The Credit Crisis
Continues…
Marshall Bennett
James A. Harrod
1
October 14, 2009
Credit Crisis Continues…
 Overview
– Effects: what characterized the
crisis?
 What Happened?
 Some of the Causes
 What happened with the Credit
Rating Agencies?
 Conclusions
2
Credit Crisis - Effects
- S&P 500 - 50% decline from January 2007 – March 2009
- U.S. DB public pension funds – equity losses total ~$1 trillion*
3
* IMF Working Paper, How the Financial Crisis Affects Pensions – July 2009
Credit Crisis - Effects
20 % decline in US Home Prices
4
Credit Crisis - Effects
massive increase in mortgage delinquencies
5
Source: The Wall Street Journal
Credit Crisis - Effects
massive declines in mortgage securities
ABX-HE-A 07-2 tracks BBB-rated MBS issued in the first half of 2007.
6
Source: CNNMoney/Markit Group
Government Intervention –
Alphabet Soup
 TARP – Troubled Asset Relief Program
 TALF – Term Asset-backed Securities Loan
Facility
 PPIP – Public-Private Investment Program
 MHAP – Making Home Affordable Program
7
Structured Finance Products
 Products created by Wall Street
 Assets packaged into securities for sale to investors
– Create a more liquid market for the asset
– Allow financial institutions to deploy capital repeatedly
 More alphabet soup:
– MBS/CMOs (mortgage backed securities/collateralized
mortgage obligations)
– ABS (asset backed securities)
– CDOs (collateralized debt obligations)
– CLOs (collateralized loan obligations)
8
Securitization Process
S e n ior t r an c h es
S PV
M BS
S u b or d in at ed tr a nc h e s
9
Credit Crisis – First Signs
 Mortgage Default Rates Increase – Q1 2007
– Adjustable Rate Mortgage Resets
– Lower lending standards – riskier borrowers
 Significant declines in ABX and related indices
 Secondary markets for structured products
experience liquidity problems
 Securitization becomes more difficult
 Monoline insurers experience capital shortages
– MBIA/AMBAC
10
Problems at Mortgage Companies
 Mortgage Companies Experience
Problems:
– New Century
– Countrywide
– Northern Rock/UK
– Indymac
11
Instability in Financial Services
 Major Commercial/Investment Banks
– Bear Stearns
– Lehman Brothers
– Merrill Lynch
– Wachovia
– Washington Mutual/WaMu
– Royal Bank of Scotland
– Citigroup
12
Crisis Effects – Beyond the Big
Banks
 FDIC has seized/closed 127 institutions
since 2007
 AIG – problems with derivatives
 December 2008 - Bernard Madoff - $64
billion Ponzi scheme
 Massive government support to General
Motors & Chrysler
13
Financial Crisis – Some Factors
 Failure of the traditional gatekeepers
– SEC – Madoff report points to failures
– Banks – loans sold to investors
– Rating Agencies – conflicts and failures
 Proliferation of Structured Finance products
 Opaque derivative markets (CDSs)
– Warren Buffet:
 “financial weapons of
mass destruction”
 Increased Leverage
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 Consumers’ high appetite for debt
Rating Agencies
 Moody’s Investors Service, Inc.
 Standard & Poor’s Ratings (owned by
McGraw-Hill, Inc.)
 Fitch Ratings Service (owned by Fimalac,
S.A.)
15
Rating Agencies’ Role
 Called Nationally Recognized Statistical Rating
Organizations (NRSROs) by the SEC:
– “official arbiters of financial soundness.”*
 Many investors have guidelines or requirements that
permit investments only in “investment grade debt”:
– Moody’s: Aaa, Aa, A, Baa
– S & P/Fitch: AAA, AA, A, BBB
 Effective marketing of securities requires rating by an
NRSRO
 Ratings particularly important in “alphabet soup”
financial products
– Capital structure relies on subordination and
diversification
16
*James Surowiecki, “Ratings Downgrade,” The New Yorker – Sept. 28, 2009
“Aaa” –
More Risk Than Expected
 “AAA” – risk free?
– Like a U.S. Treasury bond
 Bonds were purchased based on rating
and yield
 Decline in value of “AAA” securities has
affected institutional investors
– Performed much worse than expected
17
Rating Agencies –
How did they get it wrong?
