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The Subprime Crisis & Ratings: PRMIA Meeting Notes
September 24, 2007

The Subprime Crisis & Ratings: PRMIA Meeting Notes

On September 20, 2007, IRA and SunGard Bancware sponsored a meeting of Professional Risk Managers International Association at the Harvard Club in New York. Sylvain Raynes, Principal, RR Consulting; Sean Egan, Managing Director, Egan-Jones; Josh Rosner, Principal, Graham Fisher; and Thomas Day, Senior Vice President, Product and Engineering, SunGard BancWare, discussed ratings, the subprime lending market and related issues. IRA's Chris Whalen moderated. Below follow our meeting notes.

The Subprime Crisis: Scofflaws & Scapegoats

The meeting began with remarks by Thomas Day of SunGard, who formerly worked in the bank supervision function of the Board of Governors of the Federal Reserve System and now is responsible for product development at SunGard's Bancware unit. Day related his recent experience with a home purchase several years ago, where his transaction was not even subject to an appraisal and the myriad of structuring options which were available made the former safety and soundness examiner wonder if the marketplace had not grown overly complex.

"There's a regulation called 12CFR 34 which requires lenders to get appraisals," Day noted. "I'm not sure exactly how this worked, but we didn't get an appraisal. It was an AVM model, an automated valuation model, that was applied to the particular property I was buying... When they first told me how much I could borrow, I remember thinking to myself 'I'm rich.' And then it sunk in that no, I'm not. I'm not making any more money, got four kids and all of that. We eventually did a 7-1 piggyback."

Day then reflected on how, when he was still working at the Fed's board of governors three years ago, it was apparent to bank supervision personnel that "innovations" by mortgage lenders were creating the circumstances for serious credit quality problems. "Two and a half or three years ago, when I was still at the Fed, we were already talking about when it was going to happen. Looking at the type of lending going on inside the banks, we knew that this was going to hurt at some point. Everyone in the banking industry knew that risk was not priced rationally... How did this problem occur is a great question, but I think that everyone would agree that the leverage which was available when rates had declined 550 basis points is the key factor... "

Regarding bank earnings, Day noted that the obsessive focus on tactical returns, on hitting earnings numbers and short-term performance measures, combined with an extremely steep yield curve, encouraged banks and investors to take risks in terms of duration and credit that were clearly excessive. When rates began to rise, banks began to take even greater risks in order to preserve the earnings spreads which they had enjoyed for a number of years, proof again of the role of interest rate policy in causing the subprime bust. He then asked how the subprime collapse effects the still-pending Basel II process.

"The [subprime bust] has got to cause us to ask some questions about the veracity and logic about some of the imbedded models within the Basel II accord itself. If you look at those models applied in Basel II, single factor models that do really not penalize risk concentrations and assumes things like infinite portfolio granularity which really may not be good assumptions. That calls into question or raises the importance of model risk management."

Day noted that it will take several more months before all of the issues involved with the collapse of the subprime mortgage market are understood and that "knock on effects" in areas such as the warehouse lending market and asset-backed commercial paper may be considerable. "There have been a lot of problems with respect to back-up facilities as well, particularly committed back lines. I think there are some things brewing there as well."

The next speaker was Sylvain Raynes of RR Consulting, who also teaches at Baruch College in New York. Raynes began by reminding the audience that while it may seem easy to criticize the actions of the major ratings agencies, "most people are trying to find ways to look beyond the rating agencies. Most regulators have stopped believing in them a long time ago, at least five years ago, as far as I can see. But what you cannot do is throw the captain overboard in the middle of a storm because then you become the captain. This is the Caine mutiny strategy. Then you must ask yourself: Now are you going to rate structured securities? What are you going to do to do better? Most people attempting this would do even worse [than the ratings agencies]. Who are we going to trust? Are you going to look to JPMorgan (NYSE:JPM) or Goldman Sachs (NYSE:GS)? Are they going to rate structured deals? Can we trust them on valuation? We need to take the high road [in these discussions] because I might not do any better."

