Credit Rating

Credit Rating Issues:1. What Does It Mean

2. What It Does Not Mean

3. Who Does It

4. How It is Done

5. Why Is It Undertaken

6. Who Pays For It

7. What Are Its Effects

8. How It Is Expressed

9. Credit Rating & Global Financial Crisis

Credit Rating

• Credit Rating is a current opinion of an obligor’s overall financial capacity (its creditworthiness) to pay its financial obligations.

• This opinion focuses on the obligor’s capacity and willingness to meet its financial commitments as they come due.

Credit Rating

• It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, Long-Term Issuer Credit Ratings

Credit Rating

What it is not

• A recommendation to buy or sell investments

• A way of defining good or bad companies

• An audit

Who Does It?• The global credit rating business is dominated by

three agencies:

– Standard & Poor's

– Moody's

– Fitch

• From the market share of the business point of view, the biggest players are the first two agencies, who controls around 90 percent of the business.

Credit Rating

Types of ratings

• Issuer Credit Rating (ICR) or Counterparty Credit Rating (CCR)– capacity & willingness to meet financial

commitments

• Issue Rating– creditworthiness of a specific financial obligation

• Bank Loan Rating

Rating Scale

• AAA

• AA

• A

• BBB Investment Grade

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• BB Non-Investment Grade

• B (Also Called Speculative Grade)

• CCC

• CC

• C

• Debt with a maturity of one-year or less, such as commercial paper, are rated according to Short-term rating scale.

• They are given the scale of A-1+, A-1, A-2, A-3, and B.

Information requirements

1. Organisation structure

2. Senior management background

3. 5 years of detailed historical financial info

4. Detailed projections for 3 years including assumptions

5. List of bank lines available and recent usage

6. Financial documents, e.g. shareholder circular, issued over the last 3 years

7. Detailed descriptive data relating to the operations of all material divisions

8. Summary of corporate strategy together with perceptions of risks and opportunities

Credit Rating

Benefits of Credit Ratings to Issuers/ Counterparties

• Supports disclosure & transparency

• Provides independent peer comparisons

• Enhances terms and conditions of borrowings

• Enhances access to new sources of funds/markets

Credit Rating

Benefits of Ratings to Investors:• Benchmark for risk premium

• Information and reference point

• Simple global measure of credit risk

• Assist in portfolio monitoring

Credit Rating

• AAA

• An obligor rated ‘AAA’ has EXTREMELY STRONG capacity to meet its financial commitments.

• ‘AAA’ is the highest Issuer Credit Rating assigned.

Credit Rating

• AA

• An obligor rated ‘AA’ has VERY STRONG capacity to meet its financial commitments.

• It differs from the highest rated obligors only in small degree.

Credit Rating

• A

• An obligor rated ‘A’ has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

Credit Rating

• BBB

• An obligor rated ‘BBB’ has ADEQUATE capacity to meet its financial commitments.

• However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

Credit Rating

• Obligors rated ‘BB’, ‘B’, ‘CCC’, and ‘CC’ are regarded as having significant speculative characteristics.

• ‘BB’ indicates the least degree of speculation and ‘CC’ the highest.

• While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertain-ties or major exposures to adverse conditions.

Credit Rating

• BB

• An obligor rated ‘BB’ is LESS VULNERABLE in the near term than other lower-rated obligors.

• However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitments.

Credit Rating

• B

• An obligor rated ‘B’ is MORE VULNERABLE than the obligors rated ‘BB’, but the obligor currently has the capacity to meet its financial commitments.

• Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments.

Credit Rating

• CCC

• An obligor rated ‘CCC’ is CURRENTLY VUL-NERABLE, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.

Credit Rating

• CC

• An obligor rated ‘CC’ is CURRENTLY HIGHLY-VULNERABLE.

• Credit Rating is withdrawn upon the first occurrence of any of the following:– 1) a payment default on any financial

obligation, rated or unrated, other than a financial obligation subject to a bona fide commercial dispute;

Credit Rating

• 2) a voluntary bankruptcy filing by the issuer or similar action; or,

• 3) in the case of banks, upon seizure of the bank by a regulator, or, in the case of insurance companies, upon placement of the insurer under regulatory supervision due to its financial condition.

