A CONSIDERED VIEWPOINT BY RISKMETRICS

Risk Management

Operations and Regulation of the Credit Rating Industry

Dec 16th 2008, Sanya, Hainan Island, China

Alan Laubsch

[email protected]

Jorge Mina

[email protected]

2www.riskmetrics.com 2Risk Management

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


Brief History

Significant growth in subprime lending starting in 2000

Home values started declining in the second half of 2006 leading to

increased delinquencies and defaults

Losses on loans had a direct adverse impact on market values and

liquidity of RMBS and CDO’s lined to subprime loans

The subprime crisis spread to the broader credit market first and

then to the economy as a whole

Mortgage brokers, loan originators, underwriters, and credit rating

agencies (CRA) involved in subprime deals have come under

scrutiny for their role in the build up of this market


U.S. Housing Bubble Burst & MBS issuance

Source: BBC News


Tremendous growth in private sector leverage

Government Debt 1

Federal and Consumer

Debt as % of GDP 2

$0

$1,000

$2,000

$3,000

$4,000$5,000

$6,000

$7,000

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$10,000

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Total Consumer Debt Total Federal Debt

(1) Office of Management and Budget, Budget of the United States, FY 2007(2) U.S. Chamber of Commerce as of 8/27/08Source: P. Olivier Sarkozy, The Carlyle Group, “Overview: Financial Services Industry - What Went Wrong & What Does it Mean?”


United States E/A Europe E/A Asia Pacific E/A

New York Community Bancorp 13.8% Sberbank 12.7% ICICI Bank Ltd. 11.6%

National City Corp. 11.7%Banca Monte dei Paschi di Siena S.p.A. 6.7% Samba Financial Group 9.8%

Huntington Bancshares Inc. 10.5% Banco Santander S.A. 5.8% Bank Central Asia 9.4%

Sovereign Bancorp Inc. 10.1% Unicredito Italiano Spa Ord 5.3% United Overseas Bank Ltd. 8.7%

Marshall & Ilsley Corp. 10.1% Allied Irish Banks PLC 5.2% BOC Hong Kong (Holdings) Ltd. 8.4%

M&T Bank Corp. 9.9% Standard Chartered PLC 5.1% Oversea-Chinese Banking Corp. Ltd. 8.4%

SunTrust Banks Inc. 9.8% HSBC Holdings PLC 5.0% China Citic Bank Corp. Ltd. 8.3%

State Street Corp. 9.6%Banco Bilbao Vizcaya Argentaria S.A. 5.0% DBS Group Holdings Ltd. 8.1%

Hudson City Bancorp Inc. 9.6% Erste Group Bank AG 4.2% HDFC Bank Ltd. 7.7%

BB&T Corp. 9.4% KBC Group N.V. 4.1% Hang Seng Bank Ltd. 7.4%

Zions Bancorp 9.2% Nordea Bank AB 4.0% Malayan Banking Bhd 7.2%

Fifth Third Bancorp 8.4% Svenska Handelsbanken A 3.7% Bank of China Ltd. 6.7%

U.S. Bancorp 8.2% Societe Generale S.A. 3.3% China Construction Bank Corp. 6.4%

Bank of America Corp. 8.1% Royal Bank of Scotland Group Plc 3.2% State Bank of India 6.0%

Wachovia Corp. 8.0% Danske Bank A/S 3.0%Industrial & Commercial Bank of China Ltd. 5.9%

KeyCorp 7.9% Credit Suisse Group AG 3.0% Bank of Communications Co. Ltd. 5.7%

Wells Fargo & Co. 7.9% Lloyds TSB Group PLC / HBOS PLC 3.0% China Merchants Bank Co. Ltd. 5.6%

UnionBanCal Corp. 7.8% BNP Paribas S.A. 2.8%Australia & New Zealand Banking Group Ltd. 5.3%

Comerica Inc. 7.7% Credit Agricole S.A. 2.5% Commonwealth Bank of Australia 5.3%

Washington Mutual 7.3% Commerzbank AG 2.3% China Minsheng Banking Corp. Ltd. 5.1%

JPMorgan Chase & Co. 7.2% UBS Ag 2.1% Westpac Banking Corp. 4.3%

Ameriprise Financial Inc. 7.0% ING Groep N.V. 2.0% Mitsubishi UFJ Financial Group Inc. 4.1%

