session i - introduction to credit ratings (aug 7, 2009)

8/8/2019 Session I - Introduction to Credit Ratings (Aug 7, 2009)

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Immersion course at XIMB, BhubaneswarSession I (Aug 7-8, 2009)

Introduction to Credit Ratings

D. Ravishankar


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0

10

20

30

40

50

60

70

Percentag

e

Government

Private

The corporate debt market in India is

underdeveloped, amounting to lessthan 5 percent of GDP, comparedwith over 20 percent of GDP inThailand, Chile and Mexico, and 50-100 percent of GDP in moreadvanced economies.

Bonds outstanding as a % of GDP as on March 2008

Security Type No. of

Securities

Market Capitalisation

(Rs. Crore)

% of Total

Govt. Securities 125 18,08,270 67.75

PSU Bonds 766 1,19,165 4.47

State Loans 1189 3,44,721 12.92

Treasury Bills 52 1,41,888 5.32

Local Bodies 5 423 0.02

Fin Institutions 252 40,861 1.53

Bank Bonds 427 1,15,146 4.31

Supranational

Bonds

1 391 0.01

Corporate Bonds 946 98,051 3.67

Total 3,763 26,68,916 100

The share of corporate, PSUs, Banks& FIs constitute only 14% of theoverall bond market capitalisation, asof Dec 3108..


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90% of the domestic debt issues are dominated by the Government issuances

Reflects the preference for G-Sec amongst investors driven by the regulations oninvestment pattern skewed towards G-Sec

Domestic Debt Issue % of Amount O/S as of June08 by Issuer Type

in Billion USD

Domestic Debt Sec. Govt FI's Corp Total

USA 6788 15433 2933 25154

UK 910 451 23 1384Germany 1495 1142 220 2857

France 1574 1224 360 3158

Japan 7774 1021 673 9468

China 1334 541 126 2001

Singapore 79 26 5 110

India 411 38 11 460


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The use of bonds as a source of funding has been insignificant

Loans are clearly the preferred source of funding ,partially due to banks preference forloans on account of differential treatment as compared to bonds

Funding Pattern of Corporate


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Public Sector -Non-financialInstitutions

Public Sector -FinancialInstitutions

Private Sector -Non-financialInstitutions

Private Sector -FinancialInstitutions

Corporate bond market is dominated by private placements of bonds...... With issuancesby financial institutions (both public and private) dominating the private issuances

The size of the market reflects the generally small size of issuances, another hindrance in

the development of bond market

Resource Mobilisation in the Private Placement Market


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Easy access of the Indian corporate to international funding....... May be facilitated with

the then lower interest rates and access to large sum

ADR/ GDR and Net ECB Issuances by Indian Corporate

(in Rupee Crore)

Year ADRs/GDRs ECBs (Net)

1995-96 683 1275

1996-97 1366 2848

1997-98 645 3999

1998-99 270 4362

1999-00 768 313

2000-01 831 3732

2001-02 477 -15792002-03 600 -2353

2003-04 459 -1856

2004-05 613 5194

2005-06 2552 2508

2006-07 3776 16155

2007-08QE 8769 22165


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G-Sec trading volume is consistently higher, reflecting the scenario in primary market

Also reflects the availability of efficient market mechanism and information system forG-Secs

Instrument-wise Share of Securities Traded in WDM Segment of NSE


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Numbero

fTrades

Rupees

Crore

Value of Trades

Volume of Trades

There is a lacklustre trading for corporate bonds except during the last three months maybe due to the bullish interest rate scenario, weak equity market and higher participation

by the FIIs

Trading in Corporate Bonds


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Very high preference for highly rated bonds (AAA and AA category) driven by restrictionson investment for most investor classes

Rating Wise Distribution of Corporate Bonds Issued

% of Total Grade AANumber Value Number Value Number Value Number Value Number Value

1999-00 35 83 25.9 9.4 25 6.1 7.7 0.8 6.4 0.6

2000-01 38.3 76.6 33.6 10.1 21.4 11.6 3.1 1.3 3.7 0.3

2001-02 31.7 61.6 33.5 27.8 24 9.3 7.8 1.1 3 0.2

2002-03 45.6 76 27.1 13.8 18.2 7.5 6.3 1.6 2.8 1

2003-04 50.4 77.5 24.8 14.9 17.3 6.1 6.5 1.1 1 0.4

2004-05 56.7 72.2 22.4 22 11.8 3.7 7.1 1.9 1.8 0.32005-06 54.6 75.1 30.8 16.7 9.4 7.8 4.4 0.3 0.8 0