Regarding the roots of the issue with respect to the performance of the ratings agencies, Raynes focused on the difference between rating a corporate issuer and a special-purpose vehicle like a collateralized debt obligation or CDO.

"The problem as I see it, as we at RR see it, is the fundamental lack of recognition of the different basis that exists in structured finance as opposed to corporate finance. Everybody knows that a corporation lasts forever, that it is supposed to last forever. Therefore a rating for a corporation is supposed to be static. If it changes, it is usually a shock. If you are inside a rating agency and you are going through the angst of having to downgrade a corporation, you have difficulty not because you believe that this should never happen but because you believe that you the analyst have committed a sin. A corporation is supposed to be eternal. That is not true in structure finance. A structured security is issued from a trust. A trust is a finite life experiment or animal. It cannot last forever. What does this mean? It means that the ratings of structured securities are dynamic. Dynamic means that the rating changes over time, even if you [the analyst] do nothing."

"If you sit on your rear end for ten years and you are rating IBM (NYSE:IBM), nothing is going to happen guys. No one will come into your office and fire you [for not aggressively maintaining the rating]," said Raynes "But if you are rating a structured security, an MBS or any asset class, and you don't notch em, then you are not doing your job. Now, in order to recognize this does not take very much analysis. How do we change the rating of a structured security? Standard solution, what would happen today, is for somebody else to come into your office, the same way that it didn't happen with corporate finance. That somebody might have a name like Buffet or Bernanke. And what is your reaction? You take all of the deals about which you have been accused of doing nothing and you downgrade them... That is not going to help. What about the deals that should be upgraded? There are many [structured deals] in the marketplace today that are doing just fine. But all of the deals are down, all of the prices for deals are down, creating big opportunities."

Raynes continued: "So, the problem in the end is valuation. Valuation is not the most important problem in finance; valuation is not the most interesting problem in finance; valuation is the only problem for finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If you do not recognize the difference, the fundamental difference between price and value, then you are doomed. Now it didn't really matter in corporate finance because the two were supposed to remain equal forever. Who has been telling us that? These people do not live in New York. They live in Chicago. The Chicago School of Economics has been telling us for a century that price and value are identical, ie, they are the same number. What this means is that there is no such thing as a good deal, there is not such a thing as a bad deal, there are only fair deals."

Putting aside what he called the "blame game," where politicians and attorneys general will be seeking to assign fault to individuals for the subprime debacle, Raynes then asked how do we move forward from here: "The first thing I would try to do is establish a unique valuation theory for structured securities. Does this exist? Well, it could if people are listening. They are not. Two days ago, Brian Clarkson, the new President of Moody's (NYSE:MCO) actually suggested that. Of course, it was very nice of Brian to have a meeting and to admit that. I will not stand here and accuse a repentant sinner for seeing the error of his ways. He is exactly right. Why wasn't he saying this ten years ago when he had the chance? I don't know. When the alcoholic goes up to the podium and admits alcoholism, what has happened at that moment? Absolutely nothing and, yet, everything everything has happened because he or she is now in a position to make a change, to do something about it. So we are not in a position to blame people; this will not lead to an improvement. We are in a position collectively to lead real change. The window of opportunity is open right now. We can call this window a new rating agency, we can call it regulatory change, we can call it an enlightenment. But it has to result in a new framework for valuation."

"Structured finance is a beautiful thing. The men of Wall Street like to fall in love with beautiful things. Now, I am not going to stand here and tell you that being in love is something wrong. I have no intention of doing that with my beloved Anne [Rutledge] sitting here. But love is also a very dangerous game because it makes you do what you really don't want to do. So, we don't have to be in love with structured finance, we just have to respect it. Right now we have a chance; we can do something or we can sit here and blame each other. There is enough blame to go around... So hopefully we will take the high road and get all of the parties together and try to have some sort of consensus framework, and hopefully the government will be part of this. My forecast is not optimistic at all, however. Every politician in the room will look to the easy solution that will get them re-elected. Hopefully, I am wrong."

