Financial Reporting and Credit Ratings

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Financial Reporting and Credit Ratings

• Greg Jonas
• Managing Director

FARS Conference January 19, 2007 San Antonio
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Agenda

• Background about credit ratings
• Calculation, process, role of financial reporting
• Financial reporting issues

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Agenda

• Background
• Uses
• Scope
• Types
• Quality
• Calculation, process and role of financial
  reporting
• Financial reporting issues

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Background on Moodys 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

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Scope of todays discussion

• Corporate
• Financial institutions
• Corporate investment grade
• Corporate high-yield
• Municipal
• Sovereign
• Structured finance

We are here
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Uses of credit ratings
Building Portfolios
Pricing
Credit Ratings
Contracts
Trading
Regulatory Requirements
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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

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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

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Types of investment grade ratings
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Company ratings
Opinion on expected loss on unsecured obligations
Expected loss (Probability of Default) x
(Severity of Loss)
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Rating scale
Aaa Aa(1-3) A(13) Baa(1-3) Ba(1-3) B(1-3) Caa(1-3
) Ca C
Investment Grade
Minimal credit risk
High Yield
In default, little prospect of recovery
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Historical Rating Distribution
Global Corporate Ratings
By Issuer Count
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Historical Rating Distribution
US Non-Financial Corporates
By Issuer Count
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Average Loss and Default Rates
Senior Unsecured Rating
Expected Loss Rate1
Default Probability1
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
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Aaa Aa A Baa Ba B Caa Ca C
1 4 year time horizon
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Average Cumulative Expected LossSenior
Unsecured Debt
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Assume Moodys rates a companys senior unsecured
debt A2, on review for possible downgrade -
What does this mean?

• The companys 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)

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Types of investment grade ratings
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Investment gradeRelationship between long-term
and CP ratings
Long-Term
CP
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
Prime-1
Investment Grade
Prime-2
Prime-3
High Yield
Not prime
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Types of high-yield ratings
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Corporate Family Rating

• Expected loss (Probability of Default) x
  (Severity of Loss)
• Assumes Corporate family is a single entity
  with one class of debt

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Corporate Family RatingRating scale
Aaa Aa(1-3) A(13) Baa(1-3) Ba(1-3) B(1-3) Caa(1-3
) Ca C
Investment Grade
Minimal credit risk
High Yield
In default, little prospect of recovery
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Types of high-yield ratings
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Instrument ratings
Corporate Family Rating
Debt Classes
Senior Secured
B1
Subordinated
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Instrument ratings
Corporate Family Rating
Instrument Rating
Debt Classes
Senior Secured
Ba2
B1
Subordinated
B2
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Loss Given Default Rating
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Instrument ratings
Corporate Family Rating
Instrument Rating
Debt Classes
Ba2 LGD3
Senior Secured
B1
B2 LGD4
Subordinated
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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

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Types of high-yield ratings
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SGL
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Rating qualityWhat investors want from ratings

• Accurate (relative ranking of credit risk)
• Low ratings in advance of default
• Stable (few rating reversals)
• Dont incorporate market price information
  (self-fulfilling, pro-cyclical)
• Independent, stabilizing force
• Separate point of view from each agency

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Rating qualityKey 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 3notch changes divided by
  total number of rated issuers
• Rating reversals

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Ways to assess credit risk

• Fundamental approach (e.g. Moodys credit
  ratings)
• Bond implied ratings
• Credit default swap implied ratings
• Mathematical models

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Fundamental ratingsNot quite as accurate but
much more stable
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Agenda

• Background
• Calculation and process
• Risk management ratings

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Fundamental analysisAreas of analysis
Severity of Loss
Financial Reporting
Probability of Default
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Rating data flow
Company Reports
DATABASE
Adjusted Financial Statement Data
XYZ Company
Adjustment Worksheets
Rating Methodologies
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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

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Typical adjustments by Moodys analystsUS GAAP
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Typical timeframe for data
Projected
Historical
5 years
3 years
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more rating data flow
Analysis
Adjusted Financial Statement Data
Rating Committee Package and Recommendation
Other Company Specific Data
Industry / Macro Economic Data
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Industry methodologies
Analysis
Key metrics
Benchmark and rate
Weigh
Indicative Rating
Other qualitative factors
Final rating
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Key metrics global medical devices
Financial Strength

