CREDIT RATING

Introduction
A credit rating estimates the credit worthiness of an individual, corporation or even a country. A credit rating is also known as an evaluation of a potential borrowers ability to repay debt. Typically, a credit rating tells a lender or investor the probability of the borrower being able to pay back the debt. A poor credit rating indicates a high risk of defaulting on a loan, thus leads to high interest rates or the refusal of a loan by the creditor. Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, CRAs increase the range of investment alternatives and provide independent and measurements of relative credit risk, this generally increases the efficiency of the market and lowering costs for both borrowers and lenders. Ratings by NRSRO are used for a variety of regulatory purposes in the United States. In addition to net capital requirements, the SEC permits certain bond issuers to use a shorten prospectus form if it has a credit rating above a certain level. SEC regulations also require that money market funds comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators from NRSROs to ascertain the strength of the reserves held by insurance companies.

What can be rated?

The rating services by the CRAs can generally be categorized as following.

Corporate
CRAs offer their corporate clients rating services to help demonstrate a corporations financial strength to its potential business partners or investors and to improve access to the global credit market. The credit rating of a corporate is based on evaluation and interpretation of information form a multitude of sources to form an opinion about a corporations credit risk. CRAs also offer credit ratings on the counterparties, which is useful for clients who are seeking asset or joint ventures. It is also useful for comparing a companys creditworthiness to that of its peers.

Credit Rating Agencies

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. Until the early 1970s, CRAs were paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their particular offerings. Starting in the early 1970s, the Big Three rating agencies began to receive payment for their work by the securities issuers for whom they issue those ratings. The Big Three who remain as the largest CRAs worldwide are: Moodys Investor Service Standard & Poors Fitch Ratings

Financial institution
CRAs provide ratings on a broad range of financial institutions including banks, saving institutions, securities firms, mortgage institutions, finance companies, etc. The ratings are provided on the financial institutions as well as the specific debt instruments they issue. To form the rating opinions, the CRAs review a broad range of business and financial attributes that may influence the creditworthiness, i.e. the business risk (country risk, environment risk, etc.) and financial risk (risk management, capitalization, earnings, funding and liquidity, etc.).

Note that companies that issue credit scores for individuals are usually called credit bureaus and are distinct from credit ratings for corporations and sovereign debt that are assigned by CRAs.

Nationally Recognized Statistical Rating Organization

In the United States, the Securities and Exchange Commission (SEC) permits the use of credit ratings from certain CRAs for certain regulatory purposes. The CRAs whose ratings are permitted to be used for these regulatory purposes are referred to Nationally Recognized Statistical Rating Organizations (NRSROs). The single most important factor in SECs assessment of NRSRO status is whether the rating agency is nationally recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings. As of 25 September 2008, ten organizations were designated as NRSROs: Moodys Investor Service (US) Standard & Poors (US) Fitch Ratings (US) A. M. Best Company (US) Dominion Bond Rating Service, Ltd (Canada) Japan Credit Rating Agency, Ltd (Japan) Rating and Investment Information, Inc (R&I) (Japan) Egan-Jones Rating Company (US) LACE Financial (US) Realpoint LLC (US)

Sovereign
CRAs provide ratings for sovereign, sovereign-supported entities and supranational issuers. It indicates the risk level of the investing environment of a country and it takes political risk into account. It extends to local and regional governments, foreign and local currency ratings and ceilings on debt and deposits.

Special purpose company (SPC)

CRAs assess potential risks posed by the instruments legal structure and the credit quality of the project / assets held by the SPC. CRAs also consider the anticipated cashflow of the assets and any credit enhancements that could provide protection against default.

Debt instruments
CRAs undertake credit rating of debt instruments. These include medium and long-term debt securities such as: Bonds; Convertible bonds; Debentures;

and types of short-term debt / deposit obligations such as: Commercial paper; Inter-corporate deposits; Fixed deposits; and Certificates of deposit.