Next came Sean Egan, Managing Director of the Egan-Jones rating agency, which according to Egan has spent the past nine years and over $600,000 in legal fees trying to gain recognition from the SEC as a Nationally Recognized Statistical Rating Organization or NRSRO.

"Last night I received a call from a graduate student at NYU. She asked me, after all of the failures of ratings -- the Asian crisis, Enron, WorldCom, LTCM and half a dozen other crises that she had researched -- what has changed? My reply was that nothing has changed and probably nothing will change for the simple reason that [the rating agency system] is working. It is working from the perspective of the major rating firms. Whenever somebody says ratings, I ask them to use an adjective. One would be investor sponsored, which means you don't get any compensation from the issuer. And issuer sponsored ratings and there is a big difference."

Egan then related what his firm has gone through in his campaign in Washington, on Capitol Hill and with the SEC, to gain NRSRO recognition for his firm. "We're on our fourth set of attorneys and second lobbying firm," Egan noted with more than a little irony, "but I think we are making progress. Hopefully this [subprime] debacle continues for a while because then we will get the NRSRO. If it stops quickly, then we're out of luck."

Egan argues that Washington is unwilling to do anything to actually fix the ratings system "because it is working beautifully. You have a wired market. How's does it work? These are the Department of Justice's words, not mine, a "partner monopoly." Jim Grant, editor of Grant's Interest Rate Observer, calls is a two and a half firm industry. The way it works, [as an issuer] you can only work through those couple of firms. If an investment banker is stupid enough to choose another rating firm, that investment banker will be out of a job within 30 days. And then, when the ratings are proven wrong, [the rating agencies]change their models and their personnel, and then say 'good luck suing us' because we have the freedom of speech defense. We have never seen an industry like this; it's just beautiful. Absolutely beautiful. Our ratings were much more conservative on names such as Enron and WorldCom, so you would think we'd be escorted into the industry by the SEC. But no, we'll be lucky, lucky to get the NRSRO designation."

"Where are we? This [crisis] has risen to a level you have never seen before. When you see presidential candidates like Chris Dodd and others are talking about it. Heads of state in Germany and France are talking about ratings. There are three congressional hearings, including two next week. When there is a freeze on half of the commercial paper market, an SEC investigation and an IOSCO investigation, you know that there are some problems with the structure of the industry... The reason why prices are down so much for subprime paper is because these is a breakdown in investor confidence in ratings, in issuer sponsored ratings. There have been deals which dropped from "AAA" to "CCC" all in one day, just one single day, and the response from the ratings agencies is that 'its just our opinion or you should have known better.' So people just don't believe [in ratings] any longer."

"It is a waste of time and energy to say that these rating firms are bad, that S&P and Moody's are bad," Egan continued. "That they should be reformed. No, that is wrong. They are doing exactly what they should do. They are for-profit corporations and they should maximize profit. They have done a beautiful job at doing just that and they have protection in place for when they are wrong."

Egan reviewed the solutions suggested by many observers, including former SEC chief Arthur Levitt, who want to create an oversight body a la the Public Accounting Oversight Board for the audit firms. He noted that the SEC has not been able to act of his firm's application in a decade and has publicly stated from time to time that it really does not want to get involved in assessing the ratings process. "With S&P [a unit of McGraw Hill (NYSE:MGH)] and Moody's generating $120 million in operating income per month, growing at about 20% annually, there is no way to keep an oversight board honest. Both firms have already allocated millions to lobbying in Washington and, frankly, they should."

Egan's solution to the ratings crisis is to include a tobacco-type warning on ratings paid for by the issuer. "Just tell investors that you are using S&P and Moody's to set the structure of a deal... You cannot ween the major ratings firms from issuer compensation. It is a non-starter. The money earned now by the ratings firms makes such a proposal unworkable."

