1+Course+Intro,+S&P+MOODY's+Credit+Rating+Approaches

7/28/2019 1+Course+Intro,+S&P+MOODY's+Credit+Rating+Approaches

http://slidepdf.com/reader/full/1courseintrospmoodyscreditratingapproaches 1/65

Prof.EmmanuelA.Leyco

Master in Business Administration

Asian Institute of Management



A. References:1. StandardAndPoor'sFundamentalsofCorporateCreditAnalysis:

(http://ebook30.com/business/business-investing/36409/standard-and-poorsfundamentals-

of-corporate-credit-analysis.html)

By:BlaiseGanguin,JohnBilardello

2. TheRatingAgenciesandtheirCreditRatingsWhatTheyAre,HowTheyWorkandWhyTheyAreRelevantHerwigM.LangohrandPatriciaT.Langohr

(http://ebook30.com/business/business-investing/228275/the-rating-agencies-and-theircredit-ratings-what-they-are-how-they-work-and-why-they-are-relevant-the-financeseries.html)

B.Links1. StandardandPoor’s(http://www.standardandpoors.com/home/en/us)

2. Moodys(http://www.standardandpoors.com/home/en/us)



Understandthepracticeandprinciplesofcreditrating

Examinetheriskassessmentframeworkandcriteriausedbymajorcreditratingagencies

Explorethepracticalusesofcreditratingininvestmentdecisions



Creditratingagencies Investmentbanks

Treasuryoperations Governmentregulatoryagencies



Creditratingframeworks

Industryanalysis

Financialanalysis

Management

Creditratingagencypractices

Moodys

StandardandPoors



Lecturediscussion Casesdiscussion

Creditratingsimulation



Classparticipation Individualcontributiontogroupoutputs

Groupperformance



mid1800’ssawtherapiddevelopmentoftheAmericanrailroadsystemfinancedbytherisingprivatecapitalmarket

Investorsrequiredtransparency HenryVarnumPoorpublishedtheHistoryofRailroadsandCanals

OftheUS,apredecessorofhisManualoftheRailroadsoftheUS LutherLeeBlakefoundedtheStandardStatisticsBureau

JohnMoodysformedMoodysManualCoinearly1900’s RoyPorterbuysMoodysandmergedPoor’sRailroadManualCoin

1919andchangedthecompanynametoPoor’sPublishingCo.

StandardStatisticswasalsoformed

Poor’sPublishingwentbankruptin1930

StandardandPoor’sMergedin1941





Defaultrisks Recoveryprospects



Sovereign/countryrisks Industry

Companyspecific

Management

Financial

Cashflow

Instrumentspecific Ranking





Exerciseofstatepower

Rulemakingandenforcement

▪ Regulatoryframework

▪ Invasive,interventionist,liberal

▪ Tariffpolicies

▪ Fiscalpolicies

▪ Taxation

▪ Spending



Monetarypolicy

▪ Foreignexchangepolicy

▪ Limits,restrictions,multi-tierrates

Politicalstability

Legalenvironment

Naturalendowment

Physicalinfrastructure Humaninfrastructure

Labor



Financialmarkets

Bankingsystem

Accountingsystem

Macroeconomic

Consumerspending



Leadingindicators Buildingpermits,newprivatehousingunits Manufacturers’neworders,consumergoodsandmaterials

Manufacturers’neworders,non-defensecapitalgoods Vendorperformance,slowerdeliveriesdiffusionindex(ISM)

Averageweeklymanufacturinghours Averageweeklyinitialclaimsforunemploymentinsurance

(inverted)

Consumerexpectationsindex Stockprices,S&P500Composite Interest-ratespread,10yearTreasurybondslessFederalFunds

Realmoneysupply,M2



CoincidentIndicators Industrialproduction

Employeesonnonagriculturalpayrolls Personalincomelesstransferpayments

Manufacturingandtradesales



LaggingIndicators Averagedurationofunemployment(inverted)

CPIforservices,rateofchange

Commercialandindustrialloansoutstanding

Laborcostperunitofoutput,manufacturing

Ratioofconsumerinstallmentcredittopersonalincome

Inventoriestosalesratio,manufacturingandtrade

Averageprimeratechargedbybanks



InflationandInterestRates FOREIGNEXCHANGERISK





riskoflosingrevenueormarketshareorincurringanoverallfinancialdeclineasa

resultofindustrychanges,businesscycles,

productobsolescence,changesinconsumerpreferences,changesintechnology,reductioninbarrierstoentry,oranincrease

incompetition.



