mason_rosner by wuxiangyu

VIEWS: 8 PAGES: 68

									  Where Did the Risk Go? How
  Misapplied Bond Ratings Cause
  Mortgage Backed Securities and
  Collateralized Debt Obligation
  Market Disruptions
                Joseph R. Mason, Associate Professor of Finance, Drexel University
                Joshua Rosner, Managing Director, Graham Fisher & Co.


DISCLAIMER: NOTHING IN THIS REPORT SHALL BE CONSTRUED TO BE LEGAL OR INVESTMENT ADVICE. IT IS
NOT INTENDED TO BE CONSIDERED OTHER THAN THE OPINIONS OF ITS AUTHORS AND DOES NOT PROPOSE
SPECIFIC ADVICE ON ANY SECURITIES OF ANY PARTICULAR ISSUER OR COMPANY. THE INFORMATION AND
RECOMMENDATIONS CONTAINED HEREIN ARE BELIEVED TO BE ACCURATE - HOWEVER NO GUARANTEE OR
WARRANTY EXPRESSED OR IMPLIED IS GIVEN.

                                     Criterion Economics L.L.C.                            1
I. Unrecognized Risk and Bond
Ratings

Securitization can‘t make risk go away, but it
 can cause risk to get lost.




                    Criterion Economics L.L.C.   2
Figure 1: Residential MBS Yield Spreads, MBA
Refi Index, and 2x10 Swaption Volatility




   Source: Nomura (2005)

                           Criterion Economics L.L.C.   3
Figure 3: Defaults on ABS and RMBS,
1994-2005




  Source: Fitch IBCA (2006)

                              Criterion Economics L.L.C.   4
Figure 5: U.S. Home-Price Appreciation




Source: Nomura (2007)

                        Criterion Economics L.L.C.   5
Figure 6: ABX:HE Tranche Spreads for
Pricing RMBS




Source: Nomura (2007)

                        Criterion Economics L.L.C.   6
II. Structural Changes in the Bond
Rating Industry: The Move from
Passive to Active
A. A Brief Background on the Role of Credit Rating Agencies
B. Are Credit Rating Agencies Still Publishers or Are They
   Underwriters?
C. New Conflicts—The Buy Side
D. The Problems With Ratings In Structured Finance—Evolving Models
E. Regulatory Issues
F. Rating Agencies Are Activist in Ways They Have Never Been
G. Other Legal Risk Securitization Law



                          Criterion Economics L.L.C.            7
A Brief Background on the Role of
CRA’s
   Historically:
    “Approach, in both policy and practice, is
      intended to provide a consistent framework for
      risk assessment that builds reasonable ratings
      consistency within and across sectors and
      geographies”- S&P
A Brief Background on the Role of
CRAs
   Newer structured products required agencies to
    develop new models to rate newer securitized
    assets: ―learning by doing‖
A Brief Background on the Role of
CRAs
   Significant changes to meaning and manner in
    which they are employed
       “Uncertainty about the meaning of original ratings is
        significant‖ – Nomura
       “Can specific structured finance products with a AAA
        credit rating produce a return of up to 200 bp for
        investors, while a AAA corporate or a AAA MBS
        tranche produces only a 10/20 bp return? What does
        that mean? – AMF
       Strengthened the power or “partner monopoly” of
        Moody‘s, S&P and Fitch - Sean Egan
A Brief Background on the Role of
CRAs
   Unlike traditional, single issuer debt offerings
    there is a great amount of concentration in the
    structured finance industry
A Brief Background on the Role of
CRAs
Agency revenues have increasingly been generated
by issuers of structured financial securities.
 Figure 8: Quarterly
 Revenue by Segment:
 Q1 2002 to Q4 2006




 Source: Moody‘s (2007)

