too conservative and larger scale losses could occur. This will also impact the expected loss for insured portfolios and the corresponding tail risk. At this stage the financial guarantor team is actively monitoring the rating activities in all the sectors to which the financial guarantors have exposure. We do not anticipate any immediate losses for the companies and do not view recent events as a credit event for the industry as a whole or for any of the Moody’s rated companies. Given the ratings impact experiences in various insured sectors to date, our short-term outlook for the industry outlook is stable. All of the Moody’s rated companies have insured portfolios which are granular in nature and highly diversified. Additionally, the companies are highly liquid and have built into their exposures significant structural protection against loss. These portfolio characteristics and company fundamentals may adequately protect the companies and cushion the impact of recent events. Nevertheless, it is simply too early to tell how deeply effected the economy will be or how severe the impact on ratings will be in a number of sectors in which the guarantors are exposed. For all of the reasons stated above, we are cautious in our outlook for the industry in the medium-term and long-term."

Jack Dorer, senior vice president, Moody’s Investors Services: "…all of the guarantors have exposure to the airline industry and airport sector. Two of these companies, Ambac and MBIA, have been active in the EETC market. Ambac has $530 million of net exposure to EETCs, while MBIA has $945 million of net exposure to EETCs. EETCs, or "Enhanced Equipment Trust Certificates," are securitizations of aircraft owned by a particular carrier. The ratings on EETCs are a product of both the value of the collateral – the aircraft - and the rating of the airline which is making payments on the aircraft. Historically the ratings on the EETCs have been higher than the ratings on the airlines because of the low loan-to-value of the aircraft, the structure of the transactions which permit the long tier period helping to facilitate the orderly sale of the aircraft, and the presence of bank facilities to cover any short-falls in the event of a failure to pay by the airlines for a period of 18 months. In the wake of recent events, Moody’s has lowered the underlying ratings on a few of these EETC transactions. We anticipate a fall off in demand for aircraft, which will adversely affect the value of the collateral. This, coupled with the downgrades in the airline industry, has adversely affected the ratings on EETC transactions. There’s currently a high-degree of uncertainty surrounding these transactions. If defaults occur, the loss severity will be driven by the loan-to-value of the aircraft, and the current value of the aircraft, as well as the time period between the default by the airline and the sales of the collateral. It is also anticipated that the airport sector will be adversely impacted by these events. For the past several years, most airport-related debt was insured and all the guarantors have large exposures to this sector. Ambac has about $7 billion of airport-related exposure, while MBIA has about $14 billion, FGIC $11 billion, and FSA $3 billion in airport-related exposure. Additionally, some of the companies have exposure to the Metropolitan Washington Airport Authority that includes Ronald Regan Airport. As most of you know, Ronald Regan Airport remains closed and the future of this airport is unknown. MBIA has the largest exposure to this authority, with approximately $1 billion in net par outstanding. The state of the Nation’s airports is very uncertain at present and not all airport-related debt will be effected in the same way by the expected downturn in passenger volume and the potential bankruptcy of a number of large airlines..."

"A number of the guarantors have wrapped debt secured by specific revenues generated by airports or airport-related activities. For instance, all of the companies except FGIC have insured Passenger Facility Charge – or PFC - structures. These structures use passenger fees or charges to assist in financing airport infrastructure and development. Most of the PFC debt issued to date has been in the U.S. Many airports have chosen to use such charges on a pay-as-you-go basis to finance capital improvements, while others have issued debt secured by a combined pledge of airport revenues and PFCs. PFC debt is more directly affected by passenger volume and it is more likely to be immediately impacted by the current environment. There are also a number of other special revenue-type exposures in the guarantors’ portfolios including debt secured by rental cars, airport parking fees, and airport concessions. A decline in passenger traffic, coupled with changing security requirements in airports, will have an adverse impact on the cash flow available to cover debt service on these types of exposures. For all airport-related exposures, the key drivers of future performance will be the degree to which passenger volume declines, the length of the decline, and degree to which new security measures impact the generation of special fees, and the state of the airlines…

Another sector which has been severely impacted by the recent tragedy, and to which the guarantors have exposure, is the insurance sector. All of the guarantors have exposure to the multi-line insurance industry, either through obligations imbedded in CDOs and credit default swaps, or by wrapping guaranteed investment contracts issued by insurance companies. Furthermore, certain deals wrapped by the guarantors may utilize insurance as a protective measure within the deal structure. Because many multi-line insurance companies are expected to suffer huge losses extending from the World Trade Center incident, some of these multi-line insurers could experience ratings pressure and therefore the guarantors’ exposure to these entities could also be negatively impacted. Financial guarantors have also used certain highly rated multi-line insurers for reinsurance capacity. So any reinsurer downgrades could impact the amount of capital relief that the guarantors receive..."