2006-07 57.4 79.5 26.5 16 9.7 1.8 6.1 2.7 0.4 0

2007-08 39.5 73.1 30.3 19.4 19.7 5.7 7.4 1.5 3.2 0.3

2008-09 (4 months) 22 76.7 25.3 14.9 20.7 4.3 23.1 3.3 9 0.8

Source:SEBI

AAA A BBB Non-Investment


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Trading concentrated at AAA category indicating low liquidity in other rating categories Discourages investors with wider risk appetite (like mutual funds)

Bonds, 2008 (As reported on FIMMDA)

2008 AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB-

Jan 1,268 175 80 0 5 85 39 0 14 0 0 0 0

Feb 976 106 155 0 7 108 22 0 28 6 0 0 0

Mar 1,027 120 140 4 1 43 20 3 10 2 0 0 2

Apr 1,158 5 67 3 23 5 23 1 4 0 0 2 0

May 1,531 153 96 0 4 16 0 3 0 0 2 0

Jun 782 69 36 7 20 9 2 0 0 0 0

Jul 1,207 29 25 2 0 33 12 0 0 2 0 0 0Aug 963 29 11 2 0 6 6 0 0 0 0 0 0

Sep 1,300 138 47 3 0 96 65 0 0 0 0 0 0

Oct 1,294 67 148 3 0 107 7 2 2 0 0 0 0

Nov 820 92 89 0 0 82 1 0 5 1 0 0 0

Dec 2,457 161 0 0 0 106 1 0 23 1 0 9 0

Total 14,783 1,144 894 24 36 696 221 6 91 12 0 13 2

Rupee Crore


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In spite of India being an early entrant in the securitisation market, other countries havemade rapid progress

India and EEA Securitisation (% of GDP), 2007


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0

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RupeeCr

ore

Others

Partial Guarantee

CDO/LSO

MBS

ABS

Growth in the ABS has slowed down during the last one year, will continue on account of slow downin retail lending

The unique development of single loan backed CDOs has driven the securitisation market in 2007-08

highlighting the need for creating a market mechanism for trading of loans.

Size of Indian Securitisation Market

(n Rs. Crore) 2003-04 2004-05 2005-06 2006-07 2007-08

ABS 8090 22290 17850 23420 26370

MBS 2960 3340 5010 1610 590

CDO/LSO 2830 2580 2100 11920 31750

Partial Guarantee 0 1600 0 0 0Others 50 1000 680 0 0

Total 13930 30810 25640.0 36950 58710


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Issues with taxation TDS and Stamp Duty

High cost of public issuances restricting the initialparticipation by wider investor group

Absence of liquidity enhancing mechanisms shortsale, repos

Absence of credit risk hedging techniques CDS, welldeveloped interest rate futures/ options

Other Challenges


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Widen investor base

Develop retail interest in bond market

Abolishing Tax Deducted at Source (TDS) and providinga level playing field with equity / MFs

Introduction of credit derivatives

Product innovation Loan trading, Infrastructurefinancing through bonds

Develop market infrastructure and systems

A concerted efforts among Regulators to overcome any

overlaps

What is needed for developing the Indian Debt Market?


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Credit rating definitions, benefits and methodologies


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Definition of Credit Rating?

A grading of a borrower's ability to meetfinancial obligations in a timely manner.

-Ability to pay- Willingness to pay


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Current opinion on credit quality Issuers ability and inclination to meet debt obligations

in a timely manner

Performs isolated function of credit risk evaluation

Rating is an issue specific view Useful in differentiation of credit quality

What is a Credit Rating?


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General purpose evaluation of issuer Audit of the issuing company

One time assessment valid over life of the instrument

A recommendation to purchase, sell, or hold a security

What a Credit Rating is Not


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Issuers

IntermediariesRegulatory Authorities

Investors

Improved funding flexibility

Reduce borrowing costs

More access to capital markets

Counter party risk assessment, tradefinance, swaps, insurance, etc

A simple indicator of credit risk

Risk premium assessment

excellent indicator of a bond'sfuture credit performance"

Portfolio monitoring and

adjustment.

Providing underwriting in planning,

pricing and placement of issues.