                          Criterion Economics L.L.C.   12
A Brief Background on the Role of
CRAs
   CRA process in Structured Finance pose new
    risks.
   CRA Methods in Structured Finance may amplify
    risks.
A Brief Background on the Role of
CRAs
 •   Broad base of Issuers, Law Firms,       •   Concentration of Issuers, Law Firms,
     Corporate Management, Allowed,              Buyers, Structure Management (Servicer,
     Investors                                   CAM)
 •   Less complex legal structures           •   Complex Legal Structures
 •   Lengthy legal precedent on structures   •   Relatively little legal precedent on
 •   Empiracle based models                      structures
 •   Issuers are “dynamic”                   •   Statistically based models
 •   Rating is a passive opinion             •   Issuers are usually “static”
 •   Structures transparent                  •   Rating is more active iterative process
 •   Structures liquid                       •   Structures opaque
 •   Issuers generally issued for economic   •   Structures often illiquid
     business management purpose             •   Issuers often issue for speculative returns
                                                 purpose
A Brief Background on the Role of
CRAs
   The rating of structured securities helped drive
    new mortgage product development
Are the CRAs Still Publishers or are
they “Underwriters”?
   Historically, ratings are merely ―opinions‖ or
    ―world‘s shortest editorial‖ - Fitch
   First Amendment Protection:
       ―ratings are speech and… would receive the
        heightened protection of the actual malice standard.‖
Are the CRAs Still Publishers or are
they “Underwriters”?
   Are the CRAs Still Publishers or are they
    ―Underwriters‖?
   Journalists should:
       Test the accuracy of information from all sources
       Identify sources whenever feasible
       Always question sources‘ motives before promising
        anonymity.
       Distinguish between advocacy and news reporting.
       Recognize a special obligation to ensure that the
        public's business is conducted in the open

             Source: Society of Professional Journalists Code of Ethics.
Are the CRAs Still Publishers or are
they “Underwriters”?
 International Organization of Securities
  Commissions Code states the rating Agencies
  “should adopt, implement and enforce written
  procedures to ensure that the opinions it
  disseminates are based on a thorough analysis
  of all information known to the CRA that is
  relevant to its analysis according to the CRA’s
  published rating methodology”.
IOSCO Code at 1.1
Are the CRAs Still Publishers or are
they “Underwriters”?
   Rating agencies state they have:
       “no obligation to verify or audit any information provided to it from
        any source or to conduct any investigation or review, or to take
        any other action, to obtain any information that the issuer has not
        otherwise provided ” - Fitch
       “ no obligation to perform, and does not perform, due diligence
        with respect to the accuracy of information it receives or obtains
        in connection with the rating process. Moody’s does not
        independently verify any such information. Nor does Moody’s
        audit or otherwise undertake to determine that such information is
        complete. Thus, in assigning a Credit Rating, Moody’s is in no
        way providing a guarantee or any kind of assurance with regard
        to the accuracy, timeliness, or completeness of factual
        information reflected, or contained, in the Credit Rating or any
        related Moody’s publication” - Moody‘s
Are the CRAs Still Publishers or are
they “Underwriters”?
   “The (Securities and Exchange) Commission
    has emphasized that, NRSROs, as registered
    investment advisers under the Investment
    Advisers Act of 1940, have a special duty to
    base their opinions upon current and adequate
    information.” - SEC
Are the CRAs Still Publishers or are
they “Underwriters”?
   The Securities Act of 1933 States
       ―Underwriter‖ - “ broad enough to encompass all
        persons who engage in steps necessary to the
        distribution of securities.” - Harden v Raffensperger,
        Hughes
       “Congress knew of the collateral participation concept
        and employed it in the Securities Act . . .The Court's
        footnoted discussion makes clear that, in its view, one
        who “participates,” or “takes part in,” an underwriting is
        subject to section 11 liability.” - Harden v
        Raffensperger, Hughes
Are the CRAs Still Publishers or are
they “Underwriters”?
   Under Rule 436(g), the rating agencies have
    enjoyed exemption from Section 11 liability
    under the 1933 Act
   It seems that the role of rating agencies is a
    necessary function of structured products their
    sale and distribution.
Are the CRAs Still Publishers or are
they “Underwriters”?
   Interactions with other parties also paid by the
    issuing client raise further questions:
       Attorneys: ―Rating agencies do not always use outside counsel,
        they ask, on a regular basis … arranger‘s lawyers to give them
        some of the analysis originally destined for the arrangers on
        questions that concern all parties… in the event a law firm acts
        for different participants on the same deal, there could be a
        potential conflict of interest.‖- Authorities des Marches Financiers
       Accountants: ―Certified public accountants are precluded from
        issuing written reports on the application of accounting principals
        to a hypothetical transaction‖ - Deloitte & Touche LLP to
        Jonathan Katz, SEC
New Conflicts - The “Buy Side”

