PRESENTATION3 Credit Quality and the New Dynamics of Credit Ratings Dari Barzel Nikolai J. Sklaroff California Debt and Investment Advisory Commission

PRESENTATION3

Credit Quality and the New Dynamicsof Credit Ratings

Dari BarzelNikolai J. Sklaroff

California Debt and Investment Advisory CommissionMunicipal Debt Essentials

Oakland, CaliforniaFebruary 2, 2010

PRESENTATION3

Rating Agencies and Credit Ratings

PRESENTATION33 Credit RatingsCDIAC Municipal Debt Essentials Seminar

The Rating Agencies

Independent firms – so each is different

• Different definitions of what a rating is

• Different criteria

• But are opinions not formulas

Moody’s indicates there are $80 trillion of rated bonds and other fixed-income securities and “dozens” of rating agencies around the world; another website lists 73

Principally focused on three here in U.S. public finance: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings


Regulatory Definitions

Credit Rating Agency Reform Act in 2006

Provided the SEC with authority to:

• Impose registration, recordkeeping, and reporting rules on credit rating agencies registered as Nationally Recognized Statistical Rating Organizations (NRSRO).

• Currently 11 credit rating agencies are registered with the Commission as NRSROs.


Who are the NRSROs?

Nationally Recognized Statistical Rating Organizations - SEC Orders Granting NRSRO Registration

• Egan-Jones Rating Company (Release No. 34-59056)

• Realpoint LLC (Release No. 34-58000)

• LACE Financial Corp. (Release No. 34-57300)

• A.M. Best Company, Inc. (Release No. 34-56507)

• DBRS Ltd. (Release No. 34-56508)

• Egan-Jones Rating Company (Release No. 34-57031)

• Fitch, Inc. (Release No. 34-56509)

• Japan Credit Rating Agency, Ltd. (Release No. 34-56510)

• Moody's Investors Service, Inc. (Release No. 34-56511)

• Rating and Investment Information, Inc. (Release No. 34-56512)

• Standard & Poor's Ratings Services (Release No. 34-56513)


Moody’s Investors Service

John Moody published Manual of Industrial and Corporation Securities in 1900

1909 introduced ratings with Aaa through C

Worldwide offices, 3,900 employees, more than 1,000 analysts

Parent company is Moody's Corporation (NYSE: MCO) www.moodys.com


Standard & Poor’s

www.standardandpoors.com

Traces roots to 1860; Henry V. Poor published guide to U.S. Railroads

Began rating bonds in 1916 - symbols AAA to D

Global outstanding debt rated by S&P in 100 countries is about US$32 trillion

In 2008, S&P published more than 1,150,000 ratings (new and revised)


Fitch Ratings

www.fitchratings.com

Established in 1913; rating symbols AAA to D in 1924

Developments

• 1989: Recapitalized

• 1997: IBCA Merger

• 2000: Duff & Phelps

• 2002: “Fitch Ratings”

Part of Fitch Group a majority-owned subsidiary of Fimalac, S.A., France


More Competition for Rating Agencies?

Recent Press Clippings:

Financial Times: “Kroll aims to bring investigative powers to credit rating industry”

Financial Times: “Analyst [Oppenheimer’s Meredith Whitney] to rival Moody’s and S&P with own rating agency”

Bond Buyer: “National Public Finance Offers Credit Reports”


What IS a Rating?

“is a forward-looking opinion about the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium-term note programs and commercial paper programs). It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated. The opinion reflects Standard & Poor's view of the obligor's capacity and willingness to meet its financial commitments as they come due, and may assess terms, such as collateral security and subordination, which could affect ultimate payment in the event of default.”


Moody’s “Universal Approach to Credit Analysis”

“Because it involves a look into the future, credit rating is by nature subjective. Moreover, because long-term credit judgments involve so many factors unique to particular industries, issuers, and countries, we believe that any attempt to reduce credit rating to a formulaic methodology would be misleading and would lead to serious mistakes.”

“Moody's credit ratings represent a rank-ordering of creditworthiness, or expected loss. Expected loss is a function of the probability of default and the expected severity of loss given a default. Ratings are forward looking in that the rank ordering is designed to hold across multiple horizons.”

“While a rating summarizes the credit risk characteristics of an obligor or obligation, it is not a statement as to which obligors or obligations will default in the future. Rather, it is expected that lower rated entities and obligations will default, on average, at a higher frequency than more highly rated entities and obligations”

