Credit Rating
Content
Introduction
A Credit Rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history. A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau at the request of the lender Black's Law Dictionary. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit. A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates, or the refusal of a loan by the creditor.
A Credit Rating Agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.)
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Functions of Credit Rating Agencies
The primary function of the credit rating agencies is to provide credit ratings to the service providers of various forms of debt products and services. They are also meant to provide ratings to the debt instruments being provided by these service providers. The clients of the credit rating agencies are those entities that deal in the provision of debt products and services. At times, it has been observed that the companies that provide debt products and services are rating the debt instruments by themselves. The providers of securities like the companies, the governmental organizations at the state and central level and special purpose entities are the major clients of the credit rating agencies. The non-profit seeking organizations and the national governments also avail the services of the credit rating agencies.
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Credit rating Agencies in USA
Moody’s Corp.
Moody’s Corporation, through its subsidiaries, provides credit ratings and related research, data, and analytical tools; quantitative credit risk measures, risk scoring software, and credit portfolio management solutions; and securities pricing software and valuation models principally in the United States and Europe. The company operates through two segments, MIS and MA. The MIS segment publishes credit ratings on a range of debt obligations, including various corporate and governmental obligations, structured finance securities, and commercial paper programs, as well as the entities that issue such obligations in markets worldwide. This segment provides ratings in approximately 110 countries. Its ratings are disseminated via press releases to the public through a range of print and electronic media, including the Internet and real-time information systems, which is used by securities traders and investors. As of December 31, 2008, MIS had ratings relationships with approximately 13,000 corporate issuers and approximately 26,000 public finance issuers. Additionally, the company rated and monitored ratings on approximately 109,000 structured finance obligations. The MA segment develops a range of products and services that support the credit risk management activities of institutional participants in financial markets. These offerings include quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software, and valuation models, and specialized consulting services. It also distributes investor-oriented research and data, including in-depth research on debt issuers, industry studies, and commentary on topical events developed by MIS as part of its rating process. The company was founded in 1900 and is headquartered in New York, New York.
Standard & Poor’s
Standard & Poor's (S&P) is one of the world's preeminent providers of credit ratings, indices, risk evaluation, investment research and data. It also provides a wide range of other products and
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services designed to help individuals and institutions make better-informed financial decisions. Range of services provided by Standard & Poor's include advice on asset allocation, portfolio strategies, fund recommendations and research.
Standard and Poors was formed in 1941 with the merger of Standard Statistics and Poor's Publishing Company. Standard and Poor's has an unrivalled depth and breadth in coverage and analysis. Standard & Poor's has the world's largest network of credit ratings analysts. Over $1 trillion in investors' assets is directly tied to S&P indexes - more than all other index providers combined. Standard & Poor's indices include the premier U.S. portfolio index, the S&P 500. Standard & Poor's has a long history of creating standards for the financial industry. S&P has several firsts to its credit. Standard & Poor's was the first to rate Securitized financings, Bond insured transactions, Letters of credit, The financial strength of non-U.S. insurance companies, Bank holding companies, Financial guaranty companies.
Standard & Poor's issues credit ratings for the debt of corporations, be they public or private. It has been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. S&P issues both short-term and long-term credit ratings.
Fitch and Co.
Fitch Ratings, one of the top three credit rating agencies in the world (alongside Moody's and Standard & Poor's), issues ratings for thousands of banks, financial institutions, insurance companies, corporations, and governments. With dual headquarters in New York and London and about 50 offices worldwide, Fitch Ratings engages in the politically charged business of rating the debt of nations; it covers companies and governments in more than 90 nations. The company is part of the Fitch Group, which is a majority-owned subsidiary of France-based Fimalac.
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Ratings Tables
Moody’s
Long-term obligation ratings Moody's long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honored as promised. Such ratings reflect both the likelihood of default and the probability of a financial loss suffered in the event of default. Investment grade Aaa Aa1, Aa2, Aa3 A1, A2, A3 Baa1, Baa2, Baa3 highest quality, smallest degree of risk high quality, subject to very low credit risk, "their susceptibility to long-term risks appears somewhat greater" low credit risk, susceptible to impairment over the long term" moderate credit risk, medium-grade, characteristically unreliable
Speculative grade (Also known as High Yield or 'Junk') Ba1, Ba2, Ba3 B1, B2, B3 Caa1, Caa2, Caa3 Ca C questionable credit quality speculative, high credit risk, generally poor credit quality poor standing, very high credit risk, extremely poor credit quality, may be in default highly speculative, usually in default on their deposit obligations lowest rated class of bonds, typically in default, potential recovery values are low
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Special WR NR P Short-term taxable ratings Moody's short-term ratings for taxable securities are opinions of the ability of issuers to honor short-term financial obligations. Ratings may be assigned to issuers, short-term programs or to individual short-term debt instruments. Such obligations generally have an original maturity not exceeding thirteen months, unless explicitly noted. Moody's employs the following designations to indicate the relative repayment ability of rated issuers: P-1 Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay short-term debt for the obligations. P-2 Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay short-term debt obligations. P-3 Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay short-term obligations. NP
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Withdrawn Rating Not Rated Provisional
Issuers (or supporting institutions) rated Not Prime do not fall within any of the Prime rating categories. Note: Canadian issuers rated P-1 or P-2 have their short-term ratings enhanced by the senior-most long-term rating of the issuer, its guarantor or support-provider.
Short-term tax-exempt ratings Unlike S&P, Moody's has separate categories for short term municipal bonds. The ratings categories largely overlap, though, and have the same implications for the ability to repay short-term obligations.
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Individual bank ratings Moody's also rates each bank's financial strength. These ratings differ from deposit ratings in that they measure how likely the bank is to need assistance from third parties. A B C D E "superior intrinsic financial strength" "strong intrinsic financial strength" "adequate intrinsic financial strength" "modest intrinsic financial strength, potentially requiring some outside support at times" “very modest intrinsic financial strength, with a higher likelihood of periodic outside support"
S&P
Credit ratings Standard & Poor's, as a credit rating agency (CRA), issues credit ratings for the debt of public and private corporations. It is one of several CRAs that have been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. It issues both short-term and long-term credit ratings. Long-term credit ratings S&P rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between AA and CCC (i.e., BBB+, BBB and BBB-). For some borrowers, S&P may also offer guidance (termed a "credit watch") as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain (neutral).
