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  • This adds in recoveries
  • Since when an issuer defaults, they tend to default on alll their obligations simultaneously, the recovery rate is principally driven by the seniority of claim.
  • PS
  • Now lets look at rating activity in 2002 and compare it with YTD – August 2003 2002 -- $1 billion of downgrades ($872 billion were I/G) – YTD through August the dollar amount of downgrades is down at $454 (running at $681 annually – expect annual level to be lower). 2002 -- two sectors TMT and Energy/utilities/merchant energy companies constituted 60% of downgrades. Through August ’03 energy utilities alone constitutes 30% and Heavy Industries at 30% replaced TMT as the second sector highest in downgrades (airlines; chemicals; heavy industries). Note that this has been adjusted for the affect of serial downgrades during the course of a year. Multi-notch downgrades – (defined as downgrades of 3 or more notches within the year) constituted $315 billion of downgraded debt in 2002 or 29% of all downgraded debt – vs $111 billion through August 2003 (again a drop in the run rate) or 24% of all downgraded debt in 2003. In 2002 – $288 billion of rated debt was downgraded to LF (33% of downgraded I/G debt for the year). YTD though August 2003 only $30 billion has been downgraded to LF from IG (7% of downgraded debt). In 2002 crossovers to LF amounted to 27% of all downgraded debt vs. only 7% ytd through August. 46% of the 2003 downgrades to LF consisted of companies in the energy/utilities sector. In 2002 we had virtually no upgrades to I-Grade. Only $3 billion crossed to I-Grade only 3 issuer families (10 total companies). YTD through 2003 $15 billion has crossed to I/G with 7 issuer families upgraded. Notable names: Waste Management; Lennar, MDC, and IGT. In summary. 1. Energy/Utilities represent bulk of 2003 downgraded debt, multi-notch downgrades and fallen angels. 2. In 2003 we’ve seen a big drop in amount of debt downgraded to Spec Grade Drop in debt under review for downgrade from: $264 billion (year-end ‘02) to $223 billion (March) to $182 billion (August) Expect a decrease in rate of fallen angels in 2003 – smaller base I/G companies. Volume of fallen angels has blurred the lines between I/G and high yield. Dec $264 (135); March $223 (119); May $130 (77); June $108 (81); July $166 (94); and August $182 (98)
  • Negative rating action generally occurs when Category B weakness occurs along with a general uncertainty about a company’s financial reporting.
  • Material weaknesses are only reported after a problem occurs, and therefore do not provide much information about future accounting problems.
  • Material weaknesses reported do not cite the major problem – aggressive accounting.
  • Significant number of companies with aggressive accounting problems and each had significant rating impacts.
  • Significant actions have been taken to address major causes of aggressive accounting.

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  • Financial Reporting and Credit Ratings Greg Jonas Managing Director FARS Conference January 19, 2007 San Antonio
  • Agenda
    • Background about credit ratings
    • Calculation, process, role of financial reporting
    • Financial reporting issues
  • Agenda
    • Background
      • Uses
      • Scope
      • Types
      • Quality
    • Calculation, process and role of financial reporting
    • Financial reporting issues
  • Background on Moody’s ratings
    • Ratings on $35 trillion of debt outstanding
    • 170,000 corporate, government and structured finance securities
    • 10,000 corporate relationships
    • 100 sovereign nations
    • Most ratings are freely available
    • Proprietary research – 2,600 subscriber institutions, 400,000 users
  • Scope of today’s discussion…
    • Corporate
      • Financial institutions
      • Corporate investment grade
      • Corporate high-yield
    • Municipal
    • Sovereign
    • Structured finance
    We are here
  • Uses of credit ratings Credit Ratings Building Portfolios Pricing Contracts Regulatory Requirements Trading
  • Benefits of ratings for companies
    • Market access (gate keeping)
    • Expands breadth of market
    • Widens distribution
    • Improves liquidity
    • Improves pricing
    • Helps management with independent, outside perspective on company
    • Helps management monitor counterparty risk
  • Benefits of ratings for investors
    • Due diligence efficiency
    • Multiple independent perspectives
    • Facilitates comparisons
    • Tool in portfolio management
    • Enhances secondary market liquidity
    • Relatively stable over time
    • Basis for performance benchmarks
  • Types of investment grade ratings Commercial Paper Long-Term Senior Unsecured Instruments Company
  • Company ratings Opinion on expected loss on unsecured obligations Expected loss = (Probability of Default) x (Severity of Loss) Commercial Paper Long-Term Senior unsecured Instruments Company
  • Rating scale Aaa Aa(1-3) A(1–3) Baa(1-3) Ba(1-3) B(1-3) Caa(1-3) Ca C Minimal credit risk In default, little prospect of recovery Investment Grade High Yield Watch list = under review Outlook = likely direction
  • Historical Rating Distribution Global Corporate Ratings By Issuer Count
  • Historical Rating Distribution US Non-Financial Corporates By Issuer Count
  • Average Loss and Default Rates Aaa Aa A Baa Ba B Caa Ca C Senior Unsecured Rating Default Probability 1 Expected Loss Rate 1 0.002% 0.052% 0.380% 1.32% 7.48% 19.94% 48.27% 100% 100% 0.001% 0.026% 0.190% 0.66% 3.74% 9.97% 24.13% 50% 80% 1 4 year time horizon
  • Average Cumulative Expected Loss: Senior Unsecured Debt
  • Assume Moody’s rates a company’s senior unsecured debt “A2, on review for possible downgrade” - What does this mean?
