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Problems of the Credit Rating Agencies

Introduction

On July 18th, 2007, while referring to adjustable rate mortgages (ARM) (also known as subprime mortgages) bonds, an executive of the Fitch's residential mortgage group said "We continue to be confident that "AAA" ratings reflect the high credit quality of those bonds". Since then, between 2008 and 2009, 140 US banks declared bankruptcy while the International Monetary Fund now estimates world banks' global losses due to loans and credit derivatives to approximate $4.1 trillion. If the subprime crisis has been the crisis of credit, it has also been the crisis of credit rating.

Credit Rating Agencies (CRAs) (namely the tree major ones: Fitch Ratings, Moody's Investors Service and Standard & Poor's) have been under a lot of criticism in the recent credit crisis. Indeed, not only have CRAs been accused of making errors of judgment in rating structured debt securities, but also of operating a biased business model in an oligopolistic market.

As a matter of fact, bond issuers, government regulators and investors have now lost their blind faith in credit ratings and therefore feel the compelling need to change, reorganize and restructure the CRA current business model and industry. Even though CRAs cannot be considered the sole responsible agent for the credit crisis, they have encountered great irregularities and problems: How can they be fixed? What solutions should be implemented to prevent the next credit crisis from happening? How has the credit and CRA crisis affected the leveraged finance industry?

To tackle this question, we will first analyze what criticisms credit rating agencies have been subject to and what problems have been identified in the recent years. By evaluating different solutions and suggesting necessary changes, we will then examine how the credit rating business model and market structure could be improved. Finally, as it directly relates to the credit market and CRAs, we will study the impact of the crisis on the leveraged finance industry, with a special focus on leverage buyouts, buyout debt financing and structured finance.

Section1: Current problems of the Credit Rating Agencies' business model

Though many other players, such as lenders, borrowers, regulators, issuers, and macro factors, can be associated with and blamed for the current credit crunch, Credit Rating Agencies (CRAs) have been accused of being the main actors behind the malfunctioning and mispricing of the credit markets. Not only have CRAs been blamed for misrating complex structured debt products[1] and other subprime mortgage related products, but also of operating a biased business model in an oligopolistic market.

In this first section, we will summarize these three main accusations and analyze in detail the validity of each argument. Solid and pertinent recommendations can only be made if the true problems have been identified.

By analysing Moody's financial statements, we can observe that between 2002 and 2006, Moody's profits nearly tripled because of the growth of structured products, accounting for more than 40% of its total revenues in 2006, and the higher margins charged for these products.  Given the revenues generated, one would expect that CRAs did control the rating of these products. Now, after the default rate on adjustable rate mortgages (ARMs) reached its peak during the crisis and collateralized debt obligations (CDOs) became worthless, CRAs defended themselves by explaining how sophisticated these products were and how hard it was to rate them. This leads us to question, did CRAs rate products they did not understand?

Before the mortgage market collapse, analysts like John Paulson expressed incredulity at what appeared to be a complete mispricing of the structured debt products and began predicting that the market would crash:

"For me it was so obvious that these securities were completely mispriced and we were living in a casino. I think the other players that were involved in the business got caught up in the exuberance, [...] in the competition to increase their underwriting volumes, [...] to increase their fees. They were very focused on annual earnings, quarterly earnings and annual bonus pools and with the amount of the liquidity, everyone got caught up in what became a massive credit bubble." (Distressed Volatility 2009)

Mark Zandi, an economist at Moody's, noted in a report on U.S. Macro Outlook published in May 2006, that household debt was at a record and a fifth of such debt was classified as subprime. Unfortunately, the economic forecasting division is separate from the ratings division of the corporation. But how could CRAs not foresee the crisis and the flaws of their valuation models?

The model used to rate structured products has been criticized for two reasons. First, Moody's rating model for assessing CDOs is a statistical model reliant on historical patterns of default. The main assumption behind this model is that past data would remain relevant, even during a period in which the mortgage industry (and its related products) was undergoing drastic change. Second, the use of this model revealed "a large failure of common sense" (Lowenstein, Triple-A failure 2008)by rating agencies as very complex securities shouldn't have been rated as plain vanilla bonds, for which the model was designed. CRAs were checking their statistical model, but not the underlying assets.

As a consequence, Moody's noted in April 2007 that the model "was first introduced in 2002. Since then, the mortgage market has evolved considerably with the introduction of many new products and an expansion of risks associated with them" (Mason 2007) and thus revised the model it used to evaluate subprime mortgages.

Similarly, in a response letter to Roger Lowenstein's "Triple-A failure" article, Vickie Tillman, Executive Vice President of S&P's Rating Services claims that her company's rating model includes both historical data and informed assumptions to assess credit quality. This adjusted model doesn't seem to solve the accuracy problem. Deven Sharma, president of S&P, admits "[...] historical data we used and the assumptions we made significantly underestimated the severity of what has actually occurred" (Sharma 2008)

Even though one can acknowledge the greater complexity of CDOs and the difficulty of accurately assessing the risk profile of these products, the CRAs defence doesn't seem justifiable given the source of wealth these structure products represents to them. One would expect that CRAs would only provide a service they understood. There is still plenty of room for improvement in their models. Research led by Skreta and Veldkamp (Skreta and Veldkamp 2009) suggests that the complexity of any given asset hasn't increased but rather that the more complex types of assets became more prevalent. Indeed, when combined with the phenomenon of rating shopping, where issuers shop from one CRA to another to pick the best rating possible, asset complexity can lead to rating inflation and biased judgment. As a consequence, failure to address potential sources of bias inherent in the business model of the ratings industry could generate future problems. This discussion leads us to the conflict of interest inherent in the issuer-pay model, the second main accusation in our analysis.

The conflict of interest between CRAs and bond issuers has been identified as the main problem because it drives the entire CRA business model. This conflict of interest between rating agencies and the bond issuers from whom they receive fees undermines the CRAs ability to give an unbiased assessment of credit risk.

There are two types of potential conflicts of interest inherent in the issuer-pay model that may arise from the activities of the CRAs. The first is that rating agencies may be enticed to give better ratings in order to continue receiving service fees. Since CRAs' revenues come from issuers, this conflict can lead to an agency problem. The second potential conflict relates to the consulting services CRAs provide to help the issuer to better design products to meet their model's different thresholds. In both cases, CRAs run the risk of the issuer going to a different rating agency, which leads to the phenomenon of ratings shopping.

Up until the 1970s, the investor-pay business model of credit rating agencies was straightforward: investors bought a subscription to receive ratings. It was during the 1970s that the business model evolved into an issuer-initiated ratings system where the issuers of securities began paying to be rated. Free riding by investors, leading to a reduction in profits for credit rating firms, was the main reason for this transition. As White (White 2002)observes, this shift also coincided with the rise in popularity of the photocopying machine. Although the issuer-pay business model has been around for more than forty years now, concern over ratings bias only recently emerged. Indeed, the conflict of interest, amplified by the rise of complex structured financial products, calls into question the objectivity of ratings that are critical to the efficiency of the market. (Levitt, Conflicts and the Credit Crunch 2007)

In response to these accusations, CRA executives have maintained that the issuer pay model is not contradictory to the efficiency of their business model. It seems that a firm cannot support both issuers and investors simultaneously. In fact, the Report of the Staff to the Senate Committee on Governmental Affairs during the Enron case[2] cited empirical evidence:

"The conflict appears to be particularly acute for large important issues such as [...] Enron [...]. In these cases investors desperately need guidance from credit rating firms, but often do not get it because of pressure from issuers, [...] and in some cases, SEC officials". (Egan and Jones 2010)

However, CRA executives have also asserted that CRAs have nothing to benefit from adjusting their ratings to their client's needs because they have a reputation to uphold. In June 2007, S&P claimed that "reputation is more important than revenues" (Becker and Milbourn 2009) thus asserting that maintaining a good reputation had been a sufficiently strong motivating factor for CRAs to keep their high levels of efficiency and objectivity. In reference to this assertion we can ask ourselves: is reputation a sufficient motivating factor to maintain discipline among rating agencies?

As a matter of fact, research led by Mathis, McAndrews and Rochet (Mathis, McAndrews and Rochet, Rating the Raters: Are Reputation Concerns Powerful Enough to Discipline Rating Agencies? 2009)has suggested that this argument is only valid when a large fraction of the CRA revenues comes from other sources than the rating of complex products. When the reputation of a CRA is good enough, and rating complex products become a large source of revenues (more than 40% of Moody's revenues), the CRA will become too lax and inflate its ratings. This mechanism builds on a three-step reputation cycle, ultimately resulting in crises of confidence where a single default provokes a complete loss of reputation by the CRA. First, the CRA tries to build and improve its reputation and gain investor's trust by being very strict. Then, once a positive reputation has been gained, the CRA issues more ratings and takes advantage of its reputation. This is when CRAs become more lax and the risk of default increases.  Ultimately, when default occurs, there is a crisis of confidence: the "opportunistic" CRA is detected and its reputation is very negatively affected. This reputation cycle, which is also a confidence cycle, explains why opportunistic CRA are hard to spot and why ratings biases only recently emerged as a concern in response to inquiries from Vailiki Sketra (Sketra and Veldkamp 2009).[3] To exemplify this concept of reputation cycle, scholars find that CRAs are more likely to understate credit risk in booms than in recessions (Bolton, Freixa and Shapiro, The Credit Ratings Game 2009).

Moreover, reputation seems greatly affected by competition, as it will reduce the effectiveness of the reputational mechanism for two main reasons.  First, reputation is only valuable if there are future producer rents. As a result, the incentive for maintaining a good reputation is reduced by competition. Second, from a microeconomical approach, if the demand elasticity facing individual sellers is higher in a competitive market, the temptation to either reduce prices or otherwise attract business may be stronger which undermines the quality of output. Therefore, the conflict of interest is not solved by reputation concerns.

