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1 October 14, 2009October 14, 2009
The Credit Crisis Continues…
Marshall BennettJames A. Harrod
2
Credit Crisis Continues…Credit Crisis Continues…
Overview– Effects: what characterized the
crisis? What Happened? Some of the Causes What happened with the Credit
Rating Agencies? Conclusions
3
Credit Crisis - Effects Credit Crisis - Effects - S&P 500 - 50% decline from January 2007 – March 2009- U.S. DB public pension funds – equity losses total ~$1 trillion*
* IMF Working Paper, How the Financial Crisis Affects Pensions – July 2009
4
20 % decline in US Home Prices
Credit Crisis - Effects Credit Crisis - Effects
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massive increase in mortgage delinquencies
Source: The Wall Street Journal
Credit Crisis - Effects Credit Crisis - Effects
6
massive declines in mortgage securities
Credit Crisis - Effects Credit Crisis - Effects
Source: CNNMoney/Markit Group
ABX-HE-A 07-2 tracks BBB-rated MBS issued in the first half of 2007.
7
Government Intervention – Alphabet Soup
Government Intervention – Alphabet Soup
TARP – Troubled Asset Relief Program TALF – Term Asset-backed Securities Loan
Facility PPIP – Public-Private Investment Program MHAP – Making Home Affordable Program
8
Structured Finance ProductsStructured Finance Products
Products created by Wall Street
Assets packaged into securities for sale to investors– Create a more liquid market for the asset– Allow financial institutions to deploy capital repeatedly
More alphabet soup:
– MBS/CMOs (mortgage backed securities/collateralized mortgage obligations)
– ABS (asset backed securities)
– CDOs (collateralized debt obligations)
– CLOs (collateralized loan obligations)
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Securitization ProcessSecuritization Process
Senior tranches
Subordinated tranches
SPV
MBS
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Credit Crisis – First SignsCredit Crisis – First Signs Mortgage Default Rates Increase – Q1 2007
– Adjustable Rate Mortgage Resets– Lower lending standards – riskier borrowers
Significant declines in ABX and related indices Secondary markets for structured products
experience liquidity problems Securitization becomes more difficult
Monoline insurers experience capital shortages– MBIA/AMBAC
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Problems at Mortgage Companies Problems at Mortgage Companies
Mortgage Companies Experience Problems:
– New Century
– Countrywide
– Northern Rock/UK
– Indymac
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Instability in Financial ServicesInstability in Financial Services
Major Commercial/Investment Banks
– Bear Stearns
– Lehman Brothers
– Merrill Lynch
– Wachovia
– Washington Mutual/WaMu
– Royal Bank of Scotland
– Citigroup
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Crisis Effects – Beyond the Big BanksCrisis Effects – Beyond the Big Banks
FDIC has seized/closed 127 institutions since 2007
AIG – problems with derivatives
December 2008 - Bernard Madoff - $64 billion Ponzi scheme
Massive government support to General Motors & Chrysler
14
Financial Crisis – Some FactorsFinancial Crisis – Some Factors
Failure of the traditional gatekeepers– SEC – Madoff report points to failures– Banks – loans sold to investors– Rating Agencies – conflicts and failures
Proliferation of Structured Finance products
Opaque derivative markets (CDSs)– Warren Buffet:
“financial weapons of mass destruction”
Increased Leverage
Consumers’ high appetite for debt
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Rating AgenciesRating Agencies
Moody’s Investors Service, Inc.
Standard & Poor’s Ratings (owned by McGraw-Hill, Inc.)
Fitch Ratings Service (owned by Fimalac, S.A.)
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Rating Agencies’ RoleRating Agencies’ Role Called Nationally Recognized Statistical Rating
Organizations (NRSROs) by the SEC:– “official arbiters of financial soundness.”*
Many investors have guidelines or requirements that permit investments only in “investment grade debt”:– Moody’s: Aaa, Aa, A, Baa – S & P/Fitch: AAA, AA, A, BBB
Effective marketing of securities requires rating by an NRSRO
Ratings particularly important in “alphabet soup” financial products– Capital structure relies on subordination and
diversification
*James Surowiecki, “Ratings Downgrade,” The New Yorker – Sept. 28, 2009
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“Aaa” – More Risk Than
Expected
“Aaa” – More Risk Than
Expected
“AAA” – risk free?– Like a U.S. Treasury bond
Bonds were purchased based on rating and yield
Decline in value of “AAA” securities has affected institutional investors– Performed much worse than expected
18
Rating Agencies – How did they get it
wrong?
