Operations and Regulation of the Credit Rating Industry
Dec 16th 2008, Sanya, Hainan Island, China
Jorge Mina
Alan Laubsch
jorge.mina@riskmetrics.com
alan.laubsch@riskmetrics.com
Risk Management
Agenda

Background

CRA’s and Structured Finance Markets

IOSCO’s Code of Conduct

European Commission Regulation

SEC Rules on NRSRO’s 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 CDO’s 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
Debt
$10,000
300%
$9,000
$8,000
250%
$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0
Percent of GDP
Federal Debt ($ bil)
Government
Federal and
Consumer Debt
as % of GDP 2
1
200%
150%
100%
50%
0%
Total Consumer Debt
Total Federal Debt
(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
United States
E/A
Europe
E/A
12.7%
Asia Pacific
E/A
New York Community Bancorp
13.8%
Sberbank
ICICI Bank Ltd.
11.6%
National City Corp.
11.7%
Banca Monte dei Paschi di Siena S.p.A.
6.7%
Samba Financial Group
9.8%
Huntington Bancshares Inc.
10.5%
Banco Santander S.A.
5.8%
Bank Central Asia
9.4%
Sovereign Bancorp Inc.
10.1%
Unicredito Italiano Spa Ord
5.3%
United Overseas Bank Ltd.
8.7%
Marshall & Ilsley Corp.
10.1%
Allied Irish Banks PLC
5.2%
BOC Hong Kong (Holdings) Ltd.
8.4%
M&T Bank Corp.
9.9%
Standard Chartered PLC
5.1%
Oversea-Chinese Banking Corp. Ltd.
8.4%
SunTrust Banks Inc.
9.8%
HSBC Holdings PLC
5.0%
China Citic Bank Corp. Ltd.
8.3%
State Street Corp.
9.6%
Banco Bilbao Vizcaya Argentaria S.A.
5.0%
DBS Group Holdings Ltd.
8.1%
Hudson City Bancorp Inc.
9.6%
Erste Group Bank AG
4.2%
HDFC Bank Ltd.
7.7%
BB&T Corp.
9.4%
KBC Group N.V.
4.1%
Hang Seng Bank Ltd.
7.4%
Zions Bancorp
9.2%
Nordea Bank AB
4.0%
Malayan Banking Bhd
7.2%
Fifth Third Bancorp
8.4%
Svenska Handelsbanken A
3.7%
Bank of China Ltd.
6.7%
U.S. Bancorp
8.2%
Societe Generale S.A.
3.3%
China Construction Bank Corp.
6.4%
Bank of America Corp.
8.1%
Royal Bank of Scotland Group Plc
3.2%
State Bank of India
6.0%
Wachovia Corp.
8.0%
Danske Bank A/S
3.0%
Industrial & Commercial Bank of China Ltd.
5.9%
KeyCorp
7.9%
Credit Suisse Group AG
3.0%
Bank of Communications Co. Ltd.
5.7%
Wells Fargo & Co.
7.9%
Lloyds TSB Group PLC / HBOS PLC
3.0%
China Merchants Bank Co. Ltd.
5.6%
UnionBanCal Corp.
7.8%
BNP Paribas S.A.
2.8%
Australia & New Zealand Banking Group Ltd.
5.3%
Comerica Inc.
7.7%
Credit Agricole S.A.
2.5%
Commonwealth Bank of Australia
5.3%
Washington Mutual
7.3%
Commerzbank AG
2.3%
China Minsheng Banking Corp. Ltd.
5.1%
JPMorgan Chase & Co.
7.2%
UBS Ag
2.1%
Westpac Banking Corp.
4.3%
Ameriprise Financial Inc.
7.0%
ING Groep N.V.
2.0%
Mitsubishi UFJ Financial Group Inc.
4.1%
Northern Trust Corp.
6.6%
Barclays PLC
1.6%
Sumitomo Mitsui Financial Group Inc.
3.2%
Citigroup Inc.
5.2%
Deutsche Bank AG
1.6%
Mizuho Financial Group Inc.
2.5%
Average
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8.8%
Average
4.0%
Average
6.7%
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This cycle is unique with unprecedented leverage
globally

Multi-reference structured credit products like CDO’s 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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CRA’s and Structured Finance Markets -- Issues

Excessive Reliance on Ratings by Investors
In structured products ratings are often not only viewed as a CRA’s 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 don’t 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 CRA’s 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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CRA’s 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 doesn’t turn into advise
from CRA’s 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 CRA’s (similar to equity
research)
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CRA’s 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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CRA’s 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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CRA’s 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 President’s
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.

