32651377 financial crisis inquiry commission report on credit ratings(1)

8/6/2019 32651377 Financial Crisis Inquiry Commission Report on Credit Ratings(1)

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DRAFT: COMMENTS INVITED

Financial Crisis Inquiry Commission

Preliminary Staff ReportCREDIT RATINGS AND THE FINANCIAL CRISIS June 2, 2010

ThispreliminarystaffreportissubmittedtotheFinancialCrisisInquiryCommission(FCInformation,review,andcomment.Commentscanbesubmittedthrough theFCICswebsite,wwct. ThisdocumenthasnotbeenapprovedbytheCommission. ThereportprovidesbackotheCommissiononsubjectmatters thatarethefocusoftheFCICspublichearingonJuortprovidesinformationoncreditratings.Staffwillprovideinvestigative findingsasnformationonthesesubjectmatterstotheCommissionover thecourseoftheFCICstenurly14,2010


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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYble of Contents I. Introduction ............................................................................................................................... 3II. Background on Credit Ratings .................................................................................................. 4 A. A Brief History of the Credit Rating Industry .................................................................... 4 B. The Meaning of Credit Ratings.......................................

.................................................... 4 C. The Use of Ratings in Regulation ....................................................................................... 5 1. Determining Capital Requirements............................................................................... 5 2. Restrictions on Asset Allocation ................................................................................... 6 3. Statutory References to Credit Ratings ......................................................................... 7 D. The Use of Ratings by Firms,Investors, and Other Private Entities .................................. 8 E. TheRegulation of Rating Agencies .................................................................................... 9 III. The Rating of RMBS and CDOs ............................................................................................10 A. The Structure of Structured Products ......................................

.......................................... 10 B. How Pooling and Tranching Can Create AAA Securities ................................................ 13 C. Rating Methodology ......................................................................................................... 14 1. RMBS ......................................................................................................................... 14 2. CDOs........................................................................................................................... 19 3. Monitoring RMBSand CDOs .................................................................................... 20 D. Market Share of Major Rating Agencies in RMBS and CDOs ........................................ 20 E. Volume of Rated RMBS and CDOs ................................................................................. 22 IV.CreditRatings during the Financial Crisis .............................................................................. 24 A. Rise in Mortgage Defaults ..............

................................................................................

.. 24 B. Downgrades and Impairments of RMBS and CDOs .............................

........................... 26 C. Downgrades of Other Financial Institutions .....

................................................................ 39

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYferences ..................................................................................................................................... 42 Appendix 1: Moodys Ratings Idealized Expected Loss Rates ................................................... 43 Appendix 2: Sensitivity of Moodys RMBS Model to Pool Characteristics ................................ 44 Appendix 3: Moodys Model for Rating ABS CDOs................................................................... 45 Appendix

4: Downgrades and Impairments of ABS CDOs ......................................................... 47

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARY

I.

Introduction

Thepurposeofthispreliminarystaffreportistopresentbackgroundontherolethat c

yhaveplayedinthefinancialcrisis.MostsubprimeandAlt Amortgageswereheldinrerities(RMBS),mostofwhich wereratedinvestmentgradebyoneormoreRA.Furthermore,gations(CDOs),manyofwhichheldRMBS,werealsoratedbytheRAs.Between2000 and20Sand$736billioninCDOs.Thesharprisein mortgagedefaultsthatbeganin2006ultimMBSand CDOs,manyofwhichsufferedprincipalimpairments.Lossestoinvestorsandwritiesplayedakeyroleintheresultingfinancialcrisis. InflatedinitialratingsonmortsbytheRAsmayhavecontributedto thefinancialcrisisthroughanumberofchannels.nabled theissuanceofmoresubprimemortgagesandmortgagerelatedsecuritiesbyincreasndforRMBSandCDOs.IffewerofthesesecuritieshadbeenratedAAA, theremayhavebeefinancialsectorand consequentlyasmalleramountoriginated.Second,becauseregulatrementsarebasedinpartontheratingsoffinancialinstitutionsassets,theseinflatedterriskadjustedleverageinthefinancialsystem.Hadthe ratingsofmortgagerelated

ed,financialinstitutionswouldhave hadtoholdmorecapitalagainstthem.Onarelategerelated securitiesinfluencedwhichinstitutionsheldthem.Forexample,hadlesssubAA,pensionfundsanddepositoryinstitutionsmayhaveheldlessofthem. Finally,therDOsbeginninginJuly2007mayhave resultedinashocktofinancialinstitutionsthatleoblems. Inaddition,downgradesofmonolinebondinsurerssuchasAmbacandMBIAandothetectionsuchasAIGtriggeredcollateralcallsbuiltintoinsuranceand derivativecontragliquiditypressuresatthesealreadytroubledfirms.This ledtoratingsdowngradesofsinsured,promptingincreased capitalrequirementsatthefirmswhichheldthesesecuritmarketmutualfundsonlypermittedtoholdhighlyratedassetssalesofassetsintoanonIIofthereportprovidesgeneralbackgroundonthecreditratingindustry.Section Iererated.SectionIVdescribesthecollapseofcredit ratingsonRMBSandCDOsduringt

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II.

BackgroundonCreditRatingsA. ABriefHistoryoftheCreditRatingIndustry

Creditratingagencies(RAs)haveexistedforwelloveracentury,andthemarkethasbeenrssinceitsinception.Thefirstsecuritiesratingswere issuedin1909,whenJohnMoodrU.S.railroadbonds.He extendedhisratingstoutilitiesandindustrialbondsthefoltrantsfollowed,withPoorsPublishingCompanyissuingitsfirstratingsin1916, Standaysixyearslaterin1922,andFitchPublishingCompanysoon afterin1924.In1962,Dun0yearslater,in2000,it spunMoodysoffasanindependentpubliccorporation.StandanwasacquiredbyMcGrawHillin1966.Fitchmergedwithanumberof smallerratingsagegerwithIBCA,FitchRatings becameownedbyFimalacS.A.),Duff&Phelpsin2000,andThy2000,thethreemajorRAsremainingwereMoodys,Standard&Poors(S&P),and Fitch.reoftheindustrywastheevolutioninthe1970sfroma subscriberpaysmodel,inwhichraccesstotheiranalysis andratings,toanissuerpaysmodel,inwhichthebondissuerirbonds.

B.