Rating Agencies – How did they get it
wrong?
Outdated models
Structural conflicts of interest
Exemption from liability
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Outdated ModelsOutdated Models
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent.
The New York Times, Triple-A Failure, April 27, 2008
The rating agencies used statistical models that relied on historical default rates but the mortgages and underwriting standards had drastically changed and they failed to update their models to reflect this:
20
Outdated ModelsOutdated Models
In Congressional testimony, Frank Raiter, former Managing Director and Head of Residential Mortgage Backed Securities Ratings at S&P, acknowledged that S&P had a new model to use, but did not use it.
The failure to use a new model was disastrous:
– Had these models been implemented we would have had an earlier warning about the performance of many of the new products that subsequently lead to such substantial losses. That … could have thus caused some of these products to be withdrawn from the market…
– An unfortunate consequence of continuing to use out- dated versions of the rating model was the failure to capture changes in performance of the new non-prime products. . . This, in turn, generated the unprecedented number of AAA downgrades and subsequent collapse of prices in the RMBS market.
October 22, 2008, Congressional Hearing testimony
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Rating Agency – ConflictsRating Agency – Conflicts
The credit rating agencies, which until late September 2007 were not regulated by statute, notoriously gave AAA ratings to these structured mortgage-backed securities. But that was not all: the ratings agencies sometimes helped to design these securities so they could qualify for higher ratings.
SEC Chairman Christopher Cox - Congressional Testimony, October 22, 2008.
22
Rating Agency – Conflicts Rating Agency – Conflicts
Provided models to the arrangers:– Ratings-agency officials concede that they work
with Wall Street banks, even if they don’t exactly shout it from the rooftops. “You start with a rating and build a deal around a rating,” explains Brian Clarkson, Moody’s co-COO.
Portfolio, Overrated, September 2007. Providing the models to the banks allowed them to
“game” the ratings process– Huge financial incentive to keep the game going– Record Revenue
23
Rating Agencies – Record RevenueRating Agencies – Record Revenue
24
Rating “Shopping”Rating “Shopping”
Issuers would play rating agencies against each other and only use the ones that would provide the highest rating
In an April 2007 instant message chat between two S&P analysts, they acknowledged that the rating process was more about business generation for their employer than it was about getting a quality rating:
Rahul Dilip Shah: btw -- that deal is ridiculous.Shannon Mooney: I know right ... model def does not capture
half of the riskShah: we should not be rating it.Mooney: it could be structured by cows and we would rate it.
25
Exemption from the Securities ActExemption from the Securities Act
Issuers and underwriters of securities can be held liable for untrue or false statements and omissions in prospectuses.
SEC regulations provide that “the security rating assigned to a class of debt securities by a[n NRSRO] . . . shall not be considered a part of the registration statement prepared or certified by a person within the meaning of sections 7 and 11 of the Act.” – SEC Rule 436(g), 17 C.F.R. § 230.436(g)(1)– Exempts NRSRO’s from liability for ratings– Bill to revoke the exemption
Did this embolden them? Pursue alternate theories of liability
26
It’s Still Happening!It’s Still Happening!
Rating Agencies still issuing inflated ratings
– Eric Kolchinsky: Moody’s continues to issue artificially high ratings
Life Insurance Securitizations
– SEC investigating practices
27
ConclusionsConclusions
When gatekeepers fail, investors need to be in a position where policies and practices are independent and transparent– With rating agencies this was a huge
problem– Funds were required/encouraged to
purchase “investment grade” securities– Created an imprimatur of quality/safety
28
ConclusionsConclusions
Get independent expert advice
Demand transparency
Responsible parties need to be held accountable
– Lawsuits
– Political Action
29
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