Operations and Regulation of the Credit Rating Industr

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Operations and Regulation of the Credit Rating
Industry

• Dec 16th 2008, Sanya, Hainan Island, China

Alan Laubsch alan.laubsch_at_riskmetrics.com
Jorge Mina jorge.mina_at_riskmetrics.com
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Agenda

• Background
• CRAs and Structured Finance Markets
• IOSCOs Code of Conduct
• European Commission Regulation
• SEC Rules on NRSROs and Credit Ratings
• Portfolio Perspective
• Integral Risk Management
• Final Observations and Recommendations

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Brief History

• Significant growth in subprime lending starting
  in 2000
• Home values started declining in the second half
  of 2006 leading to increased delinquencies and
  defaults
• Losses on loans had a direct adverse impact on
  market values and liquidity of RMBS and CDOs
  lined to subprime loans
• The subprime crisis spread to the broader credit
  market first and then to the economy as a whole
• Mortgage brokers, loan originators, underwriters,
  and credit rating agencies (CRA) involved in
  subprime deals have come under scrutiny for their
  role in the build up of this market

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U.S. Housing Bubble Burst MBS issuance
Source BBC News
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Tremendous growth in private sector leverage
Federal and Consumer Debt as of GDP 2

• Government Debt 1

(1) Office of Management and Budget, Budget of
the United States, FY 2007 (2) U.S. Chamber of
Commerce as of 8/27/08 Source P. Olivier
Sarkozy, The Carlyle Group, Overview Financial
Services Industry - What Went Wrong What Does
it Mean?
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Broad bank leverage globally
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This cycle is unique with unprecedented leverage
globally

• Multi-reference structured credit products like
  CDOs made it easy for investors to put on a huge
  amount of leverage
• Basel 2 rules only require banks to put aside
  0.56 regulatory capital for AAA securities
  implies leverage of almost 200x.
• 2.3 tril in AAA guarantees supported by six
  monoline insurers with less than 20 bil in
  equity (0.8). Source Pershing Square Capital
  Management. How to Save the Bond Insurers,
  11/07

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CRAs and Structured Finance Markets -- Issues

• Excessive Reliance on Ratings by Investors
• In structured products ratings are often not only
  viewed as a CRAs opinion on its
  creditworthiness, but also as a stamp of approval
  (despite CRAs disclaimers)
• Lack of information on the structures makes it
  difficult to make an independent assessment
• Non-sophisticated investors dont have the
  capabilities to make an independent assessment of
  the credit risk inherent in these securities
• Sophisticated investors might have the
  capabilities, but find it expensive to
  independently validate the CRAs work
• The originate-to-distribute model eliminates
  incentives for mortgage brokers, loan
  originators, issuers, and underwriters to perform
  an independent risk assessment
• Investors do not seem (even now) very keen on
  taking more responsibility for the risk
  assessment of these securities

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CRAs and Structured Finance Markets -- Issues

• Conflicts of Interest
• A potential conflict of interest arises through
  the issuer pays model
• The potential for conflict is greater in
  structured products
• Concentration the volume of deals from a single
  institution is often large and could result in a
  concentrated revenue stream from a single issuer
• Advice to achieve a rating CRAs provide
  information allowing arrangers to understand the
  link between model outputs and rating decisions
  with respect to the credit enhancement required
  to support a particular rating. Arrangers can
  consider the feedback and determine independently
  to make changes as long as the feedback process
  doesnt turn into advise from CRAs as to how to
  attain a desired rating
• One alternative to the issuer pays business
  model is to have issuers pay, but investors
  select how to distribute rating fees across CRAs
  (similar to equity research)

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CRAs and Structured Finance Markets -- Issues

• Competition
• Information on structured finance transactions is
  less transparent making unsolicited ratings more
  difficult to provide. The same information should
  be made available to all accredited CRAs
• Without unsolicited ratings new entrants have no
  opportunity to establish a track record
• Rating shopping issuers often ask CRAs for
  prospective assessments on structures before
  hiring them. Since issuers have clear incentives
  to seek the highest rating, this practice leads
  to claims that competitive pressure leads to
  ratings inflation

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CRAs and Structured Finance Markets -- Issues

• Transparency
• Structured finance products are complex and they
  should be treated as such
• Not differentiating between ratings of structured
  products and ratings of bonds can be confusing to
  investors
• The risk profile of a structured product is very
  different from the risk profile of a plain
  vanilla bond
• A bond either defaults or does not default so the
  credit loss profile can be reasonably well
  understood and distinguished from that of other
  bonds by a single number (or notch on a rating
  scale)
• Losses on a structured product depend on how many
  of the individual underlying loans default over a
  particular period of time. This means that two
  structured products can have the same average
  losses, but very different loss distributions.
• In other words, a single number (or notch on a
  rating scale) cannot capture the entire risk
  profile of a structured product making it
  difficult to compare similarly rated structured
  products and bonds
• Model assumptions have to be disclosed and
  explained
• Provide additional information to understand
  better the full risk profile. Some options are
  margin of error, volatility of ratings, and
  analysis of extreme scenarios

