global securities industry: overview of the rated universe...global securities industry: overview of...

Rating Methodology

New YorkPeter E. Nerby 1.212.553.1653Blaine FrantzAlexander YavorskyRobert F. YoungLimassolGeorge Chrysaphinis 357.25.586.586LondonJim Hyde 44.20.7772.5454MadridMaria Cabanyes 34.91.310.14.54SydneyPatrick Winsbury 61.2.9270.8100TaipeiCherry Huang 886.2717.1999 TokyoElisabeth Rudman 81.3.5408.4000

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December 2006

Global Securities Industry Methodology

Summary

This rating methodology sets forth the key analytical factors that explain Moody’s ratings of companies in the globalsecurities industry. This methodology is not an exhaustive treatment of all factors reflected in Moody’s ratings, but itshould enable the reader to understand the key considerations and financial ratios used by Moody’s in the final ratingdetermination. The methodology focuses on the key operational and financial aspects that Moody’s believes to be thecritical cornerstones of a company's performance and its ability to remain competitive and service its debt obligations.

Importantly, this methodology is not intended to catalyze any imminent rating changes and the outlook on mostratings is stable. Furthermore, we recognize that, although the scorecard included in this methodology has produced aclose overall fit with the current ratings, it is a tool — albeit, an increasingly important one — in arriving at a ratingdecision. We will continue to expand and improve this methodology on an ongoing basis in an effort to both increasethe transparency of our ratings as well as to improve and expand our quantitative metrics.

Global Securities Industry: Overview of the Rated Universe

This methodology covers 23 securities firms from around the world that are rated by Moody’s. We do not explicitlyaddress the ratings of universal banks with large securities operations (e.g., JP Morgan, UBS, Barclays, Deutsche Bank,etc.) as these institutions will be covered by the revised methodology for bank financial strength ratings. The securitiesfirms addressed in this methodology include:

Our rated universe is international and composed of a diverse set of firms, including 14 domiciled in the US, fourin Europe and six in Asia. With nearly $43 billion in combined pre-tax earnings in 2005 and hundreds of billions ofdollars of rated debt, most of these issuers are important financial industry participants with national and/or global rel-evance.

For the purposes of this methodology we have classified the issuers in two categories: “market-makers” and“other” firms (see last column in the table above). Market-makers, which include all of the large investment banks, arefirms which raise debt as a means of financing their market-making activities, including underwriting, securities salesand trading, lending, or principal investing. By contrast, “other” firms do not have significant market-making opera-tions and raise debt for general corporate purposes, including expansion and acquisitions, or recapitalization. As a con-sequence of their different business models and attendant risks, and as the rest of this methodology will demonstrate,we take into account slightly different rating factors and factor weights in analyzing the creditworthiness of these twogroups of issuers. As regards the universe of “other” securities firms, which specialize in different segments of thebroad securities industry (e.g., retail brokerage, M&A advisory, agency-only brokerage), the main factors we considerin rating them are the same.

The rating scorecard consists of the following rating factors, which are explained in greater detail in the RatingFactors section. Note that while most of the factors apply to both categories of firms (market-makers and others),some factors only apply to only one category (as evidenced by their weight of 0%).

Issuer Country Sr. Unsecured Outlook Short-Term Classification

The Goldman Sachs Group, Inc. United States Aa3 Stable Prime-1 Market-makerMerrill Lynch & Co., Inc. United States Aa3 Stable Prime-1 Market-makerMorgan Stanley United States Aa3 Stable Prime-1 Market-makerLehman Brothers Holdings Inc. United States A1 Positive Prime-1 Market-makerBear Stearns Companies Inc. United States A1 Stable Prime-1 Market-makerMacquarie Bank Limited Australia A2 Positive Prime-1 Market-makerThe Charles Schwab Corporation United States A2 Stable Prime-1 OtherAhorro Corporacion Financiera S.V., S.A. Spain A2[1] Stable Prime-1 Market-makerNomura Holdings, Inc. Japan A3 Stable --- Market-makerJefferies Group, Inc United States Baa1 Stable --- Market-makerDaiwa Securities Group Inc. Japan Baa1 Stable --- Market-makerOddo & Cie France Baa1[1] Stable Prime-2 Market-makerInvestcorp S.A. Luxembourg Baa2 Stable Prime-3 Market-makerCollins Stewart Tullett plc United Kingdom Baa2 RUR Down Prime-2 OtherNikko Cordial Corporation Japan Baa2 Stable --- Market-makerFubon Securities Co. Taiwan Baa3 Stable --- Market-makerLazard Group, LLC United States Ba1 Stable --- OtherTD Ameritrade United States Ba1[1] Stable --- OtherE*TRADE Financial Corp. United States Ba2 Positive --- OtherLaBranche & Co, Inc. United States Ba2 Stable --- OtherOppenheimer Holdings, Inc. United States B1 Stable --- OtherConvergEx Holdings United States B2 Stable --- OtherLPL Holdings, Inc. United States B2 Stable --- Other

[1] Supported Rating

2 Moody’s Rating Methodology

Seventy percent of the 23 rated issuers are currently rated at or above investment-grade with no securities firmrated higher than Aa3 or lower than B2.

Global Securities Industry Methodology Rating FactorsModel Weight

Factor Market Makers Others

Quantitative Factors 41% 53%Earnings Strength and Stability 25% 30%

Pre-Tax Earnings ($US Millions) 15% 15%Pre-Tax Margin 5% 5%Pre-Tax Margin Volatility 5% 10%

Liquidity 8% 0%NCC/LNA 8% 0%

Capital Adequacy 8% 0%IRA/TCE 8% 0%

Debt Service Capacity 0% 23%Debt / EBITDA 0% 12%EBITDA / Interest Expense 0% 11%

Qualitative Factors 59% 47%Franchise Strength and Diversification [1] 17% 17%

Processing 2% 2%Asset/Wealth Management 2% 2%Institutional Capital Markets 2% 2%Retail Banking 2% 2%HNW Retail Brokerage, AMA 2% 2%Discount Brokerage 2% 2%Principal Investing / Prop. Trading 2% 2%Diversification 2% 2%

Management Quality And Culture 20% 20%Vulnerability to Event Risk 4% 4%Management Operating Quality/Breadth/Depth 4% 4%Corporate Governance [2] 4% 4%Culture & Ethics 4% 4%Consideration of Bondholders' Interests 4% 4%

Risk Management 12% 0%Governance 3% 0%Management 3% 0%Quantification 3% 0%Environment 3% 0%

Operating Environment 10% 10%Competitive Dynamics 5% 5%Regulatory Environment 5% 5%

[1] The weight of the Franchise Strength and Diversification factor is distributed equally among all the applicable franchise sub-factors and the diversification sub-factor. The maximum number of sub-factors is 8 = 7 franchises + diversification. For any franchise, which does not apply to a given firm, its weight is distributed equally among the remaining sub-factors.

[2] Corporate Governance is considered neutral if scored A (Strong) or above, in which case its weight is distributed equally among the remaining sub-factors.

Moody’s Rating Methodology 3

Industry Overview and Current Risk Characteristics

RISKS AND OPPORTUNITIES FACING MARKET-MAKERSThe cornerstone of our credit ratings on market-making securities firms is the franchises these firms have built at thenexus of capital markets. Many drivers of revenues of securities firms (trading volumes, assets under management,securities outstanding) have historically grown at rates exceeding those of the global GDP.

We expect capital markets to continue to grow and cross-border flows to increase driven by globalization, techno-logical advances and constant pressure on corporations and investors to improve their returns. These forces will causecapital markets to deepen and widen, and issuers and investors will call on securities firms for advice and to provideliquidity. While this should allow well-run firms to generate growing earnings with reasonable stability, securitiesfirms must manage the attendant risks.

Figure 1

Ratings Distribution

Figure 2

Global Securites Industry Revenues (by Country or Region)

Note: BRICKs = Brazil, Russia, India, China, South KoreaSource: SIFMA.

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Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3

Num

ber o

f Iss

uers

United States Europe Asia

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2001 2002 2003 2004 2005 2006

$ bi

llion

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United States United Kingdom EU (ex. UK) Japan BRICKS Canada and Australia Other Asia Other LatAm

United Kingdom

Canada and Australia

United States

Other LatAm

Other Asia

BRICKS

EU (ex. UK)

Japan

0% 10% 20% 30%

CAGR


OvercapacityWhile there is no obvious measure of industry capacity, signs of overcapacity are evident in the securities industry.Many new entrants (often commercial banks) are attracted to the growth potential of capital markets and therefore areconstantly launching new forays into the business. This sometimes takes the form of acquisitions (Credit Suisse FirstBoston buying Donaldson Lufkin and Jenrette). Sometimes it may mean purchasing boutiques in an underrepresentedbut “hot” product area (Merrill Lynch’s acquisition of Entegy-Koch to strengthen its energy trading business). Some-times it is in search of economies of scale (mergers of electronic discount brokers in 2006).

