Credit Ratings as an Investor Protection Mechanism?

1. Credit Ratings as an Investor Protection Mechanism? Anita Goulding, Head of Rating Advisory, Asia 4 November 2005

2. CONTENTS • Importance and Use of Credit Ratings • Assigning Credit Ratings • Role of Rating Agencies • Development of the Asian Bond Markets • Will Asia’s Bond Market emulate Australia’s Bond Market? • Corporate Hybrids

3. Importance and Use of Credit Ratings

4. What is a Credit Rating? • A rating is an opinion on the future ability and the legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security or other financial obligation • Comparability/Transparency • Consistent, uniform and globally comparable grading system; provides independent peer comparisons • Measures the relative risk of investing in a security (ie probability of default) • There is a strong correlation between short-term and long-term ratings. Short-term ratings typically require back-up liquidity • Supports disclosure and transparency • Forward-looking • Expected to remaining stable over 2 to 4 years • Modified only for significant and permanent changes in financial and/or operating performance

5. Counterparty Ratings Bank Loan Ratings Project Finance Listings Bond Issues Major Uses of Credit Ratings Global and domestic bond issues Straight and convertible bonds Ratings used to assist IPO process Example is CNOOC Project finance ratings for toll roads and IPP Power Projects General creditworthiness assessments Assists with negotiations Bank loan ratings increasingly in demand

6. Benefits of a public credit rating • Wider investor base • Many US institutional investors and an increasing number of European fund managers can: • only buy paper that is rated • allocate a higher percentage of their portfolio to higher rated paper • New BIS rules will require banks to allocate capital based on ratings • Better pricing • A wider investor base is likely to create more competition for a borrower’s issue, driving down pricing to the cheapest level • A rating acts as a pricing guide to investors perhaps unfamiliar with an issuer’s business and financial condition • Diversified funding sources • A rating enables an issuer to access a broader range of funding sources other than bank finance such as cross border investors in bonds, MTNs and commercial paper • A third party opinion expressed in terms of a rating gives investors comfort over longer maturities • Funding stability and liquidity • The international markets are very deep and liquid. Highly rated companies can easily place debt that is 1 day to 30 or more years in maturity • The major capital markets have rarely been closed for a highly rated corporate. Although price may be an issue, access is not

7. Benefits of a Rating - Issuers A Rating helps to optimise funding • Wider access to the global capital markets • Diversification of investor base • Means of communicating creditworthiness to key counterparties • Internal management tool • to assist financial and strategic planning • Independent benchmark • to help determine balance considerations of bondholders and shareholders

8. Benefits of a Rating - Investors Leading Institutional Investors Rely on Ratings • Independent indicator of credit quality • Enhances transparency and disclosure • Pricing benchmark • Facilitates secondary market liquidity • Strategic tool • for portfolio management techniques

9. Why do Issuers and Investors Rely on Ratings? A transparent rating process • Industry/Criteria knowledge (investigate new methodology, eg JDA) • Quantitative and qualitative approach • Long term focus • Client Feedback • Continuous monitoring • Confidentiality • Independent

10. Additional Issues to Consider • Should ratings be mandatory or discretionary? – poor financial disclosure of SMEs in Asia • Rating Compression and Investment Guidelines • Development of secondary bond market • Solicited vs Unsolicited Ratings • IOSCO Code of Conduct • Use of International Ratings (local and foreign currency) vs National Ratings – need to distinguish

11. Comparison of Thai Bank Ratings Moody’s ratings on the top banks in Thailand are at same rating as sovereign and could move up in line with sovereign rating Moodys will soon revise its bank rating methodology to better reflect bank default statistics. This could result in a significant uplift for leading banks in the region and narrow the gap between international ratings and local/national ratings.