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CRAs and Structured Finance Markets -- Issues

• Quality of Ratings
• Rating structured finance products requires more
  sophisticated analysis than rating single name
  securities
• In particular, one needs to model default
  correlations
• Ex-post the assumed correlations turned out to be
  very low. The assumptions going into the models
  need to be refined and disseminated so market
  participants can understand them
• Potential conflict issue? Issuers typically
  retain the equity tranche and sell the senior
  tranche. With lower assumed correlations senior
  tranches appear to be less risky and equity
  tranches appear to be riskier.

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Regulatory Response

• The regulatory response has been quick and
  informed by recommendations from IOSCO, CESR,
  ESME, Financial Stability Forum (FSF), and the
  Presidents Working Group on Financial Markets
• There are three main bodies of regulatory work so
  far
• May 2008 -- IOSCO publishes a revision to the
  Code of Conduct Fundamentals for Credit Rating
  Agencies (not strictly regulatory, but all rating
  agencies have pledged to follow the code of
  conduct)
• Nov 2008 European Commission publishes a final
  proposal for a Regulation of the European
  Parliament and of the Council on Credit Rating
  Agencies
• Dec 2008 SEC publishes amendments and new rules
  relating to Nationally Recognized Statistical
  Rating Organizations and Credit Ratings
• The rules are not identical, but there is
  significant overlap in the three documents.
• IOSCOs Code of Conduct is widely considered the
  global benchmark, but the actual regulations are
  more specific in certain areas

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IOSCOs Code of Conduct Highlights

• Quality of the Rating Process
• CRAs should adopt measures so that the
  information used to assign ratings is of
  sufficient quality
• CRAs should review the feasibility of rating
  structures materially different from the ones
  they currently rate
• CRAs should determine whether existing
  methodologies and models are appropriate for a
  certain type of structure product (including the
  underlying securities)
• Integrity of the Rating Process
• CRAs should prohibit analysts from making
  recommendations regarding the design of
  structured products they rate
• CRAs Procedures and Policies
• A CRA should disclose if it receives 10 percent
  or more of its annual revenue from a single
  client
• CRAs as an industry should encourage structured
  finance issuers and originators to disclose all
  relevant information regarding those products so
  other parties can perform independent analyses

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IOSCOs Code of Conduct Highlights

• Transparency and Timeliness of Ratings Disclosure
• CRAs of structured products should provide
  sufficient information about its loss and cash
  flow analysis to understand the basis for the
  CRAs rating. Sensitivity analysis of rating
  assumptions should also be disclosed
• CRAs should differentiate ratings of structured
  finance products from traditional corporate bond
  ratings
• CRAs should assist investors in developing a
  better understanding of what a credit rating is
  (including its limitations)

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European Commission Regulation Highlights

• Three main objectives. Ensure that
• Credit ratings are not affected by conflicts of
  interest
• Credit ratings are of high quality
• CRAs act in a transparent manner
• Requirements are similar to (in fact based on)
  IOSCOs Code of Conduct, but it provides an
  enforcement mechanism by establishing a
  registration and surveillance framework
• CRAs have to register so that their ratings can
  be used for regulatory purposes by credit
  institutions, investment firms, insurance
  companies, UCITS, and pension funds established
  in the European Union
• Registration is separate from the existing
  process to be authorized as an External Credit
  Assessment Institution (ECAI) for the purposes of
  the Capital Requirements Directive (CRD) for
  banks

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SEC Rules on NRSROs and Credit Ratings
Highlights

• Final Rules
• New disclosure requirements to Form NRSRO
• Transition statistics (including defaults) for 1,
  3 , and 10 year periods
• How much verification is performed on securities
  underlying structured finance products
• How assessments of the quality of originators
  affect credit ratings
• More detailed information on the surveillance
  process and differences vis-à-vis initial ratings
• NRSROs have to make publicly available a random
  sample of 10 of their issuer-paid ratings and
  their histories in XBRL no later than six months
  after the rating is made
• Recordkeeping NRSROs need to maintain records
  of rating actions, the rationale for differences
  between a rating implied by a quantitative model
  and the final rating, and any complaint regarding
  the performance of a credit analyst in
  determining, maintaining, monitoring, changing,
  or withdrawing a rating
• NRSROs are prohibited from issuing ratings where
  the NRSRO or an affiliate made a recommendation
  as to how to attain a specific rating