This overcapacity often translates into bargaining power for issuers and investors over the securities firms. Pro-prietary ideas are quickly copied by competitors. Issuers or investors can also quickly organize an auction to sell a largeblock of securities amongst many competing liquidity providers. Alternatively, firms may be driven to bank question-able clients or underwrite imprudent transactions. To succeed in this environment requires experienced managementas well as excellent risk-management and distribution.

Competition and pricing pressures are not unique to the “bulge bracket” market-making firms. Online brokers,which enjoyed considerable market-share growth in the late nineties, are another example. Dozens of online discountbrokers, including Charles Schwab, E*TRADE and TD AMERITRADE (then still known as simply Ameritrade)were able to harness technology and the increasingly ubiquitous Internet, and combine it with a no-frills, compara-tively low-price service offering to successfully lure away significant numbers of brokerage customers from the tradi-tional full-service brokers like Merrill Lynch, which were charging about five times more per trade. However, whenthe equities bubble burst in 2001, the discount brokerage industry, with its relatively low barriers to entry, was afflictedwith a classic overcapacity problem of too much supply and too little demand. Consolidation and price slashingensued, with commission rates declining from over $40 per trade to just over $10 (Figure 3 shows Charles Schwab’scommission rates and trading revenues as an illustrative example). Even as trading volumes recovered, the pricingpower was no longer in the hands of the online brokers as online trading became fully commoditized.

As the top half of Figure 3 demonstrates, Schwab (as well as E*TRADE and TD AMERITRADE) have success-fully weaned themselves from their dependence on trading in favor of more stable sources of revenue like asset man-agement and retail banking. This highlights another feature of many successful securities firms — nimble adaptabilityin response to changing competitive dynamics.

Figure 3

Trading Decline: Volumes Recovery Overshadowed By Price Erosion

Note: DARTS = Daily Average Revenue TradesSource: Public filings, Moody’s research.

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1999 2000 2001 2002 2003 2004 2005 20060

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Trading Rev. DARTs % of Total Rev Avg. Commision

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100Trading Net Revenue ($M)

Trading % Firm-Wide Net Revenue

DARTS (000's)

Avg. Commission ($)


Market, Credit and Concentration RisksTo provide liquidity, or on their own initiative, market-makers occasionally take-on large concentrated positions.These can range from a position equivalent to several days trading volume in a stock, to a private equity investment, toa large loan underwriting to fund a merger. These positions are often short-term, and Moody’s is naturally most con-cerned with longer-term positions.

Securities firms run at very high levels of leverage, as measured by traditional leverage ratios. Unfortunately, wethink traditional leverage measures such as gross assets and net assets are not insightful measures of credit risk for secu-rities firms. Such measures do not fully adjust for the volatility of the assets financed, the impact of hedges, the avail-ability of relatively stable collateralized financing for many assets, or the discipline imposed by mark-to-marketaccounting.

We focus on illiquid risk assets relative to tangible equity. This measure has two drawbacks – firms are notrequired to disclose concentrated illiquid positions and this measure ignores hedges that may be in place on the bal-ance sheet positions.

Liquidity RiskLiquidity risk, or the inability to finance the “business as usual activities” of the firm, is probably the greatest risk thatmarket-makers are exposed to. The recent collapse of Amaranth (unrated by Moody’s) and last year’s collapse of Refcoare only two recent examples of crises exacerbated by insufficient liquidity.

One of the many tools employed by market-makers to manage liquidity risk is the conceptual framework of cashcapital. Cash capital compares the sources of long-term capital (typically equity, long-term debt and other long-termfinancing) to the uses of long-term capital (typically illiquid assets such as goodwill, illiquid inventory and haircuts onliquid inventory). Our net cash capital ratio is based on this framework.

Litigation, Regulatory, and Reputation RisksThe bursting of the equity bubble in 2000-2001 and the corporate scandals of 2001-2002, highlighted the litigationand reputation risks inherent to the securities industry. The particular problem with litigation risks is the often open-ended nature of the potential losses which cannot be easily quantified. Also, firms that constantly run afoul of theirregulators raise our concerns about the management culture and the entire control infrastructure of the firm.

Moody’s assessment of the prudence of a firm’s culture and the overall quality of its management is a major factorin our assessment of the firm’s ability to manage litigation, regulatory and reputation risks.

Inherent Cyclicality of Capital MarketsCapital markets are inherently cyclical in terms of prices, volumes and volatility. Business line diversification is onedefense against this cyclicality. Expense flexibility, robust risk management and granular position-taking are also essen-tial. Well-run securities firms have tremendous expense flexibility in compensation and are generally able to managecompensation expense to roughly 50% of revenues in a wide variety of environments. Risk expenses, in the form ofmark-to-market losses, can also be controlled with effective risk management and granular risk taking. The effective-ness of these defenses is captured in pre-tax earnings and margin volatility as well as within illiquid risk concentrations.

In this Methodology:

1. IDENTIFICATION OF THE KEY RATING FACTORSThese are the key factors that Moody’s considers to be major drivers in determining a rating for a company in the glo-bal securities industry:

• Earnings Size and Stability• Liquidity• Capital Adequacy• Debt Service Capacity• Franchise Strength and Diversification• Management Quality and Culture• Risk Management• Operating Environment


The following table summarizes the different factors, sub-factors and their weights in the scorecard. In identify-ing the rating factors, we tried to reflect our existing approach to rating securities firms as well as capture the topicsand issues which dominate our rating committees. The weights were chosen with the objective of producing a reason-ably close fit with existing ratings, while being consistent with our view of the relative importance of each rating factor.

The factors and the firms’ scores are described in detail in the “Rating Factors” section.

Global Securities Industry Methodology Rating FactorsModel Weight

Factor Market Makers Others

Quantitative Factors 41% 53%Earnings Strength and Stability 25% 30%

Pre-Tax Earnings ($US Millions) 15% 15%Pre-Tax Margin 5% 5%Pre-Tax Margin Volatility 5% 10%

Liquidity 8% 0%NCC/LNA 8% 0%

Capital Adequacy 8% 0%IRA/TCE 8% 0%

Debt Service Capacity 0% 23%Debt / EBITDA 0% 12%EBITDA / Interest Expense 0% 11%

Qualitative Factors 59% 47%Franchise Strength and Diversification [1] 17% 17%

Processing 2% 2%Asset/Wealth Management 2% 2%Institutional Capital Markets 2% 2%Retail Banking 2% 2%HNW Retail Brokerage, AMA 2% 2%Discount Brokerage 2% 2%Principal Investing / Prop. Trading 2% 2%Diversification 2% 2%

Management Quality And Culture 20% 20%Vulnerability to Event Risk 4% 4%Management Operating Quality/Breadth/Depth 4% 4%Corporate Governance [2] 4% 4%Culture & Ethics 4% 4%Consideration of Bondholders' Interests 4% 4%

Risk Management 12% 0%Governance 3% 0%Management 3% 0%Quantification 3% 0%Environment 3% 0%

Operating Environment 10% 10%Competitive Dynamics 5% 5%Regulatory Environment 5% 5%

[1] The weight of the Franchise Strength and Diversification factor is distributed equally among all the applicable franchise sub-factors and the diversification sub-factor. The maximum number of sub-factors is 8 = 7 franchises + diversification. For any franchise, which does not apply to a given firm, its weight is distributed equally among the remaining sub-factors.[2] Corporate Governance is considered neutral if scored A (Strong) or above, in which case its weight is distributed equally among the remaining sub-factors.


2. MAPPING FACTORS TO THE RATING CATEGORIESThe methodology sets forth what Moody's believes to be appropriate ranges for seven broad rating categories fromAaa to Caa for the above-listed sub-factors. The ranges represent, on average, our expectations for each rating cate-gory.

