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Rating Agencies as Gatekeepers. Jerome S. Fons September 11, 2009 Federal Reserve Bank of Cleveland Consumer Protection Conference. Industry Timeline. 1841: Commercial credit bureaus 1868: Poor’s Manuals 1909: Moody’s Analyses of Railroad Investments 1970: Issuers charged for ratings

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Rating Agencies as Gatekeepers

Jerome S. Fons

September 11, 2009

Federal Reserve Bank of Cleveland

Consumer Protection Conference


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Industry Timeline

  • 1841: Commercial credit bureaus

  • 1868: Poor’s Manuals

  • 1909: Moody’s Analyses of Railroad Investments

  • 1970: Issuers charged for ratings

  • 1975: SEC creates NRSRO designation

  • 2001: Enron, WorldCom and Parmalat

  • 2006: Credit Rating Agency Reform Act

  • 2007: Subprime/CDO/SIV/CPDO debacle

Jerome S. Fons


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Current NRSROs

Jerome S. Fons


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What Do They Rate?

  • Corporate bonds

  • Commercial Paper

  • Preferred Stock

  • Syndicated bank loans

  • Sovereign nations

  • Municipal obligations

  • Infrastructure projects

  • Mutual funds

  • Bank deposits

  • Structured finance transactions

Jerome S. Fons


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Ratings Defined

  • Ratings are “opinions” of relative creditworthiness expressed through a symbol system

  • Creditworthiness: ability and willingness to pay obligations on time

    • Generally defined to mean expected loss (PD X LGD)

  • Based on “fundamental analysis”

    • Independent assessment of value

    • Financial statement/ratio analysis, industry features, management strategy, etc.

    • Not an academic subject - mix of journalism & acctng

    • But predicting credit risk is a technical endeavor

Jerome S. Fons


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Rating Symbol Systems

* From Moody's Approach To Rating Synthetic CDOs, Moody’s Rating Methodology, Jan. 2003. LGD is set at 55 for all ratings.

Jerome S. Fons


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Securitized Asset Classes

  • Asset Securitization

    • ABS

      • Credit cards

      • Auto loans

    • RMBS

    • CMBS

    • ABCP (including SIVs)

  • Derivatives

    • CDOs

      • CBOs

      • CLOs

      • CDO^2

      • Synthetic CDOs

Jerome S. Fons


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Securitization Rating Process

  • Banker (or originator) approaches RA

    • Banker typically communicates desired rating targets

  • RA’s analysts examine quality of underlying assets

    • Lead analyst recommends to rating committee the credit support level required to achieve rating target

    • Banker apprised of preliminary decision and may propose alternative structure or assets

  • If approved by final rating committee, banker and market informed of rating outcome

Jerome S. Fons


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Manufacturing Ratings

Sample Subprime RMBS Structure

Individual Mortgages

Mortgage

Pools

REMIC

Trust

RMBS

Bonds

2/28

Hybrid ARM

Mortgage

Pool

‘AAA’

RMBS

M1

M2

M3

M4

M5

M6

M7

M8

M9

M10

Special

Purpose

Vehicle

(RMBS

Trust)

M11

M12

M13

M14

M15

M16

M17

M18

M19

M20

M21

M22

M23

M24

M25

M26

M27

M28

M29

M30

M31

M32

M33

M34

M35

M36

M37

M38

M39

M40

M41

M42

M43

M44

M45

M46

M47

M48

M49

M50

M51

M52

M53

M54

M55

M56

M57

M58

M59

M60

M61

M62

M63

M64

M65

M66

M67

M68

M69

M70

‘AA’

RMBS

M71

M72

M73

M74

M75

M76

M77

M78

. . .

M

2000

‘A’

RMBS

Fixed Rate

Mortgage

M1

M2

M3

M4

M5

M6

M7

M8

M9

M10

M11

M12

M13

M14

M15

M16

M17

M18

M19

M20

‘BBB’

RMBS

M21

M22

M23

M24

M25

M26

M27

M28

M29

M30

‘BBB-’

RMBS

M31

M32

M33

M34

M35

M36

M37

M38

. . .

Residual

M

1000

Source: Tranche ABX and Basis Risk in Subprime RMBS Structured Portfolios, Kevin Kendra, Fitch, 2007

Jerome S. Fons


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Estimating RMBS Pool Risk

Probability

PROPERTY TYPE (Single Family, etc.)

LIEN STATUS (First, Second..)

DOCUMENTATION

COUPON RATE

APPRAISAL TYPE

ABOVE AVERAGE HOME PRICE

TIME TO FORECLOSURE (Varies by State)

PMI PRIMARY COVERAGE

POOL SIZE (Number of Loans)

OCCUPANCY STATUS

INSTRUMENT TYPE (Fixed/Adjustable..)

COUPON BUYDOWN (Teaser)

ORIGINAL TERM

BORROWER DEBT TO INCOME

BORROWER FICO

BORROWING PURPOSE

ORIGINATOR/PROGRAM CHARACTERISTICS

LOAN TO VALUE

ECONOMIC DIVERSIFICATION

SEASONING

SPECIAL HAZARDS

LOCATIONAL CONCENTRATION

0

Lifetime Loss

EL1

EL2

Jerome S. Fons


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Colossal Failure

  • June 2007: Moody’s downgrades $5 billion of subprime RMBS and places 184 CDO tranches on review; S&P places $7.3 billion of RMBS on review

  • August 2007: “run” on Countrywide

  • September 2007: “run” on Northern Rock; Cheyne Finance SIV (“AAA”) goes into receivership

  • March 2008: Bear Stearns (“A”) rescued by JP Morgan

  • August 2008: Fannie Mae and Freddie Mac (“AAA”) rescued

  • September 2008: Lehman Bros (“A) fails

  • Feb 2009: Moody’s places 7,942 RMBS trances on review for downgrade - $680 billion affected

Jerome S. Fons


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Ratings & Predatory Lending

  • Ratings try to capture risk to investors

    • State Anti-Predatory Lending Laws raise assignee liability

    • RAs may require higher enhancement levels, refuse to rate or limit loan share originated in state (NJ, NY, GA)

    • Flow of funding is restricted

  • Countrywide’s Multistate Settlement

    • Entered into in 2008

    • Filed by Attorney Generals of California and Illinois

    • Alleges violation of predatory lending laws

    • CW (now part of B of A) agrees to to modify numerous mortgage loans

    • RMBS investors sue to force CW to repurchase loans

Jerome S. Fons


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Industry Challenges

  • Major rating agencies’ infrastructure outmoded

    • Rating committees and senior analysts/specialists

      • Model mixed with analyst input

    • Volatile and accurate ratings displace analyst ratings

  • Regulators and legislators increasing pressure

    • Focus on conflicts and rating shopping

    • Legal risk in structured finance

  • Need to address use of ratings

    • Government regulations

      • Abolish NRSRO designation

    • Investment guidelines

    • Private contracts (loan agreements, swaps, etc.)

Jerome S. Fons