Northern Trust Corp. 6.6% Barclays PLC 1.6% Sumitomo Mitsui Financial Group Inc. 3.2%

Citigroup Inc. 5.2% Deutsche Bank AG 1.6% Mizuho Financial Group Inc. 2.5%

Average 8.8% Average 4.0% Average 6.7%

Broad bank leverage globally


This cycle is unique with unprecedented leverage globally

Multi-reference structured credit products like CDO’s made it easy

for investors to put on a huge amount of leverage

Basel 2 rules only require banks to put aside 0.56% regulatory

capital for AAA securities… implies leverage of almost 200x.

$2.3 tril in “AAA” guarantees supported by six monoline insurers

with less than $20 bil in equity (0.8%). Source: Pershing Square Capital

Management. “How to Save the Bond Insurers,” 11/07


CRA’s and Structured Finance Markets -- Issues

Excessive Reliance on Ratings by InvestorsIn structured products ratings are often not only viewed as a CRA’s opinion on its creditworthiness, but also as a stamp of approval (despite CRAs disclaimers)

Lack of information on the structures makes it difficult to make an independent assessment

Non-sophisticated investors don’t have the capabilities to make an independent assessment of the credit risk inherent in these securities

Sophisticated investors might have the capabilities, but find it expensive to independently validate the CRA’s work

The “originate-to-distribute” model eliminates incentives for mortgage brokers, loan originators, issuers, and underwriters to perform an independent risk assessment

Investors do not seem (even now) very keen on taking more responsibility for the risk assessment of these securities



Conflicts of InterestA potential conflict of interest arises through the “issuer pays” model

The potential for conflict is greater in structured products

Concentration: the volume of deals from a single institution is often large and could result in a concentrated revenue stream from a single issuer

Advice to achieve a rating: CRAs provide information allowing arrangers to understand the link between model outputs and rating decisions with respect to the credit enhancement required to support a particular rating. Arrangers can consider the feedback and determine independently to make changes as long as the feedback process doesn’t turn into advise from CRA’s as to how to attain a desired rating

One alternative to the “issuer pays” business model is to have issuers pay, but investors select how to distribute rating fees across CRA’s (similar to equity research)



CompetitionInformation on structured finance transactions is less transparent making unsolicited ratings more difficult to provide. The same information should be made available to all accredited CRAs

Without unsolicited ratings new entrants have no opportunity to establish a track record

“Rating shopping”: issuers often ask CRAs for prospective assessments on structures before hiring them. Since issuers have clear incentives to seek the highest rating, this practice leads to claims that competitive pressure leads to ratings inflation



Transparency Structured finance products are complex and they should be treated as such

Not differentiating between ratings of structured products and ratings of bonds can be confusing to investors

The risk profile of a structured product is very different from the risk profile of a plain vanilla bond

A bond either defaults or does not default so the credit loss profile can be reasonably well understood and distinguished from that of other bonds by a single number (or notch on a rating scale)

Losses on a structured product depend on how many of the individual underlying loans default over a particular period of time. This means that two structured products can have the same average losses, but very different loss distributions.

In other words, a single number (or notch on a rating scale) cannot capture the entire risk profile of a structured product making it difficult to compare similarly rated structured products and bonds

Model assumptions have to be disclosed and explained

Provide additional information to understand better the full risk profile. Some options are margin of error, volatility of ratings, and analysis of extreme scenarios



Quality of Ratings Rating structured finance products requires more sophisticated analysis than rating single name securities

In particular, one needs to model default correlations

Ex-post the assumed correlations turned out to be very low. The assumptions going into the models need to be refined and disseminated so market participants can understand them

Potential conflict issue? Issuers typically retain the equity tranche and sell the senior tranche. With lower assumed correlations senior tranches appear to be less risky and equity tranches appear to be riskier.