With the ranges identified, we map the outcomes for each of the sub-factors to a Moody’s rating category:• For quantitative sub-factors, we compare a firm’s actual value1 (e.g., pre-tax earnings) to the seven rating

category value ranges (which are expressed as Min – Max pairs) and determine which one it fits into.• For the qualitative sub-factors, we force-rank (i.e., assign sub-factor rankings) all the firms relative to a) one

another, and b) absolute criteria, including both quantitative and qualitative parameters. As with quantita-tive sub-factors, we use seven broad rating categories, since it is neither practical nor especially enlighteningto rank qualitative sub-factors (e.g., culture & ethics) with 19 possible values.

Once the broad rating category has been determined for each of the sub-factors, it is converted into a numericalequivalent, as per the conversion table below.

The seven rating categories span the full ratings spectrum from Aaa to Caa3 (19 ratings in all). Each specific rat-ing is mapped to a numerical equivalent, using a simple linear scale (e.g., Aaa = 1, Aa1 = 2, Aa2 = 3 … Caa3 = 19). Therating categories, in turn, are also mapped to a numerical equivalent, which is equal to that of the middle rating in thecategory (e.g., Aa = Aa2 = 3).

Upon converting each sub-factor’s rating category into a number, we multiply it by the sub-factor’s scorecardweight, providing a weighted average of all the sub-factor ratings. The rounded number is then mapped to one of the19 ratings using the conversion table above, producing the final scorecard-derived rating.2

3. MODEL FIT AND OUTLIER DISCUSSIONOverall, the scorecard has produced a close fit with only two outliers out of twenty three ratings (see additional score-card statistics on page 23).

We recognize that not every factor will map to the actual rating level and that the rating represents an overallblend of the key factors. Any given company may perform higher or lower on a specific factor than its actual ratinglevel. We highlight those companies whose factor mapping is two or more broad rating categories higher or lowerthan its rating and, if necessary, offer a discussion of the reasons for outliers. We further highlight and comment onany companies whose final scorecard derived ratings are three or more refined notches higher or lower than the actualrating.

1. Unless specified otherwise, fiscal 2005 year-end financials are used.

Conversion of Factor and Sub-Factor Ratings Into Numeric ValuesRating Categories Aaa Aa A Baa Ba B Caa

Ratings Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3Notches 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

2. The same approach is used to derive factor ratings, which are intermediate weighted averages of their constituent sub-factors.

In some rare instances, all of the sub-factors of a given factormay be ranked the same (e.g., Baa). This would produce anumerical outcome of nine, which, when mapped to a notchedrating, would produce Baa2 (as per the mapping table above.)This represents a limitation in the model, since in a case whenall the sub-factors are ranked Baa, the “precise” outcome ofBaa2 is no more accurate, or intentional, than Baa1 or Baa3.Therefore, in such instances, the indicative factor rating will beshown as a rating category, italicized (e.g., Baa). In all othercases, in which the factor rating is a weighted average ofdifferent sub-factor scores, we show the notched factor rating.


The Rating Factors:

RATING FACTOR: EARNINGS STRENGTH AND STABILITY

Pre-Tax Earnings

Why it mattersThe strength and persistency of a securities firm's pre-tax earnings is a direct function of its franchise strength andcompetitive position within its various lines of business. For an institutionally focused investment bank, the pre-taxearnings stream reflects the strength and breadth of its relationships with issuers and investors, which results in a flowof banking and market-making transactions and revenue. For a retail brokerage or asset management and administra-tion firm, it is the customer base that will produce a stream of asset management, commission, and net interest reve-nues. Irrespective of a firm’s specific business model, pre-tax earnings are a direct contributor to capital formation anddebt service capacity of any securities firm. In order to reduce the effect of both cyclical fluctuations as well as anyone-time gains or losses, our standard approach for computing pre-tax earnings in the context of this methodology isto use a weighted average of pre-tax earnings from the last three years, with the most recent year receiving 60% of theoverall weight, and the remaining two years receiving 20% each3.

Pre-Tax Margin

Why it mattersThe profitability of a securities firm is as much a function of its ability to generate revenue as it is a reflection of itsability to keep expenses in check. For the vast majority of securities firms, compensation tends to be the dominantexpense category, as well as one with the highest degree of variability. Achieving a close link between firm revenuesand compensation is not an easy task. To retain intellectual talent, it is critical to compensate key employees and reve-nue generators, which can sometimes mean sharp cuts in bonus pools elsewhere in the firm. In the past, Moody's hasseen some firms run into difficulty as a result of the excessive use of guaranteed compensation. If revenues do notmaterialize as planned, the compensation ratio can escalate and a firm's bonus pool for other professionals can evapo-rate. That can hurt margins and damage morale. The benefits of achieving the right balance, however, are compellingin that it both protects the bottom line during leaner cycles, and helps grow earnings through operating leverage dur-ing up-cycles.

Non-compensation expenses tend to have a higher fixed component, although costs, such as brokerage and clear-ing fees, do fluctuate depending on the level of business activity. Just as with compensation-related expenses, flexibilityis clearly important in maintaining critical earnings and margins measures. The series of restructuring efforts under-taken by Charles Schwab in 2003-2004 are a good example of both the perils of a bloated cost structure (pre-restruc-turing) and the benefits of having improved operating leverage (post-restructuring).

Factor Mapping: Earnings Size and StabilityModel Weight Rating-Value Range

FactorMarket Makers Others Aaa Aa A Baa Ba B Caa

Earnings Strength and Stability 25% 30% >= < >= < >= < >= < >= <

Pre-Tax Earnings ($US millions) 15% 15% > 10,000

3,000

10,000

1,100

3,000

500

1,100

180

500

30

180 < 30

Pre-Tax Margin 5% 5% > 43% 28% 43% 23% 28% 18% 23% 10% 18% 0% 10% < 0%Pre-Tax Margin Volatility 5% 10% < 5% 5% 15% 15% 22% 22% 29% 29% 36% 36% 50% > 50%

3. In certain cases, the weights are adjusted (including assigning a 0% weight to a given period) in order to account for significant structural or business mix changes, which may render historical results incompatible with the current situation. Such cases do not include smaller, “business-as-usual” acquisitions or divestitures, the effect and magnitude of which is viewed by Moody’s to be of only a limited nature relative to the firm’s other businesses and earnings.


Pre-Tax Margin Volatility

Why it mattersFor bondholders, a company's earnings stability is arguably more important than growth. One simple ratio thatMoody's believes provides a measure of a firm's earnings volatility relative to its level of earnings is the coefficient ofvariation, which compares the standard deviation of a firm’s pre-tax earnings in the trailing 12 quarters to the mean ofpopulation4. Moody's examines the coefficient of variation for pre-tax margins from various perspectives, includingover many different time periods and/or by excluding extraordinary events.

In some limited instances, there may not exist twelve quarters of operating history because a firm may either benew (a result of a recent merger or an LBO), or because the firm has recently undergone substantial structural or busi-ness model changes making historical comparisons inapplicable (Lazard, which until May of 2005, operated as a part-nership before a recapitalization and separation transaction, is a good example). In such cases, Moody’s uses the lowestscore received by the issuer on any of the other quantitative and qualitative factors and ascribes to it the weight thatwould normally be given to pre-tax margin volatility. The logic behind this adjustment is predicated on the fact that, fora firm that lacks an operating track record, a conservative approach that “assumes the worst”5 is warranted. In our view,the other possible alternatives, such as omitting this factor altogether or transferring its weight to the pre-tax marginrating factor, are imprudent. As soon as a firm has operated for three consecutive years, or if Moody’s becomes comfort-able using a shorter sampling period, we revert to the standard approach for calculating pre-tax margin volatility.

4. If quarterly financials are unavailable, we use semi-annual or annual data series to calculate margin volatility.5. Although not in all cases, it can nevertheless be argued that over a long enough period of time any of the other rating factors (the worst-scoring of which is counted in

lieu of pre-tax margin volatility in the absence of a long enough track record) will eventually (and this has certainly been observed a number of times in practice) man-ifest itself in way that would contribute to a firm’s actual volatility of earnings and margins.

