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A PIMCO Advisory Presentation to NAIC:
If Ratings Agencies Didn’t Exist, Would We Invent Them?
September 24, 2009
0
Advisory_NAIC(09-23-09)
AAA Through the Crisis – 05-07 Vintage RMBS Ratings Downgrades
 Only 25% of subprime bonds remain AAA, while 46% are below investment grade
 Only 4% of Alt-A remain AAA, while 76% are below investment grade
 Only 6% of prime RMBS remain AAA, while 47% are below investment grade
Has AAA Lived Up to Expectations?
05-07 Vintage AAA Ratings Transitions
% Ratings Distribution
50%
45%
Subprime
40%
Alt-A
35%
Prime
30%
25%
20%
15%
10%
5%
0%
AAA
A-AA
BBB
Current Rating Category
SOURCE: PIMCO, Moody’s and Intex (as of August 09).
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B-BB
C-CCC
What Do We Do Today?
 Problem:
– Very high percentage of originally AAA ratings are clustered in below investment grade ratings
category
– These ratings generate very high capital charges despite the fact that they are in senior positions
and would likely enjoy a high recovery. Further there is great variation in expected recoveries within
a rating category
 Potential solutions:
– Reremic: elevates a large proportion of bond to AAA
– Ignore ratings and use purely expected loss approach based on 3rd party generated model forecasts
– Notch ratings higher for below investment grade ratings where the recovery is expected to be high
– Treat like whole loans: given that most senior securities are expected to take a loss, the treatment
for capital purposes should be no worse than that for a comparable whole loan pool
– Important to consider carrying value of the bonds as it may vary by institution. Capital % held
against a bond carried at 50 for Institution A, should be less than capital against the same bond
carried at 70 by Institution B
Refer to Appendix for additional outlook information.
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What Do We Do Today?
 Additional Issues – forecasting the future:
– Forecasting methodology: Roll rates vs. econometric model? Can the two be combined?
– Model Validation: How do we know a model is accurate? What are the methods for validation?
Judgment based validation or statistical based validation?
– Macro assumptions: A well specified model can be undermined by poorly specified macro
forecasts (home prices and unemployment)
– Base case losses vs. tail: The tail risk of the bond may be underestimated relative to a base
case only (e.g. a mezz bond may be protected in base case, but wiped out in stress case)
– Judgment overlay:
- Can models produce good results purely by the magic of statistical gymnastics?
- Or do real world practitioners need to tune the model?
- How can models incorporate government policy impact?
- How do users inject judgment into a statistical model?
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How Stable Are the Expected Bond Losses? – A Framework for Capital Allocation
 Table shows the distribution of expected bond losses in base case vs. pessimistic case
using PIMCO’s RMBS model. This is a representative sample of bonds
 Table illustrates how levered bond is with respect to losses. Green means the bond isn’t so
sensitive to losses, while Red means the bond is more highly levered
 Example: 46% of bonds that take a 5-15% loss range in the base case take a 15-25% loss
in pessimistic case while 5% take a loss in the 45-55% range in the pessimistic scenario
Bond Losses in Pessimistic Case Range
Bond Losses
in Base Case
Range
0-5
5-15
15-25
25-35
35-45
0-5
79%
13%
4%
1%
1%
23%
46%
21%
3%
5%
2%
3%
40%
27%
23%
3%
25-35
43%
43%
6%
35-45
8%
25%
58%
5-15
15-25
45-55
55-65
65-75
75-85
85-95
95-100
1%
Total
100%
100%
3%
6%
3%
100%
100%
8%
100%
45-55
43%
29%
14%
14%
100%
55-65
10%
60%
10%
20%
100%
29%
29%
43%
100%
65-75
75-85
67%
85-95
33%
100%
100%
100%
95-100
Total
51%
11%
8%
6%
As of June 2009
SOURCE: PIMCO
Hypothetical Example for illustrative purposes only.
Refer to Appendix for additional hypothetical example information.
6%
4
6%
3%
2%
2%
2%
100%
100%
3%
100%
How RMBS Ratings Process Failed
 Lack of due diligence: Ratings agencies don’t do due diligence and they relied on 3 rd party
due diligence that was severely flawed and conflicted.
 Overreliance on models, with flawed assumptions: While models should be an important
part of ratings process, failure to reality check the models resulted in dramatically inflated
ratings; particularly for CDOs where correlation assumptions were wildly optimistic.
 Failure to understand the business: Structured finance analysts tended to be too far
removed from the actual business underlying the loans. They failed to fully understand the
changes in business practices, failed to properly understand the role of due diligence firms
and they missed the extent of the fraud that was occurring. The blowups in Franchise and
Manufactured Housing revealed that prior lessons weren’t learned.
 Fraud and Misrepresentations: A significant percentage of the loans had features that were
dramatically different than those represented to ratings agencies and investors. Occupancy
and income fraud were particularly pronounced.
 Competitive landscape: Limited incentives of ratings agencies to be more conservative.
Incentives were distorted up and down the securitization food chain.
CDOs: Collateralized Debt Obligations
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Future Role of Ratings Agencies: What are the Issues?
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Rating Agency Reform – 4 Themes
 Skin in the Game: Rating agencies need to have
more skin in the game. One way is for them to
assume more liability
 Enhanced Disclosure: Methodology and changes
need to be disclosed regularly
 Increased Regulatory Oversight: Stronger
regulatory oversight is needed and it’s likely that
some variation of government approved rating
agencies will be needed
 What is the basic framework for RA oversight?:
limited number of approved ratings agencies, with
continuation of issuer pay model, but with buy
side input into rating agency selection
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Should Government Bless RAs?
