NAIC Rating Agency Working Group Hearing September 24, 2009 Testimony of David Marks, CUNA Mutual Group
Good morning and thank you for the opportunity to present my views to the NAIC Rating Agency Working Group. My name is David P. Marks and I am an Executive Vice President and Chief Investment Officer of CUNA Mutual Group and President of Members Capital Advisors the investment subsidiary of CUNA Mutual Group. With more than $3 billion in revenue, CUNA Mutual Group is the premier insurance company in serving credit unions and their members. We sell 45+ insurance, investment and service related products to credit unions and their members world wide. We are based in Madison, Wisconsin and have offices in Iowa, Texas, the Caribbean, Ireland, Canada and Australia. I have a BA in Chemistry and Physics, an MBA, and a Chartered Financial Analyst certification. I have also earned an executive MBA. I have 38 years of investment experience and have been the Chief Investment Officer (CIO) of 4 major insurance companies including CUNA Mutual Group. The others include: Travelers Life/Citigroup, CIGNA and Allianz of America. All of my investment experience has been investing the policyholder surplus and the insurance premiums for companies within the insurance industry. For 35 of my 38 years, the investment organizations that I worked for or led used rating agency ratings as one of the proxies for quality when underwriting public bond purchases, sales, swaps or valuations. We no longer 2
use those rating agency ratings as we now rely on our own independent research staff that must rate and sign off on each security that we purchase, value or sell prior to the transaction. We now rigorously update those ratings quarterly. Based upon my experience and contacts with other CIO s of insurance companies, most firms have primarily used independent research staffs on private placements, commercial mortgages and some difficult to determine types of illiquid investments like private equity or alternative investments for over 30 years. But, most insurance companies and other financial services investment organizations relied on the major rating agencies for at least corroboration or verification of the credit quality of most public bonds they held or were buying or selling. These securities are separated into a series of ratings with investment grade securities rated AAA all the way down to BAA- or BBBdepending upon which firm performed the rating. In the non-investment grade category or High Yield Markets, ratings (which went from BA+ to CCC or below) were also used to verify the quality of the underlying company or security prior to a decision or approval for purchasing or selling. Structured Securities For difficult to underwrite Structured Securities (a financially engineered security made up of pieces of other types of asset or securities), ratings were still used 3
to a greater degree even though the industry began to move away from almost sole reliance in the early 2000 time frame after the Enron, World Com, Adelphia frauds impacted the bond market. When one buys a public corporate bond, a majority of the detail behind the essence of the company, its cash flows, its financial performance and in some instances even its management is readily available using Bloomberg, SEC filings, etc. However, in many types of Structured Securities information is not readily available about the collateral or pools of collateral (including residential or commercial mortgages) that support the structure nor are the details about the underlying holdings listed comprehensively in an organized manner in any offering memorandum or available on Bloomberg or other readily available sources. For those of you who might be unfamiliar with Structured Securities here is the SEC definition: U.S. Securities and Exchange Commission (SEC) Rule 434 [1] (regarding certain prospectus deliveries) defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows." 4
A healthy and vibrant securitization market needs to operate in a marketplace where the ratings on the pools can be trusted and remain in place for a good majority of the maturity of the transaction. The offering brochure of these pools is generally drafted by the selling agent usually an investment banker as the issuer (i.e. the seller of the securities or pool of securities). That information is provided to the rating agencies to evaluate before it is rated, priced and sold. The fees paid to rating agencies are also paid by the seller in conjunction with the investment banker. Errors in Ratings Historically, when a rating agency rated a security AAA, the market and the buyers understood that it was of the highest quality with a 1-in-10,000 probability of default. This was clearly not the case with billion of dollars of Collateralized Debt Obligations (CDO s), Sub Prime Residential Securities or Alt-A securities many of which went from AAA to below investment grade in a short period of time and have now either defaulted or are priced at pennies on the dollar. It also was not the case for more engineered structures like CDO squared, Re-remics and other financially engineered structures. Most, if not all of the latter, have been downgraded to junk status and many have traunches that have already gone into default or are heavily impaired. Just last week on September 17 th, California Attorney General Edmund Brown, Jr. said, At the peak of the 5
housing boom, these agencies gave their highest ratings to complicated financial instruments-- including securities backed by subprime mortgages--making them appear as safe as government-issued Treasury bonds. According to Attorney General Brown, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage-backed securities. This statistic prompted him to raise questions on whether the rating agencies understood the risks of the debt they rated. Is he right or are these types of securities extremely difficult to analyze and were there other complicating factors involved in this misalignment of risks and ratings? In my opinion, there was a lack of understanding by many parties of what the underlying collateral was supporting: the value of the pool or the entire security. Furthermore, there was no reliable historical loss statistics for the collateral in question. The sellers failed to adequately disclose the underlying collateral and the existing Nationally Recognized Statistical Rating Organizations (NRSROs) probably failed to apply conservative enough loss factors to the securities they rated. There were, of course, multiple parties at fault, in my opinion, and I am sure there will be many books written on the subject. In my opinion, everyone is culpable to some degree including the issuers, the investment 6