Rating Factor: Earnings Size and Stability

IssuerMoody’s Rating

Indicative Factor Rating

Pre-Tax Earnings (USD M)

Indicative Sub-Factor

RatingPre-Tax Margin


Rating

Pre-Tax Margin

Volatility


Rating

The Goldman Sachs Group, Inc. Aa3 Aa3 7,188 Aa 33% Aa 16% A Merrill Lynch & Co., Inc. Aa3 Aa2 6,550 Aa 28% Aa 12% Aa Morgan Stanley Aa3 Aa3 7,012 Aa 28% Aa 17% A Lehman Brothers Holdings Inc. A1 Aa2 4,108 Aa 33% Aa 9% Aa Bear Stearns Companies Inc. A1 A1 2,083 A 30% Aa 7% Aa Macquarie Bank Limited A2 A3 835 Baa 29% Aa 16% Aa The Charles Schwab Corporation A2 Baa3 983 Baa 27% A 34% Ba Ahorro Corporacion Financiera S.V., S.A. A2[1] Ba3 48 B 49% Aaa 53% Caa Nomura Holdings, Inc. A3 A2 3,698 Aa 48% Aaa 51% Caa Jefferies Group, Inc Baa1 Baa3 235 Ba 22% Baa 14% Aa Daiwa Securities Group Inc. Baa1 A2 1,672 A 45% Aaa 34% Ba Oddo & Cie Baa1[1] Ba1 72 B 33% Aa 22% A Investcorp S.A. Baa2 Ba1 117 B 30% Aa 26% A Collins Stewart Tullett plc Baa2 B2 152 B 12% Ba 45% B Nikko Cordial Corporation[3] Baa2 A2 1,173 A 39% Aa 27% Baa Fubon Securities Co. Baa3 Ba3 61 B 25% A 31% Ba Lazard Group, LLC Ba1 Ba1 342 Ba 26% A -- [2] Ba TD AMERITRADE Ba1[1] Ba2 460 Ba 38% Aa 38% B E*TRADE Financial Corp. Ba2 Ba1 527 Baa 38% Aa 87% Caa LaBranche & Co, Inc. Ba2 B3 51 B 14% Ba 100% Caa Oppenheimer Holdings, Inc. B1 B2 42 B 6% B 41% B ConvergEx Holdings B2 Caa2 N/P Caa N/P B --[2] Caa LPL Holdings, Inc. B2 B3 N/P B N/P B --[2] Caa

[1] Supported rating[2] The entity has not operated in its current form during the last 12 quarters. Model uses the lowest score received on any of the other factors in the model[3] Financial data is based on Nikko Cordial Corporation's adjusted financial statements as of December 20, 2006

N/P = non-public information

Positive Outlier Negative Outlier


RATING FACTOR: LIQUIDITY

Why it mattersOur favorite metric for measuring liquidity of a securities firm is the ratio of net cash capital to liquid net assets6

(NCC/LNA). Within the securities industry methodology, this ratio applies only to the market-makers. Net cash cap-ital is the surplus of a firm's sources of long-term capital (principally common equity and long-term debt) beyond itsuses of long-term capital (principally illiquid assets and haircuts on securities inventory).

A firm with a net cash capital deficit is therefore financing some portion of its long-term assets with short-termfinancing sources, thereby exposing itself to liquidity risk. Moody's first concern with regards to this issue is that a firmshould have an absolute cash capital surplus. By contrast, an absolute cash capital deficit is considered a serious ratingissue by Moody's, since a firm in that position could be forced to liquidate assets or portions of its business if it isunable to roll over its short-term financing. In Moody's view, a firm with a cash capital deficit is literally "at the mercy"of the confidence of the capital markets (this view was confirmed by Refco’s default in 2005).

Moody's compares a firm's cash capital surplus to its liquid net assets in order to create a relative measure withwhich to compare firms. Liquid net assets are defined as net assets less all illiquid assets. One way to think about thesurplus is that it represents a measure of how much additional haircut can be posted, as a percentage of liquid netassets, before the firm’s cash capital surplus is depleted. The cash capital surplus is also available to protect the com-pany against liquidity risks not captured by the ratio — such as an unexpectedly high level of loan commitment draw-downs over a short period of time. For more information on how this ratio is calculated, see the Moody’s Favorite Ratiosand Metrics for the Securities Industry, published in March of 2006.

Factor Mapping: LiquidityModel Weight Rating-Value Range

Factor Market Makers Others Aaa Aa A Baa Ba B CaaLiquidity 8% 0% > >= < >= < >= < >= < >= < NCC/LNA 8% 0% 21% 21% 13% 6% 13% 1% 6% -5% 1% -5% -10% -10%

6. Net (core) assets are defined as gross assets minus certain low-risk assets such as the matched repo book.

Rating Factor: LiquidityIssuer Moody's Rating NCC/LNA Indicative Factor Rating

The Goldman Sachs Group, Inc. Aa3 7% AMerrill Lynch & Co., Inc. Aa3 15% AaMorgan Stanley Aa3 9% ALehman Brothers Holdings Inc. A1 6% ABear Stearns Companies Inc. A1 6% AMacquarie Bank Limited A2 3% BaaAhorro Corporacion Financiera S.V., S.A. A2[1] 1% BaaNomura Holdings, Inc. A3 N/P AJefferies Group, Inc Baa1 20% AaDaiwa Securities Group Inc. Baa1 N/P AOddo & Cie Baa1[1] 4% BaaInvestcorp S.A. Baa2 25% AaaNikko Cordial Corporation[2] Baa2 N/P AFubon Securities Co. Baa3 78% Aaa

[1] Supported rating[2] Financial data is based on Nikko Cordial Corporation's adjusted financial statements as of December 20, 2006



RATING FACTOR: CAPITAL ADEQUACY

Why it mattersThe illiquid risk assets to tangible common equity (IRA/TCE) ratio can be considered a liquidity ratio as much asa capital adequacy ratio. When analyzing the potential loss content of the balance sheet of a securities firm (as with theNCC/LNA ratio, in our scorecard this ratio applies only to market-makers, due to the relatively balance sheet un-intensive (relative to market-makers) activities of the “other” firms), Moody's focuses on illiquid positions that mayreside on the balance sheet for longer periods of time. For this reason, illiquid risk assets/TCE is Moody's preferredleverage ratio. Illiquid risk assets include loans, illiquid bonds, uncollateralized speculative-grade derivatives, privateequity and merchant banking investments and retained interests.

Moody's believes it is inappropriate to rely on value-at-risk measures for these types of illiquid assets. Risk manag-ers in the securities industry appear to think along the same lines, as they presently use a variety of stress tests to sup-plement VaR risk measures for illiquid assets. Some firms, for example, use historical peak-to-trough analyses — whichcapture previous real estate cycles — for mortgage assets.

Moody's views increases in a firm's IRA/TCE ratio as a potential early warning signal of problems that will typicallytrigger conversations with the company. However, for three distinct reasons it is unlikely that a deterioration of thisratio would lead automatically to a downgrade of a firm's ratings. First, many of these assets are already accounted for atfair value, which means — theoretically at least — that the residual loss content is small, assuming such illiquid assetscan be marked accurately and the positions are not so large that their impact on the market would be high in a completeliquidation scenario. Second, the ratio ignores hedges, including the increasing use of credit derivatives to control creditconcentrations within loan books (for example, as of 3Q06, Goldman Sachs has hedged roughly two-thirds of its invest-ment in SMFG convertible preferred shares but the IRA/TCE ratio ignores this hedge). Finally, the ratio groups assetsof varied risk together. Therefore, we would analyze the equity capital required for each of these asset categories toreach a final rating conclusion. We also assess the firm’s track record and ability to liquidate these assets in a methodicaland disciplined fashion as an important qualitative dimension of the company’s capital adequacy. Although we believethat the IRA/TCE ratio is a more meaningful measure of capital adequacy than traditional gross and net leverage ratios,we recognize its limitations and sensitivity to differences in accounting disclosures among firms.