1. industry’sshort-andlong-termsalesgrowthtrendsandpotential,andthe

eventsandcompetitorsthatchallengethose

prospects.2. strengthorweaknessofratedcompanywithintheindustry,especiallyin

comparisontocompetitors



Salesandrevenueprospects Patternsofbusinesscyclesandseasonality

Industryhurdlesandbarrierstoentry Canindustryrisklimitacompany’scredit

quality?



IndustriesHighlyAffectedbyEconomicChanges

IndustriesModeratelyAffectedbyEconomicChanges

IndustriesSlightlyAffectedbyEconomicChanges

Paperandforestry Telecommunications Environmentalservices,

includingwastedisposal

Large-scalemanufacturingofcapitalgoodsandautomotiveproducts

Technology Healthcareandpharmaceuticals

Airlines,shipping,trucking,

andrail

Large-scalebroadcastingand

publishing

Regulatedutilities

Homebuildingandbuilding

materials

Engineeringandconstruction

companies

Cabletelevision

Oilandnaturalgas

Chemicals

Gaming Militarydefense

Retail,lodging,and

restaurants

Brandedconsumerproducts



Paperandforestry Large-scalemanufacturingofcapitalgoods

andautomotiveproducts Airlines,shipping,trucking,andrail Homebuildingandbuildingmaterials Oilandnaturalgas

Chemicals Retail,lodging,andrestaurants



Telecommunications Technology

Large-scalebroadcastingandpublishing Engineeringandconstructioncompanies Gaming



Environmentalservices,includingwastedisposal

Healthcareandpharmaceuticals Regulatedutilities Cabletelevision Militarydefense

Brandedconsumerproducts







• Emphasis on the Qualitative

- Quantification is integral to Moody's rating analysis

- Provides an objective and factual starting point

- Inquiries on numerical tools used are encouraged

- Moody's ratings are not based on a defined set of

financial ratios or rigid computer models.

- Rather, they are the product of a comprehensive

analysis of each individual issue and issuer by

analysts.



• Focus on the Long-Term

- analytical focus is on fundamental factors that will

drive each issuer's long-term ability to meet debt

payments

- As a rule of thumb, we are looking through the next

economic cycle or longer.

- ratings are not intended to ratchet up and down with

business or supply-demand cycles or to reflect lastquarter's earnings report.



• Global Consistency

- approach incorporates several checks and balances.

- designed to promote the universal comparability of

rating opinions.

- Internationally, ratings are normally limited to the

sovereign ceiling rating of the nation in which the

issuer is domiciled.

- analytical team approach supports consistency



• Level and Predictability of Cash Flow

- rating approach rests on the the level of risk

associated principal and interest payments and how

does that risk compare with that of all other debt

obligations?

- "risk to timely payment" = the ability of an issuer to

generate cash in the future.

- emphasis of the rating process is on understanding

strategic factors likely to support future cash flow,

while identifying critical factors that will inhibit future

cash flow.



• Reasonably Adverse Scenarios

- In coming to a conclusion, rating committees routinely

examine variety of scenarios.

- Moody's ratings deliberately do not incorporate a

single, internally consistent economic forecast.

- They aim rather to measure the issuer's ability to

meet debt obligations against economic scenarios

reasonably adverse to the issuer's specificcircumstances.



• "Seeing Through" Local Accounting Practices

- analysts deal frequently with different accounting

systems internationally and are not bound to any

particular one.

- focuses on understanding both the economic reality of the underlying transactions and on how differences in

accounting conventions may -- or may not -- influence

true economic values.

- For example, in the analysis of assets the concern iswith their relative ability to generate cash, not with the

value as stated on a balance sheet.



• Specific risk factors likely to be weighed in a

given rating will vary considerably by sector.

• In the following sections, we provide a very

rough outline of typical rating considerations for

two types of issuers: an industrial enterprise and

a structured financing.

• Moody's publishes more in-depth overviews of

our rating approach for each of these sectorsand many others.



