Requisite OEA disclaimer

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(No Transcript)
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Requisite OEA disclaimer

• The Securities and Exchange Commission, as a
  matter of policy, disclaims responsibility for
  any private publication or statement by any of
  its employees. The views expressed herein are
  those of the presenter and do not necessarily
  reflect the views of the Commission or of the
  presenters colleagues upon the staff of the
  Commission.

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Talking points

• The role of CDO market
• The role of the credit rating agencies
• The role of syndication securitization
• Contagion into other markets
• The role for independent research providers

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The role of CDOs

• Codependency CDO market drives liquidity in
  (subprime) mortgage business (high margin)
  subprime mortgages drive CDO collateral volume.
• CDO pricing not your fathers MBS.
• MBS Investment dependent on quality of
  inventory
• CDO Investment dependent on the quality of risk
  metrics assumptions of the underwriter.
• Risk and reward parameters determined by (IB)
  underwriter in conjunction with credit rating
  agencies.
• Excess spread yield - ? interest payable fees
  expenses
• Spread indirectly driven by the rating of the
  CDO-issued debt.

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Liquidity or solvency?

• CDO structure each position benefits from the
  credit protection of subordinated positions
• Equity tranche typically held by underwriter.
• Thus, investment grade ratings cannot be
  categorically rejected due to sub-prime
  collateral at least for higher tranches.
• Ratings intended to reflect solvency risk, not
  liquidity risk.

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Liquidity or solvency?

• But if the turmoil is merely artificial liquidity
  come to light, why the downgrades?
• July 2007 massive downgrades by all NRSROs.
• Downgrades from A and BB to as low as CCC forces
  many institutional investors to sell immediately.
• October 11, further downgrades by Moodys for the
  2006 first-lien vintage of RMBS
• downgraded 2,200 tranches (33 billion face
  amount) downgraded placed on review for
  further downgrade 320 tranches placed 575
  tranches on review

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Contagion

• Supply chain
• Developers, Contractors, Real Estate, Banking,
  Large appliances, Home furnishings, etc
• Implications for consumer spending
• Equity lines of credit, Unemployment
  implications,
• Equity markets
• International evidence
• Corporation finance?
• Implications for investment policy
• Contagion VS Information effects

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Equity markets

• Hedge Fund short positions require margin
  accounts. 
• CDOs serve as collateral.  
• Subprime defaults, CDO downgrades lower CDO
  valuations 
• Downgrades from investment to junk status
  requires many holders to sell and realize these
  losses. 
• As CDO values fall, so do margin accounts
  supporting short positions, requiring an increase
  in collateral and/or purchase of shorted stocks 
• Upward price pressure on shorted equities 
• Which further increases margin account
  requirement 
• Most liquid source of collateral? Downward price
  pressure on blue chips. 
• Many Hedge Funds (and others) were short many of
  the same stocks as other funds. Unanticipated
  correlation.

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Corporate cost of capital

• Easy Credit?
• Expansion of Covenant-lite lending
• Impacts investment, not just financing.
• Declining marginal return to investment
• Who is affected?
• Companies with different levels of financial
  health react differently to external liquidity
  crises.
• How to accurately assess health?
• Traditional credit ratings favor stability, lag
  markets
• Merton models indicate only the highest
  likelihood of bankrutpcy, not a continuum.

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Different Approach to Measuring Risk

• "The rating agencies predicted exactly zero of
  the 10 biggest disasters of recent years,"
  Hans-Helmut Kotz, president of Germany's central
  bank
• Traditional ratings reflect (preferably
  anticipate) solvency risk.
• Rapid Ratings corporate ratings reflect a
  combination of solvency, liquidity, sales
  performance, leverage, cost structure, and
  profitability risk, which together
  synergistically generate financial health risk.
• If traditional ratings are used uncritically as
  inputs for contagion models, they may increase
  inaccuracy and risk rather than reduce them.
  Quantitative models that consistently outperform
  traditional ratings are a solution.

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Déjà vu all over again?

• One hundred thousand lemmings cannot be
  wrong.
• We thought we were in the top of the eighth
  inning, when we were in the bottom of the ninth
• Stanley Druckenmiller

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Lessons from this cycle

• The role of syndication securitization
• Risk sharing liquidity
• Monitoring perverse incentives
• CDOs differ from corporate bonds and ABS
• Reliance on CRA certification
• The role for independent research providers

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CDOs are different

• ABS, MBS AND CDO COMPARED AN EMPIRICAL
  ANALYSIS Vink Thibeault (2007)
• Average (median) spreads significantly higher for
  CDO
• CDO 162.4 basis points (95.0 basis points)
• MBS 75.7 basis points (45.0 basis points)
• ABS 99.2 basis points (50.0 basis points)
• CDO more than twice as likely to have currency
  risk
• 39.8 vs 17.2 MBS or 13.3 ABS

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CDOs are different

• Insufficient historical data to estimate default
  probability?
• Divergent estimated default probability
• one-year AAA CDO one-year AA corporate bond
• three-year A CDO three year BBB ABS
• CDO default probability exceeds ABS in each
  rating category by 3X
• (see SP CDO model released mid-2006)
• CDO downgrades more severe
• 10-12 notch declines in July 2007

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Reliance on issuer-reported financial information

• Our ratings opinions are based on public
  information provided by the issuer, audited
  financial information, and qualitative analysis
  of a company and its sector.We are not auditors,
  we do not audit the auditors of the companies
  that we rate or repeat the auditors accounting
  work, and we have no subpoena power to obtain
  information that a company is not willing to
  provide.
• Ronald M. Barone before the Permanent
  Subcommittee on Investigations of the Committee
  on Government Affairs, U.S. Senate July 23, 2002

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So contagion?

• Yes, implications beyond the housing sector
• Yes, potential tightening of corporate credit
  markets
• But more an information effect than contagion?
• Need for greater focus on screening / monitoring
• A role for independent research providers

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Reference material

• Bookstaber, R., 2007, A Demon of Our Own Design
• Caragata, P., 2007, The Sub-Prime Crisis,
  Contagion, Valuation Issues and the Measurement
  of Financial Health, Rapid Ratings International
  Inc.
• Feldstein, M.S., 2007, Housing, Credit Markets
  and the Business Cycle, NBER working paper 13471
• Mason, J. R., 2007, Liquidity, Ratings, and Bond
  Insurance, Drexel University
• McKinsey Co on Corporate Investment Banking,
  Number 4, June 2007
• SEC Report on the role and function of credit
  rating agencies in the operations of the
  securities markets As required by Section 702(b)
  of the Sarbanes-Oxley Act of 2002
• Popular Press The Economist, Financial Times,
  etc.