Credit Rating

• Plus (+) or minus (-) Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

Credit Rating

• Rating Outlook Definitions

• Rating Outlook assesses the potential direction of an issuer’s long-term debt rating over the intermediate to longer term.

• In determining a Rating Outlook, consideration is given to any changes in the economic and/or fundamental business conditions.

Credit Rating

• An Outlook is not necessarily a precursor of a rating change or future CreditWatch action.– Positive indicates that ratings may be raised.– Negative means ratings may be lowered.– Stable indicates that ratings are not likely to

change.– Developing means ratings may be raised or

lowered.– N.M. means not meaningful.

Credit Rating

• Short-Term Issuer Credit Ratings

• A-1

• A-2

• A-3

• B

• C

Credit Rating

• Average cumulative 5-year probability of default

– AAA 0.11 %– AA 0.28 %– A 0.71 %– BBB 3.53 %– BB 14.77 %– B 31.99 %– CCC 56.77 %

Credit Rating and Global Financial Crisis

• On 13 Apr 2011, the US Senate Investigations Subcommittee Released the Levin-Coburn Report On the Financial Crisis.

• It has focused on the key causes of the financial crisis

• This Report focused on the Four aspects of the crisis:– high-risk mortgage lending

– regulatory inaction

– inflated credit ratings that misled investors

– the role played by investment banks

Inflated Credit Ratings.

• The Report concludes that the most immediate cause of the financial crisis was the July 2007 mass ratings downgrades by Moody’s and Standard & Poor’s that exposed the risky nature of mortgage-related investments that, just months before, the same firms had deemed to be as safe as Treasury bills.

• The result was a collapse in the value of mortgage related securities that devastated investors. Internal emails show that credit rating agency personnel knew their ratings would not “hold” and delayed imposing tougher ratings criteria to “massage the … numbers to preserve market share.”

• Even after they finally adjusted their risk models to reflect the higher risk mortgages being issued, the firms often failed to apply the revised models to existing securities, and helped investment banks rush risky investments to market before tougher rating criteria took effect.

• They also continued to pull in lucrative fees of up to $135,000 to rate a mortgage backed security and up to $750,000 to rate a collateralized debt obligation (CDO) – fees that might have been lost if they angered issuers by providing lower ratings. The mass rating downgrades they finally initiated were not an effort to come clean, but were necessitated by skyrocketing mortgage delinquencies and securities plummeting in value.

• In the end, over 90% of the AAA ratings given to mortgage-backed securities in 2006 and 2007 were downgraded to junk status, including 75 out of 75 AAA-rated Long Beach securities issued in 2006.

• When sound credit ratings conflicted with collecting profitable fees, credit rating agencies chose the fees.

Credit Rating

• Basis for Economic Risk Analysis– Size and nature of economy and its

vulnerabilities– Growth prospects– Business cycle -- volatility– Structural problems -- inflation, etc.– Sensitivity of economy to foreign investment– Openness of economy

Credit Rating

– Constraints on government’s ability to pursue appropriate

– counter cyclical policies– Country’s political stability– Dynamics of savings and investment– Level and growth of domestic credit– Structure and strength of corporate clients– Financial strength of individual clients

Credit Rating

• Leading Indicators of Financial System Stress:

– Trend in credit growth (private sector and public enterprises)

– Corporate and household indebtedness

– Asset-price inflation

– Net external funding of financial institutions

Credit Rating

• Industry Risk Analysis:– Number and relative size of banking institutions

– Geographic or product restrictions

– Size of bank loans in overall financial markets

– Non-bank competitors

– Depth of public capital market

– Barriers to entry

– Trends in industry

Credit Rating

– Equity holdings or other interlocking relationships

– Political influence on bank lending decisions– Strength and efficiency of country’s legal system– Quality and transparency of accounting– Price sensitivity– Level of sophistication of customers– Relationship between banks and corporate clients

Credit Rating

• Regulation and Deregulation:• State, national and international regulations

• Trends in regulation

• Regulatory structure -- level & quality

• Regulatory structure -- degree of independence

• Types of reporting by banks to regulators

• Regulatory authority

• Track record of regulators

• Attitude of regulators toward bank support

Credit Rating

• Management & Strategy:

• Management Factors– Organizational structure– Controls/information systems– Performance vs. peers– Credibility

• Succession planning– Realism, logic and risk– Implementation