LO 34.7: Assess the rating o f C D O s by rating agencies prior to the 2007 financial

LO 34.7: Assess the rating o f C D O s by rating agencies prior to the 2007 financial crisis.
The average investor has a very difficult time understanding securitized financial products, like collateralized debt obligations (CDOs). As such, they have come to rely on the stamp of approval from a third party that is thought to be independent. Rating agencies, like Moodys Investors Service, Standard & Poors, and Fitch Ratings, have profited from investors need for supposedly independent ratings on complex financial products. From 2000 to 2007, Moodys rated nearly 43,000 mortgage-linked securitized products. Over half of this group of 43,000 received a AAA stamp of approval. By comparison, only six U.S. private sector companies had such a rating during this same time period.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
Professor’s Note: The Financial Crisis Inquiry Commission (FCIC), which was established by Congress, found that 73% o f the pool of securitized products rated AAA by Moody’s had been downgraded to junk bond status by April 2010.
Part of the push for solidly investment-grade ratings is that insurance companies, pensions, and money market funds have regulatory and internal requirements that only allow investments in investment-grade assets. Based on this level of demand and the fact that the rating agencies all had a profit motive, they were very willing to provide high ratings for many securitized products. The process would start with rating any tranche possible with a AAA rating. Then the typical next step was to repackage below-AAA rated tranches into new CDOs whereby another group emerged as AAA-rated because the default risk kept being pushed down further and further to the lowest equity tranches. This process would be repeated a few times until a substantial portion of securitized products received the coveted AAA stamp of approval.
When adjustable rates loans reached their reset periods and default rates rose well above any previously considered margin of safety, downgrades ensued en masse. By their very nature, the downgrades drove down prices, but this cycle was further compounded because once the assets were downgraded below investment-grade, every insurance company, pension fund, money market, and bank with capital constraints had to sell as well. Investors were not so much buying an income stream as they were buying a AAA-rated income stream, and once default rates began rising, the downward spiral of prices began.
In fairness to the rating agencies, it is also important to understand an alternate interpretation beyond merely a profit motive that caused the inaccurate ratings. The Financial Crisis Inquiry Commission (FCIC) found that the rating agencies were influenced by flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight.
The competitive pressure between these rating agencies, two of which are publicly traded, was intense. Flowever, the competition did not translate into substantial salaries for key employees in the rating process. The result was that the best employees would leave the rating agencies and go to work for the financial firms who were actively securitizing products. The benefit to the originators was that the converted employees knew the internal ratings guidelines at the ratings agencies. For example, in order to achieve a AAA rating, a securitized product needs to have an average FICO score of 613 for all borrowers in the pool. Equipped with this knowledge, the originators could then package pools of loans with mostly 330 scores and just enough 680s to bring the average up to 615. This translated into higher default probabilities than should have naturally existed for a 615 rated borrower. There should have been more focus on the dispersion of credit scores and not just the average for the pool.
As the FCIC uncovered more details, they found many flaws in the system. The profit motive was paramount, but it drove creative packaging by the originators. The profit motive was also influenced by the competitive landscape of the industry. The profit motive will always exist in the world of high finance. What investors need to understand is that they need to dive deeply into the risk profile of any asset before adding it to their portfolios.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
K e y C o n c e p t s
LO 34.1
There were three key underlying flaws in the securitization process that led to the 2007 2009 financial crisis. The first is that members of the securitization supply chain were incentivized to find borrowers, sell them a loan, and package that loan for resale without retaining any default risk. This led to lax lending standards. Second, the securitized products themselves were very opaque. Neither investors nor the rating agencies that they relied upon fully understood how to evaluate their potential risks. Third, financial institutions use of off-balance-sheet techniques to hold securitized loans further disguised the risk spectrum from investors.
LO 34.2
The traditional bank credit function can remain robust in a world of concentrated risks by utilizing credit risk transfer techniques, including bond insurance, collateralization, termination, reassignment, netting, marking to market, syndication of loan origination, or the outright sale of a loan portfolio in the secondary market.
LO 34.3
The originate-to-hold model involves originating a loan using a binary approval process and then holding the loan until maturity. In this case, the lender retains all credit risk and the loan origination process will therefore be more stringent. The originate-to-distribute model enables lenders to originate a loan based on risk-reward pricing and then outsource the risk through various channels. This provides better access to capital for less creditworthy borrowers and more diversification options for investors.
LO 34.4
Credit derivative products, such as credit default swaps, first-to-default puts, total return swaps, and asset-backed credit-linked notes are all innovations that separate default risk from the underlying security. They offer the ability to insure and transfer specific risks to both investors and insurance sellers.
LO 34.3
A collateralized debt obligation (CDO) is an asset-backed security that can branch into corporate bonds, emerging market bonds, residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), real estate investment trust (REIT) debts, bank loans, other forms of asset-backed securities backed by auto and credit card loans, and even other CDOs. A collateralized loan obligation (CLO) is a specialized form of CDO that only invests in bank loans.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
LO 34.6
With a synthetic CDO, the originator retains the reference assets on their balance sheet, but they transfer credit risk, in the form of credit default swaps, to an SPV which then creates the tradable synthetic CDO. This derivative product is used to bet on the default of a pool of assets, not on the assets themselves. A single-tranche CDO is a highly customizable offshoot from synthetic CDOs. Investors can customize their maturity, coupon, collateral, subordination level, and target rating.
