CREDIT RATING. Dr. Oliver Everling Everling Advisory Services EVERLING. ppp. 4-Jun-07 Page 1

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1 CREDIT RATING Dr. Oliver Everling Everling Advisory Services 4-Jun-07 Page 1

2 ADVISORY SERVICES 21 Books, more than 400 articles in magazines and journals Magazine Encyclopedias 4-Jun-07 Page 2 Internet Newsletter weekly since 1999

3 AGENDA Ratings as the language of financial markets Role and functions of ratings for banks and corporates Systems and criteria of ratings Ratings in banking and securities markets supervision 4-Jun-07 Page 3

4 ROBINSON CRUSOE ON HIS ISLAND 4-Jun-07 Page 4 by Daniel Defoe

5 Rating/Classification Ranking/Decision RELATIVE AND ABSOLUTE INFORMATION AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C D absolute relative Bank Secrecy Act 4-Jun-07 Page 5

6 CASH FLOW t 0 Expectations Interest and amortization t n Price Rating: C 4-Jun-07 Page 6

7 DEFAULT RATES 4-Jun-07 Page 7 Moody s yearly default rates

8 CUMULATIVE DEFAULT RATES 4-Jun-07 Page 8 Moody s Statistics

9 STABILITY Comparatively little difference 4-Jun-07 Page 9

10 VARIOUS DIMENSIONS What does A mean? 4-Jun-07 Page 10

11 SYMBOLS TALK MORE THAN TABLES Given the vast amount of information available to investors today - some of it valuable, some of it not - rating agencies help investors and others sift through this information and analyze the credit risks they face when lending to a particular borrower, or when purchasing an issuer s debt and debt-like securities. For public debt instruments, most rating agenices make their credit ratings available to investors globally on a contemporaneous basis, publicly and free of charge. 4-Jun-07 Page 11

12 AGENDA Ratings as the language of financial markets Role and functions of ratings for banks and corporates Systems and criteria of ratings Ratings in banking and securities markets supervision 4-Jun-07 Page 12

13 LEVERAGED BUYOUT A leveraged buyout (LBO) may be defined as a strategy involving the acquisition of another company using borrowed money (bonds or loans). The acquiring company uses its own assets as collateral for the loan in hopes that the future cash flows will cover the loan payments. There is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds are usually not investment grade and are referred to as junk bonds. BBB+ B- 4-Jun-07 Page 13

14 SHUNNED BONDS PROMISE EXCEPTIONAL VALUE Junk bonds will forever be associated with the defunct investment bank Drexel Burnham Lambert and that firm's star trader Michael Milken, described as an unassuming, occasionally obsessive genius who sported a toupee. In 1973, there was hardly a market for such bonds. Firms rarely issued below investment grade bonds. Most of what Milken traded were fallen angles bonds issued by firms that had since become troubled. He believed that, precisely because such bonds were shunned, they offered exceptional value. In February 1990, Drexel filed for bankruptcy protection. 4-Jun-07 Page 14 Leaving court after facing charges of fraud and racketeering, in 1989.

15 MISLEADING NAME RECOGNITION? Fine quality. Fine brand. Delution. Brand abuse. 4-Jun-07 Page 15 Low risk. Low spread. Run into debts. Mislead creditors.

16 TRADITIONAL BANK CREDIT ANALYSIS YES NO Being in an awkward position: How to foretell the future? 4-Jun-07 Page 16

17 CORRELATE OF ANY DEBT MARKET Capitalism without bankruptcy is like Christianity without Hell. Frank Borman Frank Borman (born March 14, 1928) was a NASA astronaut, best remembered as one of the three crewmembers of Apollo 8, the first mission to fly around the Moon. Credit rating is the essential correlate of any debt market in a market economy. 4-Jun-07 Page 17

18 GLOBAL CHANGES IN BANKING Banking deregulation Assets and savings disintermediation Product commoditization Liberalization Globalization Internationalization Financial innovations Increased shareholder power Institutionalization Faster and cheaper technologies Rating banks stays exciting 4-Jun-07 Page 18

19 STRUCTURE OF THE BASEL II TREATY 4-Jun-07 Page 19

20 AGENDA Ratings as the language of financial markets Role and functions of ratings for banks and corporates Systems and criteria of ratings Ratings in banking and securities markets supervision 4-Jun-07 Page 20