PRESENTATION3

Ratings Basics

Credit Quality and the New Dynamics of Credit Ratings

April 2010

June 2010 1414

Rating Symbols and Definitions, January 2011

June 2010 151515

…easier-to-see summary…

AaaHighest quality, minimal credit

risk

InvestmentAa1/Aa2/Aa3 High quality, very low credit risk

GradeA1/A2/A3

Upper-medium grade, low credit risk

Baa1/Baa2/Baa3

Moderate credit risk. Medium grade,

certain speculative characteristics

Below InvestmentGrade

Ba1/Ba2/Ba3Speculative elements,substantial credit risk

B1/B2/B3Speculative,

high credit risk

Caa1/Caa2/Caa3Poor standing,

Very high credit risk

June 2010 161616

The Rating Process

Rating Releasedto Moody’s website

Annual Surveillance

ApplicationDocuments Received

Conference Call/Management/Site Visit

Rating Committee

R A T I N G

Analysis Begins

Further Analysis; Rating Recommendation

Draft Rating Report Reviewed

Rating Report Released

Continuing Disclosure Information

Requested/Received

Note: Surveillance process may not necessarily involve a call/site visit, and may not result in a formal update of the rating on the website or in a rating report

June 2010 1717

Rating Factors: General Obligation Bond/Issuer Rating – Economy – 4 Factors

Rating Methodology: General Obligation Bonds Issued by U.S. Local Governments, October 2009

June 2010 1818

Rating Factors: General Obligation Bond/Issuer Rating -- Economy

As of 1/25/2011 Aaa Aa1 Aa2 Aa3 A1

CA Cities 9 12 32 7 5

Assessed Value ($billions) 21.9 14.0 9.4 12.2 3.1

PCI as % of US 225 156 122 99 77

MFI as % of US 211 157 122 99 79

CA Counties 1 7 13 1 4

Assessed Value ($billions) 144 68 106 7 79

PCI as % of US 167 124 95 97 73

MFI as % of US 161 130 100 89 76

Unemployment % 9 10 12 13 15

June 2010 1919

Rating Factors: General Obligation Bond/Issuer Rating -- Finances

As of 1/25/2011 Aaa Aa1

Aa2 Aa3

A1

CA Cities 9 21 32 7 5

Total GF Fund Balance as % of Revenues 53 64 30 39 33

Unreserved GF Fund Balance as % of Revenues

49 41 21 32 22


Total GF Fund Balance as % of Revenues 32 30 22 15 14

Unreserved GF Fund Balance as % of Revenues

27 19 15 3 4

June 2010 2020

Rating Factors: General Obligation Bond/Issuer Rating -- Debt

As of 1/25/2011 Aaa

Aa1 Aa2

Aa3 A1

CA Cities 9 21 32 7 5

Direct Debt as % of AV 0.2 0.2 0.3 0.7 0.9


Direct Debt as % of AV 0.2 0.3 0.3 0.1 0.2

June 2010 2121

Rating Factors: General Obligation Bond/Issuer Rating -- Management

June 2010 22

Rating Factors: GO/Issuer Rating – Weighting + Lease Financing

4 Factors

weighting in GO/Issuer Rating:

22

Lease financing additional considerations: •Assets being financed•Terms and conditions of lease•Lease burden

Generally 2-notch rating distinction between issuer’s General Obligation/Issuer Rating and CA abatement leaseRating Methodology: The Fundamentals of Credit Analysis for Lease-Backed Municipal Obligations, October 2004

June 2010 23

Rating Factors – Water/Wastewater

23

Water/sewer financing additional considerations: •4 factors +•Debt affordability/debt service coverage +•Capital Improvement Plan +•Regulatory compliance +•Terms/structure of financing +Rating Methodology: Analytical Framework for Water and Sewer System Ratings , August 1999

As of 1/25/2011 All Rating Levels

Water 57

Coverage of Maximum Annual Debt Service (x)

1.7

Unrestricted Reserves as % of O&M 101

Sewer 49

Coverage of Maximum Annual Debt Service (x)

1.6

Unrestricted Reserves as % of O&M 147

June 2010 24

Municipal market is large and highly differentiated

24

June 2010 25

Information Needed for Initial Rating and Surveillance• Based on Methodologies – for both initial rating and surveillance

• Methodologies available on our website: www.moodys.com

• If we needed it for the initial rating, there’s a good chance we’ll need it for surveillance

• If you already have a rating, you can get a sense of what’s important by reviewing your prior rating report(s)

• The Official Statement also is a good source to consult in determining what’s important, e.g. updates and changes to key charts and tables

• Feel free to talk to your rating analyst if you have questions prior to a call or meeting

• If key information is not included in continuing disclosure, surveillance analyst may call and ask for it

• Surveillance analyst also may call to follow up on disclosure information, e.g. for explanation of large and/or unanticipated changes

25

June 2010 2626

Dari BarzelVice President

Moody’s Investors ServiceOne Front Street, SF, CA 94111

[email protected]

June 2010 2727

© 2009 Moody’s Investors Service, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling.

Moody’s Investors Service, Inc. (“MIS”), a wholly-owned credit rating agency subsidiary of Moody’s Corporation (“MCO”), hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MIS have, prior to assignment of any rating, agreed to pay to MIS for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,500,000. MCO and MIS also maintain policies and procedures to address the independence of MIS’s ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually at www.moodys.com under the heading “Shareholder Relations — Corporate Governance — Director and Shareholder Affiliation Policy.”

PRESENTATION3

Why Do Ratings Matter?


