Memorandum from Standard & Poor's
1.1 Standard & Poor's Rating Services
("S&P") submits this memorandum in response to the
Treasury Committee's request for written evidence on the role
and regulation of credit rating agencies. We understand that the
Treasury Committee has also asked S&P to give evidence on
Northern Rock. Representatives of S&P will attend at the hearing
on 13 November to provide oral evidence on these topics. In the
meantime, we refer the Committee to the most relevant of the public
statements we have made concerning Northern Rock from 2005 onwards,
which are listed in the appendix to this memorandum.
1.2 In section 3 we provide a description
of our credit ratings and explain what they are intended to represent.
We explain in particular that such ratings address the likelihood
of default of securities, not their marketability.
1.3 In section 4 we provide some background
on our ratings of residential mortgage-backed securities ("RMBS")
and summarise the actions that we took from early 2006 onwards,
in response to our concerns over the deteriorating quality of
1.4 S&P at section 5 underlines its
commitment to learning lessons from recent events. We have enhanced
our procedures and we are engaged in an active dialogue with numerous
market participants so that we can determine what further steps
we should take.
1.5 Section 6 deals with regulation. S&P
has replaced its prior Code of Practices and Procedures with a
new Code of Conduct which represents further alignment of its
policies and procedures with the Code of Conduct Fundamentals
for Credit Rating Agencies published by the International Organisation
of Securities Commissions ("IOSCO"). We discuss our
adherence to those standards annually with the Committee of European
Securities Regulators ("CESR") which reports on credit
rating agencies' code implementation and compliance to the European
2. STANDARD &
2.1 S&P is a business unit of Standard
& Poor's, itself a division of The McGraw-Hill Companies,
Inc, ("McGraw-Hill"), a global business services
provider in the fields of financial services, education and business
information. Standard & Poor's has roots going back to 1860.
Standard & Poor's was created in 1941, when Standard Statistics
merged with Poor's Publishing Company. Standard & Poor's currently
employs approximately 8,500 employees worldwide, of which approximately
1,000 employees are based in Europe. Standard & Poor's has
been a division of McGraw-Hill since 1966.
2.2 The business of Standard & Poor's
is to provide financial market intelligence. It is perhaps best
known as one of the world's leading providers of independent credit
ratings. Standard & Poor's also maintains a wide variety of
tradeable and benchmark index products and services (such as the
S&P Global 1200 index) and provides mutual fund analysis and
independent equity research.
2.3 Standard & Poor's has been engaged
in issuing credit ratings since 1916. The total amount of outstanding
debt rated by S&P globally is approximately US$34 trillion
in 100 countries. S&P rates and monitors developments pertaining
to these issuers from its operations in more than 21 cities in
16 countries around the world.
2.4 Standard & Poor's has had an operation
in London since 1984. Approximately 650 employees are based in
London, which is Standard & Poor's largest base in Europe.
3.1 A credit rating is an opinion that we
publish on the creditworthiness of particular issuers or financial
obligations. In order to understand our role, it is important
to recognise that our opinions relate solely to creditworthiness,
by which we mean the likelihood that a particular obligor or financial
obligation will pay, on time, the principal amount of the debt
and interest owed.
3.2 Our ratings do not constitute recommendations
as to whether investors should "buy", "sell"
or "hold" rated securities, nor do they consider
the suitability of securities for particular investors or groups
of investors. Similarly, our ratings do not address the likely
market performance of an investment or whether its price can be
said to reflect its credit risk and/or its expected returns. At
their core, our ratings speak only to the likelihood of timely
repayment. They are not designed to address other market factors,
such as supply and demand, that may affect the pricing of securities.
3.3 Our ratings are based on the facts available
to us at the time opinions are formed. They are designed to be
stable and, unlike market prices, they do not fluctuate on the
basis of market sentiment. Nevertheless, it has always been the
case that credit ratings, including high "investment grade"
ratings, can and do change. After a rating has been issued, S&P
reviews developments that might alter the initial rating, known
as the "surveillance process". A rating may be
upgraded or downgraded as a result of adjustments to the risk
profile of an obligor or security, or because of the emergence
of new information. We do not downgrade securities in response
to market sentiment; we make adjustments to our ratings when the
facts demonstrate the need to make adjustments and not before.
