RATING AGENCIES – Q&AThe Risk of Over-reliance on Ratings The Risk of Over-reliance on Ratings

Markus Krebsz, MSI

SII CPD Seminar, London – 2 July 2009

CONTENT

• Overview

• Ratings

• Application

• Constructive criticism• Constructive criticism

• Risks/Mitigants

• Questions & close

2

OVERVIEW

QWIZDOM SURVEY

As part of this interactive workshop session

• We asked 50 seminar attendees• to answer seven topical questions• and to submit their answers via each participants’• Qwizdom unit• Qwizdom unit

The following pages

• Illustrate for each question• the audience’s response• Indicated by the Qwizdom symbol:

4

Do you use Rating agencies and if so, how?

(A) I do not use them

QUESTION 1:

(B) Once a day (C) Once a weekor more or more

(D) I do, but only infrequently

A

24%

B

16%C

16%

D

44%

5

How many (Credit) rating agencies exist globally?

(A) 3 to 5

QUESTION 2:

(B) 6 to 15 (C) 16 to 30

(D) More than 30

A

10%B

13%

C

25%

D

52%

6

1) A.M. Best Company, Inc.

2) Agusto & Co. Ltd.

3) Ahbor Rating

4) Apoyo & Asociados Internacionales S.A.C.

5) Bank Watch Ratings S.A.

6) BRC Investor Services S.A.

7) Calificadora de Riesgo, PCA

8) Capital Intelligence, Ltd.

9) Caribbean Information & Credit Rating Services Ltd. (CariCRIS)

10) Central European Rating Agency (CERA)

11) Chengxin International Credit Rating Co., Ltd.

12) China Lianhe Credit Rating, Co. Ltd.

13) Clasificadora de Riesgo Humphreys, Ltda.

14) Class y Asociados S.A. Clasificadora de Riesgo

15) CMC International, Ltd.

16) Companhia Portuguesa de Rating, SA (CPR)

17) Credit Analysis & Research Ltd (CARE)

33) Islamic International Rating Agency, B.S.C. (IIRA)

34) Japan Credit Rating Agency, Ltd. (JCR)

35) JCR-VIS Credit Rating Co. Ltd.

36) Korea Investors Service, Inc. (KIS)

37) Korea Ratings Corporation

38) Lanka Rating Agency, Ltd. (LRA)

39) Malaysian Rating Corporation Berhad (MARC)

40) Mikuni & Co., Ltd.

41) Moody's Investors Service

42) National Information & Credit Evaluation, Inc. (NICE)

43) ONICRA Credit Rating Agency of India, Ltd.

44) P.T. Kasnic Credit Rating Indonesia -- Indonesia

45) P.T. PEFINDO Credit Rating Indonesia

46) Pacific Credit Rating (PCR)

47) Pakistan Credit Rating Agency, Ltd. (PACRA)

48) Philippine Rating Services, Corp. (PhilRatings)

49) RAM Rating Services Berhad (RAM)

18) Credit Rating Agency of Bangladesh, Ltd. (CRAB)

19) Credit Rating Information and Services, Ltd. (CRISL)

20) CRISIL, Ltd.

21) Dagong Global Credit Rating Co., Ltd.

22) Dominion Bond Rating Service (DBRS)

23) Duff & Phelps de Colombia, S.A., S.C.V

24) Ecuability, SA

25) Egan-Jones Rating Company

26) Equilibrium Clasificadora de Riesgo

27) European Rating Agency (ERA)

28) Feller Rate Clasificadora de Riesgo

29) Fitch Ratings, Ltd.

30) Global Credit Rating Co.

31) Interfax Rating Agency (IRA)

32) Investment Information and Credit Rating Agency (ICRA)

50) Rapid Ratings International, Inc.

51) Rating and Investment Information, Inc. (R&I)

52) Rus Ratings

53) Seoul Credit Rating & Information, Inc.

54) Shanghai Credit Information Services Co., Ltd.