21 RATING MODELS 1. Selection of the model 2. Selection of criteria 3. Development of the model 4. Model testing 5. Application of the model 6. Model supervision 4-Jun-07 Page 21

22 CRITERIA SELECTION 100 % 90 % 80 % 70 %? Default rate 60 % 50 % 40 % 30 % 20 % 10 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 % 4-Jun-07 Page 22 Proportion of hat or spectacle wearers in the company

23 RELEVANT CRITERIA Default rate 100 % 90 % 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 % 4-Jun-07 Page 23 Debt ratio

24 LINEAR REGRESSION ANALYSIS 100 % 90 % 80 % y 70 % 60 % 50 % 40 % 30 % 20 % 10 % b 1 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 % x b 2 4-Jun-07 Page 24

25 WHO IS FIT? 4-Jun-07 Page 25

26 HARD QUALITIATIVE RATING FACTORS 60% Power Education Duration of client relationship Client dependency 50% Martial status 40% 30% Successor Management Information System CFO Management seniority 20% 10% Overdraft 4-Jun-07 Page 26 0%

27 DSGV RATING Quantitative Qualitative factors Warnings Joint liability Basic rating Single client rating Rating after consideration of joint liabilities 4-Jun-07 Page 27

28 WEAKEST LINK THEORY

29 REDUCTION OF COMPLEXITY ON ALL LEVELS Country Country ratings AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ Industry Long-term ratings Industry ratings Issuer Issue Bond ratings A Loan ratings Short-term ratings 4-Jun-07 Page 29

30 AGENDA Ratings as the language of financial markets Role and functions of ratings for banks and corporates Systems and criteria of ratings Ratings in banking and securities markets supervision 4-Jun-07 Page 30

31 CUMULATIVE AVERAGE DEFAULT RATES ??? 4-Jun-07 Page 31

32 EXTERNAL CREDIT ASSESSMENT INSTITUTIONS National supervisors are responsible for determining whether an external credit assessment institution (ECAI) meets the criteria listed in the Basel II accord. The assessments of ECAIs may be recognised on a limited basis, e.g. by type of claims or by jurisdiction. The supervisory process for recognising ECAIs should be made public to avoid unnecessary barriers to entry. An ECAI must satisfy each of the following six criteria: Objectivity Independence International access/transparency Disclosure Resources Credibility 4-Jun-07 Page 32

33 BASEL II UND MARISK 4-Jun-07 Page 33

34 IOSCO CODE UND CESR 4-Jun-07 Page 34

35 CREDIT RATING AGENCY REFORM ACT OF Jun-07 Page 35

36 ISO PROJECT RATING SERVICES 4-Jun-07 Page 36

37 ANALOGY The sharpness of a view is an analogy for the evidence of ratings. The more the rating meets the expectations of its users, the higher the evidence. When the evidence is 100%: There is no doubt that the rating was well derived. If the evidence is 0%, there is no evidence for the rating. The rating appears arbitrary or coincidental. The reasons for the rating are unidentifiable. 4-Jun-07 Page 37

38 EVIDENCE RATING SCALE Very good: The highest rating. The evidence for this rating is 100%. There is no doubt that the rating was well derived. Good: The evidence is 80%. All data and facts agree with the given rating. The rating is clearly defined. Satisfactory: The evidence is 60%. The rating is still fairly defined. Sufficient: The evidence is 40%. The informational basis for the rating appears sufficient, however there are doubts. The rating is less clear. Unsatisfactory: The evidence is 20%. The basis of the rating is flawed. The rating is cloudy. Insufficient: The evidence is 0%. There is no evidence for the rating. The rating appears arbitrary or coincidental. The reasons for the rating are unidentifiable. 4-Jun-07 Page 38

39 NO RATING EVIDENCE With a 0% rating evidence there is no relation between default rates andratings. Short-term rating Long-term rating 4-Jun-07 Page 39

40 COMPLETE RATING EVIDENCE Cube Coin Rating: CCC 16,6 % Rating: C 50 % 4-Jun-07 Page 40

41 OVERLAP AND DIFFERENTIATION Rating agency Evaluator Rating advisor Auditor Consultant Certifier 4-Jun-07 Page 41

42 CONTACT RATING EVIDENCE GmbH Phone: +49 (700) Skype: oeverling Fax: +49 (69) Management Board: Dr. Oliver Everling PO Box , Frankfurt am Main, Germany A company of Everling Advisory Services 4-Jun-07 Page 42