Friday, April 5, 2019
Credit Ratings Role in the Financial Crisis
cite grades Role in the Financial CrisisThe world-wide financial clays institutional standardling has been evolving over time.Every crisis has helped decipher a gap in the financial social structure which is then fixed by the regulating governance.It hasnt been very often that the regulators were able to identify the gaps before the foodstuff identified it.This does non serve the purpose of existence of regulatory authorities.In future the role of regulatory authorities should be pro active in nature rather than reactive mode of undertaking disciplinary actions.The sub patriarchal crisis which originated in the united states learn to a global melt down which was severe.The owe market in the United States saw a tremendous produce in the initial years of the 21st century. Subprime borrowers started obtaining mortgages referable to avail magnate of cheap reference work entry, lenient lending practices and appreciation in real estate values. These mortgages were inturn sold by the lenders to investment banks who packaged them into exotic securities and sold them to juicy happen taking investors seeking high returns.Investors had reliance in these packaged securities primarily beca part of Credit evaluation Agencies (CRA) evaluates of these securities as investment grade. In 2007, the tide glowering and belief became expensive. Home values dropped. Majority of the subprime buyers started nonremittaling their loan payments. The CRAs rapidly downgraded all the securities for which they had tending(p) favourable paygrades.This thesis is under buzz offn to infer the emergence of structured financial products, the evaluate process followed by the assurance judge agencies for range them and the mistakes d unmatchable by the paygrade agencies, a major contributor to the subprime mess in the United States which had knit effect across financial markets all over the world.Literature ReviewThe followe research text file and articles fork u p been referred and reviewed in order to gain indepth know leadge about the work done about the harangue topic under consideration. This would expedite a clear understanding of different view points to the issue and alter a comprehensive abridgment of the topic. agree to V.Gupta, R.K.Mittal K.Bhalla (2010), low matter to rates, abundant liquidity and a come after for yield led to the emergence of sub prime lending which was given undue support by the quote rating agencies. Credit rating agencies gave investment grade ratings to securitization transactions based on subprime mortgage loans. The CRAs combined lower rated mortgage loans with equity to form mezzanine CDO enabling a higher(prenominal) ascribe rating. Also CRAs use the same risk metric for assessment of all instruments. The CRAs assigned supersafe, triple-A ratings to structured products that later sullen out to be extremely risky, and in more or less cases worthless. This has been illustrated with hardly a(pr enominal) examples of downgrades.The paper concludes that The regulatory framework should to a fault facilitate the conduct of stress tests by users on key mannequin parameters, and provide for the apocalypse by computer address rating agencies of the economic assumptions underlying their rating of structured products.harmonize to Katz and Salinas (2009), faulty credit ratings and the flawed rating process have been the key drivers to the financial crisis 2007-2008. While the easy availability of (what turned out to be flawed) ratings fueled the growth of thismarket, the subsequent downgrades in ratings accelerated the markets collapse.The paper suggests that While bodily debt ratings are based on universely available, audited financial statements, structured debt ratings are based on nonpublic, nonstandard, unaudited culture supplied by the originator or nominal issuer. Moreover, rating agencies had no obligation to perform due diligence to assess the accuracy of the informa tion and often relied on representations and warranties from the issuers about the property of the data, which later proved to be inadequate. The researchers note that the credit rating agencies have al styles been slow to react to market events and a few examples have been quoted.Few measures suggested by the researchers include managing conflict of interest, wagerer transparency, direct government oversight etc.According to Fender and Kiff (2004) , rating od confirmatoryised debt obligations involves assumptions such as carelessness probability, recovery rates and correlated defaults of mob additions. The research paper analyses one of the rating methodologies utilize which is termed as Binomial Expansion Technique.A comparative summary of this method and monte corlo Simulation is done. The paper elaborates the implications of usage of different techniques on the rating outcomes. It finally discusses how methodological differences aptitude induce issuers to strategically select rating agencies to get CDOS rated.According to Barnett- Hart(2009), Collateralized debt obligations (CDOs) have been responsible for $542 one million million million in write-downs at financial institutions since the beginning of the credit crisis.The poor CDO performance has been attributed to inclusion of low quality collateral with exposure to U.S residential housing market.The role of CDO underwriters and credit rating agencies in the crisis have been discussed. The credit rating agencies failed to rate the performance of CDOS precisely due to over automation in rating methodologies and ponderous reliance on input whose accuracy was not verified. The researcher concludes that by understanding the CDO market nuclear meltdown story more effective regulatory and economic policies and practices to prevent history