TheMeaningofCreditRatings

Creditratingsprovideameasureofthecreditworthinessofdebtsecuritiestoinvestors.sanumberoffactorstodetermineratings,includingfirmand securityspecificfactorstoryandlegalfactors,andmacroeconomic trends.Theirratingsintendtoprovideameanskacrossasset classesandtime. Theratingsfromdifferentagenciesmeasureslightlydharacteristics. S&PandFitch,forexample,basetheirratingsontheprobabilityofdeft,basesitsratingsonexpectedloss,whichisequaltotheproductof(1)the probabilionoftheinvestmentthatinvestorsonaverage loseintheeventofdefault.However,iniewtheratingsof themajorRAsasroughlyequivalent.Table1showstheratingscaleso

ualitycategory.Theratingsaredividedintotwocategories:bondsrated BBBandabovade;bondsratedbelowBBBarespeculative

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYade(sometimesalsocalledjunk).WhenratingastructuredproductlikeanRMBSor CDO,tyofdefaultorexpectedlossofthebondandcompare ittobenchmarksforeachoftheirenchmarksfor MoodysratingsareinAppendix1.Theexpectedlossoverfiveyearsona016%,whichfora$1millionbondamountsto$16.Fora bondratedBaa1itislessthan6,050. Table1:MeaningofCreditRatings CreditQuality Highestcreditquality Highcreditquality Strongpaymentcapacity Adequate

ntcapacity Possibilityofcreditrisk Significantcreditrisk Highcreditrisk Defaultisnent Indefault CreditRatingAgency Moodys S&P Investmentgrade Aaa AAA Aa1toAa3 AA+tA+toA Baa1toBaa3 BBB+toBBB Speculativegrade Ba1toBa3 BB+toBB B1toB3 B+toSD,D Fitch AAA AA A BBB BB B CCC CC,C D

C.

TheUseofRatingsinRegulation

TheRAsratingsofbondsandentitieshavebeenusedinfinancialregulationsince1931,

leroftheCurrency(OCC)requiredthatbankholdingsof publiclytradedbondshavearatlowedtobecarriedat bookvalue.PubliclytradedbondswithratingsbelowBBBwouldhavesheetatadiscount.Thetwoprimaryusesofcreditratingsinfinancial regulationaruirementsoffinancialinstitutionsand(2) restrictingfinancialinstitutionsassetalleterminingCapitalRequirements

CreditratingshavebeenusedasadeterminantofcapitalrequirementsintheUnitedStateonalAssociationofInsuranceCommissionersbeganimposing highercapitalrequirementsondsheldbyinsurers.However,the watershedeventintheuseofindependentcreditratinurredin

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARY75,whentheSecuritiesandExchangeCommission(SEC)modifieditsminimumcapital requiralerstotakeintoaccounttheriskinessoftheirportfoliosand baseditsassessmentofaringthatbrokerdealerdemandfor highbondratingswouldleadtoinflatedcreditratinedanew designation,thenationallyrecognizedstatisticalratingorganization(NRSRO)edthebondratingsofRAsdesignatedasNRSROs.TheSECinitiallyrecognized Moodys,Sionalfirmshavebeenrecognizedovertime. Creditratingshavemorerecentlyplayedaro

aldeterminationsof U.S.bankandthriftregulatorsaswell.Regulatorspermitbanksannelementintheirinternalassessmentsofthecreditqualityoftheassetstheyhold. Fftheregulatorycapitalcalculationsforcertainclasses ofassets.In2001,U.S.bankedanewcapitalrulegoverningasset securitizationondepositoryinstitutions.Amongoewrulesetrisk weightsforRMBSandotherassetbackedsecuritiesbasedontheratingoatedAAAorAAwerebelowweightsforlowerratedbonds.Institutions wererequiredtohiskweights.Forexample,relativetothe requiredcapitalforAAAorAAsecurities,BBBmesgreatercapital andBBsecuritiesrequiredtentimesgreatercapital. Internationaveevengreaterforceindeterminingcapitaladequacy. TheBaselIIstandards,aninternardizecapitalrequirementsthat followedthe1988BaselIstandards,allowbankstorelyngsto determinetheriskweightsforthecapitalrequirementsassociatedwithvariousexnUnionsCapitalRequirementsDirective,adoptedin2006,introducedthe riskweighted

aselIItofinancialinstitutionswithintheEU.For U.S.firms,BaselIIhadnotbeeniisisbegan. 2. RestrictionsonAssetAllocation

AnumberofU.S.regulationsusecreditratingstodeterminethepermissibilityofcertaints.Forexample,theSECmakestheuseofratedsecuritiesattractiveby restrictingmonitiesthathavereceivedcreditratingsfrom anytwoNRSROsinoneofthetwohighestsrable unratedsecurities.Similarly,in1989thefederalgovernmentrelaxedaDepartmentingpensionfundsfrominvestinginassetbackedsecuritiesincluding RMBStoallowrhigher.Additionally,bank regulatorsrestrictpermissibleinvestmentsecuritiesbynangcreditrating cutoffs.Forexample,underOCCregulationsoninvestmentsecurities,

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYyandsellforitsownaccountinvestmentcompanysharesthatmeetotherrequirements protedinvestmentgradeorthecreditequivalentofinvestment grade. 3. StatutoryReferens

Whilemuchoftheuseofcreditratingsinfinancialregulationhasoccurredviaregulatorcies,Congresshasexplicitlyprescribedtheuseofratingsinsome statutes.Primarily,

nusedinordertodefinetermsinlegislation. Forexample,P.L.98440,SecondaryMorthichpermitted federallycharteredfinancialinstitutionstoinvestinmortgagerelatedded inthedefinitionofmortgagerelatedsecuritiesarequirementthatthesecuritybetegoriesbyanNRSRO.Similarratingsdependentdefinitionshave beenusedinlegislatiovestmentsbyfederallycharteredfinancial institutionsinsmallbusinessrelatedsecuriusingAdministration eligibilitytoenterintopartnershipsorothercontractualarrangeg reinsuranceandrisksharingagreementswithaqualifiedhousingfinanceagency,2annofcertaincompaniesfromprovisionsoftheInvestment CompanyActof1940.3Further,eyActof1999,inaddition tootherreferencestoratingsagencies,gaveauthorizationtcertainactivitiesthatarefinancialinnaturetoqualifyingbankswhich,amongother rvefewerthan1issueofoutstandingeligibledebtthatiscurrently ratedwithinthe3gcategoriesbyanationallyrecognized statisticalratingorganization. Incertaincas

sincorporatedcreditratingsinotherways.Forexample,the FederalDepositInsuranceAL.10173,FinancialInstitutions Reform,Recovery,andEnforcementAct,todisallowsavmacquiring orretaininganycorporatedebtsecuritynotofinvestmentgrade,anddefinesnoneofthe4highestratingcategoriesbyatleastonenationally recognizedstatisticaL.109171,FederalDepositInsuranceReformRated in 1 of the 4 highest rating categories by at least 1 nationally recognizedstatistical rating organization; P.L. 103-325: Riegle Community Development andRegulatory Improvement Act of 1994. 2 carries the designation of `top tier

or its equivalent, as evaluated by Standard & Poors or any other nationally recognizedrating agency; receives a rating of `A

for its general obligation bonds from anationally recognized rating agency; or otherwise demonstrates its capacity asa sound and experienced agency based on, but not limited to, its experience in financing multifamily housing, fund balances, administrative capabilities, invest

ment policy, internal controls and financial management, portfolio quality, andState or local support; P.L. 102-550: Housing and Community Development Act of 1992. 3 any debt security that is rated investment grade by not less than 1 nationally recognized statistical rating organization; 15 USC 80a-6(a)(5)(A)(iv)(I))1

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYtof2005,mandatedthattheFDICuseratingsasonesourceofinformationforestimatingeSarbanesOxleyActof2002,theSecuritiesand ExchangeCommissionwasrequiredtocondtratingagencies intheoperationofthesecuritiesmarkets.Thestudyidentifiedanumination,includingdisclosureofratingsprocesses,potentialconflictsofinterest, antiractices,regulatorybarrierstoentry,andtheneedforadditionalSEC oversight.

