Moody's Investors Service released a note Friday outlining how the ratings agency assesses structured finance transactions, saying analysts look at the misalignment of interests associated with a transaction and any mitigating factors that may be provided by the transaction governance. Inherent misalignment of interest represents the risk associated within a structured finance transaction. Moody's said each transaction comes with a degree of flexibility so bond issuers can do their jobs effectively. However, this flexibility may afford a party the opportunity to act in ways that are detrimental to some note holders, according to Moody's. For example, changes within the legal, economic or political environment, could cause an issuer's incentives to change. Moody's evaluates how likely a misalignment is to occur and the impact it would have on a transaction, and not the actual misalignment or losses that would arise from it. "A significant part of the assessment is an examination of the governance measures in the transaction and how effectively they will mitigate the likelihood of risk arising from a misalignment occurring and the extent of any losses that may result to rated notes," analysts said. To asses the misalignment of interest, Moody's analyzes how the interests of the parties in a transaction are connected to the interest of the note holders. For example, when the same party has multiple roles in the transaction, the likelihood of risk from misalignment increases. There is a strong chance that fewer checks and balances will take place in this scenario, according to Moody's. The firm then considers the roles and incentives of the parties. If an originator has a book of loans, he is more likely to keep the best assets for his own transactions and to sell the poorer performing ones to a securitization, the analysts said. However, incentives may change. "If a transaction party experiences financial distress, it may be more inclined to act in a manner that best serves its interests instead of those of the note holders," Moody's said. Analysts also said some transaction governance provisions are fairly common to all structured finance transactions, such as the ability to remove a transaction party that is not performing its functions, while others will be specific to a particular asset type. For example, a transaction involving a student-loan consolidator will typically have procedures in place to ensure compliance with various consumer-protection laws. In a different type of deal, for example a managed collateralized loan obligation, the risk of mismanagement will typically be contained through a series of triggers based on portfolio performance that progressively remove the manager's discretion to deal with the portfolio assets. Moody's looks at documents, the size of a transaction, and the creditworthiness of the parties involved, as well as structural protections in place to determine how strong or valid a transaction is. After all that criteria has been defined, Moody's analyzes the potential for "detrimental behavior" and assesses the various incentives and governance provisions that may influence party behavior in different scenarios. The firm does this using a likelihood and consequence grid (see below).

"The results of this qualitative analysis can then allow misalignment of interest risks in a transaction to be compared against those in other similar structured finance transactions or against those with similar potential for misalignments," the report said. "In some cases the overall risk will reduce the possible rating ranges for a given security and may preclude a high rating." Write to Christine Ricciardi.