IOSCO’s Code of Conduct is widely considered the global benchmark, but the
actual regulations are more specific in certain areas
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IOSCO’s 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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IOSCO’s 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 CRA’s 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) IOSCO’s Code of Conduct, but it
provides an enforcement mechanism by establishing a registration and
surveillance framework

CRA’s 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 NRSRO’s 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
NRSRO’s have to make publicly available a random sample of 10% of their issuerpaid ratings and their histories in XBRL no later than six months after the rating is
made
Recordkeeping: NRSRO’s 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
NRSRO’s 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 SEC’s 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
99.5%Exp.
Shortfall
One standard deviation
Horizon value if no
rating changes
Expected horizon value
18
18.5
19
19.5
20
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?
RM 2006 99% VaR bands vs 2006-1 AAA spread
120.0%
One major outlier, a 12 sd
move on Feb 23 '07, the
day after the $10.5bn
HSBC loss announcement
100.0%
80.0%
60.0%
Spread Change
40.0%
20.0%
0.0%
-20.0%
-40.0%
300%+ increase in vol
from Dec 12 to 21 '06
Backtesting summary:
2.4% upside excessions
0.81% downside excessions
-60.0%
-80.0%
357% vol spike
on Feb 23 '07
6/19/2008
5/19/2008
4/19/2008
3/19/2008
2/19/2008
1/19/2008
12/19/2007
11/19/2007
10/19/2007
9/19/2007
8/19/2007
7/19/2007
6/19/2007
5/19/2007
4/19/2007
3/19/2007
2/19/2007
1/19/2007
12/19/2006
11/19/2006
10/19/2006
9/19/2006
8/19/2006
7/19/2006
-100.0%
Date
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Responsive VaR estimators provided ample time to
hedge…
'2006-1 AAA' Absolute Spread Levels
450
400
Feb 23 '07, first major
outlier, 350% vol increase
in 1 day, 12sd move
350
300
250
June 07, ML tries
to liquidate Bear
Subprime CDO's
The first tremor
(vol up 300% Dec 12-21)
200
150
100
50
www.riskmetrics.com
5/19/2008
3/19/2008
1/19/2008
11/19/2007
9/19/2007
7/19/2007
5/19/2007
3/19/2007
1/19/2007
11/19/2006
9/19/2006
7/19/2006
5/19/2006
3/19/2006
1/19/2006
0
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An Integral Approach to Risk Management

It’s 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 Wilber’s 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
Individual
“I”
» Integrity
» Ability to question
“It”
» Ratings
» Measures
» Data
Objective/Exterior
Subjective/Interior
» Culture of risk
management
“We”
Collective
»
»
»
»
»
Regulations
Systems
Processes
Policies
Organization
“Its”
» 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
Flex flow, constantly evolving and improving
Blend of art and science: subjective + objective
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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 don’t 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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Questions?
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asia@riskmetrics.com
Tel. +65 6826 9333
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RiskMetrics Group: One Company/Multiple Capabilities

We help investors better understand and manage risk across a broad
spectrum
RiskMetrics Group offers industry-leading products and services in the disciplines of risk
management, corporate governance and financial research & analysis
RiskMetrics – a leading provider of quantitative risk management and portfolio analytics
ISS Governance Services – a leading provider of corporate governance and proxy voting
services
Financial Research & Analysis – a leading provider of forensic accounting, legal and
regulatory research
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Addressing a Broad Spectrum of Risk
RiskMetrics Group views risk
through a wide lens, enabling
clients to make more informed
decisions based upon multiple
points of risk insight and a
more complete risk
management solution.
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