MFIN 7011: Credit Risk Summer, 2008 Dragon Tang

1. Summer 08, MFIN7011, Tang Credit Ratings MFIN 7011: Credit RiskSummer, 2008Dragon Tang Lecture 3 Credit Ratings Thursday, July 10, 2008 Readings: Duffie and Singleton, Chap 4

2. Summer 08, MFIN7011, Tang Credit Ratings Credit Ratings

3. There were two superpowers in the world � the United States and Moody�s bond-rating service � and it was sometimes unclear which was more powerful. -- Thomas Friedman, the New York Times columnist and author of �The World is Flat�, remarked on �The NewsHour With Jim Lehrer� in 1996 Summer 08, MFIN7011, Tang Credit Ratings

4. Summer 08, MFIN7011, Tang Credit Ratings What is Credit Rating? A rating simply helps investor determine the relative likelihood that they might lose money on a given fixed income investment. More technically, it is an opinion of the future ability, legal obligation, and willingness of a bond issuer or other obligor to make full and timely payments on principal and interest due to investors ----- Moody�s

5. Summer 08, MFIN7011, Tang Credit Ratings Why Get a Rating? Access the markets Build up market reputation Lower cost of funding Prepare groundwork for share flotation or privatization Distinguish oneself from the competition Required by regulators Basel II: standardized approach and FIRB approach Basel II: standardized approach and FIRB approach Regulators� requirements: e.g. a bank cannot own any noninvestment-grade bonds in amounts in excess of 10% of the bank�s capital. Basel II: standardized approach and FIRB approach Regulators� requirements: e.g. a bank cannot own any noninvestment-grade bonds in amounts in excess of 10% of the bank�s capital.

6. Summer 08, MFIN7011, Tang Credit Ratings History of the Ratings Industry Origins of the rating industry in the USA, 1890-1980 Formation of the US duopoly, 1970-1999 Expansion into Europe and Japan, 1975 Globalization and emerging markets growth 1980- Multiple ratings: managing the ratings process Cantwell & Company�s survey in 1997 Over 90% of respondents had long-term ratings from at least two agencies, and around 25% had tree long-term ratings

7. Summer 08, MFIN7011, Tang Credit Ratings Rating Agencies Major US commercial rating companies Moody�s Investors Services Standard & Poor�s Corp Fitch Ratings (merger between Fitch IBCA, and Duff and Phelps) Other rating agencies exist in most countries

8. Summer 08, MFIN7011, Tang Credit Ratings Who Pays Until the early 1970s The major credit rating firms earned their incomes by selling publications (containing their ratings) and related materials In essence, they were charging the bondholders for the information provided In 1970 Moody�s and Fitch began to charge the issuers for the ratings; S&P followed a few years later The bulk of their ratings-related incomes now come from issuer fees Absence of fees from issuers gave the rating agency independence in rating them. Charging issuers resulted from several defaults of issuers so that issuers must reassure investors they were sound credits. Credibility of rating agencies has not been eroded by this practice. Reputation is everything for a rating agency! Absence of fees from issuers gave the rating agency independence in rating them. Charging issuers resulted from several defaults of issuers so that issuers must reassure investors they were sound credits. Credibility of rating agencies has not been eroded by this practice. Reputation is everything for a rating agency!

9. Summer 08, MFIN7011, Tang Credit Ratings Ratings For long term debts, Moody�s uses Aaa to denote highest credit, S&P uses AAA Second grade is Aa/AA, third is A/A The next three grades are Baa/BBB, Ba/BB, and B/B. Then C grades begins

10. Summer 08, MFIN7011, Tang Credit Ratings Ratings Moody�s uses 1, 2 or 3 to denote the sub-rating; S& P uses +/- sign Aaa/AAA to Baa/BBB are referred to as investment grade bonds Ba/BB and below are called non-investment grade bond, speculative grade bonds, high-yield bonds, or junk bonds

11. Summer 08, MFIN7011, Tang Credit Ratings Ratings AAA is rare. Only about ten companies.AAA is rare. Only about ten companies.

12. Summer 08, MFIN7011, Tang Credit Ratings Ratings

13. Summer 08, MFIN7011, Tang Credit Ratings Ratings Rating categories for Commercial Papers 1. CP: issued by big companies, short term usually1. CP: issued by big companies, short term usually

14. Summer 08, MFIN7011, Tang Credit Ratings Ratings Issuers pay rating agency to get a rating Sometimes, rating agencies provide unsolicited rating The number of issuers rated has increased substantially. E.g. Moody�s rated 3841 issuers in 1997, 2593 in 1990, and 912 in 1960 S&P and Moody�s rate nearly every taxable security in the US market that has been registered with the SEC Unsolicited rating: only if rating agencies believe there is sufficient quantity and quality of information on which to base a rating decision. S&P and Moody�s rate nearly every taxable security in the US market that has been registered with the SEC Unsolicited rating: only if rating agencies believe there is sufficient quantity and quality of information on which to base a rating decision.