   In structured finance there is an increased need
    for investors to rely on the rating agencies.
New Conflicts - The “Buy Side”

   Rating Agencies have responded to structured
    finance investor‘s needs with new products that
       “provide(s) present values… and … calculate book-
        level hedging requirements.” - Fitch RAP CD
       Give investors “full access to.. in-house team of
        quants and market risk specialists, thereby enabling
        them to out-source the entire CDO risk management
        process to third party experts” - Fitch RAP CD
New Conflicts - The “Buy Side”

   Should they provide secondary market values, in
    illiquid assets, on structures they may have rated
    at issuance?
Evolving Models

   Agencies claim ―all products they are asked to
    rate are subject to a common rating process
The Problems with Ratings in SF -
Evolving Models
   Agencies rarely re-rate existing structures
   New methods are rarely retrospective
   Lack of transparency makes it difficult to
    determine whether these adjustments, in part or
    in aggregate, would have a meaningful impact to
    existing structures.
   Ability of Collateral Managers to reinvest may
    increase these risks
The Problems with Ratings in SF -
Evolving Models
   A hypothetical example of risk:
       Assume a 2005 Issued Market Value CDO that is
        invested in subprime RMBS assets from 2003, 2004,
        2005
       In 2006 an agency increases required collateral
        support for 2006 issued subprime MBS
       Could a Collateral Manager, in the revolving period,
        buy 2006 assets in his 2005 issue without increased
        collateral or change in rated risk?
       Sources suggest that they are often merely charged a
        standardized 50bp increase if any.
Evolving Risks - Models - Another
Example
   Moody‘s: “the data fields essential for running
    the model were established when the model
    was first introduced in 2002. Since then, the
    mortgage market has evolved considerably,
    with the introduction of many new products
    and an expansion of risks associated with
    them” - Moody’s, April 3, 2007
The Problems with Ratings in SF -
Evolving Models
   On April 3, 2007 Moody‘s: requesting increased
    levels of loan details from mortgage securitizers:
    “the data fields essential for running the model
    were established when the model was first
    introduced in 2002. Since then, the mortgage
    market has evolved considerably, with the
    introduction of many new products and an
    expansion of risks associated with them”.
The Problems with Ratings in SF -
Evolving Models
   The existing data used as a ―primary‖ field for running their proprietary mortgage
    rating system ―Moody‘s mortgage Metrics‖ has not included:
       Debt-to-income
       Appraisal type
       Originating lender
   The Company announced that ―new data fields‖ they were requesting included:
       Option Arm information
       Interest rate of loan at origination
       Indicators governing adjustments to loans interest rate
       Month of first reset
       How often the rate resets
   While the Company stated ―generally, in absence of key information
    assumptions are utilized‖ though is it not clear how conservative those
    assumptions will prove to be
The Problems with Ratings in SF -
Evolving Models
   Servicer Ratings and CDO CAM Ratings are
    similarly evolving “Fitch Rating, for example, has
    profiled 66 CDO managers, about a third of
    which have some exposure to subprime debt”
    and “a backlog of about 60 new managers still
    need to be profiled” - Reuters Feb. 28, 2007
Regulatory Issues