LO 34.7
Rating agencies were at the core of the selling process of securitized products, such as CDOs. The average investor could not understand the complex products, so they relied on the stamp of approval from the ratings agencies, who were biased by their profit motive and were often unable to fully understand the securitized products themselves.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
C o n c e p t C h e c k e r s
1.
Which of the following statements was not one of the flaws in the securitization process prior to the start of the credit crisis in 2007? A. An active originate-to-distribute model where a strong profit motive took
precedence over ethical lending and underwriting.
B. The securitized products were so opaque that investors could not evaluate the
true risks of the investment.
C. Structured investment vehicles (SIVs) were used to enhance the risk discovery
process for investors and regulators.
D. Banks held securitized assets in off-balance-sheet entities, thus further masking
the true risks in the system.
2.
3.
Which of the following statements is not correct regarding total return swaps (TRS)? A. A TRS is designed to mirror the return on an underlying asset like a loan, stock,
or even a portfolio of assets.
B. The payer pays any depreciation in the underlying asset to the receiver. C. The payer pays any dividends or interest received to the receiver. D. The receiver is creating a synthetic long position in the underlying asset.
XYZ Hedge Fund wants to get exposure to a high-yield pool of commercial loans without actually investing in the loans. It wants a leverage ratio of 7.3. If the hedge fund is willing to invest $33 million in this investment, which credit derivative is best for them and what is their expected return given that the reference asset earns LIBOR plus 285 basis points, the counterparty earns LIBOR plus 150 basis points, and the required collateral earns 3.5%? A. Total return swap with a 13.63% return. B. Asset-backed credit-linked note with an 11.34% return. C. Total return swap with an 11.34% return. D. Asset-backed credit-linked note with a 13.63% return.
4.
Which of the following statements describe part of the risk mitigation process for a collateralized debt obligation (CDO)?
I. Default risk is restructured in such a way that previously lower-rated issues can
be re-formulated into highly rated debt instruments.
II. The equity tranche has no certain return and bears the highest level of default
risk. A. I only. B. II only. C. Both I and II. D. Neither I nor II.
5.
Which of the following was not a cause of the misalignment between investors and rating agencies incentives prior to the credit crisis of 2007-2009? A. Profit motive of the rating agencies. B. Pressure from the originators of securitized products. C. Manipulation of the ratings process by the originators. D. Investors lack of understanding of the products they were purchasing.
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Topic 34 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 12
C o n c e p t C h e c k e r An s w e r s
1. C Structured investment vehicles (SIVs) were actually used to create further layers of
opaqueness. These are the off-balance-sheet entities used by banks to hold securitized products in a way that made them very difficult for investors to scrutinize.
2. B A total return swap transfers both credit and market risk. The payer only pays any
appreciation and any dividends or interest connected with the underlying asset. The receiver is responsible to pay the payer any depreciation in the underlying asset.
3. D The best credit derivative for this hedge fund is an asset-backed credit-linked note. With leverage of 7.5 and an investment of $35 million, we know that the notional value of the pool of commercial loans is $262.5 million. The hedge fund will earn 3.5% on their $35 million in collateral. This translates into $1,225 million. They will also earn the 135 basis point spread on the entire $262.5 million. This translates into $3.54375 million. The hedge funds percentage return is 13.63% [($1,225 million + $3.54375 million) / $35 million].
4. C The default risk in a CDO is structured through various tranches in such a way that a pool of assets that were once lower rated could be AAA rated after the securitization process. The equity tranche is the most junior tranche. Therefore, it offers the highest return potential but with no certain return. The equity tranche also bears the highest level of default risk.
5. D According to the findings of the congressionally formed Financial Crisis Inquiry
Commission, the root causes of the misalignment were the flawed computer models at the rating agencies, the profit motive of the rating agencies, pressure from the originators, the drive for market share coming from the rating agencies, the rating agencies lack of provided (not available) resources to conduct the proper due diligence, and the absence of meaningful public oversight. A thorough post-audit of the crisis will also reveal that originators also manufactured the securitized products to specifically arrive at a AAA rating given their acquired knowledge of the rating agencies decision flow charts.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
A n In t r o d u c t i o n t o S e c u r i t i z a t i o n
Topic 35
E x a m F o c u s
Securitization is the process of selling cash-flow producing assets to a third party special purpose entity (SPE), which in turn issues securities backed by the pooled assets. Mortgage- backed securities (MBSs) securitize residential mortgages where the property serves as the collateral. For the exam, be prepared to discuss the securitization process of selling cash-flow producing assets to a special purpose vehicle (SPV) and contrast the differences between amortizing, revolving, and master trust structures. Also, be familiar with the different types of credit enhancements, and be prepared to define and calculate the various performance tools for securitized structures discussed.
S e c u r i t i z a t i o n P r o c e s s

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