    • The company’s debt is investment grade
    • Based on historical averages, investors can expect to lose 0.19% from a portfolio of all debt obligations at this rating over a 4-year period
    • Based on an average loss in default of 50%, the probability of the debt defaulting is 0.38%
    • Because debt is on review, it will probably trade as a Baa1 rated debt (2 notch discount)
  • Types of investment grade ratings Commercial Paper Long-Term Senior Unsecured Instruments Company
  • Investment grade Relationship between long-term and CP ratings Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 High Yield Prime-1 Prime-2 Prime-3 Not prime Long-Term CP Investment Grade
  • Types of high-yield ratings Loss Given Default (LGD) Speculative Grade Liquidity (SGL) Risk of Loss Corporate Family Rating (CFR) Instruments Company
  • Corporate Family Rating
    • Expected loss = (Probability of Default) x (Severity of Loss)
    • Assumes = Corporate family is a single entity with one class of debt
  • Corporate Family Rating Rating scale Aaa Aa(1-3) A(1–3) Baa(1-3) Ba(1-3) B(1-3) Caa(1-3) Ca C Minimal credit risk In default, little prospect of recovery Investment Grade High Yield Watch list = under review Outlook = likely direction
  • Types of high-yield ratings Loss Given Default (LGD) Speculative Grade Liquidity (SGL) Risk of Loss Corporate Family Rating (CFR) Instruments Company
  • Instrument ratings B1 Senior Secured Subordinated Corporate Family Rating Debt Classes
  • %
  • Instrument ratings B1 Senior Secured Subordinated Corporate Family Rating Debt Classes Instrument Rating Ba2 B2
  • Loss Given Default Rating 90% - 100% LGD6 70% - 90% LGD5 50% - 70% LGD4 30% - 50% LGD3 10% - 30% LGD2 0% - 10% LGD1 Loss Range LGD Assessment
  • Instrument ratings B1 Senior Secured Subordinated Corporate Family Rating Debt Classes Instrument Rating Ba2 LGD3 B2 LGD4
  • Assume Senior Secured Debt is Rated Ba2, LGD3 (40%) - What does this mean?