Marketing - to help sales forces placenew issues.

Monitoring counter party risks.

Investor protection

Market discipline

Benefitsof

Rating

Benefits of RatingBenefits of Rating


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CRISIL Ltd. Credit Analysis & Research Ltd (CARE)

ICRA Ltd.

Fitch Rating India Pvt. Ltd

Brickwork Ratings

Rating Agencies in India


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Independence of Rating Agencies is critical Unbiased opinion

Credibility of ratings

Integrity driven business

Rating agencies have an Independent Board No shareholder representation on the Board

Independence of Rating Agencies


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Rating agencies cannot rate debt issued by their promoters

If promoter is a lending institution, theChairperson/Director/employee cannot be theChairperson/Director/employee of the rating agency, nor can theybe part of the rating committee that assigns the rating

All publicly placed debt must have a rating

All publicly placed debt of quantum greater than Rs. 100 crore musthave dual ratings

Ratings must be released to the public even if it is not accepted, ifthe debt is publicly placed

Continuous monitoring of the rating through the lifetime of the

instrument SEBI has the power to conduct inspections and investigations on

Rating Agencies

Rating agencies are required to frame policies for employees toprevent insider trading in securities

SEBI The Watchdog

Th R ti d fi iti l b tt t


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The Rating definitions . . . always better to recap

Short-term ratings relate to securities of up to 12 months' maturity and focus primarily on liquidity ratios.

International credit ratings assess issuers' capacity to meet foreign or local currency commitments. The ratings are

internationally comparable. National ratings are for credit within a single country relative to the best credit risk in the

country, which may or may not be the sovereign issuer.

National ratings are not internationally comparable. They have the same rating identifier as international long-term

ratings. Country ceiling ratings are assigned internationally and reflect the risk of capital and exchange controls being

imposed by sovereign authorities such that the private sector would be impeded in undertaking foreign exchange

transactions.

Shadow ratings are not generally intended for publication and have a degree of conditionality attached. Structuredfinance ratings relate to individual securities or to tranches within transactions, rather than to an issuer and account

for the particular features of the tranche.

Issuer default ratings reflect the ability of an issuer to meet financial commitments on a timely basis. Recovery ratings

are assigned to securities and issues, particularly those rated B and below in distress or default. Recoveries are

important at lower rating levels because of the greater probability of default. Ratings range from RR1+, with

'outstanding recovery prospects given default' to RR5, with 'poor recovery prospects given default'.

Rating watch notifies investors that there is a probability of a rating change and the direction of change. Rating watch

may be positive, negative or evolving, the latter indicating that the rating may be raised, lowered or maintained. Rating

watch is typically resolved in a relatively short period.

Rating outlook indicates the direction a rating is likely to move on a one- to two-year period and may be positive, stable

or negative. While there are myriad ratings actions, the main ones are affirmed, upgrade and downgrade.


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Brickwork Ratings Overall Process

Pre-Rating

Rating Mandate

& Agreement

Quality Integrity - Non-Assurance

of Particular Rating

Explanation of Critical Policy

and Process to Issuer

Confidentiality Requirements

Rating

Consistent Application of

Rating Policies

Use of Criteria, Research &

Management Meetings

Quality Assurance by

Rating Committee

Initial Rating Assignment &

Appeal Process

Post-Rating

Publication of Ratings

Surveillance

Withdrawal


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The Transparent Rating Process

Rating

Agreement

With the client

Commence

Information

review

Top

Management

Meetings

Rigorous

evaluation

Ratingcommittee

Assign rating(option for

appeal)

Publish ratings Ongoingsurveillance


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Brickwork Rating Scale Long Term Ratings

Symbols (+, - ) denote modifiers within a rating grade

D

C

B

BB

BBB

A

AA

AAA

AAA+

A

AA

Default Grade

Very Low Safety

Low Safety

Inadequate Safety

Moderate safety

Adequate Safety

High Safety

Excellent Safety

BEST Safety

+

+

+

+

+

+

-

-

-

-

-

-

Investment

Grades

SpeculativeGrades


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Global Credit Crisis

h C i i l C i ? ( i bbl )


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What Causes Financial Crises? (A. Puncturing Asset Bubbles)

Cheap Money + Leverage

Financial Innovation

Asset Bubble

InterestRate(%)

+


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What Caused the Current Credit Crisis?

