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
Authority on Ratings Artificially propped up demand Barriers to entry From 1975-2006 Vague NRSRO requirements Credit Rating Reform Act 2006
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
Subprime Securitization StructureSource: 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
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.
“There are two superpowers in the worldtoday in my opinion. Theres the UnitedStates and theres Moodys Bond RatingService.”Thomas Friedman (NYT), Feb. 13, 1996
Credit Rating BusinessCredit rating agencies sell Ratings (or “opinions”) not statements of facts and certainly not investment advice Advice to rated firms Credit Rating Advisory Services
Current Business ModelCredit agencies are paid By investors prior to 1970s By rated issuers or by underwriters now
So, who should pay? Issuers? Provides benefits via rapid dissemination of ratings. Strong potential conflict of interest Power to suppress unwanted ratings
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
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
Conflicts of Interest 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
Conflicts of Interest Traditional corporate bond rating business Large base of clientele Lower profit margin Reputation risk
Deepened Conflicts of Interest Structured finance business A handful of banks Excessively high profit margin Rating shopping Huge pressure for getting the deals done
In subprime crisis, ratingagencies 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
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)
Whom Can We Rely On…when there is no one to trust?
Views from ThreePerspectivesRegulators (SEC)InvestorsRating Agencies Themselves
SEC’s New Regulation onRating Agencies SEC’s Summary Report (July 2008) http://www.sec.gov/news/studies/2008/craex amination070808.pdf An evaluation report on Fitch, Moody, and S&P
Examinations Summary of SECReleasea substantial increase in the number and in the There was 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
SEC New Rules for Rating Agencies Additional requirements on the conduct of Nationally Recognized Statistical Rating Organizations (NRSROs) Release No. 34-59342, available at http://www.sec.gov/rules/final/2009/34-59342.pdf• Additional proposed rules for NRSROs Release No. 34-59343 available at http://www.sec.gov/rules/proposed/2009/34-59343.pdf
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
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 Commissions rules.
Statutory Structure Registration Oversight Conflicts of InterestRegistration at the SEC as The SEC has sole Appropriate policies and procedures toNRSRO. responsibility for manage and address conflicts of interest. supervision.Application includes The SEC has the authority to issue rulesinformation on: The SEC has no concerning conflict of interests related to:1. ratings’ performance say in the ratings’ 1.Compensation2. procedures and substance, 2.Consulting and advisory services 3.Personal and ownership conflictsmethodologies procedures and 4.Affiliation with issuers3. policies against misuse of methodologies. 5.Other conflicts of interest the SECprivate information deems necessary;4. organizational structure The SEC can5. code of ethics suspend or limit prohibit an NRSRO from issuing a rating6. conflicts of interest operations or where the NRSRO or a person associated7. 20 largest issuers or revoke the license with the NRSRO has madesubscribers if the NRSRO does recommendations as to structuring the8. certification of institutional not comply with same products that it rates;investors that the ratings are the regulation orconsidered significant fails to maintain prohibit anyone who participates in adequate determining a credit rating from resources negotiating the fee that the issuer pays for to produce valid it, to prevent business considerations from ratings. undermining the NRSRO’s objectivity; prohibit gifts from those who receive ratings to those who rate them, in any amount over $25.
Statutory Structure (Cont.) Transparency Competition GovernancePeriodic private disclosure of financial conditions Require NRSROs to Prohibit an NRSRO make all of their ratings from issuing a ratingRequire disclosure by the NRSROs of whether and how and on a structuredinformation about verification performed on the assets subsequent rating product unlessunderlying a structured product is relied on in determining actions publicly information on thecredit ratings. available, to facilitate characteristics of comparisons of assets underlyingRequire disclosure of how frequently credit ratings are NRSROs by making it thereviewed; whether different models are used for ratings easier to analyze the product is available,surveillance than for initial ratings; and whether changes performance of the in order to allowmade to models are applied retroactively to existing ratings. credit ratings the other credit rating NRSROs issue in agencies to use theRequire NRSROs to make an annual report of the terms of assessing information to ratenumber of ratings actions they took in each ratings class. creditworthiness. the product and, potentially, expose aRequire documentation of the rationale for any Require NRSROs to rating agency whosematerial difference between the rating implied by a publish performance ratings were undulyqualitative model that is a “substantial component” in the statistics for one, influenced by theprocess of determining a credit rating and the final rating three and ten years product’s sponsors.issued. within each rating category, in a way Prohibition of use ofRequire NRSROs to differentiate the ratings they that facilitates non-publicissue on structured products from other securities, either comparison with information forthrough issuing a report disclosing how procedures and their competitors in profit.methodologies and credit risk characteristics for structured the industry.finance products differ from other securities, or usingdifferent symbols, such as attaching an identifier to therating.
Criticism to SECRegulations Too little, too late June 2008 Proposals – very bold; final document – very limited Any real desire to drastically reform or remake the industry? Dont wean investors off their reliance on credit rating agencies Do nothing to ensure accurate ratings A furtherance of the abdication of its responsibility
Some LegislativeSuggestions 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
Some LegislativeSuggestionsfrom consultancy and Separating rating 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
Some LegislativeSuggestions 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
As Investors… Be objective towards rating agencies and their ratings The investor’s reliance on rating results has an amplifying effect on the products
As Rating AgenciesThemselves… 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