• Unlike Moody's Bank Deposit Ratings, Bank

Financial Strength Ratings do not address the

probability of timely payment. Also, it excludes

certain external credit risks and credit support

elements.

• As such, Bank Financial Strength Ratings ...

- represent Moody’s opinion of a bank’s intrinsic safety

and soundness,

- do not take into account the probability that the bankwill receive external support, nor address risks

arising from sovereign actions



• Factors considered in the assignment of Bank

Financial Strength Ratings include...

- bank-specific elements such as financial

fundamentals, franchise value, and business and

asset diversification.

- take into account other risk factors in the bank's

operating environment, including the strength and

prospective performance of the economy, structure

and relative fragility of the financial system, and the

quality of banking regulation and supervision.



• Moody’s employ the alphabetic notation A through

E to indicate gradation.- A, banks rated A possess exceptional intrinsic financial

strength.

- B, banks rated B possess strong intrinsic financialstrength.

- C, banks rated C possess good intrinsic financialstrength.

- D, banks rated D possess adequate financial strength.

- E, banks rated E possess very weak intrinsic financialstrength.

- Intermediate Categories, where appropriate, a "+" maybe appended to ratings below the "A" category todistinguish those banks that fall into intermediatecategories.



• The Same Rating from Different Agencies Only

Looks the Same

- don't be fooled by appearances.

- ratings are opinions about risk, not formulas.

- How do you decide which agency provides thegreatest value?

- Ultimately, the only true test of a rating agency's

future value comes from "kicking the tires.”

- Above all, talk with the agency’s analysts.



• “In virtually every period over most of thetwentieth century, bonds rated Aaa by

Moody's have consistently had the lowest

yields, thus representing the lowest

funding costs for their issuers. And bondsrated lower by Moody’s have commanded

the consistently higher yields that

investors demand in return for greater

expected credit loss.”





• Issue credit ratings are based in varyingdegrees, on the following considerations:

- Likelihood of payment;

- Nature of and provisions of the obligation; and

- Protection afforded by, and relative position of,

the obligation in the event of bankruptcy,

reorganization, or other arrangement under the

laws of bankruptcy and other laws affectingcreditors’ rights.



• The issue ratings definitions are expressed in

terms of default risk and they pertain to senior

obligations of an entity.

- AAA, the obligor’s capacity to meet its financial

commitment on the obligation is extremely strong.- AA, the obligor’s capacity to meet its financial

commitment on the obligation is very strong.

- A, the obligor’s capacity to meet its financial

commitment on the obligation is still strong.

- BBB, weakened capacity of the obligor to meet its

financial commitment on the obligation.



• Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and ‘C’ are

regarded as having significant speculativecharacteristics. ‘BB’ indicates the least degree of

speculation and ‘C’ the highest.

- BB, less vulnerable to nonpayment than other

speculative issues.

- B, more vulnerable to nonpayment than obligations

rated ‘BB’

- CCC, currently vulnerable to nonpayment

- CC, highly vulnerable to nonpayment.

- C, used to cover a situation like a bankruptcy petition.

- D, payment default.



• The ratings from ‘AA’ to ‘CCC’ may be modified

by the addition of a plus or minus sign to showrelative standing within the major rating

categories.

- the ‘c’ subscript is used to provide additional

information to investors.

- the letter ‘p’ indicates that the rating is provisional.

- the * sign, continuance of the ratings is contingent

upon Standard & Poor’s receipt of an executed copy

of the escrow agreement or closing documentation

confirming investments and cash flows.- the ‘r’ highlights derivative, hybrid, and certain other

obligations

- N.R., not rated.



• Debt obligations of issuers outside the United

States and its territories are rated on the samebasis as domestic corporate and municipal

issues.

• The ratings measure the creditworthiness of the

obligor but do not take into account currencyexchange and related uncertainties.

• Bond Investment Quality Standards

- Under present commercial bank regulations issued by

the Comptroller of the Currency, bonds rated in thetop four categories (‘AAA’, ‘AA’, ‘A’, ‘BBB’, commonly

known as investment-grade ratings) generally are

regarded as eligible for bank investment.



