1. The Role of Credit Rating Agencies in the Sub-Prime Crisis Charles Cronin, CFA Head CFA Institute Centre, EMEA Wien/Vienna 2 nd June 2008 CRAs – their last call!

2. Page 2 Agenda ♠ Introduction ♠ What is Structured Finance? ♠ How did it all go wrong ♠ Can we blame the CRAs for …? ♠ Notching ♠ The CFA Institute Centre response ♠ The Regulatory response Acknowledgement to Arturo Cifuentes, MD Structured Finance at R.W.Pressprich & Co. New York for some of the slides in this presentation.

3. Page 3 What is Structured Finance? AlchemyGenius

4. Page 4 What is Structured Finance? The Basic Idea Water = 99 l Poison (  ) = 1l  = 0.01 or 1% 1%  is board line toxic Senior Bottle Water 90 l Poison 0.1 l  = 0.0011 Very Safe Mezzanine Bottle Water 6 l Poison 0.05 l  = 0.008 Drinkerable Equity Bottle Water 3 l Poison 0.85 l  = 0.221 Lethal Note – the amount of poison is unchanged only the allocation is different

5. Page 5 What is Structured Finance? Credit Risk - What is it? It is the Risk of Loss as a Result of a Debtor’s Inability or Unwillingness to Repay a Debt Inability (Cannot): WorldCom Unwillingness (Don’t Feel Like It): Argentina

6. Page 6 What is Structured Finance? Ratings and their meanings S&P - Fitch / Moody’s AAA / Aaa AA / Aa A / A BBB / Baa ________________________________________ BB / Ba B / B CCC / Caa CC / Ca C / C Investment Grade!? Non-Investment Grade aka “High Yield” or “Junk”

7. Page 7 What is Structured Finance? Issuer-Weighted Default Rates (Year 5) in % [*] % AAA/Aaa 0.163 AA/Aa 0.718 A/A 1.132 BBB/Baa 3.262 _________________________________________ % BB/Ba 9.833 B/B 22.451 CCC/Caa CC/Ca ≈ 40 C/C Important: ratings measure credit risk (they do not reflect liquidity, volatility, appreciation potential, etc.; ONLY Credit Risk) [*] Corporate Default and Recovery Rates, Moody’s Report, February 2007

8. Page 8 What is Structured Finance? Mechanics of a CDO Many Assets (rating ≈ B) $100 + Yield ≈ 9% Senior $70 Mezzanine $20 Equity $10 Assets Liabilities SPV Trust Cash flows (Waterfall) AAA/Aaa C = 6% BBB/Baa C = 8% Residual Unrated IRR = 20%

9. Page 9 So what went wrong?

10. Page 10 So what went wrong?

11. Page 11 So what went wrong?

12. Page 12 Can we blame the CRAs for …? Yes and no – Investors need to shoulder much of the blame ♠ Trustees/fiduciaries/managers at fault ♠ Seal of approval ♠ Failures of due diligence ♠ Credit constraint on bond portfolios ♠ Investment managers not incentivised to raise concerns

13. Page 13 Can we blame the CRAs for …? CRAs made some key contributions ♠ The smoking gun – AAA recovery 60¢ on the $1 ♠ Model failure ♦ Default correlations ♠ Failure to disclosure assumptions ♦ An assumption is an opinion ♠ CFAI Code & Standards ♦ Exercise diligence ♦ Act with reasonable basis

14. Page 14 Notching A dark practice? ♠ Unsolicited rating of debt ♦ An anecdote ♦ Sour grapes or sound advice?

15. Page 15 CFA Institute Centre response Capital Markets Policy Council ♠ Change in nomenclature for structured products ♠ Eliminate the use of the term “Investment Grade” ♠ Prohibit “Notching” ♠ Executive level compliance officer at CRAs ♠ Refrain from rating without “robust” analysis ♠ Strong SRO for CRAs In EMEA responded to CESR & IOSCO consultations

16. Page 16 The Regulatory response CESR – robust and uncompromising ♠ “immediate”, “short term”, “should step in” ♠ International CRA standard setter of all stakeholders ♦ International > European > Regulate ♠ Transparency > model assumptions/which methodology ♠ Human Resources > must be adequate for quality ♠ Monitoring > resourced for timely rating changes ♠ Conflicts of Interest > acceptable interaction w/ Issuers

17. Page 17 The Regulatory response IOSCO? ♠ Awaiting news