Introduction

Originally 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

Authority on Ratings

Artificially propped up demand Barriers to entry

From 1975-2006 Vague NRSRO requirements Credit Rating Reform Act 2006

Why do we need them?

Information asymmetries between borrowers and lenders

Issuers have superior information

Efficiency
Costly and duplicative for purchasers to do

their own research Rapid dissemination of information

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

Structured Finance
Home Mortgages (Ba2) Special Purpose Vehicle RMBS (AAA Ba1)

CDOs

(AAA Ba1)

CDOs Squared

What went wrong?

Tremendous growth of structured finance combined with Limited Historical Data

RMBS rely on quantitative models and analyst judgment

whereas corporate debt includes long historical records.

Underestimated housing downturn

Pooling reduced idiosyncratic risk but increased exposure to

systematic risk Change in economic conditions extremely important, whereas corporate credit assumes neutral economic conditions

Underestimated originator risk

Diversification 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.

Sources: WSJ, Financial Statements,

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, 1996

Credit Rating Business

Credit rating agencies sell Ratings (or opinions)
not statements of facts and certainly not

investment advice

Advice to rated firms

Credit Rating Advisory Services

Current Business Model

Credit agencies are paid By investors prior to 1970s By rated issuers or by underwriters now

So, who should pay?

Issuers?
Provides benefits via rapid dissemination of

ratings. Strong potential conflict of interest Power to suppress unwanted ratings

So, who should pay?

Investors?
Free-riding problem
If to a select group of willing and able

investors, may stoke populist fears Still 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

Pivotal Role in Structure Finance

Theme of the game

Only added value to rated securities

Sole source of confidence in the process

Opacity of rated securities

Rating-dependent investment by large institutional investors

Only allowed to invest in investment-grade

or above

Conflicts of Interest

Inherent conflicts under the issuerspay model

Issuers only cares about high rating -

accuracy becomes less relevant Rating 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

Conflicts of Interest

Traditional corporate bond rating business

Large base of clientele Lower profit margin

Reputation risk

Deepened Conflicts of Interest

Structured finance business

A handful of banks
Excessively high profit margin Rating shopping

Huge pressure for getting the deals done

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 securities failed to adjust those ratings sooner as the performance of the underlying assets deteriorated

Resemblance to Enron?

Similarities in fee structures (the ratedpay) Reliance on certified opinions (investors) Reluctance to give negative opinion on the ground of revenue consideration (accounting firms)

Whom Can We Rely On

when there is no one to trust?

Views from Three Perspectives

Regulators Investors Rating Agencies

(SEC)

Themselves

SECs New Regulation on Rating Agencies

SECs Summary Report (July 2008)

http://www.sec.gov/news/studies/2008/craex

amination070808.pdf

An evaluation report on Fitch, Moody, and S&P

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.

SEC New Rules for Rating Agencies

Additional requirements on the conduct of Nationally Recognized Statistical Rating Organizations (NRSROs)
Release No. 34-59342, available at http://www.sec.gov/rules/final/2009/34-59342.pdf

Additional proposed rules for NRSROs

Release No. 34-59343 available at http://www.sec.gov/rules/proposed/2009/34-59343.pdf

Abstract of Adopted Rules

Disclosure of Information Used in the Rating Process

When 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; and NRSROs 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 Rule

Prohibits NRSROs from providing any structuring advice relating to the securities that they rate.

Other New Rules

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; and Amendments intended to reduce reliance on NRSRO ratings in the Commission's rules.

Statutory Structure
Registration
Registration at the SEC as NRSRO. Application includes information on: 1. ratings performance 2. procedures and methodologies 3. policies against misuse of private information 4. organizational structure 5. code of ethics 6. conflicts of interest 7. 20 largest issuers or subscribers 8. certification of institutional investors that the ratings are considered significant

Oversight
The SEC has sole responsibility for supervision. The SEC has no say in the ratings substance, procedures and methodologies. The SEC can suspend or limit operations or revoke the license if the NRSRO does not comply with the regulation or fails to maintain adequate resources to produce valid ratings.

Conflicts of Interest
Appropriate policies and procedures to manage and address conflicts of interest. The SEC has the authority to issue rules concerning conflict of interests related to: 1.Compensation 2.Consulting and advisory services 3.Personal and ownership conflicts 4.Affiliation with issuers 5.Other conflicts of interest the SEC deems necessary; prohibit an NRSRO from issuing a rating where the NRSRO or a person associated with the NRSRO has made recommendations as to structuring the same products that it rates; prohibit anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it, to prevent business considerations from undermining the NRSROs objectivity; prohibit gifts from those who receive ratings to those who rate them, in any amount over $25.

Statutory Structure (Cont.)

Transparency
Periodic private disclosure of financial conditions Require 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 the number of ratings actions they took in each ratings class. Require documentation of the rationale for any material 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 they issue on structured products from other securities, either through issuing a report disclosing how procedures and methodologies and credit risk characteristics for

Competition
Require NRSROs to make all of their ratings and subsequent rating actions publicly available, to facilitate comparisons of NRSROs by making it easier to analyze the performance of the credit ratings the NRSROs issue in terms of assessing creditworthiness. Require NRSROs to publish performance statistics for one, three and ten years within each rating category, in a way that facilitates comparison with their competitors in the industry.

Governance
Prohibit an NRSRO from issuing a rating on a structured product unless information on the characteristics of assets underlying the product 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 unduly influenced by the products sponsors. Prohibition of use

Criticism to SEC Regulations

Too little, too late June 2008 Proposals very bold; final document very limited Any real desire to drastically reform or remake the industry? Don't wean investors off their reliance on credit rating agencies Do nothing to ensure accurate ratings A furtherance of the abdication of its responsibility

Reform?

No Easy Answer

Some Legislative Suggestions

Urge rating agencies to

Provide a range for the risk of each instrument

rather than a point estimate; Develop a distinct rating scale for structured finance products

Introduce explicit legal liability for negligence or malfeasance

Some Legislative Suggestions Separating rating from consultancy and

advisory functions
Give up highly remunerative advisory work

will be extremely difficult politically

More rating agencies

Introducing competitiveness

Eliminating the regulatory license by abolishing recognition

i.e., removing the NRSRO designation and

merely requiring agencies to register with the regulators

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 quality

Unsolicited Rating vs. Solicited Rating

encourage solicited rating, strengthen information

disclosure

As Investors

Be objective towards rating agencies and their ratings The investors reliance on rating results has an amplifying effect on the products

As Rating Agencies Themselves

Interest related with clients

Hard to stick to neutrality and self-integrity

$25 cannot solve Strengthening internal management

capital structure internal governance rating data base, theories, models