• CFO/Debt (7.27)
• FCF/Debt (7.27)
• EBIT/Interest Expense (7.27)

Financial Policies

• Reliance on acquisitions, share buybacks and
  dividends (7.27)
• Debt/Book Capitalization (7.27)
• Debt/EBITDA (7.27)

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Mapping metrics to ratings Global Medical Devices
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Company Mapping Table Global Medical Device
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Industry methodologies
Analysis
Key metrics
Benchmark and rate
Weigh
Indicative Rating
Other qualitative factors
Final rating
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Examples of qualitative factors

• Financial policy
• Industry structure
• Management quality
• Contingent liabilities
• Aggressive accounting
• Weak accounting control
• Governance risk
• Event risk

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Agenda

• Background
• Calculation, process, role of financial reporting
• Financial reporting issues
• Moodys response to Enron/Worldcom
• Recent financial reporting issues

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Crisis in Financial Reporting

• Companies
• Credibility
• Capital
• Costs

• Investors
• Losses
• Trust

Enron, WorldCom Others

• Professions
• Credibility
• Litigation
• Regulation

• Law Makers
• Public Anger
• Credibility
• Confidence

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Global Investment-Grade Defaults (by year)
2002 A bad year
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2002 Rating Transitions(Corporates, Americas)
Downgrades

• 1,077 billion
• - 38 TMT
• -- 24 Energy/Utilities
• - 19 Industrials

• 315 billion
• 29 of all downgraded debt
• -- 40 Energy/Utilities
• - 39 TMT

Multi-Notch Downgrades
Downgrades to Speculative

• 288 billion
• 27 of all downgraded debt
• 89 families downgraded
• - 39 Energy/Utilities
• -- 32 TMT

Upgrades to Investment
3 billion 3 families upgraded
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Analytical ResponseWhats In Whats Out
Whats In
Whats Out
Journeyman culture
Process culture
Transparency
Black Box
National Industry Reviews
Global Portfolio Reviews
Show me
Tell me
Non-cash measures
Liquidity under stress
Generalists only
Specialists
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Moodys Specialist Groups
Group
Focus
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What do accounting specialists do?
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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?

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Getting ratings right -Flagging aggressive
accounting
Analyst Concern
Specialist Scrutiny
Aggressive Accounting
Moodys Metrics
Business Press
Muckraking Service 1
Muckraking Service 3
Muckraking Service 2
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Getting ratings right -Impact of control
weaknesses
Category B1 weakness


General uncertainty about companys reporting2
Rating that does not yet reflect uncertainty

Negative rating action

• 2Examples
• Delinquent filings
• Continuing restatements
• Aggressive accounting
• Investigations
• Weak remediation

• 1Pervasive weakness, e.g.
• Not enough folks
• Insufficient skills

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404 problem 1 reports lag reporting problems
Types of Financial Reporting Errors Preceding
Material Weakness Disclosures
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404 problem 2 No one is talking about fraud
Percentage of Companies with Material Weaknesses
Citing Fraud Controls
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Getting ratings right -Impact of a meltdown
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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?
• Managements plan to mitigate damage?
• Rating impact when we dont have s - basis to
  continue ratings?

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Published materials 2006 examples
Accounting? Credit Impact? Data?
Content
Backdating
Volumetric production payments
Multi-employer pensions
Adjustments
Pooling adjustments at oil and gas companies
Internally funded pension plans
Standard adjustments
SAB 108
Uncertain tax positions
Pensions - Phase 1
Expensing stock comp.
New Rules
Fair value for servicing assets
Fair Value Option
Leveraged leases
Pension reform
Short-cut method
404 reporting - Year 2
Internal audit
Events
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Examples of training courses for analysts on
financial reporting issues
Accounting? Insight? Impact?
Adjustments
Moodys adjustments
Whats new
Impact of new reporting rules
Analyzing cash flows
Analyzing income taxes
Analyzing pensions and OPEB
Analyzing leases
Complex topics
Analyzing business combinations
Derivatives and risk management
Analyzing restructuring activities
Auditor involvement
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Conclusion Were making progress
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But, must remain vigilant, because when the
market gets nervous
Bonus Illiquidity
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Financial Reporting and Credit Ratings

• Greg Jonas
• Managing Director

FARS Conference January 19, 2007 San Antonio