Rating Agencies and Credit Ratings: Recent Developments and Outlook for the Future

Mark Adelson Executive Managing Director Senior Research Fellow Washington Association of Money Managers 11 January 2012

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Pythagorean Theorem

a 2 +b 2 =c 2 a 2 a a b c c 2 c b a b b

Q.E.D.

2 2.

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Impetus for Change

•

The big picture of S&P ratings performance is good …

– Rank ordering of default rates by rating category within key sectors – Good Gini coefficients over multiple time horizons

•

…but some sectors were outliers…

– Residential mortgage-backed securities (RMBS – CDOs of ABS (backed by RMBS) – Bond insurance – Banks

•

…which disappointed the market’s expectations…

•

…and hurt the firm’s credibility

3.

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Impetus for Change: Example – Structured Finance Ratings

Adverse Credit Migrations of 2005-2007 Vintages of U.S. RMBS, CDOs of ABS, and SIV Lites

Original Rating AAA AA A BBB

Inv. Grade

Status as of 31 December 2010 Default + Near Default 60.1% 78.2% 88.5% 94.0% 82.8% Default 22.7% 45.8% 59.7% 69.4% 52.8% Near Default 37.4% 32.4% 28.8% 24.7% 30.0% Any Downgrade 77.3% 87.6% 93.4% 95.2% 89.8% No. of Ratings 4,043 8,340 7,456 7,806 27,645 Note:

'AAA' ratings from the same transaction are treated as a single rating in this table's calculation. Multiple rating actions are aggregated to calculate a security's cumulative rating performance. Near default means rated 'CCC+' or lower.

Source:

Erturk, E.,

Global Structured Finance Securities End 2010 With Rising Credit Stability

(7 Feb 2011) (Table 6a).

4.

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Impetus for Change: Example – Financial Firm Ratings

Company

AIG Bear Stearns Citigroup IndyMac Lehman Merrill Lynch Northern Rock RBS UBS Wachovia WaMu Fannie Mae Freddie Mac

ICR at 1/1/07

AA+ AA AA BBB AA AA A+ AA AA+ AA A AA AA-

Δ Eq Px 2007-08

-97.7% -94.2% -86.7% -99.6% -100.0% -18.1% -92.4% -92.6% -76.3% -89.3% -100.0% -98.6% -98.9%

Notes

~$183b in bailouts. US govt owns 80% stake Shotgun marriage with JP Morgan for $10/share Hybrids exchanged, U.S. gov’t took 36% equity Seized by FDIC in 2008, auctioned off in March 2009 Bankruptcy 9/15/2008.

Bought out by B-of-A 9/14/2008 Nationalized 2/22/2008 Part nationalization, UK gov’t holds 84% stake Write-downs >$50B since 2007 “Silent run" in Sep 2008; acquired by Wells Fargo Receivership 9/25/2008 Conservatorship 9/7/2008. U.S. Treasury holds preferred stock and warrants worth 80% stake 5.

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Impetus for Change: Example – Financial Firm Ratings (#2)

Company

Ambac MBIA FGIC FSA ACA AGC CIFG

ICR at 1/1/07

AAA AAA AAA AAA A AAA AAA

Δ Eq Px 2007-08

-98.5% -94.3% n.a.

n.a.

n.a.

-56.4% n.a.

Notes

Bankruptcy 11/8/2010 Rated B, attempting restructuring Bankruptcy 8/3/2010 Acquired by AGC in July 2009 Restructuring plan 8/8/2008 Now rated AA CC rating withdrawn 2/16/2010 6.

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Recent Rating Industry Changes

•

S&P is:

– Updating criteria to increase transparency & comparability – Incorporate lessons learned from financial crisis – Publishing more on credit risks in unrated deals – Increasing investor outreach and education efforts

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New regulations in U.S., E.U., Japan and Australia

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Regulatory changes include:

– Increasing oversight and accountability – Removing ratings from regulation – Strengthening prohibitions on conflicts of interest

7.

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Key Criteria Goals

• • • •

Comparability

– Each rating symbol – for example, 'AAA‘ – to connote a comparable view of creditworthiness, wherever and whenever it appears – Provides a common vocabulary for discussing credit risk – Achieved through application of common stress for each rating category – Use historical studies as part of criteria calibration (e.g., NBER papers)

Transparency

– Allows users to understand how S&P reaches rating conclusions (the “what”) – Clearer definition and weighting of variables driving the conclusion – Rationales explaining choice of methodology and assumptions (the “why”)

Harmonization

– Similar factors analyzed consistently across sectors (e.g., management, default rate simulation parameters, treatment of guarantees)

Simplification

– Common design framework: key elements, scoring, roll-up – Modularization (plug and play components) – Ease of application 8.

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Behind the Goals

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Comparability makes S&P ratings more relevant to those responsible for top-level asset allocation and investment policy decisions

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Superior comparability and transparency positively differentiate S&P ratings from our competitors’

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Leading the credit rating industry …

– Moody’s, “Recalibration of Moody’s U.S. Municipal Ratings to its Global Rating Scale” (March 2010) – Fitch, “Ratings Comparability” (21 June 2010) 9.

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Illustration of Weak Cross-sector Comparability (past) …

Corporate Banks Insurance Sovereigns U.S. Municipal RMBS CMBS ABS CDO B B B B B B B B B

A AA AAA A AA AAA A A A AA AA AA AAA AAA AAA AAA A A AA A AA AA

Creditworthiness 

AAA AAA AAA

10.