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Investment Grade
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AAA : the best quality borrowers, reliable and stable (many of them governments) AA : quality borrowers, a bit higher risk than AAA A : economic situation can affect finance BBB : medium class borrowers, which are satisfactory at the moment
Non-Investment Grade (also known as junk bonds)
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BB : more prone to changes in the economy B : financial situation varies noticeably CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments
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CC : highly vulnerable, very speculative bonds C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
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CI : past due on interest R : under regulatory supervision due to its financial situation SD : has selectively defaulted on some obligations D : has defaulted on obligations and S&P believes that it will generally default on most or all obligations
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NR : not rated
Short-term issue credit ratings S&P rates specific issues on a scale from A-1 to D. Within the A-1 category it can be designated with a plus sign (+). This indicates that the issuer's commitment to meet its obligation is very strong. Country risk and currency of repayment of the obligor to meet the issue obligation are factored into the credit analysis and reflected in the issue rating.
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A-1 : obligor's capacity to meet its financial commitment on the obligation is strong A-2 : is susceptible to adverse economic conditions however the obligor's capacity to meet its financial commitment on the obligation is satisfactory
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A-3 : adverse economic conditions are likely to weaken the obligor's capacity to meet its financial commitment on the obligation
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B : has significant speculative characteristics. The obligor currently has the capacity to meet its financial obligation but faces major ongoing uncertainties that could impact its financial commitment on the obligation
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C : currently vulnerable to nonpayment and is dependent upon favorable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation
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D : is in payment default. Obligation not made on due date and grace period may not have expired. The rating is also used upon the filing of a bankruptcy petition.
Stock market indices Standard & Poor's publishes a large number of stock market indices, covering every region of the world, market capitalization level, and type of investment (e.g. indices for REITs and preferred stocks) These indices include:
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S&P 500 -- value weighted index of the prices of 500 large-cap common stocks actively traded in the United States. S&P 400 MidCap Index S&P 600 SmallCap Index
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Fitch Co.
Long-term credit ratings Fitch Rating' long-term credit ratings are set up along a scale from 'AAA' to 'D', first introduced in 1924 and later adopted and licensed by S&P. Moody's also uses a similar scale, but names the categories Page | 9
differently. Like S&P, Fitch also uses intermediate modifiers for each category between AA and CCC (i.e., AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB- etc.). Investment grade
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AAA : the best quality companies, reliable and stable AA : quality companies, a bit higher risk than AAA A : economic situation can affect finance BBB : medium class companies, which are satisfactory at the moment
Non-investment grade (also known as junk bonds)
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BB : more prone to changes in the economy B : financial situation varies noticeably CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments
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CC : highly vulnerable, very speculative bonds C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
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D : has defaulted on obligations and Fitch believes that it will generally default on most or all obligations
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NR : not publicly rated
Short-term credit ratings Fitch's short-term ratings indicate the potential level of default within a 12-month period.
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F1+ : best quality grade, indicating exceptionally strong capacity of obligor to meet its financial commitment F1 : best quality grade, indicating strong capacity of obligor to meet its financial commitment Page | 10
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F2 : good quality grade with satisfactory capacity of obligor to meet its financial commitment F3 : fair quality grade with adequate capacity of obligor to meet its financial commitment but near term adverse conditions could impact the obligor's commitments
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B : of speculative nature and obligor has minimal capacity to meet its commitment and vulnerability to short term adverse changes in financial and economic conditions
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C : possibility of default is high and the financial commitment of the obligor are dependent upon sustained, favourable business and economic conditions
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D : the obligor is in default as it has failed on its financial commitments.
What was the US Subprime crisis all about?
How and when did the sub-prime mortgage crisis begin? Charity begins at home, it is said. Here, crisis began at home, or more exactly, home loans. Housing prices began spiralling upwards in the US in the early years of this decade and continued through mid-2006, with the borrowing and lending rates extremely low which helped boost the demand for and supply of new and existing houses. Many institutions offered home loans to borrowers with poor or no credit histories by requiring higher than normal repayment levels — creating what is now referred to as “sub-prime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy. When did the slide begin?
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A retrospect does help when the market is in a crisis. The countdown began on June 30, 2004, when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels registered since the 1950s. It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.25 per cent. The US housing market began sliding in August 2005 and that continued through 2006. Building rates and housing prices tumbled. Did this cause business failure? Yes. Several sub-prime mortgage holders defaulted on their loans and the first sign of a “crisis” emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy. Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7 billions of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans. What do you think was the spillover effect of the slide? The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares in Bear Stearns came under pressure in May 2007 because of the bank’s exposure to the US subprime market. In June, Merrill Lynch seized and sold $800 millions of bonds used as collateral for loans made to Bear Stearns’ hedge funds that were used to bet on the sub-prime mortgage market. In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge funds hit by the defaulting sub-prime mortgages. Can you give us a timeline of the recent events?
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Given the dominance of US financial markets in other developed and developing economies, the sub-prime mortgage market crisis affected markets and institutions all over the globe.
Who is to Blame?
Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the instance of subprime mortgage woes, there is no single entity or individual to point the finger at. Instead, this mess is a collective creation of the world's central banks, homeowners, lenders, credit rating agencies and underwriters, and investors. Let's investigate. The Book The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this situation was compounded by the September 11 terrorist attacks that followed in 2001. In response, central banks around the world tried to stimulate the economy. They created capitalliquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments. Lenders took on greater risks too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time
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highs in the summer of 2005, which ultimately collapsed in August of 2006. (For an in-depth discussion of these events, see The Fuel That Fed The Subprime Meltdown.)
The end result of these key events was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who's to blame? Let's take a look at the key players. Biggest Culprit : The Lenders Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default. (To learn more about subprime lending, see Subprime Is Often Subpar.) When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.
In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments.
As you can see in Figure 1, subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.
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Figure 1
Partners in Crime : Home Buyers While we're on the topic of lenders, we should also mention the home buyers. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and minimal initial costs such as "no down payment". Their hope lay in price appreciation, which would have allowed them to refinanceat lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. (To learn more, read Why Housing Market Bubbles Pop.)
As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.
In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may
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have given the impression that there was no risk to these mortgages and that the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. (To learn about moral debate surrounding all things subprime, read Subprime Lending: Helping Hand Or Underhanded?) Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.
Investment Bankers Worsen The Situation The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum. (For a crash course on the secondary mortgage market, check out Behind The Scenes Of Your Mortgage.)
A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.
The chart below demonstrates the incredible increase in global CDOs issues in 2006.
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Rating Agencies : Possible Conflict of Interest A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. (To learn more on the ratings system, see What Is A Corporate Credit Rating?)
Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market Final Culprit: Hedge Funds
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demand.
Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. (To learn more. check out Taking A Look Behind Hedge Funds.)
To illustrate, there is a type of hedge fund strategy that can be best described as "creditarbitrage". It involves purchasing subprime bonds on credit and hedging these positions withcredit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.
Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. (For more on this, see Massive Hedge Fund Failures and Losing The Amaranth Gamble.) Plenty of Blame To Go Around Overall, it was a mix of factors and participants that precipitated the current subprime mess. Ultimately, though, human behavior and greed drove the demand, supply and the investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious that there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part of investors. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future good, bad or ugly.
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Role of CRAs
Credit rating agencies played an important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Impact on the crisis Credit rating agencies are now under scrutiny for giving investment-grade, "money safe" ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. These high ratings encouraged a flow of global investor funds into these securities, funding the housing bubble in the U.S.[1] An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007.
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These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors. Higher ratings were believed justified by various credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings , demand for these securities would have been considerably less. Bank writedowns and losses on these investments totaled $523 billion as of September 2008.[2][3] Competitive pressure to lower rating standards The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was strong within the firms. This rating business was their "golden goose" (which laid the proverbial golden egg or wealth) in the words of one manager.[4] Author Upton Sinclair (1878-1968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." [5] This competitive pressure and the resulting profits gave a personal financial incentive to management to lower standards. Internal rating agency emails from before the time the credit markets deteriorated, discovered and released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results.[6] For example, one email between colleagues at Standard & Poor's states "Rating agencies continue to create and [sic] even bigger monster--the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[7]
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Conflicts of interest Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks. [8] John C. Bogle wrote in 2005 that there is an inherent conflict of interest when a professional firm is also publicly-traded, as the pressure to grow and increase profits is relatively stronger, which may detract from the quality of work performed.[9] Moody's became a public firm in 2001, while Standard & Poor's is part of the publicly-traded McGraw-Hill Companies. SEC Investigation On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers.[10 Rating actions during the crisis Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, another indicator that their initial ratings were not accurate. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower.[11] As of July 2008, Standard & Poor's (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those
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downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P.[12] Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation.[13] Actions taken to improve rating approach Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.[14] In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates.
Case Studies
California probes credit rating agencies
California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's, Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.
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"These agencies gave their seal of approval, their highest ratings, to underlying securities that were highly dangerous and in fact wreaked havoc on the lives of millions of people," Brown said at a news conference. The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition. "The agencies have been coddled and protected," Brown said. "It's time we smoked 'em out." Agencies claim first amendment freedom-of-speech protection for their ratings, but courts have given mixed support. A federal court in early September allowed a lawsuit against agencies claiming such protection to go forward. Supervising Deputy Attorney General Kathrin Sears, who heads the probe, said the agencies had hidden behind the First Amendment, in her view. The investigation was just beginning, and the state needed to review the agencies responses, she added. The agencies must respond to subpoena questions and requests for documents by Oct. 19, but could seek an extension, she said. S&P, owned by McGraw-Hill Companies Inc. (MHP.N), said it had not received a subpoena and could not comment. Fitch, owned by Fimalac SA (LBCP.PA), said it expected to provide information once it received a request, and Moody's Corp (MCO.N) said it had received inquiries from state and regulatory authorities about its ratings and would cooperate as appropriate after reviewing them.
SUBPRIME CRISIS PROBE
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At the peak of the housing boom, the agencies gave their highest ratings to complicated financial instruments, including securities backed by subprime mortgages, making them appear as safe as government-issued Treasury bonds, Brown's office said. But California's economy slumped as house prices fell sharply in the past couple of years. Its unemployment rate has hit record highs and government faced a major crisis as tax revenue plummeted. The purchases of the securities helped fuel the housing bubble by providing funds for lenders to "issue ever-riskier subprime and other toxic mortgages," Brown's statement said. "When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them," the statement said. "Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage backed securities, a tacit acknowledgment of their failure to adequately assess the risks of the debt they rated." Brown said it was unclear how long the probe would take and what remedies and remuneration it would seek if California sued the agencies. "This is real stuff here, and yet for the last year and a half, action has not been taken," he said. Federal Securities and Exchange Commission Chair Mary Schapiro on Thursday in prepared remarks said the agency was considering a series of proposals to bolster regulation of the agencies, including ones to shed light on 'rating shopping' and conflicts of interest by the companies, which are paid by the issuers they rate. [ID:nN17202110] Brown's probe was applauded in California State Treasurer Bill Lockyer's office, which has been a harsh critic of credit rating agencies and has been pressing them to grade corporate debt and less risky municipal debt by the same standards.
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"The state of California along with other municipal issuers are all too familiar with wildly inaccurate ratings from the agencies," Lockyer spokesman Tom Dresslar said. "The ratings do not come close to reflecting the risk of default, which in our case is nil." "It's clear that the rating agencies played a significant role in the downfall of the U.S. economy," Dresslar said.
SEC REPORT ON RATING AGENCIES ROLE IN SUBPRIME CRISIS
The Securities & Exchange Commission (SEC) publishedits ‘Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies’ [NRSROs]. The SEC concluded (in a year-long study released on July 8th), that rating agencies improperly managed conflicts of interest and violated internal procedures in granting topratings tostructured securities. The SEC report lists eight major areas of deficiencies in processes, procedures and conflict of interest, including:
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The massive volume and complexity of deals overwhelmed NRSROs’ resources, leading to errors and shortcuts in procedures and documentation. Aspects of the rating process were not always disclosed. There was a lack of consistency in documentation on rating processes, models and rating committee meetings. As to the quality of information underlying the ratings, there was no obligation for rating agencies to verify the information provided by arrangers. Significant aspects of the rating process, including rationale for rating committee actions and decisions, were not always documented. No due diligence on information was provided to NRSROs. The surveillance process used appears to have been less robust than it should have been. There were issues in the management of conflicts, for instance, with analysts taking part in pricing. Internal audit process varied significantly between rating agencies and were ineffective in part due to lack of documentation.