S&P may also designate other rating symbols which are related to default categories: Past due on interest CI Under regulatory supervision due to its financial situation R Has selectively defaulted on some obligations SD Has defaulted on most or all obligations D Not rated NR

Structured finance instruments

The instruments are termed structured finance because these securities may be structured through specific choices relating to the type and amount of assets and particular structural features such as credit enhancements. These instruments may be structured to achieve a desired rating level. Structured finance instruments are usually held by a special purpose company. Different types of structured asset include the following: Structured bonds / project bonds Asset-backed securities Residential mortgage-backed securities Collateralized-debt obligations

Types of rating
Credit ratings are generally divided into two types, Short-term obligation rating and Long-term obligation rating. Short-term obligation rating Short-term ratings are opinions of the ability of issuers to honor short-term financial obligations. Ratings may be assigned to issuers or short-term debt instruments. Such obligations generally have a maturity of no more than 365 days, such as commercial paper. Medium-term notes are generally assigned long-term ratings. Long-term obligation rating Long-term ratings are opinions of the relative credit risk of obligations with a maturity of one year or more. Such ratings reflect the followings: Likelihood of payment capacity and willingness to meet the financial commitment. Nature of and provisions of the obligation. Assessment of relative seniority or ultimate recovery in the event of default.

Rating grades and types

Rating grades
The credit ratings assigned by Moodys, Standard & Poors and Fitch to have letter designations which represent the quality of the debt obligation. Each rating agency has developed its own system of rating grades. Fitch developed a rating grade system in 1924 that was adopted by S&P. Moodys grading is slightly different. The following table match credit rating of Moodys with comparable ratings of S&P and Fitch. Moodys assigns credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P/Fitch assign ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C. All of them also assign intermediate ratings at levels, e.g. Baa1, Baa2, Baa3 (Moodys) and BBB+, BBB, BBB- (S&P/Fitch).

In addition to the official credit rating on short-term / long-term obligations, credit rating agency may also issue an opinion which is generally short-term in nature,, e.g. to address market demand for timely information on particular types of credit ratings. Indicative rating Indicative rating is a one-time opinion of the credit quality of securities or financial contracts that may be issued in the future based on draft documentation and discussions early in the rating process. Rating outlook - Credit watch The rating outlook also assesses the potential direction of a longterm credit rating over the intermediate term (typically six months to two years), termed a credit watch. In determining a rating outlook, consideration is given to any changes in the economic and/or fundamental business conditions. Positive means that a rating may be raised. Negative means that a rating may be lowered. Stable means that a rating is not likely to change Developing means a rating may be raised or lowered.

Understanding rating
Screenshot: Credit rating table (Source: Wikipedia) Other rating symbols Moodys may designate other rating symbols include the following: Expected ratings e Provisional ratings (P) Withdrawn WR Not rated NR Not available NAV

Investment grade vs. Sub-investment grade

Ratings play a critical role in determining how much company and other entities that issue debt, including sovereign governments; have to pay to access credit markets. Moodys and S&P classify bond issues as either investment grade or sub investment grade. An issue is considered investment grade if its credit rating is BBB- or higher by S&P/Fitch or Baa3 or higher by Moodys.

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The threshold between investment grade and speculative grade ratings has important market implications for issuers borrowing cost. Investment grade Typically provides the highest degree of principal and interest payment protection and they are generally the least likely to default. Sub investment grade It is sometimes referred as high-yield or junk status, they may be suitable for more aggressive investors willing to accept greater degrees of credit risk in exchange for significantly higher yields. The difference between rates for first-class government bonds and investment grade bonds is called investment grade spread. It is an indicator for the markets believe in the stability of the economy. The higher these investment grade spreads are, the weaker the economy is considered.

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Why get a credit rating?