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Illustration of Stronger Cross-sector Comparability (future)

Corporate Banks Insurance Sovereigns U.S. Municipal RMBS CMBS ABS CDO B B B B B B B B B

A A A A A AA AA AA AA AA A AA A A AA AA A

Creditworthiness 

AA AAA AAA AAA AAA AAA AAA AAA AAA AAA

11.

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Four Dimensions of Comparability

We are currently emphasizing cross-sector comparability at the expense of comparability over time in order to address calibration

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Delivering Comparability

•

Retrospective

– Gini coefficients (rank ordering power) – Comparing default rates across sectors, regions, and over time •

Prospective

– Common approaches to risk analysis (harmonization) – Stress scenarios for criteria calibration

ΔGDP Unemp.

Equities Criteria Calibration Stress Scenarios – Key Parameters AAA

-26 ½%

AA

-15%

A

-6%

BBB

-3%

BB

-1% 25% -85% 20% -70% 15% -60% 10% -50% 8% -25%

B

½% 6% -10% 13.

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Understanding S&P Rating Definitions (3 Jun 2009)

•

Ratings are forward looking and reflect views on relative ranking of overall creditworthiness

•

S&P ratings are not just opinions of likelihood of default

– Likelihood of default – Payment priority – Recovery – Credit stability •

New stress scenarios adopted to further our goal of comparability across sectors, geographies and time

•

'AAA' (“extreme”) stress scenario is based on the Great Depression

– AAA face greater possibility of default under extreme scenario – AAA are likely to face more transitions with increasing decline in economy •

Stress scenarios used as a calibration tool for criteria

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Transparency

•

Both “how” and “why”

•

How



replicability; providing a thorough explanation about how we do analysis so that a skilled analyst could replicate it if he wanted to

•

Why



credibility; providing the intellectual underpinnings and justifications – the facts and the logic – explaining why we do what we do

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Delivering Transparency

•

Criteria design framework

– Creating a path for replicability  Step 1: select items that drive creditworthiness  Step 2: define methods for scoring/ranking/grading each selected item  Step 3: define system for combining scores from step 2 into a final rating – Allows for future modularization of criteria components (e.g., management, group support, etc.) – Gives criteria articles a consistent structure to make the entire body criteria easier to navigate and manage – Embraces both quantitative and qualitative aspects of analysis – Emphasizes objectivity and establishing a factual basis for qualitative judgment 16.

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Criteria Project Examples

•

Substantive changes

– CMBS (26 Jun 2009) – RMBS (10 Sep 2009) – Corporate CDOs (17 Sep 2009) – Covered Bonds (16 Dec 2009) – Counterparty (6 Dec 2010, proposed update 21 Nov 2011) – Bond insurers (25 Aug 2011) – Banks (9 Nov 2011)

•

Creating a rigorous and systematic process

– U.S. States (3 Jan 2011) – Sovereigns (30 Jun 2011)

•

Transparency emphasis in all of the above

17.

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Criteria Change: CMBS (26 Jun 2009)

•

Reason for the change: Review of historical credit performance

•

Changes:

– Recalibrate 'AAA' credit enhancement levels to 19% for archetypical pool – 'AAA' credit enhancement levels to remain anchored over time – CE levels for 'BBB' based on 4-pronged approach – CE levels for ‘B’ based on expected performance – CE levels for intermediate ratings interpolated

•

Impact: Many CreditWatches and DGs of CMBS from 2006-07 vintages

•

Further update in process

18.

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Criteria Change: RMBS (10 Sep 2009)

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Reasons for the change include: Review of historical credit performance

•

Changes:

– Recalibrate 'AAA' credit enhancement levels for archetypical prime pool to 7.5% – 'AAA' credit enhancement levels to remain anchored over time – CE levels for 'B' float based on forecasts – CE levels for intermediate ratings interpolated

•

Impact: Many outstanding RMBS already downgraded or under review in surveillance; future deals generally would have higher CE levels

19.

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Criteria Change: Corporate CDOs (17 Sep 2009)

•

Reasons for the change include: Further consideration of Gaussian copula-type models

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Changes:

– Additional tests ("outside" the model)  Single name exposure tests  Industry exposure tests – Recalibration of the simulation model to target outputs based on peak historical default rates (incl. Great Depression)

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42% ‘AAA’ CE for typical 9-yr CLO of ‘B’ credits

•

18% ‘AAA’ CE for typical 5-yr synthetic CDO of ‘BBB’ credits

•

Impact: many CreditWatches and downgrades

20.

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Bank Criteria (9 Nov 2011)

BICRA

Methodology Bank Rating Methodology

Bank-Specific Factors External Support Macro Factors

Business Position Economic Risk Score Capital & Earnings Group Support Industry Risk Score

Anchor Stand Alone Credit Profile

Risk Position

SACP Stand Alone Credit Profile

Gov’t Support

ICR Issuer Credit Rating

Funding & Liquidity

Banking Industry Country Risk Assessment Score Hybrid debt and preferred stock ratings

21.

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Senior Unsecured Ratings

Criteria in the Larger Scheme

•

Transparent criteria that enhances ratings comparability is aligned with and supports:

•

S&P’s Mission Statement: To be the definitive source of transparent benchmarks, independent research, quality data, and in-depth analytics demanded by financial professionals

•

S&P’s Core Values:

–

Independence

–

Quality & Analytical Rigor

–

Integrity

22.

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