D.

TheUseofRatingsbyFirms,Investors,andOtherPrivateEntities

Ratingagenciesinfluenceeconomicactivitythroughmarketchannelsaswell.Most prominecontractsrelyuponcreditratingstoprotectcreditors.Ratings triggers,forinstancorpostcollateral,orgivecreditorstheright todemandimmediaterepaymentofdebtsinde.4InJanuary 2008suchtriggersmademonolinebondinsurerMBIAliablefor$2.9billisand$4.5billionincollateralandleftmanyofthesecuritiesithadinsured vulnerablytheAssociationforFinancialProfessionals revealedthat87percentofrespondingorgaremostlylargecorporations, withoutstandingdebthadbeenrequiredtomaintainaspecitoneof thefourNRSROsinexistenceatthetime.6 Ratingsalsofigureintothedecis

xtendcreditor purchasesecurities.Manyinstitutionalinvestors,suchaspensionfundswments,donothavetheresourcestoevaluateallofthesecuritiestheypurchase, whichveoftheagencieswork.Inaddition,theseinvestors donothaveaccesstothesameinsdo.Consequently, theyusecreditratingsasasubstituteforthemoregranularinformehavetogather.AsformerMoodysManagingDirectorJeromeFonshas acknowledged,subfferlittletransparencyaroundthe compositionandcharacteristicsoftheloancollateraighest levelofdetail,isgenerallynotavailabletoinvestors.Methodsofcreditanal

4SecuritiesandExchangeCommission,ReportontheRoleandFunctionofCreditRatingAgeSecuritiesMarkets(Jan.2003),29. 5MBIACommentsontheImpactoftheMoodysDowengthRatingto A2onitsAsset/LiabilityManagementBusiness,pressrelease(June20,2inancialProfessionals,2004CreditRatingAgencySurvey:ReportofSurveyResults(Oct

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYuitetechnical,oftenrelyingonadvancedstatisticaltechniquesandtherefore beyondtrs.7 However,notallinvestorsandcreditdefaultswapprotectionwritersreliedexclusG,forexample,usedinternalmodelstocalculatetheexposureitwould agreetoassumeoultswapsitwrote.8However,provisionsin theunderlyingcontractsdidstipulatethatldtriggercollateral calls,whichwereaproximatecauseofthefirmsproblemsthatledon.

E.

TheRegulationofRatingAgencies

TheprimaryregulationofRAsoccursviarecognitionasanNRSRObytheSEC.In1975, whingstodeterminethecapitaladequacyofbroker dealers,itrecognizedS&P,Moodys,andognizedfour additionalNRSROsbetween1982and1991(Duff&Phelps,McCarthy,Crisanti&sonBankWatch).TheprocedureforapprovinganewNRSROwasnot explicitlydefinedinstementwasthattheagencybenationally recognizedbythepredominantusersofratingsifcredible andreliableratings.FollowingtherequestofanRAtobecomeanNRSRO,therdstointernalprocesses,financialresources,and organizationalstructure.IfanRAw

uedanoactionletterstating thatitwillnotrecommendenforcementactiontotheCogencyareconsideredbyregisteredbrokerdealerstoberatingsfromanNRSROfor purposeortionsofthenetcapitalrule.9 Followingtheexpansionoftheuseofcreditratingsiewof thepotentialneedforgreaterregulatoryoversightbeginninginaConceptReleaseicitedpubliccommentontheCommissionsuseofNRSROratings. FollowingoveradecaderesspassedCreditRatingAgency ReformActof2006,P.L.109291,whichdefinedanNRSROrectionregardingtherecognitionprocessofNRSROsbytheSEC.Introducingthefirst ovRSROs,thenewapplicationprocessrequired,amongother things,ananalysisofthehistoreditratingsbytheapplicant,rating7QuotedinOhioPolice&FirePensionFundetal.v.Standard&Poorsetal.(USDistricernationalGroupInvestorMeeting,ThomsonStreetEventstranscript(Dec.5,2007),11. 9

Ohio,2009),caseno.2:09cv1054.

U.S. Securities and Exchange Commission (2003) Report on the Role and Function ofCredit Rating Agencies in the Operation of the Securities Markets: as requiredby Section 702(b) on the Sarbanes-Oxley Act of 2002.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYoceduresandmethodologies,policiesregardingpotentialmisuseofmaterial, organizationre,potentialconflictsofinterest,andalistofthetwentylargest issuersandsubscrievenueintheyearprecedingtheapplication date.ThelawtookeffectinJune2007,andiedthroughthe applicationprocess.However,thelawfocusedonmandatorydisclosureofdsandexpresslyprohibitedtheSECfromregulatingthesubstanceofthecredit ratingsologiesbywhichanyNRSROdeterminescredit ratings.10 Overtheyears,ratingsagencie

efensesagainstbeingheldliablefor erroneousratingsthroughprivatelitigation.Most36(g)(1)ofthe SecuritiesActof1933explicitlyexemptsthemfromliabilityformisstattionwithsecuritiesregistrationstatements.MoodysandS&Phavealsosucceeded inusiieldagainstliabilityandinquashingsubpoenaswith theargumentthattheyareprovidincesprotectedbytheFirst Amendmentorreportersprivilege.11Moreover,courtcaseshaclaimersthattheirratingsaremerelyopinions,withonejudgegoingsofarastoruleemwasnotreasonabledespitethefactthat regulatorsrelieduponthesesameratings.1

III.

TheRatingofRMBSandCDOsA. TheStructureofStructuredProducts

RMBSandCDOsaretypesofstructuredproducts.Generally,structuredproductsinvolve toaspecialpurposevehicle(SPV)andthetranchingofthebonds issuedbytheSPVintocularpaymentrights.Thecashflows oftheSPVsassetsareusedtomakethepromisedpalgoalofthetranchedcapitalstructureoftheSPVistocreatesomebondsthatare deeentgraderatingsfromtheratingagencies.One keytoolusedtoachievethisissubordiesissuedbytheSPV areorderedaccordingtotheirpriorityinreceivingdistributionsfetuptooperatelikeawaterfall,withtheholdersofthemoreseniortranches beingpaidinate)tranches.Themostseniorsetof10

15 U.S.C.78-o7(c)(2),

11See,forexample,InrePanAmCorp.,161BR577(SDNY,1993). 12Quinnv.McGrawHilldCDOsarediscussedinmoredetailintheFCICsApril7,2010,PreliminaryStaffReport,

SecuritizationandtheFinancialCrisis.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYanchesreferredtosimplyasseniorsecuritiesrepresentthelowestriskand consequentlystrate.Theyaresetuptobepaidpriortoanyofthe classesbelowandaretypicallykeupthemajority ofbondsissuedbytheSPV.Thenextmostseniortranchesarethemezrriskandpayacorrespondinglyhigherinterestrate.Themostjunior trancheinthestsidualtrancheandreceiveswhatevercash flowisleftoverafterallothertrancheshavehicharetypically notrated,sufferthefirstlossesonanydefaultsofassetsintheco

esanotionalbalancesheetforatypicalRMBS.Theentityholdsapoolof residentialmnterestpayments.InthecaseofanRMBS, theassetsareresidentialmortgages.