The second aspect of the conflict of interest relates to the collaboration between CRAs and issuers when designing a debt security. Lewis Ranieri, a pioneer in the mortgage bonds market, once said "The whole creation of mortgage securities was involved with a rating" (Norberg 2009). As a consequence, starting in the 1990's, CRAs started to offer consulting and advisory services to issuers to improve their ratings; a process that involves extended consultations between the agency and its client. The collaborative process that ensues is as follows: issuers propose a rating structure on a pool of debt. Then, the CRA will usually request a cushion of extra capital, known as an "enhancement," to meet the necessary conditions for a specific rating. This practice can be dangerous because it is the CRA's responsibility to ensure that the cushion is big enough to safeguard the product, but issuers will try to minimize this extra capitalization in order to maximize their profit margin. Inside the CRAs, consultants and raters were meant to be strictly separated by a 'Chinese wall'[4]. Regardless, CRAs (namely Moody's) began providing unsolicited ratings and offering consultancy services to improve them. Mr. Arthur Levitt, a former chairman of the Securities and Exchange Commission, pointed out in a recent article in the Wall Street journal that the conflicts of interest arising from such activities are the central problems with CRAs:

"[Credit rating agencies] are playing both coach and referee in the debt game. They rate companies and issuers that pay them for that service. And, in the case of structured financial instruments, which make it possible to securitize all those subprime mortgages, they help issuers construct these products to obtain the highest possible rating. These conflicts are hard to spot because transparency among these agencies is murky at best, and currently it is difficult to hold these agencies accountable for any wrongdoing" (Levitt, Conflicts and the Credit Crunch 2007)

The agencies are aware of the conflicts that are inherent to their business model but they claim that they are doing their best as to avoid them. In a letter to Roger Lowenstein's "Triple-A failure" article, Vickie Tillman, Executive Vice President of S&P's Rating Services defends her company's business models and practices:

"At Standard & Poor's, we recognize the business model we use may raise potential conflicts of interest. That's why we have always had rigorous policies in place to manage conflicts, and why we currently are implementing additional measures to further strengthen the independence and quality of our ratings opinions. [...] the role ratings firms play in the market [...] is to provide independent assessments of the creditworthiness of bonds."             

In order to make up for these practices, the US Securities and Exchange Commission (SEC) issued a release in February 2007 proposing rules which would identify the issue of unsolicited credit ratings (those not issuer-initiated), as unfair, coercive, or abusive, and thus would prohibit Nationally Recognized Statistical Rating Organizations (NRSROs) from releasing unsolicited credit ratings.  Even though the SEC intervention seemed necessary, it didn't change the industry's business model: by 2007, the mortgage boom had already reached its peak.

Regardless of the criticism surrounding the relationship between issuers and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand, which clearly indicates a crisis of the issuer-based model. CRAs' misbehaviour has played a central role in the current subprime mortgage crisis. As such, the governments and regulatory bodies should take steps forward to correct the current business model. We shall therefore investigate alternatives to this model in Section 2 of this paper.

This conflict of interest leads us to ask, who finally owns the ratings? The evidence regarding whether rating agencies bend to the issuer's will is mixed.

A paper written by contract-theory scholars, Faure-Grimaud, Peyrache and Quesada (Faure-Grimaud, Peyrache and Quesada 2007) investigates this issue by looking at corporate governance ratings in a market with truthful CRAs and rational investors. They show that at equilibrium, in a monopoly, a CRA will fully disclose information but that issuers may prefer to suppress their ratings if they are too noisy because full disclosure is impossible even when firms have the possibility for ownership (i.e., the right to disclose the rating). Additionally, they find that competition between rating agencies can result in less information disclosure since CRAs make zero profit and fully disclose information on firms that have values higher than the CRAs' marginal observation cost.

In fact, the current business model seems to favour the banks in their quest to receive better ratings. Dr. Joseph Mason compared default rates for corporate bonds to equally BAA-rated CDOs before the bubble burst and found that the CDOs defaulted more than ten times as often (Mason 2007). While, as we discussed earlier, it may be true that CDOs are much more complex securities than plain-vanilla bonds, another interpretation of the data is that CRAs were much more lax when dealing with a Wall Street securitizer as client. But who can blame them? While it is true that on the traditional side of the business (unsophisticated bond rating) CRAs have a large variety of clients (virtually every corporation and municipality that issues public debt), this is not the case in structured finance. On the contrary, the panel of clients is much smaller and the fees are much bigger. The only issue is that the client pays only if the CRA delivers the desired rating. If they do not, the client can either adjust the numbers or take another chance with a competitor, a process known as "ratings shopping".

Brian Clarkson, former president and CEO of Moody's Investor's Service acknowledged, "There is a lot of rating shopping that goes on. What the market doesn't know is who's seen certain transactions but wasn't hired to rate those deals" (Bolton, Freixa and Shapiro, The Credit Ratings Game 2009). In fact, an important feature of the credit ratings market microstructure is the capacity for a security issuer to choose which ratings to purchase. During this process, a structured debt product is issued and the issuer typically proposes a structure to a CRA. The issuer then asks for a "shadow rating," which remains private between the CRA and the issuer, unless the issuer pays to make the rating official.

Such choices can reflect both explicit and implicit shopping for desired credit reviews and induce a selection effect in the rating process. Selection highlights the relation between the decision about whether to rely on unsolicited ratings and the potential for ratings shopping, illustrating how different types of potential conflicts of interest in the credit rating process could interact. Indeed, shopping for ratings is a practice at the heart of the different conflicts of interest we mentioned above, as it partly invalidates the reputation argument because there seems to be a trade-off between reputation concerns and the risk for ratings shopping. It also encourages CRAs to strengthen their ties and relationship with issuers, most notably by offering a wider range of services. In an interesting paper, Skreta and Veldkamp (Sketra and Veldkamp 2009) examine cherry-picking in ratings, especially for securitization, by issuers who shop for the highest ratings in order to obtain the highest price when selling to naive or little-informed investors. They highlight the influence of risk aversion in motivating the purchase of multiple ratings. Indeed, because investors are risk-averse, they will try to invest in the best-rated securities for an expected yield without having to asses the risk of every security they may be interested in, and thus rely heavily on ratings. The more ratings they have for a security, the more likely they will be to invest in it. Skreta and Veldkamp (Sketra and Veldkamp 2009) conclude that when combined with asset complexity, rating shopping can lead to rating inflation and thus biased judgment. To support that evidence, Kurt Schacht, managing director of the CFA Institute Centre explained that CRA executives

"[...] were concerned about the hype and insinuation that CRAs easily inflate their ratings in response to pressure from issuers and issuers, implicating the integrity of their process and ratings. In exploring that topic, we were very surprised by the results of our member poll where some 211 of the 1,956 respondents said they have indeed witnessed a CRA change ratings in response to external pressures" (CFA Institute 2008).

As a consequence, not only does ratings shopping enhance ratings distortion, but it also corrupts the entire rating process by giving issuers an incentive to trick their clients into buying overrated securities.

A third and final issue to investigate is the lack of competition in the credit-rating industry.  According to The Economist (The Economist 2007), Moody's and Standard & Poor's dominated the industry by controlling about 80% of the total market in 2007. The third-place competitor, Fitch, had only about 15% of the total share that same year. The current form of these institutions received legal status when the SEC introduced the notion-barrier of the NRSROs in 1975. The rest of the market is divided among only a few other institutions that have received legal status.  While alluding to the dominance of Moody's and Standard & Poor's in the credit market, the U.S. Department of Justice has referred to the credit-rating industry as a "partner duopoly" (Laing 2007). As noted by Jonathan R. Laing, a partner duopoly differs from an oligopoly because the partners in the duopoly do no face fierce competition against each other because "one's good fortune in winning a piece of business is typically followed by the other's receiving the same deal at the same lush fee level" (Laing 2007).This duopoly has proven quite profitable, as Moody's operating margin is typically around 50% (if not more) better than Microsoft, Accenture, Intel, Nike or Coca-Cola. In fact, according to Congressman Henry Waxman's statement during the Congressional hearings in October 2008, Moody's had the highest profit margin of any company of the S&P 500 index for five years in a row. An important complaint arising from this situation is that the lack of competition permits the main players "to shirk, engaging in less effort and research that if they were true active competition" (Coffee 2006). It may therefore seem that a free market would ensure competition among its CRAs guaranteeing a higher quality and lower price of the ratings. For that reason, competition from new agencies might create a healthy diversity of opinion, leading to more accurate assessments of debt issuers' default probabilities

Many scholars have analyzed whether this industry structure contributes to the efficiency of the global credit market. We shall investigate in further detail what seems to be the optimal market structure in the next section by examining the solutions and changes necessary to combating the various issues we have so far considered.

Other scholars recognize that the existing duopoly may present risks to the market, especially since the 'two-rating' norm is still in full force. Furthermore, since the CRA business model is reputational-driven business, new competitors may face very high barriers to entry. The CRA industry could therefore not allow for more participants. On the other hand, some scholars suggest that the SEC's role in both creating and perpetuating this duopoly by which establishing the status and necessary requirements to become a NRSROs, and an official registry. Since competition can both be seen as a problem and as a solution to the CRA industry and business model, we shall now examine the different initiatives that can be undertaken to improve the overall model and functioning of the credit rating market.

Section2: Solutions to fix the identified problems

The subprime crisis has brought to light the poor performance of CRAs in rating structured financial products and reminded investors of CRA's past poor performance in predicting the East Asian crisis and the collapse of Enron[5]. Either directly by regulations, or by market force, there are strong signals that the credit rating business is about to change. The main accusations we previously addressed and the perception that CRAs contributed to the financial crisis led to various investigations and calls for reform. In this section, after briefly presenting CRAs' reaction to criticism, we will first analyze the different alternatives suggested by scholars and experts to the current business model and the overall industry structure. We will then study the different reforms and regulatory recommendation that have been suggested to the current business model that would improve CRAs' effectiveness and enhance the overall market efficiency. Finally, once these changes examined, from a regulatory standpoint, we will observe the measures recently adopted by both the European Union and the US government (and regulating agencies), determine how the approaches differ and how necessary regulation is.

CRA's reaction to accusations

CRAs have responded to the allegations with cries of innocence.  If some rating firms claimed that they did nothing wrong and have indicated that they will cooperate openly in any investigation that comes their way, others  did acknowledge some mistakes and have announced the intention to reform their practices.  For example, spokespersons for Moody's, Standard & Poor's and Fitch have claimed that their organizations "will demand more data and more verification and will subject their analysts to more outside checks" (Lowenstein, Triple-A failure 2008) However, some may say that CRAs might have implemented these changes simply to avoid further criticism and regulatory intervention.  Indeed, as Lowenstein claims, "none of this [...] will remove the conflict of interest in the issuer-pays model" .  We shall further analyze the case for self regulation in our analysis.

