Global Financial Markets & The Recent Credit Crisis: Impressions from a Personal Journey and Lessons for the Future


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This presentation in two parts was given at a Royal Holloway University London (RHUL) event on 22 March 2012. Part 1 covers CRAs and Part 2 covered career tips for students interested in the financial markets.

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Global Financial Markets & The Recent Credit Crisis: Impressions from a Personal Journey and Lessons for the Future

  1. 1. Global Financial Markets &the Recent Credit Crisis:Impressions from a Personal Journey andLessons for the FutureMarkus Krebsz22 Mar 2012Evening Lecture & Student Event
  2. 2. 1) ‘Lessons from the Financial Crisis’Lesson 1: Use of Credit Rating agencies (CRAs)Lesson 2: What are CRAs?Lesson 3: Inter-agency comparability?Lesson 4: ’Super Seniors’ (Intra-agency comparability)?Lesson 5: Definition of ‘Rating’Lesson 6: Captured risksLesson 7: Constructive criticismLesson 8: FailuresLesson 9: Risk of Over-Reliance & MitigantsLesson 10: Using CRAs’ analysis sensibly __________________________________________Appendix: Origin & History, Global CRAs, Rating scope, Rating actions & Process, Benefits, Limitations 2
  3. 3. Lesson 1:Use of CreditRating agencies 3
  4. 4. Q) Who uses credit ratings – and why? 4 Source:
  5. 5. WHO uses ratings …Banks, Other Financial Institutions, Originators & Issuers,Investors, Financial Regulators, Other Rating agencies, etc. …WHY are ratings used…● Outsource analysis● Determine required economic and regulatory capital charges● Manage individual credit & portfolio risks● Feature as input into Structured Finance models (CDO2 etc.) 5
  6. 6. Lesson 2:What are CRAs? 6
  7. 7. Q) How many CRAs exist globally? 7
  8. 8. Source: New ‘concept’: Wikirating ( 8
  9. 9. WHAT are Credit Rating Agencies?• Rating agencies are intermediaries in capital markets• They collate and evaluate information on the issuer, and disseminate opinions to investors (and other interested parties)• Other intermediaries are banks and insurance companies• Issuers expect reduced cost of funds• Issuers expect access to broader investor pool• Increased role of rating agencies: - Financial disintermediation; bank/ borrower to issuer/ buyer - Regulation 9
  10. 10. Lesson 3:Inter-agencyComparability 10
  11. 11. Q) D (F) = D (S&P) = D (M) 11
  12. 12. RATINGS ‘MAPPING’ TABLE Fitch Ratings Moody’s Standard & Poors Mapped Long-term rating Short-term rating Long-term rating Short-term rating Long-term rating Short-term rating internal r a t i n g Investment Grade AAA Aaa AAA iAAA AA+ F1+ Aa1 AA+ iAA+ A-1+ AA Aa2 P1 AA iAA AA- Aa3 AA- iAA- F1+ or F1 A+ A1 A+ A-1 iA+ A F1 A2 P-1 or P-2 A A-1 or A-2 iA A- F1 or F2 A3 A- iA- P-2 A-2 BBB+ F2 Baa1 BBB+ iBBB+ BBB F2 or F3 Baa2 P-2 or P-3 BBB A-2 or A-3 iBBB BBB- F3 Baa3 P-3 BBB- A-3 iBBB- BB+ Ba1 BB+ iBB+ BB B Ba2 BB iBB Speculative Grade B BB- Ba3 BB- iBB- Ranges within B+ B1 B+ iB+ B-1, B-2 and B-3 B B2 B iB B- B3 Not Prime B- iB- CCC+ Caa1 CCC+ iCCC+ C CCC Caa2 CCC iCCC CCC- Caa3 CCC- C iCCC- CC Ca CC iCC C C C iC DDD, DD, D D Moody’s: D D D iDSource: Bloomberg, Fitch, Moody’s and S&P 12
  13. 13. 13
  15. 15. RATING PRINCIPLESFitch Ratings, Standard & Poor’s:Probability of default (PD) = First dollar of loss What is the ultimate default risk?Moody’s:Expected loss (EL) = [(PD) X (LGD)] What is the amount of net loss suffered? 15
  16. 16. STATISTICAL : Probability of Default 16
  17. 17. Lesson 4:‘SUPER SENIORS’( or: Intra-agencyComparability) 17
  18. 18. Q) SF Bond - Tranche 1 rated AAA= SF Bond - Tranche 2 rated AAA? 18
  19. 19. ‘SUPER-SENIOR’ RATINGS SF Bond Tranche 1: AAAAA Tranche 2: AAAA Tranche 3: AAA Tranche 4: AA+ Tranche 5: A Tranche 6: BBB- Tranche 7: BB Tranche 8 B+ First Loss piece: NRSource: 19
  20. 20. Lesson 5:Definition of‘Rating’ 20
  21. 21. Q) How would you define ‘rating’? A) Benchmark measure B) Benchmark measure for LGD for PD C) Opinion D) Not necessarily based on facts or knowledge 21