55) Shanghai Far East Credit Rating Co., Ltd.

56) Slovak Rating Agency, a.s. (SRA)

57) SME Rating Agency of India Limited (SMERA)

58) Sociedad Calificadora de Riesgo Centroamericana, S.A. (SCRiesgo)

59) Standard and Poors (S&P)

60) Taiwan Ratings, Corp. (TCR)

61) Thai Rating and Information Services Co., Ltd. (TRIS)

62) TheStreet.com Ratings, Inc.

63) Türk KrediRating (TCRating)

64) Veribanc, Inc.

7Source: www.defaultrisk.com

AAA (Fitch) = AAA (S&P) = Aaa (Moody’s)?

QUESTION 3:

NO

68%

8

YES

32%

RATING PRINCIPLES

Fitch Ratings, Standard & Poor’s:

Probability of default (PD) = First dollar of loss

� What is the ultimate default risk?

Moody’s:

Expected loss (EL) = [(PD) X (LGD)]

� What is the amount of net loss suffered?

9

D (Fitch) = D (S&P) = D (Moody’s)?

QUESTION 4:Y

NO

53%

10

YES

47%

RATINGS MAPPING TABLEF i t c h R a t i n g s

Long-term rating Short-term rating

AA-

AA

A

A+

BBB+

A-

BBB

AA+

AAA

F1+

F1

F1+ or F1

F1 or F2

F2 or F3

M o o d y ’ s

Long-term rating Short-term rating

Aa3

Aa2

A2

A1

Baa1

A3

Baa2

Aa1

Aaa

P1

P-1 or P-2

P-2

P-2 or P-3

S t a n d a r d & P o o r s

Long-term rating Short-term rating

AA-

AA

A

A+

BBB+

A-

BBB

AA+

AAA

A-1+

A-1 or A-2

A-1

A-2

A-2 or A-3Investment Grade

F2

M a p p e d

i n t e r n a l

r a t i n g

iAA-

iAA

iA

iA+

iBBB+

iA-

iBBB

iAA+

iAAA

11

B-

B

CCC

CCC+

CC

CCC-

DDD, DD, D

C

BB

BB+

B+

BB-

BBB- F3

B

C

B3

B2

Caa2

Caa1

Ca

Caa3

C

Ba2

Ba1

B1

Ba3

Baa3 P-3

Not Prime B-

B

CCC

CCC+

CC

CCC-

D

C

BB

BB+

B+

BB-

BBB- A-3

B

Ranges within

B-1, B-2 and B-3

C

Speculative Grade

iB-

iB

iCCC

iCCC+

iCC

iCCC-

iD

iC

iBB

iBB+

iB+

iBB-

iBBB-

D DMoody’s: D

Source: Bloomberg, Fitch, Moody’s and S&P

SF Bond 1 rated AAA (Fitch/ S&P/ Moody’s)

= SF Bond 2 rated AAA (Fitch/ S&P/ Moody’s)?

QUESTION 5:

NO

87%

12

YES

13%

Structure 2

SUPER-SENIOR RATINGS

Structure 1

Tranche 1: AAA

Tranche 2: AA+

Tranche 3: A

Tranche 1: AAA AA

Tranche 2: AAA A

Tranche 3: AAATranche 3: A

Tranche 4: BBB-

Tranche 5: BB

Tranche 6: B+

First Loss piece: NR

13

Tranche 3: AAA

Tranche 4: AA+

Tranche 5: A

Tranche 6: BBB-

Tranche 7: BB

Tranche 8 B+

First Loss piece: NR

RATINGS

How would you define ‘rating’?

(A) Opinion

(B) Benchmark (C) Benchmark

QUESTION 6:

measure measure

for PD for LGD

(D) View not necessarily based on facts or knowledge

A

25%

B

31%C

3%

D

41%

15

AAA

RATING DEFINITION

• An opinion… * [Financial journalists]

• …on the relative ability…

• …of an entity to meet financial commitments.

