Rating Agencies: The Risk Of Over-reliance On Ratings

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As presented to the Securities and Investment Institute\'s Risk Forum, London, 24 Feb. 2009.

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Rating Agencies: The Risk Of Over-reliance On Ratings

  1. 1. RATING AGENCIES: The Risk of Over-reliance on Ratings An “Insider’s” View Markus Krebsz, MSI SII Risk Forum, London - 24 Feb 2009
  2. 2. CONTENT <ul><li>Overview </li></ul><ul><li>Ratings </li></ul><ul><li>Application </li></ul><ul><li>Constructive criticism </li></ul><ul><li>Risks/Mitigants </li></ul><ul><li>Questions & close </li></ul>
  3. 3. OVERVIEW
  4. 4. QUESTION 1: <ul><li>How many (Credit) rating agencies exist globally ? </li></ul><ul><ul><li> </li></ul></ul><ul><ul><li> 3 to 5 </li></ul></ul><ul><ul><li>6 to 15 16 to 30 </li></ul></ul><ul><ul><li> </li></ul></ul><ul><ul><li>More than 30 </li></ul></ul>
  5. 5. <ul><li>1) A.M. Best Company, Inc. </li></ul><ul><li>2) Agusto & Co. Ltd. </li></ul><ul><li>3) Ahbor Rating </li></ul><ul><li>4) Apoyo & Asociados Internacionales S.A.C. </li></ul><ul><li>5) Bank Watch Ratings S.A. </li></ul><ul><li>6) BRC Investor Services S.A. </li></ul><ul><li>7) Calificadora de Riesgo, PCA </li></ul><ul><li>8) Capital Intelligence, Ltd. </li></ul><ul><li>9) Caribbean Information & Credit Rating Services Ltd. (CariCRIS) </li></ul><ul><li>10) Central European Rating Agency (CERA) </li></ul><ul><li>11) Chengxin International Credit Rating Co., Ltd. </li></ul><ul><li>12) China Lianhe Credit Rating, Co. Ltd. </li></ul><ul><li>13) Clasificadora de Riesgo Humphreys, Ltda. </li></ul><ul><li>14) Class y Asociados S.A. Clasificadora de Riesgo </li></ul><ul><li>15) CMC International, Ltd. </li></ul><ul><li>16) Companhia Portuguesa de Rating, SA (CPR) </li></ul><ul><li>17) Credit Analysis & Research Ltd (CARE) </li></ul><ul><li>18) Credit Rating Agency of Bangladesh, Ltd. (CRAB) </li></ul><ul><li>19) Credit Rating Information and Services, Ltd. (CRISL) </li></ul><ul><li>20) CRISIL, Ltd. </li></ul><ul><li>21) Dagong Global Credit Rating Co., Ltd. </li></ul><ul><li>22) Dominion Bond Rating Service (DBRS) </li></ul><ul><li>23) Duff & Phelps de Colombia, S.A., S.C.V </li></ul><ul><li>24) Ecuability, SA </li></ul><ul><li>25) Egan-Jones Rating Company </li></ul><ul><li>26) Equilibrium Clasificadora de Riesgo </li></ul><ul><li>27) European Rating Agency (ERA) </li></ul><ul><li>28) Feller Rate Clasificadora de Riesgo </li></ul><ul><li>29) Fitch Ratings, Ltd. </li></ul><ul><li>30) Global Credit Rating Co. </li></ul><ul><li>31) Interfax Rating Agency (IRA) </li></ul><ul><li>32) Investment Information and Credit Rating Agency (ICRA) </li></ul><ul><li>33) Islamic International Rating Agency, B.S.C. (IIRA) </li></ul><ul><li>34) Japan Credit Rating Agency, Ltd. (JCR) </li></ul><ul><li>35) JCR-VIS Credit Rating Co. Ltd. </li></ul><ul><li>36) Korea Investors Service, Inc. (KIS) </li></ul><ul><li>37) Korea Ratings Corporation </li></ul><ul><li>38) Lanka Rating Agency, Ltd. (LRA) </li></ul><ul><li>39) Malaysian Rating Corporation Berhad (MARC) </li></ul><ul><li>40) Mikuni & Co., Ltd. </li></ul><ul><li>41) Moody's Investors Service </li></ul><ul><li>42) National Information & Credit Evaluation, Inc. (NICE) </li></ul><ul><li>43) ONICRA Credit Rating Agency of India, Ltd. </li></ul><ul><li>44) P.T. Kasnic Credit Rating Indonesia -- Indonesia </li></ul><ul><li>45) P.T. PEFINDO Credit Rating Indonesia </li></ul><ul><li>46) Pacific Credit Rating (PCR) </li></ul><ul><li>47) Pakistan Credit Rating Agency, Ltd. (PACRA) </li></ul><ul><li>48) Philippine Rating Services, Corp. (PhilRatings) </li></ul><ul><li>49) RAM Rating Services Berhad (RAM) </li></ul><ul><li>50) Rapid Ratings International, Inc. </li></ul><ul><li>51) Rating and Investment Information, Inc. (R&I) </li></ul><ul><li>52) Rus