Figure1:BalanceSheetofanRMBSAssetsfirst Principal and interest payments next claim

Liabilities AAAseniorbonds:80% AandAAbonds:15% MezzanineBBBbonds:3% BBBonds

Mortgages

next claim

last

ACDOcanholdapoolofcollateralthatincludesmanytypesofassets.CDOsthatcontaincuritiesarecalledABSCDOs.ABSCDOsthatlargely containthemezzaninetranchesofRMeCDOs;those containinghigherratedRMBSarecalledhighgradeCDOs. Figure2providpicalmezzanineABSCDO.Inthis example,theAAAseniorbondsmakeup76percentoftheheSPV,AAAbondsaccountfor14percent,mezzanineBBBbondsmakeup6percent, andt.

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B.

HowPoolingandTranchingCanCreateAAASecurities

Thegoalofthepoolingofassetsandtranchingandsubordinationofliabilitiesinstruct

formrelativelyriskycollateralassets(e.g.,mortgagesorBBBrated mezzanineRMBStransthatincludesverylowriskbonds.Acrucial assumptionforthistobepossibleisthactly correlatedsothattherearebenefitstodiversification. Toseethis,considertheple.15SupposeaCDOholdstwoidentical$1 bondsasassets.Ifabonddoesnotdefaulthing. Supposeeachbonddefaultswithprobabilityequaltoonehalf(0.5).Furthermore,hajuniorandseniortrancheofbonds,eachofwhichpay$1.Thesenior tranchegetsthatitonlydefaultsifbothofthe bondsheldascollateraldefault.Incontrast,thejusand defaultsifeitherofthecollateralbondsdefaults. Toseetheimportanceofcorrecaseinwhichthetwobondsheldas collateralareperfectlycorrelated.Thismeansthltor bothpayoutitisnotpossibleforonetodefaultandtheothernottodefault.Ohasnomoneytopayeitherofitsbonds,andwith probabilityonehalftheCDOcanpayfect correlationinitsassetsdefaults,then,theCDOhasnottransformeditscollatera

kbonds.Boththebondsheldascollateralandthebondsissuedbythe CDOallhaveapronsidernowthealternativeextremeassumptioninwhichthebondsheldascollateralaresthatwhetheronebonddefaultsdoesnotprovideany informationaboutwhethertheothersumption,therearethree possibleamountsofcashpaidoutbytheCDOscollateral:$0,illonlydefaultiftheCDOreceives$0,whichoccurswhenbothbondsdefault. Becausetdsdefaultwithprobability0.5x0.5=0.25.The CDOreceives$1ifjustoneofthebonity0.5.Inthis scenariotheseniortrancheispaidbutthejuniortranchedefaults.Fherofthebondsdefault,whichoccurswithprobability0.25.Thisisthe onlyscenarioaid,sothejuniortranchedefaultswith probability0.75.

15ThisexampledrawsonCoval,etal(2009).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYesetwocasesrepresenttheextremesofperfectcorrelationandzerocorrelation.More reralassetsaretypicallyimperfectlycorrelated.Thismeansthatknowing thatoneofthrelikely(butnotcertain)thattheotherbond willdefault.Commonfactorsthatinfluereonesourceof correlation.Forexample,whenhousingpricesgodown,itcanaffectthuchimperfectcorrelation,poolingandtranchingcanproduceaseniortrancheof securitihantheCDOsunderlyingassets,asinthecaseofzero correlationconsideredabove.Th

setsdefaults,however, thelessthepoolingandtranchingcanreducethedefaultriskoche.Intuitively,theseniorCDObondwilldefaultonlyiftheCDOscollateralpool exversified(i.e.,lowcorrelation)collateralportfoliois unlikelytosustainsuchlargencentrated(i.e.,highcorrelation) collateralportfoliohasahigherprobabilityofrealossesbecauseifone assetdefaults,manyotherassetsarealsomorelikelytodefault.

C.

RatingMethodology

WedescribenowthemethodologyusedtorateRMBSandCDOsaccordingtotherating agencientation.Thesefinancialinstrumentsarecomplex,and theratingagenciesmethodologie

lowsistheFCICstaffsattemptto distilltheessenceofthesemethodologies,whichasstatistics andomitsmanydetails. 1. RMBS

TheRAsmethodologyforratinganRMBSbeginswithanassessmentoftheriskinessoftheheRMBS.HerewedescribeMoodysapproachtorating subprimeRMBSfromroughly1996throodyspublic documentation.16 TheanalysiswouldbeginwithanevaluationofthecrediRMBSscollateralpool.Moodysusedasetofquantitativerelationshipsthatrelate morefaultprobabilityanddefaultseverity(i.e.,thelossonthe mortgagegiventhatitdefected(i.e.,mean)poollossestimate, whichisthetotallossexpectedtooccuroverthenofthe originaltotalprincipalbalanceofthepool.AkeyadjustmentthatMoodysmad16

Moodys (1996) lays out the basic analytic framework.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYpectedpoollossestimatewasbasedontheoriginatoroftheloans.Lossestimatesfor patorsthatMoodysdeemedtobelowerriskwere adjusteddownward.Fororiginatorsdeemereadjusted upward. Becausethepoollossisuncertain,Moodysalsoassumedsomevaridasastandarddeviationandadjustedthatstandarddeviationbasedonthe numberofloaicdiversification,andotherfactors.Thepool lossdistributionwasthenmodeledasaanexampleofwhichis shownbelowinFigure3)withthisestimatedmeanandstandarddev

salistoftheprincipalpoolcharacteristicsthatMoodysconsidered inestimatingthesthesensitivityofmeanpoollossto changesinvariouspoolcharacteristicsusingMoodasing averageLTVinthehypotheticalpoolAby10pointsincreasesmeanpoollossfrom0sesmeanpoollossfrom2.96%to4.76%. Table2:PrincipalFactorsConsideredbyMoodyor Loantovalueratio(LTV) Combinedloantovalueratio (CLTV) Creditscore Debttotorquality Effect HigherLTVincreasesdefaultprobabilityanddefault severity. Highsdefaultprobabilityanddefault severity. Highercreditscorelowersdefaultprobabilicreasesdefaultprobability. Expectedlossestimatesaremultipliedbyanoriginator fatyoriginatorsgettingafactorless thanone,andlowqualityoriginatorsgettingafactnsthatwereoriginatedalongertimepriortothe RMBSbeingissuedaregenerallyconsidityofdefaultanddefaultseverityduetothe accumulationofequity.Moodysfactorsinonseasonedloansaswell,whichcan increasetheirdefaultprobabilityanddefaultsev