Factor Mapping: Capital AdequacyModel Weight Rating-Value Range

Factor Market Makers Others Aaa Aa A Baa Ba B Caa

Capital Adequacy 8% 0% < >= < >= < >= < >= < >= < > IRA/TCE 8% 0% 0.3x 0.3x 1.0x 1.0x 2.0x 2.0x 3.0x 3.0x 4.0x 4.0x 5.0x 6.0x

Rating Factor: Capital AdequacyIssuer Moody's Rating IRA/TCE Indicative Factor Rating

The Goldman Sachs Group, Inc. Aa3 2.2x BaaMerrill Lynch & Co., Inc. Aa3 2.7x BaaMorgan Stanley Aa3 1.8x ALehman Brothers Holdings Inc. A1 1.1x ABear Stearns Companies Inc. A1 1.4x AMacquarie Bank Limited A2 3.3x BaAhorro Corporacion Financiera S.V., S.A. A2[1] 1.3x ANomura Holdings, Inc. A3 N/P AaJefferies Group, Inc Baa1 0.1x AaaDaiwa Securities Group Inc. Baa1 0.3x AaOddo & Cie Baa1[1] 0.2x AaaInvestcorp S.A. Baa2 2.0x BaaNikko Cordial Corporation[2] Baa2 0.5x AaFubon Securities Co. Baa3 0.3x Aaa

[1] Supported rating[2] Financial data is based on Nikko Cordial Corporation's adjusted financial statements as of December 20, 2006



RATING FACTOR: DEBT SERVICE CAPACITY

Why it mattersDebt service capacity as measured by debt leverage (Debt/EBITDA) and interest coverage (EBITDA/Interest Cover-age) is a critical rating factor for cash flow-based firms. It not only quite literally, albeit often imperfectly, measures afirm’s ability to service and ultimately repay its debt, but is also an important quantitative reflection of management’schosen financial strategy. Because EBITDA is often an imperfect barometer of the amount of cash flow that is avail-able to pay down debt, we tend to also focus on retained cash flow (RCF) and free cash flow (FCF) characteristics of afirm. Furthermore, we usually adjust EBITDA to exclude non-core earnings and certain non-recurring expenses,which are not reflective of a firm’s true earnings-generating capacity. We also focus on the current and likely futurecapital expenditure requirements and dividend policy of an issuer and run various revenue short-fall stress tests as partof analyzing a firm’s debt service capacity. In conjunction with all of these important adjustments, simple leverage andcoverage measures do allow for meaningful peer comparisons among securities firms and against the full universe offirms rated by Moody’s.

Factor Mapping: Debt Service CapacityModel Weight Rating-Value Range


Debt Service Capacity 0% 23% >= < >= < >= < >= < >= < Debt / EBITDA 0% 12% <1.0x 1.0x 1.5x 1.5x 2.0x 2.0x 2.9x 2.9x 4.1x 4.1x 6.2x >6.2x EBITDA / Interest Expense 0% 11% >22.0x 15.0x 22.0x 10.5x 15.0x 7.0x 10.5x 3.2x 7.0x 1.6x 3.2x < 1.6x

Rating Factor: Debt Service Capacity

IssuerMoody's Rating

Indicative Factor Rating

Debt / EBITDA


RatingEBITDA/Interest

Expense


Rating

The Charles Schwab Corporation A2 Aaa 0.4x Aaa 22.1x Aaa Collins Stewart Tullett plc Baa2 A3 1.9x A 7.7x Baa Lazard Group, LLC Ba1 Ba2 3.0x Ba 4.3x Ba TD AMERITRADE Ba1[1] Ba2 5.8x B 10.1x Baa E*TRADE Financial Corp. Ba2 A2 1.4x Aa 7.1x Baa LaBranche & Co, Inc. Ba2 B2 4.3x B 2.3x B Oppenheimer Holdings, Inc. B1 Ba2 4.1x Ba 5.0x Ba ConvergEx Holdings B2 B2 N/P B N/P B LPL Holdings, Inc. B2 Caa2 N/P Caa N/P Caa

[1] Supported ratingN/P = non-public information



RATING FACTOR: FRANCHISE STRENGTH AND DIVERSIFICATION

Why it matters:We categorized the activities of firms into the following business lines. We placed a “ceiling rating” on each businessline in terms of its bondholder attractiveness — i.e. its potential to generate stable predictable cash flows to servicedebt. One way to think about the ceiling is the highest theoretical rating that a pure-play firm active only in that lineof business could achieve. We force-ranked the franchises of all the firms relative to one another as well as in the con-text of their other local and global competitors. In so doing, we relied on both quantitative measures, such as marketshare and absolute earnings, as well as our qualitative assessment of the strength and sustainability of each of a givenfirm’s franchises.

Processing (Aaa Ceiling)We view a well-established processing franchise as an excellent business for bondholders. The best example is primebrokerage – providing financing, securities lending, clearing and settlement and other administrative services to hedgefunds. A well-run prime brokerage is essentially a well-collateralized banking business which can produce high pre-taxmargins (in excess of 40%), stable net interest earnings, with minimal credit losses and tiny economic capital require-ments. Running the business well requires good technology, operations and risk controls whose considerable cost anddevelopment time are significant barriers to entry. Nevertheless, this business is attracting new entrants who may nothave the requisite infrastructure to control the operations risk or may choose to compete by offering lenient creditterms. Providing infrastructure and support services to independent investment advisors is another attractive process-ing business, with similar barriers to entry.

Asset Management (Aaa Ceiling)Asset management is another potentially excellent business for bondholders characterized by low-capital intensity andcapable of pre-tax margins exceeding 30%. This is still a fragmented business. Asset gathering ability (net assetinflows) is an important proxy for the strength of an asset management franchise, while the ability to successfully mon-etize client assets is the key to producing predictable, annuitized revenues. Ultimately, however, superior investmentperformance relative to benchmarks is the most important factor for a successful asset management business. It is alsouseful to diversify the asset management complex by asset class and investing strategy, but outstanding performancewithin each segment must be maintained.

Institutional Capital Markets (Aa Ceiling)A best-in-class institutional capital markets business can be an outstanding business for bondholders. This is the big-gest business segment of the large US investment banks and comprises investment banking and secondary sales andtrading.

Factor Mapping: Franchise Strength and DiversificationModel Weight* Rating-Value Range


< > < >= < >= < >= < >= < >Franchise Strength and Diversification 17% 17% 1.5 1.5 4.5

5

8 7.5 10.5 10.5 13.5 13.5 16 16

Processing 2% 2% Excellent Outstanding Strong Good Modest Weak Poor Asset/Wealth Management 2% 2% Excellent Outstanding Strong Good Modest Weak Poor Institutional Capital Markets 2% 2% Outstanding Strong Good Modest Weak Poor Retail Banking 2% 2% Outstanding Strong Good Modest Weak Poor HNW Retail Brokerage, AMA 2% 2% Strong Good Modest Weak Poor Discount Brokerage 2% 2% Good Modest Weak Poor Principal Investing/Prop. Trading 2% 2% Modest Weak Poor Diversification 2% 2% Excellent Outstanding Strong Good Modest Weak Poor

* The weight of the Franchise Strength and Diversification factor is distributed equally among all the application franchise sub-factors and the diversification sub-factor. The maximum number of sub-factors is 8 = 7 franchises + diversification. For any franchise, which does not apply to a given firm, its weight is distributed equally among the remaining sub-factors.


Conceptually we view proprietary trading within a market-making business as a separate activity that is much lessattractive for bondholders. Well-run secondary trading firms have strong relationships with issuers and investors,allowing them to “see the flows.” A well-managed firm then employs its wide distribution and structuring skills torepackage risks and move these risks quickly off its balance sheet, capturing a spread. Such a business can generateexcellent pre-tax profitability but is capital intensive.

Generating robust pre-tax margins in investment banking is increasingly challenging. Chronic overcapacity hascommoditized many transactions (investment grade bond offerings, follow-on equity offerings) and shifted bargainingpower to issuers. Issuers may require firms to risk capital through loans or bought deals. Nonetheless strategic transac-tions, such as M&A and IPOs, still command high margins.

Overcapacity and the constant pressure to take on risk concentrations can lead to unexpected credit, market oreven litigation charges in this segment which can lead to quarterly losses and damage the franchise value of a givenfirm.

Retail Banking (Aa Ceiling)This can be an outstanding business for bondholders. In fact, there are a handful of banks with a proven broad-basedretail banking franchise benefiting from a strong direct, branch-based network providing ample core deposits, that arerated Aaa. Many securities firms are expanding their banking capabilities to capture a greater “share of wallet” fromtheir traditional retail customer bases. In many cases the brokerage customer is an affluent or high-net-worth customerand is therefore high credit quality and very attractive. Brokers are beginning to leverage their banking charters androll-out the whole suite of traditional retail banking products — such as deposits, mortgages and credit cards.

Best-in-class retail banks produce excellent pre-tax margins of roughly 40%, but many securities firms have yet toachieve the scale to produce these margins, although the online brokers, E*TRADE, in particular, have made notableprogress in this business.

High-Net-Worth (HNW) Retail Brokerage (A Ceiling)We consider this a strong business for industry leaders. Over the past decade, this business has evolved away from thecommission-driven “stock-picker” at a typical US wirehouse, to more of a relationship-based, full-service money man-agement scorecard. This business is people intensive and generally produces lower pre-tax margins with industry lead-ers achieving only 20% across the cycle. As with asset management, the ability to attract client assets is an importantmeasure of a firm’s HNW brokerage franchise, while pre-tax profit per advisor is an insightful indicator of how well-run the franchise is.