*

16

*

‹ä|xã ÇÉà ÇxvxáátÜ|Äç utáxw ÉÇ ytvà ÉÜ ~ÇÉãÄxwzx

Ratings are benchmark measures of…

• Probability of default (PD)

• Expectations of Loss given default (LGD)

RATINGS…

…can capture:

• Credit risk

…do NOT capture:

���� Market risk ����

���� Liquidity risk ����

• by Basel II

• into banks’ credit rating models

• Investment guidelines and Asset management mandates

���� Liquidity risk ����

���� Operational risk ����

���� Basis risk (IR risk) ����

17

…and are “hard-wired”…

STATISTICAL: Probability of Default

0%

5%

10%

15%

20%

25%

30%

AA

A

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B B-

CC

C/C

1-year PD

Moodys

S&P

Fitch

18

AA

A

AA

+

AA

AA

BB

B+

BB

B

BB

B

BB

+

BB

CC

C/C

0%

10%

20%

30%

40%

50%

60%

70%

80%

AA

A

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B B-

CC

C/C

10-year PD

Moodys

S&P

Fitch

Source: Fitch Ratings

RATINGS SCOPE

• Public

• Private

• Credit assessment

• Market-Implied ratings

(CDS, Equity, Spread, Price etc.)19

RATING ACTIONS

Rating

DEAL STAGE

• Preliminary

• Final

Suffix

RATING WATCH

• Positive

• Negative• Final

• Paid in Full (PIF) /

Redemption

INDICATORS

• Upgrade, Downgrade

• Affirmation / Confirmation

• Withdrawn

• Negative

• Evolving / Uncertain

OUTLOOK

• Positive

• Negative

• Stable

20

APPLICATION

RATINGS are used by …

Banks, Other Financial Institutions, Originators & Issuers,

Investors, Financial Regulators, Other Rating agencies, etc. …

Outsource analysis

in order to … • Outsource analysis

• Determine required economic and regulatory capital charges

• Manage individual credit & portfolio risks

• Feature as input into Structured Finance models (CDO2 etc.)

22

CONSTRUCTIVE CRITICISM

FAILURESAIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic banks,

Lehman Bros., Monolines, Northern Rock, Parmalat, etc.

In their own words...

Fitch: “… did not foresee the magnitude of the decline…or the

dramatic shift in borrower behavior…”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

24

CRITICISM

• Business model: Too slow to react

• Assumptions, methodologies & models

• Conflict of interest (“issuer-pays” model)

• Limited capture• Limited capture

• Split ratings

• Notching

• Implied ratings & internal competition

• etc.

25

THE RISKS OF OVER-RELIANCE - AND SUITABLE MITIGANTS

TIMELY ACTIONS and DEFERRAL

• Process stages to reach

rating decisions

• Detection of bond- vs.

Rating scope vs. time:

Bond maturity profile

• Legal final vs. expected final

maturity

• Life-time ratings (40+ years)

Rating process:

Timeliness of Rating changes

• Detection of bond- vs.

asset class-specific

and/or systemic issues

• Life-time ratings (40+ years)

• Timely payment of interest

& ultimate payment of

principal

27

TIMELAG of RATING ACTIONS

176,046

130,000

140,000

150,000

160,000

170,000

180,000

190,000

TOTAL S&P Moody's Fitch

Number of Global SF Bond Downgrades

by CRA

28

1,166 2,042

7,992

30,749

49,594 50,96847,510

68,372

111,605

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

110,000

120,000

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09(Since January 2007 - Source: Bloomberg)

Regional problem ���� GLOBAL IMPACT

175,208

120,000

130,000

140,000

150,000

160,000

170,000

180,000

190,000

TOTAL Europe US

Number of Global SF Bond Downgrades by Region

29

1,161 2,0357,981

30,597

49,160 50,67647,284

68,073

111,239

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

110,000

120,000

1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09(Since January 2007 - Source: Bloomberg)

OPERATIONAL RISKS

• Changing methodologies and assumptions

• Timeliness of rating decisions

• Model risks

• Striking the right balance between non- and

over-regulation

30

RISK MITIGANTS

• Understanding the meaning of ratings

• Understanding instruments’ risks

• Independent analysis

• Internal ratings• Internal ratings

• Disputing rating decisions and methodologies

with the agencies – is it really worth it?

