the role of credit rating agencies in the sub-prime crisis

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

Charles Cronin, CFA

Head CFA Institute Centre, EMEA

Wien/Vienna 2nd June 2008

CRAs – their last call!

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.

What is Structured Finance?

Alchemy Genius


The Basic Idea

Water = 99 l

Poison () = 1l = 0.01 or 1%1% is board line toxic

Senior BottleWater 90 lPoison 0.1 l= 0.0011Very Safe

Mezzanine BottleWater 6 lPoison 0.05 l= 0.008Drinkerable

Equity BottleWater 3 lPoison 0.85 l= 0.221Lethal

Note – the amount of poison is unchanged only the allocation is different


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


Ratings and their meanings

S&P - Fitch / Moody’sAAA / AaaAA / AaA / ABBB / Baa

________________________________________

BB / BaB / BCCC / CaaCC / CaC / C

Investment Grade!?

Non-Investment Grade aka “High Yield” or

“Junk”


Issuer-Weighted Default Rates (Year 5) in % [*] %

AAA/Aaa 0.163AA/Aa 0.718A/A 1.132BBB/Baa 3.262

_________________________________________

%BB/Ba 9.833B/B 22.451CCC/CaaCC/Ca ≈ 40C/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


Mechanics of a CDO

Many

Assets

(rating ≈ B)

$100 +

Yield ≈ 9%

Senior$70

Mezzanine$20

Equity$10

Assets Liabilities

SPV

Trust

Cash flows

(Waterfall)

AAA/AaaC = 6%

BBB/BaaC = 8%

ResidualUnrated

IRR = 20%

So what went wrong?

So what went wrong?

US & UK 10 year Government Bond Yields

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

Yld 10 $ Yld 10 £

So what went wrong?

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

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

Notching

A dark practice?

♠ Unsolicited rating of debt♦ An anecdote♦ Sour grapes or sound advice?

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

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

The Regulatory response

IOSCO?

♠ Awaiting news

the role of credit rating agencies in the sub-prime crisis

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