2 IntroductionOriginally intermediaries that specialized in assessing the credit worthiness of railroads, industrial corporations, and financial institutions.April 2007: “it could be structured by cows and we would rate it.” (Internal communication between rating agency analysts)No opinion on whether debt instrument should be bought or sold
3 Authority on Ratings Artificially propped up demand Barriers to entry From Vague NRSRO requirementsCredit Rating Reform Act 2006
4 Why do we need them?Information asymmetries between borrowers and lendersIssuers have superior informationEfficiencyCostly and duplicative for purchasers to do their own researchRapid dissemination of information
5 Subprime Securitization Structure Source: Written Testimony of Christopher L. Peterson,– Hearing before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, , Subprime Mortgage Market Turmoil: examining the role of securitization
6 Structured Finance Home Mortgages (Ba2) Special Purpose Vehicle RMBS (AAA – Ba1)CDOs (AAA – Ba1)CDO’s Squared
7 What went wrong? Tremendous growth of structured finance combined with Limited Historical DataRMBS rely on quantitative models and analyst judgment whereas corporate debt includes long historical records.Underestimated housing downturnPooling reduced idiosyncratic risk but increased exposure to systematic riskChange in economic conditions extremely important, whereas corporate credit assumes neutral economic conditionsUnderestimated originator riskDiversification across borrowers within a mortgage pool but not across originators, issuers or servicers.correlated risk across the loans related to servicer and/or originator quality.
10 Thomas Friedman (NYT), Feb. 13, 1996 “There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service.”Thomas Friedman (NYT), Feb. 13, 1996T. Friedman on NPR news 1996
11 Credit Rating Business Credit rating agencies sellRatings (or “opinions”)not statements of facts and certainly not investment adviceAdvice to rated firmsCredit Rating Advisory Services
12 Current Business Model Credit agencies are paidBy investors prior to 1970sBy rated issuers or by underwriters now
13 So, who should pay? Issuers? Provides benefits via rapid dissemination of ratings.Strong potential conflict of interestPower to suppress unwanted ratings
14 So, who should pay? Investors? Free-riding problem If to a select group of willing and able investors, may stoke populist fearsStill has conflicts of interest - creating demand for lower rating which means higher interest.“go back to their roots and have investors pay for the ratings”Sen. Schumer (D-NY), Sept. 26, 2007
15 Pivotal Role in Structure Finance Theme of the gameOnly added value to rated securitiesSole source of confidence in the processOpacity of rated securitiesRating-dependent investment by large institutional investorsOnly allowed to invest in investment-grade or above
16 Conflicts of Interest Sen. Robert Menendez, D-NJ, Sept. 26, 2007 Inherent conflicts under the “issuers-pay” modelIssuers only cares about high rating - accuracy becomes less relevantRating and advisory business“Credit rating agencies are playing both coach and referee in giving advice to issuers of debt”Sen. Robert Menendez, D-NJ, Sept. 26, 2007
17 Conflicts of Interest Traditional corporate bond rating business Large base of clienteleLower profit marginReputation risk
18 Deepened Conflicts of Interest Structured finance businessA handful of banksExcessively high profit marginRating shoppingHuge pressure for getting the deals done
19 In subprime crisis, rating agencies assigned too favorable ratings, especially for subprime residential mortgage-backed securities (RMBS)did not maintain appropriate independence from the issuers and underwriters of those securitiesfailed to adjust those ratings sooner as the performance of the underlying assets deterioratedInternal among S&P employees in December 2006:…Rating agencies continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.
20 Resemblance to Enron? Similarities in fee structures (the rated-pay) Reliance on certified opinions (investors)Reluctance to give negative opinion on the ground of revenue consideration (accounting firms)
21 Whom Can We Rely On…when there is no one to trust?
22 Views from Three Perspectives Regulators (SEC)InvestorsRating Agencies Themselves
23 SEC’s New Regulation on Rating Agencies SEC’s Summary Report (July 2008)An evaluation report on Fitch, Moody, and S&P
24 Examinations Summary of SEC Release There was a substantial increase in the number and in the complexity of RMBS and CDO deals since 2002, and some of the rating agencies appear to have struggled with the growth.Significant aspects of the ratings process were not always disclosed.Policies and procedures for rating RMBS and CDOs can be better documented.The rating agencies are implementing new practices with respect to the information provided to them.The rating agencies did not always document significant steps in the ratings process - including the rationale for deviations from their models and for rating committee actions and decisions - and they did not always document significant participants in the ratings process.The surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings.Issues were identified in the management of conflicts of interest and improvements can be made.The rating agencies' internal audit processes varied significantly.