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SEC Rules on NRSROs and Credit Ratings Highlights

• Proposed Rules
• NRSROs would have to disclose 100 of their
  current issuer-paid ratings in an XBRL format 12
  months after the action is taken (to protect CRAs
  data businesses)
• NRSROs would be prohibited from issuing a rating
  for a srtuctured finance product paid for by the
  issuer, sponsor, or underwriter unless the
  information provided to the NRSRO to determine
  the rating is available to other NRSROs
• Proposals still under discussion
• Differentiation of ratings for structured
  products from those for traditional bonds
• Elimination of references to NRSROs from certain
  SECs rules and forms

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A Portfolio Based Perspective of Credit Risk is
Essential
This simulation output shows the distribution of
credit portfolio
99.5 VaR
Expected loss
99.5Exp. Shortfall
One standard deviation
Horizon value if norating changes
Expected horizon value
Portfolio value at 1 year horizon
High chance of small gain with a small chance of
catastrophic loss
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Correlations are primary drivers of systemic risk

• Higher correlations increase systemic
  (non-diversifiable) risk

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Correlations loss distribution

• Higher correlations increase capital
  requirements, since more counterparties tend to
  default at together

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Did VaR forecast the U.S. Subprime crisis?
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Responsive VaR estimators provided ample time to
hedge
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An Integral Approach to Risk Management

• Its clear we need more than quantitative models
  to manage risk
• We will never have a perfect model of risk.
  Alan Greenspan
• Risk Management is a combination of art and
  science. Stephen Thieke
• "Integral" means balanced, comprehensive,
  interconnected, and whole
• We will apply Ken Wilbers Integral AQAL (All
  Quadrant All Levels and Lines) approach to
  highlight essential components of a strong risk
  management process
• Quadrants
• Lines
• Levels

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Integral Risk Management All Quadrants

• Ratings
• Measures
• Data

• Integrity
• Ability to question

• Regulations
• Systems
• Processes
• Policies
• Organization

• Culture of risk management

• See Ken Wilber, A Theory of Everything

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Levels 3 Stages of Risk Management

• 1. Pre-conventional Primal
• Emphasis on return
• Risk taking driven by gut instinct and emotions
  subjective view of risk
• Actions and thinking dominated by principals
• Focused on pieces (positions), not the whole
  (portfolio)
• 2. Conventional Rules Based
• Classification of risks (operational, market,
  credit, liquidity, etc.)
• Implementation of standardized risk measures
• Risk controlled with policies, procedures, and
  limits
• Hierarchical organization with clearly defined
  roles, including risk management function
• Focus on quantifying, controlling, and minimizing
  risk objective view of risk
• 3. Post Conventional Integral
• Proactive culture of risk management throughout
  the organization
• Constant engagement and discussion about risk
• Harness intelligence both within and outside the
  organization
• Risk viewed as both danger and opportunity
• Enterprise portfolio perspective, not just
  position level

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The Cycle Of Risk Management

• Risk management is a continuous process of
  identifying, measuring monitoring, and managing
  risk.
• The process begins with risk identification
• One of the most crucial targets is the
  identification of hidden risk concentrations

Risk managers need to be perceived like good
goalkeepers always in the game and occasionally
absolutely at the heart of it, like in a penalty
shoot-out. Source Economist.com, Confessions of
a Risk Manager
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Final Observations and Recommendations

• Structured products are very complex and
  additional information is required to understand
  their credit risk profile
• Portfolio effects (correlations) are very
  important. Correlation assumptions need to be
  disclosed together with sensitivity analysis
• Embedded leverage in the structure has to be well
  understood by investors
• Sensitivity of ratings changes with respect to
  model assumptions and credit scenarios would be
  helpful
• Credit ratings only measure risk due to credit
  events, investors also need measures of
  mark-to-market and liquidity risk
• Understanding the underlying securities is
  critical since securitization markets face
  information asymmetries that encourage lax
  lending
• Originators often dont have incentives to
  perform strong due diligence on the underlying
  loans
• Loans with FICO scores of 620 or above were
  highly likely to be securitized. It has been
  shown1 that subsequent loan performance was worse
  for loans slightly above the 620 threshold
  compared with loans where the score was slightly
  below 620

1Keys, B J, T K Mukherjee, A Seru and V Vig
(2008)
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Final Observations and Recommendations

• Sponsors of structured products should disclose
  all relevant information to CRAs and as much
  information as possible to investors
• All CRAs should have access to the same
  information regardless of whether they are
  retained to rate a specific product
• Information about the structure and the pool of
  underlying assets should be made available in
  machine readable format
• Disclaimer The views in this presentation are
  that of the authors and may not necessarily
  reflect those of RiskMetrics Group.

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