  22. 22. RATING DEFINITION• An opinion… * [Financial journalists]• …on the relative ability…• …of an entity to meet financial commitments. *…view not necessarily based on fact or knowledgeRatings are benchmark measures of…• Probability of default (PD)• Expectations of Loss given default (LGD) 22
  23. 23. Lesson 6:Captured Risks 23
  24. 24. Q) Which RISKS are captured by credit ratings? A) Credit & Market risk B) Credit, Market & Operational risk C) Credit, Market, Operational, Liquidity & Basis risk D) None of the above 24
  25. 25. RATINGS……can capture: …do NOT capture:Credit risk  Market risk   Liquidity risk   Operational risk only !  Basis risk (IR risk)  …but, even so, are ’hard-wired’…• by Basel II• into banks’ credit rating models• Investment guidelines and Asset management mandates 25
  26. 26. Lesson 7:ConstructiveCriticism 26
  27. 27. CONSTRUCTIVE CRITICISM• Business model: Too slow to react• Assumptions, methodologies & models• Conflict of interest (‘issuer-pays’ model)• Limited capture• Split ratings• Notching of competitor’s ratings• Implied ratings & internal competition• “Getting it wrong”• etc. 27
  28. 28. Regional problem GLOBAL IMPACT(Sub-prime mortgages) (SF Bond Tranche Downgrades) 28
  29. 29. Lesson 8:Failures 29
  30. 30. FAILURES AIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic banks, Lehman Bros., Monolines, Northern Rock, Parmalat, Sovereigns (Eurozone), Sub-prime bonds etc.In their own words...Fitch: “… did not foresee the magnitude of the decline…or the dramatic shift in borrower behavior…”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...”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…”Source: US Government Oversight and Reform Committee, Oct 2008 30
  32. 32. OPERATIONAL RISKS• Changing Rating methodologies and assumptions• Time lag of rating actions• Rating model risks• ‘Fat fingers’, i.e. technical glitches• Striking the right balance between non- and over-regulation 32
  33. 33. RISK MITIGANTS• Understanding the meaning & limitations of ratings• Understanding instruments’ risks• Independent analysis• Internal ratings• Disputing rating decisions with the agencies• Awareness that agencies CAN and DO get their ratings wrong (Operational risk scenario) 33
  34. 34. 10:UsingCRAs’analysissensibly 34
  35. 35. SENSIBLE USE of CRAs’ Analysis• Fully understand the instrument you are investing in – particularly when using other peoples’ monies• Understand ratings’ limitations and know how to mitigate rating-related risks (previous slide)• ‘Ignore’ ratings designators (i.e. AAA etc.) and focus on CRAs’ analytical narrative instead• Look out for what is NOT there in the narrative but should e.g. Why are obvious issues missing in the analysis? Why has this bond not been rated by all three CRAs?• Apply common sense and trust your gut feeling 35
  36. 36. Q) Would you now give CRAs more or less credit? More ? Less ? 36
  37. 37. APPENDIX: Origin & History Global Rating Agencies The Rating Process Benefits Limitations 37
  38. 38. ORIGIN & HISTORY 1922 – Standard Statistics company1841 – 1st mercantile rating agency  Founded by Louis Tappan 1924 – Fitch Publishing company  Rating merchants’ ability to pay  Taken over by Robert Dun 1933 – Merger: Dun & Bradstreet  Becomes owner of Moody’s in 19621849 – 2nd rating agency established  By John Bradstreet 1941 – Merger: Standard & Poor’s1859 – 1st rating guide published 1966 – Takeover: S&P by McGraw Hill  By Robert Dun’s agency 1975 – Fundamental change1909 – Moody’s founded  Business model  By John Moody  ‘Subscriber-pays’ to ‘Issuer-pays’  ‘Manual of Railroad Securities’ 2007 to 2011 – Global credit crisis1916 – Poor’s Publishing Company  Part blame for market collapse  Publishes its first ratings guide  New rating agency regulation 38
  39. 39. WHO PROVIDES RATINGS?• More than 2,400 institutions worldwide• Ratings and analysis track debt covering more than: • 100 sovereign nations • 11,000 company issuers • 25,000 public finance issuers • 70,000 structured finance obligations• Employs more than 2,400 people worldwide, ~1,000 analysts.• Rates 170,000 corporate, government and structured finance 39