15. Summer 08, MFIN7011, Tang Credit Ratings Ratings Rating is not static. Ratings are updated and published on a continuing basis S&P�s credit Watch, and Moody�s Rating Review List notify investors of potential important rating changes. For Moody�s, go to http://www.moody�s.com Login: yfhou@business.hku.hk PW:527533; use internet to show. On the website, can find Rating Methodology. For Moody�s, go to http://www.moody�s.com Login: yfhou@business.hku.hk PW:527533; use internet to show. On the website, can find Rating Methodology.

16. Summer 08, MFIN7011, Tang Credit Ratings Rating Process Rating agencies� credit analysis uses similar tools as equity analysis However, horizon is longer Equity analysis uses shareholder�s perspective Credit analysis sees things from debtholder's angle horizon: could be several years in credit rating Tools: cashflows, fin ratios horizon: could be several years in credit rating Tools: cashflows, fin ratios

17. Summer 08, MFIN7011, Tang Credit Ratings A Typical Credit Rating Procedure Analyze the issuer�s environment The checklist Meet with the issuer Focus on the analysis Approach to differing structures The analytical process The draft report Presentation of a draft report to the issuer Check accuracy Remove confidential items Amendments and circulation to the rating committee Dissemination (or non-dissemination) of the ratings Meeting with the issuer is very important. Meeting with the issuer is very important.

18. Summer 08, MFIN7011, Tang Credit Ratings Sovereign Credit Ratings Demographics, education and structural factors Labour market Output and trade Private sector characteristics Supply and demand Balance of payments Growth constraints

19. Summer 08, MFIN7011, Tang Credit Ratings Sovereign Credit Ratings Macroeconomic policy Trade and foreign investment policy Banking and finance External assets External liabilities Political framework International position

20. Summer 08, MFIN7011, Tang Credit Ratings Sovereign Credit Ratings Moody�s Moody�s

21. Summer 08, MFIN7011, Tang Credit Ratings Bank Credit Ratings Lending and other counterparties risk Investment and security risk Fund management and administration of fiduciary funds risk Interest rate and currency risk Derivatives risk Funding risk

22. Summer 08, MFIN7011, Tang Credit Ratings Bank Credit Ratings Capital and hidden reserves, loan loss and risk reserves Performance and earnings risk Market environment and planning Ownership Audit and control by supervisory authority Contingent liabilities

23. Summer 08, MFIN7011, Tang Credit Ratings Corporate Credit Ratings Industry Market position Ownership and support Management Accounting quality Earnings Profitability and protection measures Cash flow Capital and debt structure Funding and financial flexibility

24. Summer 08, MFIN7011, Tang Credit Ratings S&P Model for Industrial Credit Business Risk Industrial characteristics Competitive position Marketing Technology efficiency Management Financial Risk Financial characteristics Financial policy Profitability Capital structure Cash flow protection Financial flexibility Industry risk receives the highest weight in the rating decision. Often set an upper limit on the rating attainable by any firm in that industry.Industry risk receives the highest weight in the rating decision. Often set an upper limit on the rating attainable by any firm in that industry.

25. Summer 08, MFIN7011, Tang Credit Ratings S&P Model for Industrial Credit At S&P, there is often a ceiling on the rating in each industry S&P computes financial ratios and tracks them over time. Debt coverage Leverage Cash flow � Usually financial industry has a ceiling of AA (only a few financial firms have AAA). Usually financial industry has a ceiling of AA (only a few financial firms have AAA).

26. Summer 08, MFIN7011, Tang Credit Ratings Moody�s Moody�s does not disclose the factors they use for the rating process That led to the phrase: �S&P is statistical, but Moody�s is mystical� � This might overstate the actual differences Two rating agencies agree with one another in the great majority of ratings. Two rating agencies agree with one another in the great majority of ratings.

27. Summer 08, MFIN7011, Tang Credit Ratings S&P and Moody�s

28. Summer 08, MFIN7011, Tang Credit Ratings Some Relevant Issues Split Rating S&P and Moody�s ratings are highly correlated Split ratings are common in the noninvestment-grade or junk sector of the bond market May be due to qualitative part in the analysis Rating Transition Rating performance Split rating: different rating agencies give different ratings to the same entity. S&P and Moody�s ratings are highly correlated. Split ratings are common in the noninvestment-grade or junk sector of the bond market. Rating transition: ratings may change over time.Split rating: different rating agencies give different ratings to the same entity. S&P and Moody�s ratings are highly correlated. Split ratings are common in the noninvestment-grade or junk sector of the bond market. Rating transition: ratings may change over time.