   The rating agencies offer little public disclosures
    of information on the training and number of
    rating staff
   There seems, even in the face of IOSCO Code
    requirements, no full legal separation of some of
    the businesses of some CRAs.
Rating Agencies are Activist in Ways They
Have Never Been
   One CRA seemed to become involved in GSE
    legislation by suggesting they would downgrade
    GSE debt if ―receivership‖ language was
    included in the bill.
       ―First of all, Senator, if I may, let me start by saying that Standard
        & Poor‘s does not advocate positions on any legislation‖ - S&P
        President Kathleen Corbet
       ―I think a quote from a report by (S&P analysts) would be, ‗The
        slightest evidence that Congress would in any way agree to
        lessen its authority or cede it to others would in itself necessitate
        a rethinking of how much confidence bondholders should have
        that their interests would be taken into consideration in the case
        of a failed GSE‘.‘‘ - Senator Reed
Rating Agencies are Activist in Ways They
Have Never Been
   The CRAs drove changes in Georgia predatory-
    lending legislation
Other Legal Risk - Securitization Law

   While the CRAs were vocal in their view that
    they could not rate ―unquantifiable‖ legal risks to
    ―legal isolation‖ and liabilities in securitization
    trusts, they:
        Have not made such sweeping pronouncements after a NextBank
         securitization clause was abrogated by FDIC powers
        Nor have they made such grand pronouncements in the wake of LTV
         Steel; in fact, in the wake of LTV Steel it was reported that “Standard
         & Poor's insisted that attorneys submitting true-sale opinions to
         the rating agency stop referring to LTV, noting that the court never
         made a final decision and that such citations inappropriately cast doubt
         on the opinion. Seven months later, in a delicately worded press
         release, S&P withdrew that prohibition--apparently because lawyers
         refused to ignore such an obvious legal land mine.”
Traditional Bond Ratings Do Not
Properly Account for RMBS Risks
                                Capital
                         Dynamic        Static
                         Corporate
   Assets    Dynamic                    CDOs
                          Bonds
              Static           ???                  RMBS/ABS



            Four Main Implications

                       Criterion Economics L.L.C.              38
Figure 11: Expected Losses in Corporate
and Structured Finance Debt




                                1. SF Pool Losses are Moving Target




Source: R&R Consulting (2004)

                            Criterion Economics L.L.C.           39
Figure 12: Actual and Expected Losses on
Corporate Investments and Mortgage Pools




                                2. SF Pool Losses Don’t Recover



Source: R&R Consulting (2004)

                            Criterion Economics L.L.C.            40
Figure 14: Skewed Mortgage Pool Loss
Distributions




                             3. SF Pool Losses are
                             Distributionally Skewed




Source: Fitch IBCA (2007)

                            Criterion Economics L.L.C.   41
Figure 13: Statistical Distributions of Cumulative
Losses on Corporate Investments and Mortgage Pools
  4. Moving, Increasing, Skewed SF Pool Loss Distribution
                    Narrows Over Time




Source: R&R Consulting (2004)

                            Criterion Economics L.L.C.      42
Figure 15: Relying on Corporate Debt Rating
Methods Results in Late Downgrades on RMBS




Source: R&R Consulting (2004)

                            Criterion Economics L.L.C.   43
Figure 16: Consistent RMBS Performance Warrants Credit
Ratings Upgrades




 Source: R&R Consulting (2004)

                             Criterion Economics L.L.C.   44
Figure 17: Expensive Credit Enhancement is Wasted if the
Loss Scenarios it Covers are Statistically Less Likely Over
Time




 Source: R&R Consulting (2004)

                             Criterion Economics L.L.C.       45
Traditional Bond Ratings Do Not
Properly Account for RMBS Risks
                               Capital
                        Dynamic        Static
                        Corporate
   Assets   Dynamic                    CDOs
                         Bonds
             Static           ???                  RMBS/ABS


            Four Main Implications:
     1. SF Pool Losses are Moving Target
     2. SF Pool Losses Don’t Recover
     3. SF Pool Losses are Skewed
     4. SF Pool Loss Distribution Narrows Over Time
                      Criterion Economics L.L.C.              46
IV. THE COMPLEXITY OF RMBS
MASKS RISK TRANSFER




           Criterion Economics L.L.C.   47
Why does Complexity Matter?


