The Role of the CREDIT Rating Agencies

1. The Role of the CREDIT Rating Agencies

2. 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

3. Authority on Ratings • Artificially propped up demand • Barriers to entry • From 1975-2006 Vague NRSRO requirements • Credit Rating Reform Act 2006

4. 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

5. Subprime Securitization Structure Source: 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

6. Structured Finance

7. 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.

8. Sources: WSJ, Financial Statements, ewrockwell.com

9. I know it was bad, but…

10. “There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service.” Thomas Friedman (NYT), Feb. 13, 1996

11. Credit Rating Business Credit rating agencies sell • Ratings (or “opinions”) • not statements of facts and certainly not investment advice • Advice to rated firms • Credit Rating Advisory Services

12. Current Business Model Credit agencies are paid • By investors prior to 1970s • By rated issuers or by underwriters now

13. So, who should pay? • Issuers? • Provides benefits via rapid dissemination of ratings. • Strong potential conflict of interest • Power to suppress unwanted ratings

14. 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

15. 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

16. 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

17. Conflicts of Interest • Traditional corporate bond rating business • Large base of clientele • Lower profit margin • Reputation risk

18. Deepened Conflicts of Interest • Structured finance business • A handful of banks • Excessively high profit margin • Rating shopping • Huge pressure for getting the deals done

19. In subprime crisis, rating agencies • 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 Internal email among S&P employees in December 2006: …Rating agencies continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.

20. 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)

21. Whom Can We Rely On… when there is no one to trust?

22. Views from Three Perspectives • Regulators (SEC) • Investors • Rating Agencies Themselves

23. SEC’s New Regulation on Rating Agencies • SEC’s Summary Report (July 2008) • http://www.sec.gov/news/studies/2008/craexamination070808.pdf • An evaluation report on Fitch, Moody, and S&P

24. Examinations Summary of SEC Release • There was a substantial increase in the number and in the 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 and improvements can be made. • The rating agencies' internal audit processes varied significantly.

25. 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

26. 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

27. 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 Commission's rules.

28. Statutory Structure

29. Statutory Structure (Cont.)

30. Criticism to SEC Regulations • Too little, too late • June 2008 Proposals – very bold; final document – very limited • Any real desire to drastically reform or remake the industry? • Don't wean investors off their reliance on credit rating agencies • Do nothing to ensure accurate ratings • A furtherance of the abdication of its responsibility

31. Reform? • No Easy Answer

32. Some Legislative Suggestions • 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

33. Some Legislative Suggestions • Separating rating from consultancy and 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

34. Some Legislative Suggestions • 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

35. As Investors… • Be objective towards rating agencies and their ratings • The investor’s reliance on rating results has an amplifying effect on the products

36. As Rating Agencies Themselves… • 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