October 14, 2009

1. The Credit Crisis Continues… Marshall Bennett James A. Harrod October 14, 2009

2. Credit Crisis Continues… • Overview • Effects: what characterized the crisis? • What Happened? • Some of the Causes • What happened with the Credit Rating Agencies? • Conclusions

3. Credit Crisis - Effects - S&P 500 - 50% decline from January 2007 – March 2009 - U.S. DB public pension funds – equity losses total ~$1 trillion* * IMF Working Paper, How the Financial Crisis Affects Pensions – July 2009

4. Credit Crisis - Effects 20 % decline in US Home Prices

5. Credit Crisis - Effects massive increase in mortgage delinquencies Source: The Wall Street Journal

6. Credit Crisis - Effects massivedeclines in mortgage securities ABX-HE-A 07-2 tracks BBB-rated MBS issued in the first half of 2007. Source: CNNMoney/Markit Group

7. 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

8. 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)

9. Securitization Process

10. 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

11. Problems at Mortgage Companies • Mortgage Companies Experience Problems: • New Century • Countrywide • Northern Rock/UK • Indymac

12. Instability in Financial Services • Major Commercial/Investment Banks • Bear Stearns • Lehman Brothers • Merrill Lynch • Wachovia • Washington Mutual/WaMu • Royal Bank of Scotland • Citigroup

13. 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

14. 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 • Consumers’ high appetite for debt

15. Rating Agencies • Moody’s Investors Service, Inc. • Standard & Poor’s Ratings (owned by McGraw-Hill, Inc.) • Fitch Ratings Service (owned by Fimalac, S.A.)

16. 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 *James Surowiecki, “Ratings Downgrade,” The New Yorker – Sept. 28, 2009

17. “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

18. Rating Agencies – How did they get it wrong? • Outdated models • Structural conflicts of interest • Exemption from liability

19. Outdated Models 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. 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: The New York Times, Triple-A Failure, April 27, 2008

20. 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 tosuch 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. • October 22, 2008, Congressional Hearing testimony

21. 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.

22. 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

23. Rating Agencies – Record Revenue

24. 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.

25. 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

26. 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

27. 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

28. Conclusions • Get independent expert advice • Demand transparency • Responsible parties need to be held accountable • Lawsuits • Political Action

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