Alert July 15, 2008

BIS Publishes Study on Lessons Learned in the Recent Failure of Structured Finance Ratings and Provides Recommendations

The Basel Committee on the Global Financial System (the “Basel Committee”) published a study (the “Study”) of ratings in structured finance.  The Study notes that since the second half of 2007, asset-backed securities (“ABS”) have suffered through a period of dramatic repricing due to performance deterioration of subprime mortgages that were packaged into residential mortgage-backed securities (“RMBS”).  There has been a simultaneous wide-scale revision in ratings on structured finance (“SF”) products backed by RMBS that has revealed weakness in investors’ risk management and raised questions about the ability of credit rating agencies (“CRAs”) to rate complex SF products.  The Study focused on lessons derived from the recently revealed weaknesses in the ratings and provided possible solutions.  

The Study states that CRAs’ underestimation of the severity of the housing market downturn, reliance on limited historical data and the underestimation of originator risk, combined with a failure to adequately monitor rated SF securities, produced the frequent ratings downgrades that have characterized the SF market in the past year.  Drawing on these failures and their results, The Basel Committee sets our four lessons: (1) credit rating information should support, not replace, investor due diligence, particularly when assessing the risk of the underlying collateral; (2) CRAs should enhance the information underlying SF ratings to facilitate comparison of risk with and across different SF products; (3) better information on the CRAs assumptions regarding the key risk factors that influence SF ratings is needed; and (4) CRAs should, when assigning ratings, periodically take into account the system-wide risk implications of  rapid growth by similar SF instruments or vehicles.  

The Basel Committee also offered ten recommendations to address weaknesses and improve investor confidence in SF product ratings.  These recommendations include:

  1. Investment fund trustees and managers should review how ratings information on SF products is used in their investment mandates and decisions. 
  2. Rating reports should be standardized and presented in a way that facilitates comparisons of risk within and across classes of SF products.
  3. Rating agencies should provide clearer information on the frequency of rating updates, including the timing of post-issuance reviews.  
  4. More user-friendly access to CRA models and their documentation should be provided.  Rating models made available by CRAs should facilitate stress tests and allow users to alter CRA assumptions on key model parameters.
  5. CRAs should document the sensitivity of SF tranche ratings to changes in their central assumptions regarding default rates, recovery rates and correlations. 
  6. CRAs should clearly and regularly disclose to investors their economic assumptions underlying the rating of SF products, including how the CRA expects each rated tranche to perform under different economic scenarios. 
  7. Where only limited historical data on underlying asset pools is available, this should be clearly disclosed as a source of model risk, as should any adjustments made to mitigate this risk. 
  8. CRAs should monitor more intensively the performance of the various agents involved in the securitization process and assign ratings to mortgage originators’ loan approval processes.
  9. CRAs should periodically consider the wider systemic implications of rapid growth of similar SF instruments or vehicles, or of new business undertaken by existing SF vehicles, for the continued accuracy of their original ratings criteria.
  10. CRAs should consider how to incorporate additional information on the risk properties of SF products into the rating framework.