Implications of Current Market Turmoil for
Credit Ratings and Implementation of
Basel 2
Institute of International
Bankers
Basel II Seminar
David Fanger
Chief Credit Officer
Financial Institutions
December 11, 2007
Introduction

Current turmoil raises questions about the
structured ratings paradigm
– Aaa’s should be risk remote, but many were not

What went wrong?
– Unexpected poor performance of mezzanine RMBS
– Knock-on effects on Aaa-rated CDOs, SIVs, and other
market value-based structured products
– Market price declines on Aaa-rated RMBS, other Aaa
SF securities, and the debt of financial institutions

Bad luck, poor transparency, or flawed models?
2
Agenda

Complexity of SF

Historical performance of SF

Recent criticisms and concerns

Moody’s response to date

Implications for Basel 2
3
Are SF Products More Complex than Corporates?

While some structures may be complex, ordinary ABS and
RMBS are not really very complex
– Cash flow modeling is relatively straightforward
– Determinants of collateral pool loss performance are
generally understood, though key parameters unknown
– Look-up tables from expected loss rates to ratings are
transparent



Predicting corporate risk seems much more complex
The apparent simplicity of SF models may encourage
overconfidence in models & assumptions, and thereby
induces excessive leverage
Wider spreads in SF could be due to greater sensitivity to
systematic (as opposed to idiosyncratic) risks
– Systematic risk cannot be reduced through diversification
4
Historical Performance of Structured Finance Ratings


Until now, loss rates in SF were low & comparable to
corporates (except Baa loss rates were higher)
Over 60,000 Aaa SF securities were issued since 1993
(compared to about 100 corporate Aaa issuers), yet only
45 Aaa tranches, from 30 deals, involving just 7 originators
were ever impaired
– LGD rates were often small; large LGDs due to fraud
– Impaired Aaa’s involved subprime RMBS, franchise loans, MH
ABS, healthcare receivables, retail store credit cards,
equipment lease ABS
– Originators were all weakly capitalized specialty finance
companies
5
Corporate & SF Downgrade Rates From Aaa: ’83-06
Performance of SF Aaa’s Was Strong Prior to 2007
Downgrade Rates from Aaa over a
Five-Year Horizon
Downgrade Rates From Aaa over a
One-Year Horizon
35%
35%
30%
30%
All
Structured
Finance
25%
20%
25%
20%
All
Corporates
15%
10%
5%
5%
0%
0%
A
Baa
All
Corporates
15%
10%
Aa
All
Structured
Finance
Spec
Grade
Rating One Year Later
Aa
A
Baa
Spec
Grade
Rating Five Years Later
6
Comments We Have Heard in the Market





Rating agencies need to improve the data on which their
analysis is based
Should not be Aaa if rating transition risk is large, price
risk great, originator weak, or asset class untested
Rating agencies should provide a measure of tail risk,
expected variability around expected loss rates
Structured finance ratings should be on a different scale
than corporates
SF ratings are unreliable because issuers pay for ratings
and discuss multiple scenarios with agencies before
finalizing structures
7
Moody’s Responses –
Enhancements to SF Methodologies

Asset-specific model/methodology enhancements
– Revised RMBS loan loss assumptions
– Increased ABS CDO correlation assumptions
– Increased focus on quality/completeness of third party
data

Ongoing reassessments of key methodologies
– Greater involvement by analysts outside of structured
finance
– Greater use of economic forecasts provided by Moody’s
Economy.com
– Independent review by Credit Policy of methodologies,
models and assumptions
8
Market-Level Initiatives



Improve third party oversights of loan portfolio
attributes
Strengthen representations and warranties
Enhance reporting and disclosure for increased
transparency
9
Potential Additional Tools for Investors

Rating transition risk assessments

Price volatility assessments





Rating sensitivity analysis to changes in key parameter
assumptions
Clear descriptions of potential collateral performance
levels that would likely trigger tranche-level defaults
Assessments of data quality underlying each asset class’
parameter assumptions
Assessments of data quality underlying each transaction’s
collateral pool analysis
Fair/fundamental value estimation tools
– Moody’s Discounted Cash Flow Valuation Service
10
Implications for Basel 2

Pillar 1 may not adequately address rating transition
risk
– Procyclicality of Pillar 1 is already well understood

Investors have clearly viewed current bank
disclosures as inadequate
– Lack of transparency has contributed to wider debt
spreads and increased volatility, which in turn has an
adverse impact on bank funding and liquidity


Re-intermediation of banks highlights the
importance of maintaining “excess capital,” raises
questions about capital reduction
Liquidity remains the proximate cause of bank
failure
– Basel 2 is silent on liquidity risk

Can these all be addressed through Pillar 2 and
Pillar 3?
11
© Copyright 2007, Moody’s Investors Service, Inc. and/or its licensors including Moody’s Assurance
Company, Inc. (together, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS
PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE
REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR
RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM
OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN
CONSENT.
Contact: [email protected]
www.moodys.com
12