2. 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

3. Authority on Ratings
 Artificially propped up demand
 Barriers to entry
From 1975-2006 Vague NRSRO requirements
Credit Rating Reform Act 2006

4. 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

5. 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

6. Structured Finance

7. 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.

8. Sources: WSJ, Financial Statements,

10. “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

11. Credit Rating Business
Credit rating agencies sell
 Ratings (or “opinions”)
 not statements of facts and certainly not
investment advice
 Advice to rated firms
 Credit Rating Advisory Services

12. Current Business Model
Credit agencies are paid
 By investors prior to 1970s
 By rated issuers or by underwriters now

13. So, who should pay?
 Issuers?
Provides benefits via rapid dissemination of
ratings.
Strong potential conflict of interest
Power to suppress unwanted ratings

14. So, who should pay?
 Investors?
Free-riding problem
If to a select group of willing and able
investors, may stoke populist fears
Still 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

15. 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

16. 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

17. Conflicts of Interest
 Traditional corporate bond rating
business
Large base of clientele
Lower profit margin
Reputation risk

18. Deepened Conflicts of Interest
 Structured finance business
A handful of banks
Excessively high profit margin
Rating shopping
Huge pressure for getting the deals done

19. 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

20. 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)

21. Whom Can We Rely On…
when there is no one to trust?

22. Views from Three
Perspectives
Regulators (SEC)
Investors
Rating Agencies Themselves

23. SEC’s New Regulation on
Rating Agencies
 SEC’s Summary Report (July 2008)
 http://www.sec.gov/news/studies/2008/craex
amination070808.pdf
 An evaluation report on Fitch, Moody,
and S&P

24. Examinations Summary of SEC
Releasea substantial increase in the number and in the
 There was
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

25. 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

26. 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

27. 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.

28. Statutory Structure
Registration Oversight Conflicts of Interest
Registration at the SEC as The SEC has sole Appropriate policies and procedures to
NRSRO. responsibility for manage and address conflicts of interest.
supervision.
Application includes The SEC has the authority to issue rules
information on: The SEC has no concerning conflict of interests related to:
1. ratings’ performance say in the ratings’ 1.Compensation
2. procedures and substance, 2.Consulting and advisory services
3.Personal and ownership conflicts
methodologies procedures and
4.Affiliation with issuers
3. policies against misuse of methodologies. 5.Other conflicts of interest the SEC
private information deems necessary;
4. organizational structure The SEC can
5. code of ethics suspend or limit prohibit an NRSRO from issuing a rating
6. conflicts of interest operations or where the NRSRO or a person associated
7. 20 largest issuers or revoke the license with the NRSRO has made
subscribers if the NRSRO does recommendations as to structuring the
8. certification of institutional not comply with same products that it rates;
investors that the ratings are the regulation or
considered significant fails to maintain prohibit anyone who participates in
adequate determining a credit rating from
resources negotiating the fee that the issuer pays for
to produce valid it, to prevent business considerations from
ratings. undermining the NRSRO’s objectivity;
prohibit gifts from those who receive
ratings to those who rate them, in any
amount over $25.

29. Statutory Structure (Cont.)
Transparency Competition Governance
Periodic private disclosure of financial conditions Require NRSROs to Prohibit an NRSRO
make all of their ratings from issuing a rating
Require disclosure by the NRSROs of whether and how and on a structured
information about verification performed on the assets subsequent rating product unless
underlying a structured product is relied on in determining actions publicly information on the
credit ratings. available, to facilitate characteristics of
comparisons of assets underlying
Require disclosure of how frequently credit ratings are NRSROs by making it the
reviewed; whether different models are used for ratings easier to analyze the product is available,
surveillance than for initial ratings; and whether changes performance of the in order to allow
made to models are applied retroactively to existing ratings. credit ratings the other credit rating
NRSROs issue in agencies to use the
Require NRSROs to make an annual report of the terms of assessing information to rate
number of ratings actions they took in each ratings class. creditworthiness. the product and,
potentially, expose a
Require documentation of the rationale for any Require NRSROs to rating agency whose
material difference between the rating implied by a publish performance ratings were unduly
qualitative model that is a “substantial component” in the statistics for one, influenced by the
process of determining a credit rating and the final rating three and ten years product’s sponsors.
issued. within each rating
category, in a way Prohibition of use of
Require NRSROs to differentiate the ratings they that facilitates non-public
issue on structured products from other securities, either comparison with information for
through issuing a report disclosing how procedures and their competitors in profit.
methodologies and credit risk characteristics for structured the industry.
finance products differ from other securities, or using
different symbols, such as attaching an identifier to the
rating.

30. 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

31. Reform?
 No Easy Answer

32. 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

33. Some Legislative
Suggestionsfrom consultancy and
 Separating rating
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

34. 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 Rating
 encourage solicited rating, strengthen information
disclosure

35. As Investors…
 Be objective towards rating agencies
and their ratings
 The investor’s reliance on rating results
has an amplifying effect on the products

36. 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