Committee on the Global Financial System The role of ratings in structured finance: issues and implications Report submitted by a Working Group established by the Committee on the Global Financial System January 2005 Copies of publications are available from: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2005. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISBN 92-9131-676-8 (print) ISBN 92-9197-676-8 (online) Contents Executive summary ..................................................................................................................................1 1. Introduction ....................................................................................................................................4 2. Structured finance markets: structure and development ...............................................................4 2.1 Key characteristics of structured finance.............................................................................4 2.2 Market participants and their roles.......................................................................................5 2.3 Market size...........................................................................................................................7 2.4 Basic structured finance economics ....................................................................................8 2.5 Complexity and risk properties of structured finance instruments.....................................11 2.6 Market evolution.................................................................................................................13 3. Rating structured finance instruments .........................................................................................14 3.1 Structured finance versus traditional ratings: nature and process ....................................14 3.2 Structured finance rating methodology..............................................................................16 Credit risk modelling: traditional ABS versus CDO pools..................................................17 Assessing the credit risk of CDO pools .............................................................................17 Assessing structural risks ..................................................................................................20 4. The role of ratings in structured finance: an assessment ............................................................22 4.1 Reliance on ratings ............................................................................................................22 4.2 The usefulness of structured finance ratings.....................................................................22 4.3 Standard-setting and implicit regulation ............................................................................23 5. Possible issues arising for structured finance markets................................................................24 5.1 Model risk...........................................................................................................................24 Model risk in agency ratings ..............................................................................................24 Model risk in pricing and hedging: single-tranche CDOs...................................................24 5.2 Rating agency conflicts of interest.....................................................................................25 Conflicts of interest in the ratings industry.........................................................................25 Conflicts of interest and structured finance ratings............................................................26 6. Implications and policy issues......................................................................................................29 6.1 General implications ..........................................................................................................30 Market efficiency................................................................................................................30 Financial stability................................................................................................................30 Market structure and discipline in the ratings industry.......................................................30 6.2 Implications for central banks, regulators and market participants ...................................31 Central banks’ market monitoring......................................................................................31 Risk management and investor due diligence...................................................................31 Disclosure and transparency .............................................................................................33 7. Concluding remarks .....................................................................................................................34 The role of ratings in structured finance: issues and implications iii Executive summary Structured finance, which involves the pooling of assets and the subsequent sale to investors of tranched claims on the cash flows backed by these pools, has become an important part of the financial system. Issuance volumes have grown steadily over recent years and the dynamics of market development, together with the benefits afforded to issuers and investors, suggest that growth is likely to continue. Given this and the prominent role played by the rating agencies in structured finance markets, the Committee on the Global Financial System established a Working Group on the Role of Ratings in Structured Finance to explore the rapidly evolving markets for these instruments. This report documents the Group’s main findings. It highlights several of the characteristics of structured products and the challenges arising for the rating agencies and other market participants. The remainder of the document is organised as follows. Section 2 sets out the broader background of structured finance markets, their structure, their development over time and the main drivers of activity. This is followed, in Section 3, by a discussion of the nature of structured finance ratings and of the methodologies applied by the major rating agencies in assigning these ratings. Section 4 evaluates the role of ratings - and rating agencies - in structured finance. Section 5 discusses some of the concerns that have been expressed regarding this role. Section 6 offers a set of implications. What is structured finance? Structured finance instruments can be defined through three key characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional “pass-through” securitisations); (3) de-linking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through use of a finite-lived, standalone special purpose vehicle (SPV). Forces driving financial intermediaries’ issuance of structured finance instruments have included reduction of regulatory capital, access to new and cheaper sources of funding, and portfolio management. Investors’ interest has been motivated by portfolio diversification and attractive risk-return profiles. A key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral asset pool or to create rated securities from a pool of unrated assets. This is accomplished through the use of credit support specified within the transaction structure to create securities with different risk-return profiles. The equity/first-loss tranche absorbs initial losses, followed by mezzanine tranches which absorb some additional losses, again followed by more senior tranches. Thus, due to the credit support resulting from tranching, the most senior claims are expected to be insulated - except in particularly adverse circumstances - from default risk of the underlying asset pool through the absorption of losses by the more junior claims. Tranching, in turn, contributes to both the complexity and risk properties of structured finance products. Beyond the challenges posed by estimation of the asset pool’s loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired characteristics, such as the seniority ordering of the various tranches, will be delivered under all plausible scenarios. In addition, complexity may be further increased by the need to account for the involvement of asset managers and other third parties, whose own incentives to act in the interests of some investor classes at the expense of others may need to be balanced. Risk properties are a related issue. Depending on their position in the seniority structure, tranches of structured finance instruments can be more leveraged than the portfolio of underlying assets: the more subordinated a given tranche, the greater the probability that the holder of that tranche will lose a significant portion of its investment. Losses to senior tranches, therefore, will be relatively rare, since, by construction, they should occur only with the very worst outcomes for the underlying portfolio. The variety