Loanseasoning

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYmetoforeclose Localhousingmarket projections Propertytype Housevaluerelativeto.FRM Balloonmortgages Interestonlyandnegatively amortizingloans Loanpurpose Owtgageinsurance Coupon Poolsize Geographicdiversification Mortgageservicer Moodyssvariationacrossstatesinthetimeto foreclose,whichaffectsdefaultseverity. Moodrketsprospectsare representedbyafactorthatraisesorlowersaloans defaultprob. Attachedhousingandmultifamilypropertiesareassigned ahigherdefaultseverity. T

elativeprice,thehigherthe assigneddefaultseverityanddefaultprobability. ThedeffARMsisadjustedupward. Defaultprobabilityisadjustedupward. DefaultprobabilityiHomepurchasesandrefinanceloansareassignedlower defaultprobabilitythanhomeequitobabilityisadjusteddownward. Presenceofmortgageinsurancereducesdefaultseverity.strateloanshavehigherexpectedloss. Largerpoolshavelowerstandarddeviation. Poophicdiversificationhavelower standarddeviation. Moodysratesservicerqualityincosand effectivenessinmodifyingdelinquentloansandadjusts thecreditenhancementsnegslevel. Moodysadjustsupwardthecreditenhancementrequired forloansthatcontainionofthe borrowersincomeorassets. Secondliensareassumedtohavehigherexpected

Documentationstatus

Lientype

Sources:Moodys(1996),Moodys(2001),Moodys(2004a),Moodys(2004b).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYlativelyminorlossesintheoverallpool.Hence,thecreditsupportlevel,orCS,forthftofthecreditsupportlevelofthemoreseniortranche. Ifthepoolofmortgagessusreareunsupportedlosses equaltothedifferencebetweenthetotallossestotheoveralllevelforthetranche.Forexample,ifapoolexperiencesalossof$3millionduetodefarticulartrancheis$1million,theunsupportedlossfor thistrancheis$2million.Moabilityofeachpossiblescenario oflossestoestimatetheexpectedlosstothetranche.

heis equaltothesumacrossalllossoutcomesgreaterthanCSoftheproductoftheunstythatthelossoutcomeoccurs. Finally,Moodysassignsaratingtoeachtranche.Itct ontheyieldofthebondfromtheseexpectedlosses.Inasense,theexpectedloss curity.Moodyscomparesthisdiscounttoa standardizedscheduleofratingsanddiscounanches. In2003,MoodysadoptedanewmodelforratingprimejumboandAltAmortgagepocs(M3),whichincorporatedlossesassociatedwith macroeconomicfactors.Inpublicdocuescribedtheadoptionofthe model.Whilethepublicdocumentsarenotcompletelyclearatpreciselychangedovertime,in2003MoodysstatedthatithasrefineditsRMBS modydiverseJumboAandAltApoolsfromestablished originatorsandratedservicerstothehedeterminationof thesecreditsupportlevelstothemodel.18ItwasnotadoptedattasbasedonadatasetfromLoanPerformance,Inc.,containingover 500,000mortgages.Thformanceofeachloaninthepool through1,250differenteconomicscenarios.Theseecon

ated usingMoodysprojectionsofinterestrates,statelevelunemploymentscenarios,andceappreciationscenarios.Inthesimulation,homepricesbroadlytrend upwardatapproxrage.19Moodysusestheresulting distributionofpoollossestoestimatetheexpectednits rating. AsimilarmodelwasthendevelopedforusewithsubprimepoolscalledM3Soodysratingsprocessinlate2006.

18Moodys(2003). 19Moodys(2003p.10).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYdditiontothequantitativeanalysisdescribedabove,Moodyslegalanalystsconsidered wylegalissuesthatwouldaffectthebondspayments.20 Whentheinitialquantitativeandscomplete,theleadanalystonthe dealconvenedaratingcommitteecomposedofotheranmine theratingsfortheRMBSsbonds.Theleadanalystpresentedanoverviewofthe trveandqualitativeanalysesofthetransaction,andafter deliberationandpotentialadjutteevotedonMoodysratingsforthe bonds. 2. CDOs

TheRAsrateABSCDOsusinginformationabouttheratingandtypeofeachbondheldin thobabilitydistributionoflossestothecollateral.Here wedescribeMoodysapproach.stimatethecollateralpool lossdistributionarethedefaultcorrelationamongthecollallateral bondsdefaultratesandrecoveryrates.Thedefaultcorrelationisthedegreeecollateralbondsimpliesahigherprobabilityofdefaultoftheother bondsthattheCDmportanceisdescribedinsectionIII.B. above.Theratingagenciesuseamixofassumptterminethe defaultcorrelationbetweendifferenttypesofassets.Defaultratesandrecedontheratingsofthecollateralbonds. OnceMoodyshasestimatedacollaterallossdtestheexpected lossestoeachoftheCDOstranches. Thefinalstepinthequantitatdlossforeachtranche toasetofbenchmarksinordertodeterminethemodeledratingosthefiveyearidealizedexpectedlosspercentagesforeachofMoodysratings. Themod

ehighestratingforwhichitsexpectedlossover theappropriatetimehorizonislessthssforthatrating. Inadditiontothisquantitativeanalysis,Moodyslegalanalystsconysis,examiningtheCDOslegaldocumentationandadjustingratingsforanyrisks associaDO.Intheend,thepublishedratingassignedtothebond issetbyaratingscommitteeiveandqualitative analysisoftheCDOsbonds.Asaresult,thepublishedratingcand20Moodys(2001).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYMonitoringRMBSandCDOs

AfterissuinganinitialratingonanRMBSorCDO,theratingagenciesmonitorthebondstormasexpectedorinsteadshouldbeeitherdowngradedtoa lowerratingorupgradedtoagsonRMBSonamonthlybasis,Moodysusesquantitativescreenstoflag RMBSwhoseperfoerchangingtheirratings.21One importanttoolisthepipelinelosscalculation.This

f mortgagesinthepoolinvariousstagesofdelinquencyordefault(e.g.,current,30dauent,inforeclosure,etc.)andusingassumedrollratesatwhich eachdelinquencytypewoss,anewexpectedlossforthepoolis calculated.Moodysthencalculatesaratioofe updatedexpectedlossandflagstranchesforwhichthisratiosuggeststhatthetrancheopriate.Ananalystisthenassignedtodoanindepthreviewofthe bondsandMoodysmatchlistforpossible downgrade.AratingcommitteeultimatelydecideswhethertodowngrysprocedureformonitoringCDOsisdescribedinMoodys(2002).Moodys regularlyrevetoconformtotheguidelinesthatwere thebasisoftheinitialratings.22Itmonitorgforany deteriorationinthequalityoftheCDOscollateralpool.IfMoodysdetectsl,itwillcontacttheCDOsmanagertoinvestigateanddetermine whetheritisnecessaryerminesthatthereisa chancethattheCDOsratingswillchange,theMoodysratingcomcuritiesonawatchlist.ItwillthenproceedtomodelthecashflowsoftheCDO basedo

heirperformancetodate.Onceithasupdated itsexpectedlossanalysis,theratingcomheraratingactionis appropriatefortheCDOssecurities.

D.

MarketShareofMajorRatingAgenciesinRMBSandCDOs

Moodys,S&P,andFitchdominatethemarketforratingbothRMBSandCDOs.Figure4 beloreratedbyeachofthethreeRAsineach quarterfrom2000to2007.ThemarketsharesareratedbymorethanoneRA.WhilethethreeRAshadsimilarmarketsharesof

21SeeMoodys(2003b). 22Moodys(2002,p.2).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYtween50%and70%in2000,overthenextsevenyearsMoodysandS&Pssharesgrew toove

Figure5showsthesamemarketshareplotforCDOs.From2003to2004Moodysshareinn60%and70%.Bythethirdquarterof 2005,though,Moodysshareincreasedbackover9

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E.

