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Title: Operations and Regulation of the Credit Rating Industr

Operations and Regulation of the Credit Rating
  • Dec 16th 2008, Sanya, Hainan Island, China

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

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
  • 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

U.S. Housing Bubble Burst MBS issuance
Source BBC News
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?
Broad bank leverage globally
This cycle is unique with unprecedented leverage
  • 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,

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

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)

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

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
  • 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
  • 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
  • Provide additional information to understand
    better the full risk profile. Some options are
    margin of error, volatility of ratings, and
    analysis of extreme scenarios

CRAs and Structured Finance Markets -- Issues
  • Quality of Ratings
  • Rating structured finance products requires more
    sophisticated analysis than rating single name
  • In particular, one needs to model default
  • 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.

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
  • 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
  • Nov 2008 European Commission publishes a final
    proposal for a Regulation of the European
    Parliament and of the Council on Credit Rating
  • 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

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
  • 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

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
  • CRAs should assist investors in developing a
    better understanding of what a credit rating is
    (including its limitations)

European Commission Regulation Highlights
  • Three main objectives. Ensure that
  • Credit ratings are not affected by conflicts of
  • 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

SEC Rules on NRSROs and Credit Ratings
  • 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

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

A Portfolio Based Perspective of Credit Risk is
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
Correlations are primary drivers of systemic risk
  • Higher correlations increase systemic
    (non-diversifiable) risk

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

Did VaR forecast the U.S. Subprime crisis?
Responsive VaR estimators provided ample time to
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

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

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
  • 2. Conventional Rules Based
  • Classification of risks (operational, market,
    credit, liquidity, etc.)
  • Implementation of standardized risk measures
  • Risk controlled with policies, procedures, and
  • 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
  • Risk viewed as both danger and opportunity
  • Enterprise portfolio perspective, not just
    position level

The Cycle Of Risk Management
  • Risk management is a continuous process of
    identifying, measuring monitoring, and managing
  • 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
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
  • 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
  • Originators often dont have incentives to
    perform strong due diligence on the underlying
  • 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
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.

  • www.riskmetrics.com
  • asia_at_riskmetrics.com
  • Tel. 65 6826 9333

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