Ratings </li></ul><ul><li>53) Seoul Credit Rating & Information, Inc. </li></ul><ul><li>54) Shanghai Credit Information Services Co., Ltd. </li></ul><ul><li>55) Shanghai Far East Credit Rating Co., Ltd. </li></ul><ul><li>56) Slovak Rating Agency, a.s. (SRA) </li></ul><ul><li>57) SME Rating Agency of India Limited (SMERA) </li></ul><ul><li>58) Sociedad Calificadora de Riesgo Centroamericana, S.A. (SCRiesgo) </li></ul><ul><li>59) Standard and Poors (S&P) </li></ul><ul><li>60) Taiwan Ratings, Corp. (TCR) </li></ul><ul><li>61) Thai Rating and Information Services Co., Ltd. (TRIS) </li></ul><ul><li>62) TheStreet.com Ratings, Inc. </li></ul><ul><li>63) Türk KrediRating (TCRating) </li></ul><ul><li>64) Veribanc, Inc. </li></ul>Source: www.defaultrisk.com
  6. 6. QUESTION 2: <ul><li>AAA (Fitch) = AAA (S&P) = Aaa (Moody’s) ? </li></ul><ul><ul><li> </li></ul></ul>
  7. 7. RATING PRINCIPLES <ul><li>Fitch Ratings, Standard & Poor’s: </li></ul><ul><li>Probability of default (PD) = First dollar of loss </li></ul><ul><li> What is the ultimate default risk? </li></ul><ul><li>Moody’s: </li></ul><ul><li>Expected loss (EL) = [(PD) X (LGD)] </li></ul><ul><li> What is the amount of net loss suffered? </li></ul>
  8. 8. QUESTION 3: <ul><li>D (Fitch) = D (S&P) = D (Moody’s) ? </li></ul><ul><ul><li> </li></ul></ul>
  9. 9. RATINGS MAPPING TABLE Moody’s: D Source: Bloomberg, Fitch, Moody’s and S&P
  10. 10. QUESTION 4: <ul><li>SF Bond 1 rated AAA (Fitch/ S&P/ Moody’s) </li></ul><ul><li>= SF Bond 2 rated AAA (Fitch/ S&P/ Moody’s) ? </li></ul>
  11. 11. <ul><li>Structure 2 </li></ul>SUPER-SENIOR RATINGS <ul><li>Structure 1 </li></ul><ul><li>Tranche 1: AAA </li></ul><ul><li>Tranche 2: AA+ </li></ul><ul><li>Tranche 3: A </li></ul><ul><li>Tranche 4: BBB- </li></ul><ul><li>Tranche 5: BB </li></ul><ul><li>Tranche 6: B+ </li></ul><ul><li>First Loss piece: NR </li></ul><ul><li>Tranche 1: AAA AA </li></ul><ul><li>Tranche 2: AAA A </li></ul><ul><li>Tranche 3: AAA </li></ul><ul><li>Tranche 4: AA+ </li></ul><ul><li>Tranche 5: A </li></ul><ul><li>Tranche 6: BBB- </li></ul><ul><li>Tranche 7: BB </li></ul><ul><li>Tranche 8 B+ </li></ul><ul><li>First Loss piece: NR </li></ul>
  12. 12. RATINGS
  13. 13. RATING DEFINITION <ul><li>An opinion … * [Financial journalists] </li></ul><ul><li>… on the relative ability … </li></ul><ul><li>… of an entity to meet financial commitments . </li></ul><ul><li>* </li></ul><ul><li> … view not necessarily based on fact or knowledge </li></ul><ul><li>Ratings are benchmark measures of… </li></ul><ul><li>Probability of default (PD) </li></ul><ul><li>Expectations of Loss given default (LGD) </li></ul>
  14. 14. RATINGS… <ul><li>… can capture: </li></ul><ul><li>Credit risk </li></ul><ul><li>by Basel II </li></ul><ul><li>into banks’ credit rating models </li></ul><ul><li>Investment guidelines and Asset management mandates </li></ul><ul><li>… do NOT capture: </li></ul><ul><li> Market risk  </li></ul><ul><li> Liquidity risk  </li></ul><ul><li> Operational risk  </li></ul><ul><li> Basis risk (IR risk)  </li></ul>… and are “hard-wired”…
  15. 15. STATISTICAL: Probability of Default Source: Fitch Ratings
  16. 16. RATINGS SCOPE <ul><li>Public </li></ul><ul><li>Private </li></ul><ul><li>Credit assessment </li></ul><ul><li>Market-Implied ratings </li></ul><ul><li> (CDS, Equity, Spread, Price etc.) </li></ul>
  17. 17. RATING ACTIONS <ul><li>Rating </li></ul><ul><li>DEAL STAGE </li></ul><ul><li>Preliminary </li></ul><ul><li>Final </li></ul><ul><li>P aid i n F ull (PIF) / Redemption </li></ul><ul><li>INDICATORS </li></ul><ul><li>Upgrade, Downgrade </li></ul><ul><li>Affirmation / Confirmation </li></ul><ul><li>Withdrawn </li></ul><ul><li>Suffix </li></ul><ul><li>RATING WATCH </li></ul><ul><li>Positive </li></ul><ul><li>Negative </li></ul><ul><li>Evolving / Uncertain </li></ul><ul><li>OUTLOOK </li></ul><ul><li>Positive </li></ul><ul><li>Negative </li></ul><ul><li>Stable </li></ul>