• Operational risk scenario: Awareness that

agencies CAN and DO get their ratings wrong

31

QUESTIONS & CLOSE

32

Would you now give CRAs more or less credit ?

QUESTION 7:

More

Less

70%

More

30%

33

LessMore

CONTACT

Markus Krebsz+44 (0) 79 85 065 045

krebsz@web.de

markus.krebsz@4-most.co.uk

4mostLinen Hall

162-168 Regents Street

London, W1B 5TE

Tel. +44 (0) 207 038 3690

www.4-most.co.uk

ANNEX: Ratings & Probability of Default (PD)

Moodys S&P Fitch Moodys S&P Fitch Moodys S&P Fitch

Aaa 0.00% AAA 0.00% 0.00% Aaa 0.18% AAA 0.10% 0.11% Aaa 0.40% AAA 0.45% 0.37%

Aa1 0.00% AA+ 0.00% 0.00% Aa1 0.15% AA+ 0.16% 0.11% Aa1 0.25% AA+ 0.34% 0.47%

Aa2 0.00% AA 0.00% 0.00% Aa2 0.28% AA 0.15% 0.14% Aa2 0.67% AA 0.77% 0.68%

Aa3 0.00% AA- 0.02% 0.01% Aa3 0.18% AA- 0.52% 0.25% Aa3 0.33% AA- 1.11% 0.91%

A1 0.00% A+ 0.05% 0.02% A1 0.38% A+ 0.64% 0.41% A1 0.84% A+ 1.68% 1.30%

A2 0.03% A 0.04% 0.04% A2 0.68% A 0.42% 0.57% A2 1.69% A 1.80% 1.78%

A3 0.03% A- 0.04% 0.04% A3 0.65% A- 0.86% 0.75% A3 1.69% A- 2.44% 1.91%

1 year 5 year 10 year

35

Baa1 0.17% BBB+ 0.22% 0.22% Baa1 1.46% BBB+ 2.30% 1.82% Baa1 2.31% BBB+ 4.65% 3.82%

Baa2 0.12% BBB 0.28% 0.21% Baa2 2.11% BBB 2.17% 2.14% Baa2 5.49% BBB 5.27% 5.61%

Baa3 0.41% BBB- 0.39% 0.42% Baa3 3.60% BBB- 4.94% 4.03% Baa3 7.20% BBB- 8.97% 8.23%

Ba1 0.66% BB+ 0.56% 0.63% Ba1 6.76% BB+ 6.47% 6.19% Ba1 12.38% BB+ 11.74% 12.25%

Ba2 0.62% BB 0.95% 0.90% Ba2 8.82% BB 9.98% 8.37% Ba2 14.66% BB 17.34% 17.08%

Ba3 2.23% BB- 1.76% 2.05% Ba3 19.14% BB- 15.03% 15.92% Ba3 36.24% BB- 24.97% 30.27%

B1 3.03% B+ 3.01% 3.10% B1 25.27% B+ 20.86% 21.53% B1 47.43% B+ 30.15% 38.18%

B2 5.93% B 8.34% 7.24% B2 31.24% B 29.44% 27.84% B2 44.48% B 36.29% 41.06%

B3 10.77% B- 12.15% 11.71% B3 43.55% B- 37.71% 39.23% B3 62.32% B- 45.05% 53.69%

Caa-C 22.24% CCC/C 28.83% 25.54% Caa-C 60.40% CCC/C 50.85% 53.55% Caa-C 78.81% CCC/C 56.45% 65.07%