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

1. Criterion Economics L.L.C. 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.

2. I. Unrecognized Risk and Bond Ratings Criterion Economics L.L.C. 2 Securitization can�t make risk go away, but it can cause risk to get lost.

3. Criterion Economics L.L.C. 3 Figure 1: Residential MBS Yield Spreads, MBA Refi Index, and 2x10 Swaption Volatility

4. Criterion Economics L.L.C. 4 Figure 3: Defaults on ABS and RMBS, 1994-2005

5. Criterion Economics L.L.C. 5 Figure 5: U.S. Home-Price Appreciation

6. Criterion Economics L.L.C. 6 Figure 6: ABX:HE Tranche Spreads for Pricing RMBS

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 Conflicts�The Buy Side D. The Problems With Ratings In Structured Finance�Evolving Models E. Regulatory Issues F. Rating Agencies Are Activist in Ways They Have Never Been G. Other Legal Risk Securitization Law Criterion Economics L.L.C. 7

8. A Brief Background on the Role of CRA�s 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�- S&P

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 Moody�s, S&P 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. Criterion Economics L.L.C. 12 Figure 8: Quarterly Revenue by Segment: Q1 2002 to Q4 2006

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.

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 �world�s 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 CRA�s 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. Moody�s does not independently verify any such information. Nor does Moody�s audit or otherwise undertake to determine that such information is complete. Thus, in assigning a Credit Rating, Moody�s 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 Moody�s publication� - Moody�s

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 � arranger�s 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 investor�s 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 Moody�s: �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� - Moody�s, April 3, 2007

31. The Problems with Ratings in SF - Evolving Models On April 3, 2007 Moody�s: 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 �Moody�s 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 & Poor�s does not advocate positions on any legislation� - S&P President Kathleen Corbet �I think a quote from a report by (S&P 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, S&P 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 Criterion Economics L.L.C. 38

39. Criterion Economics L.L.C. 39 Figure 11: Expected Losses in Corporate and Structured Finance Debt

40. Criterion Economics L.L.C. 40 Figure 12: Actual and Expected Losses on Corporate Investments and Mortgage Pools

41. Criterion Economics L.L.C. 41 Figure 14: Skewed Mortgage Pool Loss Distributions

42. Criterion Economics L.L.C. 42 Figure 13: Statistical Distributions of Cumulative Losses on Corporate Investments and Mortgage Pools

43. Criterion Economics L.L.C. 43 Figure 15: Relying on Corporate Debt Rating Methods Results in Late Downgrades on RMBS

44. Criterion Economics L.L.C. 44 Figure 16: Consistent RMBS Performance Warrants Credit Ratings Upgrades

45. Criterion Economics L.L.C. 45 Figure 17: Expensive Credit Enhancement is Wasted if the Loss Scenarios it Covers are Statistically Less Likely Over Time

46. Traditional Bond Ratings Do Not Properly Account for RMBS Risks Criterion Economics L.L.C. 46

47. IV. THE COMPLEXITY OF RMBS MASKS RISK TRANSFER Criterion Economics L.L.C. 47

48. Why does Complexity Matter? Criterion Economics L.L.C. 48

49. Criterion Economics L.L.C. 49 Figure 21: Prepayment and Default Rates as a Function of Mortgage Duration

50. Criterion Economics L.L.C. 50 Figure 22: Common Prepayment Vectors used in Prepayment Analysis

51. Why does Complexity Matter? Criterion Economics L.L.C. 51

52. Criterion Economics L.L.C. 52 Figure 23: Tranches Issued in European Securitizations 1987-2003

53. Criterion Economics L.L.C. 53 Table 2: Issues with the Given Number of Tranches as a Percentage of All Issues Per Type (Mean Number of Tranches Per Issue)

54. Criterion Economics L.L.C. 54 Figure 24: Examples of Actual MBS Funding Structures

55. IV. THE COMPLEXITY OF RMBS MASKS RISK TRANSFER Criterion Economics L.L.C. 55

56. V. BOND RATINGS DO NOT ACCOUNT FOR CDO RISKS Criterion Economics L.L.C. 56

57. Criterion Economics L.L.C. 57 Figure 25: CDO Capital Structure Arbitrage through Vintage Substitution

58. Criterion Economics L.L.C. 58

59. Criterion Economics L.L.C. 59 Figure 27: Default Probabilities Used in S&P CDO Rating Criteria

60. Criterion Economics L.L.C. 60 Figure 28: Annual Cash CDO Issuance

61. Criterion Economics L.L.C. 61 Figure 29: Subprime RMBS Compositions in CDOs Grew Quickly over Recent Years

62. Criterion Economics L.L.C. 62 Figure 30: Ratings Distribution of RMBS in CDO Portfolios

63. Criterion Economics L.L.C. 63 Figure 31: How Much and What Kind of MBS are in CDOs?

64. Criterion Economics L.L.C. 64 Table 5: CDO Risk Premiums and Credit Spreads and Macroeconomic Performance

65. Criterion Economics L.L.C. 65 Figure 35: Mortgage-backed Security Spreads, Risk Premia, and Eurodollar Futures

66. Criterion Economics L.L.C. 66 Figure 36: Exchange Rates for Selected Major Industrial Countries

67. VIII. Policy Implications Opacity for New Products Ratings Reliance of ERISA Investments US Market Supremacy US Economic Ranking Consumer Spending Stagflation Potential Criterion Economics L.L.C. 67

68. Criterion Economics L.L.C. 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.