    • The debt is speculative grade
    • Based on historical averages, investors can expect to lose 3.7 percent from a portfolio of these debt securities over a 4-year period
    • If the security defaults, investors can expect to lose about 40% of the principle and accrued interest
    • The probably that the company will default on this security is about 10%
  • Types of high-yield ratings Loss Given Default (LGD) Speculative Grade Liquidity (SGL) Risk of Loss Corporate Family Rating (CFR) Instruments Company
  • SGL Few alternatives Mostly secured Mostly unsecured Unsecured Assets Little Unlikely Present but impairment Present Back door Likely violation Barely compliant Compliant Compliant with headroom Covenants Needs external sources Reliant and used, but not fully Needed only for extra capex Undrawn Committed facility Insufficient Breakeven and limited cash Sufficient except for extra capex Sufficient Operating cash flow + cash on hand SGL 4 SGL 3 SGL 2 SGL 1
  • Rating quality What investors want from ratings
    • Accurate (relative ranking of credit risk)
    • Low ratings in advance of default
    • Stable (few rating reversals)
    • Don’t incorporate market price information (self-fulfilling, pro-cyclical)
    • Independent, stabilizing force
    • Separate point of view from each agency
  • Rating quality Key performance measures
    • Investment grade defaults
    • Accuracy measure (90% = average defaulter rating lower than 95% of all issuers)
    • Stability measure
      • # of issuers with rating changes divided by total number of rated issuers
      • # of issuers with 3+notch changes divided by total number of rated issuers
    • Rating reversals
  • Ways to assess credit risk
    • Fundamental approach (e.g. Moody’s credit ratings)
    • Bond implied ratings
    • Credit default swap implied ratings
    • Mathematical models
  • Fundamental ratings Not quite as accurate but much more stable 32 26 5 Large action rate 76 98 25 Rating action rate B2 B3/Caa1 B2/B3 Average rating 55 66 63 5-year accuracy 76 87 79 1-year accuracy MDP Bond-Implied Moody’s
  • Agenda
    • Background
    • Calculation and process
    • Risk management & ratings
  • Fundamental analysis: Areas of analysis Severity of Loss Probability of Default Financial Reporting Issue Structure Sovereign/Macro- Econ Management Quality Operating / Financial Position Company Structure Industry/Regulatory Trends
  • Rating data flow… DATABASE Rating Methodologies Adjustment Worksheets Company Reports XYZ Company Adjusted Financial Statement Data
  • Reasons for adjustments to reported amounts
    • GAAP does not reflect reality
    • Unreasonable estimates or judgments
    • Unusual or non-recurring transactions and events
    • Improve comparability and consistency
  • Typical adjustments by Moody’s analysts US GAAP Highlight core earnings Unusual items Adjust balance sheet to FIFO LIFO Treat as securitized borrowings Securitizations Apply Moody’s framework Hybrid securities Expense and flag on CFS Stock compensation Expense capitalized interest Capitalized interest Capitalize operating leases Leases Eliminate smoothing Pensions Purpose Adjustment
  • Typical timeframe for data Historical Projected 5 years 3 years
  • …more rating data flow Industry / Macro Economic Data Adjusted Financial Statement Data Other Company Specific Data Analysis Rating Committee Package and Recommendation
  • Industry methodologies… Analysis Key metrics Benchmark and rate Weigh Indicative Rating Other qualitative factors Final rating
  • Key metrics – global medical devices Financial Strength Financial Policies
    • Reliance on acquisitions, share buybacks and dividends (7.27%)
    • Debt/Book Capitalization (7.27%)
    • Debt/EBITDA (7.27%)
    • CFO/Debt (7.27%)
    • FCF/Debt (7.27%)
    • EBIT/Interest Expense (7.27%)
    Size and Diversification
    • Revenue (20%)
    • Segment diversification (7.27%)
    • Concentration of customers (7.27%)
    Product Portfolio & Profitability
    • R&D as % of sales (7.27%)
    • EBIT margin (7.27%)
    • ROA (7.27%)
  • Mapping metrics to ratings : Global Medical Devices
  • Company Mapping Table : Global Medical Device
  • Industry methodologies… Analysis Key metrics Benchmark and rate Weigh Indicative Rating Other qualitative factors Final rating
  • Examples of qualitative factors
    • Financial policy
    • Industry structure
    • Management quality
    • Contingent liabilities
    • Aggressive accounting
    • Weak accounting control
    • Governance risk
    • Event risk
    Key metrics Benchmark and rate Weigh Indicative Rating Other qualitative factors Final rating
  • Agenda
    • Background
    • Calculation, process, role of financial reporting
    • Financial reporting issues
      • Moody’s response to Enron/Worldcom
      • Recent financial reporting issues
  • Crisis in Financial Reporting Enron, WorldCom & Others
    • Investors:
    • Losses
    • Trust
    • Companies:
    • Credibility
    • Capital
    • Costs
    • Professions:
    • Credibility
    • Litigation
    • Regulation
    • Law Makers:
    • Public Anger
    • Credibility
    • Confidence
  • Global Investment-Grade Defaults (by year) 2002 – A bad year…
        • $1,077 billion
        • - 38% TMT
        • -- 24% Energy/Utilities
        • - 19% Industrials
        • $315 billion
        • 29% of all downgraded debt
        • -- 40% Energy/Utilities
        • - 39% TMT
        • $288 billion
        • 27% of all downgraded debt
        • 89 families downgraded
        • - 39% Energy/Utilities
        • -- 32% TMT
        • $3 billion
        • 3 families upgraded
    2002 Rating Transitions (Corporates, Americas) Downgrades Multi-Notch Downgrades Downgrades to Speculative Upgrades to Investment
  • Analytical Response What’s In – What’s Out What’s In What’s Out Non-cash measures Journeyman culture Black Box National Industry Reviews Tell me Liquidity under stress Process culture Transparency Global Portfolio Reviews Show me Generalists only Specialists
  • Moody’s Specialist Groups Focus Group Impact of complex financial instruments on credit risk Risk Management Credit impact of off-balance sheet structures OBS/Structured Impact of governance issues on credit risk Governance Credit-relevant issues related to financial reporting Accounting
  • What do accounting specialists do? 15% Communicate with outsiders 15% Train Moody’s analysts 30% Publish on companies and topics 40% Help get ratings right
  • Getting ratings right - the big questions
    • Are analytical adjustments useful?
