Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions

1
Where Did the Risk Go? How Misapplied Bond
Ratings Cause Mortgage Backed Securities and
Collateralized Debt Obligation Market Disruptions

• Joseph R. Mason, Associate Professor of Finance,
  Drexel University
• Joshua Rosner, Managing Director, Graham Fisher
  Co.

DISCLAIMER NOTHING IN THIS REPORT SHALL BE
CONSTRUED TO BE LEGAL OR INVESTMENT ADVICE. IT IS
NOT INTENDED TO BE CONSIDERED OTHER THAN THE
OPINIONS OF ITS AUTHORS AND DOES NOT PROPOSE
SPECIFIC ADVICE ON ANY SECURITIES OF ANY
PARTICULAR ISSUER OR COMPANY. THE INFORMATION AND
RECOMMENDATIONS CONTAINED HEREIN ARE BELIEVED TO
BE ACCURATE - HOWEVER NO GUARANTEE OR WARRANTY
EXPRESSED OR IMPLIED IS GIVEN.
2
I. Unrecognized Risk and Bond Ratings

• Securitization cant make risk go away, but it
  can cause risk to get lost.

3
Figure 1 Residential MBS Yield Spreads, MBA Refi
Index, and 2x10 Swaption Volatility
Source Nomura (2005)
4
Figure 3 Defaults on ABS and RMBS, 1994-2005
Source Fitch IBCA (2006)
5
Figure 5 U.S. Home-Price Appreciation
Source Nomura (2007)
6
Figure 6 ABXHE Tranche Spreads for Pricing RMBS
Source Nomura (2007)
7
II. Structural Changes in the Bond Rating
Industry The Move from Passive to Active

• A. A Brief Background on the Role of Credit
  Rating Agencies
• B. Are Credit Rating Agencies Still Publishers or
  Are They Underwriters?
• C. New ConflictsThe Buy Side
• D. The Problems With Ratings In Structured
  FinanceEvolving Models
• E. Regulatory Issues
• F. Rating Agencies Are Activist in Ways They Have
  Never Been
• G. Other Legal Risk Securitization Law

8
A Brief Background on the Role of CRAs

• Historically
• Approach, in both policy and practice, is
  intended to provide a consistent framework for
  risk assessment that builds reasonable ratings
  consistency within and across sectors and
  geographies- SP

9
A Brief Background on the Role of CRAs

• Newer structured products required agencies to
  develop new models to rate newer securitized
  assets learning by doing

10
A Brief Background on the Role of CRAs

• Significant changes to meaning and manner in
  which they are employed
• Uncertainty about the meaning of original
  ratings is significant Nomura
• Can specific structured finance products with a
  AAA credit rating produce a return of up to 200
  bp for investors, while a AAA corporate or a AAA
  MBS tranche produces only a 10/20 bp return? What
  does that mean? AMF
• Strengthened the power or partner monopoly of
  Moodys, SP and Fitch - Sean Egan

11
A Brief Background on the Role of CRAs

• Unlike traditional, single issuer debt offerings
  there is a great amount of concentration in the
  structured finance industry

12
Figure 8 Quarterly Revenue by Segment Q1 2002
to Q4 2006
A Brief Background on the Role of CRAs
Agency revenues have increasingly been generated
by issuers of structured financial securities.
Source Moodys (2007)
13
A Brief Background on the Role of CRAs

• CRA process in Structured Finance pose new risks.
• CRA Methods in Structured Finance may amplify
  risks.

14
A Brief Background on the Role of CRAs

• Broad base of Issuers, Law Firms, Corporate
  Management, Allowed, Investors
• Less complex legal structures
• Lengthy legal precedent on structures
• Empiracle based models
• Issuers are dynamic
• Rating is a passive opinion
• Structures transparent
• Structures liquid
• Issuers generally issued for economic business
  management purpose

• Concentration of Issuers, Law Firms, Buyers,
  Structure Management (Servicer, CAM)
• Complex Legal Structures
• Relatively little legal precedent on structures
• Statistically based models
• Issuers are usually static
• Rating is more active iterative process
• Structures opaque
• Structures often illiquid
• Issuers often issue for speculative returns
  purpose

15
A Brief Background on the Role of CRAs

• The rating of structured securities helped drive
  new mortgage product development

16
Are the CRAs Still Publishers or are they
Underwriters?

• Historically, ratings are merely opinions or
  worlds shortest editorial - Fitch
• First Amendment Protection
• ratings are speech and would receive the
  heightened protection of the actual malice
  standard.