For almost a century, CRAs have been providing opinions on the creditworthiness of issuers of securities and their financial obligations. During this time, the importance of these opinions to investors, lenders and other market participants, and the influence of these opinions on the securities markets have increased significantly. Today, credit ratings affect markets in many ways, including an issuers access to capital, the structure of transactions and the ability to make particular investments. In summary: It provides independent opinion. Easy-to-understand measurements of credit risk. Globalization of the financial markets It is important to gain insight into different investment environments but also to understand the risks / advantages these environments pose.

Country / sovereign ceiling

Sovereign credit risk is always a key consideration in the assessment of the credit standing of issuers (corporates or banks). Sovereign risk is crucial because the unique, wide-ranging powers and resources of a national government affect the financial and operating environments of entities under its jurisdiction. The credit ratings of borrowers most often are at, or below, the ratings of the relevant sovereign due to these considerations: In the case of foreign currency debt, the sovereign has first claim on available foreign exchange, and it controls the ability to obtain funds to repay creditors. To service debt denominated in local currency, the sovereign can exercise its powers to control the domestic financial system and even to issue local currency in potentially unlimited amounts.

An investment grade rating can put a security, company or country on the global radar, attracting foreign capital and boosting a nations economy. Therefore, credit rating generally increases the efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases the total supply of capital in the economy. It also opens the capital markets to certain categories of borrower, e.g. small governments, start-up companies, hospitals, universities. Financial institutions also may have capital requirements depending on the rating of the structured assets they hold. For example under Basel II, a triple-A rated security requires capital allocation of only 0.6%, a triple-B requires 4.8%, a BB requires 34%, whilst a BB (-) securitization requires a 52% allocation. For a number of reasons, many institutional investors relied on the ratings agencies rather than conducting their own analysis of the risks these instruments posed.

Default probability
The credit rating opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default. For example, a bond that is rated as having a higher credit quality isnt a guarantee that it will not default. Some studies have estimated default probabilities by rating class, which was based on historical default probabilities and other modelling. The Municipal Bond Fairness Act introduced on 9 September 2008 a table giving bond default rates up to 2007 for municipal versus corporate bonds by rating and rating agency.

Rating methodology and principles

Rating methodology
In general, CRAs use methodology that divides the assessment task into several categories to ensure all salient issues are considered. As a guideline, the following factors are considered in credit rating evaluation process: Business measures Industry characteristic Competitive position Management

Screenshot: Historical default rates (Source: Wikipedia)

Financial measures Financial characteristics Financial policy Profitability Capital structure Cashflow Financial flexibility & stress analysis

At times, a rating decision may be influenced strongly by financial measures. At other times, business risk factors may dominate. Industry risk This analysis focuses on the strength of industry prospects (growth, stability, cyclicality), as well as the competitive factors affecting that industry. E.g. it would be hard to assign AAA/Aaa to debt instrument of companies with extensive participation in industries of aboveaverage risk regardless of how conservative their financial profile. Competitive position The nature of competition is obviously different for different industries. For e.g. a power generation companys competitive position may be based on relative costs of production, alternatives to electricity, plants importance to transmission support. Competition may be on a national basis or global. Management Management is assessed for its role in determining operational success and also for its risk tolerance. Financial characteristics The business risk profile determines the level of financial risk appropriate for any rating category. Accounting quality is also reviewed to determine whether ratios and statistics derived from financial statements can be used accurately to measure the performance. Financial policy Rating credit agencies pay great importance to managements policies involving financial risk. Many firms that have set goals do not have the management commitment to achieve these objectives. Profitability Profitability is a critical determinant of credit protection. A company that generates higher operating margins and returns on capital has a greater ability to generate equity capital internally, attract capital externally, and withstand business adversity. Earnings power ultimately attests to the value of the firms assets as well. The measures of profitability include the following: Return on capital Operating income as a percentage of sales Earnings on business segment assets Ratio of earnings before interest and taxes (EBIT) over the interest While the absolute levels of ratios are important, it is equally important to focus on trends and compare these ratios with the competitors. Capital structure Ratios commonly employed to capture the degree of leverage include the following: Total debt / Total debt + equity Total debt + off-balance-sheet liabilities / Total debt + off-balancesheet liabilities + equity Total debt / Total debt + market value of equity

