Issuer-Pay vs. Investor-Pay Business Model

Session II: Issuer-Pay vs. Investor-Pay Business Model

Mark Adelson Executive Managing Director Senior Research Fellow

Debt Rating Agencies’ Role in the Global Debt Capital Markets: Past Present and Future Global Interdependence Center & CFA Society of Philadelphia 29 February 2012

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Copyright © 2011 Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.

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

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2.

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

Status as of 31 December 2010 Default + Near Default

Default

Near Default

Any Downgrade

No. of Ratings

AAA

60.1%

22.7%

37.4%

77.3%

4,043

AA

78.2%

45.8%

32.4%

87.6%

8,340

A

88.5%

59.7%

28.8%

93.4%

7,456

BBB

94.0%

69.4%

24.7%

95.2%

7,806

82.8%

52.8%

30.0%

89.8%

27,645

Inv. Grade

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).

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3.

Impetus for Change: Example – Financial Firm Ratings ICR at 1/1/07

Δ Eq Px 2007-08

AIG

AA+

-97.7%

~$183b in bailouts. US govt owns 80% stake

Bear Stearns

AA-

-94.2%

Shotgun marriage with JP Morgan for $10/share

Citigroup

AA

-86.7%

Hybrids exchanged, U.S. gov’t took 36% equity

IndyMac

BBB

-99.6%

Seized by FDIC in 2008, auctioned off in March 2009

Lehman

AA-

-100.0%

Merrill Lynch

AA-

-18.1%

Bought out by B-of-A 9/14/2008

Northern Rock

A+

-92.4%

Nationalized 2/22/2008

RBS

AA

-92.6%

Part nationalization, UK gov’t holds 84% stake

UBS

AA+

-76.3%

Write-downs >$50B since 2007

Wachovia

AA-

-89.3%

“Silent run" in Sep 2008; acquired by Wells Fargo

WaMu

A

Fannie Mae

AA-

-98.6%

Freddie Mac

AA-

-98.9%

Company

-100.0%

Notes

Bankruptcy 9/15/2008.

Receivership 9/25/2008 Conservatorship 9/7/2008. U.S. Treasury holds preferred stock and warrants worth 80% stake

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4.

Impetus for Change: Example – Financial Firm Ratings (#2) ICR at 1/1/07

Δ Eq Px 2007-08

Ambac

AAA

-98.5%

Bankruptcy 11/8/2010

MBIA

AAA

-94.3%

Rated B, attempting restructuring

FGIC

AAA

n.a.

Bankruptcy 8/3/2010

FSA

AAA

n.a.

Acquired by AGC in July 2009

ACA

A

n.a.

Restructuring plan 8/8/2008

AGC

AAA

-56.4%

CIFG

AAA

n.a.

Company

Notes

Now rated AA-

CC rating withdrawn 2/16/2010

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5.

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

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6.

Behind the Goals • Comparability makes S&P ratings more relevant to those responsible for top-level asset allocation and investment policy decisions • Superior comparability and transparency positively differentiate S&P ratings from our competitors’ • 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)

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7.

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

Criteria Calibration Stress Scenarios – Key Parameters

AAA

AA

A

BBB

BB

B

-26½%

-15%

-6%

-3%

-1%

-½%

Unemp.

25%

20%

15%

10%

8%

6%

Equities

-85%

-70%

-60%

-50%

-25%

-10%

ΔGDP

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8.

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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9.

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

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10.

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

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11.

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12.

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