Regulatory Response

The regulatory response has been quick and informed by

recommendations from IOSCO, CESR, ESME, Financial Stability Forum

(FSF), and the President’s Working Group on Financial Markets

There are three main bodies of regulatory work so far:May 2008 -- IOSCO publishes a revision to the Code of Conduct Fundamentals for Credit Rating Agencies (not strictly regulatory, but all rating agencies have pledged to follow the code of conduct)

Nov 2008 – European Commission publishes a final proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies

Dec 2008 – SEC publishes amendments and new rules relating to Nationally Recognized Statistical Rating Organizations and Credit Ratings

The rules are not identical, but there is significant overlap in the three

documents.

IOSCO’s Code of Conduct is widely considered the global benchmark,

but the actual regulations are more specific in certain areas


IOSCO’s Code of Conduct – Highlights

Quality of the Rating ProcessCRAs should adopt measures so that the information used to assign ratings is of sufficient quality

CRAs should review the feasibility of rating structures materially different from the ones they currently rate

CRAs should determine whether existing methodologies and models are appropriate for a certain type of structure product (including the underlying securities)

Integrity of the Rating ProcessCRAs should prohibit analysts from making recommendations regarding the design of structured products they rate

CRAs Procedures and PoliciesA CRA should disclose if it receives 10 percent or more of its annual revenue from a single client

CRAs as an industry should encourage structured finance issuers and originators to disclose all relevant information regarding those products so other parties can perform independent analyses


IOSCO’s Code of Conduct – Highlights

Transparency and Timeliness of Ratings DisclosureCRAs of structured products should provide sufficient information about its loss and cash flow analysis to understand the basis for the CRA’s rating. Sensitivity analysis of rating assumptions should also be disclosed

CRAs should differentiate ratings of structured finance products from traditional corporate bond ratings

CRAs should assist investors in developing a better understanding of what a credit rating is (including its limitations)


European Commission Regulation – Highlights

Three main objectives. Ensure that:Credit ratings are not affected by conflicts of interest

Credit ratings are of high quality

CRAs act in a transparent manner

Requirements are similar to (in fact based on) IOSCO’s Code of

Conduct, but it provides an enforcement mechanism by establishing

a registration and surveillance framework

CRA’s have to register so that their ratings can be used for

regulatory purposes by credit institutions, investment firms,

insurance companies, UCITS, and pension funds established in the

European Union

Registration is separate from the existing process to be authorized

as an External Credit Assessment Institution (ECAI) for the purposes

of the Capital Requirements Directive (CRD) for banks


SEC Rules on NRSRO’s and Credit Ratings Highlights

Final RulesNew disclosure requirements to Form NRSRO

Transition statistics (including defaults) for 1, 3 , and 10 year periods

How much verification is performed on securities underlying structured finance products

How assessments of the quality of originators affect credit ratings

More detailed information on the surveillance process and differences vis-à-vis initial ratings

NRSRO’s have to make publicly available a random sample of 10% of their issuer-paid ratings and their histories in XBRL no later than six months after the rating is made

Recordkeeping: NRSRO’s need to maintain records of rating actions, the rationale for differences between a rating implied by a quantitative model and the final rating, and any complaint regarding the performance of a credit analyst in determining, maintaining, monitoring, changing, or withdrawing a rating

NRSRO’s are prohibited from issuing ratings where the NRSRO or an affiliate made a recommendation as to how to attain a specific rating


SEC Rules on NRSROs and Credit Ratings Highlights

Proposed RulesNRSROs would have to disclose 100% of their current issuer-paid ratings in an XBRL format 12 months after the action is taken (to protect CRAs data businesses)

NRSROs would be prohibited from issuing a rating for a srtuctured finance product paid for by the issuer, sponsor, or underwriter unless the information provided to the NRSRO to determine the rating is available to other NRSROs

Proposals still under discussionDifferentiation of ratings for structured products from those for traditional bonds

Elimination of references to NRSROs from certain SEC’s rules and forms


A Portfolio Based Perspective of Credit Risk is Essential

18 18.5 19 19.5 20

Portfolio value at 1 year horizon

Horizon value if norating changes

Expected horizon value

99.5% VaR Expected loss

One standard deviation

This simulation output shows the distribution of credit portfolio

99.5%Exp. Shortfall

High chance of small gain with a small chance of catastrophic loss


Correlations are primary drivers of systemic risk

Higher correlations increase systemic (non-diversifiable) risk


Correlations & loss distribution

Higher correlations increase capital requirements, since more counterparties

tend to default at together


Did VaR forecast the U.S. Subprime crisis?