                                                                      A s eries of securities                                       Which have different priorities in
     Mortgages are originated…                 A nd  pooled        ( tranches) are created               Investors  buy the     repayment, and thus different levels of
                                             together into a trust    bac ked by the pool of              i ndividual securities             ri sk and yields
                                                                           m ortgages…



                        Mortgage
                                                                                                                                       Higher priority
                                                                                                                                        of repayment        Lower yield
                 $   for purchase or refi
    Property
                                                                                             Buy security
                      Mortgage P&I                                                              purchased
                                                                          AAA
                                                                                            Security P&I
                                                                                                   paid
    Property




                                                                           AA

    Property                                    Mortgage
                                                    pool
                                                                            A



    Property                                                             BBB



                                                                           BB


    Property                                                               B
                                                                                                                                       Lower priority      Higher yield

                                                                        Unrated
                                                                                                                                        of repayment




                                                                     Criterion Economics L.L.C.                                                                              48
Figure 21: Prepayment and Default Rates
as a Function of Mortgage Duration




 Source: Calomiris & Mason (2007)

                            Criterion Economics L.L.C.   49
Figure 22: Common Prepayment Vectors
used in Prepayment Analysis




 Source: Fitch IBCA (2001)

                             Criterion Economics L.L.C.   50
Why does Complexity Matter?


                                                                      A s eries of securities                                       Which have different priorities in
     Mortgages are originated…                 A nd  pooled        ( tranches) are created               Investors  buy the     repayment, and thus different levels of
                                             together into a trust    bac ked by the pool of              i ndividual securities             ri sk and yields
                                                                           m ortgages…



                        Mortgage
                                                                                                                                       Higher priority
                                                                                                                                        of repayment        Lower yield
                 $   for purchase or refi
    Property
                                                                                             Buy security
                      Mortgage P&I                                                              purchased
                                                                          AAA
                                                                                            Security P&I
                                                                                                   paid
    Property




                                                                           AA

    Property                                    Mortgage
                                                    pool
                                                                            A



    Property                                                             BBB



                                                                           BB


    Property                                                               B
                                                                                                                                       Lower priority      Higher yield

                                                                        Unrated
                                                                                                                                        of repayment




                                                                     Criterion Economics L.L.C.                                                                              51
Figure 23: Tranches Issued in European
Securitizations 1987-2003




   Source: Firla-Cuchra and Jenkinson (2005)

                           Criterion Economics L.L.C.   52
Table 2: Issues with the Given Number of
Tranches as a Percentage of All Issues Per
Type (Mean Number of Tranches Per Issue)




  Source: Firla-Cuchra and Jenkinson (2005)

                           Criterion Economics L.L.C.   53
Figure 24: Examples of Actual MBS
Funding Structures




  Source: ABSnet

                   Criterion Economics L.L.C.   54
IV. THE COMPLEXITY OF RMBS
MASKS RISK TRANSFER

      ?


           Criterion Economics L.L.C.   55
V. BOND RATINGS DO NOT
ACCOUNT FOR CDO RISKS
                              Capital
                       Dynamic        Static
                       Corporate
  Assets   Dynamic                    CDOs
                        Bonds
            Static           ???                  RMBS/ABS



        Four Main Implication
       Variants PLUS Arbitrage
                     Criterion Economics L.L.C.              56
Figure 25: CDO Capital Structure
Arbitrage through Vintage Substitution




 Source: Fitch IBCA (2007)