  40. 40. • 6,300 employees• Located in 21 countries and markets• Has played a leading role for more than 90 years• Ratings on US$ 34 trillion of debt issued in 100+ countries• Issuers and debt obligations of corporations, states and municipalities, financial institutions, insurance companies and sovereign governments• Ratings, indices, equity research, risk solutions  S&P U.S. Indices  S&P/Citigroup Global Equity Indices  S&P Emerging Market Indices  S&P Alternative or 40
  41. 41. • Dual-headquartered in NY & London• 90 countries 1,500 employees  3,100 financial institutions  1,600 banks  1,400 insurance companies.  1,200 corporates, 89 sovereigns, 45,000 municipal transactions.  8,600 structured finance transactions under surveillance, including 4000 RMBS pools, 440 CMBS, 1600 ABS, and 600 CDOs.  1200 European & 200 Asian structured finance 41
  42. 42. RATINGS SCOPEPublicly ratedPrivately ratedCredit assessmentMarket-Implied ratings (CDS, Equity, Spread, Price etc.) 42
  43. 43. RATING ACTIONSRating SuffixDEAL STAGE RATING WATCH (1-6 months)• Preliminary • Positive• Final • Negative• Paid in Full (PIF) / • Evolving / Uncertain RedemptionINDICATORS OUTLOOK (1-2 years)• Upgrade, Downgrade • Positive• Affirmation / Confirmation • Negative• Withdrawn • Stable 43
  44. 44. THE RATING PROCESS: A detailed view (Part 1) Source: Moody’ s, S&P, Fitch Ratings 44
  45. 45. THE RATING PROCESS: A detailed view (Part 2) Source: Moody’ s, S&P, Fitch Ratings 45
  46. 46. BENEFITSTo Investors To the company (issuer)• Safety to investments • Easier to raise funding• Recognition of Risk & • Reduced cost of borrowing Returns • Reduced cost of public• Freedom of investment issuance (bonds) decisions • Ratings help increase image• Wider choice of & reputation investments • Facilitation of growth• Dependable credibility of • Access to wider investor issuer base• Easy understanding of • Recognition of relatively investment proposals unknown companies• Continuous monitoring (Surveillance) 46
  47. 47. LIMITATIONS• Non-disclosure of significant information• Static study of present and past historic data at one particular point in time• Rating is no certificate of soundness and users of ratings should form an independent view of the meaning of the particular rating• Rating may be biased due to certain views of the lead analysts• Rating under unfavourable conditions which may not always be representative of the true image of the company• Differences in rating grades: split ratings between different rating agencies which may confuse investors 47
  48. 48. TIMELY ACTIONS and DEFERRALTimeliness of Rating changes Bond maturity profile • Process stages to reach • Legal final vs. expected rating decisions maturity • Detection of bond- vs. • Life-time ratings (40+ years) asset class-specific • Timely payment of interest & and/or systemic issues ultimate payment of principal31 July 07 20 Aug 07 31 Aug 07 9 Oct 07 16 Oct 07 25 Oct 07Cut-off date CRA analyst Proposal: RWN CRA Analyst Proposal: DG Indiv. or Asset-class? Bulk rating actions & Report format & frequency, Analyst’s experience, Models, Quorum ... Criteria 15 Aug 07 27 Aug 07 25 Sept 07 12 Oct 07 23 Oct 07 You get Distribution st 1 Analysis result st 1 Committee nd 2 Analysis result nd 2 Committee the idea... Changes 48
  49. 49. 49
  50. 50. 2) ‘Tips & Tricks for working in the Financial Markets’ Topic 1: Personal traits Topic 2: Professional attitudes & values Topic 3: Opportunities __________________________________________ Appendix: Presenter biography, Book information 50
  51. 51. “…The Only Constant = Change…” 51
  52. 52. “…Know where to find it…” 52
  53. 53. “…Pay it forward…” 53
  54. 54. “…Vitamin B…” “…Physical health…”“…Sufficient Sleep…” “…Emotional health…” 54
  55. 55. “…Gut feeling / Instinct…” “…Positive Thinking…”“…Common sense is not so common…” “…Mind Maps…” 55
  56. 56. “…Personal &Professional Values…” “…Business Ethics & Code of Conduct” 56
