Rating Agencies and Credit Ratings: Recent Developments and
Outlook for the Future
Mark Adelson
Executive Managing Director
Senior Research Fellow
Washington Association of Money Managers
11 January 2012
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Copyright © 2011 Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.
Pythagorean Theorem
a2+b2=c2
a2
a
a
b
2
c
c
b
b
c
b2
a
Q.E.D.
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2.
Impetus for Change
• The big picture of S&P ratings performance is good…
– Rank ordering of default rates by rating category within key sectors
– Good Gini coefficients over multiple time horizons
• …but some sectors were outliers…
– Residential mortgage-backed securities (RMBS
– CDOs of ABS (backed by RMBS)
– Bond insurance
– Banks
• …which disappointed the market’s expectations…
• …and hurt the firm’s credibility
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3.
Impetus for Change: Example – Structured Finance Ratings
Adverse Credit Migrations of 2005-2007 Vintages of
U.S. RMBS, CDOs of ABS, and SIV Lites
Original
Rating
Status as of 31 December 2010
Default +
Near Default
Default
Near
Default
Any
Downgrade
No. of
Ratings
AAA
60.1%
22.7%
37.4%
77.3%
4,043
AA
78.2%
45.8%
32.4%
87.6%
8,340
A
88.5%
59.7%
28.8%
93.4%
7,456
BBB
94.0%
69.4%
24.7%
95.2%
7,806
82.8%
52.8%
30.0%
89.8%
27,645
Inv. Grade
Note: 'AAA' ratings from the same transaction are treated as a single rating in this table's calculation. Multiple rating
actions are aggregated to calculate a security's cumulative rating performance. Near default means rated 'CCC+' or
lower.
Source: Erturk, E., Global Structured Finance Securities End 2010 With Rising Credit Stability (7 Feb 2011) (Table 6a).
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4.
Impetus for Change: Example – Financial Firm Ratings
ICR
at 1/1/07
Δ Eq Px
2007-08
AIG
AA+
-97.7%
~$183b in bailouts. US govt owns 80% stake
Bear Stearns
AA-
-94.2%
Shotgun marriage with JP Morgan for $10/share
Citigroup
AA
-86.7%
Hybrids exchanged, U.S. gov’t took 36% equity
IndyMac
BBB
-99.6%
Seized by FDIC in 2008, auctioned off in March 2009
Lehman
AA-
-100.0%
Merrill Lynch
AA-
-18.1%
Bought out by B-of-A 9/14/2008
Northern Rock
A+
-92.4%
Nationalized 2/22/2008
RBS
AA
-92.6%
Part nationalization, UK gov’t holds 84% stake
UBS
AA+
-76.3%
Write-downs >$50B since 2007
Wachovia
AA-
-89.3%
“Silent run" in Sep 2008; acquired by Wells Fargo
WaMu
A
Fannie Mae
AA-
-98.6%
Freddie Mac
AA-
-98.9%
Company
-100.0%
Notes
Bankruptcy 9/15/2008.
Receivership 9/25/2008
Conservatorship 9/7/2008. U.S. Treasury holds preferred
stock and warrants worth 80% stake
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5.
Impetus for Change: Example – Financial Firm Ratings (#2)
ICR
at 1/1/07
Δ Eq Px
2007-08
Ambac
AAA
-98.5%
Bankruptcy 11/8/2010
MBIA
AAA
-94.3%
Rated B, attempting restructuring
FGIC
AAA
n.a.
Bankruptcy 8/3/2010
FSA
AAA
n.a.
Acquired by AGC in July 2009
ACA
A
n.a.
Restructuring plan 8/8/2008
AGC
AAA
-56.4%
CIFG
AAA
n.a.
Company
Notes
Now rated AACC rating withdrawn 2/16/2010
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6.