VolumeofRatedRMBSandCDOs

Forsimplicity,wefocushereonthevolumeofratingsbyMoodys,whichasdescribed aboOmarkets.Figures6and7belowdepictthe amountofRMBSandABSCDOs,respectively,nel foreachquarterfrom2000through2007.Bothmarketsgrewdramaticallyoverthe perfRMBS,totaling$4.7trillion,wereratedbyMoodys duringthisperiod.TheCDOmarketsofABSCDOs,totaling $736billion,ratedbyMoodysovertheperiod.23Thebulkofthollaramount)and2,160tranchesofCDOs(84%bydollar amount)wereratedAaa.

There were also unrated tranches of RMBS and CDOs, typically just the equity tranche of each SPV, issued over this period.

23

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYgure6:VolumeofnewRMBSratingsfromMoodys

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYgure7:VolumeofnewABSCDOratingsfromMoodys

IV.

CreditRatingsduringtheFinancialCrisisA. RiseinMortgageDefaults

Mortgagerelatedsecuritiesperformedworsethanexpectedduetoalargefallinhousingeinmortgagedefaultsbeginningin2006.Nominalhousing pricespeakedin2005andin2y.Figure8showsnational nominalhousingpricesoverthisperiodasmeasuredbytheCangof2007,nationalhousingpricesweredownabout2%fromtheirpeak.Bythe beginninghefirstquarterof2009,housing priceshadfallen31%nationally.

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InOctober2006,withthehousingmarketdownturnwellunderway,Moodys Economy.coaryfromtheMoodysunitthatrates structuredproducts,issuedareportauthoredbyChied HousingattheTippingPoint:TheOutlookfortheU.S.ResidentialRealEstateMarkettricmodelofhousingsupplyanddemand,thereport concludedthat: Nearly20ofthenatnceacrashin houseprices:adoubledigitpeaktotroughdeclineinhouse pricesThe

pected alongtheSouthwestcoastofFlorida,inthemetroareasof ArizonaandNevada,i, throughoutthebroadWashington,D.C.area,andinandaround Detroit.Manymoremetrence onlyhousepricecorrectionsinwhichpeaktotroughprice declinesremaininthesesome30 metroareasthatarealreadyexperiencingpricedeclines,the structuraleconotified70othermetro areasthatwillsoonexperienceameasurabledeclineinprices.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYsimportanttonotethatpricedeclinesinvariousmarkets areexpectedtoextendinto20etroareasrepresentingnearlyonehalfofthe nationshousingstockexperiencingoraboclines,nationalhousepricesarealsosettodecline. Indeed,oddsarehighthatnationn 2007;thefirstdeclineinnominalnationalhousepricessince theGreatDepression.24clineinhousingpriceswasasharpincreaseinmortgage delinquencies.Figure9belowsespastdueandinforeclosure overtime.Theriseindelinquencieswasinitiallyconcen

esand includedanabnormallylargenumberofearlypaymentdefaultsinwhichtheborroweeemonthsofhismortgage.

B.

DowngradesandImpairmentsofRMBSandCDOs

Tocharacterizewhathappenedtocreditratingsduringthefinancialcrisis,weagainfordysratings.Theinitialriseinmortgagedefaultswasconcentrated insubprimemortgagdin2005and2006.

24Moodys(2006).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYan.18,2007,MoodysissuedaSpecialReport,EarlyDefaultsRiseinMortgage Securitizgesbackingsecuritiesissuedinlate2005andearly 2006havehadsharplyhigherratesoyissuedsecuritiesat similar,earlypointsintheirlives.25Theseforeclosuresweremortgagepools. OnMarch7,2007,MoodysissuedaSpecialReport,ChallengingTimesforket,whichstatedthat: Itisgenerallytooearlytopredictultimateperformanceforthriginatedin2006andthebonds securedbysuchloans.Anumberoffactorswilldetermin

eappreciationandrefinancing opportunitiesavailableinthenextfewyearsareexpectedpact.Economicfactors,suchasinterest ratesandunemployment,willalsoplayasignifitigationtechniquesemployedbyloanservicers.26 Moodysattributedthepoorperformanceansprimarilytotherecent slowdowninhomepriceappreciationandtheintroductionorthepastseveralyearsNevertheless,Moodysassertedthatwebelievethat performannificantlyforthevastmajorityofbondsratedA orhighertobeatriskofloss.Onavfloss, performancewouldhavetocontinuetodeclinematerially.Moodysconcludedthahetherultimatelosseswillmateriallyexceedouroriginalloss expectationsfor2006secemortgagepools. OnMarch23,2007,MoodysissuedaSpecialComment,titledTheImpacageBackedSecuritiesonMoodysRatedStructuredFinanceCDOs:A PreliminaryReview,whationsofthesubprimemortgagecrisisfor CDOs.Moodyshadperformedananalysisofthriosof subprimeRMBSportfoliodeteriorationonCDOs.MoodysfoundthatforCDOsthat

tionsofRMBSascollateral,thepotentialdowngradeimpacton theCDO[bonds]wassevample,fora CDOwith100%ofitscollateralinsubprimeRMBS,if10%ofsubprimeRMBScotedwitha20%recoveryandtheremainderwasimmediately25Moodys(2007a).

26Moodys(March7,2007). 27Moodys(March23,2007,p.2).

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYwngradedfournotches,thenMoodysestimatedthatalloftheCDOsbondswouldbe downgrradedtospeculativegrade.28 OnApril20,2007,Moodysissuedareportstatingthat:esforthe2006securitizedloans arecloselytrackingthoseofloansbackingdealsissueossesofapproximately6%after72 monthsearlylossesforthe2006loansaretrending.Whiletheemploymentoutlook todayisstrongerthanthatactuallyexperiencedinthepookforothermajordriversofmortgage losseshomepriceappreciation,interestrates,

nitiesforsubprimeborrowersfacingrate/ paymentrestsislessfavorable.Asaresungthatcumulativelossesforloansbacking 2006subprimesecuritizationswillgenerallyd8%,thoughparticularlystrongorpoorperforming poolsmayfalloutsideofthisrange.swellinexcessofcurrentexpectations,wedonotexpect amaterialnumberofdowngradeirstmassdowngradeofRMBSoccurredonJuly10,2007.InthemorningS&P announcedthatanchesissuedinlate2005through 2006onwatchforpossibledowngrade.Thatafternooning 399tranchesof2006vintagesubprimeRMBSandplacinganadditional32tranchesonde.Thedowngradedsecuritiestotaled$5.3billioninvalueand constituted1.3%of20069Allbutoneofthedowngradedtranches wasoriginallyratedBaaorbelow.Moodysalsn subprimeRMBSissuedin2005. Thenextday,onJuly11,2007,Moodysplaced184tran,withoriginalfacevalueofapproximately$5billion,onwatchforpossible downgrade.

expectationsaboutthefutureperformanceofsubprimeRMBS. 29MoodysJuly12,2007,teltion,p.12.