bankers, the mortgage brokers, the banks who lent the money to unqualified borrowers, the individual borrowers who felt that housing prices only went higher, the rating agencies and lastly the buyers of these securities who honestly felt that if they bought a AAA quality investment it was a good investment. In terms of understanding risk, there was a recent study done by Summit Real Estate Advisors of 25 major Commercial Mortgage Backed Securities (CMBS) sold by one major investment banker rated AAA or AA by the major rating agencies, in which only 6 remain investment grade today. That banker and rating agencies did not understand the quality of the entire pool of properties because, according to Summit, a majority of the underwriting completed by both organizations only focused on the top 10 properties in each pool. While those top 10 properties were generally well underwritten, the remaining properties went into default or foreclosure and the entire structure collapsed as there was not enough collateral value to cover the interest or principal within the entire structure. These deals, originally rated AAA or AA in 2006 and 2007, have been significantly downgraded and certain traunches are now in default. Within the insurance industry, billions of dollars of Residential Mortgage and Commercial Mortgage Backed Securities have been downgraded by the rating agencies not less than 3 years after they were first rated A to AAA forcing the insurers to either write down 7
those investments or impair them. When ratings of individual pools of securities all move down multiple letter grades over a short period time one has to ask the question: Were these securities rated properly to begin with? How the NAIC and the Insurance Industry Can Help The real issue or question should be: Is there a better or more logical process to the ever important rating function? Not every investor or firm has the capability or staff to fully underwrite and rate these complex securities. Plus, the NAIC and our independent auditing firms base their audits and valuations to some degree on other verifiable independent rating systems. I believe this is an area where NAIC can help the industry improve the system. Here are some logical suggestions for the NAIC Working Group to consider: 1. In order to align interests, the buyer should pay for the rating of each particular security. This would be a welcomed change. 2. There should be a requirement that ratings be updated continually to reflect any material developments. We do this today at our company. 8
3. Rating agencies should detail their track record of how many securities retain their original ratings 1, 3, 5, 7 and 10 years after originally rated. This record should be included in every prospectus or offering memo and should be classified by asset class or sub sector. How many of the CDO s, and Sub Prime Residential Mortgage Backed Securities pools, Alt-A, CMBS securities have retained their original rating now, 2-3 years after issuance? These are just score keeping statistics that all rating firms should detail for buyers of any type of security as an indication of a performance track record; just like we do when we measure our total return results versus our benchmarks. This idea enhances what the SEC proposed on September 17 th to bolster oversight of credit ratings agencies by enhancing disclosure and improving the quality of credit ratings. 4. In any type of financially engineered security structure, the issuer/investment banker should file all the information on the underlying collateral pools and assets with the SEC in an SEC file open to the public so everyone can view it. This is normal in the rating process for new issue corporate bonds. Why can t it be similar for structured products? Assuming this does not delay the sale of the security, this should be part of every offering. 9
5. The NAIC, the SEC and all of our auditing firms should allow and accept ratings from other NRSROs and others who meet certain performance standards. 6. One idea to consider Allow insurance companies to submit their own internal ratings of Securities to an independent, self-regulating body to both share ratings across the industry and to referee differences between companies. This low-cost alternative depends on companies to policing themselves based upon guidelines, models and other tests like cash-flow coverages, debt-service coverages, debt/equity ratios, appraised collateral value coverages, etc. To avoid internal conflicts, the referee should not be affiliated with any insurance company and should have the final say if there were an impasse on a rating. The beauty of this approach is that each insurance company would also need to justify the rating through their investment committees and auditors. 7. Lastly, another approach would have the insurance industry create an independent not-for-profit rating agency. The agency could be funded and staffed by the insurance industry based upon either size of assets and/or amount of securities purchased or sold or a combination of these and other factors. The fees would be paid by the buyers and the process, and, hopefully, the resulting ratings would be sound, verifiable, replicable and independent. 10
Certainly anti-trust issues would have to be addressed, but my point is that alternative approaches should be examined. 8. I hope you find these comments helpful. And, I would again like to thank the NAIC and the Working Group very much for the opportunity to express my views on the Structured Securities marketplace and the role of rating agencies. 11