Recent Rating Industry Changes
• S&P is:
– Updating criteria to increase
transparency &
comparability
– Incorporate lessons learned
from financial crisis
– Publishing more on credit
risks in unrated deals
– Increasing investor
outreach and education
efforts
• New regulations in U.S.,
E.U., Japan and
Australia
• Regulatory changes
include:
– Increasing oversight and
accountability
– Removing ratings from
regulation
– Strengthening prohibitions
on conflicts of interest
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7.
Key Criteria Goals
• Comparability
– Each rating symbol – for example, 'AAA‘ – to connote a comparable view of creditworthiness,
wherever and whenever it appears
– Provides a common vocabulary for discussing credit risk
– Achieved through application of common stress for each rating category
– Use historical studies as part of criteria calibration (e.g., NBER papers)
• Transparency
– Allows users to understand how S&P reaches rating conclusions (the “what”)
– Clearer definition and weighting of variables driving the conclusion
– Rationales explaining choice of methodology and assumptions (the “why”)
• Harmonization
– Similar factors analyzed consistently across sectors (e.g., management, default rate
simulation parameters, treatment of guarantees)
• Simplification
– Common design framework: key elements, scoring, roll-up
– Modularization (plug and play components)
– Ease of application
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8.
Behind the Goals
• Comparability makes S&P ratings more relevant to those
responsible for top-level asset allocation and investment policy
decisions
• Superior comparability and transparency positively differentiate
S&P ratings from our competitors’
• Leading the credit rating industry…
– Moody’s, “Recalibration of Moody’s U.S. Municipal Ratings to its Global
Rating Scale” (March 2010)
– Fitch, “Ratings Comparability” (21 June 2010)
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9.
Illustration of Weak Cross-sector Comparability (past)…
BBB
Banks
B
Insurance
B
BBB
A
Sovereigns
B
BB
BBB
A
U.S. Municipal
B
BB
BBB
A
AA
AA
AAA
AAA
AA
A
AAA
AA
AAA
AAA
BBB
A
AA
BBB
A
A
AAA
AA
AA
Creditworthiness 
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10.
AAA
AA
AA
BBB
B
A
CDO
BB
B
BB
ABS
BB
B
BBB
CMBS
BB
B
BB
RMBS
BBB
B
BB
BB
A
Corporate
AAA
AAA
Illustration of Stronger Cross-sector Comparability (future)
BBB
B
BB
Insurance
B
BB
Sovereigns
B
BB
U.S. Municipal
B
BB
RMBS
B
BB
CMBS
B
BB
ABS
B
BB
CDO
B
BB
AA
A
AA
AAA
A
AA
AAA
A
AA
AAA
BBB
A
AA
AAA
BBB
A
AA
AAA
BBB
A
AA
AAA
BBB
A
AA
AAA
BBB
A
AA
AAA
Creditworthiness 
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11.
AAA
BBB
BB
Banks
A
BBB
B
BBB
Corporate
Geography
Geography
Four Dimensions of Comparability
We are currently emphasizing cross-sector comparability at the
expense of comparability over time in order to address calibration
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12.
Delivering Comparability
• Retrospective
– Gini coefficients (rank ordering power)
– Comparing default rates across sectors, regions, and over time
• Prospective
– Common approaches to risk analysis (harmonization)
– Stress scenarios for criteria calibration
Criteria Calibration Stress Scenarios – Key Parameters
AAA
AA
A
BBB
BB
B
-26½%
-15%
-6%
-3%
-1%
-½%
Unemp.
25%
20%
15%
10%
8%
6%
Equities
-85%
-70%
-60%
-50%
-25%
-10%
ΔGDP
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13.
Understanding S&P Rating Definitions (3 Jun 2009)
• Ratings are forward looking and reflect views on relative ranking of
overall creditworthiness
• S&P ratings are not just opinions of likelihood of default
– Likelihood of default
– Payment priority
– Recovery
– Credit stability
• New stress scenarios adopted to further our goal of comparability
across sectors, geographies and time
• 'AAA' (“extreme”) stress scenario is based on the Great Depression
– AAA face greater possibility of default under extreme scenario
– AAA are likely to face more transitions with increasing decline in economy
• Stress scenarios used as a calibration tool for criteria
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14.