3.4 Our ratings range from the highest category
of AAA, through AA, A, BBB (which is the lowest of what are referred
to as to the "investment grade" ratings) to D
(indicating a situation where an obligation is in default). Ratings
for AA to CCC may be modified by the addition of a plus (+) or
minus (-) to show relative standing within the major rating categories.
Our highest rating of AAA denotes that, in our opinion, an issuer
or security has an extremely strong capacity to meet its financial
commitments. Nevertheless, this rating, in common with our other
ratings, is not intended to act as an assurance that there is
no possibility of default. Instead, our respective ratings are
designed to show the relative probabilities of default, so that
the risk increases as the rating lowers.
3.5 Transition studies of our historical
ratings demonstrate a strong correlation between our various rating
categories and the rates of default that have actually occurred.
For example, for the period from 1978 to 2006, the weighted average
five-year default rate for investment grade structured securities
rated by S&P is less than 1%, while for speculative grade
securities it is slightly over 15%. By comparison, over a comparable
period (1981 to 2006), the weighted average five-year default
rate for investment grade corporate issuers is 1.19% and for speculative
grade issuers it is 18.07%.
3.6 The following table illustrates, as
of 28 October 2007, the cumulative five-year default rate for
the initial RMBS ratings that we have issued over a 30 year period.
|Initial Rating||% of Default
3.7 Public ratings are made available in real time. When
a public rating is assigned or changed, the announcement is made
on our publicly available website and a press release may also
be provided to news outlets and other media. Currently there are
approximately 9 million current and historical ratings available
on RatingsDirect, which is a subscription-based product. In addition,
there are as many as 1.3 million active ratings available for
free on our publicly available website: www.sandp.com.
4. S&P'S RATINGS
4.1 S&P has been rating RMBS for approximately 30
years and has developed specific processes and models for evaluating
the creditworthiness of these transactions. Our track record of
assessing RMBS credit quality has been strong as can be seen from
the table at 3.6 above.
4.2 When rating RMBS, S&P uses default and cashflow
models specially designed for the purpose and made commercially
available to the public. With the assistance of these models,
S&P rates RMBS by analysing creditworthiness and cash flow
aspects of the structure. These models are regularly amended and
enhanced over time and those modifications are also made commercially
available. S&P also reviews the practices, policies and procedures
of originators and servicers as well as the legal documents of
the securities to be listed.
4.3 In response to deteriorating sub-prime performance,
S&P has adjusted its criteria and assumptions to increase
its credit enhancement requirements for certain transactions,
having identified certain sub-prime loans as being more likely
to default than others. S&P has also heightened the stress
levels at which it rates and surveils transactions to account
for deteriorating performance as evidenced by data which it has
received and has increased the frequency of its review of rated
4.4 At the same time as we were modifying our models
to reflect our observations about the sub-prime market, during
the period from early 2006 onwards, we issued a series of publications
in which we repeatedly and consistently warned the market of our
concerns about the deteriorating quality of RMBS transactions.
Furthermore, we also took rating actions where appropriate in
response to sub-prime deterioration.
4.5 In July and October 2007 S&P again took steps
in the light of increasingly poor performance data. This included
increasing the severity of the surveillance assumptions we used
to evaluate the ongoing creditworthiness for RMBS transactions
and downgrading those that did not meet these stress test scenarios
within given time-frames. We will continue to take rating actions,
as appropriate, to reflect the continuing evolution of the position
and our assessment of the RMBS market.
4.6 What has happened in the sub-prime market and the
US housing market generally has been more severe and more precipitous
than anyone had anticipated. Furthermore, recent sub-prime transactions
have been performing significantly worse than transactions from
earlier periods, even for transactions sharing similar underlying
characteristics. Delinquencies and defaults in the sub-prime mortgage
market have increased significantly. This has been ascribed to
a number of factors, including in particular stretched underwriting
standards, possible fraud in the origination process, sharply
rising interest rates and an unexpectedly steep drop in house
prices in the US. In addition to these underlying factors, other
new trends have occurred. For example, individuals who purchase
homes have historically paid their mortgages before paying off
their credit cards, but that now appears no longer to be true
to the extent that it once was. Similarly, individuals who live
in the homes that they purchase have historically repaid the mortgages
on those homes more readily than those who live elsewhere, but
this long-standing pattern also now appears to be changing.
