Rating Agencies and Financial Crisis Asim Yaqub Kushal Bhalla Abbes Tangaoui Amir Zemoodeh

CREDIT RATING AGENCIES Firms that offer judgment about the credit- worthiness of debt instruments, specifically their likelihood of default Evaluate the securities of various companies against a probable default risk Providers of independent research and in-depth credit analysis Use different policies, procedures and practices comprising of rating models and rating criteria, assumptions, methodologies and etc

CREDIT RATING AGENCIES Agencies serve industrial groups by providing corporate ratings, financial institutions ratings, fund ratings, insurance ratings, governments ratings and structured finance ratings Rating agency team of credit rating agencies Various rating scales are used for investment grade (AAA, AA, A, BBB) and speculative grade (BB, B, CCC, CC, C) securities Three Bigs: Moody’s, S&P and Fitch

Rating Process Rating Company Rating Applicant Rating Group Rating Model Audited Financial Statements, Non-Financial Information (Shareholder Structure, Strategies, Market Share, …), Market and Industry Analysis, Macroeconomic Analysis Rating Company Management meeting with high level managers Rating Committee

Moody’s Methodology to Rate RMBS Independent Third Party Collateral Key Borrower Characteristics (FICO Score, Documentation) Key Property Characteristics (Location, Occupancy) Key Loan Characteristics (Loan to Value Ratio, Loan Term, …) Simulation of Default by Scenario analysis Calculate Loss Distribution Moody’s Mortgage Metrics (MMM) Servicer Rating Committee Originator Legal Considerations Debt to Income Ratio Risk of Early Delinquency Macroeconomic Environment Mortgage Insurance Interest rates Home Price Changes Unemployment rates Macroeconomic Inputs

CRA’s Role in Financial Crisis Quantity and Complexity Rating Criteria Internal Documentation Surveillance Process Internal Audit Quality of Information Conflict of Interest

Conflict of Interests Legislation requires the SEC to adopt rules on the way CRA are paid to enhance reliability on ratings and post-rating surveillance prohibits rating agencies from providing services other than rating services to companies that contract for rating

Corporate Governance Regulators seek to improve corporate governance practices at credit rating agencies Require credit rating agencies or their parent companies to have a board of directors, to assume responsibility of sensitive functions for credible ratings Clarify and expand the authority of the compliance officer Ensure the independence of the compliance officer

Regulatory Oversight Regulation stipulates the creation of new office within the SEC to oversee ratings agencies Rating agencies will be required to be registered with the SEC The SEC will conduct inspections for compliance with procedures for reliable ratings Authorize the SEC to impose fines for violations

Liability Legislation reduces significantly CRA liability protection

Reliance on Ratings To reduce reliance on ratings, regulators have two different approaches: House bill eliminates reliance on ratings entirely and the Senate bill requires only a GAO study

Transparency Regulators require new disclosure requirements from credit rating agencies The rating methodologies The quality of data Business relationships that may create conflicts of interest disclosure of post-rating surveillance practices

Universal Ratings Scale Reforms require NRSROs to implement clear policies and procedures to assess default risks, to clearly define different symbols for structured finance products, to indicate that theses products may carry high risk