The Credit Crisis

and beyond:

Lessons from the Financial Crisis

& Sound Practice Principles

Markus Krebsz 7 March 2013, London

European & International Financial Institutions lecture

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1) Lessons from the Financial Crisis

Lesson 1: Data, Disclosure and Standardization

Lesson 2: Due diligence

Lesson 3: Deal motives

Lesson 4: Arbitrage

Lesson 5: Rating shopping & Over-reliance on ratings

Lesson 6: Models, Assumptions & Black boxes

Lesson 7: Proprietary analysis & Risk management

Lesson 8: Senior management awareness

Lesson 9: Lack of drill-down capability

Lesson 10: Mark-to-market, Mark-to-model & Illiquidity ________________________________________________________________________________________________________________________

Source: “Securitization & Structured Finance

post Credit Crunch” – Part I

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Lesson 1: Data, Disclosure + Standardization

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Data, Disclosure & Standardization

• Banks’ due diligence vs. outsourced analysis (CRA)

• Historical information Future performance: NO!!!

• Model = Always model, NOT true reflection of reality

• Paper reports issues & problems

• Electronic reports depends on file format really

• Data feeds & APIs

• Definitions Product taxonomy

• Non-comparability of ratings across CRAs

• Lack of clear reporting or underwriting standards 5

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Lesson 2: Due diligence?

Due diligence

• Activities investors should undertake prior to

purchasing new or secondary market bond issuance

• CRAs don’t do “due diligence” but only “servicer

reviews” – investors don’t always know this

• Thorny issues & digging deeper: not really

• CRAs are always conflicted in their opinion given

that they are paid by the bond issuer for the rating!

• Issuer pays model (since 1970)

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Lesson 3: Deal motives

Deal motives

• Investors need to ask more questions such as:

“What is in it for us?” (i.e. the investors)

AND

“What is in it for THEM?” (i.e. the issuers)

• Plausible explanation for a particular deal?

• Why has the deal been structured?

• Capital structure of the transaction?

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Lesson 4: Arbitrage

Arbitrage

• Financial motivation, such are arbitrage

• Aim is to leverage an actual or perceived advantage

• Regulatory arbitrage: applying different rules for

calculating capital charges under BII regime

• Informational arbitrage: different levels of insights

or information on underlying assets

• Technological arbitrage: more sophisticated

models with perceived or real analytical edge

• Financial arbitrage: Cash flow advantage, excess

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5:

Using CRAs’ analysis sensibly

Rating shopping and Over-reliance on Ratings

• Rating by one CRA missing?

It’s worth digging deeper!

• Reasons: cheaper credit enhancement (C/E)

Indicating rating shopping!

• Happened often in the run up to the Credit Crisis

• If you are an investor, simply ASK the CRA

• Credit ratings have been key investment criteria

• Outsourcing analysis possible, BUT:

outsourcing losses is not

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• Legal final vs. expected

maturity

• Life-time ratings (40+ years)

• Timely payment of interest &

ultimate payment of principal

Report format & frequency, Analyst’s experience, Models, Quorum ...

31 July 07

Cut-off date

15 Aug 07

Distribution

Bulk rating

actions &

Criteria

Changes

20 Aug 07

CRA analyst

27 Aug 07

1st Analysis result

31 Aug 07

Proposal: RWN

25 Sept 07

1st Committee

9 Oct 07

CRA Analyst

12 Oct 07

2nd

Analysis result

16 Oct 07

Proposal: DG

23 Oct 07

2nd

Committee

25 Oct 07

Indiv. or Asset-class?

You get

the idea...

Timely rating actions and Deferral

• Process stages to reach

rating decisions

• Detection of bond- vs.

asset class-specific

and/or systemic issues

Bond maturity profile Timeliness of Rating changes

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Constructive Criticism

• Business model: Too slow to react

• Assumptions, methodologies & models

• Conflict of interest (‘issuer-pays’ model)

• Limited capture

• Split ratings

• Notching of competitor’s ratings

• Implied ratings & internal competition

• “Getting it wrong”, “Fat fingers”

• etc. 15

Failures of CRAs

AIG, Bear Stearns, Bradford & Bingley, Enron, Icelandic

banks, Lehman Bros., Monolines, Northern Rock, Parmalat,

Sovereigns (Eurozone), Sub-prime bonds etc.