The industry leaders have encouraged the adoption of asset-based pricing. This fee structure “annuitizes” the rev-enue stream and may better align the interests of the broker and the customer. Partly in response to competition fromthe discounters, firms have also sharpened their focus on high-net-worth customers who are more interested in advice.Also, as mentioned above, firms are adding banking capabilities in an attempt to grab a greater wallet share and solidifycustomer relationships. Margin lending is a very attractive sub-segment of the retail brokerage business that generatesa stable stream of net interest margins (somewhat akin to prime brokerage from a risk-return point of view).

Firms typically run into difficulty in this business line for a couple of reasons. First, retail investors, as a group, arefickle and their activity can swing wildly in response to changing capital market conditions. Second, the industry has apenchant for attracting regulatory fines and attention, in part due to questionable practices by many brokers who areclearly not acting in their client’s interests.

Discount Brokerage (Baa Ceiling)We consider this a good business for bondholders of those firms that have a leading franchise in this space. This is arelatively new business spurred on over the last two decades by commission deregulation in the US, the growth of newtechnology, the spread of the internet and, of course, the bull stock markets of the late 1990s.

E-brokerage was a classic case of disruptive innovation that, for a time, successfully attacked a segment of the tra-ditional full-service wirehouses. After the equity bubble burst, many day traders imploded and retail activity withered.The profitability of many E-brokers disappeared.

This eventually forced a rethinking of business scorecards at E-brokers and drove consolidation in search of costsaves or stronger partners (such as a big bank partner). Once again, like the wirehouses, these firms are expanding theirbanking and asset management activities (for the most part, successfully) to reduce their reliance on volatile commis-sions and to try to cement customer relationships.


Principal Investing/Proprietary Trading (Ba Ceiling)From the bondholder’s perspective we see these activities as non-investment grade franchises. Lumpy principal invest-ments and risky trading strategies can increase the firm’s overall risk exposure, and the earnings are almost impossibleto forecast. This business encompasses an incredibly wide range of activities — from merger arbitrage to real estateinvesting in Asia. Conceptually we see proprietary trading as a transaction that is initiated by the firm, not a customer(the latter being liquidity provision). In practice, financial disclosures make this distinction almost impossible, particu-larly with respect to trading revenues.

We recognize that principal investing can act as an incubator for future investment banking transactions and mayalso cultivate important investment banking relationships. Margins can be very high but we think that most of the ben-efits of these businesses effectively accrue to the equity holder. For individual investments the capital intensity is veryhigh – arguably 100% of the amount invested, and we are skeptical of arguments for portfolio diversification.

DiversificationThe degree of diversification of a firm’s sources of revenues can be an important factor in analyzing the future stabilityof its earnings. High concentrations in any one business line, or geographic area, or an oversized dependence on asmall group of customers may leave a firm vulnerable to macro-economic and other factors beyond its control. Indetermining the overall degree of a firm’s diversification, we focus on quantitative metrics encompassing business line,customer, geographic and asset class diversification.

Rating Factor: Franchise Strength and DiversificationIssuer Moody's Rating Indicative Factor Rating

The Goldman Sachs Group, Inc. Aa3 A1 Merrill Lynch & Co., Inc. Aa3 A2 Morgan Stanley Aa3 A2 Lehman Brothers Holdings Inc. A1 A1 Bear Stearns Companies Inc. A1 A3 Macquarie Bank Limited A2 A3 The Charles Schwab Corporation A2 A1 Ahorro Corporacion Financiera S.V., S.A. A2[1] Baa2 Nomura Holdings, Inc. A3 Baa1 Jefferies Group, Inc Baa1 Baa1 Daiwa Securities Group Inc. Baa1 Baa1 Oddo & Cie Baa1[1] Baa2 Investcorp S.A. Baa2 Baa2 Collins Stewart Tullett plc Baa2 Aa3 Nikko Cordial Corporation Baa2 Baa2 Fubon Securities Co. Baa3 Baa3 Lazard Group, LLC Ba1 Baa1 TD AMERITRADE Ba1[1] Baa3 E*TRADE Financial Corp. Ba2 A3 LaBranche & Co, Inc. Ba2 Ba1 Oppenheimer Holdings, Inc. B1 B1 ConvergEx Holdings B2 Baa3 LPL Holdings, Inc. B2 Baa3

[1] Supported rating



RATING FACTOR: MANAGEMENT QUALITY AND CULTURE

Why it matters:Management quality and culture is an important rating factor for the simple, but critical, reason that it enablesMoody’s to gauge the direction in which the firm is likely to head, and the management’s willingness and ability tomake and execute choices, including the firm’s financial strategy, that protect bondholders’ interests. Managementquality and culture (like its five sub-factors) is a fairly broad category that does not lend itself well to discrete quantita-tive metrics. We do believe that the firm’s overall performance and track record acts as a report card on the quality ofmanagement and the corporate culture.

Moody’s opinion of management is often formed through extensive dialogue over many meetings each year with afirm’s business leaders and finance staff. There is also a strong institutional memory at Moody’s. For example, it is notuncommon for several members of a typical rating committee for a major securities company to each have over fifteenyears of experience with the issuer.

The sub-factors we evaluate in assessing management quality and culture are the following:

Vulnerability to Event RiskEvent risk in this context includes the classic definition — the possibility of a leveraged buyout. We also consider otherevent risks such as litigation risk (e.g., resulting from an underwriting or an advisory assignment) and regulatory sanc-tion (e.g., inappropriate sales practices by a brokerage force). Although it is not directly related to management qualityand culture, another example of event risk is the potential, and our estimation of its likelihood and impact, for exoge-nous events, including political developments and regulatory rulings, which may have significant adverse effects on thecompany’s competitive position and its very ability to conduct business in one or more of its operating markets. Forexample, the global research settlement instituted a few years back with the New York Attorney General affected theability of investment banking to “compensate” the costs of equity research and was an important factor in restructuringthe economics of equity underwriting and distribution.

Corporate GovernanceCorporate governance of a securities firm is an important analytical consideration. High-quality corporate governancereduces the likelihood of future problems and speeds remediation when problems occur. Moody’s sets a high standardfor securities firm governance because we believe that financial institutions generally are more confidence-sensitivethan corporates, particularly in their funding. Corporate governance focuses not only on the relationship between theboards of directors (also known as supervisory boards), management and shareholders, but also on the degree to whichthe board and management team have shown that they effectively balance shareholder and creditor interests.

For public companies, we evaluate the effectiveness of the board’s oversight of management and the firms riskappetite and its role in management succession and development. We also consider factors such as the board’s inde-pendence and the firm’s ownership and organizational complexity. This analysis is performed in tandem with Moody’scorporate governance specialists, and, for the larger firms, is outlined in depth in our published corporate governanceassessments (CGA).

Within the global securities industry methodology, we focus on particular aspects of corporate governance that arefairly easy to observe or measure and which we consider to be potential “red flags,” indicating more serious problems.

Factor Mapping: Management Quality and CultureModel Weight Rating-Value Range


< > < >= < >= < >= < >= < >

Management Quality and Culture 20% 20% 1.5 1.5 4.5

5

8 7.5 10.5 10.5 13.5 13.5 16 16 Vulnerability to Event Risk 4% 4% Excellent Outstanding Strong Good Modest Weak Poor Management Operating Quality/Breadth/Depth 4% 4% Excellent Outstanding Strong Good Modest Weak Poor Corporate Governance [1] 4% 4% Excellent Outstanding Strong Good Modest Weak Poor Culture & Ethics 4% 4% Excellent Outstanding Strong Good Modest Weak Poor Consideration of Bondholders' Interests 4% 4%

Excellent Outstanding Strong Good Modest Weak Poor

[1] Corporate Governance is considered neutral if scored A (Strong) or above, in which case its weight is distributed equally among the remaining sub-factors.


When one of these governance issues is identified, the firm is assigned a Baa or lower score on this sub-factor, depend-ing on the severity of the problem. Where none of these red flag issues are identified within a firm, corporate gover-nance is considered neutral, and contributes neither positively nor negatively to the rating.

Management Operating Quality/Depth/BreadthWe have seen numerous examples over time of a new management team with more effective business leaders who takecharge and strengthen the performance of a franchise. The transformation at Merrill Lynch in 2001-2002 is a primeexample. Our impressions here are formed by detailed reviews with the management teams that supervise each business.