In their effort to defend themselves, the CRAs have sought to minimize their role and influence within the financial industry.  According to a spokesperson for Moody's:

"We perform a very significant but extremely limited role in the credit markets. We issue reasoned, forward-looking opinions about credit risk. [...] Our opinions are objective and not tied to any recommendations to buy and sell" (Benner and Lashinsky 2007)

The consensus of these critics is that "the agencies dropped the ball by issuing investment-grade ratings on securities backed by subprime mortgages they should have known were shaky" (Benner and Lashinsky 2007)

Rather than accept responsibility for their own lack of diligence, the major CRAs have sought to "lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans" (Lowenstein 2008).  Of course, it must be noted that other groups and individuals share the responsibility for the global financial downturn.  As Laing says in regard to CRAs, "they were just one link in a subprime production line that stretched from sleazy storefront mortgage brokers, corrupt appraisers and avaricious originators to fee-crazed securitizers and, yes, mendacious borrowers" (Laing 2007).  Nonetheless, as Laing further notes, CRAs must be seen as "key enablers" in the problem's development. 

i) New agency industry structure and business model

Proposals have been made to improve the credit-rating system and thereby reduce the problems we identified. First, it seems that CRA need more independence. As Laing suggests it, many of the changes implemented in the auditing industry with the Sarbanes-Oxley Act could be similarly carried out. (Even though one may discuss whether this Act has improved capital markets transparency or not, one must note it has enforced the implementation of internal control, due diligence and transparency procedures in firms)For instance ratings agency employees should be prohibited from accepting any favors (whether it is money of gifts) from their clients and the leading analyst should rotate from a client to another with a certain frequency and should wait at least one year before joining their clients' firm (an issuer or investment bank in this case) Laing also suggests that the 2003 SEC proposal, which prohibits the linkage of analyst compensation with new business development, could be reenacted.

First, CRAs should be more transparent in two distinctive ways. The global credit market needs greater transparency about CRAs' overall rating model: rating assumptions, methodologies, but also the fee structures, and past performance. To be more transparent CRAs should follow stricter disclosure requirements (as mentioned in the Rating Agency Act in 2006). Professor Charles W. Calomiris (Calomiris 2009) suggests that, more disclosure could also be required for publicly traded companies with rated debt when filling in debt-offering documents Particularly, in order to prompt CRAs to reduce or eliminate their conflicts of interest, they should disclose any structuring service or consulting-related activity (and the fees related to such practices) provided to a company in connection with the rating of fixed-income securities

Second, there is a strong need, expressed by both scholars and analysts, for a clear distinction between the rating of structured products and traditional debt products and thus different rating symbols could be used so as to avoid confusion. The issue is, not all AAA-rated securities are created equally. As demonstrated in the current credit crisis and as proven by Drexel University finance professor Joseph Mason, CDOs receiving a Baa rating from Moody's were more than ten times as likely to default as similarly rated corporate bonds (Mason 2007). As a matter of fact, despite the identical symbols, structured products typically do not have the same risk profile as traditional corporate bonds. By nature, whereas corporate default can be estimated by very few factors (namely the level of leverage of the firm and its capacity to generate stable cash flows from operations), "default on structured debt is dependent on hundreds or thousands of individual defaults [e.g., an underlying mortgage pool] that are estimated given some distribution. They are not the same analysis so they should not be the same ratings." (CFA Institute 2008) A different rating scale according to the risk profile of the products could be used as to not mislead investors into buying misrated securities. As an alternative, Professor Coffee at Columbia University suggests the SEC could define a maximum default rate for different class of ratings, so that if a CRA's ratings were to exceed SEC parameters, it would loose their NRSRO status. (Coffee 2006) Building on this, the entire rating nomenclature could be changed and ratings could be expressed quantitatively as to avoid grade inflation in CRAs' opinions. Indeed, in contrast to numerical estimates (of the probability of default (PD) and loss given default (LGD)),which do have objective and quantifiable meanings, letter grades leave more room for subjective manipulation and estimation and thus have no objective meaning that can be evaluated. Moreover, quantitative ratings could be associated with legal sanctions: a CRA could be penalized for systematically underestimating risk over a significant period of time. In such a situation, forcing CRAs to express ratings using numbers could alter their incentives dramatically as they would see their civil liability enhanced.

As we've noticed it in the first section, these misaligned incentives led to conflicts of interest within CRAs. Implementing difference policies and changing the rating process within the CRA business model could limit these incentives.

CRA Self-Regulation

"Exchanges are self-regulating. Ratings can be as well. But the incentives should be established so that their interests are aligned with investors" (CFA Institute 2008) and for that matter, CRAs should regulate themselves. Self regulation can have different meanings.

First CRAs could enhance their internal oversight and compliance procedures by having an executive-level committee that includes investors as members, which would ensure full implementation and enforcement of the International Organization of Securities Commissions (IOSCO) code. (International Organization of Securities Commissions 2008) Complete adoption of this code should be required for CRAs in order to claim compliance. Building on this idea, the CFA Institute Centre suggests an even larger oversight body: CRAs would "group themselves into an international standard-setting and monitoring self-regulatory body of all stakeholders with powers of enforcement" (CFA Institute 2008). For that purpose, Professor Goodhart suggests the creation of an independent agency in charge of assessing private ratings, the CRA Assessment Centre (CRAAC) (Goodhart 2008). Even though the idea sounds appealing, it may be hard to precisely determine what powers this regulatory body may have. Moreover, as we shall see further in this analysis, one may discuss the influence of regulation. Furthermore, within CRAs, teams for initial ratings and for continued ratings surveillance should be different as to avoid continued communication between issuers and the CRA for a same product, if any, and enhance objectivity in the ratings. To build on this idea, CRAs could also periodically rotate ratings teams to prevent abuse and uncover faulty ratings. Finally, in order to ensure precise ratings, CRAs should not rate new structures until available statistical data are sufficient to produce a defensible rating. Internal regulation seems like a desirable first step as to improve transparency in the rating process.

As we've noticed, not only should CRA restructure their internal organization but also reassess and reconsider the overall business model in order to remove the problem of conflict of interest. Easy solutions that could be easily implemented would be to prevent CRAs from recommending how issuers structure their offerings and force separate fee discussions from ratings discussions. Furthermore, different suggestions have been made which we shall now consider.

As the issuer-pays model has inherent conflicts-of-interests, one suggestion is to return to the investor-pay model, i.e. for CRAs to be required to charge investors for their fees rather than charging bond-issuers (Lowenstein 2008) (Lowenstein, 2008). As we mentioned earlier, the credit rating industry in the U.S. underwent a transformation in the early 1970s from investors paying for ratings to issuers paying for them, which coincides with the spread of low-cost photocopying. As a consequence, the issuers were going to have difficulties in preventing free-riding on the publication of their information. (White 2002) In a paper entitled "The Credit Ratings Game" (Bolton, Freixa and Shapiro, The Credit Ratings Game 2009), Bolton, Freixa and Shapiro suggest, in order to get around the information leakage problem, the creation of transactions tax on investors to pay for the ratings of fixed-income securities (plain-vanilla or structured) and therefore impose full disclosure. However, such as the authors admit it; this solution is very unlikely to be considered by regulators as it would be both a complicated and expensive solution. In addition, one must note that both issuer-paid and investor-paid ratings models have real and potential conflicts of interest to manage. As Michel Madelain, COO of Moody's says it:

"The potential for conflicts of interest exist in any model in which the payer has an interest in the rating outcome. [...] A change in the payment model for credit-rating agencies won't eliminate potential conflicts; instead the discussion should focus on their proper management. Additionally, asserting that alternative business models eliminate potential conflicts is dangerous because it de-emphasizes the strong focus on prudent management that all models demand." (Madelain 2009)

Consequently, a return to the investor–pay model seems hard to implement, costly but also inefficient as it would not fix the conflict of interest, but only change its focus. One could ask himself if, free-riding apart, the investor-pay model better than the issuer-pay model? Indeed, the conflict of interest seems more obvious in the later.

Another alternative that has gained momentum recently is the concept of a central database, in which CRAs would be required to disclose default rates on the securities they have rated in the past. By keeping records of their default rates in a central database, CRAs with bad results (i.e., a significant number of misrated products) would have their SEC approvals (the NSRO status) yanked temporarily.  With this database, "regulators and investors would thus have an effective means of assessing the raters' rigor" (Laing 2007). As a matter of fact, the European Union Commission just adopted a very similar proposal. Even though this solution doesn't solve the entire conflict of interest problem, it appears to be an efficient and easy to implement tool to enhance transparency.

A very interesting solution to realign CRAs' incentives and a more comprehensive alternative to the current business model is the platform-pays model designed by (Mathis, McAndrews et Rochet 2009). The model is the following: to apply for a credit rating by a CRA, recognized by the NRSRO, an issuer will first have to contact a platform (which can either be a clearing house or a central depository) which would be fully in control of the ratings process and would also keep record of the services to the different parties in the securitization operation (just like the database idea we previously mentioned). The issuer would then pay an upfront fee to the central platform which in turn would organize the rating of the pool of loans by one or several NRSROs. Finally, the rating fees, independently of the outcome of the rating process and of the fact that the issue finally takes place or not, would be paid by the central platform to the CRAs.

This solution has various advantages. First, it would cut any direct commercial links between issuers and CRAs. By providing direct supervision of CRAs, requiring CRAs to guarantee their ratings and an upfront payment upon application this alternative would also eliminate any perverse incentives for CRAs. Overall, since the central platform's profit maximization depends on appropriately aggregating the interests of the two sides of the market, solve the conflict of interest between issuers and investors.

However, as Dwight M. Jaffee (M. Jaffee 2009) says it:  "The devil [...] is in the details". Indeed, even though he admits the "mechanism would likely dominate other proposals" it is not problem-free as many questions remain without answers: How will the platform allocate customers among the available rating firms? How would the platform deal with revisions to the proposed security structure? Could the issuer ask for a second rating for a same security? As a response to this model, and in order to provide warnings for investors to treat some ratings with caution, Dwight M. Jaffee suggest a simple and low-cost disclosure rule which would require CRAs to disclose any preliminary discussions with any potential issuer. In my opinion, even though Jaffee's analysis and questioning of the model pertinent, the platform model still offers a solid alternative to the current model with a few minor details that should be considered before being implemented. Need more competition for incumbent CRAs.

"Competition in the ratings industry has been increasing, and there have been calls for yet more competition. Whether competition is likely to reduce quality or improve it has been unclear," says HBS professor Bo Becker, an expert on bank finance and debt markets. Indeed, as we mentioned in the previous section of this paper, increased competition can both be considered as a problem and as a solution to the CRA industry and business model.

