The Role of the CREDIT Rating Agencies

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) CDO’s 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, ewrockwell.com

I know it was bad, but…

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, 1996 T. Friedman on NPR news 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 Sen. Robert Menendez, D-NJ, Sept. 26, 2007 Inherent conflicts under the “issuers-pay” 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 Internal email 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.

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)

Whom Can We Rely On… when there is no one to trust?

Views from Three Perspectives Regulators (SEC) Investors Rating Agencies Themselves

SEC’s New Regulation on Rating Agencies SEC’s Summary Report (July 2008) http://www.sec.gov/news/studies/2008/craexamination070808.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. The rating agencies' internal audit processes varied significantly.

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 Oversight Conflicts of Interest 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 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. 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 NRSRO’s objectivity; prohibit gifts from those who receive ratings to those who rate them, in any amount over $25.

Statutory Structure (Cont.) Transparency Competition Governance 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 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 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. 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 product’s sponsors. Prohibition of use of non-public information for profit.

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 investor’s 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