1. The Role of the CREDIT Rating Agencies

2. 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

3. Authority on Ratings Artificially propped up demand Barriers to entry
From Vague NRSRO requirements
Credit Rating Reform Act 2006

4. 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

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 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.

8. Sources: WSJ, Financial Statements,
ewrockwell.com

9. I know it was bad, but…

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, 1996
T. Friedman on NPR news 1996

11. 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

12. Current Business Model
Credit agencies are paid
By investors prior to 1970s
By rated issuers or by underwriters now

13. So, who should pay? Issuers?
Provides benefits via rapid dissemination of ratings.
Strong potential conflict of interest
Power 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 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

15. 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

16. 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

17. Conflicts of Interest Traditional corporate bond rating business
Large base of clientele
Lower profit margin
Reputation risk

18. Deepened Conflicts of Interest
Structured finance business
A handful of banks
Excessively high profit margin
Rating shopping
Huge 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 securities
failed to adjust those ratings sooner as the performance of the underlying assets deteriorated
Internal 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)
Investors
Rating 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 at
Additional proposed rules for NRSROs
Release No available at

26. 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

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; and
Amendments 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’ 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.

29. 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.

30. 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

31. Reform?
No Easy Answer

32. 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

33. 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

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 quality
Unsolicited Rating vs. Solicited Rating
encourage 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 clients
Hard to stick to neutrality and self-integrity
$25 cannot solve
Strengthening internal management
capital structure
internal governance
rating data base, theories, models