12. Assigning Credit Ratings

13. Corporate Ratings – the Three Pillars Quantitative and qualitative approach Management influences determines Business Risk Financial Risk

14. Industry Characteristics maturity cyclicality Diversification geographic product Competitive Position market share technology efficiency Management credibility experience strategies Rating Analysis Factors for Corporates Business Risk Financial Risk • Financial Policy • financial strategy • risk tolerance • Profitability • level and volatility • trends of key measures • Cash Flow Protection • Debt service capacity • Capital Structure • asset quality • leverage • Financial Flexibility • availability of internal and external funds • potential asset disposals

15. Sovereign ceiling not only factor likely to hold back ratings • Corporate governance • Concern over related party transactions • Group and accounting transparency • Inter-group holdings, transactions and guarantees • Internal controls • Risk management regarding investments • Liability management

16. Ratings Look Through the Economic Cycle Incorporating Expected Variations in Performance Performance RATING “Band” Time

17. Ratings reflect priority or preference among obligations (Contd) • Issue Ratings • Issue ratings also take into account the recovery prospects associated with the specific debt being rated. • Junior debt (subordinated debt) is rated below the corporate credit rating and preferred stock is rated still lower • Well-secured debt can be rated above the corporate credit rating

18. The case for Notching UP • Key principles • For investment grade ratings, focus is on timeliness rather recovery • Well-secured bank loans or a first mortgage bond will be rated ONE notch above a rating in the “BBB” or “A” rating categories but enhancement would be TWO notches in the case of a “BB” or “B” corporate • The following guidelines relate more to the speculative grade portion of the rating spectrum. At the upper end, notching is generally less generous

19. The case for Notching DOWN • Key principles • Where priority claims exist, lower-ranking obligations are at a disadvantage because a smaller pool of assets will be available to satisfy remaining claims • Subordinated debt can be rated up to TWO notches BELOW a non-investment grade corporate credit rating but ONE notch at most if rating is investment grade • Notching can arise if a company conducts its operations through one or more legally separate subsidiaries but issues debt at the holding company level (ie structural subordination)

20. Role of Rating Agencies

21. Defaults by Rating after 1, 5, 10, and 15 years Cumulative Average Default Rates 1981 to 2004 (%)

22. Defaults on Rated Debt

23. Role of Ratings and Rating Agencies Regulators Corporate Issuers BankTrading Desks • SEC • Government • Placement • Structure feedback CapitalMarkets • Secondary trading • Market information Rating Agencies • Portfolio monitoring • Risk assessment • Market information Fixed Income Sales Force Institutional Investors • New issue pricing • Transaction feedback • Market information

24. Rating Myths • #1Credit ratings are for investor protection • #2A “BBB” rating is investment grade • #3Harmonization of rating standards

25. Non-rating requirements for Asian Bond Markets • High accounting and disclosure standards • Fair and transparent capital markets regulations and supervision • A legal environment that instills confidence among investors to participate in financial transactions • Efficient trading mechanisms and clearing/settlement systems that are safe and low-cost

26. Development of the Asian Bond Markets

27. Lessons from 1997 Asian Crisis • Excessive dependency on banking sector • Underdeveloped domestic capital markets • Undisciplined foreign currency borrowings • Lack of adequate disclosure and transparency • Inadequate risk management practices

28. Goals of Domestic Fixed Income Markets • Provide local issuers with alternative sources of finance • Provide local investors with new investment opportunities • Attract foreign issuers • Attract foreign investors • Be an integral part of the global financial markets

29. Effective but underused Hong Kong Singapore Relative Maturity of Asian Domestic Debt Markets Based on Transparency, Liquidity, Depth, Role of Govt., # of active participants Effective but not efficient Korea Malaysia Taiwan, China Semi-effective or blocked India Indonesia Philippines Thailand © Hong Kong Institute for Monetary Research

30. Asia Capital Markets Update Issuance Volume by Region FY 04 vs YTD 05 Issuance Volume by Tenor Issuance Volume by Currency Source: Bondware

31. Asia Capital Markets Update (Contd) # Deals by Size Issuance Volume by Rating FRN vs FX Volume by Industry Sector Source: Bondware