 Outdated models
 Structural conflicts of interest
 Exemption from liability
18
Outdated Models
The rating agencies used statistical models that relied on historical
default rates but the mortgages and underwriting standards had
drastically changed and they failed to update their models to reflect
this:
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The
ratings were derived using a mathematical construct known as a
Monte Carlo simulation -- as if each of the underlying bonds would
perform like cards drawn at random from a deck of mortgage bonds in
the past. There were two problems with this approach. First, the
bonds weren't like those in the past; the mortgage market had
changed. As Mark Adelson, a former managing director in Moody's
structured-finance division, remarks, it was ''like observing 100 years
of weather in Antarctica to forecast the weather in Hawaii.'' And
second, the bonds weren't random. Moody's had underestimated the
extent to which underwriting standards had weakened everywhere.
When one mortgage bond failed, the odds were that others would,
too.
Moody's estimated that this C.D.O. could potentially incur losses of 2
percent. It has since revised its estimate to 27 percent.
19
The New York Times, Triple-A Failure, April 27, 2008
Outdated Models
 In Congressional testimony, Frank Raiter, former Managing Director
and Head of Residential Mortgage Backed Securities Ratings at S&P,
acknowledged that S&P had a new model to use, but did not use it.
 The failure to use a new model was disastrous:
– Had these models been implemented we would have had an earlier
warning about the performance of many of the new products that
subsequently lead to such substantial losses. That … could have
thus caused some of these products to be withdrawn from the
market…
– An unfortunate consequence of continuing to use out- dated
versions of the rating model was the failure to capture changes in
performance of the new non-prime products. . . This, in turn,
generated the unprecedented number of AAA downgrades and
subsequent collapse of prices in the RMBS market.
20

October 22, 2008, Congressional Hearing testimony
Rating Agency – Conflicts
The credit rating agencies, which until
late September 2007 were not regulated
by statute, notoriously gave AAA ratings
to these structured mortgage-backed
securities. But that was not all: the
ratings agencies sometimes helped to
design these securities so they could
qualify for higher ratings.
SEC Chairman Christopher Cox Congressional Testimony, October 22,
2008.
21
Rating Agency – Conflicts
 Provided models to the arrangers:
– Ratings-agency officials concede that they work
with Wall Street banks, even if they don’t exactly
shout it from the rooftops. “You start with a rating
and build a deal around a rating,” explains Brian
Clarkson, Moody’s co-COO.
Portfolio, Overrated, September 2007.
 Providing the models to the banks allowed them to
“game” the ratings process
– Huge financial incentive to keep the game going
– Record Revenue
22
Rating Agencies – Record Revenue
23
Rating “Shopping”
 Issuers would play rating agencies against each other and only
use the ones that would provide the highest rating
 In an April 2007 instant message chat between two S&P
analysts, they acknowledged that the rating process was more
about business generation for their employer than it was about
getting a quality rating:
Rahul Dilip Shah: btw -- that deal is ridiculous.
Shannon Mooney: I know right ... model def does not capture
half of the risk
Shah: we should not be rating it.
Mooney: it could be structured by cows and we would rate it.
24
Exemption from the Securities Act
 Issuers and underwriters of securities can be
held liable for untrue or false statements and
omissions in prospectuses.
 SEC regulations provide that “the security rating
assigned to a class of debt securities by a[n
NRSRO] . . . shall not be considered a part of the
registration statement prepared or certified by a
person within the meaning of sections 7 and 11 of
the Act.”
– SEC Rule 436(g), 17 C.F.R. § 230.436(g)(1)
– Exempts NRSRO’s from liability for ratings
– Bill to revoke the exemption
 Did this embolden them?
 Pursue alternate theories of liability
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It’s Still Happening!
 Rating Agencies still issuing inflated
ratings
– Eric Kolchinsky: Moody’s
continues to issue artificially high
ratings
 Life Insurance Securitizations
– SEC investigating practices
26
Conclusions
 When gatekeepers fail, investors need to
be in a position where policies and
practices are independent and transparent
– With rating agencies this was a huge
problem
– Funds were required/encouraged to
purchase “investment grade” securities
– Created an imprimatur of quality/safety
27
Conclusions
 Get independent expert advice
 Demand transparency
 Responsible parties need to be held
accountable
– Lawsuits
– Political Action
28
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