17
Are the CRAs Still Publishers or are they
Underwriters?

• Are the CRAs Still Publishers or are they
  Underwriters?
• Journalists should
• Test the accuracy of information from all sources
• Identify sources whenever feasible
• Always question sources motives before promising
  anonymity.
• Distinguish between advocacy and news reporting.
• Recognize a special obligation to ensure that the
  public's business is conducted in the open
• Source Society of Professional Journalists Code
  of Ethics.

18
Are the CRAs Still Publishers or are they
Underwriters?

• International Organization of Securities
  Commissions Code states the rating Agencies
  should adopt, implement and enforce written
  procedures to ensure that the opinions it
  disseminates are based on a thorough analysis of
  all information known to the CRA that is relevant
  to its analysis according to the CRAs published
  rating methodology.
• IOSCO Code at 1.1

19
Are the CRAs Still Publishers or are they
Underwriters?

• Rating agencies state they have
• no obligation to verify or audit any information
  provided to it from any source or to conduct any
  investigation or review, or to take any other
  action, to obtain any information that the issuer
  has not otherwise provided - Fitch
• no obligation to perform, and does not perform,
  due diligence with respect to the accuracy of
  information it receives or obtains in connection
  with the rating process. Moodys does not
  independently verify any such information. Nor
  does Moodys audit or otherwise undertake to
  determine that such information is complete.
  Thus, in assigning a Credit Rating, Moodys is in
  no way providing a guarantee or any kind of
  assurance with regard to the accuracy,
  timeliness, or completeness of factual
  information reflected, or contained, in the
  Credit Rating or any related Moodys publication
  - Moodys

20
Are the CRAs Still Publishers or are they
Underwriters?

• The (Securities and Exchange) Commission has
  emphasized that, NRSROs, as registered investment
  advisers under the Investment Advisers Act of
  1940, have a special duty to base their opinions
  upon current and adequate information. - SEC

21
Are the CRAs Still Publishers or are they
Underwriters?

• The Securities Act of 1933 States
• Underwriter - broad enough to encompass all
  persons who engage in steps necessary to the
  distribution of securities. - Harden v
  Raffensperger, Hughes
• Congress knew of the collateral participation
  concept and employed it in the Securities Act . .
  .The Court's footnoted discussion makes clear
  that, in its view, one who participates, or
  takes part in, an underwriting is subject to
  section 11 liability. - Harden v Raffensperger,
  Hughes

22
Are the CRAs Still Publishers or are they
Underwriters?

• Under Rule 436(g), the rating agencies have
  enjoyed exemption from Section 11 liability under
  the 1933 Act
• It seems that the role of rating agencies is a
  necessary function of structured products their
  sale and distribution.

23
Are the CRAs Still Publishers or are they
Underwriters?

• Interactions with other parties also paid by the
  issuing client raise further questions
• Attorneys Rating agencies do not always use
  outside counsel, they ask, on a regular basis
  arrangers lawyers to give them some of the
  analysis originally destined for the arrangers on
  questions that concern all parties in the event
  a law firm acts for different participants on the
  same deal, there could be a potential conflict of
  interest.- Authorities des Marches Financiers
• Accountants Certified public accountants are
  precluded from issuing written reports on the
  application of accounting principals to a
  hypothetical transaction - Deloitte Touche LLP
  to Jonathan Katz, SEC

24
New Conflicts - The Buy Side

• In structured finance there is an increased need
  for investors to rely on the rating agencies.

25
New Conflicts - The Buy Side

• Rating Agencies have responded to structured
  finance investors needs with new products that
• provide(s) present values and calculate
  book-level hedging requirements. - Fitch RAP CD
• Give investors full access to.. in-house team of
  quants and market risk specialists, thereby
  enabling them to out-source the entire CDO risk
  management process to third party experts -
  Fitch RAP CD

26
New Conflicts - The Buy Side

• Should they provide secondary market values, in
  illiquid assets, on structures they may have
  rated at issuance?

27
Evolving Models

• Agencies claim all products they are asked to
  rate are subject to a common rating process

28
The Problems with Ratings in SF - Evolving Models

• Agencies rarely re-rate existing structures
• New methods are rarely retrospective
• Lack of transparency makes it difficult to
  determine whether these adjustments, in part or
  in aggregate, would have a meaningful impact to
  existing structures.
• Ability of Collateral Managers to reinvest may
  increase these risks

29
The Problems with Ratings in SF - Evolving Models

• A hypothetical example of risk
• Assume a 2005 Issued Market Value CDO that is
  invested in subprime RMBS assets from 2003, 2004,
  2005
• In 2006 an agency increases required collateral
  support for 2006 issued subprime MBS
• Could a Collateral Manager, in the revolving
  period, buy 2006 assets in his 2005 issue without
  increased collateral or change in rated risk?
• Sources suggest that they are often merely
  charged a standardized 50bp increase if any.