In their own words...

Fitch: “… did not foresee the magnitude of the decline…or

the dramatic shift in borrower behavior…”

Moody’s: “…We did not . . . anticipate the magnitude and

speed of the deterioration in mortgage quality or the

suddenness of the transition to restrictive lending...”

S&P: “…It is now clear that a number of assumptions used

in preparing ratings on mortgage-backed securities issued

between 2005 and mid-2007 did not work…”

Source: US Government Oversight and Reform Committee, Oct 2008

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Sensible use of CRAs’ analysis

• Fully understand the instrument you are investing in –

particularly when using other peoples’ monies

• Understand ratings’ limitations and

know how to mitigate rating-related risks (previous slide)

• ‘Ignore’ ratings designators (i.e. AAA etc.) and

focus on CRAs’ analytical narrative instead

• Look out for what is NOT there in the narrative but should

e.g. Why are obvious issues missing in the analysis?

Why has this bond not been rated by all three CRAs?

• Apply common sense and trust your gut feeling 17

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Lesson 6: Captured Risks

Models, Assumptions & Black Boxes

• Extensive use of financial models to do “analysis”

• Fairly simple to highly complex quantitative models

• A “model” is ALWAYS only a “model”!

• Models CANNOT simulate reality!

• Model failures exacerbated by using inadequate

assumptions, i.e. through the cycle – 10-12 years only

• Historic data points as input into model: limited data?

• Black box: locked-down back-end with no access for

users, i.e. not easy and often impossible to reconcile 19

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Lesson 7: Proprietary analysis

Proprietary analysis & Risk management

• Often overlooked: Good old-fashioned analysis

• Done by dedicated teams of credit analysts

• Analysis, loads of analysis

• Gut feeling & Common sense (which is not so common)

• Lack of qualified risk management practices

• Firm’s strategy Risk appetite Risk policy

Investment guidelines etc.

• Robust risk management function needs to be

empowered by the firm to say “NO!” sometimes

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Lesson 8:

Senior management

awareness

Senior management awareness

• Management reporting – or lack of it

• Limited systems capabilities

• Filtering of reports through distribution channels up the

chain

• Does the information at board level paint a full picture?

• Senior mgmt. ignorance or misinterpretation of data

• Senior mgmt. does not understand

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Lesson 9: Lack of Drill-down + Group-wide Controls

Lack of drill-down capability & Group-wide controls

• US subprime replaced with investments in CDO of ABS

• Minor issue becomes major disaster

• “Repackaged” garbage is still garbage!

• One desk sells and the other buys, largely ignoring firm-

wide strategy

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Lesson 10: Mark-to-Market, Market-to-model + Illiquidity

Mark-to-market, Mark-to-model & Illiquidity

“Normal times”: Mark-to-market

• Electronic trading matching bid/offers or

• Collection of broker quotes by phone

“Periods of limited market stress”: Mark-to-model

• If there is no “normal” market market-to-model

• Based on pricing models which are based on “normal”

markets

“Periods of prolonged illiquidity”:

• Difficult to price if there is no market at all! Force sale?

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2) Sound practice principles

DATA

Principle 1: Access: Open source

Principle 2: Information asymmetries

Principle 3: Data formats

Principle 4: Data delivery

Principle 5: On deal level

Principle 6: For the market at large

Principle 7: Industry data portals

DEFINITIONS

Principle 8: Simplifications

Principle 9: Transparency

Principle 10: Standardisation

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STANDARDS

Principle 11: Underwriting standards

Principle 12: Reporting standards

Principle 13: Representations & warranties

INVESTOR FOCUSED

Principle 14: Government facilities

Principle 15: Private investors

Principle 16: Incentive alignments

MOTIVATION & DEAL DRIVERS

Principle 17: Arbitrage

Principle 18: Rating shopping

Principle 19: Risk transfer & “Skin in the game”

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ANALYSIS

Principle 20: Reduced over-reliance on credit ratings

Principle 21: Increased proprietary analysis

Principle 22: Models, assumptions and common sense

Principle 23: Risk management & Risk mitigation

References & Appendix

“Securitization & Structure Finance post Credit Crunch –

A Best Practice Deal Lifecycle Guide”, M. Krebsz (Wiley 2011)

Please see Part I of the book attached for your kind reference:

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