Let’s Call the RAs Independent Risk Evaluators or IRE
 Two ends of the spectrum: 1) Free unregulated market vs. 2) limited set of government regulated
and blessed RAs – which is the best model?
 What if we had no ratings agencies?:
– Would all investors have to do their own analysis?
– What about smaller investors who don’t have the capacity to evaluate investments?
– Assuming most investors can’t evaluate securities on their own, isn’t a 3rd party still needed?
– How would smaller investors compare independent 3rd parties?
– For large investors, even if capable of performing their own analysis (e.g. internal risk/ratings based
approached), who would evaluate their results? How would I compare my corporate bond portfolio to
brand X?
– How do third party users of financial statements evaluate financial statements and investment risk
absent 3rd party evaluation (e.g. ratings)?
 Plenty of examples where ratings aren’t directly used:
– Bank balance sheet loans, unrated private placements, equity, etc.
– If it works for these assets why not structured finance bonds?
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Skin in the Game: RAs Publishing Companies or Fiduciary?
 Ratings agencies traditionally have viewed
their ratings as an opinion generally
protected under First Amendment
 Is the free press argument consistent with
the critical role ratings agencies play in the
global capital markets?
 Is there a middle way? More liability than
today, but less than what other fiduciaries are
exposed to?
 We note a recent court ruling may call into
question ability of rating agencies to use First
Amendment rights
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How to Quantify Ratings: Or the Meaning of AAA
 In order to assess the role of ratings in risk management, it’s important to translate
the letter rating to something that is comparable across all IREs/RAs
 AAAs represent the lion’s share of a securitization and it’s therefore important to get
the meaning of AAA right
– Quantitative definition of AAA Example (rating agency): .006bps expected
annual losses over a 10 year period
– Qualitative definition – eg should withstand a severe economic stress
comparable to the Great Depression
 A related question is: how sensitive do we want the ratings to be?
– When asked if we want timely ratings updates, most would say yes
– When asked whether ratings should be relatively stable and not frequently
change, we would also say yes
 We want ratings to be stable but updated on a timely basis.
How should we balance the competing needs?
 Regardless of the answers to the above, we need to ask what we want of ratings in
order to properly chart the course forward
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How Many IREs or RAs?
 The greater the number of IREs, the more difficult it is
for the investment community to manage and the more
challenging it becomes to avoid rating shopping
 If there were 10 ratings agencies offering structured
finance ratings and issuers followed the typical path of
selecting the 2-3 IREs with lower credit support, it’s
likely the structured finance ratings debacle would have
been far worse
 Having a limited number of IREs or RAs may be
unappealing from a free market standpoint, but having
an unlimited number would render ratings shopping
difficult to control and would make it harder to compare
ratings across deals
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Who Pays?
 Issuer pay vs. Investor pay is a red herring issue
 There are conflicts in any of the alternative approaches
and the key is to manage the conflicts
 Investor/subscriber based model:
– Can investors influence ratings?
– I.e. Can investor shop for favorable ratings by terminating
subscription with vendor who provides unacceptable
ratings
– Do investors have incentives to have inflated ratings or
deflated ratings (i.e. a hedge fund shorting a bank)
 Conflicts can’t be eliminated, only managed
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Disclosure
 Ratings agencies should be required to disclose detailed rating
methodology, and the methodology should be updated
annually
 Further, updates to methodology or credit enhancement levels
should be subject to immediate disclosure prior to being used
on actual ratings
 By requiring IREs to publicly disclose changes in methodology,
it will be harder for them to win market share by lowering credit
enhancement levels
 When IREs can lower credit enhancement levels under cover
of the night, under pressure from investment banks, ratings
shopping and conflicts of interest can more easily corrupt the
ratings process
 If IREs had to disclose the rationale for ratings changes prior
to them taking effect, it would reduce temptation to lower credit
enhancement in order to win business
13
Ratings Shopping
 Ratings shopping was a major issue during the crisis
 The ability of bankers/issuers to put ratings agencies “in
comp”, resulted in undue pressure for ratings agencies to
lower credit enhancement levels
 Ratings shopping risk increases proportionately with the
number of “approved” ratings agencies
 Unless issuers are required to hire all agencies, ratings
shopping needs to be controlled
 Ratings shopping could be controlled by:
– Using all ratings agencies:
– Random selection of ratings agencies:
– Issuer paid/investor selects: Allow investors to select via consortium
one of the ratings agencies on a deal. So perhaps issuer selects
one, investor selects another, but issuer pays for both
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Regulatory Oversight
 The framework for overseeing the role of RAs or
IREs needs to be significantly strengthened
 The approval process and oversight of RAs is
enormously complicated and requires sufficient
resources including data modelers, industry
experts, etc.
 Non- NRSRO entities can be leveraged to provide
input to the regulatory bodies, but the regulator
needs to sufficient expertise as well
 Given the global nature of capital flows, it’s
important for international regulatory bodies to
reach consensus on the role of RAs in the global
capital markets
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Appendix
Past performance is not a guarantee or a reliable indicator of future results.
Hypothetical Example
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp
differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any
specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No
guarantee is being made that the stated results will be achieved.
Outlook
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment
strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn
in the market.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for
informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained
from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without
express written permission. Pacific Investment Management Company LLC, ©2009, PIMCO.
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Advisory_NAIC(09-23-09)Appendix