30
Evolving Risks - Models - Another Example

• Moodys the data fields essential for running
  the model were established when the model was
  first introduced in 2002. Since then, the
  mortgage market has evolved considerably, with
  the introduction of many new products and an
  expansion of risks associated with them -
  Moodys, April 3, 2007

31
The Problems with Ratings in SF - Evolving Models

• On April 3, 2007 Moodys requesting increased
  levels of loan details from mortgage
  securitizers the data fields essential for
  running the model were established when the model
  was first introduced in 2002. Since then, the
  mortgage market has evolved considerably, with
  the introduction of many new products and an
  expansion of risks associated with them.

32
The Problems with Ratings in SF - Evolving Models

• The existing data used as a primary field for
  running their proprietary mortgage rating system
  Moodys mortgage Metrics has not included
• Debt-to-income
• Appraisal type
• Originating lender
• The Company announced that new data fields they
  were requesting included
• Option Arm information
• Interest rate of loan at origination
• Indicators governing adjustments to loans
  interest rate
• Month of first reset
• How often the rate resets
• While the Company stated generally, in absence
  of key information assumptions are utilized
  though is it not clear how conservative those
  assumptions will prove to be

33
The Problems with Ratings in SF - Evolving Models

• Servicer Ratings and CDO CAM Ratings are
  similarly evolving Fitch Rating, for example,
  has profiled 66 CDO managers, about a third of
  which have some exposure to subprime debt and a
  backlog of about 60 new managers still need to be
  profiled - Reuters Feb. 28, 2007

34
Regulatory Issues

• The rating agencies offer little public
  disclosures of information on the training and
  number of rating staff
• There seems, even in the face of IOSCO Code
  requirements, no full legal separation of some of
  the businesses of some CRAs.

35
Rating Agencies are Activist in Ways They Have
Never Been

• One CRA seemed to become involved in GSE
  legislation by suggesting they would downgrade
  GSE debt if receivership language was included
  in the bill.
• First of all, Senator, if I may, let me start by
  saying that Standard Poors does not advocate
  positions on any legislation - SP President
  Kathleen Corbet
• I think a quote from a report by (SP analysts)
  would be, The slightest evidence that Congress
  would in any way agree to lessen its authority or
  cede it to others would in itself necessitate a
  rethinking of how much confidence bondholders
  should have that their interests would be taken
  into consideration in the case of a failed
  GSE. - Senator Reed

36
Rating Agencies are Activist in Ways They Have
Never Been

• The CRAs drove changes in Georgia
  predatory-lending legislation

37
Other Legal Risk - Securitization Law

• While the CRAs were vocal in their view that they
  could not rate unquantifiable legal risks to
  legal isolation and liabilities in
  securitization trusts, they
• Have not made such sweeping pronouncements after
  a NextBank securitization clause was abrogated by
  FDIC powers
• Nor have they made such grand pronouncements in
  the wake of LTV Steel in fact, in the wake of
  LTV Steel it was reported that Standard Poor's
  insisted that attorneys submitting true-sale
  opinions to the rating agency stop referring to
  LTV, noting that the court never made a final
  decision and that such citations inappropriately
  cast doubt on the opinion. Seven months later, in
  a delicately worded press release, SP withdrew
  that prohibition--apparently because lawyers
  refused to ignore such an obvious legal land
  mine.