32. Issues for Regional Bond Market • Currency risk : who will bear • Transparency and disclosure • Protection of creditor rights • Ratings: • Which standards and criteria to adopt • One pan Asian rating scale • Rating compression • Independence and objectivity • Affects competitive dynamics • How will Pan Asian rating agency be monitored

33. Will Asia’s Bond Market emulate Australia’s Bond Market?

34. Growth of the A$ market Issuance Summary • Issuance volumes in the Australian domestic market have experienced a fundamental change during the period 2000-2005. • Starting from annual issuance levels of approximately A$18-A$20bn during the beginning of this period, issuance has surpassed A$40bn during each of 2004 and 2005 ytd. • Strong investor demand has enabled primary market activity to consistently surpass volumes for corresponding periods in previous years. This unprecedented volume of issuance has been readily absorbed by the market as secondary spreads remain at or near historic lows. • Third quarter issuance of nearly A$20bn has been a highlight of the year. Issuance in this period was timed to correspond with the record A$8bn of corporate redemptions matched to the 15 July 2005 Australian Government Bond. Issuance Volumes Issuance levels have increased from A$17.7bn in 2000, to A$45.5bn in 2005 ytd.

35. Drivers of growth in the A$ market • The Australian corporate bond market has experienced dramatic growth over the last 2 years. Following a period of relatively stable issuance activity, issuance levels in 2004-2005 have been more than double the 2000–2003 average. This growth has been driven by a combination of factors. • In March 2004 the Reserve Bank of Australia extended the criteria for repo eligible issuers. A number of Supranational and Agency borrowers such as Eurofima, KFW, LBBW and Rentenbank were made repo eligible, significantly increasing the attractiveness of these issuers to Australian investors. These entities have now become among the most active issuers in the Australian market, together with domestic banks. • Issuers who are rated AAA and have explicit or very strong government guarantees can apply for eligibility. Rapid Growth 2000-05 Regulatory Changes

36. Supportive Technicals Drivers of growth in the A$ market • Bond/swap spreads moved to historically wide levels in early 2004 and remain at similar levels. This means that sub-swap product, for which there has traditionally been little demand, has now became more attractive on a yield basis. Investors saw this as an opportunity to move out of Government and Semi-government bonds. • In addition, the widening of the AUD/USD basis during this period made A$ issuance more attractive to offshore borrowers. Kangaroo issuance increased from 29% of domestic issuance in 2003 to 46% in 2004, and 47% for 2005 ytd. AUD/USD Basis Bond/Swap Spreads

37. Issuance trends Issuance by Rating AA rated borrowers make up a greater proportion of the market, driven by large volume issuance from domestic and offshore AA banks such as Wells Fargo, Citigroup and Bank of America. • 2005 2004 2003 2002 Issuance by Sector • 2005 2004 2003 2002 Banks have consistently been the dominant borrowers in Australia. Supranational and agency issuance has increased at the expense of corporates.

38. Consistently improving issuance conditions The increasing sophistication of the Australian market means that a greater variety of structures, tenors and volumes has become available to issuers. Issuance conditions have become increasingly favourable with issue spreads at or near historic lows. • The increasing sophistication of the domestic investor base has made for improving issuance conditions in the Australian market. • As a result, a greater variety of issue types and structures are now available to issuers. For example, an increasing proportion of issuance is made up of long dated transactions: 23% of 2005 ytd issuance is of a maturity of 8 or more years compared to 12% in 2001 and 10% in 2002. • In addition, the domestic corporate hybrid market has seen investors willing and able to invest in lower rated instruments. Since December 2000, A$17.7bn of hybrid instruments have been issued, nearly A$7bn of which has been unrated. A$ Hybrid Issuance

39. Consistently improving issuance conditions (Contd) • Issue spreads have contracted considerably over recent years. 5 yr domestic bank issuance is the best example, as there are a number of such issues each year and the credit rating of the major Australian banks have been stable over this time. Average issue swap spread for an AA- rated 5 yr domestic issue has decreased from around +20bps in 2002 to +15bps currently. Similarly, 5 yr A / A- rated corporate issue spreads have also contracted markedly since 2000. 5 yr Bank Issue Spreads 5 yr Corporate Issue Spreads