Ratings Are Used in Many Ways

Ratings

Borrowers

Investors

PortfolioStakeholders

Regulators

NonStakeholders


Factors in the Pricing of Bonds

BondPricing

EconomicExpectations

Demand forBonds

CreditRatings

Supply ofBonds

LegalStructure

MarketConstraints

PortfolioNeeds

InterestRates

RedemptionProvisions

PortfolioConstraints


Market Perceptions of Rating Agencies

Role of the RatingAgencies is More

Important than Ever

Role of the Rating?

RegulatoryOversight

Global FinancialCrisis

Potential NewCompetitors


Do ratings predict defaults? S&P Default Study


Ratings and the Global Financial Crisis Financial crisis has created

calls for regulation* U.S. Congress* U.S. Regulators* International

SEC Chairman Schapiro. " it is incumbent upon us to do all that we can to improve the reliability and integrity of the ratings process and give investors the appropriate context for evaluating whether ratings deserve their trust."


0%

1%

2%

3%

4%

5%

6%

7%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29Year

Rat

e

AAA (pure) Insured AA A BAA

Interest Rates by Credit Ratings Before the Crisis (October 9, 2007)

Interest Rates by Credit Ratings Before the Crisis (October 9, 2007)

Only 0.50% separatedthe top and bottom“investment grade” rated bonds in 2007

Impact of Credit Ratings – Before the Financial Crisis

Source: Municipal Market Data


0%

1%

2%

3%

4%

5%

6%

7%

2012 2016 2021 2026 2031 2036 2041Year

Rat

e

AAA (pure) Insured AA A BAA

Interest Rates by Credit Ratings Today (January 24, 2011)Interest Rates by Credit Ratings Today (January 24, 2011)

Now 1.47% separatesthe top and bottom“investment grade”

bonds today

Impact of Credit Ratings – Today

Source: Municipal Market Data


Credit Spreads

What has the Credit Spread between Aaa/AAA and BBB/Baa General Obligations Been?

• January 2007 33 basis points



Credit worries heighten credit spreads


Bond Insurers Helped Get Ratings to Aaa/AAA/AAA

Borrower’s could purchase bond insurance to “insure” debt service on the bonds.

The following bond insurers enjoyed Aaa/AAA/AAA Ratings:


WithdrawnR

Negative OutlookCa

Watch Developing

WithdrawnWithdrawnWithdrawn

WithdrawnCC

Negative WatchCaa2

Negative Watch

WithdrawnBBB-

Negative WatchBa1

Stable Outlook

WithdrawnA

Watch DevelopingBaa1

Watch Developing

WithdrawnCC

Watch DevelopingCaa2

Watch Developing

AANegative Outlook

AAANegative Outlook

Aa3Negative Watch

AA-Negative Outlook

AAANegative Outlook

Aa2Negative Watch

N/ AAAA

Negative OutlookAa1

Stable Outlook

FitchS&PMoody’sInsurer

WithdrawnR

Negative OutlookCa

Watch Developing

WithdrawnWithdrawnWithdrawn

WithdrawnCC

Negative WatchCaa2

Negative Watch

WithdrawnBBB-

Negative WatchBa1

Stable Outlook

WithdrawnA

Watch DevelopingBaa1

Watch Developing

WithdrawnCC

Watch DevelopingCaa2

Watch Developing

AANegative Outlook

AAANegative Outlook

Aa3Negative Watch

AA-Negative Outlook

AAANegative Outlook

Aa2Negative Watch

N/ AAAA

Negative OutlookAa1

Stable Outlook

FitchS&PMoody’sInsurer

Assurance CorporationAssurance Corporation

Formerly MBIA

Assured Guaranty and FSA merged

effective 7/ 1/ 2009

Bond Insurers Lose Their Triple-A Ratings

Rating Downgrades

Ratings Withdrawn

Litigation

• Recent positive news for MBIA in appeals court

Only Assured Guaranty Municipal and Assured Guaranty Corp wrote insurance in 2010

• $22.7 billion for 1,700 issuers

New firms considering formation


The Rise and Fall of Municipal Bond Insurance

0

50

100

150

200

250

300

350

400

450$ b

illions

2001 2003 2005 2007 2009

Insured Total

From nearly 57% in 2005 to 6% in 2010

Source: SourceMedia; The Bond Buyer


Outlook for Rating Agencies

Remain vital and relevant

Changes are coming around the globe

Regulatory focus

Congressional focus

Internal changes and introspection

PRESENTATION3

Tips For Working with Rating Agencies


Tips for Working with Rating Agencies

Selecting a Rating Agency

Selecting the Number of Ratings

Managing the Rating Request and Process

• What are you asking for?

Tips for Communicating with Rating Analysts (and Other Credit Analysts)

• How to deal with bad or negative news

Presentations and Site Tours

Maintaining the Rating After the Bonds Are Sold

PRESENTATION3

Interactive Discussion


Interactive Discussion

How is the process changing?

Variable rate debt and concerns?

Public finance ratings in the current environment?

Audience Questions?