Transparency
• Both “how” and “why”
• How  replicability; providing a
thorough explanation about how
we do analysis so that a skilled
analyst could replicate it if he
wanted to
• Why  credibility; providing the
intellectual underpinnings and
justifications – the facts and the
logic – explaining why we do
what we do
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15.
Delivering Transparency
• Criteria design framework
– Creating a path for replicability
 Step 1: select items that drive creditworthiness
 Step 2: define methods for scoring/ranking/grading each selected item
 Step 3: define system for combining scores from step 2 into a final rating
– Allows for future modularization of criteria components (e.g.,
management, group support, etc.)
– Gives criteria articles a consistent structure to make the entire body
criteria easier to navigate and manage
– Embraces both quantitative and qualitative aspects of analysis
– Emphasizes objectivity and establishing a factual basis for qualitative
judgment
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16.
Criteria Project Examples
• Substantive changes
– CMBS (26 Jun 2009)
– RMBS (10 Sep 2009)
– Corporate CDOs (17 Sep 2009)
– Covered Bonds (16 Dec 2009)
– Counterparty (6 Dec 2010, proposed update 21 Nov 2011)
– Bond insurers (25 Aug 2011)
– Banks (9 Nov 2011)
• Creating a rigorous and systematic process
– U.S. States (3 Jan 2011)
– Sovereigns (30 Jun 2011)
• Transparency emphasis in all of the above
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17.
Criteria Change: CMBS (26 Jun 2009)
• Reason for the change: Review of historical credit performance
• Changes:
– Recalibrate 'AAA' credit enhancement levels to 19% for archetypical pool
– 'AAA' credit enhancement levels to remain anchored over time
– CE levels for 'BBB' based on 4-pronged approach
– CE levels for ‘B’ based on expected performance
– CE levels for intermediate ratings interpolated
• Impact: Many CreditWatches and DGs of CMBS from 2006-07
vintages
• Further update in process
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18.
Criteria Change: RMBS (10 Sep 2009)
• Reasons for the change include: Review of historical credit
performance
• Changes:
– Recalibrate 'AAA' credit enhancement levels for archetypical prime pool
to 7.5%
– 'AAA' credit enhancement levels to remain anchored over time
– CE levels for 'B' float based on forecasts
– CE levels for intermediate ratings interpolated
• Impact: Many outstanding RMBS already downgraded or under
review in surveillance; future deals generally would have higher
CE levels
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19.
Criteria Change: Corporate CDOs (17 Sep 2009)
• Reasons for the change include: Further consideration of
Gaussian copula-type models
• Changes:
– Additional tests ("outside" the model)
 Single name exposure tests
 Industry exposure tests
– Recalibration of the simulation model to target outputs based on peak
historical default rates (incl. Great Depression)
• 42% ‘AAA’ CE for typical 9-yr CLO of ‘B’ credits
• 18% ‘AAA’ CE for typical 5-yr synthetic CDO of ‘BBB’ credits
• Impact: many CreditWatches and downgrades
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20.
Bank Criteria (9 Nov 2011)
Bank Rating Methodology
BICRA
Bank-Specific Factors
Methodology
Macro Factors
Economic
Risk Score
Business
Position
Group
Support
Capital &
Earnings
Anchor
Industry
Risk Score
External Support
StandAlone
Credit
Profile
SACP
Risk
Position
StandAlone
Credit
Profile
ICR
Gov’t
Support
Issuer
Credit
Rating
Funding &
Liquidity
Banking Industry
Country Risk
Assessment
Score
Hybrid debt
and preferred
stock ratings
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21.
Senior
Unsecured
Ratings
Criteria in the Larger Scheme
• Transparent criteria that enhances ratings comparability is
aligned with and supports:
• S&P’s Mission Statement: To be the definitive source of
transparent benchmarks, independent research, quality data,
and in-depth analytics demanded by financial professionals
• S&P’s Core Values:
– Independence
– Quality & Analytical Rigor
– Integrity
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22.
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30.
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