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____________________________________________________________
The Role of the Credit Rating Agencies in the Structured Finance Market
Testimony of
Mark Adelson
before the
Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises,
Committee on Financial Services, U.S. House of Representatives
27 September 2007
____________________________________________________________
Introduction

This written testimony embodies and amplifies on the main points of my brief oral
testimony. The key points are as follows:
1. Securitization is an important and beneficial financing tool. America today is better off
because securitization got started nearly forty years ago.
2. Credit ratings are important to the healthy operation of the securitization markets. Credit risk
is a complex phenomenon and credit ratings help investors to understand credit risk and
make comparisons among different kinds of bonds in a simplified way.
3. Despite the outward simplicity of credit ratings, the inherent complexity of credit risk in
many securitizations means that reasonable professionals starting with the same facts can
reasonably reach different conclusions. This is one reason that the market benefits from the
presence of multiple ratings (from different rating agencies) on most securities.
4. Rating methodologies for MBS and CDOs are fully transparent to knowledgeable
professionals in the field. The evidence of transparency is abundant and includes the very
public debate and discourse among securitization professionals about the pros and cons of
different rating approaches and about the merits of entirely different approaches for
analyzing risk.
5. The rating agencies acted in a timely manner in downgrading various CDOs and MBS in
July. The evidence to support such actions was too thin in the spring. Had the rating
agencies waited until the start of fall, they would have been late in reacting to firm The Role of the Credit Rating Agencies
House Subcommittee
Testimony of
in the Structured Finance Market
on Capital Markets
Mark Adelson
Adelson & Jacob Consulting, LLC

2
27 September 2007

indications of credit deterioration. Criticism based on hindsight and Monday-morning-
quarterbacking is unwarranted.
6. Most potential conflicts faced by rating agencies are exactly the same as the ones faced by
other publishing companies in preserving editorial independence in the face of pressure from
advertisers. Rating agencies can handle those conflicts just the same way that other
publishers do.

"Rating shopping" by issuers creates the unique problem of "competitive laxity" for the credit
rating industry. In the past, the practice of assigning unsolicited ratings was the industry's
method for counter-balancing the harmful effects of rating shopping. However, pressure
from issuers and bankers, as well as from policymakers, has caused the rating agencies
largely to abandon unsolicited ratings. To restore appropriate balance, policymakers should
encourage or require a resumption of unsolicited ratings.
Securitization Basics

Because securitization is the canvas on which we must paint the issues and conclusions of
this discussion, I am starting with a description of securitization:

Securitization is a modern financing tool. It is a close cousin to traditional secured debt.
In a typical securitization, a company raises money by issuing securities that are backed by
specific assets. In most cases, the underlying assets are loans, such as mortgage loans or auto
loans. The cash flow from the underlying assets is usually the source of funds for the
borrower/issuer to make payments on the securities. Securitization products are generally
viewed as including the following: residential mortgage-backed securities ("MBS"),
1
commercial
mortgage-backed securities ("CMBS"), asset-backed securities ("ABS"),
2
collateralized debt
obligations ("CDOs"),
3
and asset-backed commercial paper ("ABCP").

1
For a basic introduction to MBS, see MBS Basics, Nomura fixed income research (31 Mar 2006). For an
introduction to securitizations of sub-prime mortgage loans, see Home Equity ABS Basics, Nomura fixed income
research (1 Nov 2004).
2
The term "ABS" generally refers to securities backed by specific assets, where the payments on the securities are
tied to or derived from the cash flows produced by the assets. Examples of typical collateral backing ABS include
the following: auto loans, credit card receivables, home equity loans, manufactured housing loans, student loans, and
equipment leases. In the U.S., the term ABS does not include securities backed by: (1) prime-quality first-lien
residential mortgage loans, (2) commercial mortgage loans, or (3) pools of corporate bonds and loans. Outside the
U.S., the term ABS may include deals backed by such collateral. ABS also includes securities backed by "esoteric
assets" such as; healthcare receivables, tax liens, trade receivables, structured settlements, entertainment royalties,
patent and trademark receivables, etc.
3
A CDO is a securitization structure/technique similar to a hedge fund. In a U.S. CDO, an actively managed pool of
rated bonds or loans serves as the collateral backing other debt securities. The underlying bonds and loans may
include junk bonds, investment grade corporate bonds, securitization instruments, or syndicated bank loans. A CDO
generally issues multiple tranches of debt securities, each at its own level of seniority in the transaction's capital
structure. For a basic introduction to CDOs see CDOs in Plain English, Nomura fixed income research (13 Sep
2004). The Role of the Credit Rating Agencies
House Subcommittee
Testimony of
in the Structured Finance Market
on Capital Markets
Mark Adelson
Adelson & Jacob Consulting, LLC

3
27 September 2007


Compared to traditional secured debt, securitizations are intended to provide a
lender/investor with greater protection against the corporate credit risk of the originator of the
assets. In principle, a securitization lender/investor is a kind of "super-secured creditor," with
rights that surpass those of a traditional secured lender. Securitization employs the notion that
the subject assets have been "sold" by the originator and, therefore, will not become entangled in
bankruptcy proceedings if the originator files for protection under the bankruptcy code.

Accomplishing a "sale" of the securitized assets often requires the use of a special
purpose entity or "SPE." A typical securitization is structured as a two-step transaction. In the
first step, the originator transfers the subject assets to an SPE in a transfer designed to constitute
a "true sale." In the second step, the SPE issues securities backed by the assets. The SPE uses
the proceeds from selling the securities to pay the originator for the assets. In addition, part of
the "consideration" that the originator receives for transferring the assets to the SPE is ownership
of the SPE.

In some securitizations, the originator does not receive the equity in the SPE. Instead, the
originator may retain the subordinate or equity position in the securitized assets through other
means, such as variable fee structure.
Importance of Securitization

The Positives:
As a financing technique, securitization offers certain important
advantages, which translate into benefits to America and to the American economy. The most
vivid example of such benefits is in the residential mortgage sector. The securitization activities
of the GSEs Ginnie Mae, Fannie Mae, and Freddie Mac have produced a highly liquid
secondary mortgage market. Roughly $4 trillion of residential mortgage loans are packaged into
MBS issued or guaranteed by the GSEs. Another $2¼ trillion is packaged into MBS issued by
private companies. In all, about half of all the nation's residential mortgage loans are packaged
into MBS.

As a result, funds for residential mortgage loans are available all across the nation, and
regional differences in interest rates for residential home loans are virtually non-existent. The
MBS market has directly molded lending practices. It has standardized the application process
for most mortgage loans, thereby providing faster decisions to applicants. Most important, MBS
have helped to boost the rate of homeownership in America. Increasing home ownership
arguably strengthens America's democracy by giving more Americans an economic stake in their
communities. A homeowner with an economic stake is more likely to care about his community
and, therefore, to participate in the political process by casting his vote each November on
Election Day. For this alone securitization can rightly be viewed as the greatest financial
innovation of the 20
th
Century.

Beyond the mortgage area, securitization has expanded the availability of consumer
credit in general. Securitization of auto loans and credit card receivables has made auto loans
and credit cards available to more Americans than would otherwise be the case. Superior access
to credit by responsible households is undeniably beneficial, even though easier availability
causes some consumers to borrow more than they should. The Role of the Credit Rating Agencies
House Subcommittee
Testimony of
in the Structured Finance Market
on Capital Markets