Implications: Tighter regulations are now inevitable, but rating agencies are pushing back stating that some of the recommendations are too costly and beyond the current mandate of the SEC. However it is important to note that the NRSROs are proceeding with the implementation of many of the recommendations made by the SEC. There are many proponents for a tighter regulatory regime, here in the USA and on the other side of the Atlantic at the European Commission. But there are others who caution that the NRSROs are not the only participants in the value chain of bringing financial securities to the market. There is along route from origination to investors all of which have to be part of a‘ credit system overhaul’. In regard to entrusting NRSROs to European regulators the Financial Times wrote recently:“If the world’s best-paid financiers did not spot subprime, is it fair to entrust this tasks to Europe’s supervisors?” BIIA suspected all along that there was a disconnect with regard to the use of consumer information. The USA has the highest penetration of credit due to the availability of reliable information, and based on this fact the subprime debacle should not have happened. It is now evident that there was wholesale misrepresentation, misuse of information and outright fraud in
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the origination process of subprime mortgages. FICO scores appeared to have been imprecise because the absence of underlying credit performance of subprime candidates (no loan history). Experts are now questioning the reliability of credit scores. Others counter by proposing a greater use of nonfinancial data (forexampleutilitypaymentsetc.) to compensate for the absence of previous credit performance data from the financial sector) to improve the performance of‘ subprime credit scores’.
Subprime crisis claims S&P scalp
STANDARD & POOR'S has named Deven Sharma to replace Kathleen Corbet as president after lawmakers and investors criticised the credit rating company for failing to judge the risks of securities backed by subprime mortgages. McGraw-Hill, the parent of Standard & Poor's, said in a statement yesterday that Ms Corbet had resigned to spend more time with her family. Her exit was not related to the current turmoil
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in credit markets, said Steven Weiss, a spokesman for the company. Mr Sharma is executive vice-president of investment services and global sales. S&P and Moody's Investors Service failed to downgrade bonds backed by loans to borrowers with poor credit until July, when some had already lost more than 50c in the dollar. McGrawHill shares have dropped 26 per cent this year amid concerns that the rout in the credit markets may curtail new debt sales. The chairman of the US Senate Banking Committee, Christopher Dodd, said yesterday credit rating companies had to explain why they assigned "AAA ratings to securities that never deserved them". "The business is at a critical juncture, a turning point," said Joshua Rosner, a managing director at the investment research firm Graham Fisher & Co in New York, and co-author of a study that found rating companies understated the risks of subprime mortgage bonds. "Perhaps this is a sign of further personnel and business changes to come." McGraw-Hill shares rose 48c to $US50.27 in New York Stock Exchange composite trading. Moody's, the parent of the rating company Moody's Investors Service, fell 95c to $US45.09, and is down 35 per cent this year. The French President, Nicolas Sarkozy, called last month for an investigation into rating companies and the European Union's financial services commissioner, Charlie McCreevy, plans to review the management and resources of the companies, and any conflicts of interests. The firms did "great damage" said Senator Dodd, who is seeking the Democratic Party's presidential nomination. He wants to examine the "special status" that allows credit rating companies more access than investors to information about public companies. Mr Sharma's background is in strategy and consulting rather than the financial markets. He joined McGraw-Hill in 2002 from Booz Allen & Hamilton, a management consulting firm, where he served as a partner and advised companies on strategy, branding and sales management for 14 years, according to a biography on S&P's website. He also worked for Dresser Industries and Anderson Strathclyde.
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He is a graduate of Birla Institute of Technology in India and received a master's degree from the University of Wisconsin and a doctoral degree in business management from Ohio State University. Credit-rating companies may be successfully sued by investors who lost money on subprimemortgage securities and similar bonds, according to a study published in May by Mr Rosner and Joseph Mason, an associate finance professor at Drexel University in Philadelphia. Short-selling of Moody's and McGraw-Hill shares has soared this year, a sign investors are betting their earnings will suffer. Short interest in McGraw-Hill has tripled since February to about 6.1 million shares. The short interest on Moody's has increased about ninefold in the same period to 31 million shares, data compiled by Bloomberg show. McGraw-Hill and Moody's have declined partly because of concerns that subprime mortgage defaults will slow demand for ratings of collateralised debt obligations. Growth at S&P, McGraw-Hill's most profitable unit, would slow in the second half from the "very, very hot" first half, its chief executive, Terry McGraw, said on July 24. "Deven Sharma is a very skilled executive with global experience and knowledge," Mr Weiss said. "We remain very positive about the long-term trends that drive demand for S&P's credit ratings, index services, equity research and other data products."
News Corp. hit by credit re-rating
NEWS Corporation shares hit a year low on the Sydney stock exchange yesterday, as credit rating agency Standard & Poor's revised its outlook on Rupert Murdoch's media company from "stable" to "negative". The agency said a decision by Haim Saban, chairman of cable business Fox Family Worldwide, to exercise an option to sell his 49.5pc stake in the cable business to News Corp was "a source of potential concern".
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In Sydney, the shares fell 45 cents to A$13.65 (511p), less than half their A$28 record high hit last March. Under the terms of Mr Saban's put option, Mr Murdoch would have to pay between $700m (£473m) and $2 billion in cash to Saban Entertainment, News Corp's Fox Family joint venture partner. S&P warned that this cash payment, combined with the consolidation of Fox Family's $1.4 billion to $1.5 billion debt on News Corporation's balance sheet, "could put pressure on News Corp's ratings". The media company remains on a BBB (stable) S&P's rating, based on its underlying profitability in relation to both interest cover and debt. Mr Saban's decision could also put pressure on Mr Murdoch's hopes to buy American satellite broadcaster DirecTV and float News Corp's satellite business, Sky Global Networks, which includes BSkyB and British set-top box manufacturer NDS, in the new year. However, Mr Murdoch is expected to take action to alleviate News Corporation's credit profile. This could include selling Mr Saban's stake in Fox Family to a third party, or selling the cable company's main asset, the Fox Family Channel. News Corp may also try to negotiate with Mr Saban to inject some shares into the final sale. A News Corp spokesman said the S&P downgrade was "not a concern for the company" because it would "not do anything to risk its debt rating". News Corp's bankers, Bear Stearns, have until January 31 to negotiate an agreed valuation with Saban Entertainment for the stake in Fox.
Bibliography
Reuters.com Standardandpoors.com Fitch.com
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Moodys.com Wikipedia.org Google.com BIIA.com
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A Credit Rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history. A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau at the request of the lender Black's Law Dictionary. Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit. A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates, or the refusal of a loan by the creditor.
A Credit Rating Agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.)
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Functions of Credit Rating Agencies
The primary function of the credit rating agencies is to provide credit ratings to the service providers of various forms of debt products and services. They are also meant to provide ratings to the debt instruments being provided by these service providers. The clients of the credit rating agencies are those entities that deal in the provision of debt products and services. At times, it has been observed that the companies that provide debt products and services are rating the debt instruments by themselves. The providers of securities like the companies, the governmental organizations at the state and central level and special purpose entities are the major clients of the credit rating agencies. The non-profit seeking organizations and the national governments also avail the services of the credit rating agencies.