from rep tireing itself in the future.According to Securities and Exchange commission(2008), few observations about credit rating agencies with respect to CDOS hav e been made. secant claims that few credit rating agencies could not deal with the substantial increase in the human activity and analyzableity of the CDOS since 2002. Rating agencies failed to document real steps in rating of CDOS including reasons behind deviation from the types. Also the internal audit procedure of rating agencies varied significantly.The report summarises the remedial actions that the Nationally Recognised Statistical Rating Organisations(NRSRO) would take after the SEC examined them and came up with issues to be looked into. Under the new law and rules, NRSROs are required to make indisputable public disclosures, make and retain certain records, furnish certain financial reports to the Commission, establish procedures to manage the handling of somatic non-public information and disclose and manage conflicts of interest. The Commissions rules additionally prohibit an NRSRO from having certain conflicts of interest and engaging in certain unfair, abusive, o r coercive practices.According to Partnoy (2008), Credit rating agencies have been the primary drivers of mo level securitisation.Investors did not examine the underlying assets and depended on parameters set by rating agencies to assess the CDOS. If the Credit rating agencies had used reasonable and accurate models and assumptions , the CDO transactions would not have been conundrumatic. The paper suggests some policy prescriptions which include settlement of explicit reliance on credit ratings and the claims made by rating agencies that the ratings are mere opinions should not be accepted any longer. The researcher suggests that rolling average of market measures is a much better representation of the instrument than the unchanged credit rating .Credit default swap spreads would provide a process of monition about the CDOs and their true performance in the market.According to M.K.Datar(2011), the role of CRAs in the crisis has attracted attention staple fiberally owing to the severe downgrades during the initial stages of the crisis. The conflict of interest in the payment model has been discussed and the author suggests that investor pay model should be adopted as the issuer pay model creates a bias as rating agencies might be prone to give good ratings because the issuers are paying for it.An alternative platform pay model has been suggested in the paper wherein an issuer approaches a clearing house (platform) with a preset fee to get a rating. The platform would get the ratings done from a pool of recognised CRAs. This process avoids direct contact betwixt the issuer and the rating agency.The paper concludes that better disclosures by CRAs and their subsidiaries in respect of details of earning from rating and non-rating revenues, default and passing statistics would play a key role in improved governance in CRAs.Problem translationThe dissertation work is undertaken to understand the reasons behind the emergence of the subprime crisis in late 2000 s and the role of credit rating agencies in the crisis.The t each(prenominal) is divided into two parts try outing the pre crisis and post crisis situations and analysing the change in credit ratings of motley complex instruments in response to the crisis.The objectives are briefly stated as under picture the evolution of structured financial productsUnderstand the causes of subprime crisisStudy the credit rating process for CDOSStudy the factors that lot the rapid downgrade of CDOs in the initial meltdown stagesAnalyse the flaws in the rating process which led to failure in forecasting true performance.Suggestions and corrective action for facilitating accuracy in credit ratings of complex products.Research methodologyResearch DesignThe method adopted for research is causal research wherein the problem in question is understood and the degree of jounce of the cause on the effect under study is analysed. The financial crisis that began in 2007 is studied and the part of cre dit ratings to the crisis is analysed. Credit ratings serve as the control classify in this research. Finally suggestions for improvement in credit ratings and measures to be taken are proposed.Methods and Techniques of data disposition and analysisTo achieve the research objectives, secondary data from reliable sources are being used. Thorough study of the existing literature is being done to understand different ideas and view points on the topic which would facilitate a comprehensive analysis of the issue. methodological analysis adopted for rating complex products by leading credit rating agencies has been studied in detail which includes statistical tools and financial models.Data sourcesData is being obtained from various secondary data sources for study and analysis.The major sources used for research are as followsCredit Rating Agencies websites and reportsBanking for International Settlements(BIS) working papers and reportsSecurities and Exchange Commission reportsJournal s and papers published on Credit ratings contribution to the Crisis.DRIVERS TO EMERGENCE OF FINANCIAL CRISIS 2007-2008The financial crisis was fuelled right from the early 2000s through various factors , the most important of which is sub-prime lending. This inturn led to construction of CDOs at a later stage in order to transfer the concentrated risk of banks to the investors . Hence it is vital to get a clear idea about the emergence of sub prime lending and evolution of CDOs .Sub-Prime lendingThe sub-prime mortgage market caters to customers who are unable to meet normal credit and/or documentation requirements for mortgages. Subprime lending is riskier than normal lending for