Given the long duration of most of Moody’s rating relationships we have witnessed numerous management turn-overs. This is an excellent way to form an opinion about the breadth and depth of management. We are also able toobserve management’s performances through the peaks and troughs of the capital markets cycle. Conversely, some ofour rated issuers have relatively short track records, prompting a more conservative view in such cases. While we feelthat this approach is appropriate, we also work to make up for any track record shortfall by getting to know the man-agement as quickly and closely as possible.

Culture and EthicsOnce again, we come to an opinion on this “soft” factor over a long period of time. A track record of litigation or reg-ulatory fines can have a strong effect on our opinion. The flip-side of this, however, it that a series of litigation or reg-ulatory troubles can also have an eventual corrective effect on management’s behavior. Sometimes the culture andethics of the firm are best defined by the business that a firm turns down as demonstrated, for instance, by the Enron-related settlements (or lack thereof) at various firms.

Consideration of Bondholders InterestsManagement’s first duty is to the shareholders. However, some management teams can be explicitly committed tomaintaining a certain credit rating and are willing to live within certain constraints (such as a minimum capital level) tomaintain the rating. In the securities industry we often see a strong commitment to maintaining a robust liquidity pro-file, which benefits bondholders. Conversely, leveraged buyouts and debt-financed dividend payouts or share buy-backs indicate a higher tolerance level for debt and the resultant risks for bondholders.

Rating Factor: Management Quality and CultureIssuer Moody's Rating Indicative Factor Rating

The Goldman Sachs Group, Inc. Aa3 Aa2 Merrill Lynch & Co., Inc. Aa3 A1 Morgan Stanley Aa3 A1 Lehman Brothers Holdings Inc. A1 Aa2 Bear Stearns Companies Inc. A1 A1 Macquarie Bank Limited A2 Aa3 The Charles Schwab Corporation A2 A2 Ahorro Corporacion Financiera S.V., S.A. A2[1] Baa1 Nomura Holdings, Inc. A3 Baa1 Jefferies Group, Inc Baa1 Baa1 Daiwa Securities Group Inc. Baa1 Baa1 Oddo & Cie Baa1[1] A3 Investcorp S.A. Baa2 Baa2 Collins Stewart Tullett plc Baa2 Baa3 Nikko Cordial Corporation Baa2 Ba Fubon Securities Co. Baa3 Baa3 Lazard Group, LLC Ba1 Baa3 TD AMERITRADE Ba1[1] Baa2 E*TRADE Financial Corp. Ba2 Baa1 LaBranche & Co, Inc. Ba2 Ba2 Oppenheimer Holdings, Inc. B1 Ba3 ConvergEx Holdings B2 Ba1 LPL Holdings, Inc. B2 Baa3




On the management quality and culture factor, Merrill Lynch and Morgan Stanley score below the other institu-tionally-oriented US investment banks and this merits some explanation. This is due, in part, to the unique challengespresented by controlling a widespread network of brokers and branches. MER and MS must ensure suitable sales prac-tices as well as regulatory compliance, while at the same time maintaining the entrepreneurial culture critical to successin retail brokerage. This has been a problematic area for the retail brokerage industry in general. In addition, we thinkthe strong partnership cultures at Bear, Goldman and Lehman have fostered exceptionally deep management benches,which has often allowed for seamless turnover and excellent continuity in important lines of business.

RATING FACTOR: RISK MANAGEMENT

Why it matters:Risk management is a core competency for the market makers in the securities industry and a critical rating driver. Riskmanagement is a very dynamic process and most firms have seriously engaged in a cycle of continuous improvement intheir practices, measurements and technological platforms. Above all, Moody’s believes that successful risk manage-ment at any securities firm is ultimately dependent upon the risk culture of the organization, which entails individualrisk takers having a “risk compass” that guides their decision-making and also encompasses the inter-personal relation-ships and authority structures among delegated risk-takers (traders), risk managers and senior management.

Moody’s published its Risk Management Assessment Methodology in July 2004. The methodology provides aframework with which we evaluate the rigor of the risk management process, the buy-in of management, the appropri-ateness of measures given the business mix and issues of technical competence. In particular we have determined thatour analysis should be articulated around the four key domains of a risk framework:• Risk governance

– Involvement of directors (including external / non-executive) in reviewing risk appetites and controleffectiveness, directors’ awareness of risks, relevance of their backgrounds to assess risks

– Collective and individual responsibilities of and awareness by executive management on risk matters,integration of risk considerations in budgeting, capital allocation, and determination of capitaladequacy

– Organization, staffing, resources, veto powers and enterprise-wide role of risk management function(s)• Risk management

– Risk control processes — mandates of units controlling market credit and operational risk, extent ofseparation of reporting lines of operating level risk, front line and support functions, tradereconciliations, practices to ensure limit discipline

– Risk appetite, limit setting, relationship of risk appetite to earnings, capital, business decisions,portfolio mix and diversification

– Risk mitigation (including hedging policies)• Risk analysis and quantification

– Quantification, measures used for setting of limits and running the business, stress testing, capitaldetermination

– Monitoring and reporting – rigor, appropriateness and usefulness of reports and alert systems• Risk infrastructure and intelligence

– Risk infrastructure — information and knowledge systems– Risk intelligence — validity of scorecards and data used

Factor Mapping: Risk ManagementModel Weight Rating-Value Range


< > < >= < >= < >= < >= < >

Risk Management 12% 0% 1.5 1.5 4.5

4.5

7.5 7.5 10.5 10.5 13.5 13.5 16 16 Governance 3% 0% Excellent Outstanding Strong Good Modest Weak Poor Management 3% 0% Excellent Outstanding Strong Good Modest Weak Poor Quantification 3% 0% Excellent Outstanding Strong Good Modest Weak Poor Environment 3% 0% Excellent Outstanding Strong Good Modest Weak Poor


In May of 2006, Moody’s published comprehensive risk management assessments (RMAs) of six securities firms:Bear Stearns, Goldman Sachs, Lehman Brothers, Macquarie, Merrill Lynch, and Morgan Stanley. The risk manage-ment rankings of these firms included in the present methodology incorporate our findings and conclusions from theRMA process. The rankings of those market-making firms for which we have not yet published formal RMAs arebased on our continual dialogue with the firms and our ongoing analysis of their risk management practices. For“other” firms, which do not engage in market-making and principal investing activities to a significant extent, we havenot assigned an explicit weight to the risk management factor. Their risk management competency is captured in thevarious sub-factors within Management Quality and Culture.

RATING FACTOR: OPERATING ENVIRONMENT

Competitive Dynamics

Why it matters:A firm’s competitive environment (as opposed to the strength of a firm’s franchise and its competitive position, whichare reflected in the “Franchise Strength and Diversification” rating factor) can have a profound impact on its financialand operating strategy as well as on current and future profitability. Intense competition – for customers and talentedemployees – while usually beneficial to customers, does put pressure on firms’ margins and requires constant nimble-ness and innovation to stave off market share erosion and obsolescence. We feel that the securities industry is charac-terized by a heightened level of competition, particularly in the US institutional capital markets segment, in which thebulge-bracket firms operate. By contrast, the retail brokerage and asset management segment tend to be more frag-mented. In Japan, the top securities firms have been able to protect their strong competitive position, earning themrelatively high scores on this factor. The flip-side of this, however, has been their relative lack of geographic diversifi-cation, which, combined with their relatively high cost structures, has resulted in elevated margin volatility.

Competitive environment also addresses industry fundamentals, which may undergo long-term, secular changes.If industry fundamentals change for the worse, as a result of either endogenous or exogenous factors (e.g., disruptivechanges from technological innovations), firms may be forced to make difficult decisions, including consolidation (ashappened with e-brokers and exchange specialist firms), or expansion into other businesses or markets.

