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
Authority on Ratings

Artificially propped up demand
 Barriers to entry
 From 1975-2006 Vague NRSRO requirements
 Credit Rating Reform Act 2006
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
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
Structured Finance
Home Mortgages (Ba2)
Special Purpose Vehicle
RMBS
CDOs
(AAA – Ba1)
(AAA – Ba1)
CDO’s Squared
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
across originators, issuers or servicers.
 correlated risk across the loans related to servicer and/or
originator quality.
not
Sources: WSJ, Financial Statements,
“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
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
Current Business Model
Credit agencies are paid
 By investors prior to 1970s
 By rated issuers or by underwriters now
So, who should pay?

Issuers?
 Provides benefits via rapid dissemination of
ratings.
 Strong potential conflict of interest
 Power to suppress unwanted ratings
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
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
Conflicts of Interest

Inherent conflicts under the “issuerspay” 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
Conflicts of Interest

Traditional corporate bond rating
business
Large base of clientele
Lower profit margin
Reputation risk
Deepened Conflicts of Interest

Structured finance business
A handful of banks
Excessively high profit margin
Rating shopping
Huge pressure for getting the deals done
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
Resemblance to Enron?

Similarities in fee structures (the ratedpay)
 Reliance on certified opinions (investors)
 Reluctance to give negative opinion on
the ground of revenue consideration
(accounting firms)
Whom Can We Rely On…
when there is no one to trust?
Views from Three Perspectives
 Regulators
(SEC)
 Investors
 Rating Agencies
Themselves
SEC’s New Regulation on Rating
Agencies

SEC’s Summary Report (July 2008)
 http://www.sec.gov/news/studies/2008/craex
amination070808.pdf

An evaluation report on Fitch, Moody,
and S&P
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.
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
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
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.
Statutory Structure
Registration
Registration at the SEC as
NRSRO.
Application includes
information on:
1. ratings’ performance
2. procedures and
methodologies
3. policies against misuse of
private information
4. organizational structure
5. code of ethics
6. conflicts of interest
7. 20 largest issuers or
subscribers
8. certification of institutional
investors that the ratings are
considered significant
Oversight
The SEC has sole
responsibility for
supervision.
The SEC has no
say in the ratings’
substance,
procedures and
methodologies.
The SEC can
suspend or limit
operations or
revoke the license
if the NRSRO does
not comply with
the regulation or
fails to maintain
adequate resources
to produce valid
ratings.
Conflicts of Interest
Appropriate policies and procedures to
manage and address conflicts of interest.
The SEC has the authority to issue rules
concerning conflict of interests related to:
1.Compensation
2.Consulting and advisory services
3.Personal and ownership conflicts
4.Affiliation with issuers
5.Other conflicts of interest the SEC
deems necessary;
prohibit an NRSRO from issuing a rating
where the NRSRO or a person associated
with the NRSRO has made
recommendations as to structuring the
same products that it rates;
prohibit anyone who participates in
determining a credit rating from
negotiating the fee that the issuer pays for
it, to prevent business considerations from
undermining the NRSRO’s objectivity;
prohibit gifts from those who receive
ratings to those who rate them, in any
amount over $25.
Statutory Structure (Cont.)
Transparency
Periodic private disclosure of financial conditions
Require disclosure by the NRSROs of whether and how
information about verification performed on the assets
underlying a structured product is relied on in
determining credit ratings.
Require disclosure of how frequently credit ratings are
reviewed; whether different models are used for ratings
surveillance than for initial ratings; and whether changes
made to models are applied retroactively to existing
ratings.
Require NRSROs to make an annual report of the
number of ratings actions they took in each ratings
class.
Require documentation of the rationale for any
material difference between the rating implied by a
qualitative model that is a “substantial component” in the
process of determining a credit rating and the final rating
issued.
Require NRSROs to differentiate the ratings they
issue on structured products from other securities, either
through issuing a report disclosing how procedures and
methodologies and credit risk characteristics for
Competition
Governance
Require NRSROs to
make all of their
ratings and
subsequent rating
actions publicly
available, to facilitate
comparisons of
NRSROs by making it
easier to analyze the
performance of the
credit ratings the
NRSROs issue in
terms of assessing
creditworthiness.
Prohibit an
NRSRO
from issuing a
rating
on a structured
product unless
information on the
characteristics of
assets underlying
the
product is
available,
in order to allow
other credit rating
agencies to use
the information to
rate the product
and, potentially,
expose a rating
agency whose
ratings were
unduly
influenced by the
product’s
sponsors.
Require NRSROs to
publish performance
statistics for one,
three and ten years
within each rating
category, in a way
that facilitates
comparison with
their competitors in
the industry.
Prohibition of use
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
Reform?

No Easy Answer
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
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
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
As Investors…

Be objective towards rating agencies
and their ratings
 The investor’s reliance on rating results
has an amplifying effect on the products
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