According to (Laing 2007)"competition from new agencies might create a healthy diversity of opinion, leading to more accurate assessments of debt issues' default probabilities". In fact, despite the predominance of Moody's and Standard & Poor's,and to a lesser extent, Fitch, there are an estimated 150 CRAs to be found around the world.  Since thus far, the SEC has only given official status (NSRO) to seven of these agencies, there seems to be a lot of room for growth in terms of competitiveness in the credit-rating industry. Laing indicates that the SEC can help to increase competition in the industry by speeding up the process of approving new agencies.

The real question underlying this problem is: Is more competition desirable?

To answer that question, analyzing Fitch's recent growth in the market seems like an interesting case to study to test for the effect of competition on ratings. Indeed, Fitch used to be much smaller than S&P and Moody's, but has become a peer during the 90's. In a study by (Becker and Milbourn 2009)of the implied competition between S&P and Moddy's, when Fitch has a higher market share in issuing ratings for the corporate bonds of a specific industry, they find three pieces of evidence, all consistent with a reduction in credit rating quality as Fitch increased its market presence across industries.

First, competition is associated with friendlier ratings (i.e., they are closer to the highest rating AAA). In fact, they find that almost twelve percent of bonds get higher ratings when Fitch has a higher market share. Second, they find a correlation between ratings and bond yields, which thus appear less informative. Indeed, ratings main function is to provide investors with information about the expected bond yield and spread depending on its risk profile. If that function is not fulfilled anymore, then Fitch is contributing to a distortion of ratings. Finally, they find that equity prices react more to downgrades (especially for downgrades from investment grade to junk status) as competition increases, consistent with a lowering of the bar for ratings categories and thus suggesting that CRAs have failed to reach a very low threshold, making the news particularly bad.

Event though these implications may not apply to other industries, these conclusions imply that a higher level of competition reduces future economic rents and increases the short terms gains and incentives to cheating. Becker and Milbourn's indicate that "increasing competition in the ratings industry involves the risk of impairing the reputational mechanism that underlies the provision of good quality ratings".

The main problem with regards to competition is the enforcement of the oligopoly (or "partner duopoly" as mentioned earlier) by the US government. Both at the federal and state levels, various rules still favor the big three. For instance, the Federal Reserve will only accept as securities as collateral rated investment grated by the three major CRAs, without considering other NSRO designated CRAs. Similarly, various state investment funds (Wisconsin) or retirement boards (Vermont, Pennsylvania) will only invest in securities rated by the big three or even just the big two. As a matter of fact, the best way to approach the competition problem would be to make CRAs compete in a market where no one is required to hire them. There is therefore a need to remove regulatory and statutory requirements for investors to buy only securities rated by regulator sanctioned CRAs, some even suggest the plain eradication of the NSRO charter. For instance, Lowenstein recommends that the federal government should stop certifying credit-CRAs:

"Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves - not farm the job out to Moody's. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less." (Lowenstein 2008)

Finally, investors should still have the ultimate responsibility in the evaluation of structured financial products. Too often, institutional investors have been investing in sophisticated credit products on the sole basis of the credit rating, sometimes without fully understanding the inherent risks they are undertaking.. If, The fixed-income managers still have to do their own analytical work rather than rely on CRAs, and distinguish the acceptable risk versus reward profile for securities an,. As they say it themselves, CRAs play a crucial role in the capital markets, but their judgments are "guides, not stamps of approval" (Levitt 2007). But to remedy this further, a new set of rules worked out by the Basel Committee on Banking Supervision (Basel II) and their emphasis on internal risk evaluations (the IRB approach) represents a possible model to consider.

No more CRAs

"How badly do the major credit-rating firms have to perform before investors stop using their services?" (The Wall Street Journal 2008). Indeed, why not just abolish the agencies' special status and let the market gauge creditworthiness? If the equity market can regulate on its own and grade its securities itself, then why would the debt market be unable to do the same? For that matter, some critics want to eliminate the agencies' special standing altogether. For instance, NYU professor Lawrence White recommended the elimination of the NRSRO designation at a Senate hearing last fall. As a result, "The participants in the financial markets could then freely decide which bond rating organizations (if any) are worthy of their trust and dealings, while financial regulators and their regulated institutions could devise more direct ways of determining the appropriateness of bonds for those institutions." (United States Senate 2007) Market discipline, in the form of fear of loss of reputation, should thus provide the right incentives for high-quality ratings. In this scenario, responsibility for ensuring the creditworthiness of securities would be put back on banks and other regulators, thus letting investors buy ratings. Finally, removing regulatory and statutory requirements that issuers obtain ratings from incumbent CRAs could also be an indirect way to dismantle CRAs as issuers would not "need" (but they might still do) to get a rating for their securities.

Nonetheless, such a radical move wouldn't be cost-less, easy and consequence-less. First, one must note that credit spreads don't apply to new or complex issues. There would also be a need to develop a flaw-less formula or procedure, if possible, for determining the credit rating equivalent of a credit spread. Finally, it would force a rewrite of the previously mentioned regulations that require pension funds to hold securities that meet specific risk standards. In my opinion, getting rid of the problem doesn't seem like a good reaction to fixing the problem. On the opposite, I believe CRAs definitely need to be more regulated as to ensure a better functioning of the global credit market.

ii) New Legal and regulatory framework: calls for reform

As we have seen it, CRAs, supposedly because they care for their reputation, already have internal compliance procedures as to ensure the best quality of their ratings: there are internal procedures to appeal a rating, there are Chinese walls to divide consultants from raters, there are codes of ethics seriously applied, and other enhancement mechanisms: they should thus never err in their ratings. However, the perception that -CRAs contributed to the financial crisis led to investigations and calls for reform.  In light of this observation, regulators have taken preventing steps because in financial markets. The Credit Rating Agency Reform Act of 2006 and the recent proposals of the SEC (on oversight) are examples of such preventing measures. In this analysis of regulatory and legal reforms, we will first analyze the variety of recommendations that have been suggested by investors, scholars and regulators. We will then compare what decisions have been made by both European and US regulatory bodies. Finally, we will consider the limitations of regulation on the credit rating industry.

Reforms

While the American Congress a legislation passed a legislation in 2006  to bring competition and accountability to the credit ratings agencies, more reforms have been called to change the fundamentals of the industry.

First, in addition to internal oversight and self-regulation, we need more industry surveillance. When referring to the auditing sector, such industry oversight, implemented after the Enron crisis with the Sarbanes-Oxley Act, has made a difference in behavior that benefits investors by providing stricter rules on transparency and corporate governance. Under current rules, even though the SEC can judge whether or not the agencies are complying with their internal procedures and policies but cannot judge the quality of these standards nor set new ones. For that matter, to quote Arthur Levitt, the SEC should thus be "given the authority to set standards, monitor and evaluate compliance, and discipline ratings agencies for violations" (Levitt 2007), including the revocation of the NSRO status, and thus SEC recognition and all the privileges that it implies. To ensure full implementation of such supervision regime, in order to make sure that CRAs are serving investors, the SEC should provide itself with the right tools and personnel. Unfortunately, Arthur Levitt points out the absence of any budget for additional SEC personnel inspect CRAs.

Second, we need more accountability. As a matter of fact, sometimes called "the world's shortest editorials," credit ratings enjoy First Amendment protection and are not subject to underwriters' liability. Many lawsuits have been filed against CRAs, in some cases, by rated institutions, in others by investors. Plaintiffs have not been successful in either event. There is the need of a global strategy for imposing liability on credit CRAs to ensure appropriate (both pubic and private) accountability. Indeed CRAs (just like other "gatekeepers" to quote (Lowenstein 2008)) should therefore be held liable for any significant wrongdoing. Misconduct may be a difficult concept to precisely explain in this precise case: liability should be dependant on the negligent breach ofa pre-determined (and revisable in the course of time) set of duties. In their defense, CRAs will reply that their ratings are protected by the First Amendment of the American constitution, stating that their role remains limited to producing a rating opinion and informing the investing public. Nonetheless, when it comes to ratings of structured debt products that the CRAs helped create, their defense and claims of First Amendment protections do not seem valid anymore. Mauro Bussani, suggests a more regulated system in which CRAs would be insured and would also compensate complainants:

"Beyond stay or stop of the activity, agencies should be liable to compensation, disgorgement, and penalties, whose amount should be linked to a fixed multiple, and imposed not to benefit plaintiffs but to feed an international fund to be set up with the aim to compensate victims of financial entities that become insolvent and leave investors holding an empty bag. Third party insurance coverage should be mandatory imposed upon the agencies, also to set a market-users friendly threshold for the agencies' choice to leave, or to keep playing into, the market." (Bussani 2009)

To summarize, whether done through Congress or court, one should point out that CRAs' opinions are not different from other "gatekeepers", and thus should be held accountable for wrongdoing. However, the practical effect of more civil claims could be crippling liability. The burden of this liability would be carried by the three largest CRAs, with the risk of potentially decreasing competition in an already oligopolistic industry. It would in turn reduce the amount of information available to the investing public, the opposite of the First Amendment and the securities laws which promote the free access of information.

Regulatory Reliance on Credit Ratings

Third, there is a strong need to redefine or possibly eliminate the concept of "investment grade" to reduce investor confusion about purpose of ratings and a need to remove regulatory and statutory requirements for investors to buy only securities rated by regulator sanctioned CRAs. One of the main factors behind the subprime crisis is that a major part of the fixed income market is set up on the assumption that the agencies are omniscient, and that a debt instrument's rating is the main piece of information a portfolio manager needs to consider when investing. As we have mentioned it earlier, both at the state and federal level, entities ranging from the Federal Reserve to the Vermont retirement system operate under rules that mandate that only securities of a certain minimum rating (the investment grade threshold, usually BBB-) are eligible for purchase or as collateral. As Thomas Brown points out, if public pension funds aren't required to only buy stocks all rated "Buy" by equity research analysts, then why should fixed-income investors be restricted to invest only in debt instruments rated "investment grade"? (Brown 2008) Indeed, this defined threshold restricts many of fixed-income managers' investments, potentially inhibiting returns. Moreover, when a security gets downgraded below the investment grade threshold, managers have to liquidate their positions "en masse" (Brown 2008), thus causing unneeded sudden volatility and possible portfolio losses. This argument is in line with our recommendation earlier on to create quantitative ratings instead of using letters.

Fourth, in addition to the actions taken by the SEC, U.S. Congress, EU and IOSCO, which we will study in the next part, the Attorney Generals of New York Andrew Cuomo launched his own investigations into the matter in late 2007 and has now reached an agreement with credit ratings firms to change some features of the rating process. This agreement between Andrew Cuomo and Standard & Poor's, Moody's, and Fitch essentially prevents issuers from paying for specific ratings and forcing issuers to pay the CRA upfront before it does its initial analysis. This restriction can eliminate CRA conflicts of interest and incentives to ratings inflation, but importantly it does not eliminate shopping by the issuer, it is therefore not optimal.