the banks. Hence banks tend to charge a higher interest rate to jog for the risk. Over the past decade, this mark-up over prime rates has been about 2%, making lending potentially very lucrative. Only by the mid-1990s did the subprime mortgage market begin to take off as a bod of factors emerged which app arently mitigated the default risk on such loans and hence led to an increasing number of banks lending ever-larger amounts to this sector. Some important factors which contributed to a boom in subprime lending are discussed below.Introduction to Sub Prime LendingEvolution of Structured Financial ProductsCollateralised debt obligations have been one of the complex financial products which have been instrumental in driving the financial system into a crisis. The evolution of CDOs needs to be understood in order to study the emergence of the financial crisis.The basic principle behind a CDO involves re-packaging of fixed income securities and division of their hard capital flows according to a specified structure. A CDO is constructed by creating a brain-dead company, a special purpose entity (SPE) or structured investment vehicle (SIV), which buys assets and issues bonds back by the assets cash flows. The bonds are divided into a number of tranches with different claims on the prin cipal and interest generated by the CDOs assets. The mechanics of a typical CDO are illustrated in Diagram A.1In order to understand the sudden growth in the demand for CDOs which in turn led to the financial crisis , it is vital to hear out the reasons behind the growth of CDOs which are as below.Rationale behind growth of CDOsSecuritisation has been a way that helped banks to bundle loans and sell it to investors or make it off-balance sheet items .Once these items are removed from the balance sheet the heavy(p) adequacy gets more space and hence banks make new loans and the process continues. This basically facilitates banks to free up cash and easily meet BASEL norms for capital adequacy.The second rationale is re-allocation of risk.CDOs helps banks reduce the concentration of risk and also create securities as per specific requirements and risk profiles of the investors. This facilitated institutional investors to purchase CDOs as they can invest exactly in highly rated inv estment grade securities.CDOs allowed these investors to gain exposure to assets that, on their own, had been too risky, while investors flavour to take more risk and receive potentially higher returns could buy the most junior or equity CDO tranches.2These are the major reasons behind growth of CDOs . Banks alone thought of their own benefits and growth and the outcome of this action was left to the market to face in reality few years down the lane . The consequences of this act of the highly knowledgeable financial community has been faced by people across the globe.Credit Ratings and CDOs An overviewInvestors invest in securities based on various criteria one such being reliable ratings given by well known credit rating agencies. Credit rating agencies(CRA) were basically formed to guide investors assess risk of fixed income securities. CRAs have played a major role in the growth of CDOs market as investors relied on the ratings given to these complex structures and based the ir investments majorly on these credit ratings. They used credit ratings in place of their due diligence for assessment of CDOs.Credit rating agencies are approved by Nationally recognised Statistical rating organisation(NRSRO) . there are three well known players in the U.S financial market which areMoodysFitchStandard and PoorsThese three agencies rated CDOs and the fees generated by rating CDOs were quite high which led to record profits . The percentage of CDO deals that were rated by the credit rating agencies has been given in the below diagram.Source UBS CDO researchNote The percentage total exceeds 100 as the same instruments have been rated by more than one agency.Revenue earned by the rating agencies has grown since 2002 which has been depicted in the diagram belowSourcethismatter.com/moneyAccording to Mark Adelson, current Chief Credit Officer at SP The advent of CDOs in the mid-1980s was a watershed event for the evolution of rating definitions. Until the first CDOs, r ating agencies were only producers of ratings they were not consumers. With the arrival of CDOs, rating agencies made use of their previous ratings as ingredients for making new ratings they had to eat their own cooking. For rating CDOs, the agencies used ratings as the primary basis for ascribing mathematical properties (e.g., default probabilities or anticipate wantes) to bonds.3Credit rating agencies failed to examine the accuracy of the prior collateral ratings. They also used other rating agencies ratings as base for rating CDOS without verifying accuracy.To adjust for the shortcomings in other agencies ratings they used a system called notching where the rating would be decreased by one notch if the rating has been done by another(prenominal) rating agency.For example , if Moodys is rating a CDO which has a collateral rated BB+ by Fitch , Moodys would consider the rating as BB and plug it into their rating model. No analysis of accuracy had been done and it would be assume d that the notching would compensate for any errors in the rating done by Fitch.Figure below illustrates a comparison betwixt the collateral ratings and the corresponding CDO ratings at the beginning and also the current scenario.This shows that the CRAs somehow gave huge amounts of AAA rated CDO securities from collateral with much lower ratings, reassuring the fact that that main reason why CDOs were so profitable in 2005-2007 is that it was possible to generate a high proportion of highly rated securities from lower quality