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Rating Agencies as Gatekeepers

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

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  1. Rating Agencies as Gatekeepers Jerome S. Fons September 11, 2009 Federal Reserve Bank of Cleveland Consumer Protection Conference

  2. 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

  3. Current NRSROs Jerome S. Fons

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

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