28Moodys(March23,2007,p.6).MoodysdidnotintendthescenariostorepresentMood

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYgure11:ABSCDOdowngradesbyMoodys

Bythefirstquarterof2008,housingpriceshadfallen15%fromtheirpeak. Figure1imateprincipalimpairmentssufferedbythe 2006vintageofRMBSthatwereratedAaaandcumulativefractionofeachsetofbondsdowngradedateachpointintime;downgrades indctationsaboutthebondsperformance.Thesolidlines depictthecumulativefractionof

feredanyprincipal impairment(i.e.,forwhichpromisedprincipalpaymentsonthebondsnchesofRMBSweredowngradedfirst,withaparticularlylargejumpinOctober 2007.Byncheshadbeendowngraded. Impairmentsofthosetranchesoccurredafterthedowngrades,airmentsoccurringinApril2008andOctober2008.ImpairmentsofBaatranches

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYveledoutbythemiddleof2009,withover80%oftranchesfailingtomakepromised princowngradesofAaatranchesofRMBSdidnotbegininearnestuntilthemiddleof2008and cleof2009,whentheyleveledoffwithabout80%of tranchesdowngraded.Impairmentsofwerlevels,witha numberofbondsdefaultinginthespringof2009,bringingthetotalfustunder10%. Figure12:Moodysdowngradesandimpairmentsof2006vintageRMBS.

Figure13belowdepictsthedowngradesandimpairmentsoftheAaaandBaanotesfromntsofRMBSascollateral.BaaCDOdowngradesbegan afewmonthsafterBaaRMBSdowngradaaRMBSclosely. ImpairmentsofBaaCDOstrackdowngradesveryclosely,suggestingthat

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYingdowngradedataboutthesametimetheywerefailingtomakeprincipalpayments. AaarthantheBaaCDOnotes,butbytheendof2008 morethan90%ofbothAaaandBaaCDOnod80%ofAaaCDObondswereultimatelyimpaired. Appendix4containsfiguresthatfurthpairmentsof ABSCDOsintovarioussubgroups,suchasmezzanineCDOs,highgradeCDOs,anre13:Moodysdowngradesandimpairmentsof2006vintagecashflowandhybridABSCDOs.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYotal,$2.5trillionworthofRMBSand$564billionworthofCDOshavebeendowngraded sinessthetimingofcreditratingagencydowngradesofRMBSrelativeto contemporaneousmareriskofsubprimemortgagesecuritiesisby comparingthedowngradesof2006vintageRMBXindex. TheABXisaseriesofbenchmarkindicesforthepriceofcreditdefaultswapsivecontractthatrequiresthebuyertomakeaseriesof paymentstotheprotectionselleinsttheeventthatthe referencebonddefaults.LaunchedbyMarkitinJanuary2006,eac

SthatareratedbyMoodysandS&Pandissuedinthesixmonthspriortothe launchoftveindividualsubindices,each referencingexposurestothesame20underlyingsubprimemzationsat differentratinglevels:33AAA,AA,A,BBB,BBB.Therefore,eachABXindexreditdefaultswapsonRMBSwithinacertainratinglevelfora6month vintage.AdeclinreaseinCDSrates,whichinturn reflectsanincreaseintheprobabilityassessedbyinvMBSwill default. Figures14and15depictthepriceofeachratingsbasedABXindexdurageand2007H1vintage,respectively.Theindexforeachvintage representstranchesfrongintheprevioushalfyear.For example,theABX062AAAindexreferencestrancheswiatedinthefirsthalfof2006,whereastheABX071BBBindexreferencestranches withanginthelatterhalfof2006. AsearlyasFebruary2007,the2006H2ABXand2007H1ABXiencingnoticeabledrops,signalinganexpectedincreaseintherateofdefault onlowininatedin2006.OnFebruary27,2007,the2007H1 BBBpriceindexwastradingat67.13,d

ingpriceof 100.00.Bycomparison,Figure12showsthattheearliestdateatwhichBaantlydowngradedwasOctober2007,almosteightmonthsafterthe initialdropinthecorre.

These are the total principal amount of securities that were ever downgraded; securities that were downgraded multiple times are only counted once. 32MarkitABXMarketingPresentation,January2006. 33Thereferencesecuritiesaresortedintotheseindicfthetworatingsassignedby MoodysandS&P.Oncecreated,indexcompositionremainsflyingcredit qualitycanmigratetoratingslowerthanindicatedbytheindexname.

31

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYFigure14:ABXHomeEquityindexpricesbyratingforthe2006H2vintage.

Similarly,theAAAABXindicesexperiencedtheirfirstsignificantdeclinesinearlyAugf2007,withthe2007H1vintagedecliningmoreprecipitouslythanthe 2006H2vintage.In

aatranchesofRMBSwerevirtually nonexistentuntilthemiddleof2008.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYFigure15:ABXHomeEquityindexpricesbyratingforthe2007H1vintage.

In2007through2008,thefrequencyofdowngradesofRMBSandCDOsreachedrecord level9)comparedthemassdowngradesofRMBSandCDOs duringthistimetothehistoricalrate

onds.Between1983 and1996,thenumberofratedcorporatebondsthatexperienceddowngrysimilarproportions.Moreover,theaveragechangeincreditratingsofoutstanding bonsanddowngradesremainedessentiallystable;from1983to 1996,theaveragedowngradenesinanygivenyear.These modesttransitionsinthecreditratingsofcorporatebonds,omicevents,contrastwiththerapidityandmagnitudewithwhichRMBSand CDOtrancheswe08.Evenwhencorporatebonds underwentsignificantdowngradingduringthebankruptcywa00 2002,wherethenumberofoutstandingbondsdowngradedatleastonceincreasedfrom 1eincreditratingwhentherewasanupgradeordowngrade

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYsonly1.8notches.Incontrast,theaveragedowngradeofstructuredfinancesecuritiesd5.6notches,respectively. Throughout2006andthefirsthalfof2007,MoodyscontinOsandRMBSdespitemarketeventssuggestingacontinuedriseindelinquencyand foreclosradesofCDOsandRMBS.Itwasnotuntilthesummerof 2007,aroundthetimeofthefirsatthe amountofnewissuancesbegantodecline.MoodysgaveAaaratingstobillionsofrthosemassdowngrades.Outofatotalof$119billionin RMBSratedsincethedowngrad

milarly,outofa totalof$51billioninCDOsMoodysratedsinceJuly10,2007,88%werlnumberofdollarsofnewlyratedRMBSandCDOsper monthfromthebeginningof2006thrsontothe progressionofthemortgagecrisisaschronicledbyseveralMoody

sreports.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYgure17:Moodysdowngradesandimpairmentsof2007H2vintageRMBS

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYgure18:Moodysdowngradesandimpairmentsof2007H2vintage cashflowandhybridABSCD

C.

