RATING AGENCIES

THE POWER OF A LETTER

AN OVERVIEW

CRA

Ratings: what’s behind a

simple letter?

Are ratings all they do?

Are they really useful?

3 players. Are they alone?

Why?

WHY WERE CRAS BORN?

Rating Agencies

Investors need

Information: railways

Development of financial

markets

Help pricing issues: bonds

WHO ARE THE BIG THREE?

1913 John Fitch

Introduced letter rating

now the smallest

1890 Henry Poor

1906 Luther Blake

1941 merge

Largest, diversified

1909 John Moody

1970 stop rating Gov

First one

IS THE MARKET CONCENTRATED?

YES, YES IT IS!

BUT WHY?

Is it the SEC’s fault?

More efficient, less costly

Informal entry barriers

The two-rating norm

WHAT IS A RATING?

An opinion on credit risk

Forward looking and continually evolving

Not suggestions to buy or sell

Not an absolute measure of default probability

WHAT ARE THE CHARACTERISTICS OF A RATING?

A,B,C. What’s up with the Alphabeth?

Short and long term

Probability of Default

PIT vs TTC

Outlook and Watching

A, B, C

Categories of issuers and issues with

relatively higher levels of creditworthiness and

credit quality

Categories of issuers or issues with the

ability to repay but a likelihood of default or

failure

SHORT AND LONG TERM

LONG TERM: Original maturity of more than one year

SHORT TERM: Maturity of less than

one year and reduced scale

Relationship between long and short term

ratings.

PROBABILITY OF DEFAULT?

Precision for

autorities

Stability for

investors

PIT AND TTC

Point in time Current conditions

Through the cycle Survive economic cycle

OUTLOOK AND WATCHING

•  Long term credit •  Positive/negative •  Stable/developing

Outlook

•  Short term credit •  In 3 circumstances •  Within 90 days •  Positive/negative •  Stable/developing

Watching

They must be transparent

The criteria are public

Ratings models are proprietary

CRA encourage dialogue and confront

Committee, made up of a lead analyst, a managing director and junior analytical staff.

HOW ARE ISSUERS AND ISSUES RATED?

WHAT ARE THE BASIC MODELS?

Model driven

Quantitative data

Proprietary mathematical

formulas

Based on financial

statements

Analyst driven

Review of financial

information

Weight qualitative information (stategies)

Sector specific analysts

HOW IS AN ANALYST DRIVEN RATING COMPILED?

Rating an Issuer

Rating an Issue

Rating a structured finance instrument

HOW DO WE RATE AN ISSUER?

External support Higher rated guarantor/

parent Can have negative

impact

Creditworthiness before external support

Projecting cash flows

Economic environment

Balance sheet ratios

DIFFERENCES BETWEEN CORPORATE AND GOVERNMENT

Corporate Country risk

Industry

Competition

Diversification

Strategy

Regulatory environment

Management

Labor relations

Government Political stability

Growth prospects

Wealth, GDP

Demographics

Budget performance

Debt burden

War

Corruption

IN PARTICULAR FOR GOVERNMENTS: Category Fitch Moody’s S&P

Macro GDP Fiscal policy Competitiveness Balance of payments Economic growth

GDP, GDP per capita Scale of the economy

Economic growth Savings Behavior in economic cycles

Public finance Government’s assets Revenue to GDP Volatility of revenue

Ability to raise taxes, cut spending and sell assets

Revenue trends Size and health of non financial public enterprises

Debt Size and growth of public debt Maturity, interest Payments record

Level and structure of debt Interest payments

Composition and size of debt

Financial sector Foreign ownership quality

Sector strength Sector strength and effectiveness

Political Legimacy War Diplomatic relations

War Political consensus Transparency

Stability Geopolitical risk Corruption

Institutional Effectiveness of gov Trade openness Rule of law Human capital

Level of innovation Property rights Human capital Natural disasters

Public efficiency Competiveness private sector Labor flexibility

IN PARTICULAR FOR ENTERPRISES

Company Rating

•  Accounting •  Governance •  Cash flow adequacy •  Capital structure •  Liquidity

Financial Risk

•  Country risk •  Industry characteristics •  Market position •  Profitability

Business Risk

Rating an issuer

Rating an issue

Rating a structured finance instrument

HOW DO WE RATE AN ISSUE?