Rating Factor: Risk ManagementIssuer Moody's Rating Indicative Factor Rating

The Goldman Sachs Group, Inc. Aa3 Aaa Merrill Lynch & Co., Inc. Aa3 Aa2 Morgan Stanley Aa3 Aa2 Lehman Brothers Holdings Inc. A1 Aaa Bear Stearns Companies Inc. A1 Aa2 Macquarie Bank Limited A2 Aaa Ahorro Corporacion Financiera S.V., S.A. A2[1] Baa1 Nomura Holdings, Inc. A3 A3 Jefferies Group, Inc Baa1 A2 Daiwa Securities Group Inc. Baa1 Baa1 Oddo & Cie Baa1[1] Baa1 Investcorp S.A. Baa2 Baa2 Nikko Cordial Corporation Baa2 Ba2 Fubon Securities Co. Baa3 Ba1



Factor Mapping: Operating EnvironmentModel Weight Rating-Value Range


< > < >= < >= < >= < >= < >Operating Environment 10% 10% 1.5 1.5 4.5 5 8 7.5 10.5 10.5 13.5 13.5 16 16 Competitive Dynamics 5% 5% Excellent Outstanding Strong Good Modest Weak Poor Regulatory Environment 5% 5% Excellent Outstanding Strong Good Modest Weak Poor


Regulatory Environment

Why it matters:Regulation and supervision are important considerations in Moody’s analysis of securities firms globally as they pro-vide a basis for the assessment of systemic issues that may affect firms’ solvency. We believe that the existence of inde-pendent regulatory bodies with credible and demonstrated enforcement powers and with adherence to globalstandards of best practices for the control of risk is consistent with strong ratings.

One of the important factors in our evaluation of securities regulators is a strong commitment to transparency infinancial reporting supported by a healthy dialogue with the private sector on topics of prudential regulation. In ana-lyzing a firm’s regulatory environment we focus on the firm’s primary regulator, but we also recognize and take intoaccount that securities firms, particularly those that are global in scope, are subject to multiple regulatory regimes,include those imposed by self-regulatory organizations (e.g., exchanges.)

The sub-factors we consider when evaluating a securities firm’s regulatory environment include the following:• Licensing• Capital Regulation• Other Prudential Regulations• Supervision• Independence and Enforcement

Rating Factor: Operating Environment

Issuer Moody's RatingIndicative Factor

Rating

The Goldman Sachs Group, Inc. Aa3 Baa1 Merrill Lynch & Co., Inc. Aa3 Baa1 Morgan Stanley Aa3 Baa1 Lehman Brothers Holdings Inc. A1 Baa1 Bear Stearns Companies Inc. A1 Baa1 Macquarie Bank Limited A2 Aa The Charles Schwab Corporation A2 A1 Ahorro Corporacion Financiera S.V., S.A. A2[1] A Nomura Holdings, Inc. A3 A Jefferies Group, Inc Baa1 Baa1 Daiwa Securities Group Inc. Baa1 A Oddo & Cie Baa1[1] A1 Investcorp S.A. Baa2 Ba1 Collins Stewart Tullett plc Baa2 Aa3 Nikko Cordial Corporation Baa2 A Fubon Securities Co. Baa3 Ba1 Lazard Group, LLC Ba1 Ba1 TD AMERITRADE Ba1[1] A E*TRADE Financial Corp. Ba2 A LaBranche & Co, Inc. Ba2 Ba1 Oppenheimer Holdings, Inc. B1 A ConvergEx Holdings B2 Baa1 LPL Holdings, Inc. B2 A




Model Fit and Outlier Discussion:

Based on the rating factors and weights discussed in this methodology, the scorecard has output the following ratings.

There are two outliers in the rated population of twenty three firms: Ahorro Corporacion Financiera S.V., S.A. (asupported rating) and E*TRADE Financial Corp.

Ahorro’s A2 issuer rating reflects the degree of support expected from its ultimate shareholders, the Spanish Con-federation of Savings Banks (CECA, Aa3/P-1/B-) and most importantly 43 of the 46 Spanish savings banks, given thecompany's strategic service provider role to these entities.

The differential between Moody’s current Ba2 rating on E*TRADE Financial and the projected Baa1 rating fromthe scorecard is attributable to several factors. The current Ba2 rating is a holding company rating, and is notched tworating sub-categories below the Baa3 deposit rating of E*TRADE Bank, the company’s principal rated operating sub-sidiary. Also, at Ba1 the bank’s long-term issuer rating is one notch above that of the holding company. UnderMoody’s historical notching practices, the spread between the senior most subsidiary rating (i.e. the deposit rating) andthe senior holding company rating narrows as the deposit rating approaches the “A” category. The scorecard does notexplicitly distinguish between holding company and regulated bank subsidiary ratings, but rather assesses quantitativeand qualitative factors from a consolidated perspective.

On a fundamental operating basis, E*TRADE’s rating carries the weight of high historical earnings volatility andthe bank’s dependence on sourcing wholesale assets and leveraging wholesale funds. With that said, E*TRADE’srecent acquisitions have increased scale and operating leverage at the company, helping to strengthen profit margins.The growth in customer cash balances and deposits attributable both to acquisitions and organic growth have helpedE*TRADE to reduce its dependence on market-sensitive trading revenues. This momentum is reflected inE*TRADE's positive rating outlook, which Moody's assigned in June of 2006. In Moody’s opinion, anticipation ofcontinued future improvements in E*TRADE’s balance sheet and revenue composition should help dampen earningsand margin volatility in the future, and are primary considerations underlying the firm’s positive rating outlook.

Overall, we are pleased with the accuracy of the scorecard. In identifying the rating factors, weights and valueranges, we tried to reflect our existing approach to rating securities firms as well as capture the topics and issues thatdominate our rating committees.

Issuer Country Moody's Rating Model Rating

The Goldman Sachs Group, Inc. United States Aa3 Aa3Merrill Lynch & Co., Inc. United States Aa3 A1Morgan Stanley United States Aa3 A1Lehman Brothers Holdings Inc. United States A1 Aa3Bear Stearns Companies Inc. United States A1 A1Macquarie Bank Limited Australia A2 A2The Charles Schwab Corporation United States A2 A2Ahorro Corporacion Financiera S.V., S.A. Spain A2[1] Baa2Nomura Holdings, Inc. Japan A3 A2Jefferies Group, Inc United States Baa1 A3Daiwa Securities Group Inc. Japan Baa1 A3Oddo & Cie France Baa1[1] Baa1Investcorp S.A. Luxembourg Baa2 Baa2Collins Stewart Tullett plc United Kingdom Baa2 Baa2Nikko Cordial Corporation Japan Baa2 Baa1Fubon Securities Co. Taiwan Baa3 Baa2Lazard Group, LLC United States Ba1 Ba1TD AMERITRADE United States Ba1[1] Baa3E*TRADE Financial Corp. United States Ba2 Baa1LaBranche & Co, Inc. United States Ba2 Ba3Oppenheimer Holdings, Inc. United States B1 Ba3ConvergEx Holdings United States B2 Ba3LPL Holdings, Inc. United States B2 Ba3




Related Research

Rating Methodologies:Risk Management Assessments, July 2004 (87539)Moody's Methodology for Risk Management Assessments: The Global Securities Firms Industry, April 2005 (91947)Industry Outlooks:2006 US Securities Industry Outlook, January 2006 (96500)2006 Japan Securities Industry Outlook, March 2006 (96945)Special Comments:Moody's Favorite Ratios and Metrics for the Securities Industry, March 2006 (96362)Private Equity Activities of Japanese Securities Firms, November 2006 (100424)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this reportand that more recent reports may be available. All research may not be available to all clients.

Scorecard SummaryRegion Ratings Outliers Notches Off Average Notches Off Scorecard Bias

Asia 5 0 4 0.8 4Europe 4 1 3 0.8 -3United States 14 1 15 1.1 9Total 23 2 22 1.0 10

Outlier - a scorecard-generated rating that is three or more notches higher or lower than the actual ratingNotches Off - the aggregate difference of scorecard-generated ratings with actual ratings, expressed in notches. This measure is sign-neutral meaning that rating differences are converted into their absolute values and then summed.Average Notches Off - Ratings / Notches OffModel Bias - similar to Notches Off, except that positive and negative differences cancel each other out producing an aggregate difference that indicates the overall directional bias of the scorecard. In this case, the overall scorecard bias is positive.


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© Copyright 2007, Moody’s Investors Service, Inc. and/or its licensors and affiliates including Moody’s Assurance Company, Inc. (together, “MOODY’S”). All rights reserved. ALLINFORMATION 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, INANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained byMOODY’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, such information is provided “asis” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitnessfor any particular purpose of any such information. 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 oragents 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 suchdamages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the informationcontained 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 OTHEROPINION 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 anyinvestment 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 ofeach issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated byMOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to $2,400,000. Moody’s Corporation(MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS’s ratings and ratingprocesses. 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 publiclyreported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder Relations — CorporateGovernance — Director and Shareholder Affiliation Policy.” This credit rating opinion has been prepared without taking into account any of your objectives, financial situation or needs. You should, before acting on the opinion, consider theappropriateness of the opinion having regard to your own objectives, financial situation and needs.


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