• ECONOMIC RISK

- Size of the economy;

- Growth prospects for the economy;

- Dynamics of savings and investment in the economy;

- Structure and overall financial strength of the

corporate and personal sectors;

- Openness of the economy;

- Typical business cycle;

- Structural problems facing the economy;

- Constraints on policymakers’ ability to pursue

appropriate countercyclical policies; and

- The country’s political stability.



• INDUSTRY RISK

Structure

- basic structure of the banking system;

- Proportion of finance in the economy that isintermediated through the banks;

- Depth of publicly traded capital markets;

- Dynamics of inter- and intra-industry competition;

- Consolidation trends in banking system;

- Strategic stakes in industrial companies;

- Extent of influence of political or other interests

- Quality and transparency of accounting and reportingsystems and the quality of external auditing; and

- Strength and efficiency of country’s legal system.





• INDUSTRY RISK

Ownership structure of banks.

- Degree of government ownership within the

banking system ; and

extent to which government-owned banks

perform any special public sector role or competeon an equal footing with private sector banks,

the extent to which government involvement in

the system affects the competitive dynamics in

the banking market; and

- Degree of ownership of banks by corporate groups

or individuals.



MARKET POSITION

- Bank’s market shares in key businesses and

the size of those markets;

- Real advantages stemming from bank’smarket position; and

- Vulnerability of market position.



DIVERSIFICATION

- Diversity of products/business lines/

customer base;

- Geographical spread of bank’s

business base;

- Economic diversity of bank’s home

market(s); and

- International diversification.



MANAGEMENT AND STRATEGY

- Organizational structure;

- Quality and depth of management;

- Independence of bank management;

- Quality of planning process;

- Credibility of management;

- Logic and risk of strategic direction; and

- Growth



CREDIT RISK

- Structure of balance sheet;

- Fixed-income securities;

- Equity securities;

- Credit portfolio;

- Concentrations of credit risk;

- Problem loans;

- Loan loss reserves;and- Reserving policy and adequacy.



MARKET RISK

Structural risks.

- Management’s philosophy;

- Levels of interest rate,foreign exchange,and equity

risks in the balance sheet;- Role of Treasury Department,objectives, and risk

appetite;

- Reasons for structural risk;

- Use of noncash market instruments;and- Past and future position-taking and balance sheet

flexibility.



MARKET RISKTrading risk.

- Description of current organization;

- Trading strategy;

- Review of historic trading activities;

- Perceived market strengths and weaknesses;

- Future product and market expansion plans; and

- Breakdown of products.



FUNDING AND LIQUIDITY

- Composition of bank’s funding;

- Diversity of funding sources;

- Flow of funds;

- Asset liquidity; and

- Management’s philosophy.



CAPITALIZATION

- Capital composition;

- Comparison of capital;

- Bank’s capital position;

- Dividend payout ratio;

- Absolute size of bank’s capital base;

- Ability to tap external sources of capital and

long-term funding; and

- Management’s philosophy.



EARNINGS

- Net interest income;

- Noninterest income;

- Operating expenses;

- Loan loss provision;

- Net operating income analysis (level and trend);

- Quality of earnings;

- Impact of extraordinary gains and/or charges;

- Tax position;

- Impact of inflation;

- Earnings outlook;and

- Quality of bank’s accounting practices.



RISK MANAGEMENT

Credit risk.

- Underwriting criteria;

- Monitoring of credit exposures; and

- Problem assets.



RISK MANAGEMENT

Market risk.

- Senior management’s understanding;

- Membership of the asset-liability committee(ALCO);

- Information technology;

- Strategy regarding intentional position-taking, limits,

and authorities required for breaching limits;

- How traders and desk heads monitor positions and

how the system interacts with overall risk

management system;



RISK MANAGEMENT

Market risk.

- Hedging strategies;

- Description of method(s), measurement and

assumptions;

- Stress testing;

- Back office and operations;

- Audit function;

- Accounting policies;and

- Track record versus intended risk exposure.



FINANCIAL FLEXIBILITY

- Ability to access various funding markets

and raise capital;

- Internal reserves;

- Franchise value of discreet businesses; and

- Likelihood of support from governmental or

private shareholders.



OutputSalesContract PowerCosts

FuelRisk Structure TechnologyRisk Purchaser’sCreditStrength ProjectedFinancialResults

1+Course+Intro,+S&P+MOODY's+Credit+Rating+Approaches

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