40. 2005 Australian market highlights

41. 2005 issuance characteristics

42. Demand for corporates remains strong True corporate borrowers were relatively absent early in the year, exacerbating the already present supply/demand imbalance. Despite increased corporate issuance in Q3, demand for corporates remains high amongst the large volume of bank supply. • Despite the unprecedented large volume of issuance since July, demand for corporates in particular remains buoyant for two reasons: • A breakdown of bonds maturing in July 2005 against those issued in the same month reveals that investors replaced their higher yielding corporate paper with a large volume of lower yielding financial supply. • The regular SMR DB Money Manager survey conducted fortnightly reveals that investors are still holding high levels of cash on a historical basis, despite the unprecedented level of issuance during July – September 2005. • Corporate activity has been buoyant recently with several issuers coming to market in September. Santos (BBB+), Alinta (AAA wrapped) and Woolworths (A-) all issued during the week of September 19 and were extremely well received by investors. • The tight levels achieved by these issuers of different ratings and for different maturities highlight the demand for corporate paper. July 2005 Redemptions vs Issuance Investors’ Cash Holdings

43. Corporate Hybrids

44. Hybrids provide benefits of “debt” Hybrids provide benefits of “equity”            No shareholder approval required Improve balance sheet ratios Fixed, tax deductible payments No dilution of earnings or voting rights Repurchase flexibility (call rights) Positive signal to rating agencies Capital structure flexibility “Buy” time with rating agencies in need Access to a new investor base Increase debt capacity, covenant relief Equity credit from rating agencies  Deferral of payment obligations without default … and provide issuers with combined benefits Benefits of hybrid capital • Hybrid capital combines features of both debt and equity and accordingly, can provide issuers with specific benefits of both debt and equity • Hybrids are highly flexible and may be tailored to achieve specific accounting, tax, rating agency and legal outcomes   Non-dilutive capital to fund growth / M&A that also provides ratings support Opportunity to improve financial ratios (e.g. WACC & EPS) via buyback

45. Hybrid capital – inexpensive equity • Issuers are now viewing hybrid capital as a non-dilutive form of equity that is significantly below the cost of equity • Hybrid capital is widely accepted as an “equity substitute” for up to 15% of an issuer’s capital base • An analysis of recently issued € hybrids indicates that hybrid capital is approximately 56% less expensive than issuing equity on an after-tax basis – see below

46. Moody’s Moody’s Moody’s Moody’s Moody’s Moody’s S&P S&P S&P S&P S&P S&P Rating Agency Credit Basket D75% Basket C50% Baa3 Baa2 Basket D75% n/a Basket C50% n/a -2 Baa3 n/a -2 Baa1 -2 -2 Baa2 -2 Basket D75% 50% n/a 50% n/a 60% 50% BBB- 50% -3 BBB -3 -2 BBB- n/a -2 BBB- -3 BBB- Highlights • Company underratings pressure • Both equity and hybridsecurities issued • Hybrid equity creditimproved capitalstructure and costof equity • Unlisted & whollyowned by Danishgovernment • Issuer unable toaccess traditionalequity capital markets • Hybrid provided significant equity creditand no dilution ofgovernment stake • Ratings support andfinancial liquidity • Unlisted & wholly owned by Swedishgovernment • Issuer unable to access traditionalequity capital markets • Hybrid providedsignificant equity creditand no dilution ofgovernment stake • Hybrid accessedadditional equitywithout dilution of existing shareholders Rationale for issuance • Hybrid provided additional headroom for growth withincurrent ratings band Recent hybrid transactions & issuance rationale Notching fromsenior rating Hybrid rating • First hybrid following rating agencydevelopments • €700m issued • €1.1b issued • Book in excess of €3b • Most recent hybridoffering • €500m issued • €1b issued • Book in excess of €2b • Unrated hybrid • €150m issued • Largest hybrid to date • €1.3b issued • Book in excess of €5b