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Credit rating Agencies in USA
Moody’s Corp.
Moody’s Corporation, through its subsidiaries, provides credit ratings and related research, data, and analytical tools; quantitative credit risk measures, risk scoring software, and credit portfolio management solutions; and securities pricing software and valuation models principally in the United States and Europe. The company operates through two segments, MIS and MA. The MIS segment publishes credit ratings on a range of debt obligations, including various corporate and governmental obligations, structured finance securities, and commercial paper programs, as well as the entities that issue such obligations in markets worldwide. This segment provides ratings in approximately 110 countries. Its ratings are disseminated via press releases to the public through a range of print and electronic media, including the Internet and real-time information systems, which is used by securities traders and investors. As of December 31, 2008, MIS had ratings relationships with approximately 13,000 corporate issuers and approximately 26,000 public finance issuers. Additionally, the company rated and monitored ratings on approximately 109,000 structured finance obligations. The MA segment develops a range of products and services that support the credit risk management activities of institutional participants in financial markets. These offerings include quantitative credit risk scores, credit processing software, economic research, analytical models, financial data, securities pricing software, and valuation models, and specialized consulting services. It also distributes investor-oriented research and data, including in-depth research on debt issuers, industry studies, and commentary on topical events developed by MIS as part of its rating process. The company was founded in 1900 and is headquartered in New York, New York.
Standard & Poor’s
Standard & Poor's (S&P) is one of the world's preeminent providers of credit ratings, indices, risk evaluation, investment research and data. It also provides a wide range of other products and
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services designed to help individuals and institutions make better-informed financial decisions. Range of services provided by Standard & Poor's include advice on asset allocation, portfolio strategies, fund recommendations and research.
Standard and Poors was formed in 1941 with the merger of Standard Statistics and Poor's Publishing Company. Standard and Poor's has an unrivalled depth and breadth in coverage and analysis. Standard & Poor's has the world's largest network of credit ratings analysts. Over $1 trillion in investors' assets is directly tied to S&P indexes - more than all other index providers combined. Standard & Poor's indices include the premier U.S. portfolio index, the S&P 500. Standard & Poor's has a long history of creating standards for the financial industry. S&P has several firsts to its credit. Standard & Poor's was the first to rate Securitized financings, Bond insured transactions, Letters of credit, The financial strength of non-U.S. insurance companies, Bank holding companies, Financial guaranty companies.
Standard & Poor's issues credit ratings for the debt of corporations, be they public or private. It has been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. S&P issues both short-term and long-term credit ratings.
Fitch and Co.
Fitch Ratings, one of the top three credit rating agencies in the world (alongside Moody's and Standard & Poor's), issues ratings for thousands of banks, financial institutions, insurance companies, corporations, and governments. With dual headquarters in New York and London and about 50 offices worldwide, Fitch Ratings engages in the politically charged business of rating the debt of nations; it covers companies and governments in more than 90 nations. The company is part of the Fitch Group, which is a majority-owned subsidiary of France-based Fimalac.
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Ratings Tables
Moody’s
Long-term obligation ratings Moody's long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honored as promised. Such ratings reflect both the likelihood of default and the probability of a financial loss suffered in the event of default. Investment grade Aaa Aa1, Aa2, Aa3 A1, A2, A3 Baa1, Baa2, Baa3 highest quality, smallest degree of risk high quality, subject to very low credit risk, "their susceptibility to long-term risks appears somewhat greater" low credit risk, susceptible to impairment over the long term" moderate credit risk, medium-grade, characteristically unreliable
Speculative grade (Also known as High Yield or 'Junk') Ba1, Ba2, Ba3 B1, B2, B3 Caa1, Caa2, Caa3 Ca C questionable credit quality speculative, high credit risk, generally poor credit quality poor standing, very high credit risk, extremely poor credit quality, may be in default highly speculative, usually in default on their deposit obligations lowest rated class of bonds, typically in default, potential recovery values are low
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Special WR NR P Short-term taxable ratings Moody's short-term ratings for taxable securities are opinions of the ability of issuers to honor short-term financial obligations. Ratings may be assigned to issuers, short-term programs or to individual short-term debt instruments. Such obligations generally have an original maturity not exceeding thirteen months, unless explicitly noted. Moody's employs the following designations to indicate the relative repayment ability of rated issuers: P-1 Issuers (or supporting institutions) rated Prime-1 have a superior ability to repay short-term debt for the obligations. P-2 Issuers (or supporting institutions) rated Prime-2 have a strong ability to repay short-term debt obligations. P-3 Issuers (or supporting institutions) rated Prime-3 have an acceptable ability to repay short-term obligations. NP
•
Withdrawn Rating Not Rated Provisional
Issuers (or supporting institutions) rated Not Prime do not fall within any of the Prime rating categories. Note: Canadian issuers rated P-1 or P-2 have their short-term ratings enhanced by the senior-most long-term rating of the issuer, its guarantor or support-provider.
Short-term tax-exempt ratings Unlike S&P, Moody's has separate categories for short term municipal bonds. The ratings categories largely overlap, though, and have the same implications for the ability to repay short-term obligations.
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Individual bank ratings Moody's also rates each bank's financial strength. These ratings differ from deposit ratings in that they measure how likely the bank is to need assistance from third parties. A B C D E "superior intrinsic financial strength" "strong intrinsic financial strength" "adequate intrinsic financial strength" "modest intrinsic financial strength, potentially requiring some outside support at times" “very modest intrinsic financial strength, with a higher likelihood of periodic outside support"
S&P
Credit ratings Standard & Poor's, as a credit rating agency (CRA), issues credit ratings for the debt of public and private corporations. It is one of several CRAs that have been designated a Nationally Recognized Statistical Rating Organization by the U.S. Securities and Exchange Commission. It issues both short-term and long-term credit ratings. Long-term credit ratings S&P rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between AA and CCC (i.e., BBB+, BBB and BBB-). For some borrowers, S&P may also offer guidance (termed a "credit watch") as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain (neutral).
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Investment Grade
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AAA : the best quality borrowers, reliable and stable (many of them governments) AA : quality borrowers, a bit higher risk than AAA A : economic situation can affect finance BBB : medium class borrowers, which are satisfactory at the moment
Non-Investment Grade (also known as junk bonds)
• • •
BB : more prone to changes in the economy B : financial situation varies noticeably CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments
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CC : highly vulnerable, very speculative bonds C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
• • • •
CI : past due on interest R : under regulatory supervision due to its financial situation SD : has selectively defaulted on some obligations D : has defaulted on obligations and S&P believes that it will generally default on most or all obligations
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NR : not rated
Short-term issue credit ratings S&P rates specific issues on a scale from A-1 to D. Within the A-1 category it can be designated with a plus sign (+). This indicates that the issuer's commitment to meet its obligation is very strong. Country risk and currency of repayment of the obligor to meet the issue obligation are factored into the credit analysis and reflected in the issue rating.
