This lecture has been part of the European and International Financial Institutions module at Glasgow-Caledonian University (GCU) and was delivered by Markus Krebsz on 7th March 2013 in London.

1. The Credit Crisis
and beyond:
Lessons from the Financial Crisis
& Sound Practice Principles
Markus Krebsz
7 March 2013, London
European & International Financial Institutions lecture

2. 1) Lessons from the Financial Crisis
Lesson 1: Data, Disclosure and Standardization
Lesson 2: Due diligence
Lesson 3: Deal motives
Lesson 4: Arbitrage
Lesson 5: Rating shopping & Over-reliance on ratings
Lesson 6: Models, Assumptions & Black boxes
Lesson 7: Proprietary analysis & Risk management
Lesson 8: Senior management awareness
Lesson 9: Lack of drill-down capability
Lesson 10: Mark-to-market, Mark-to-model & Illiquidity
________________________________________________________________________________________________________________________
Source: “Securitization & Structured Finance
post Credit Crunch” – Part I
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3. 3

4. Lesson 1:
Data, Disclosure +
Standardization
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5. Data, Disclosure & Standardization
• Banks’ due diligence vs. outsourced analysis (CRA)
• Historical information  Future performance: NO!!!
• Model = Always model, NOT true reflection of reality
• Paper reports  issues & problems
• Electronic reports  depends on file format really
• Data feeds & APIs
• Definitions  Product taxonomy
• Non-comparability of ratings across CRAs
• Lack of clear reporting or underwriting standards 5

6. Lesson 2:
Due diligence?
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7. Due diligence
• Activities investors should undertake prior to
purchasing new or secondary market bond issuance
• CRAs don’t do “due diligence” but only “servicer
reviews” – investors don’t always know this
• Thorny issues & digging deeper: not really
• CRAs are always conflicted in their opinion given
that they are paid by the bond issuer for the rating!
• Issuer pays model (since 1970)
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8. Lesson 3:
Deal motives
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9. Deal motives
• Investors need to ask more questions such as:
“What is in it for us?” (i.e. the investors)
AND
“What is in it for THEM?” (i.e. the issuers)
• Plausible explanation for a particular deal?
• Why has the deal been structured?
• Capital structure of the transaction?
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10. Lesson 4:
Arbitrage
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11. Arbitrage
• Financial motivation, such are arbitrage
• Aim is to leverage an actual or perceived advantage
• Regulatory arbitrage: applying different rules for
calculating capital charges under BII regime
• Informational arbitrage: different levels of insights
or information on underlying assets
• Technological arbitrage: more sophisticated
models with perceived or real analytical edge
• Financial arbitrage: Cash flow advantage, excess
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12. 5:
Using
CRAs’
analysis
sensibly
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13. Rating shopping and Over-reliance on Ratings
• Rating by one CRA missing?
 It’s worth digging deeper!
• Reasons: cheaper credit enhancement (C/E)
 Indicating rating shopping!
• Happened often in the run up to the Credit Crisis
• If you are an investor, simply ASK the CRA
• Credit ratings have been key investment criteria
• Outsourcing analysis possible, BUT:
outsourcing losses is not
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14. Timely rating actions and Deferral
Timeliness of Rating changes Bond maturity profile
• Process stages to reach • Legal final vs. expected
rating decisions maturity
• Detection of bond- vs. • Life-time ratings (40+ years)
asset class-specific • Timely payment of interest &
and/or systemic issues ultimate payment of principal
31 July 07 20 Aug 07 31 Aug 07 9 Oct 07 16 Oct 07 25 Oct 07
Cut-off date CRA analyst Proposal: RWN CRA Analyst Proposal: DG Indiv. or Asset-class?
Bulk rating
actions &
Report format & frequency, Analyst’s experience, Models, Quorum ...
Criteria
15 Aug 07 27 Aug 07 25 Sept 07 12 Oct 07 23 Oct 07 You get
Distribution
st
1 Analysis result st
1 Committee nd
2 Analysis result nd
2 Committee the idea... Changes
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15. Constructive Criticism
• Business model: Too slow to react
• Assumptions, methodologies & models
• Conflict of interest (‘issuer-pays’ model)
• Limited capture
• Split ratings
• Notching of competitor’s ratings
• Implied ratings & internal competition
• “Getting it wrong”, “Fat fingers”
• etc. 15

