A PRIMER on CRAs: Credit Rating Agencies

1. A PRIMER on CRAs:Credit Rating Agencies What Is the Role of Rating Agencies? How Did Rating Agencies Start? How Did They Get Government-Sanctioned Roles? Why Are There Only Three? Do the Agencies Have Insider Information? How Do the Agencies Make Ratings? They are private, for-profit companies that are privy to insider information. Have come to play a quasi-regulatory role in the market. They are private, for-profit companies that are privy to insider information. Have come to play a quasi-regulatory role in the market.

2. What Is the Role of Rating Agencies? Assess and grade creditworthiness Of entities that issue debt Of specific debt securities Their assessment helps determine interest rates in the market gets written into loan covenants as a trigger point is a key measure of corporate financial health affects loan restructuring and access to alternative financing sources in the market Do this from the perspective of a lender—A reasonable expectation that an issue will not be paid on time is the classic dividing line betwee investment grade and junk. Expectation that an issue will not be paid in full is difference between a B rating and a C rating. Do this from the perspective of a lender—A reasonable expectation that an issue will not be paid on time is the classic dividing line betwee investment grade and junk. Expectation that an issue will not be paid in full is difference between a B rating and a C rating.

3. How Did Rating Agencies Start? Moody, John. Manual of Railroad Securities, 1909. Provided operating statistics for 200 railroads and their securities. 1916—Standard Co. began grading bonds. 1920s—Poor and Fitch began bond rating. 1941—Poor’s and Standard merged. Customers were investors who wanted unbiased, arms-length financial analysis

4. Changes Occurred! 1970s—Began charging issuers for ratings, because of ease of photocopy! 1990s—Began lucrative side business in “rating impact studies” to predict effect of M/A activity on credit ratings 2000s—Began moving into Euro market ratings in a big way Until the advent of the copy machine, investors paid for the info. With the copy machine, they were losing money because investors shared information they had purchased! Imagine that! Until the advent of the copy machine, investors paid for the info. With the copy machine, they were losing money because investors shared information they had purchased! Imagine that!

5. How Did They Acquire Government-Sanctioned Roles? 1936—Comptroller of the Currency: “Banks can hold only investment grade securities!” 2002—Basle Accord changes are likely to require use of ratings for capital adequacy measures (if adopted, will go into effect 2006)

6. Why Are There Only Three? 1975—SEC designated the companies whose ratings were acceptable—NRSROs “The SEC has enveloped the agencies in a very protective webbing that keeps anyone else from challenging them. There they are, a 2 ½ firm industry, sitting pretty.” (Lawrence White, Economics, NYU) Nationally Recognized Statistical Ratings Organizations. Moody’s, S&P, and Fitch orignially designated. Four others added later, but all have now merged into original three again. Nationally Recognized Statistical Ratings Organizations. Moody’s, S&P, and Fitch orignially designated. Four others added later, but all have now merged into original three again.

7. Do the Agencies Have Insider Information? Usually! “Selective disclosure” SEC allows sensitive financial information to be released to bond raters, without requiring it to be revealed to the public. No on-going disclosure requirement. Lack of competition keeps it “insider” status “Market mover” status keeps it as insider information “On an on-going basis, an agency will typically have a management forecast that the public side doesn’t have, and an agency’s opinion includes all those forward-look forecasts that the issue is never allowed to make publicly as well as detailed historic data that those in the public market don’t have access to” . Nigel Myer, credit researcher J.P. Morgan. Quoted in Baccardax) The agencies are not just observers, but active participants in the course of events. A downgrade can become a self-fulfilling prophecy: If the rating agencies act to rashly, they could be accused of causing a bankruptcy. If they deliberate too long, they’ll simply be stating what everyone already knows. “On an on-going basis, an agency will typically have a management forecast that the public side doesn’t have, and an agency’s opinion includes all those forward-look forecasts that the issue is never allowed to make publicly as well as detailed historic data that those in the public market don’t have access to” . Nigel Myer, credit researcher J.P. Morgan. Quoted in Baccardax) The agencies are not just observers, but active participants in the course of events. A downgrade can become a self-fulfilling prophecy: If the rating agencies act to rashly, they could be accused of causing a bankruptcy. If they deliberate too long, they’ll simply be stating what everyone already knows.

8. How Do the Agencies Make Ratings of Countries? Trends within a country: economic condition, reforms, % of government debt held by domestic investors Consistency among countries: stability, inflation When governments rack up huge debts in their own currency, inflation, not default is the real riskt o creditors. --because they have the right to print more money. (The Economist, May 18, 2002)When governments rack up huge debts in their own currency, inflation, not default is the real riskt o creditors. --because they have the right to print more money. (The Economist, May 18, 2002)

9. How Do the Agencies Make Ratings of Companies 80/20 rule—for debt, 80% based on the past, 20% based on projections. Reversed for equity Issuer’s market position and size

10. How Do the Agencies Make Ratings of Specific Securities? Rating agency picks a sample of loans to inspect and underwrite 50-70% of the package, including largest 10 Loan-to-value ratios, debt service coverage, individual cash flow component analysis Results are extrapolated to the non-sampled portion of the portfolio of underlying assets Often more than one agency rates a deal “In the financial services business, there would be no commerce without credibility” (Bergsman)

11. Scope of the Business Today Lucrative—Moody’s as the example $4.2 billion assets $158 million (2000) revenues—85% paid by security issuers $770 million (2001) revenues ? $382 million operating income 36% of revenues come from “relationship pricing”; 64% from “transactional pricing” 1/3 of revenues from structured financing Rates $30 trillion, from 100 countries, 4,200 corporations, and 68,000 public finance obligations Moody’s is the only listed entity of the big three Relationship pricing creates an annuity—is basically an annual retainer rather than transactional pricing for individual issues Structured financing—CDOs, CMOs, MBSs, etc. 0% in 1980. Moody’s is the only listed entity of the big three Relationship pricing creates an annuity—is basically an annual retainer rather than transactional pricing for individual issues Structured financing—CDOs, CMOs, MBSs, etc. 0% in 1980.

12. Scope of the Business Today Accurate predictions Less than 1% of A- or better rated bonds default over 5 years 85% of A rated securities retain the rating for more than 1 year Growth outside the US Europe: 1500 unrated companies with revenues greater than €1 billion 10 years ago, only 50 European corps had ratings. Together Moody and S&P now rate over 500. Europe accounts for over 20% of Moody’s sales now. 10 years ago, only 50 European corps had ratings. Together Moody and S&P now rate over 500. Europe accounts for over 20% of Moody’s sales now.

13. References Baccardax, Martin. “Who’s Watching the Watchdogs?”, Corporate Finance, August, 2001, p. 33-35. Bergsman, Steve. “Rating Agencies Waging War over Market Pie”, National Real Estate Investor, October 1, 1999, p. 46-60. Borrus, Amy. “The Credit-Raters: How They Work and How They Might Work Better”, Business Week, April 8, 2002, p. 38-40. “Finance and Economics: A1 for Risk, D for Effort; Japan’s Credit Rating”, The Economist, May 18, 2002, p. 70-71. McLean, Bethany. “The Geeks Who Rule the World”, Fortune, December 24, 2001, p. 93-96.

14. Who is the largest shareholder of Moody’s?