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• •
A-1 : obligor's capacity to meet its financial commitment on the obligation is strong A-2 : is susceptible to adverse economic conditions however the obligor's capacity to meet its financial commitment on the obligation is satisfactory
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A-3 : adverse economic conditions are likely to weaken the obligor's capacity to meet its financial commitment on the obligation
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B : has significant speculative characteristics. The obligor currently has the capacity to meet its financial obligation but faces major ongoing uncertainties that could impact its financial commitment on the obligation
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C : currently vulnerable to nonpayment and is dependent upon favorable business, financial and economic conditions for the obligor to meet its financial commitment on the obligation
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D : is in payment default. Obligation not made on due date and grace period may not have expired. The rating is also used upon the filing of a bankruptcy petition.
Stock market indices Standard & Poor's publishes a large number of stock market indices, covering every region of the world, market capitalization level, and type of investment (e.g. indices for REITs and preferred stocks) These indices include:
•
S&P 500 -- value weighted index of the prices of 500 large-cap common stocks actively traded in the United States. S&P 400 MidCap Index S&P 600 SmallCap Index
• •
Fitch Co.
Long-term credit ratings Fitch Rating' long-term credit ratings are set up along a scale from 'AAA' to 'D', first introduced in 1924 and later adopted and licensed by S&P. Moody's also uses a similar scale, but names the categories Page | 9
differently. Like S&P, Fitch also uses intermediate modifiers for each category between AA and CCC (i.e., AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB- etc.). Investment grade
• • • •
AAA : the best quality companies, reliable and stable AA : quality companies, a bit higher risk than AAA A : economic situation can affect finance BBB : medium class companies, which are satisfactory at the moment
Non-investment grade (also known as junk bonds)
• • •
BB : more prone to changes in the economy B : financial situation varies noticeably CCC : currently vulnerable and dependent on favorable economic conditions to meet its commitments
• •
CC : highly vulnerable, very speculative bonds C : highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
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D : has defaulted on obligations and Fitch believes that it will generally default on most or all obligations
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NR : not publicly rated
Short-term credit ratings Fitch's short-term ratings indicate the potential level of default within a 12-month period.
•
F1+ : best quality grade, indicating exceptionally strong capacity of obligor to meet its financial commitment F1 : best quality grade, indicating strong capacity of obligor to meet its financial commitment Page | 10
•
• •
F2 : good quality grade with satisfactory capacity of obligor to meet its financial commitment F3 : fair quality grade with adequate capacity of obligor to meet its financial commitment but near term adverse conditions could impact the obligor's commitments
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B : of speculative nature and obligor has minimal capacity to meet its commitment and vulnerability to short term adverse changes in financial and economic conditions
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C : possibility of default is high and the financial commitment of the obligor are dependent upon sustained, favourable business and economic conditions
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D : the obligor is in default as it has failed on its financial commitments.
What was the US Subprime crisis all about?
How and when did the sub-prime mortgage crisis begin? Charity begins at home, it is said. Here, crisis began at home, or more exactly, home loans. Housing prices began spiralling upwards in the US in the early years of this decade and continued through mid-2006, with the borrowing and lending rates extremely low which helped boost the demand for and supply of new and existing houses. Many institutions offered home loans to borrowers with poor or no credit histories by requiring higher than normal repayment levels — creating what is now referred to as “sub-prime mortgages” —attracting investment banks and hedge fund owners to bet big on this emerging aspect of the US economy. When did the slide begin?
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A retrospect does help when the market is in a crisis. The countdown began on June 30, 2004, when the Federal Reserve (the central bank in the US) began a cycle of interest rate hikes that raised the cost of borrowing from the lowest levels registered since the 1950s. It increased the interest rates seventeen times and paused only in June 2006 when the borrowing cost touched 5.25 per cent. The US housing market began sliding in August 2005 and that continued through 2006. Building rates and housing prices tumbled. Did this cause business failure? Yes. Several sub-prime mortgage holders defaulted on their loans and the first sign of a “crisis” emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy. Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7 billions of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of bad loans. What do you think was the spillover effect of the slide? The sub-prime mortgage crisis went on to affect major global investment banks as well. Shares in Bear Stearns came under pressure in May 2007 because of the bank’s exposure to the US subprime market. In June, Merrill Lynch seized and sold $800 millions of bonds used as collateral for loans made to Bear Stearns’ hedge funds that were used to bet on the sub-prime mortgage market. In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge funds hit by the defaulting sub-prime mortgages. Can you give us a timeline of the recent events?
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Given the dominance of US financial markets in other developed and developing economies, the sub-prime mortgage market crisis affected markets and institutions all over the globe.
Who is to Blame?
Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the instance of subprime mortgage woes, there is no single entity or individual to point the finger at. Instead, this mess is a collective creation of the world's central banks, homeowners, lenders, credit rating agencies and underwriters, and investors. Let's investigate. The Book The economy was at risk of a deep recession after the dotcom bubble burst in early 2000; this situation was compounded by the September 11 terrorist attacks that followed in 2001. In response, central banks around the world tried to stimulate the economy. They created capitalliquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments. Lenders took on greater risks too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time
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highs in the summer of 2005, which ultimately collapsed in August of 2006. (For an in-depth discussion of these events, see The Fuel That Fed The Subprime Meltdown.)
The end result of these key events was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who's to blame? Let's take a look at the key players. Biggest Culprit : The Lenders Most of the blame should be pointed at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default. (To learn more about subprime lending, see Subprime Is Often Subpar.) When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.
In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments.
As you can see in Figure 1, subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.
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Figure 1
Partners in Crime : Home Buyers While we're on the topic of lenders, we should also mention the home buyers. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) that offered low introductory rates and minimal initial costs such as "no down payment". Their hope lay in price appreciation, which would have allowed them to refinanceat lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. (To learn more, read Why Housing Market Bubbles Pop.)
As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.
In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may
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have given the impression that there was no risk to these mortgages and that the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. (To learn about moral debate surrounding all things subprime, read Subprime Lending: Helping Hand Or Underhanded?) Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.