16. Failures of CRAs
AIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic
banks, Lehman Bros., Monolines, Northern Rock, Parmalat,
Sovereigns (Eurozone), Sub-prime bonds etc.
In their own words...
Fitch: “… did not foresee the magnitude of the decline…or
the dramatic shift in borrower behavior…”
Moody’s: “…We did not . . . anticipate the magnitude and
speed of the deterioration in mortgage quality or the
suddenness of the transition to restrictive lending...”
S&P: “…It is now clear that a number of assumptions used
in preparing ratings on mortgage-backed securities issued
between 2005 and mid-2007 did not work…”
Source: US Government Oversight and Reform Committee, Oct 2008
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17. Sensible use of CRAs’ analysis
• Fully understand the instrument you are investing in –
particularly when using other peoples’ monies
• Understand ratings’ limitations and
know how to mitigate rating-related risks (previous slide)
• ‘Ignore’ ratings designators (i.e. AAA etc.) and
focus on CRAs’ analytical narrative instead
• Look out for what is NOT there in the narrative but should
e.g. Why are obvious issues missing in the analysis?
Why has this bond not been rated by all three CRAs?
• Apply common sense and trust your gut feeling 17

18. Lesson 6:
Captured Risks
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19. Models, Assumptions & Black Boxes
• Extensive use of financial models to do “analysis”
• Fairly simple to highly complex quantitative models
• A “model” is ALWAYS only a “model”!
• Models CANNOT simulate reality!
• Model failures exacerbated by using inadequate
assumptions, i.e. through the cycle – 10-12 years only
• Historic data points as input into model: limited data?
• Black box: locked-down back-end with no access for
users, i.e. not easy and often impossible to reconcile
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20. Lesson 7:
Proprietary
analysis
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21. Proprietary analysis & Risk management
• Often overlooked: Good old-fashioned analysis
• Done by dedicated teams of credit analysts
• Analysis, loads of analysis
• Gut feeling & Common sense (which is not so common)
• Lack of qualified risk management practices
• Firm’s strategy  Risk appetite  Risk policy 
Investment guidelines etc.
• Robust risk management function needs to be
empowered by the firm to say “NO!” sometimes
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22. Lesson 8:
Senior management
awareness
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23. Senior management awareness
• Management reporting – or lack of it
• Limited systems capabilities
• Filtering of reports through distribution channels up the
chain
• Does the information at board level paint a full picture?
• Senior mgmt. ignorance or misinterpretation of data
• Senior mgmt. does not understand
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24. Lesson 9:
Lack of Drill-down +
Group-wide Controls
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25. Lack of drill-down capability & Group-wide controls
• US subprime replaced with investments in CDO of ABS
• Minor issue becomes major disaster
• “Repackaged” garbage is still garbage!
• One desk sells and the other buys, largely ignoring firm-
wide strategy
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26. Lesson 10:
Mark-to-Market,
Market-to-model
+ Illiquidity
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27. Mark-to-market, Mark-to-model & Illiquidity
“Normal times”: Mark-to-market
• Electronic trading matching bid/offers or
• Collection of broker quotes by phone
“Periods of limited market stress”: Mark-to-model
• If there is no “normal” market  market-to-model
• Based on pricing models which are based on “normal”
markets
“Periods of prolonged illiquidity”:
• Difficult to price if there is no market at all! Force sale? 27

28. 2) Sound practice principles
DATA
Principle 1: Access: Open source
Principle 2: Information asymmetries
Principle 3: Data formats
Principle 4: Data delivery
Principle 5: On deal level
Principle 6: For the market at large
Principle 7: Industry data portals
DEFINITIONS
Principle 8: Simplifications
Principle 9: Transparency
Principle 10: Standardisation
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29. STANDARDS
Principle 11: Underwriting standards
Principle 12: Reporting standards
Principle 13: Representations & warranties
INVESTOR FOCUSED
Principle 14: Government facilities
Principle 15: Private investors
Principle 16: Incentive alignments
MOTIVATION & DEAL DRIVERS
Principle 17: Arbitrage
Principle 18: Rating shopping
Principle 19: Risk transfer & “Skin in the game”
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30. ANALYSIS
Principle 20: Reduced over-reliance on credit ratings
Principle 21: Increased proprietary analysis
Principle 22: Models, assumptions and common sense
Principle 23: Risk management & Risk mitigation
References & Appendix
“Securitization & Structure Finance post Credit Crunch –
A Best Practice Deal Lifecycle Guide”, M. Krebsz (Wiley 2011)
Please see Part I of the book attached for your kind reference:
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