-100.0%

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300%+ increase in vol from Dec 12 to 21 '06

357% vol spike on Feb 23 '07

RM 2006 99% VaR bands vs 2006-1 AAA spread

One major outlier, a 12 sd move on Feb 23 '07, the day after the $10.5bn HSBC loss announcement

Backtesting summary: 2.4% upside excessions0.81% downside excessions


Responsive VaR estimators provided ample time to hedge…

'2006-1 AAA'

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Feb 23 '07, first major outlier, 350% vol increase in 1 day, 12sd move

June 07, ML tries to liquidate Bear Subprime CDO's

Absolute Spread Levels


An Integral Approach to Risk Management

It’s clear we need more than quantitative models to manage risk “We will never have a perfect model of risk. “ Alan Greenspan

“Risk Management is a combination of art and science.” Stephen Thieke

"Integral" means “balanced, comprehensive, interconnected, and

whole”

We will apply Ken Wilber’s Integral AQAL (All Quadrant All Levels and

Lines) approach to highlight essential components of a strong risk

management processQuadrants

Lines

Levels


Integral Risk Management: All Quadrants

Objective/ExteriorSubjective/Interior

Individual

Collective

» Ratings» Measures» Data

» Regulations» Systems» Processes» Policies» Organization

» Integrity» Ability to question

» Culture of risk management

» See Ken Wilber, “A Theory of Everything”

“I”

“We”

“It”

“Its”


Levels: 3 Stages of Risk Management

1. Pre-conventional: PrimalEmphasis on return

Risk taking driven by gut instinct and emotions: subjective view of risk

Actions and thinking dominated by principals

Focused on pieces (positions), not the whole (portfolio)

2. Conventional: Rules BasedClassification of risks (operational, market, credit, liquidity, etc.)

Implementation of standardized risk measures

Risk controlled with policies, procedures, and limits

Hierarchical organization with clearly defined roles, including risk management function

Focus on quantifying, controlling, and minimizing risk: objective view of risk

3. Post Conventional: IntegralProactive culture of risk management throughout the organization

Constant engagement and discussion about risk

Harness intelligence both within and outside the organization

Risk viewed as both danger and opportunity

Enterprise & portfolio perspective, not just position level

Flex flow, constantly evolving and improving

Blend of art and science: subjective + objective


The Cycle Of Risk Management

Risk management is a continuous process of identifying, measuring &

monitoring, and managing risk.The process begins with risk identification

One of the most crucial targets is the identification of hidden risk concentrations…

Identify

MeasureM

anage

Risk managers need to be perceived like good goalkeepers: always in the game and occasionally absolutely at the heart of it, like in a penalty shoot-out. Source: Economist.com, Confessions of a Risk Manager



Structured products are very complex and additional information is required to understand their credit risk profile

Portfolio effects (correlations) are very important. Correlation assumptions need to be disclosed together with sensitivity analysis

Embedded leverage in the structure has to be well understood by investors

Sensitivity of ratings changes with respect to model assumptions and credit scenarios would be helpful

Credit ratings only measure risk due to credit events, investors also need measures of mark-to-market and liquidity risk

Understanding the underlying securities is critical since securitization markets face information asymmetries that encourage lax lending

Originators often don’t have incentives to perform strong due diligence on the underlying loans

Loans with FICO scores of 620 or above were highly likely to be securitized. It has been shown1 that subsequent loan performance was worse for loans slightly above the 620 threshold compared with loans where the score was slightly below 6201Keys, B J, T K Mukherjee, A Seru and V Vig (2008)



Sponsors of structured products should disclose all relevant

information to CRAs and as much information as possible to

investorsAll CRAs should have access to the same information regardless of whether they are retained to rate a specific product

Information about the structure and the pool of underlying assets should be made available in machine readable format

Disclaimer: The views in this presentation are that of the authors

and may not necessarily reflect those of RiskMetrics Group.


Questions?

www.riskmetrics.com

[email protected]

Tel. +65 6826 9333


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A CONSIDERED VIEWPOINT BY RISKMETRICS

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Transcript of A CONSIDERED VIEWPOINT BY RISKMETRICS