    • Evidence of aggressive accounting?
    • Evidence of weak reporting control?
    • Impact of a financial reporting meltdown?
  • Getting ratings right - Flagging aggressive accounting Muckraking Service #3 Analyst Concern Business Press Moody’s Metrics Muckraking Service #1 Specialist Scrutiny Muckraking Service #2 Aggressive Accounting
  • = Category “B 1 ” weakness General uncertainty about company’s reporting 2 Rating that does not yet reflect uncertainty Negative rating action + +
    • 2 Examples:
      • Delinquent filings
      • Continuing restatements
      • Aggressive accounting
      • Investigations
      • Weak remediation
    Getting ratings right - Impact of control weaknesses
    • 1 Pervasive weakness, e.g.:
      • Not enough folks
      • Insufficient skills
  • 404 problem #1: reports lag reporting problems Types of Financial Reporting Errors Preceding Material Weakness Disclosures
  • 404 problem #2: No one is talking about fraud Percentage of Companies with Material Weaknesses Citing Fraud Controls
  • Getting ratings right - Impact of a meltdown…
  • Getting ratings right – Reporting meltdown – factors to consider
    • Covenant violations?
    • Will bond holders accelerate?
    • Is backup liquidity ready and bulletproof?
    • What will banks do?
    • Crisis of confidence with customers and vendors?
    • Management distraction?
    • Management’s plan to mitigate damage?
    • Rating impact when we don’t have #’s - basis to continue ratings?
  • Published materials – 2006 examples Fair Value Option Leveraged leases Standard adjustments Volumetric production payments Short-cut method Pooling adjustments at oil and gas companies Internally funded pension plans Fair value for servicing assets Pensions - Phase 1 Expensing stock comp. 404 reporting - Year 2 Backdating Uncertain tax positions Multi-employer pensions Pension reform SAB 108 Internal audit Events New Rules Adjustments Accounting? Credit Impact? Data? Content
  • Examples of training courses for analysts on financial reporting issues… Complex topics What’s new Adjustments Accounting? Insight? Impact? Analyzing income taxes Analyzing cash flows Moody’s adjustments Analyzing pensions and OPEB Analyzing leases Analyzing business combinations Auditor involvement Analyzing restructuring activities Impact of new reporting rules Derivatives and risk management
  • Conclusion: We’re making progress… Actions Taken Since 2002 Risk Greater investor focus on transparency, Sarbanes-Oxley regulations Minimum compliance mindset - do no more than peers Steep criminal sentences, more aggressive prosecution several high profile convictions, higher SEC fines Modest criminal penalties More scrutiny of weak boards, greater independence and financial expertise on corporate boards, enhancement of corporate governance policies and procedures Weak corporate governance PCAOB - focus on core-auditing business Lax auditing – “race to the bottom” accommodating philosophy Sections 302 and 404, reinvestment in accounting personnel and systems Weak internal accounting controls Greater investor skepticism Investor “irrational exuberance” in some industries Expensing of stock options, more vigilant boards of directors Incentive compensation schemes
  • But, must remain vigilant, because when the market gets nervous… Bonus: Illiquidity 18 5.5 Caa high yield 10 3.5 Corporate high yield 2.5 1 Corporate investment grade October 2002 Current Spread over Treasury Rate Investment
  • Financial Reporting and Credit Ratings Greg Jonas Managing Director FARS Conference January 19, 2007 San Antonio