Regulatory measures introduced during the financial crisis

After the subprime loan crisis in 2007, the EU-commission and US politicians blamed the CRAs of being jointly responsible for the financial crisis. The EU- commission considered reacting with legal regulations for the credit CRAs and also US authorities announced to investigate the role of CRAs in the subprime loan crisis that was set of in August 2007 Now that we have considered alternative business models and new regulatory reforms, we shall now analyze what has really been decided by regulatory bodies and governments in both the US and the EU.

International Organization of Securities Commissions (IOSCO)

In 2008, the IOSCO, the international standard setter in the securities markets, revised the Code of Conduct Fundamentals for Credit Rating Agencies which it initially wrote in 2004. In response to the role of CRAS in the recent debacle, the IOSCO's revisions include measures to strengthen the quality of the rating process, ensure subsequent monitoring and timeliness of ratings, proscribe analysts' involvement in the design of structured debt products, increase required public disclosures, periodically review compensation policies, and clearly distinguish ratings of structured securities from more traditional plain-vanilla bonds. Furthermore, in order to avoid cross-border regulatory fragmentation and facilitate inspections worldwide, the IOSCO has proposed the use of its code as a template for supervision of CRAs. 

Political leaders of the Group of 20 (G-20)

In April 2009, building on the IOSCO's suggestions and examination model, the G-20 leaders agreed on more reforms of the rating industry. First, in the Declaration on Strengthening the Financial System, CRAs whose ratings are used for regulatory purposes as we've seen earlier should comply with the IOSCO code. Second, national authorities, not limited to the G-20 nations, should enforce compliance with the IOSCO code, notably the implementation of a different ratings scale for structured products and increased public disclosures. Finally, G-20 leaders the Basel Committee to review the role of external ratings in prudential regulation and identify adverse incentives that needs to be addressed. How were those recommendation considered and implemented in the U.S. and the E.U.?

Regulation in the United States

The SEC now requires CRAs to improve their record keeping and annual reporting by publicly disclosing their rating methodologies and performance statistics. Furthermore, as to reduce potential conflicts of interest, the SEC now prohibits CRAs from advising issuers on ratings and analysts from participating in any negotiations. Nonetheless, the SEC has not yet decided whether NSROs should change their ratings nomenclature specifically for structured finance products and whether references and restrictions on the use to NRSRO ratings should be eliminated or not.

Regulation in the European Union

Finally, both the European Commission and the European Parliament took actions to reform the ratings industry. First, similarly to the NSRO status in the U.S., all CRAs will first need to apply for registration to the Committee of European Securities Regulators (CESR) and be supervised by it and the relevant home member state if they want their ratings to be used in the E.U... These newly-registered CRAs will have to abide rules based on the IOSCO Code, which, as we've seen, includes enhanced public disclosure and transparency requirements, different ratings for structured products, interdiction of from advisory services and stronger internal governance requirements. Similar to the concept of a central database we discussed earlier, the CESR will establish a public central depository which will provide historical data on the ratings performance of all registered CRAs.

The difference between the E.U. and the U.S. reactions to the financial crisis

In spite of the much-proclaimed U.S.-EU transatlantic dialogue, regulation of CRAs remains an area divergence between the world's two largest economic blocs. How do those approaches differ?

Although the EU and U.S. approaches share certain principles such as greater transparency, corporate governance, and organizational requirements concerning conflicts of interest, the philosophies underlying the interventions are not the same.

On the one hand, the Act[7] cements the status quo, by raising barriers of entry in the rating business and providing an implicit recognition to registered CRAs.

These differences in the approaches stem from different understanding of the CRA industrial organization. U.S. authorities believe that they can re-establish a competitive, reputation-driven market for ratings by eliminating the regulatory license and enhancing competition and transparency. By eliminating references of ratings in regulation, CRAs would compete on the quality of ratings and investors would be free to choose the agency they trust the most. By contrast, because EU authorities are more preoccupied by ratings shopping, the proposal implicitly acknowledges that ratings are an essential component of global risk-sensitive prudential regulation and doesn't suggest any market-driven regulation.

To summarize, U.S. authorities prefer market discipline through transparency and competition, whereas EU authorities aim to promote CRAs' accountability through supervision.

Problems due to regulation

"The fundamental flaw is that the agencies are paid by issuers, not by investors. No amount of regulation can fix that conflict of interest" said a CFA charterholder (CFA Institute 2008). Indeed, is it really better to be safe than sorry? What are the limitations of regulation?

More regulatory arbitrage

One of the stated purposes of the European Commission's proposal on CRAs was "to ensure an efficient registration and surveillance framework, avoiding forum shopping and regulatory arbitrage between EU jurisdictions". The registration and supervision procedures involve all member states where the relevant rating is used, which may create unnecessary regulatory costs and inefficiencies. Conflicts between national regulators are likely to arise in the exercise of their supervisory powers. CRA may be able to take advantage of these conflicts and implement a regulatory arbitrage (where market participants seek out jurisdictions with lower regulatory burdens to cut costs and increase their competitiveness) strategy. This regulatory arbitrage will then create a downward spiral by creating competition amongst member states, which in turn will encourage local regulators to decrease their supervision.

In addition, home member state competent authorities are the ones responsible for registration, withdrawal or any other supervisory measures, but the regulation does not prescribe specific penalties for violation. Disparities between penalties will then raise the risk of regulatory arbitrage.

To fine tune their geographical strategy (i.e. the country of jurisdiction of its operations), CRAs are likely to take into account the responsiveness of the member state's regulator, the penalties they impose by the member state's regulator for delinquency and their ability to cooperate with other regulators worldwide.

Difficult international cooperation

The ability of cooperation raises another difficulty. Cooperation within EU members and between EU and overseas regulators is crucial in regulating CRAs. A lack of cooperation will mot only enhance regulatory arbitrage, but it will also cause misaligned rules, inconsistent across nations, which will disrupt rating activities for global CRAs, i.e., the majority of them. The division of responsibility between CESR and member states in Europe could hinder global cooperation. As we have mentioned, local competent authorities of single member states, have full discretion with regards to their regulation powers, and thus may have misaligned interests in respect of international cooperation. In order to avoid entering into conflicting arrangements with overseas regulators, a homogeneous global cooperative approach between regulators in the implementation and enforcement of regulations is critical to restoring investor confidence in ratings.

These risks associated with global regulation lead us to ask ourselves, is regulation really necessary? More than limits, are there any drawbacks to regulation?

For instance, Professor Schwarcz advocates against regulation to control the CRAs because, it would "neither limit the negative consequences of rating agency action nor improve rating agency performance" and would only "impose unnecessary costs and thereby diminish efficiency". (Schwarcz 2002) Moreover, one should remember that increased regulation in the accounting industry,as a result of the Sarbanes-Oxley Act, turned out to be very beneficial for the few auditing companies left (namely the "Big Four") and greatly fostered the consolidation of the industry.

In the ratings industry, it is important not to overstate the role regulation can play in preserving against certain dangers inherent in ratings. Indeed, it is difficult to see how market behaviour, which is inherent in ratings-based investment, can be effectively reduced or eliminated through regulation. Even worse, regulation can in practice create perverse consequences. For example, the regulation's registration process in the EU could give CRAs a more official status, just like the NSRO status in the U.S. However, investors may interpret this status as an official approval for the ratings, thus increasing investor reliance on them: the exact contrary to the very first objective. Moreover, as it was the case in the auditing industry, some have suggested that registration requirements will also increase barriers to entry, disrupting competition and leading to a decline in the quality of the industry, as it was the case in the US until very recently.

To conclude, one should note that the previous approach of minimal regulation has not worked and should thus admit that further regulation of the credit rating business is required. In fact, the impact that this regulation will have on credit rating business in Europe and in the US is considerable. Many aspects, such as the rules on disclosure of rating information and the conflicts of interest rules, may increase market efficiency and restore investor confidence. Others, such as the lack of due process, the increasingly complex procedures and the lack of global approach, may increase worldwide regulatory inefficiencies and costs. It is yet to be seen whether the regulation will prevent some of the rating mistakes that caused market participants to blame CRAs for contributing to the financial crisis.

Section3: The impact of the credit crisis on the leveraged finance industry

The Impact of the credit crunch on the private equity industry: the "Big unwind" [8]

Credit rating agencies are at the heart of the financial system, especially in the corporate finance world and in the leveraged finance industry. In fact, the subprime mortgage-initiated credit crunch, credit rating agency crisis and ensuing international financial crisis have deeply impacted the global private equity industry as debt is a key component of its investment strategy and business valuation is crucial to a successful leverage buyout (LBO). In 2008, the value of private equity investments decreased by two-thirds, and the funds raised nearly 75% less than a year earlier. With reduced lending from banks and lower funds allocated, venture capital activity will slow, large LBOs will most likely disappear for a while, and private equity funds will likely focus on distressed securities and infrastructure projects.  In this section, we shall thus further analyze the impact of the credit crisis on the leverage finance industry. More specifically, we shall first study the recent crisis in the private equity (PE) industry, by comparing it to previous crashes, investigating the causes of the boom and bust, and considering the resulting evolution and trends in the industry. Secondly, as debt is at the core of this industry, we will determine how the crisis changed buyouts financing and its structure in the following order: high-yield financing, mezzanine debt and finally second-lien loans. Third, as an illustrative example, we will examine the evolution in the infrastructure finance industry in a post-crisis context as it has recently been getting a lot of attention and financing from PE investors. This case analysis naturally leads us to consider in our final part the structured finance industry as it is at the heart of the crisis: which products have survived? Is financial engineering and securitization over?

Introduction: A turn in the cycle for a cyclical industry

«One thing you must remember about private equity is that everything cycles, literally everything» explains Terry Theodore, Partner at Wynnchurch Capital, a Chicago-based private equity firm. As a matter of fact, since it emerged as an asset class in the 1980s, private equity has experienced three major booms, and subsequent busts.

The recent crisis is by far the biggest one as the credit bubble that accompanied the boom in the industry, mainly inflated by low interest rates, led to record deal values and skyrocketing leverage levels. Indeed, leveraged lending grew larger and more complex than ever before, as structured finance vehicles, such as collateralized loan/debt obligations (CDOs and CLOs), entered the market. Favorable debt-market and fund-raising conditions provided the capital to finance multibillion-dollar buyouts: the "mega buyouts", until the credit and mortgage crisis brought this boom to an end and eventually triggered the recent global recession. Before we consider the recent bust, we shall analyze what were the factors that fueled the unprecedented boom in the LBO market until 2008.