Investment Bankers Worsen The Situation The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum. (For a crash course on the secondary mortgage market, check out Behind The Scenes Of Your Mortgage.)
A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.
The chart below demonstrates the incredible increase in global CDOs issues in 2006.
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Rating Agencies : Possible Conflict of Interest A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. (To learn more on the ratings system, see What Is A Corporate Credit Rating?)
Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it's hard to sell a security if it is not rated. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market Final Culprit: Hedge Funds
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demand.
Another party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. (To learn more. check out Taking A Look Behind Hedge Funds.)
To illustrate, there is a type of hedge fund strategy that can be best described as "creditarbitrage". It involves purchasing subprime bonds on credit and hedging these positions withcredit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.
Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. (For more on this, see Massive Hedge Fund Failures and Losing The Amaranth Gamble.) Plenty of Blame To Go Around Overall, it was a mix of factors and participants that precipitated the current subprime mess. Ultimately, though, human behavior and greed drove the demand, supply and the investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious that there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom, most recently the dotcom bubble and ensuing "irrational exuberance" on the part of investors. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future good, bad or ugly.
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Role of CRAs
Credit rating agencies played an important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Impact on the crisis Credit rating agencies are now under scrutiny for giving investment-grade, "money safe" ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. These high ratings encouraged a flow of global investor funds into these securities, funding the housing bubble in the U.S.[1] An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007.
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These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors. Higher ratings were believed justified by various credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. Economist Joseph Stiglitz stated: "I view the rating agencies as one of the key culprits...They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings , demand for these securities would have been considerably less. Bank writedowns and losses on these investments totaled $523 billion as of September 2008.[2][3] Competitive pressure to lower rating standards The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was strong within the firms. This rating business was their "golden goose" (which laid the proverbial golden egg or wealth) in the words of one manager.[4] Author Upton Sinclair (1878-1968) famously stated: "It is difficult to get a man to understand something when his job depends on not understanding it." [5] This competitive pressure and the resulting profits gave a personal financial incentive to management to lower standards. Internal rating agency emails from before the time the credit markets deteriorated, discovered and released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results.[6] For example, one email between colleagues at Standard & Poor's states "Rating agencies continue to create and [sic] even bigger monster--the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[7]
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Conflicts of interest Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks. [8] John C. Bogle wrote in 2005 that there is an inherent conflict of interest when a professional firm is also publicly-traded, as the pressure to grow and increase profits is relatively stronger, which may detract from the quality of work performed.[9] Moody's became a public firm in 2001, while Standard & Poor's is part of the publicly-traded McGraw-Hill Companies. SEC Investigation On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers.[10 Rating actions during the crisis Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, another indicator that their initial ratings were not accurate. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower.[11] As of July 2008, Standard & Poor's (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those
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downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P.[12] Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation.[13] Actions taken to improve rating approach Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.[14] In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates.
Case Studies
California probes credit rating agencies
California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's, Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.
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"These agencies gave their seal of approval, their highest ratings, to underlying securities that were highly dangerous and in fact wreaked havoc on the lives of millions of people," Brown said at a news conference. The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition. "The agencies have been coddled and protected," Brown said. "It's time we smoked 'em out." Agencies claim first amendment freedom-of-speech protection for their ratings, but courts have given mixed support. A federal court in early September allowed a lawsuit against agencies claiming such protection to go forward. Supervising Deputy Attorney General Kathrin Sears, who heads the probe, said the agencies had hidden behind the First Amendment, in her view. The investigation was just beginning, and the state needed to review the agencies responses, she added. The agencies must respond to subpoena questions and requests for documents by Oct. 19, but could seek an extension, she said. S&P, owned by McGraw-Hill Companies Inc. (MHP.N), said it had not received a subpoena and could not comment. Fitch, owned by Fimalac SA (LBCP.PA), said it expected to provide information once it received a request, and Moody's Corp (MCO.N) said it had received inquiries from state and regulatory authorities about its ratings and would cooperate as appropriate after reviewing them.
SUBPRIME CRISIS PROBE
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At the peak of the housing boom, the agencies gave their highest ratings to complicated financial instruments, including securities backed by subprime mortgages, making them appear as safe as government-issued Treasury bonds, Brown's office said. But California's economy slumped as house prices fell sharply in the past couple of years. Its unemployment rate has hit record highs and government faced a major crisis as tax revenue plummeted. The purchases of the securities helped fuel the housing bubble by providing funds for lenders to "issue ever-riskier subprime and other toxic mortgages," Brown's statement said. "When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them," the statement said. "Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage backed securities, a tacit acknowledgment of their failure to adequately assess the risks of the debt they rated." Brown said it was unclear how long the probe would take and what remedies and remuneration it would seek if California sued the agencies. "This is real stuff here, and yet for the last year and a half, action has not been taken," he said. Federal Securities and Exchange Commission Chair Mary Schapiro on Thursday in prepared remarks said the agency was considering a series of proposals to bolster regulation of the agencies, including ones to shed light on 'rating shopping' and conflicts of interest by the companies, which are paid by the issuers they rate. [ID:nN17202110] Brown's probe was applauded in California State Treasurer Bill Lockyer's office, which has been a harsh critic of credit rating agencies and has been pressing them to grade corporate debt and less risky municipal debt by the same standards.
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"The state of California along with other municipal issuers are all too familiar with wildly inaccurate ratings from the agencies," Lockyer spokesman Tom Dresslar said. "The ratings do not come close to reflecting the risk of default, which in our case is nil." "It's clear that the rating agencies played a significant role in the downfall of the U.S. economy," Dresslar said.
SEC REPORT ON RATING AGENCIES ROLE IN SUBPRIME CRISIS
The Securities & Exchange Commission (SEC) publishedits ‘Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies’ [NRSROs]. The SEC concluded (in a year-long study released on July 8th), that rating agencies improperly managed conflicts of interest and violated internal procedures in granting topratings tostructured securities. The SEC report lists eight major areas of deficiencies in processes, procedures and conflict of interest, including:
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• • • • • • • •
The massive volume and complexity of deals overwhelmed NRSROs’ resources, leading to errors and shortcuts in procedures and documentation. Aspects of the rating process were not always disclosed. There was a lack of consistency in documentation on rating processes, models and rating committee meetings. As to the quality of information underlying the ratings, there was no obligation for rating agencies to verify the information provided by arrangers. Significant aspects of the rating process, including rationale for rating committee actions and decisions, were not always documented. No due diligence on information was provided to NRSROs. The surveillance process used appears to have been less robust than it should have been. There were issues in the management of conflicts, for instance, with analysts taking part in pricing. Internal audit process varied significantly between rating agencies and were ineffective in part due to lack of documentation.