47. Equity credit designation Primary variables Moody’s approach Basket D 1 out of 3 primary variables 2 out of 3 primary variables Basket C Basket B Moody’s approach - overview • An assessment of equity credit will focus on the extent to which a hybrid contains three “equity-like” attributes: • Payment relief – ability to omit payments, eliminate the potential for payment default • Permanence – long term effective maturity • Loss absorption – provides creditors a cushion in bankruptcy • Equity credit reflected in both balance sheet and income statement • All balance sheet (leverage) ratios are adjusted based on equity credit designation • Full interest / dividend (servicing cost) ratios also adjusted based on equity credit designation • Replacement language (vs non-replacement) • Mandatory deferral (vs. optional) • Non-cumulative payments (vs. cumulative) 100% debt Basket A 75% debt / 25% equity Basket B 50% debt / 50% equity Basket C 25% debt / 75% equity Basket D 100% equity Basket E 3 out of 3 primary variables

48. Maturity • Perpetual / super long-dated (49+ years) • Perpetual / 100+ years Subordination • Preferred security or junior subordinated • Subordinated Basket D Basket C Basket B Moody’s approach – required terms • Perpetual / 100+years • Preferred security or junior subordinated with covenant to remain most junior Deferral • Optional discretionary • Deferred payments cash cumulative • Optional discretionary • Deferred payments non-cumulative on a cash basis • Cumulative payments that are payable by equity funded ACSM acceptable • Mandatory trigger based deferral • Mandatory deferred payments non-cumulative on a cash basis (may be cumulative where payable by equity funded ACSM) • Optional discretionary (cash cumulative) Call / Replacement Language • Minimum NC 5 • Replacement language not required • Step-up maximum 100bps • Minimum NC 5 • Replacement language required for corporates • Step-up maximum 100bps • Minimum NC 5 • Replacement language required for corporates • Step-up maximum 100bps

49. Intermediate equity content – key features S&P equity content scale PreviousScale NewScale Common equity 100% Interest Deferral • Requires no on-going payment that could lead to default • Nature of dividend stopper / pusher will be considered Mandatory conversion pfd - within 3 years 80% High Equity Content(71% - 100%) Mandatory conversion debt - within 3 years 70% Convertible pfd 60% Conventional perpetual pfd - 5 year no call 50% Intermediate Equity Content(31% - 70%) Deferrable payment pfd (trust pfd) - 25+ years 40% Deferrable payment debt - 25+ years 30% Convertible pfd -15+ years 20% Subordination • S&P favours preference share structures • Where otherwise, hybrid must be economically equivalent to a preference share Various pfd -15+ years 10% Minimal Equity Content (0% - 30%) Deferrable payment debt - 10-15 years 0% Maturity • No maturity or repayment requirement • Replacement language will provide S&P comfort • Step-up limited to 100 bps at year 10 Standard & Poor’s approach Hybrids with high equity content will be treated as equity for balance sheet and coverage ratios Hybrids with minimal equity content will be treated as debt for balance sheet and coverage ratios Hybrids with intermediate equity content will be treated both ways -alternatively as debt and equity for both balance sheet and coverage purposes (normally the analyst will then “split the difference”) • Standard & Poor’s has simplified it’s approach to hybrids with equity content assigned on the basis of 3 categories and formally adjusts financial ratios reflective of the hybrid • The majority of recently issued corporate hybrids have achieved “intermediate” equity content • The requirements to achieve “high” equity content are restrictive including legally binding replacement language and a tightly positioned trigger for mandatory deferral

50. Direct issue structure Rating Agency considerations Tax deductibility Accounting considerations FX hedging Possible to structure Moody’s Basket C or D / S&P “intermediate” credit Possible to structure Moody’s Basket C or D / S&P “intermediate” credit Indirect issue structure  (subject to jurisdiction where deduction claimed and potential tension with accounting and rating agency objectives) Possible to structure as debt or equity  (requires debt classification)  (via on-loan) Possible to structure as debt or equity  Technical & commercial considerations