Cashflow Cashflow analysis is the single most critical aspect of all credit rating decisions. While companies with investment grade ratings generally have ready access to external cash to cover temporary shortfalls, sub-investment grade issuers lack this degree of flexibility to internally generated cash for servicing debt. Some of the cashflow ratios considered are: Funds from operations / total debt Free operating cashflow / interest + principal repayment obligation\

In analyzing debt issuance for project financing structure, cashflow analysis is particularly important because the loan structure relies primarily on the projects cashflow. Focusing on debt service coverage and free cash flow also becomes more critical in the analysis of a weaker company as speculative-grade issuers typically face near-term vulnerabilities which are better measured by cashflow ratios. Financial flexibility and stress analysis An analytical task covered at this point is the evaluation of a companys options under stress. The potential impact of various contingencies is considered, along with a firms contingency plans. As going concerns, companies should not be expected to repay debt by liquidating operations. Nonetheless, a companys ability to generate cash through asset disposals enhances its financial flexibility.

Basic principles
It involves a look into the future and involves so many factors unique to particular industries, issuers and countries. It involves factors as discussed above during the credit evaluation process. Basic principles to credit rating are summarized below. Emphasis on the qualitative Quantification provides an objective and factual starting point for each rating committees analytical discussion. Some financial ratios commonly used in the evaluation process are discussed above. Long-term focus The ratings are measurement of long-term risks. Hence the analytical focus is on fundamental factors that will drive each issuers long-term ability to meet debt payments such as a change in management strategy or regulatory trends. As a rule of thumb, the CRAs are looking through the next economic cycle or longer. Global consistency Internationally ratings are normally limited to the sovereign ceiling rating in which the issuer is domiciled. Credit rating approach must incorporate parameters designed to promote the universal comparability of rating opinions. Global consistency The analysis focuses on an assessment of the level and predictability of future cash generation in relation to its commitments to repay the debt. Generally, the greater the predictability of the cashflow and the larger the cushion supporting anticipated debt payments, the higher the rating will be. Adverse scenarios This is the measurement of the issuers ability to meet debt obligations against variety of scenarios reasonably adverse to the issuers specific circumstances.

What is considered debt and equity for the purpose of ratio calculation needs to be identified, e.g. in the case of convertible debt. Industry nature is also a critical determinant of the appropriate leverage for a given level of risk. Assets with stable cash flow or market values justify greater use of debt financing.

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Founded in 2004, Navigator Project Finance Pty Ltd (Navigator) is the project finance specialist. Headquartered in Sydney, Australia, Navigator is raising the global benchmark in financial modelling services to the project finance sector. At any stage in your projects lifecycle, our project advisory team can inject world class expertise into your team; strengthening both the project and team structure. Navigator designs and constructs financial models for complex project financings, offers training courses throughout the Middle East, Asia, the US and Europe. Navigator delivers fast, flexible and rigorously-tested project finance services that provide unparalleled transparency and ease of use. Navigator Project Finance Pty Ltd P +61 2 9229 7400 [email protected]

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Accounting practices Understanding both the economic reality of the underlying transactions and on how differences in accounting conventions influence the economic values. Sector-specific analysis Specific risk factors likely to be weighed in a given rating will vary considerably by factor. Navigators courses are presented in the following cities Sydney Brisbane Melbourne Perth London Frankfurt New York Toronto Singapore Johannesburg

However, the point to make is that the importance of the triple-A ratings to the monoline business means that the monolines work closely with the rating agencies in order to preserve their ratings. The CRAs have focused heavily on measuring the risk of credit deterioration and the levels of deterioration needed to result in such downgrade. This is a source of protection for investors in that the monolines are managing themselves within the context of the rating agencies expectations.

