the role of credit rating agencies in the sub-prime crisis charles cronin, cfa head cfa institute...
TRANSCRIPT
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!
Page 2
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.
Page 3
What is Structured Finance?
Alchemy Genius
Page 4
What is Structured Finance?
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
Page 5
What is Structured Finance?
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
Page 6
What is Structured Finance?
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”
Page 7
What is Structured Finance?
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
Page 8
What is Structured Finance?
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%
Page 9
So what went wrong?
Page 10
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 £
Page 11
So what went wrong?
Page 12
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
Page 13
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
Page 14
Notching
A dark practice?
♠ Unsolicited rating of debt♦ An anecdote♦ Sour grapes or sound advice?
Page 15
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
Page 16
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
Page 17
The Regulatory response
IOSCO?
♠ Awaiting news