29. Summer 08, MFIN7011, Tang Credit Ratings Rating Migration

30. Summer 08, MFIN7011, Tang Credit Ratings Rating Transition Matrix

31. Summer 08, MFIN7011, Tang Credit Ratings One-Year S&P Rating Migration: 1981-2003

32. Summer 08, MFIN7011, Tang Credit Ratings One-Year Moody�s Rating Migration: 1920-1996

33. Summer 08, MFIN7011, Tang Credit Ratings One-Year Moody�s Rating Migration: 1920-1996 (excluding withdrawal)

34. Summer 08, MFIN7011, Tang Credit Ratings Reasons for Rating Withdrawal

35. Summer 08, MFIN7011, Tang Credit Ratings Five-Year Moody�s Rating Migration: 1920-1992

36. Summer 08, MFIN7011, Tang Credit Ratings Estimating Rating Transition Matrix: 3 Approaches

37. Summer 08, MFIN7011, Tang Credit Ratings One-Year Rating Migration ComparisonA/K: Altman and Kao (1991), M: Moody�s, and S&P

38. Summer 08, MFIN7011, Tang Credit Ratings Ten-Year Rating Migration ComparisonA/K: Altman and Kao (1991), M: Moody�s, and S&P

39. Summer 08, MFIN7011, Tang Credit Ratings Implications of Rating Migration

40. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance Efficacy: extra info It is well known that the ratings do correlate well with average default rates The ratings might simply be reflecting financial market outcomes (e.g., the spreads), rather than the other way around

41. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance For corporate bonds, defaults are inversely related to credit ratings. The most abrupt increase in default probability occurred between Baa and Ba, i.e. between investment-grade and noninvestment-grade bonds. For corporate bonds, defaults are inversely related to credit ratings. The most abrupt increase in default probability occurred between Baa and Ba, i.e. between investment-grade and noninvestment-grade bonds.

42. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance Rating reflects market outcomes (spreads), not the other way around. Spreads may change over time, but the relationships between rating categories remain constant: higher ratings are more secure than lower ones to investors. Rating reflects market outcomes (spreads), not the other way around. Spreads may change over time, but the relationships between rating categories remain constant: higher ratings are more secure than lower ones to investors.

43. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance Credit Rating changes are major news in the fixed income market Rating agencies are more reliable in measuring relative risk than in measuring absolute credit risk. Over time, the rate of default associated with a given rating is subject to drift. Rating of Japan was once downgraded as that of Botswana.Rating of Japan was once downgraded as that of Botswana.

44. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance The correspondence of ratings to default probabilities is subject to substantial change over time. The correspondence of ratings to default probabilities is subject to substantial change over time.

45. Summer 08, MFIN7011, Tang Credit Ratings Rating Performance There is overwhelming evidence that credit ratings are of scant informational value There have been multiple unexpected defaults and sudden credit downgrades in recent years, involving major issuers such as Enron, Orange County, Mercury Finance 1997 Asia Crisis In the aftermath of Asia crisis, Economist (Rating Agencies 1997) wrote: �Asia�s financial crises have cost investors dear. As always on such occasions, the search is on for somebody to blame. Among the leading suspects are the firms that rate the creditworthiness of bond issuers, The raters � are supposed to be the financial market�s early warning system. Instead, the agencies have spent the past few months belatedly reacting to events.� Rating is an useful tool, but it should not the exclusive measure of credit risk Scant info value: partly due to the manipulation of accounting information; indeed, rating agencies claim they were prevented from accessing full information of the companies. Rating agencies downgraded the bonds of Korea and Thailand to below investment grade respectively only after the press had reported that Korea�s central bank was nearly out of foreign currency reserves and Thailand�s baht collapsed. Reasons: Raters prefer to err on the side of caution because if they reacted too harshly, it would make it harder for the issuer to raise the money to solve the problem. By centralizing the decision making in New York or London the raters miss the developments at the local level. Credit spread: more efficient in reflecting credit informationScant info value: partly due to the manipulation of accounting information; indeed, rating agencies claim they were prevented from accessing full information of the companies. Rating agencies downgraded the bonds of Korea and Thailand to below investment grade respectively only after the press had reported that Korea�s central bank was nearly out of foreign currency reserves and Thailand�s baht collapsed. Reasons: Raters prefer to err on the side of caution because if they reacted too harshly, it would make it harder for the issuer to raise the money to solve the problem. By centralizing the decision making in New York or London the raters miss the developments at the local level. Credit spread: more efficient in reflecting credit information

46. Summer 08, MFIN7011, Tang Credit Ratings Internal Ratings Banks often have their own internal ratings desk Which is more or less replicating the rating process of external rating agencies, applied to their corporate customers Internal ratings are usually numeric Should have enough risk categories Rating is a subjective process, the outcome differs by assessors Different banks with different credit culture might come out with totally different ratings for the same applicant To distinguish among the range of risk levels and whether the system allows the bank to associate a rating with a measurable loss. To distinguish among the range of risk levels and whether the system allows the bank to associate a rating with a measurable loss.

47. Summer 08, MFIN7011, Tang Credit Ratings Summary