38
Traditional Bond Ratings Do Not Properly Account
for RMBS Risks
Capital Capital
  Dynamic Static
Assets Dynamic Corporate Bonds CDOs
Static ??? RMBS/ABS
Four Main Implications
39
Figure 11 Expected Losses in Corporate and
Structured Finance Debt
1. SF Pool Losses are Moving Target
Source RR Consulting (2004)
40
Figure 12 Actual and Expected Losses on
Corporate Investments and Mortgage Pools
2. SF Pool Losses Dont Recover
Source RR Consulting (2004)
41
Figure 14 Skewed Mortgage Pool Loss Distributions
3. SF Pool Losses are Distributionally Skewed
Source Fitch IBCA (2007)
42
Figure 13 Statistical Distributions of
Cumulative Losses on Corporate Investments and
Mortgage Pools
4. Moving, Increasing, Skewed SF Pool Loss
Distribution Narrows Over Time
Source RR Consulting (2004)
43
Figure 15 Relying on Corporate Debt Rating
Methods Results in Late Downgrades on RMBS
Source RR Consulting (2004)
44
Figure 16 Consistent RMBS Performance Warrants
Credit Ratings Upgrades
Source RR Consulting (2004)
45
Figure 17 Expensive Credit Enhancement is Wasted
if the Loss Scenarios it Covers are Statistically
Less Likely Over Time
Source RR Consulting (2004)
46
Traditional Bond Ratings Do Not Properly Account
for RMBS Risks
Capital Capital
  Dynamic Static
Assets Dynamic Corporate Bonds CDOs
Static ??? RMBS/ABS
Four Main Implications 1. SF Pool Losses are
Moving Target 2. SF Pool Losses Dont Recover 3.
SF Pool Losses are Skewed 4. SF Pool Loss
Distribution Narrows Over Time
47
IV. THE COMPLEXITY OF RMBS MASKS RISK TRANSFER
48
Why does Complexity Matter?
49
Figure 21 Prepayment and Default Rates as a
Function of Mortgage Duration
Source Calomiris Mason (2007)
50
Figure 22 Common Prepayment Vectors used in
Prepayment Analysis
Source Fitch IBCA (2001)
51
Why does Complexity Matter?
52
Figure 23 Tranches Issued in European
Securitizations 1987-2003
Source Firla-Cuchra and Jenkinson (2005)
53
Table 2 Issues with the Given Number of Tranches
as a Percentage of All Issues Per Type (Mean
Number of Tranches Per Issue)
Source Firla-Cuchra and Jenkinson (2005)
54
Figure 24 Examples of Actual MBS Funding
Structures
Source ABSnet
55
IV. THE COMPLEXITY OF RMBS MASKS RISK TRANSFER
?
56
V. BOND RATINGS DO NOT ACCOUNT FOR CDO RISKS
Capital Capital
  Dynamic Static
Assets Dynamic Corporate Bonds CDOs
Static ??? RMBS/ABS
Four Main Implication Variants PLUS Arbitrage
57
Figure 25 CDO Capital Structure Arbitrage
through Vintage Substitution
Source Fitch IBCA (2007)
58

• A series of securities (tranches) are created
  backed by the pool of mortgages

• Which have different priorities in repayment, and
  thus different levels of risk and yields

• And pooled together into a trust

• Investors buy the individual securities

• Mortgages are originated

• Mortgage

• Higher priority of repayment

• Property

• Mortgage pool

• AAA

• Lower yield

• for purchase or refi

• Buy security purchased

• Mortgage PI

• Security PI paid

• Property

• AA

• Property

• A

• Property

• BBB

• BB

• Property

• B

• Higher yield

• Lower priority of repayment

• Unrated

• AAA

• Synthetics (e.g. ABX)

• CDO Pool

• AA

• A

• BBB

• Other RE and non-RE obligations

• BB

• B

• Unrated

59
Figure 27 Default Probabilities Used in SP CDO
Rating Criteria
Ratings Arbitrage CDO Ratings Methods Are Looser
than RMBS Ratings Methods, Even when CDOs are
Solely made up of RMBS
AA CDO
AA- ABS
Source Nomura (2006)
60
Figure 28 Annual Cash CDO Issuance
Source Lucas, Goodman, and Fabozzi (2006)
61
Figure 29 Subprime RMBS Compositions in CDOs
Grew Quickly over Recent Years
Source Fitch IBCA (2007)
62
Figure 30 Ratings Distribution of RMBS in CDO
Portfolios
Source Fitch IBCA (2007)
63
Figure 31 How Much and What Kind of MBS are in
CDOs?
64
Table 5 CDO Risk Premiums and Credit Spreads and
Macroeconomic Performance
Source DAmato (2005)
65
Figure 35 Mortgage-backed Security Spreads, Risk
Premia, and Eurodollar Futures
Source IMF (2007)
66
Figure 36 Exchange Rates for Selected Major
Industrial Countries
Source IMF (2007)
67
VIII. Policy Implications

• Opacity for New Products
• Ratings Reliance of ERISA Investments
• US Market Supremacy
• US Economic Ranking
• Consumer Spending
• Stagflation Potential

68
Where Did the Risk Go? How Misapplied Bond
Ratings Cause Mortgage Backed Securities and
Collateralized Debt Obligation Market Disruptions

• Joseph R. Mason, Associate Professor of Finance,
  Drexel University
• Joshua Rosner, Managing Director, Graham Fisher
  Co.

DISCLAIMER NOTHING IN THIS REPORT SHALL BE
CONSTRUED TO BE LEGAL OR INVESTMENT ADVICE. IT IS
NOT INTENDED TO BE CONSIDERED OTHER THAN THE
OPINIONS OF ITS AUTHORS AND DOES NOT PROPOSE
SPECIFIC ADVICE ON ANY SECURITIES OF ANY
PARTICULAR ISSUER OR COMPANY. THE INFORMATION AND
RECOMMENDATIONS CONTAINED HEREIN ARE BELIEVED TO
BE ACCURATE - HOWEVER NO GUARANTEE OR WARRANTY
EXPRESSED OR IMPLIED IS GIVEN.