Existence of credit enhancement

Letters of credit Guarantees Insurance

Relative seniority of the issue

In regard to others Priority of repayment

Issue’s characteristics

Term Conditions Legal structure

Creditworthiness of the issuer

At the start of the process Both for corporate and Gov.

Rating an issuer

Rating an issue

Rating a structured finance instrument

HOW TO RATE A STRUCTURED FINANCE INSTRUMENT

Not move forward with rating if there are not sufficient information

Analysts maintain they do not tell arrangers what to do

Analysts do not tell arrangers how to structure transactions

PROCEDURE TO RATE A STRUCTURED FINANCE INSTRUMENT

Operational risks

Servicer ability Servicer change

Payment structure

Sufficient cash flow Credit enhancement fees Effectiveness of insurance

Legal and regulator risks

Isolation Previous owners SPE exposure to bankruptcy

Credit quality of securitized assets

Loss estimation Benchmark comparison Historical data

WHO USES RATINGS?

Interest payments

Regulatory requirements

Banks

Interest payments

More attractive

Issuers

Rating triggers

Contracts

Risk assessment

Risk premium

Individual investors

Issue pricing

Sell securitized assets

Investment banks

Limitations

Bases for own analysis

Build benchmark indexes

Institutional investors

WHO PAYS FOR RATINGS? USER MODEL

User •  No conflict of

interest

•  Investors’

pressure •  Limited

information access

WHO PAYS FOR RATINGS? ISSUER MODEL

Issuer •  Free for investors • More info •  Reputation •  Analyst

compensation •  Negotiator

•  Financial ties •  Ratings shopping •  Unsolicited punitive

ratings

DEVELOPING NEW IDEAS…

Introduction of innovative lines of business

Gain more market share

Enrich the value

proposition

Diversify the activity

MOODY’S CASE

Moody’s Corporation

Moody’s Investors Services (MIS)

Credit ratings on a wide range of debt obligation and their

issuers

Moody’s Analytics (MA)

Research, Data and Analytics (RD&A)

Research on debt issuers, industry

studies, quantitative credit risk score

Risk Management Software (RMS)

Software solutions

Professional Services

Quantitative credit risk measures, credit

portfolio management solutions et al.

CORE BUSINESS

ALTERNATIVE AREA

MOODY’S REVENUE

MIS Revenue 1569 mil$

MA Revenue 712 mil$

Tot Revenue 2281 mil$

69%

31% MIS REVENUE

TOTAL MA REVENUE

Increasing Trend

RD&A 451 mil$

+6%

RMS 183 mil$

+6%

PS 77 mil$ +168%

MA 712 mil$ 13,5%

0

100

200

300

400

500

600

700

800

FY05 FY06 FY07 FY08 FY09 FY10 FY11

MA REVENUE

WHAT ARE THE REASONS FOR AN INCREASING TREND?

RD&A: greater demands for products supporting analysis

RMS: increased client usage of financial software

PS: Acquisition of companies providing other financial services

ARE CRAS ANY GOOD?

Advantages •  Good institution get better

results (lower cost of debt) •  Warn investors of risky

companies •  Provide a Fair Risk-Return

Ratio •  Wake up call for those in

need of improvement

Disadvantages •  Subjective evaluation •  Aren’t always accurate,

people trust less •  Conflict of interest

BIBLIOGRAPHY

Butler, Cornaggia, Rating through the Relationship: Soft Information and Credit Rating, 2012

Claire Hill, Regulating the Rating Agencies IMF, Global Financial Stability Report, October 2010 IOSCO, Report on the Activity of Credit Rating Agencies, 2003 Moody’s, Annual Report, 2011 Moody’s, Annual Report, 2012 Federico Parmeggiani, La Funzione Economica e la Regolazione delle

Agenzie di Rating, 2011 Standard and Poor’s, General rating Criteria, 2012 Standard and Poor’s, Credit watch and Outlook, 2008 World Bank, Rating Agencies. No easy regulatory solutions, October 2009 Fitchratings.com Moneycrashers.com Moodys.com Standardandpoors.com/aboutcreditratings Wikipedia.com

TEAM MEMBERS:

Calamia Andrea Corriere S. Gianluca Martignoni Eleonora

Salituro Valeria Vanni Gianluca