Pre-crisis context

The leveraged buyout market has grown enormously over the last two decades. As we can see in the graph above, in 1991, new transactions were valued at $10 billion whereas by early 2006, they had reached $500 billion. According to Thomson Financial, this annualized total is equivalent to 5% of the capitalization of the U.S. stock market and 1.4% of global GDP.

As a matter of fact, transactions during this period have grown as much in volume as in value. For instance, between 2000 and 2005, the number of transactions in the U.S. almost doubled, while the value rose four times as private equity funds had access to the credit market to finance large individual transactions ("megadeals") ranging between 20 to $30 billion. As we can see in the chart below, this bubble in the private equity market reached its peak in 2006 and 2007, before the collapse of the credit market. The most immediate impact of tightening credit markets since the summer of 2007 was to cut off the financial fuel that powered leveraged lending, where credit markets were hit hardest. The impact on PE's access to leverage was quick and dramatic.

Leverage and acquisition multiple paid in buyout transactions reached their all-high levels, as the number of merger and acquisition deals led by private equity firm was booming.

This unique growth and leverage bubble in the PE industry, made the credit crunch even more impactful and the consequences much worse. Indeed, after the credit crisis hit, many deals met with big difficulties as the leverage level used left very little room, if any, for a slowdown in the economy and a reduction in the companies' cash flows. Furthermore, as the credit market was collapsing, investment banks could not syndicate LBO debt and a massive $389 billion debt backlog developed. As a result, the number of deals dramatically decreased from $500 billion worth of deals in 2006 and 2007 to $81 billion worldwide in 2009, according to Thomson Reuters, as investors were calling back their money, when possible because of the sudden fall in returns. This decline brought buyout activity to its lowest level since 2001.

The precipitous drop in deal value was most dramatic in PE's traditionally strong North American and European markets, where activity plunged at a compound annual rate of 66 percent and 62 percent, respectively, from 2007 peak levels.

Average IRR by Vintage Year

As we have noticed, the private equity industry is a very cyclical industry and the recent is unprecedented in terms of losses and consequent changes tot the industry.

According to the chart above, we can see that both the unadjusted and adjusted ratios of EBITDA[9] to capital are at their lowest in 2006 which implies thatprices paid in buyouts (in terms of EBIDTA multiple) are at their highest since 1985. Many businesses prior to the crisis were overvalued and thus bough at unjustified high premiums, encouraged by cheap financing.Moreover, this fact must also be put back into perspective by considering the macro-economic environment at the time. Indeed, the steep decline in the EBITDA to capital ratios for LBO transactions (and thus sharp increase in prices) that occurred between 2003 and 2006 (ratio fell from 11% in 2003 to 4% in 2006) is closely related to trends in the credit market. The credit market before the crisis was very favorable: Interest rates were low and therefore credit spreads were reduced, and as a result funding for buyouts was inexpensive. Low real interest rates drove private equity firms to use more leverage and pay higher prices in their LBO transactions.                            

In terms of debt level, scholars Ulf Axelson, Tim Jenkinson, Per Stromberg, and Michael Weisbach (Axelson, et al. 2008), who examined 153 buyouts by major private equity firms in different countries over the period 1980 to 2006, find that the debt ratio is almost as high as it was in the 1980s boom.  In fact, the debt ratio observed in recent transactions (2004-2006) was 73%, almost equal to the 77% level observed between 1985 and 1989 (Axelson, et al. 2008). The nature of debt was also different: in addition to the surge in subordinated (second-lien for instance) and mezzanine debt, debt was usually structured as interest-only with a lump sum payment at maturity, as well as debt with PIK[10] (pay in-kind) provisions. Moreover, many of these loans were "covenant-lite", meaning without the basic "maintenance" covenants (cash flow coverage, interest coverage, and firm leverage). This kind of loans with loans are particularly convenient to finance LBO deals as they provide a lot of flexibility to the firm taken over:  default will happen only if the borrower is no longer able to pay the debt, as opposed to when covenants are breached.

To conclude; the recent boom, and now bust, in the LBO market is unseen. It has been fuelled by a combination of cheap credit, huge levels of liquidity, and higher valuations than at the start of the century. However, a much larger fraction of the financing has come from bank debt (often covenant-light loans), through structured products (namely CDOs and CLOs), which have been sold in the syndicated market. This notable difference between the crises leads us to ask ourselves how, considering the new economic environment, the few new private equity deals are structured.

The new deal: changes in the PE landscape

Debt isn't cheap and easily accessible anymore

Since debt is a major component in PE transactions, it is worth mentioning the severe impact of the crisis on the cost of debt. Heading into 2009, private equity deals involved less favorable debt terms as the spread on LBO loans had more than doubled from mid-decade levels. As we can notice it on the graph below, the average spread on US LBO loans increased at a drastic pace since 2007, until reaching a maximum spread of 650 basis points (BPS) above the London Interbank Offered Rate (LIBOR) in early 2009, before declining to the 500 basis-point range in the final quarter of that same year.

With credit scarce and higher cost of debt, recent LBO deals 2009 were structured with modest amounts of debt, well below the leverage levels witnessed in 2006 and 2007. For instance, according to Standard & Poor's Leveraged Commentary and Data, the average amount of debt in the US dropped from the record six times EBITDA in 2007 we noticed earlier to only 3.8 times EBITDA in 2009, whereas acquisitions multiples declined more modestly from 8.7 times in 2006-2007 to 7.7 times in 2009. As a result of this negative combination in the credit market for PE firms, one would expect higher infusions of equity in LBO transactions, which indeed was the case as the average equity contribution increased from 34 % in 2007 to 56 % last year. However, this trend seems to reverse itself as the amount of equity has drastically fallen in the fourth quarter of 2009.

Lower deal valuations

Major North American stock indexes

Even though most of the major equity market indexes began strong recoveries in mid-2009, the drop-off in equity prices and rebound within the space of just a few months did not allow valuation multiples enough time to reset. However, EBITDA multiples on almost all major exchanges recovered to near their 2007 level.

The net result was that confusion about growth prospects, reduced levels of more expensive debt and the valuations gap between buyers and sellers made it very hard to complete deals. As a consequence of the combination of a scarce credit market and recovering yet lower equity valuation multiples, valuation on private equity deals has been constantly decreasing to lower levels.

In fact, as deal values drop, new private equity deals look different. As opposed to the pre-crisis market, there was no megabuyout ($10 billion and more) since 2007. As a result of the credit crisis, deals are not only less numerous but also much smaller in size. Even mid-market and smaller deals, which many investors anticipated would fill the gap, were hit hard.

Private equity deals are smaller

A cease in fundraising.

As a result of all the factors we mentioned earlier: little debt, low valuation, smaller deals and fewer opportunities, Fund-raising has declined across all major asset classes. Popularity with investors is reflected in the increasing flows of capital they have entrusted to PE fund managers over the past five years. Indeed, as opposed to more than $1 trillion PE funds raised globally between before the crisis, new funds raised worldwide tumbled to just $140 billion.

Number of Funds Closed and Total Capital Raised by Year

This widening gap between funds invested and funds raised led to a record level of "dry powder" of $400B, putting considerable pressure on PE investors.

Capital Overhang for US-Focused Funds Raised by US Investors

Conclusion: What's ahead for PE? Opportunities and trends for the industry.

Although difficult to separate, the economic slowdown and the credit crunch are impacting the private equity sector very significantly. The credit crunch is having a significant impact on PE investment strategy as the market is still facing a tightened credit market, reduced debt and valuation multiples and the disappearance of the 'covenant-lite' structures that featured in the years before the crisis. As a cyclical business, PE firms faced the same downturn as the economy did, and is now slowly recovering. From this conclusion we can distinguish and assume some trends in the industry. First, we can assume that holding periods will rise as private equity firms are spending time and effort improving portfolio companies' operational performance. As a result, many exits will be delayed until the market (and equity valuation multiples) recovers. Furthermore, since one the primary characteristic of private equity investment is illiquidity, many investors got their money locked in investments they wanted to withdraw their fund from. As we've seen, returns on private equity investments have dropped-off, and as a result, we expected investors to become more risk-averse. Decreased global liquidity will result in reduced commitments to new private equity funds. We therefore expect a higher share of bigger players such as sovereign wealth funds or corporate partners to invest in buyouts funds, and less institutional investors or wealthy individuals.

Furthermore, the crisis has also brought some new opportunities, but also challenges. Indeed, we can expect that the reduction in valuations will create substantial buying opportunities for mid-market PE players when debt will become accessible again. First, as many companies are struggling to service expensive yields and meet repayments, there is a very strong need to restructure these companies' balance sheets to more sustainable gearing levels. Even though overcoming theses turnarounds will not be easy, any PE firms have developed an expertise in restructuring. Combined with solid banking partnerships, these PE firms will be in a strong position to provide new capital, support management teams through restructurings and work towards a sustainable growth. Such investments can be very attractive for PE investors since distressed sales and low acquisition prices can yield significant returns: as valuations have dramatically fell, acquisition is less expensive and subsequent growth will have a more significant impact on valuation. Second, as public and private equity investors' risk aversion has increased, there has been a flight to investing in larger, more established businesses. However, many businesses with significant growth potential have been struggling to raise capital. PE's longer investment horizons and strong appetite to inject growth funding into high performance businesses will therefore represent an attractive alternative to public markets for management teams. Private equity could well rebound soon, if the industry moves carefully along the global economic turnaround.

However, private equity also faces new challenges. In addition to restoring and maintaining confidence in financial institutions and investors during times of market disruption, private equity firms will be operating under an even greater level of public scrutiny such as the recent Volcker Rule, a financial reform proposal by President Obama's economic advisor, Paul Volcker.  Under this rule, banks would no longer be allowed to own, invest or sponsor private equity funds, thus worsening the fundraising and financing environment.

How has the crisis affected the financing of leverage buyouts?

High Yield financing

The high-yield, high-risk bonds just recently beat investment-grade debt for the first time this year as confidence in the U.S. economic recovery gains strength. Speculative-grade notes returned 1.93 percent in March 2010, bringing year-to-date gains to 3.63 percent, according to Bank of America Merrill Lynch index data.

In contrast, high yield bonds suffered their worst year in the history of the asset class in 2008—the J.P. Morgan Global High Yield Index, the index of reference in the industry and main benchmark, declined by 26%.

