Rating Agencies: The Risk Of Over-reliance On Ratings

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Information about Rating Agencies: The Risk Of Over-reliance On Ratings

Published on February 25, 2009

Author: Krebsz

Source: slideshare.net

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As presented to the Securities and Investment Institute\'s Risk Forum, London, 24 Feb. 2009.

RATING AGENCIES: The Risk of Over-reliance on Ratings An “Insider’s” View Markus Krebsz, MSI SII Risk Forum, London - 24 Feb 2009

CONTENT Overview Ratings Application Constructive criticism Risks/Mitigants Questions & close

Overview

Ratings

Application

Constructive criticism

Risks/Mitigants

Questions & close

OVERVIEW

QUESTION 1: How many (Credit) rating agencies exist globally ? 3 to 5 6 to 15 16 to 30 More than 30

How many (Credit) rating agencies exist globally ?



3 to 5

6 to 15 16 to 30



More than 30

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) 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) 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) 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. Source: www.defaultrisk.com

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)

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)

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)

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.

QUESTION 2: AAA (Fitch) = AAA (S&P) = Aaa (Moody’s) ?

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



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?

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?

QUESTION 3: D (Fitch) = D (S&P) = D (Moody’s) ?

D (Fitch) = D (S&P) = D (Moody’s) ?



RATINGS MAPPING TABLE Moody’s: D Source: Bloomberg, Fitch, Moody’s and S&P

QUESTION 4: SF Bond 1 rated AAA (Fitch/ S&P/ Moody’s) = SF Bond 2 rated AAA (Fitch/ S&P/ Moody’s) ?

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

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

Structure 2 SUPER-SENIOR RATINGS Structure 1 Tranche 1: AAA Tranche 2: AA+ Tranche 3: A Tranche 4: BBB- Tranche 5: BB Tranche 6: B+ First Loss piece: NR Tranche 1: AAA AA Tranche 2: AAA A Tranche 3: AAA Tranche 4: AA+ Tranche 5: A Tranche 6: BBB- Tranche 7: BB Tranche 8 B+ First Loss piece: NR

Structure 2

Structure 1

Tranche 1: AAA

Tranche 2: AA+

Tranche 3: A

Tranche 4: BBB-

Tranche 5: BB

Tranche 6: B+

First Loss piece: NR

Tranche 1: AAA AA

Tranche 2: AAA A

Tranche 3: AAA

Tranche 4: AA+

Tranche 5: A

Tranche 6: BBB-

Tranche 7: BB

Tranche 8 B+

First Loss piece: NR

RATINGS

RATING DEFINITION An opinion … * [Financial journalists] … on the relative ability … … of an entity to meet financial commitments . * … view not necessarily based on fact or knowledge Ratings are benchmark measures of… Probability of default (PD) Expectations of Loss given default (LGD)

An opinion … * [Financial journalists]

… on the relative ability …

… of an entity to meet financial commitments .

*

… view not necessarily based on fact or knowledge

Ratings are benchmark measures of…

Probability of default (PD)

Expectations of Loss given default (LGD)

RATINGS… … can capture: Credit risk by Basel II into banks’ credit rating models Investment guidelines and Asset management mandates … do NOT capture:  Market risk   Liquidity risk   Operational risk   Basis risk (IR risk)  … and are “hard-wired”…

… can capture:

Credit risk

by Basel II

into banks’ credit rating models

Investment guidelines and Asset management mandates

… do NOT capture:

 Market risk 

 Liquidity risk 

 Operational risk 

 Basis risk (IR risk) 

STATISTICAL: Probability of Default Source: Fitch Ratings

RATINGS SCOPE Public Private Credit assessment Market-Implied ratings (CDS, Equity, Spread, Price etc.)

Public

Private

Credit assessment

Market-Implied ratings

(CDS, Equity, Spread, Price etc.)

RATING ACTIONS Rating DEAL STAGE Preliminary Final P aid i n F ull (PIF) / Redemption INDICATORS Upgrade, Downgrade Affirmation / Confirmation Withdrawn Suffix RATING WATCH Positive Negative Evolving / Uncertain OUTLOOK Positive Negative Stable

Rating

DEAL STAGE

Preliminary

Final

P aid i n F ull (PIF) / Redemption

INDICATORS

Upgrade, Downgrade

Affirmation / Confirmation

Withdrawn

Suffix

RATING WATCH

Positive

Negative

Evolving / Uncertain

OUTLOOK

Positive

Negative

Stable

APPLICATION

RATINGS are used by … Banks, Other Financial Institutions, Originators & Issuers, Investors, Financial Regulators, Other Rating agencies, etc. … Outsource analysis Determine required economic and regulatory capital charges Manage individual credit & portfolio risks Feature as input into Structured Finance models (CDO 2 etc.) in order to …

Banks, Other Financial Institutions, Originators & Issuers,

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

Outsource analysis

Determine required economic and regulatory capital charges

Manage individual credit & portfolio risks

Feature as input into Structured Finance models (CDO 2 etc.)

CON STRUCTIVE CRITICISM

FAILURES AIG, 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…” 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

AIG, 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…”

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

CRITICISM Business model: Too slow to react Assumptions, methodologies & models Conflict of interest (“issuer-pays” model) Limited capture Split ratings Notching Implied ratings & internal competition etc.

Business model: Too slow to react

Assumptions, methodologies & models

Conflict of interest (“issuer-pays” model)

Limited capture

Split ratings

Notching

Implied ratings & internal competition

etc.

THE RISKS OF OVER-RELIANCE - AND SUITABLE MITIGANTS

TIMELY ACTIONS and DEFERRAL Process stages to reach rating decisions Detection of bond- vs. asset class-specific and/or systemic issues Rating scope vs. time: Bond maturity profile Legal final vs. expected final maturity Life-time ratings (40+ years) Timely payment of interest & ultimate payment of principal Rating process: Timeliness of Rating changes

Process stages to reach rating decisions

Detection of bond- vs. asset class-specific and/or systemic issues

Rating scope vs. time:

Bond maturity profile

Legal final vs. expected final maturity

Life-time ratings (40+ years)

Timely payment of interest & ultimate payment of principal

TIMELAG of RATING ACTIONS

OPERATIONAL RISKS Changing methodologies and assumptions Timeliness of rating decisions Model risks Striking the right balance between non - and over -regulation

Changing methodologies and assumptions

Timeliness of rating decisions

Model risks

Striking the right balance between non - and over -regulation

RISK MITIGANTS Understanding the meaning of ratings Understanding instruments’ risks Independent analysis 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

Understanding the meaning of ratings

Understanding instruments’ risks

Independent analysis

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

QUESTIONS & CLOSE

Q & A For the Risk Forum Has this presentation changed your view and perception of Ratings (= Opinion)? Would you now give CRA more or less credit? Do you think that CRAs should be properly regulated? For the Presenter Q1)…? Q2)…? Q3)…?

For the Risk Forum

Has this presentation changed your view and perception of Ratings (= Opinion)?

Would you now give CRA more or less credit?

Do you think that CRAs should be properly regulated?

For the Presenter

Q1)…?

Q2)…?

Q3)…?

CONTACT Markus Krebsz +44 (0) 79 85 065 045 [email_address] [email_address] 4most Linen Hall 162-168 Regents Street London, W1B 5TE Tel. +44 (0) 207 038 3690 www.4-most.co.uk

Markus Krebsz

+44 (0) 79 85 065 045

[email_address]

[email_address]

4most

Linen 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)

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