DowngradesofOtherFinancialInstitutions

InadditiontoratingRMBSandCDOs,thecreditratingagenciesratedthedebtofmany fiayedkeyrolesinthefinancialcrisis.Insomecasestheratings ofthoseinstitutionshewarningsofOctober2006and theirowndowngradesofRMBSinJuly2007,theNRSROsdidhatheldorinsuredthosesecuritiesuntilNovember2007attheearliest,thelone excepts,whichtwooftheagencieshaddowngradedinJune.In thecaseofBearStearns,thefisdaysbeforeJPMorgan ChaseacquireditwiththehelpoftheU.S.Treasury.Similarly,veLehmanBrothersratingsintheuppermediumrangeofinvestmentgradetheweek beforeirmscreditdefaultswapshadbeentradingatspreads Page 39 of 47


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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYnsistentwithjunkbonds(Ba1)sinceJuly2007.Uptodaysbeforeitsbailout,AIG receiaderatingsbyallthreemajorcreditratingagencies; Moodys,S&P,andFitchratedthevertheless,it warrantsattentionthatapartfromLehmanBrothersnoneofthesefirmsevebts.Therefore,totheextentthattheagencieswerepresumingthatthese institutionswingsmayhavebeenaccurate.Table3summarizes thecreditratingsofseveralmajorfinaeforemajorevents occurred. AmbacandMBIAwerealsodowngradedwellafterthefinancia

thesebondinsurershaddisclosedinpublicfilingsthatithadinsuredbillionsofdollarsifiedCDOs,andCDOsquareds.Nevertheless,inDecember2007 S&PaffirmeditsAaaratinhoughitassignedthemanegative outlook.Inmakingthisdetermination,S&Pcitedtheiting,thebackendedtimingoftheirpotentialliabilities,andtheiraccessto opportgencyinturnbaseditsevaluationofthefirms underwritingupontheAAAandsuperAAAencies didnottakedefinitiveactiontorevisetheirratingsofthesefirmsuntilJanuarenS&PandFitchdowngradedAmbacandMBIA,andMoodysplaced themoncreditwatch. Tabsattimeofbankruptcy,acquisitionorbailout.Firm Lehman Bros. AIG Date 9/15/08 Filedforbankruptcy. Event Moodys A2 S&P A

9/16/08

Receivedan$85billionloanfromtheFederal Reserveinexchangefora79.9percentequiioninequityandguaranteeson $300billionofitsassetsfromtheUSTreasury. Struckca.

A2

A

A

Citigroup Merrill Lynch

11/23/08

Aa3

AA

AA

9/14/08

A2

A

A+

34DavidEvansandCarolineSalas,FlawedCreditRatingsReapProfitsasRegulatorsFail,.Smith,DavidVeno,andRobertE.Green,DetailedResultsofSubprimeStressTestofFin

29,2009).

Guarantors,Standard&PoorsCommentaryReport(Dec.19,2007),14.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYWachovia 9/29/08 Announcedagovernmentforcedsale to Citigroup (laterWellsFargo).llionloanfor28daysbytheFederal Reserve. A1 A+ A+

3/14/08 Bear Stearns

A2

A

A+

PurchasedbyJPMorganChasewiththehelpofa 3/16/08 governmentguaranteeonthefirm

Baa1

BBB

BBB

Source:Bloomberg

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ReferencesBenmelech,EfraimandJenniferDlugosz,2009.TheCreditRatingCrisis,NBERWorking Paa,JakubJurek,andErikStafford,2009,TheEconomicsofStructuredFinance, Journalo(1):325. Moodys,Nov.8,1996,MoodysApproachtoRatingResidentialMortgagePassTh

n.19,2001a,MoodysApproachtoRatingResidentialMortgageServicers. Moodys,JulyitativeAnalysisandStatisticalModels intheRatingofSecuritizations. Moodys,Septh:TheCDOMonitoringProcess. Moodys,April1,2003a,MoodysMortgageMetrics:AModgagePools. Moodys,Aug.13,2003b,OverviewofMoodysRMBSMonitoringProcess. MooingInitialperiod,InterestOnly MortgagesinPrimeRMBS. Moodys,Nov.12,2004b,MoltAResidential MortgageDocumentationPrograms:UpdatedMethodology. MoodysEconomy.ingattheTippingPoint:TheOutlookfortheU.S. ResidentialRealEstateMarket. Moodt:Moodysupdatesitskeyassumptionsforrating structuredfinanceCDOs. Moodys, Marpproach to Rating SF CDOs.

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Appendix1:MoodysRatingsIdealizedExpectedLossRatesRating 5yearIdealized ExpectedLossRate Aaa 0.0016% Aa1 0.0171% Aa2 0.0374% Aa% A2 0.2569% A3 0.4015% Baa1 0.6050% Baa2 0.8690% Baa3 1.6775% Ba1 2.9040% Ba0% B1 8.8660% B2 11.3905% B3 14.8775% Caa1 19.9726% Caa2 26.8125% Caa3 38.40170.0000% Source:Moodys(2009).

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Appendix2:SensitivityofMoodysRMBSModeltoPoolCharacteristics

Source:Moodys(1996).

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Appendix3:MoodysModelforRatingABSCDOsWefocushereonMoodysapproachtoratingcashflowCDOs.ItbeginswithaquantitativehofthetranchesofsecuritiesissuedbytheCDO.36The goalofthequantitativeanalyssofeachofthetranches.This isdonebyspecifyingasetofscenariosforlossesexpethento: 1. Specifytheprobabilityofeachlossscenario. 2. Foreachscenario,calcula

cheoftheCDO. 3. CalculatetheexpectedlosstoeachtrancheoftheCDObyaveragingthyofeachlossscenarioand(b)thelosstothetrancheunderthat lossscenario. Toestollateralassetpoolinstep1,forstatictransactions MoodysreliesonaGaussiancopuionoftheperformanceof thecollateralpool,whichisastatisticaltechniqueformodeln.Each RMBSinthepoolisassignedadefaultprobabilityandrecoveryrate(i.e.,theethatisretainedintheeventtheassetdefaults).Moodys assumptionsabouttherecovreafunctionofthesector type(e.g.,RMBS,ABS,etc.),thethickness(i.e.,amountofbondstranche(thickertrancheshavegreaterrecoveryrates),andthebondsrating (higdtohavehigherrecoveryrates).Thedefaultprobability assumedforanassetisbasedoesentsexpectedloss)and theassetsassumedrecoveryrate. Formanagedtransactionsornsthathavenotyetbeenfullyrampedup (i.e.,forwhichnotallofitscollateralhaslateral assetportfolioasasetofidenticalcorrelatedbonds,tospecifythecollateral

rthesetypesofCDOs,thecollateralmanagerisboundbycovenantsthat specifyboundsoagecharacteristicsofthecollateralpool, includingitsaveragerating,recoveryrate,antedaverage characteristicsareusedtospecifytheparametersofthemodel.Thefourbutionarethe(1)commondefaultprobability;(2)numberofrepresentative assets;(3)cnd(4)acorrelationassumption.Whenthecollateral

36Moodys(2005)describesMoodysquantitativeanalysisofcashflowCDOs.

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FINANCIALCRISISINQUIRYCOMMISSION CREDITRATINGSANDTHEFINANCIALCRISIS PRELIMINARYcquired,thecollateralmanagerhastocheckthecollateralpoolscorrelationassumptionlinputtingtheCDOsactualcollateral. Oncethecollaterallossdistributionisspecilowmodelthat incorporatestheCDOssubordinationstructuretocalculateanexpectedlohes.

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Appendix4:DowngradesandImpairmentsofABSCDOs

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32651377 financial crisis inquiry commission report on credit ratings(1)

Documents