Operations and Regulation of the Credit Rating Industry

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Operations and Regulation of the Credit Rating Industry Dec 16 th 2008, Sanya, Hainan Island, China Jorge Mina jorge.mina@riskmetrics.com Alan Laubsch alan.laubsch@riskmetrics.com

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Agenda Background CRA's and Structured Finance Markets IOSCO's Code of Conduct European Commission Regulation SEC Rules on NRSRO's and Credit Ratings Portfolio Perspective Integral Risk Management Final Observations and Recommendations

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Brief History Significant development in subprime loaning beginning in 2000 Home estimations began declining in the second 50% of 2006 prompting to expanded wrongdoings and defaults Losses on advances had a direct unfriendly effect on market qualities and liquidity of RMBS and CDO's lined to subprime advances The subprime emergency spread to the more extensive credit showcase first and after that to the economy all in all Mortgage agents, advance originators, guarantors, and FICO assessment organizations (CRA) required in subprime bargains have gone under examination for their part in the development of this market

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U.S. Lodging Bubble Burst & MBS issuance Source: BBC News

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$10,000 $9,000 300% $8,000 $7,000 $6,000 250% $5,000 Federal Debt ($ bil) $4,000 200% $3,000 $2,000 Percent of GDP 150% $1,000 $0 100% 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 half 0% 1947 1963 1975 1991 1943 1955 1959 1967 1971 1979 1983 1987 1995 1999 2003 2007 1951 Total Consumer Debt Total Federal Debt Tremendous development in private area influence Federal and Consumer Debt as % of GDP 2 Government Debt (1) Office of Management and Budget, Budget of the United States, FY 2007 (2) U.S. Assembly of Commerce starting 8/27/08 Source: P. Olivier Sarkozy, The Carlyle Group, "Diagram: Financial Services Industry - What Went Wrong & What Does it Mean?"

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Broad bank influence internationally

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This cycle is novel with phenomenal influence all around Multi-reference organized credit items like CDO's made it simple for speculators to put on an immense measure of influence Basel 2 leads just oblige banks to set aside 0.56% administrative capital for AAA securities… infers influence of very nearly 200x. $2.3 tril in "AAA" ensures bolstered by six monoline back up plans with under $20 bil in value (0.8%). Source: Pershing Square Capital Management. "The most effective method to Save the Bond Insurers," 11/07

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CRA's and Structured Finance Markets - Issues Excessive Reliance on Ratings by Investors In organized items appraisals are frequently not just saw as a CRA's supposition on its financial soundness, additionally as a blessing (in spite of CRAs disclaimers) Lack of data on the structures makes it hard to make a free evaluation Non-complex speculators don't have the capacities to make an autonomous appraisal of the credit chance inalienable in these securities Sophisticated speculators may have the abilities, however think that its costly to freely approve the CRA's work The "begin to-disperse" demonstrate takes out motivating forces for home loan specialists, advance originators, guarantors, and guarantors to play out an autonomous hazard evaluation Investors don't appear to be (even now) exceptionally excited about assuming more liability for the hazard evaluation of these securities

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CRA's and Structured Finance Markets - Issues Conflicts of Interest A potential irreconcilable circumstance emerges through the "backer pays" display The potential for struggle is more noteworthy in organized items Concentration: the volume of arrangements from a solitary organization is regularly expansive and could bring about a concentrated income stream from a solitary guarantor Advice to accomplish a rating: CRAs give data permitting arrangers to comprehend the connection between model yields and rating choices as for the credit improvement required to bolster a specific rating. Arrangers can consider the criticism and decide autonomously to roll out improvements the length of the input procedure doesn't transform into prompt from CRA's with respect to how to accomplish a craved rating One other option to the "backer pays" plan of action is to have guarantors pay, yet financial specialists select how to circulate rating expenses over CRA's (like value research)

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CRA's and Structured Finance Markets - Issues Competition Information on organized fund exchanges is less straightforward making spontaneous appraisals more hard to give. A similar data ought to be made accessible to all licensed CRAs Without spontaneous evaluations new contestants have no chance to build up a reputation "Rating shopping": backers regularly approach CRAs for forthcoming appraisals on structures before procuring them. Since guarantors have clear motivating forces to look for the most astounding rating, this practice prompts to cases that aggressive weight prompts to appraisals swelling

