May 6, 2013
On Friday 5/May I volunteered to participate on "Panel 3 - Alternative Compensation Models" of the SEC May 14 Roundtable on Credit Rating Agencies. Below, I present my credentials and suggest other rating agency specialists who would similarly inform panel discussion (NRSRO analysts trained in U.S. law who can discuss treatment of "flip clauses" when rating debt backed by assets and derivatives.)
I was a (non-attorney) analyst in the Derivatives Group of Moody's Investors Services from 1999 to 2010 and participated in 1700 structured finance committees (conservatively assuming 3 committees per week.) I was the lead analyst for roughly 700 of the 1700 committees, preparing committee memos, making rating recommendations, defending my recommendations in committee and communicating committee decisions to structured finance issuers and their agents.
(Agents were generally arrangers and underwriting banks. Structured finance issuers are legal fictions that exist solely for purposes of registration in domiciles such as the Cayman Islands. With respect to structured finance, the "issuer-pay" model is more properly termed the "arranger-pays-with-issuer-money" model. )
Each Moody's rating opinion emanates from a committee vote and is accurate only to the extent that committee proceedings are robust, particularly with respect to voting. Unless each committee member votes independently after fully informing herself, she votes inaccurately, the committee as a whole votes inaccurately and the rating is inaccurate. Robust discussion in committee undermines rating accuracy unless it is followed by equally robust voting.
Comparatively few people can discuss voting practices at Moody's and fewer still can discuss committee voting on structured finance ratings. According to an autumn 2012 report by the SEC, Moody's employs fewer than 1,000 analysts worldwide in all sectors - corporate, sovereign, municipal, financial, project finance and structured finance. The profile is similar at S&P and Fitch. Again per the SEC fall 2012 report, the 10 NRSROs employ 4,000 analysts worldwide across all sectors.
In contrast, the SEC employs more than 4,000 professionals, Capital Hill employs some 15,000 staffers and the large U.S. banks each employ 200,000 people or more. Discussion of how to improve rating agency opinions is being led by observers who have no experience working in rating agencies, let alone voting in committees. External observation of flawed rating outcomes does not provide the same insights as voting 1700 times in committee or as leading 700 committees.
Separately, I spearheaded development of two derivative methodologies, one of which is used throughout structured finance worldwide (Framework for De-Linking Counterparty Risks from Global Structured Finance Transactions or "Moody's Hedge Framework.")
Moody's continues to apply the Hedge Framework in near original form although it has proved severely deficient. Moody's has proposed to remedy the deficiencies by application of the second methodology that I spearheaded (Termination Derivative Product Companies and Continuation Derivative Product Companies.) I will forward my working papers on the topic later this week.
As has been the case previously, the analogous two methodologies of S&P and Fitch (and now DBRS and Kroll) mirror each other and the Moody's methodologies almost exactly. In fact, a Moody's colleague who formerly worked for S&P structured finance offered that the Moody's Hedge Framework had been used there as well. Incentives driving the herd mentality among five NRSROs rating structured finance must be considered when discussing Panel 3 topics such as "NRSRO rotation" and "small" rating agencies.
Currently, Moody's faces no obstacle in applying a deficient methodology in rating some $1 trillion ($2 trillion?, $3 trillion?) of structured finance debt. The deficiency is particularly pronounced when a structured finance issuer is subject to U.S. bankruptcy law given the 2010 decision by Judge Peck of the Lehman bankruptcy proceedings to vitiate "flip clauses."
I propose that the SEC ask one or more NRSRO analysts trained in U.S. law (and not outside counsel) to discuss the treatment of "flip clauses" in structured finance transactions governed by U.S. law. For a start, the non-enforceability of "flip "clauses" under U.S. bankruptcy law makes the Panel 3 topic of "subordination" incomplete, given that affected structured finance transactions might pay termination payments at the top of a priority of payments.
Following are my Moody's publications.
June 2010 "Update on the Lehman Brothers Derivative Products Companies' Bankruptcy"
July 2009 "Mitigating Voluntary Bankruptcy Risk of U.S.-Domiciled Termination Derivative Product Companies and Assessing the Effectiveness of Continuation Derivative Product Companies"
June 2006 "Framework for De-Linking Hedge Counterparty Risks from Global Structured Finance Cashflow Transactions"
2004 "Capping Hedge Termination Payments in Moody's Rated Structured Notes Following Default of the Underlying Debt Instrument"
2002 "Guidelines for CDO Hedge Counterparties"