As the financial crisis deepened in 2007 and 2008, the junk bond market was trading as the economy headed towards a depression. Yield spreads over US Treasuries with comparable maturities widened to record levels of about 19.25 percentage points, more than triple the historical average. In fact, more than 80% of high yield securities were trading at distressed levels, indicating that they had a high probability of defaulting or restructuring.

However, these record-high yields attracted investors and as a consequence, an unprecedented amount of new cash flow came into the junk bond market in the first half of 2009.In fact, as companies were ongoing some major restructuring and refinancing, weaker companies were able to refinance their maturing debt and consequently, high yield bond issuance surged: the economic crisis set the stage for the recent rally. Furthermore, along the recent stock market rebound and thus improved liquidity, there has been a catalyst for many depressed high yield bonds with near-term maturities, as well as the new bonds issued to refinance the maturing debt. In fact, as money flows into the asset class and refinancing activity increases, private equity investors could use it used to do more deals: increased cash flow is allowing companies to repair their balance sheets and improve their earnings.

Nonetheless, as Han Yeung, credit analyst at ICG, a mezzanine provider, suggests it, the pace of recent gains by the high yield market in recent months is unsustainable. As she explains it, the recent surge in the high-yield loan market is mainly explained by the low level of the LIBOR rate, which remains to date at its lowest historical level (close to 0%).

However, this scenario is just temporary as the Federal Reserve will most likely raise the Federal Funds rate in the next months in order to contain liquidity in the markets and prevent inflationary pressures when the economy fully recovers. When this happens, the high-yield current risk-reward profile will be affected and demand for such financing should most likely decrease. Explain

Mezzanine financing and second lien loans: How has the crisis affected less senior debt funding?

We shall first study the case of mezzanine funding and will then consider the second-lien loan market; two widely-used financing sources in buyouts.

Mezzanine

Prior to the financial crisis, thanks to its strong position in the capital structure, which struck a balance between risk and reward, between debt and equity, the market for mezzanine financing had been growing steadily. However, as a consequence of the credit crisis, there are now far fewer leveraged transactions in the current market, and both the value and volume of deals incorporating mezzanine debt have fallen as a result. According to Dealogic figures, $12.1bn of mezzanine debt was invested in Europe in 2008, compared to $38.2bn in 2007and the number of deals fell from 203 to 91. How has the credit crunch affected the mezzanine market?

Impact of the current turmoil

During the crisis, mezzanine lending activity has remained relatively subdued due to the reluctance of senior lenders to finance private equity deals. Mezzanine and other subordinated debt instruments are increasingly seen as essential tools to fill the gap between severely constrained senior bank loans and equity put up by financial sponsors.

More recently, the financial crisis has made banks wary of all types of lending. "The credit crunch and subsequent economic downturn has affected all layers of the capital structure, including junior debt," confirms Han Yeung, credit analyst at Intermediate Capital Group. This is due to a combination of the limited availability of institutional mezzanine capital and the constrained senior lending market, as well as concerns about sustainable transaction leverage multiples and the underlying borrower credit quality. As such, the covenant-light structures that were popular prior to the subprime crash are not expected to make a comeback soon.

In spite of the crisis, mezzanine finance has become relevant again. Indeed, the mezzanine market downturn has highly reduced competition and financial risk in buyouts, and it is thought that mezzanine debt will become an interesting investment. In effect, as Michael Small, a partner at Park Square Capital explains it: "risk has declined because leverage multiples on an EBITDA basis have come down. More importantly, leverage multiples on a free cash flow basis have declined. As such, most new buyouts will be able to service their debt through internally generated cash flow, which was rarely the case before the crisis".(Renaud 2009)

As a matter of fact, signs of recovery are already appearing. In fact, the flexibility of subordinated debt is proving to be particularly attractive to companies who are struggling to secure debt from other sources. Mezzanine lenders say that in addition to more deals, they're also taking up a larger piece of the debt structure within individual transactions.

In times of economic uncertainty, buyers are reluctant to commit to floating-rate debt and as a consequence, the credit crunch constrained senior debt providers and handed second lien lenders their first major test. As a result, demand for mezzanine has skyrocketed, from both buyers and institutional investors.In fact, Mike Hahn, president and head of mezzanine finance at Churchill Capital notices an inverse cycle between senior debt and mezzanine financing: "If you went back over the numerous cycles, as senior lenders become conservative, mezzanine becomes more popular."(Renaud 2009)

That recovery can be explained by the fact that mezzanine debt from the perspective of acquirers seeking debt is more stable than other sources of financing. While it may be more expensive than other senior lending sources (mezzanine providers do traditionally seek higher returns than other lenders, usually in the range of between 15 percent and 20 percent IRR), it is accessible throughout economic cycles: most mezzanine providers typically have between four and five years to put capital to work and can take a longer-term view.

Ron Kahn, a managing director at Lincoln International, a global investment bank, explains that attractiveness of the stability of mezzanine debt: "Mezzanine is the one source of capital that was not really impacted by the August credit turmoil. They get their money from pension funds and endowments, which are committed to a five-year program. So they have just as much money as they did beforehand. It's a luxury that a lot of other players don't have today." (Renaud 2009)

"Second lien loans are here to stay"

After a very significant growth in the market, second lien loan issuance decreased as a result of the credit crunch. According to Loan Pricing Corporation, second lien loan issuance has been declining since 2007. (Papavassiliou 2008)

Even though second lien loans are less available than pre-credit crisis, they remain available to companies willing to deal with equity kickers or stronger creditor protections, and those refinancing existing facilities. Just like mezzanine lenders, second lien holders have few rights during debt restructurings: the more constrained credit environment has affected some of the legal rights that second lien holders are negotiating.

However, Colin Cross, managing director at Crystal Capital explains that "as a product, second lien is here to stay. And while it will cycle up and down from time to time, it is certainly not going away and this will prove true as we pass through the credit crunch we're experiencing now". (Papavassiliou 2008)

There has been stabilization in the market with more loan activity going on mainly due to refinancings and a reopen in M&A activity. Companies are successfully securing second lien financing as part of a large scale recapitalizations. In fact, the second liens market is expected to grow as deals start again. Even though there are far fewer buyouts than there were before the crisis, a larger proportion of these buyouts and refinance activities are requiring junior debt. Private equity funds are using second liens to pipe liquidity into portfolio companies and new investments, mostly innovative private investment in a public entity structure (PIPE). Prior to the credit crisis, PIPEs were normally structured as convertible preferred securities or convertible debentures, but because of the troubles they encountered during the crisis, investors are interested in investing as high in the capital structure as possible.

To sum up, between refinancing and PIPEs, second liens are experiencing a return to growth after a significant dry-up. As distressed companies get closer to their maturity date, second liens will most likely continue to play a key role in refinancing deals. Mezzanine and second-lien debt have well survived through the financial crisis and actually showed their best features during this period. What are the ongoing changes and new trends in the industry in a post-crisis context?

First, as a result of the crisis, lenders are now providing more tailored financial solutions, allowing companies to be able to think longer term without struggling under the burden of simply meeting the interest payments on their debt. For example, after disappearing for some time no-call periods, prepayment premiums and equity kickers were used in a number of small primary transactions in 2009 in Europe. As Han Yeung explains it: "The structure of mezzanine is constantly evolving and there has been some adjustments to the cash/PIK model in order to better suit companies going forward in the current economic climate. Before the crisis, we would use a high level of PIK and little cash. Now, the weights are inverted". These structural developments may potentially attract companies that do not have access to the leveraged loan market.

Second, given the amount of restructuring involved recently and the difficulties encountered in such situations, mezzanine lenders will want to make better use of their rights as to avoid such scenarios, such as requiring separate legal representation or the ability to replace facility agents[11]. In the case of a complex capital structure, which is often the case when dealing with mezzanine debt, facility agents can be a source of conflict if they represent both senior and mezzanine lenders. Last but not least, Michael Crosby, a partner at Proskauer Rose LLP suggests a change of the perception of mezzanine debt: rather than a form of quasi-equity, it should be seen as senior loans 'in waiting' (Papavassiliou 2008). As we mentioned it earlier, mezzanine debt represents an increasing percentage of the capital structure. Therefore, the terms offered to mezzanine lenders should be improved and be given a more senior status.

To conclude, like all forms of lending, mezzanine and subordinated debt have been out of favor in today's market, but this is clearly set to change. Maintaining a long-term view is likely to be the key concept for mezzanine financing in the upcoming years, which should result in a stable, more ordered market with fewer players.

Having discussed the impact of the crisis on the private equity industry, leverage buyouts and the different sources of financing used in leverage operations, an interesting case to study would thus be the infrastructure industry as it has been one of the most dynamic asset class for private equity investors. For many years infrastructure was considered the unattractive end of the debt markets due to the perceived high risk arising from the long life of the asset and the inherent difficulty to forecast revenues and costs related to the asset. That perception changed in the 1990s when project finance teams began focusing on infrastructure as a dedicated asset class: many new funds were created by banks, fund managers and private equity groups in which institutional investors can participate. The size of the infrastructure fund market has been estimated at between US$250bn-$300bn.  This part will help us make the transition between the leverage finance industry and the structured finance industry since infrastructures are usually financed with structured debt products.

The crisis and the infrastructure finance industry

Background on the infrastructure industry

The demand for infrastructures in the world is growing and as a consequence, many private equity investments and funds were raised as to help financing these projects. On the one hand, the world's developed economies are facing the significant investment need in order to upgrade ageing infrastructure, whereas on the other hand, emerging economies are building new infrastructure as to enable and facilitate economic growth. Globally, the OECD estimates that the required investment in infrastructure (namely road, rail, telecoms, electricity and water infrastructure but not taking into account seaports, airports and social infrastructure) will reach US$71 trillion by 2030: approximately 3.5% of global GDP to 2030.(OECD 2007)

Traditionally, public funding has dominated the infrastructure market. However, as a consequence of the crisis, the proportion of public spending on infrastructures, especially in developed economies, has dramatically fallen as governments face both political and financial constraints on their ability to raise taxes and increase debt, already at very high level. As a result, the OECD report Infrastructure to 2030 suggests that the use of private finance to finance such project is growing: that's where private equity and private debt lenders comes in.

What was the impact of the credit crunch on infrastructure finance?