4.7 S&P regards factors such as these as significant
changes of behaviour, particularly at a time of substantial falls
in property prices. It was these factors and trends, among others,
that led S&P to downgrade some of its RMBS ratings, even though
there had been no substantial losses on the pools of assets that
back the sub-prime RMBS.
4.8 It is important however to put these developments
in context. While the "credit crunch" was serious,
the fact is that the market has not to date witnessed widespread
defaults of mortgage-backed securities.
5. LESSONS LEARNED
5.1 S&P is committed to learning lessons from the
events that have led to the recent turmoil in the credit markets,
including any lessons on the role and responsibilities of credit
5.2 S&P is taking steps to ensure that its ratingsand
the assumptions that underlie themare analytically sound
in the light of changing circumstances. For example, as indicated
above, we have significantly heightened the stress levels which
we use in our analytical models and increased the frequency of
our reviews of rated transactions. We have also undertaken a survey
of originators and their practices, particularly in relation to
data integrity and the ability to detect and manage fraud in the
origination process. In sum, we are continually reviewing our
models and processes in order to consider what further changes
may be appropriate.
5.3 S&P is also maintaining a dialogue with market
participants and other interested parties in an effort to determine
the steps that the credit rating agencies and others should take
in response to recent events. To this end, we are actively engaging
in a number of different fora. We are also holding ongoing discussions
with regulators and other policy-makers on the role of credit
rating agencies and their treatment of structured products.
5.4 In this context, we have noted with interest the
comment made by the Bank of England's Financial Stability Report
about the role of credit rating agencies and its suggestions aimed
at facilitating a more sophisticated use of ratings by investors
(Issue No. 22, October 2007). We are giving careful consideration
to those suggestions.
6. THE REGULATION
6.1 The issue of the regulation of credit rating agencies
was recently reviewed by the European Commission ("the
Commission"), which published its conclusions in March
2006. The Commission noted that there were already three Directives
in place that are relevant to the position of credit rating agencies
and concluded that no new legislative initiatives were needed.
In reaching this conclusion, the Commission noted that in December
2004 IOSCO had developed a Code of Conduct for credit rating agencies
and that many agencies had set up their own Codes of Conduct along
the lines of the IOSCO Code.
6.2 The Commission concluded that this was an encouraging
development, provided that the credit rating agencies implemented
their Codes of Conduct in practice, on a day-to-day basis. It
therefore asked CESR to monitor compliance with the IOSCO Code
and to report back to it on an annual basis.
6.3 In October 2005, S&P replaced its prior Code
of Practice and Procedures with a new Code of Conduct in order
to align further its policies and procedures with the IOSCO Code.
S&P and certain other credit rating agencies have also agreed
to adhere to the following framework for monitoring compliance
with the IOSCO Code:
(a) each agency sends an annual letter to CESR (which
is made public) outlining how it has complied with the IOSCO Code
and explaining any deviations from the Code;
(b) CESR holds an annual meeting with each agency to discuss
any issues related to its implementation of the IOSCO Code; and
(c) each agency provides an explanation to the national
CESR member where any substantial incident occurs with a particular
issue in its market.
6.4 The framework established by this agreement is already
in place, and in December 2006 CESR published its first report
to the Commission on the compliance of credit rating agencies
with the IOSCO Code (S&P subsequently revised its Code in
response to CESR's comments). S&P and other credit rating
agencies are continuing to participate in this framework and CESR
is due to publish its next annual report by mid-May 2008.
6.5 The framework established by IOSCO, the Commission
and CESR is a relatively new one, but one that S&P believes
provides an effective, flexible and transparent mechanism for
ensuring that credit rating agencies comply with a clearly defined
and comprehensive set of external standards.
These Directives are the Market Abuse Directive, the Capital Requirements
Directive and the Markets in Financial Instruments Directive. Back