At this point in the program, IRA's Chris Whalen asked Egan point blank: "As and when the SEC gives you the NRSRO recognition, will you take issuer money?" Egan replied: "No."

The next speaker was Josh Rosner, a buy-side research analyst and banking industry expert who spoke about the roots of the subprime real estate bubble, but first opined on the ratings agencies.

"I am dumbfounded. I feel a little like a deer in the headlights tonight. Listening to the previous speakers, I almost want to defend the rating agencies. There are some significant differences between corporate ratings and structured finance ratings. I think that those differences really need to be considered in looking at the ratings process. I don't have a problem with getting paid by the issuer. I think that can be balanced via regulations, which have not be appropriate up until now. I supported increased regulation on the ratings industry in a New York Times editorial recently. A lot of my conservative friends called and complained angrily: 'How dare you support regulation?' It seems to me that, a la the GSEs, the rating agencies should be recognized as having a public mission, in which case they actually are open to and welcoming of greater regulation. After all, we all know that their revenues are largely derived from that public mission. Bank capital, insurance capital, pension capital are all tied to ratings... Either banks and insurers should not need to use agency ratings at all or we need greater regulation."

Rosner agreed with previous speakers that rating agencies have a duty to follow "dynamic" instruments such as structured assets and to follow changes in these instruments during their limited lives. He also noted that whereas analysts can themselves obtain sufficient data on corporate issuers, CDOs and other structured assets which are generally not registered with the SEC are almost impossible for investors to analyze, making the role of the rating agency that much more essential.

Regarding the origins of the subprime disaster, Rosner provided a fascinating history of the policy roots in Washington. "The reason for the boom in housing in the past decade were the result of structural changes in the housing industry over a decade before. I would argue that most of these changes were a result of the 1980s recession. We came out of the 1980s recession and a lot of the industry players had lost their shirts in the S&:L crisis. We saw Fannie Mae (NYSE:FNM) insolvent on a mark-to-market basis in 1986 and that was largely because of the OREO portfolio. We saw housing in 1993 and 1994 with home ownership rates stagnant, exactly where they were at the beginning of the 1980s. Home ownership rates have consistently ranged in this country between 62 and 64 percent during the post-WWII priod, and yet affordability had actually locked people out."

"So what we saw actually was the largest public-private partnership to date, started as the National Partners in Home Ownership in 1994. It was signed onto by the realtors, the home builders, Fannie, Freddie, the mortgage bankers, HUD. It was a massive effort, with more than 1,500 public and private participants, and the state goal was to reach all time home ownership levels by the end of the century. And the stated strategy proposal to reach that goal was, quote: "to increase creative financing methods for mortgage origination." Those seeds were sown in 1994. Those policies were put in place in 1994."

Rosner continued: "By 1995 we saw home prices start to rise and home ownership levels also start to rise. How did we do that? There was no private label [mortgage] market at that point. We were really dealing in a world of enterprise [GSE] paper. We saw most of the features [of CDOs and structured assets] that we are now looking at as having been atrocious or irresponsible or poor risk management having started in the enterprise markets. We saw changes in the LTV, changes from manual underwriting to automated underwriting. The approval models used were easy to game. We saw reductions in documentation requirements. We saw changes for mortgage insurance requirements. We saw the perversion of the appraisal process and a move to automated appraisals. All of these features which we now look at and point our fingers at the subprime originators and say 'you bad boys,' all started in the enterprise market. This, by the way, is why I believe there is still significant risk [in the GSEs]."