                             Criterion Economics L.L.C.   57
                                                    A s eries of securities                                   W hich have different  priorities in
 Mortgages are originated…       A nd pooled      ( tranches) are created            Investors  buy the      repayment, and thus different
                                  together into a    backed by the pool of            i ndividual securities       l evels of risk and yields
                                      trust              m ortgages…


                   Mortgage
                                                                                                                      Higher
  Propert                                                                                                           priority of        Lower yield
              $for purchase or
  y                  refi                                                Buy security                              repayment
               Mortgage P&I
                                                         AAA             purchased
                                                                        Security P&I
                                                                               paid
  Propert
  y

                                                          AA
  Propert
                                    Mortgag
  y
                                      e pool
                                                           A

  Propert
  y                                                      BBB


                                                          BB

  Propert
                                                           B
  y                                                                                                               Lower priority    Higher yield

                                                       Unrated                                                    of repayment


                                                          AAA
                                                                                                                                      Synthetics      (e.g. ABX)
                                                           AA

                                                           A
                                      CDO
                                      Pool                BBB
 Other RE
                                                           BB
and non-RE
obligations                                                B

                                                        Unrated




                                                    Criterion Economics L.L.C.                                                                                      58
Figure 27: Default Probabilities Used in S&P CDO Rating
Criteria
Ratings Arbitrage:
CDO Ratings
Methods Are                  AA+ CDO
Looser than             AA- ABS
RMBS Ratings
Methods, Even
when CDOs are
Solely made up of
RMBS




Source: Nomura (2006)

                        Criterion Economics L.L.C.    59
Figure 28: Annual Cash CDO Issuance




  Source: Lucas, Goodman, and Fabozzi (2006)

                          Criterion Economics L.L.C.   60
Figure 29: Subprime RMBS Compositions
in CDOs Grew Quickly over Recent Years




Source: Fitch IBCA (2007)

                            Criterion Economics L.L.C.   61
Figure 30: Ratings Distribution of RMBS
in CDO Portfolios




Source: Fitch IBCA (2007)

                            Criterion Economics L.L.C.   62
Figure 31: How Much and What Kind of
MBS are in CDOs?




               Criterion Economics L.L.C.   63
Table 5: CDO Risk Premiums and Credit
Spreads and Macroeconomic Performance




  Source: D‘Amato (2005)

                           Criterion Economics L.L.C.   64
Figure 35: Mortgage-backed Security Spreads,
Risk Premia, and Eurodollar Futures




   Source: IMF (2007)

                        Criterion Economics L.L.C.   65
Figure 36: Exchange Rates for Selected
Major Industrial Countries




Source: IMF (2007)

                     Criterion Economics L.L.C.   66
VIII. Policy Implications

   Opacity for New Products
   Ratings Reliance of ERISA Investments
   US Market Supremacy
   US Economic Ranking
   Consumer Spending
   Stagflation Potential



                    Criterion Economics L.L.C.   67
  Where Did the Risk Go? How
  Misapplied Bond Ratings Cause
  Mortgage Backed Securities and
  Collateralized Debt Obligation
  Market Disruptions
                Joseph R. Mason, Associate Professor of Finance, Drexel University
                Joshua Rosner, Managing Director, Graham Fisher & Co.


DISCLAIMER: NOTHING IN THIS REPORT SHALL BE CONSTRUED TO BE LEGAL OR INVESTMENT ADVICE. IT IS
NOT INTENDED TO BE CONSIDERED OTHER THAN THE OPINIONS OF ITS AUTHORS AND DOES NOT PROPOSE
SPECIFIC ADVICE ON ANY SECURITIES OF ANY PARTICULAR ISSUER OR COMPANY. THE INFORMATION AND
RECOMMENDATIONS CONTAINED HEREIN ARE BELIEVED TO BE ACCURATE - HOWEVER NO GUARANTEE OR
WARRANTY EXPRESSED OR IMPLIED IS GIVEN.

                                     Criterion Economics L.L.C.                           68

								
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