Introduction Originally intermediaries that specialized in

assessing the credit worthiness of railroads, industrial corporations, and financial institutions.

April 2007: “it could be structured by cows and we would rate it.” (Internal communication between rating agency analysts)

No opinion on whether debt instrument should be bought or sold

Authority on Ratings Artificially propped up demand Barriers to entry

From 1975-2006 Vague NRSRO requirementsCredit Rating Reform Act 2006

Why do we need them?

Information asymmetries between borrowers and lenders Issuers have superior information

Efficiency○ Costly and duplicative for purchasers to do

their own research○ Rapid dissemination of information

Subprime Securitization Structure

Source: Written Testimony of Christopher L. Peterson,– Hearing before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, , Subprime Mortgage Market Turmoil: examining the role of securitization

Structured Finance

What went wrong? Tremendous growth of structured finance combined with Limited Historical Data

RMBS rely on quantitative models and analyst judgment whereas corporate debt includes long historical records.

Underestimated housing downturn Pooling reduced idiosyncratic risk but increased exposure to

systematic risk Change in economic conditions extremely important, whereas

corporate credit assumes neutral economic conditions Underestimated originator risk

Diversification across borrowers within a mortgage pool but not across originators, issuers or servicers.

correlated risk across the loans related to servicer and/or originator quality.

Sources: WSJ, Financial Statements,ewrockwell.com

“There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service.”

Thomas Friedman (NYT), Feb. 13, 1996

Credit Rating Business

Credit rating agencies sell Ratings (or “opinions”)

not statements of facts and certainly not investment advice

Advice to rated firmsCredit Rating Advisory Services

Current Business Model

Credit agencies are paid By investors prior to 1970s By rated issuers or by underwriters now

So, who should pay?

Issuers?Provides benefits via rapid dissemination of

ratings.Strong potential conflict of interestPower to suppress unwanted ratings

So, who should pay?

Investors?Free-riding problemIf to a select group of willing and able

investors, may stoke populist fearsStill has conflicts of interest - creating

demand for lower rating which means higher interest.

“go back to their roots and have investors pay for the ratings”

Sen. Schumer (D-NY), Sept. 26, 2007

Pivotal Role in Structure Finance Theme of the game

Only added value to rated securities

Sole source of confidence in the process Opacity of rated securities

Rating-dependent investment by large institutional investors Only allowed to invest in investment-grade

or above

Conflicts of Interest Inherent conflicts under the “issuers-

pay” model Issuers only cares about high rating -

accuracy becomes less relevant Rating and advisory business

“Credit rating agencies are playing both coach and referee in giving advice to issuers of debt”Sen. Robert Menendez, D-NJ, Sept. 26, 2007

Conflicts of Interest

Traditional corporate bond rating businessLarge base of clienteleLower profit marginReputation risk

Deepened Conflicts of Interest Structured finance business

A handful of banksExcessively high profit marginRating shoppingHuge pressure for getting the deals done

In subprime crisis, rating agencies assigned too favorable ratings,

especially for subprime residential mortgage-backed securities (RMBS)

did not maintain appropriate independence from the issuers and underwriters of those securities

failed to adjust those ratings sooner as the performance of the underlying assets deteriorated

Resemblance to Enron?

Similarities in fee structures (the rated-pay)

Reliance on certified opinions (investors) Reluctance to give negative opinion on

the ground of revenue consideration (accounting firms)

Whom Can We Rely On…

when there is no one to trust?

Views from Three PerspectivesRegulators (SEC)

Investors

Rating Agencies Themselves

SEC’s New Regulation on Rating Agencies SEC’s Summary Report (July 2008)

http://www.sec.gov/news/studies/2008/craexamination070808.pdf

An evaluation report on Fitch, Moody, and S&P

Examinations Summary of SEC Release There was a substantial increase in the number and in the

complexity of RMBS and CDO deals since 2002, and some of the rating agencies appear to have struggled with the growth.

Significant aspects of the ratings process were not always disclosed. Policies and procedures for rating RMBS and CDOs can be better

documented. The rating agencies are implementing new practices with respect to

the information provided to them. The rating agencies did not always document significant steps in the

ratings process - including the rationale for deviations from their models and for rating committee actions and decisions - and they did not always document significant participants in the ratings process.

The surveillance processes used by the rating agencies appear to have been less robust than the processes used for initial ratings.

Issues were identified in the management of conflicts of interest and improvements can be made.

The rating agencies' internal audit processes varied significantly.

SEC New Rules for Rating Agencies

Additional requirements on the conduct of Nationally Recognized Statistical Rating Organizations (NRSROs) Release No. 34-59342, available at

http://www.sec.gov/rules/final/2009/34-59342.pdf

• Additional proposed rules for NRSROs Release No. 34-59343 available at

http://www.sec.gov/rules/proposed/2009/34-59343.pdf

Abstract of Adopted Rules Disclosure of Information Used in the Rating Process

When an NRSRO is hired by an arranger to rate a structured finance product, the following rules would all apply: The NRSRO would be required to disclose to other NRSROs that it was

providing the rating; The arranger would be required to represent to each hired NRSRO that

the arranger will provide the same rating-related information to other NRSROs that it gives to the hired NRSRO; and

NRSROs seeking to access information maintained by hired NRSROs and arrangers would be required to certify annually to the Commission the limits on their use of the information.