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CRA's and Structured Finance Markets - Issues Transparency Structured fund items are perplexing and they ought to be dealt with thusly Not separating between evaluations of organized items and appraisals of securities can befuddle to speculators The hazard profile of an organized item is altogether different from the hazard profile of a plain vanilla security A security either defaults or does not default so the credit misfortune profile can be sensibly surely knew and recognized from that of different securities by a solitary number (or indent on a rating scale) Losses on an organized item rely on upon what number of the individual hidden advances default over a specific timeframe. This implies two organized items can have a similar normal misfortunes, however altogether different misfortune circulations. As it were, a solitary number (or indent on a rating scale) can't catch the whole hazard profile of an organized item making it hard to look at comparatively appraised organized items and bonds Model suspicions must be unveiled and disclosed Provide extra data to see better the full hazard profile. A few alternatives are safety buffer, instability of appraisals, and examination of extraordinary situations

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CRA's and Structured Finance Markets - Issues Quality of Ratings Rating organized fund items requires more advanced investigation than rating single name securities specifically, one needs to model default relationships Ex-post the expected connections ended up being low. The suspicions going into the models should be refined and scattered so advertise members can comprehend them Potential clash issue? Guarantors normally hold the value tranche and offer the senior tranche. With lower accepted relationships senior tranches have all the earmarks of being less unsafe and value tranches have all the earmarks of being less secure.

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Regulatory Response The administrative reaction has been brisk and educated by suggestions from IOSCO, CESR, ESME, Financial Stability Forum (FSF), and the President's Working Group on Financial Markets There are three primary collections of administrative work in this way: May 2008 - IOSCO distributes an update to the Code of Conduct Fundamentals for Credit Rating Agencies (not entirely administrative, but rather all evaluating offices have promised to take after the set of principles) Nov 2008 – European Commission distributes a last proposition for a Regulation of the European Parliament and of the Council on Credit Rating Agencies Dec 2008 – SEC distributes revisions and new guidelines identifying with Nationally Recognized Statistical Rating Organizations and Credit Ratings The standards are not indistinguishable, but rather there is critical cover in the three archives. IOSCO's Code of Conduct is generally viewed as the worldwide benchmark, however the real directions are more particular in specific ranges

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IOSCO's Code of Conduct – Highlights Quality of the Rating Process CRAs ought to embrace measures so that the data used to dole out appraisals is of adequate quality CRAs ought to survey the plausibility of rating structures substantially not quite the same as the ones they at present rate CRAs ought to figure out if existing philosophies and models are suitable for a specific sort of structure item (counting the hidden securities) Integrity of the Rating Process CRAs ought to restrict investigators from making suggestions with respect to the plan of organized items they rate CRAs Procedures and Policies A CRA ought to uncover on the off chance that it gets 10 percent or a greater amount of its yearly income from a solitary customer CRAs as an industry ought to support organized back guarantors and originators to reveal all applicable data in regards to those items so different gatherings can perform autonomous examinations

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IOSCO's Code of Conduct – Highlights Transparency and Timeliness of Ratings Disclosure CRAs of organized items ought to give adequate data about its misfortune and income investigation to comprehend the reason for the CRA's evaluating. Affectability investigation of rating suppositions ought to likewise be revealed CRAs ought to separate evaluations of organized back items from customary corporate security appraisals CRAs ought to help speculators in building up a superior comprehension of what a FICO score is (counting its constraints)

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European Commission Regulation – Highlights Three fundamental destinations. Guarantee that: Credit evaluations are not influenced by irreconcilable circumstances Credit appraisals are of amazing CRAs act in a straightforward way Requirements are like (in reality in light of) IOSCO's Code of Conduct, yet it gives an authorization system by setting up an enlistment and observation structure CRA's need to enlist so that their appraisals can be utilized for administrative purposes by credit organizations, venture firms, insurance agencies, UCITS, and annuity reserves set up in the European Union Registration is separate from the current procedure to be approved as an External Credit Assessment Institution (ECAI) for the motivations behind the Capital Requirements Directive (CRD) for banks

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SEC Rules on NRSRO's a