Rosner argues that besides low interest rates c/o of Alan Greenspan and the FOMC, mortgage lenders "began to see loss mitigation as a very valuable tool. So whereas in 1998, about 77 percent of 90-day plus borrowers ended up loosing their homes, by 2002 the measure had dropped to only 16 percent did. There is very little disclosure. Most investors don't know [when a default has actually been] cured because when you modify you go from 'delinquency risk' to 'current' without putting out a penny. And this [example] actually suggests where we are going because there is still no transparency, still no standards for disclosure. Loss mitigation is becoming the next biggest predatory lending problem out there. When you speak to servicers, they tell you that the first thing they consider when entering into a loss mitigation is how much more capital they can drain out of the borrower before he blows up again. You have to wonder. When re-default rates on modified loans are 20-25 percent within two years, you have to ask if there is a social benefit of saving those remaining 80 percent of borrowers or not?"

Rosner then raises the ugly image of two banks, one using mitigation to keep visible loan defaults down, while the other does not use mitigation. Rosner raised the troubling question of whether the loss mitigation being pushed by Washington is actually eroding the safety and soundness of the US banking system.

"If Institution A is modifying 50 percent of current defaults and Institution B is modifying 10 percent, then on the surface Institution A is a better credit. Moreover, Institution A is achieving social policy goals... But two years later, when Institution A is seeing 30 percent re-default rates while Institution B is seeing 4-5 percent re-default rates, then you will have a very different opinion of these two institutions. This is part of the public policy debate which has not yet happened."

"The structural change [put in place in the 1990s] drove housing to be a speculative asset," continues Rosner. "Historically, investor share in the housing market was only about 8-9 percent. In the past three years, roughly 40 percent of sales have been for investment purposes. That creates what I call phantom inventory, usually in the fastest appreciating markets. These homes were purchased for speculative purposes with the most risky loan structures which required the least documentation... There is a lot of inventory that is not showing in the official numbers. At some point, that [inventory] gets thrown into the market."

Rosner closed by commenting on the rating methods used by the major agencies for looking at mortgage conduits: "I was looking at a conduit the other day that is a multi-seller sponsored conduits, sponsored by nine of the largest financial institutions in the world. And when you look at the actual rating of the conduit, the ratings are not tied to the underlying collateral. The rating agency graded based upon the financial strength of the sponsor. And so the assets which have been sold into this conduit this year, 80% or those assets are unrated or sub-investment grade, but the conduit actually has an investment grade rating. And this raises the question: is this part of the reason why there is not a liquidity crisis, but a crisis in confidence because we really don't know what is in these assets... There is no disclosure, no transparency, and in fact it gets even a little bit uglier. By contributing unrated assets to this conduit, the issuer is turning toxic waste into gold, because the CP issued by the conduit carries an investment grade rating. If one of the sponsors buys the CP, they can get 95 percent of face value from the Fed discount window."

During the Q&A session, Robert Selvaggio , Managing Director of the Risk Analysis Group at AMBAC, offered a scathing analysis of the performance of the ratings agencies with respect to structured assets.

"Just a comment on the responsibilities of the rating agencies to take a forward looking view. The rating agencies, whether Moody's, S&P or Fitch, actually define what their ratings mean. S&P and Fitch say that their ratings mean probability of default. You can't value the probability of default by simply responding to current events, you have to look forward. Moody's says that they rate to an expect loss standard. They only way to rate an expect loss is to take a forward looking view. As expectations change and probabilities change, rating have to change. This is more than an academic exercise. Ratings have direct implications for cash flows by the structure of the deal. If you talk about ABS CDOs now a days, you are talking about subprime. ABS CDOs have triggers in them. Many of these triggers are a function of ratings. There are "CCC" triggers there at "BB" triggers. To the extend the ratings agencies who -- and I have to say that I work very closely with rating agency analysts -- but to the extent that they are dragging their feet on changing the rating on subprime MBS, what they are doing is is they are preventing the reallocation of cash flows to the senior traunches, to change the sequential structure on "AAA" and "AA" ABS CDOs. So they are actively harming the cash flow profile of this CDOs and are actively hurting ABS CDOs, and something has to be done about it. They have to speed up the process of re-rating these CDOs."

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