Adoption of the No-Advice Rule Prohibits NRSROs from providing any structuring advice relating to the

securities that they rate.

Other New Rules

Abstract of Adopted Rules Rules not finalized relating to the other two

subjects: A change in the rating symbols or disclosure applied

to ratings of structured finance products; and Amendments intended to reduce reliance on NRSRO

ratings in the Commission's rules.

Statutory StructureRegistration Oversight Conflicts of Interest

Registration at the SEC as NRSRO.

Application includes information on:1. ratings’ performance2. procedures and methodologies3. policies against misuse ofprivate information4. organizational structure5. code of ethics6. conflicts of interest7. 20 largest issuers or subscribers8. certification of institutionalinvestors that the ratings areconsidered significant

The SEC has soleresponsibility forsupervision.

The SEC has nosay in the ratings’substance,procedures andmethodologies.

The SEC cansuspend or limitoperations orrevoke the licenseif the NRSRO doesnot comply withthe regulation orfails to maintainadequate resourcesto produce validratings.

Appropriate policies and procedures tomanage and address conflicts of interest.

The SEC has the authority to issue rulesconcerning conflict of interests related to:1.Compensation2.Consulting and advisory services3.Personal and ownership conflicts4.Affiliation with issuers5.Other conflicts of interest the SECdeems necessary;

prohibit an NRSRO from issuing a ratingwhere the NRSRO or a person associatedwith the NRSRO has maderecommendations as to structuring thesame products that it rates;

prohibit anyone who participates indetermining a credit rating fromnegotiating the fee that the issuer pays forit, to prevent business considerations fromundermining the NRSRO’s objectivity;

prohibit gifts from those who receiveratings to those who rate them, in anyamount over $25.

Statutory Structure (Cont.)Transparency Competition Governance

Periodic private disclosure of financial conditions

Require disclosure by the NRSROs of whether and how information about verification performed on the assets underlying a structured product is relied on in determining credit ratings.

Require disclosure of how frequently credit ratings are reviewed; whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings.

Require NRSROs to make an annual report of thenumber of ratings actions they took in each ratings class.

Require documentation of the rationale for anymaterial difference between the rating implied by a qualitative model that is a “substantial component” in the process of determining a credit rating and the final rating issued.

Require NRSROs to differentiate the ratings theyissue on structured products from other securities, either through issuing a report disclosing how procedures and methodologies and credit risk characteristics for structured finance products differ from other securities, or using different symbols, such as attaching an identifier to the rating.

Require NRSROs to make all of their ratings andsubsequent ratingactions publiclyavailable, to facilitatecomparisons ofNRSROs by making it easier to analyze the performance of the credit ratings the NRSROs issue interms of assessingcreditworthiness.

Require NRSROs to publish performancestatistics for one,three and ten yearswithin each ratingcategory, in a waythat facilitatescomparison withtheir competitors inthe industry.

Prohibit an NRSROfrom issuing a ratingon a structuredproduct unlessinformation on thecharacteristics ofassets underlying theproduct is available,in order to allow other credit rating agencies to use the information to rate the product and, potentially, expose a rating agency whose ratings were undulyinfluenced by theproduct’s sponsors.

Prohibition of use ofnon-publicinformation for profit.

Criticism to SEC Regulations Too little, too late June 2008 Proposals – very bold; final

document – very limited Any real desire to drastically reform or

remake the industry? Don't wean investors off their reliance on

credit rating agencies Do nothing to ensure accurate ratings A furtherance of the abdication of its

responsibility

Reform?

No Easy Answer

Some Legislative Suggestions Urge rating agencies to

Provide a range for the risk of each instrument rather than a point estimate;

Develop a distinct rating scale for structured finance products

Introduce explicit legal liability for negligence or malfeasance

Some Legislative Suggestions Separating rating from consultancy and

advisory functions Give up highly remunerative advisory work will

be extremely difficult politically More rating agencies

Introducing competitiveness

Eliminating the “regulatory license” by abolishing recognition i.e., removing the NRSRO designation and

merely requiring agencies to register with the regulators

Some Legislative Suggestions Rating quality could be improved by adopting

a rule requiring a rating agency to either:

(a) disgorge that it believes that its ratings on a new product is of low quality; or

(b) disgorge profits derived from selling ratings on new products that turn out to be of poor quality

Unsolicited Rating vs. Solicited Ratingencourage solicited rating, strengthen information

disclosure

As Investors…

Be objective towards rating agencies and their ratings

The investor’s reliance on rating results has an amplifying effect on the products

As Rating Agencies Themselves… Interest related with clients

Hard to stick to neutrality and self-integrity

$25 cannot solve Strengthening internal management

capital structure internal governance rating data base, theories, models