  57. 57. Desk / Network banking: Perception vs. Reality…” “…Investment“…Know what happens to it when it leaves your desk…” “…Sum of All Job Specs does not add up to 100%...” 57
  58. 58. “…Things other don’t want to do…can be very rewarding…” “…find your ‘Niche’, Specialism – or Island if you must…” 58
  59. 59. “…Walk away… …for 5mins every hour… …for 30mins over lunch… …at a reasonable time at night… …or completely if you had enough…” 59
  60. 60. “…If you want to walk on water……you got to get out of the boat!...” 60
  61. 61. “…Mundane tasks need also doing – make the most out of them…” “…Enjoy the Ride…” 61
  62. 62. “…Be a Diplomat…” “… ‘BS’ Detector…” “…Put yourself into someone else’s shoes…” “…Understand your firm’s culture…” 62
  63. 63. 63
  64. 64. “…Under-promise & Over-deliver…”“…Don’t keep the manager awake…” “…Be the solution to your bosses’ problem(s)…” 64
  65. 65. [This page has been unintentionally left blank] 65
  66. 66. “Opportunity is missed by most people, because it is dressed in overalls and looks like work.” (Thomas A. Edison 1847 – 1931) 66
  67. 67. CLOSEThank you very much for your attention, contribution and listening today!________________________________________________________________________________CONTACT:+ 44 (0) 79 85 065 | 67
  68. 68. Markus KrebszSubject matter expert : Rating agencies & Securitisation • Freelance Consultant with nineteen years experience in banking & financial institutions - thereof ten years covering rating agencies • Credit rating advisor for the World Bank as part of various large-scale projects involving GSEs of several African & Asian nations • Industry expert in credit rating agency as well as Structured finance-related issues and frequent speaker on international conferences • Author and passionate reviewer/editor of several risk workbooks • Frequent contributor to various industry working groups consulting regulators, exchanges and central banksPublications • ‘Securitisation & Structured Finance post Credit Crunch: A Best Practice Deal Lifecycle Guide’, John Wiley & Sons Inc., Apr. 2011 • ‘Product Taxonomy: A Key Tool for Understanding Risk/Return within the Banking Framework’ Qfinance chapter, exp. Jan 2012 • ‘Investor Requirements for 2011 and beyond: Due diligence and Risk analysis in a post-crisis world’, Euromoney Yearbook chapter • Workbooks of the Chartered Institute for Securities & Investments (CISI): ‘Derivatives’ (Senior Reviewer), ‘IT in Investment Operations’, (Senior reviewer), ‘Operational Risk’ , (Senior reviewer) & ‘Risk in Financial Services’, (Technical Reviewer) • ‘Frontiers of Risk management – Chapter 14: Credit rating agencies and the IRB approach’, Euromoney Book, 2007 • Numerous special, research and criteria reports on Fitch Rating’s website as Performance & Rating analyst, Aug 2004 to Oct 2006 • SAP Risk Analyzer Manual (in-house publication, in German), Jan 2002Professional qualifications & affiliations Assignments (Past & current) • Individually Chartered Member of the Chartered • The World Bank Securities and Investment Institute (CISI) • Deutsche Bank & UBS • Bachelor of Banking Services and Operations, CCI • Lloyds Banking Group • ‘Train the Trainers’ Certificate • Bank of Scotland Treasury • ‘Banking in Britain’ Certificate • The Royal Bank of Scotland Group • German Banking Certificate (‘Bankkaufmann’) • HypoVereinsbank / Unicredit • Volunteer at and Member of the Professional Risk • Dresdner Bank Manager’s International Association (PRMIA) • Primary insight (Subsidiary of Bear Stearns) • Member of the Global Association of Risk • De Matteo Monness (Subsidiary of Goldman Sachs) Professionals (GARP) • Fitch / • Vista Research (Subsidiary of Standard & Poor’s) 68
  69. 69. More on Credit ratings and Analytical tools can be found here: A special offer for a 30% discount (of the RRP) for orders is currently available for a limited time only, if the order is placed directly at the publishers website and the promotion code VA817 is entered. Thank you for your interest. 69