assets. That practice backfired, resulting in massive downgrades of the CDO tranches as it became apparent that the rating agencies had been overly optimistic. While in 2005-2007, the initial ratings given to CDO tranches were on average better than the ratings of their underlying collateral assets, current CDO tranche ratings are worse than their associated collateral pool ratings which is an firmament that needs attention.The following figure shows the dow ngrades of CDOs over the years. The numbers on the y-axis correspond to the rating scale with lower numbers equal to higher-quality ratings (1=AAA, 22=D).An overview about the credit ratings and CDOs has been done. The following section elaborates the rating methodologies adopted by the rating agencies which have different variables considered for the purpose of rating the complex financial instruments and the assumptions behind them.CDO Rating MethodologyCDOs are based on portfolios of instruments combined together and not on a single loan. Rating these complex structures requires ascertaining a probability of default (PD) to each instrument in the portfolio and involves assumptions relating to recovery rates and default correlations. Thus it combines credit risk assessments of the individual assets and estimates about default correlations using credit risk modelling.There are two widely used methodologies for rating CDOs namelyBinomial expansion techniqueMonte Carlo SimulationEac h method is discussed initially and then a comparison is done between the techniques and their impact on the ratings.Steps in the Rating ProcessThe reliability of a CDO rating depends on the agencys ability to assess the credit risk in the underlying asset pool and accurate modelling of the scattering of cash flows from the asset pool to different groups. All rating agencies generally follow a two stage rating process. In the first stage, analytical models are used to assess credit risk. The tools utilise for analysing CDO pools differ according to the nature of underlying assets and are also based on the rating agencies.The second stage of the process comprises of structural analysis. This stage involves detailed modelling of cash flows, legal assessments and evaluations of third parties knotty in the deal such as asset managers. The results of the cash flow analysis are used as input in the credit model in the form of adjustments in particular model assumptions. Finally, all inf ormation is aggregated and combined into a single, alphanumeric rating which is benchmarked to the historical performance of bonds. range METHODOLOGIESThe famous CDO rating methodology is based on Moodys quantitative approach for determining judge losses for CDO tranches which is called the binomial expansion technique (BET). BET was introduced in the year 1996 and is still used in CDO analysis along with a number of other new methodologies. The method relies on the use of diversity home run (DS) which is used to map the underlying CDO portfolio with a hypothetical portfolio that consists of homogeneous assets equal to the diversity score. For calculating expected loss disseminations a simpler hypothetical portfolio of homogeneous, uncorrelated securities is used in place of the original portfolio. As the number of assets in the hypothetical pool is assumed to equal the diversity score, it will be lower than the number of assets in the actual CDO portfolio to account for uncorrel atedness under the BET.Given the homogeneous nature of the hypothetical portfolio, the behaviour of the asset pool can be explained by DS+1 default scenarios with default occurring for 0 assets, 1 asset, DS assets, where the probability of each scenario is calculated using the binomial formula. After working out the cash flows and losses under each default scenario, the obtained output from the binomial distribution are converted into estimates of the portfolio and tranche loss distributions.An alternative method that is used in by three major rating agencies is Monte Carlo example technique which estimates the default properties of the underlying CDO asset pool based on repeated trials of random defaults with correlation structure that is assumed. In this process, default events are simulated within a credit risk model, where default occurs when the value of assets fall below that of its liabilities. The models main inputs are asset-level probabilities of default and pair-wise cor relations of assets, which are converted into an estimate of the complete pools loss distribution. This distribution is used with other inputs, to determine the required subordination level (level of credit enhancement) for each CDO tranche, where desired tranche ratings are assumed constant or given.MC approaches give more accurate loss distribution estimates, they are computer intensive and take a long time to provide accurate results. specially for cash flow CDOs it is very difficult to construct an efficient MC simulation that accounts for all cash flow nuances .Sometimes it takes hours for an MC simulation to determine the subordination level for an AAA tranche and this can be compound when further assumptions are made. In managed portfolios, the relative value of the simulation approachs asset-by-asset analysis is less while some of the BETs implicit simplifying assumptions (like equal position sizes) closely resemble typical covenants in managed deals. The choice of rating methodology basically considers a trade-off between accuracy and efficiency, and the result may differ for certain types of CDO structures. This is one of the reasons for Moodys to introduce a new Monte Carlo simulation-based method called CDOROM to rate static synthetic CDOs, while it continues to use the BET and its modifications for rating cash CDOs and managed structures.