Implications: Tighter regulations are now inevitable, but rating agencies are pushing back stating that some of the recommendations are too costly and beyond the current mandate of the SEC. However it is important to note that the NRSROs are proceeding with the implementation of many of the recommendations made by the SEC. There are many proponents for a tighter regulatory regime, here in the USA and on the other side of the Atlantic at the European Commission. But there are others who caution that the NRSROs are not the only participants in the value chain of bringing financial securities to the market. There is along route from origination to investors all of which have to be part of a‘ credit system overhaul’. In regard to entrusting NRSROs to European regulators the Financial Times wrote recently:“If the world’s best-paid financiers did not spot subprime, is it fair to entrust this tasks to Europe’s supervisors?” BIIA suspected all along that there was a disconnect with regard to the use of consumer information. The USA has the highest penetration of credit due to the availability of reliable information, and based on this fact the subprime debacle should not have happened. It is now evident that there was wholesale misrepresentation, misuse of information and outright fraud in
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the origination process of subprime mortgages. FICO scores appeared to have been imprecise because the absence of underlying credit performance of subprime candidates (no loan history). Experts are now questioning the reliability of credit scores. Others counter by proposing a greater use of nonfinancial data (forexampleutilitypaymentsetc.) to compensate for the absence of previous credit performance data from the financial sector) to improve the performance of‘ subprime credit scores’.
Subprime crisis claims S&P scalp
STANDARD & POOR'S has named Deven Sharma to replace Kathleen Corbet as president after lawmakers and investors criticised the credit rating company for failing to judge the risks of securities backed by subprime mortgages. McGraw-Hill, the parent of Standard & Poor's, said in a statement yesterday that Ms Corbet had resigned to spend more time with her family. Her exit was not related to the current turmoil
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in credit markets, said Steven Weiss, a spokesman for the company. Mr Sharma is executive vice-president of investment services and global sales. S&P and Moody's Investors Service failed to downgrade bonds backed by loans to borrowers with poor credit until July, when some had already lost more than 50c in the dollar. McGrawHill shares have dropped 26 per cent this year amid concerns that the rout in the credit markets may curtail new debt sales. The chairman of the US Senate Banking Committee, Christopher Dodd, said yesterday credit rating companies had to explain why they assigned "AAA ratings to securities that never deserved them". "The business is at a critical juncture, a turning point," said Joshua Rosner, a managing director at the investment research firm Graham Fisher & Co in New York, and co-author of a study that found rating companies understated the risks of subprime mortgage bonds. "Perhaps this is a sign of further personnel and business changes to come." McGraw-Hill shares rose 48c to $US50.27 in New York Stock Exchange composite trading. Moody's, the parent of the rating company Moody's Investors Service, fell 95c to $US45.09, and is down 35 per cent this year. The French President, Nicolas Sarkozy, called last month for an investigation into rating companies and the European Union's financial services commissioner, Charlie McCreevy, plans to review the management and resources of the companies, and any conflicts of interests. The firms did "great damage" said Senator Dodd, who is seeking the Democratic Party's presidential nomination. He wants to examine the "special status" that allows credit rating companies more access than investors to information about public companies. Mr Sharma's background is in strategy and consulting rather than the financial markets. He joined McGraw-Hill in 2002 from Booz Allen & Hamilton, a management consulting firm, where he served as a partner and advised companies on strategy, branding and sales management for 14 years, according to a biography on S&P's website. He also worked for Dresser Industries and Anderson Strathclyde.
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He is a graduate of Birla Institute of Technology in India and received a master's degree from the University of Wisconsin and a doctoral degree in business management from Ohio State University. Credit-rating companies may be successfully sued by investors who lost money on subprimemortgage securities and similar bonds, according to a study published in May by Mr Rosner and Joseph Mason, an associate finance professor at Drexel University in Philadelphia. Short-selling of Moody's and McGraw-Hill shares has soared this year, a sign investors are betting their earnings will suffer. Short interest in McGraw-Hill has tripled since February to about 6.1 million shares. The short interest on Moody's has increased about ninefold in the same period to 31 million shares, data compiled by Bloomberg show. McGraw-Hill and Moody's have declined partly because of concerns that subprime mortgage defaults will slow demand for ratings of collateralised debt obligations. Growth at S&P, McGraw-Hill's most profitable unit, would slow in the second half from the "very, very hot" first half, its chief executive, Terry McGraw, said on July 24. "Deven Sharma is a very skilled executive with global experience and knowledge," Mr Weiss said. "We remain very positive about the long-term trends that drive demand for S&P's credit ratings, index services, equity research and other data products."
News Corp. hit by credit re-rating
NEWS Corporation shares hit a year low on the Sydney stock exchange yesterday, as credit rating agency Standard & Poor's revised its outlook on Rupert Murdoch's media company from "stable" to "negative". The agency said a decision by Haim Saban, chairman of cable business Fox Family Worldwide, to exercise an option to sell his 49.5pc stake in the cable business to News Corp was "a source of potential concern".
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In Sydney, the shares fell 45 cents to A$13.65 (511p), less than half their A$28 record high hit last March. Under the terms of Mr Saban's put option, Mr Murdoch would have to pay between $700m (£473m) and $2 billion in cash to Saban Entertainment, News Corp's Fox Family joint venture partner. S&P warned that this cash payment, combined with the consolidation of Fox Family's $1.4 billion to $1.5 billion debt on News Corporation's balance sheet, "could put pressure on News Corp's ratings". The media company remains on a BBB (stable) S&P's rating, based on its underlying profitability in relation to both interest cover and debt. Mr Saban's decision could also put pressure on Mr Murdoch's hopes to buy American satellite broadcaster DirecTV and float News Corp's satellite business, Sky Global Networks, which includes BSkyB and British set-top box manufacturer NDS, in the new year. However, Mr Murdoch is expected to take action to alleviate News Corporation's credit profile. This could include selling Mr Saban's stake in Fox Family to a third party, or selling the cable company's main asset, the Fox Family Channel. News Corp may also try to negotiate with Mr Saban to inject some shares into the final sale. A News Corp spokesman said the S&P downgrade was "not a concern for the company" because it would "not do anything to risk its debt rating". News Corp's bankers, Bear Stearns, have until January 31 to negotiate an agreed valuation with Saban Entertainment for the stake in Fox.
Bibliography
Reuters.com Standardandpoors.com Fitch.com
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Moodys.com Wikipedia.org Google.com BIIA.com
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