  18. 18. APPLICATION
  19. 19. RATINGS are used by … <ul><li>Banks, Other Financial Institutions, Originators & Issuers, </li></ul><ul><li>Investors, Financial Regulators, Other Rating agencies, etc. … </li></ul><ul><li>Outsource analysis </li></ul><ul><li>Determine required economic and regulatory capital charges </li></ul><ul><li>Manage individual credit & portfolio risks </li></ul><ul><li>Feature as input into Structured Finance models (CDO 2 etc.) </li></ul>in order to …
  20. 20. CON STRUCTIVE CRITICISM
  21. 21. FAILURES <ul><li>AIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic banks, </li></ul><ul><li>Lehman Bros., Monolines, Northern Rock, Parmalat, etc. </li></ul><ul><li>In their own words... </li></ul><ul><li>Fitch: “… did not foresee the magnitude of the decline…or the dramatic shift in borrower behavior…” </li></ul><ul><li>Moody’s: “ We did not . . . anticipate the magnitude and speed of the deterioration in mortgage quality or the suddenness of the transition to restrictive lending.” </li></ul><ul><li>S&P: “ it is now clear that a number of assumptions used in preparing ratings on mortgage-backed securities issued between 2005 and mid-2007 did not work.” </li></ul><ul><li>Source: US Government Oversight and Reform Committee, Oct 2008 </li></ul>
  22. 22. CRITICISM <ul><li>Business model: Too slow to react </li></ul><ul><li>Assumptions, methodologies & models </li></ul><ul><li>Conflict of interest (“issuer-pays” model) </li></ul><ul><li>Limited capture </li></ul><ul><li>Split ratings </li></ul><ul><li>Notching </li></ul><ul><li>Implied ratings & internal competition </li></ul><ul><li>etc. </li></ul>
  23. 23. THE RISKS OF OVER-RELIANCE - AND SUITABLE MITIGANTS
  24. 24. TIMELY ACTIONS and DEFERRAL <ul><li>Process stages to reach rating decisions </li></ul><ul><li>Detection of bond- vs. asset class-specific and/or systemic issues </li></ul><ul><li>Rating scope vs. time: </li></ul><ul><li>Bond maturity profile </li></ul><ul><li>Legal final vs. expected final maturity </li></ul><ul><li>Life-time ratings (40+ years) </li></ul><ul><li>Timely payment of interest & ultimate payment of principal </li></ul>Rating process: Timeliness of Rating changes
  25. 25. TIMELAG of RATING ACTIONS
  26. 26. OPERATIONAL RISKS <ul><li>Changing methodologies and assumptions </li></ul><ul><li>Timeliness of rating decisions </li></ul><ul><li>Model risks </li></ul><ul><li>Striking the right balance between non - and over -regulation </li></ul>
  27. 27. RISK MITIGANTS <ul><li>Understanding the meaning of ratings </li></ul><ul><li>Understanding instruments’ risks </li></ul><ul><li>Independent analysis </li></ul><ul><li>Internal ratings </li></ul><ul><li>Disputing rating decisions and methodologies with the agencies – is it really worth it? </li></ul><ul><li>Operational risk scenario: Awareness that agencies CAN and DO get their ratings wrong </li></ul>
  28. 28. QUESTIONS & CLOSE
  29. 29. Q & A <ul><li>For the Risk Forum </li></ul><ul><li>Has this presentation changed your view and perception of Ratings (= Opinion)? </li></ul><ul><li>Would you now give CRA more or less credit? </li></ul><ul><li>Do you think that CRAs should be properly regulated? </li></ul><ul><li>For the Presenter </li></ul><ul><li>Q1)…? </li></ul><ul><li>Q2)…? </li></ul><ul><li>Q3)…? </li></ul>
  30. 30. CONTACT <ul><li>Markus Krebsz </li></ul><ul><li>+44 (0) 79 85 065 045 </li></ul><ul><li>[email_address] </li></ul><ul><li>[email_address] </li></ul><ul><li>4most </li></ul><ul><li>Linen Hall </li></ul><ul><li>162-168 Regents Street </li></ul><ul><li>London, W1B 5TE </li></ul><ul><li>Tel. +44 (0) 207 038 3690 </li></ul><ul><li>www.4-most.co.uk </li></ul>
  31. 31. ANNEX: Ratings & Probability of Default (PD)

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