Stanislas Rouyer, senior credit officer, Moody’s Investors Services: "In addition to the specific exposures discussed earlier, the financial guarantees industry is exposed to the adverse consequences of a general economic downturn. The tragic events of September 11th have further weakened an already feeble U.S. economy, and no one seriously questions that we are entering into recession. Other OECD economies are exposed to similar prospects… Despite the central banks’ best efforts to avoid this from happening, one has to seriously consider the combined effect of a recession and liquidity crunch. As expected, the financial guarantee industry will be affected by the weakening economy and sectoral downturns in some of the underlying credits … In some ways, we are facing three distinct credit events occurring at the same time. One, a U.S. recession; two, a steep cyclical downturn of the travel and entertainment sectors; and three, a possible OECD recession. Particular attention will have to be paid to the credit default swaps and CDO portfolios of financial guarantors, especially when they contain exposures to high-yield credits… CDO exposures may take some time to access, given the changing collateral. Downgrades and losses may not be limited to the financial guarantee and credit default swap portfolios but could also materialize in the investment portfolios…It is also interesting to note that some of the business lines that will be the most hurt by recession – namely credit default swaps, CDOs, and some sectors of the ABS and MBS markets, will be tested for the first time in a downturn. This reflects the resilience of the U.S. economy over the last 10 years and the relatively short history of these products…"

Laura Levenstein, Managing Director Moody’s Investor Service: "I think what has happened over the course of the last several years – and this is not unique to the airline industry or airport industry – is people have looked for and become more creative about sources of revenue to utilize for capital expenditures and to utilize to back bonds to fund capital expenditures, and the flipside of all of that is that you have more narrow revenue streams pledged to back certain bond issuance, which may be more vulnerable to certain events..."

"The aggregate amount of exposure that we are talking about here is obviously a very large number. If you add up all the direct exposure, all the airline-related exposure, the CDO exposure, etc. you are looking at numbers for MBIA, as an example, in the $60/ $70 billion range. You need to keep in mind, however, that we’re not looking – those numbers are not at all representative of potential losses. The aggregate amount of par (insurance written) - even the par at risk, which would be assuming everything defaulted – so that’s not that case. And the ratings on those credits vary tremendously, so the expected loss for the individual transactions and the sectors are considerably, considerably lower than that. And what we are really looking at is changes in expected losses, not the absolute par that’s outstanding, but the expected loss, and that’s where the default probabilities play in, and that’s sort of the kind of analysis that we are doing now. Those numbers compared to the capital base and surplus are obviously much more reasonable…"

"There is sort of an inverse relationship between the amount of losses a company can withstand coupled with the amount of downgrades a company can withstand. To the extent that there are unexpected levels of downgrades, we may not need to see any loss for there to be some sort of credit event. That again, I want to stress, is not a likely scenario, but that’s a possibility. The flipside is that if there are some large losses, then you wouldn’t need to see a lot of deterioration in the credit portfolios to have the combination of the losses plus the change in the composition of existing portfolios to contribute to some concern over the adequacy of capital. Right now, just to give you a quick example in terms of the magnitude of losses, and this is an average so its probably not that precise, but in terms of magnitude of losses that the companies could withstand and stay within the range, assuming no downgrades of any sort, you are looking at numbers that range from, for some of the smaller companies a billion and one-half dollars of net losses upwards to two and one-half billion."

Going forward, we will have more to say regarding the methodology of analyzing the risk of the financial guarantors (and credit risk generally), but suffice it for now that we question the basic Moody’s premise that the "benchmark for the output of the model is not the margin of capital over potential credit losses in low probability scenarios." There is a serious fundamental problem with contemporary risk models, as they do not incorporate boom and bust Bubble dynamics. But, then again, so much of modern "finance" would lose its viability incorporating the inevitability of bursting Bubbles. We can say today with overwhelming confidence that the unfolding environment would be considered a very low probability scenario by historical models, just as models in Japan in 1989 would have forecast little possibility of the Nikkei (then at 39,000) below 10,000 twelve years down the road, or in early 2000, with the NASDAQ above 5,000, that it could sink to 1,500 hundred over the following 18 months. The bottom line, as we proceed through the process of the bursting of an historic financial and economic Bubble, is that a "portfolio approach" to analyzing the "expected loss severity based upon historical performance" will consistently and significantly understate future credit losses and resulting financial fragility. Historical loss performance and sector correlations will prove troublingly inapplicable to the developing Credit Bubble bust, a great dilemma for a credit system and economy that has come to be governed by "sophisticated" risk modeling.