25 SEC New Rules for Rating Agencies Additional requirements on the conduct of Nationally Recognized Statistical Rating Organizations (NRSROs)Release No , available atAdditional proposed rules for NRSROsRelease No available at
26 Abstract of Adopted Rules Disclosure of Information Used in the Rating ProcessWhen an NRSRO is hired by an arranger to rate a structured finance product, the following rules would all apply:The NRSRO would be required to disclose to other NRSROs that it was providing the rating;The arranger would be required to represent to each hired NRSRO that the arranger will provide the same rating-related information to other NRSROs that it gives to the hired NRSRO; andNRSROs seeking to access information maintained by hired NRSROs and arrangers would be required to certify annually to the Commission the limits on their use of the information.Adoption of the No-Advice RuleProhibits NRSROs from providing any structuring advice relating to the securities that they rate.Other New Rules
27 Abstract of Adopted Rules Rules not finalized relating to the other two subjects:A change in the rating symbols or disclosure applied to ratings of structured finance products; andAmendments intended to reduce reliance on NRSRO ratings in the Commission's rules.
28 Statutory Structure Registration Oversight Conflicts of Interest Registration at the SEC as NRSRO.Application includes information on:1. ratings’ performance2. procedures and methodologies3. policies against misuse ofprivate information4. organizational structure5. code of ethics6. conflicts of interest7. 20 largest issuers or subscribers8. certification of institutionalinvestors that the ratings areconsidered significantThe SEC has soleresponsibility forsupervision.The SEC has nosay in the ratings’substance,procedures andmethodologies.The SEC cansuspend or limitoperations orrevoke the licenseif the NRSRO doesnot comply withthe regulation orfails to maintainadequate resourcesto produce validratings.Appropriate policies and procedures tomanage and address conflicts of interest.The SEC has the authority to issue rulesconcerning conflict of interests related to:1.Compensation2.Consulting and advisory services3.Personal and ownership conflicts4.Affiliation with issuers5.Other conflicts of interest the SECdeems necessary;prohibit an NRSRO from issuing a ratingwhere the NRSRO or a person associatedwith the NRSRO has maderecommendations as to structuring thesame products that it rates;prohibit anyone who participates indetermining a credit rating fromnegotiating the fee that the issuer pays forit, to prevent business considerations fromundermining the NRSRO’s objectivity;prohibit gifts from those who receiveratings to those who rate them, in anyamount over $25.
29 Statutory Structure (Cont.) TransparencyCompetitionGovernancePeriodic private disclosure of financial conditionsRequire disclosure by the NRSROs of whether and how information about verification performed on the assets underlying a structured product is relied on in determining credit ratings.Require disclosure of how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings.Require NRSROs to make an annual report of thenumber of ratings actions they took in each ratings class.Require documentation of the rationale for anymaterial difference between the rating implied by a qualitative model that is a “substantial component” in the process of determining a credit rating and the final rating issued.Require NRSROs to differentiate the ratings theyissue on structured products from other securities, either through issuing a report disclosing how procedures and methodologies and credit risk characteristics for structured finance products differ from other securities, or using different symbols, such as attaching an identifier to the rating.Require NRSROs to make all of their ratings andsubsequent ratingactions publiclyavailable, to facilitatecomparisons ofNRSROs by making it easier to analyze the performance of the credit ratings the NRSROs issue interms of assessingcreditworthiness.Require NRSROs to publish performancestatistics for one,three and ten yearswithin each ratingcategory, in a waythat facilitatescomparison withtheir competitors inthe industry.Prohibit an NRSROfrom issuing a ratingon a structuredproduct unlessinformation on thecharacteristics ofassets underlying theproduct is available,in order to allow other credit rating agencies to use the information to rate the product and, potentially, expose a rating agency whose ratings were undulyinfluenced by theproduct’s sponsors.Prohibition of use ofnon-publicinformation for profit.
30 Criticism to SEC Regulations Too little, too lateJune 2008 Proposals – very bold; final document – very limitedAny real desire to drastically reform or remake the industry?Don't wean investors off their reliance on credit rating agenciesDo nothing to ensure accurate ratingsA furtherance of the abdication of its responsibility
32 Some Legislative Suggestions Urge rating agencies toProvide a range for the risk of each instrument rather than a point estimate;Develop a distinct rating scale for structured finance productsIntroduce explicit legal liability for negligence or malfeasance
33 Some Legislative Suggestions Separating rating from consultancy and advisory functionsGive up highly remunerative advisory work will be extremely difficult politicallyMore rating agenciesIntroducing competitivenessEliminating the “regulatory license” by abolishing recognitioni.e., removing the NRSRO designation and merely requiring agencies to register with the regulators
34 Some Legislative Suggestions Rating quality could be improved by adopting a rule requiring a rating agency to either:(a) disgorge that it believes that its ratings on a new product is of low quality; or(b) disgorge profits derived from selling ratings on new products that turn out to be of poor qualityUnsolicited Rating vs. Solicited Ratingencourage solicited rating, strengthen information disclosure
35 As Investors… Be objective towards rating agencies and their ratings The investor’s reliance on rating results has an amplifying effect on the products
36 As Rating Agencies Themselves… Interest related with clientsHard to stick to neutrality and self-integrity$25 cannot solveStrengthening internal managementcapital structureinternal governancerating data base, theories, models