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The Role of Credit Rating Agencies in the Sub-Prime Crisis

The Role of Credit Rating Agencies in the Sub-Prime Crisis. CRAs – their last call!. Charles Cronin, CFA Head CFA Institute Centre, EMEA. Wien/Vienna 2 nd June 2008. Agenda. Introduction What is Structured Finance? How did it all go wrong Can we blame the CRAs for …? Notching

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The Role of Credit Rating Agencies in the Sub-Prime Crisis

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  1. The Role of Credit Rating Agencies in the Sub-Prime Crisis CRAs – their last call! Charles Cronin, CFA Head CFA Institute Centre, EMEA Wien/Vienna 2nd June 2008

  2. Agenda • Introduction • What is Structured Finance? • How did it all go wrong • Can we blame the CRAs for …? • Notching • The CFA Institute Centre response • The Regulatory response Acknowledgement to Arturo Cifuentes, MD Structured Finance at R.W.Pressprich & Co. New York for some of the slides in this presentation.

  3. What is Structured Finance? Alchemy Genius

  4. What is Structured Finance? The Basic Idea • Senior Bottle • Water 90 l • Poison 0.1 l • = 0.0011 Very Safe • Mezzanine Bottle • Water 6 l • Poison 0.05 l • = 0.008 Drinkerable • Equity Bottle • Water 3 l • Poison 0.85 l • = 0.221 Lethal • Water = 99 l • Poison () = 1l • = 0.01 or 1% 1%  is board line toxic Note – the amount of poison is unchanged only the allocation is different

  5. What is Structured Finance? • Credit Risk - What is it? • It is the Risk of Loss as a Result of a Debtor’s • Inability or Unwillingness to Repay a Debt • • Inability (Cannot): WorldCom • • Unwillingness (Don’t Feel Like It): Argentina

  6. What is Structured Finance? • Ratings and their meanings • S&P - Fitch / Moody’s • AAA / Aaa • AA / Aa • A / A • BBB / Baa • ________________________________________ • BB / Ba • B / B • CCC / Caa • CC / Ca • C / C Investment Grade!? Non-Investment Grade aka “High Yield” or “Junk”

  7. What is Structured Finance? • Issuer-Weighted Default Rates (Year 5) in % [*] • % AAA/Aaa 0.163 AA/Aa 0.718 A/A 1.132 BBB/Baa 3.262 • _________________________________________ • % BB/Ba 9.833 B/B 22.451 CCC/Caa CC/Ca ≈ 40 C/C • Important: ratings measure credit risk • (they do not reflect liquidity, volatility, appreciation potential, etc.; ONLY Credit Risk) • [*] Corporate Default and Recovery Rates, Moody’s Report, February 2007

  8. What is Structured Finance? • Mechanics of a CDO Assets Liabilities AAA/Aaa C = 6% BBB/Baa C = 8% Residual Unrated IRR = 20% Many Assets (rating ≈ B) $100 + Yield ≈ 9% Senior $70 Cash flows (Waterfall) SPV Trust Mezzanine $20 Equity $10

  9. So what went wrong?

  10. So what went wrong?

  11. So what went wrong?

  12. Can we blame the CRAs for …? • Yes and no – Investors need to shoulder much of the blame • Trustees/fiduciaries/managers at fault • Seal of approval • Failures of due diligence • Credit constraint on bond portfolios • Investment managers not incentivised to raise concerns

  13. Can we blame the CRAs for …? • CRAs made some key contributions • The smoking gun – AAA recovery 60¢ on the $1 • Model failure • Default correlations • Failure to disclosure assumptions • An assumption is an opinion • CFAI Code & Standards • Exercise diligence • Act with reasonable basis

  14. Notching • A dark practice? • Unsolicited rating of debt • An anecdote • Sour grapes or sound advice?

  15. CFA Institute Centre response • Capital Markets Policy Council • Change in nomenclature for structured products • Eliminate the use of the term “Investment Grade” • Prohibit “Notching” • Executive level compliance officer at CRAs • Refrain from rating without “robust” analysis • Strong SRO for CRAs • In EMEA responded to CESR & IOSCO consultations

  16. The Regulatory response • CESR – robust and uncompromising • “immediate”, “short term”, “should step in” • International CRA standard setter of all stakeholders • International > European > Regulate • Transparency > model assumptions/which methodology • Human Resources > must be adequate for quality • Monitoring > resourced for timely rating changes • Conflicts of Interest > acceptable interaction w/ Issuers

  17. The Regulatory response • IOSCO? • Awaiting news

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