The markets have regressed from pre-credit crunch peaks: current global project finance volumes are on track to match 2007. It demonstrates the partial resilience of the sector to the turmoil in the wider market. On the one hand, on the debt side, the liquidity crisis that occurred as a result of the crisis has impacted the appetite of lenders into infrastructure. Furthermore, investment banks, which were willing to enter into sole-underwrite positions at a fixed price on large infrastructure deals pre-credit crunch, are now requiring systematic syndication of the loans on such projects as to share the risk with other underwriters. On the other hand, on the equity side, infrastructure assets tend to be highly leveraged, with equity ranging between five to forty percent of the total funding. Infrastructure funds returns may be impacted by reduced demand and higher interest rates arising from the credit crunch. The precise impact will be varying across funds, since some of them have relied on short-term leverage to boost returns, and will thus face a particular challenge when refinancing. Similarly, funds which were looking for short term exit strategies, rather than the traditional long term view that infrastructure represents and requited, will have a hard time find exiting in the current market. Logically, both fund managers and investors may see a reduction in returns over the next couple of years. Since the financial risk of the infrastructure business is largely driven by the borrower, it is therefore reasonable to expect short term reductions in profitability and possible debt restructuring. However, the long term fundamentals of infrastructure investments remain unchanged as the industry offers an indispensable core service(everyone country needs infrastructures), high barriers to entry due to the significant investment required in capital expenditures to build the project, a relatively low business risk and reasonably predictable cash flows and revenues linked to inflation.

To conclude, even though the credit crunch and global economic slowdown will continue to curb activity in financial markets, infrastructure finance has shown itself to be more resilient than many other markets. Thanks to its fundamental characteristics, the appetite for infrastructure finance shall remain strong, especially for core, stable operating infrastructure. This is evidenced by a growing flow of new projects and a rise in the number of infrastructure funds worldwide. As a matter of fact, the entrance of the capital debt markets into the infrastructure market provided increased competition with bank debt and consequently more competitive costs of finance. It also brought with it the era of highly structured, often off-balance sheet, conduit finance vehicles and instruments such as CDOs, CLOs but also SPIVs (special purpose investment vehicles). This fact leads us to ask ourselves how credit derivatives, the instruments that led to the widespread of subprime mortgages, have been affected by the credit crunch. What is the future of structured debt products? How has securitization been affected or modified as a consequence? Is structured financial engineering over?

The future of CDOs and the structured credit market

As we mentioned it when analyzing CRAs, the market for structured credit has boomed over the last decade thus creating a paradigm shift in the business model of financial institutions. More precisely, in the case of the US mortgage market, a CDO included residential mortgage loans, then transferred default risk of home buyers from the lender to the investors, therefore allowing for the default risk to be shared among a greater number of investors and enabling banks to lower the interest rates charged on mortgages. Even though the widespread use of these structured credit products is not the main reason for the credit crisis, it has certainly exacerbated it.  The collapse of the U.S. sub-prime market and the ensuing credit crisis has raised serious challenges for the future development of the structured credit product markets as a whole.

Structured financial engineers have been blamed for causing the immense degradation of asset value over the past 18 months by violating rules of prudent financial engineering which ledto the severe drying- up of market liquidity for structured debt products such as CDOs, and other asset-backed securities. As a result, the market was oversupplied with financial instruments whose underlying quality was doomed to deteriorate over time. As Han Yeung explains it: "Financial engineering as we know it, is over. Future products will have to be more transparent, less opaque and less complex". However, even though the structured credit market has dramatically fallen during the crisis, it is deemed far from dead as there is still a demand by investors and banks' off-balance sheet entities according to a report by (Davies, Tell and Van Duyn 2008). Moreover, according to Robert J. Shiller (Shiller 2008), the current crisis presents an opportunity for the financial community to develop a better and more suitable infrastructure for financial innovation and to help boost the development of future products. In order to bring back confidence to the structured credit market and overall financial system, banks should use more transparent and possibly simple products. Over the short run, new issues of CDOs may have simpler structures; more will be plain vanilla rather than squared[13].

Diversification of the collateral assets

As we mentioned it earlier, part of the blame for the magnitude of the current credit crisis has been on credit rating agencies as they awarded triple-A ratings to products which clearly deserved it. One of the assumptions in the ratings was that the pool of collateral assets in a CDO is deemed to be well diversified, and systematic risk was thus assumed to be diversified away. However, as the current crisis proved it, diversification has turned out to be an illusion as the slump in house price in the US has spread across the globe, thus demonstrating how products were correlated to one another and how diversification did not eliminate market risk. Consequently, it is expected that in the future CDOs will be backed by a more diversified pool of assets, including different asset classes.

Clearinghouse for credit derivatives

Since many credit derivatives, such as CDOs, are over-the-counter contracts between two parties, there is neither supervision nor control of the market. While contracts are usually set for a fixed period, one party can still get out of the contract earlier than the maturity date by entering into an offsetting position with a third party which then leads to situations where one party in a particular contract may not know its actual counterparty. In this complex setting of financial obligations, the default of one party could affect the whole system as all parties are linked to each other and thus can create systemic risk, which is the scenario that recently occurred. In fact, Princeton professor Brunnermeier (Brunnermeier 2009) reports that the number of derivatives contracts vastly exceeds the number of underlying securities. For example, the CDS market in 2007 was worth forty-five trillion dollars, whereas the value of the underlying bond market was only five trillion dollars. A solution to tackle this issue would be to create a central clearinghouse which would monitor all contracts and arrange settlements in case of default. Just like mark-to market accounting, such a clearinghouse could also show a clear overview of outstanding settlements at the end of every trading day, enforcing margin calls on open positions, and managing member defaults early.

This concept of clearinghouse has already been mentioned and is still seriously considered by regulators for the global CDS market. However, this concept of clearing house has proven to be an efficient tool to reduce counterparty risk for standardized products, as it is the case for many derivatives contracts such as futures. However, the core characteristic of a CDO or CLO is that it is a bundle of underlying assets (mortgages or loans), with various tranches of debt. As a result, every CDO/CLO is different from one another as it has different assets, and standardization is thus inconceivable.

Enhanced risk management and improved reporting systems

Finally, one must agree that the credit crisis was also a crisis of risk management and transparency. For that matter, there should be mandatory enhancements to risk management and reporting systems of financial institutions. However, this is expected to be but one result of the credit crisis. Financial risk model should be better stress-tested in a wider range of scenarios and new specific financial reporting standards should enhance the transparency of these complex financial instruments.

To conclude, even though the structured product market has greatly suffered because of the crisis, such products are here to stay and financial engineering will still be needed. However, the market will only recover if the framework in which theses products are created, structured, and securitized is modified. More precisely, the risks included in the use of any structured investment product should be better understood, identified, and mitigated through diversification of the underlying assets: full-transparency is key. Furthermore, more stringent regulations on risk and financial valuations and the creation of a central clearinghouse would greatly improve overall credit market and trading structure. This optimistic view on the structured finance market lead us to ask ourselves, how will securitization change as a result?

The future of securitization

Prof. Gorton observes, "[t]here are no such issues [as occurred in the subprime crisis] with securitization generally, or with the use of off- balance sheet vehicles for the securitization of those [other] asset classes. Other securitizations are not so sensitive to the prices of the underlying assets and so they are not so susceptible to bubbles." (Schwarcz 2008) In fact, "Securitization, in the long run, is a good thing," says Wharton finance professor Franklin Allen (Knowledge@Wharton 2008), who explains the US mortgage-backed securities market crisis because "(the market) didn't have much experience with falling real estate prices in recent years. The mechanisms weren't designed for that." In addition, "The way the collateralized debt obligations (CDOs) and other vehicles are structured will change. They are too complicated," says Allen. However, he remains confident about the prosperity of the market as "there will be a lot of industry-generated reform and the industry will prosper" and believes financial markets will get back to their pre-crisis levels of securitization. What are these changes?

Professor Schwarcz points out important problems associated with securitization. First, he indicates that structurers should be more diligent with respect to the potential vulnerabilities and risk associated with any asset underlying securitizations as it was apparently not the case with mortgage-backed securities (MBS). Second, Schwarcz criticizes the overreliance on complex math models and on the "originate-and-distribute model" (Schwarcz 2008) in which the actual loan originators sold assets to be repackaged without sharing any significant risk of loss.  Since lenders "did not have to live with the credit consequences of their loans." (Schwarcz 2008), this feature of securitization is problematic as it creates a moral hazard issue. 

As we mentioned it earlier, simpler and more transparent products will be required in the near future at least, and thus, securitization transactions will refocus on basic structures and asset types in order to attract investors back. First, there should be more transparency with respect to tranche allocation in ABS transactions. Second, a reporting methodology could be developed, and rating agencies could act intermediaries to perform this task. Building on this, if an international supervisory body of CRAs were to be implemented, it could validate the ratings given to securitization tranches. Whether securitization will remain stable in the long term depends on the ability of structurers and financial engineers to developed simpler and more transparent products, whose value can be more easily estimated and rated.

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[1] Complex structured debt products include synthetic securitization structures such as: collateralized debt obligations (CDOs and CDOs squared), which are securities backed by a pool of different types of debt, which may include debentures, loans made to corporations by institutional lenders, and tranches of securitizations, mortgage backed securities (MBS), and asset-backed securities (ABS), which include consumer loans and credit card receivables.

[2] You need to explain the significance of the Enron case or at least identify it.

[3] Page 1: "To argue that it took 30 years to detect the bias is to suggest that financial markets participant learn unrealistically slow"

[4] In the finance world, a Chinese wall refers to the procedures enforced within a company to prevent the exchange of confidential information between the firm's different departments in order to avoid the illegal use of inside information.

[5] Enron, an energy company which went bankrupt in 2001, had its public debt rated as "investment grade" up to four days before the company went bankrupt.

[6] The Credit Rating Agency Reform Act voted on by U.S. Congress on September 29, 2006

[7] The Commission's proposal for regulation adopted by the European Parliament and European Council on April 24, 2009

[8] Term used by Paul D. Barnett, Managing Director at Ulysses Management, LLC.

[9] EBITDA: Earnings before Interest, Taxes, Depreciation, and Amortization. Commonly used as an approximate measure of a company's operating cash flow.

[10] A PIK (pay in kind) loan typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity or refinancing date, not even interest or parts thereof, thus making it an expensive, high-risk financing instrument. PIK is to be interpreted as interest accruing until maturity or refinancing.

[11] Agency that administers and services syndicated loan facility and simultaneously serves as a mediator between the debtor and the group of lenders.

[12] A CDO-squared is backed by a pool of other CDO tranches.

[13] A synthetic CDO is a CDO in which underlying credit exposures are taken on using a credit default swap (CDS) rather than by having a vehicle buy physical assets.


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