Lessons from global financial crisis

The rapid and large market losses associated with rating downgrade have often raised concerns related to CRAs, especially after the fall of Enron and WorldCom. Abrupt and unanticipated credit rating downgrades of a number of participants and securities particularly in structured finance have led to large market losses. As a result, there has been strong pressure on policy makers to regulate the credit rating industry. CRAs have also begun taking action to re-examine the rating processes and approach. Below are some concerns to take note as lessons from previous rating crisis. CRAs do not downgrade companies promptly enough Enrons rating remained at investment grade four days before the company went bankrupt. In public hearings held by the SEC in 2002 in the aftermath of Enron, CRAs insisted that ratings are only opinions and should have a limited role which is to assess the creditworthiness of issuers on an ongoing basis and the likelihood that debt will be repaid in a timely manner. Quality of information CRAs also insist that their analysis is largely dependent on the quality of information provided to them. For instance, the largest rating downgrades during the Asian crisis occurred following the triggers of what the CRAs regarded as material new information such as the reports on the size of the Bank of Thailands forward exchange position. In the case of Enron and WorldCom, CRAs also stressed that they do not conduct formal audits of rated companies or search for fraud. Relationship with company management Large rating credit agencies have been criticised for having too familiar a relationship with company management, possibly exposing themselves to undue influence or the vulnerability of being misled. Rating triggers may create a vicious cycle The lowering of a credit rating can create a vicious cycle, as not only interest rates would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. Under a worstcase scenario, once the companys debt is downgraded, the companys loans become due in full and it may sometimes forced into bankruptcy. Errors of judgment CRAs have made errors of judgment in rating structured produces, particularly in assigning triple-A ratings to structured debt which in a large number of cases has subsequently being downgraded or defaulted. This has led to problems for several banks whose capital requirements depend on the rating of the structured assets they hold as well as large losses in the banking industry.

Credit wrappers
Credit enhancement is a key part of the securitization transaction in structured finance. A wrapped security is insured or guaranteed by a third party. The third-party guarantees are typically provided by AAArated financial guarantors or monoline insurance companies.

Benefits of wrapping
There are a number of benefits to wrapping transactions; the only one major negative is the price of the wrap. However, depending on issuer preferences and prevailing interest rates, the all-in cost of let say a project bond issue can be lowered by the use of such credit wrapper. Commonly, a triple-A rated monoline would insure project bonds with an underlying risk rating of triple-B. The savings from the reduced credit spread on a triple-A bond versus something just inside the border of investment grade would more than offset the cost of the credit insurance. Outlined below is the key reasons for credit wrapping from issuer and investor perspective. Issuer Pricing benefits that outweigh cost of guarantee. The credit focus shifts to the guarantor than the issuer. Investor Investors have recourse to the guarantor in the event of default. Comfort that the guarantor is sharing the risk by lending their credit quality to the issue. Benefits from the added scrutiny brought to the transaction by the wrapper both in the development process and throughout the life of transaction. Benefits from the rating agency scrutiny in that they analyse both the transaction and the wrapper.

Issuer benefits from the expertise and experience of the guarantor.

Help to broaden market acceptance of new / complex transactions. Helps in the secondary market by promoting liquidity.

Downgrade risk
The main primary monolines have triple-A ratings, on which they rely given that their business is lending their balance sheets. However, there are some risks that may trigger a downgrade. From an investors perspective, the major risk is that the rating of the bond will be downgrade. This risk therefore applies to the bond insurers rating rather than the underlying credit.

References
U.S. Securities and Exchange Commission Credit Rating Agencies NRSROs 25 September 2008 Standard & Poors Rating methodology Moodys Rating policy and approach Barclays Capital, Securitisation Research Unwrapping the Wrappers Wikipedia Credit rating agency International Monetary Fund Working paper The Systemic Regulation of Credit Rating Agencies and Rated Markets, June 2009