CheapMoney

FinancialInnovation

AssetBubble

Attractivemortgagefinancing

No-doc/low-docPiggyback seconds

Option ARMsHousing

Fed funds 3%(9/01-6/05)

Collateralized DebtObligations (CDOs):Structuring/Valuation

Housing

High-yield ratesbelow 8%

Collateralized LoanObligations (CLOs):

Structuring/Valuation

Corporations?

The Conditions for the Current Credit Crisis Emerged in a Number of Ways in 20052006:

CurrentCreditCrisis

id h di i i


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How Did The Current Credit Crisis Start?

SubprimeBorrower

MortgageBrokers

CDOManager

Housing Mortgages RMBS CDO

EquityNot Rated

MezzanineAA-BB

SeniorAAA

Banks

RMBS: Residential Mortgage-Backed Securities CDO: Collateralized Debt Obligations

A bubble inhousing prices

enabled by a loosening

of lending standards

fed mortgages into complex structured

transactions, with high-grade ratings

led to a perfect storm of troubled mortgages, RMBS and CDOs

When the Music Stopped, Banks & Brokers Retained Hundred of Billions of Senior CDOTranches and Warehoused Subprime Loans Leading to Major Writedowns

1 In 2001 following a massive stock market and capital spending bubble Federal Reserve
http://www2.standardandpoors.com/portal/site/sp/en/us/page.siteselection/home.jsphttp://www.fitchratings.com/corporate/index.cfm


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1. In 2001, following a massive stock market and capital spending bubble, Federal ReserveChairman Alan Greenspan worried that the U.S. faced a severe recession. He begancutting interest rates down to 1% and kept them at that level until 2004, raising themslowly only 0.25% at a time thereafter.

2. With interest rates so low, the financial services industry sensed a lot of money could be

made and went all in on real estate, seemingly unaware that low interest rates weremasking large risks.

3. Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst.But, they soon realized that money lost in the stock market was more than offset by risinghome prices. So, Americans continued to spend freely.

4. As Americans spent freely, the U.S. went further into debt with the rest of the world.Foreigners, used their dollar IOUs from these debts to start their own bubbles too.

5. Eventually, things started to unravel in 2006 when those that could least afford to purchasehomes, so called subprime borrowers, started to default in the U.S., prices having run wellout of their range of affordability.

6. In February 2007, HSBC issued the first major warning, a harbinger of things tocome, writing down tens of billions in losses from their ill-timed 2002 acquisition of U.S.subprime lender Household International. At first things looked fine and policy makersconvinced themselves and the wider public that the problem was contained to subprime.

7. However, when two Bear Stearns hedge funds with exposure to the U.S. housing market

blew up in June 2007, people became worried that the risks had been underestimated.

8 It was in August 2007 when BNP Paribas a large French bank froze withdrawals in three


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8. It was in August 2007 when BNP Paribas, a large French bank, froze withdrawals in threeinvestment funds that people began to panic. If a bank with zero obvious exposure to theU.S. mortgage sector could have this measure of difficulty, anyone could be hiding untoldlosses. This marked the official beginning of the credit crisis. The result was mutualdistrust amongst large banks operating in the global market for interbank loans whichmeant credit was hard to come by for many banks.

9. By September, liquidity in the interbank market was so bad that rumors were swirlingabout various institutions which received most of their funding in wholesale markets. Oneof these was Northern Rock, an aggressive British mortgage lender. The British publicpanicked and began lining up to pull their money out of the institution. The Bank ofEngland was forced to bail out the company, subsequently nationalizing it altogether.

10. Meanwhile U.S. housing prices continued to decline. The result was massive losses in thealphabet soup of mortgage-related derivative assets held by large global banks.
http://www.creditwritedowns.com/wordpress/wp-content/uploads/1.bp.blogspot.com/files/2008/10/case-shiiler-20.png


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These instruments are called derivatives because their value is derived from the value inunderlying assets like mortgages. The first wave of mortgage-related losses were concentratedin these instruments and investing vehicles: RMBSs (Residential Mortgage Backed Securities)CDOs (Collateralized Debt Obligations), and SIVs (Structured Investment Vehicles) and CDOsof CDOs. Merrill Lynch was the first to report a large loss, at $5.5 billion on 5 Oct 2007. Only tocome back less than three weeks later on 24 Oct 2007 to say that the losses were now over $8

billion. Eventually, losses reached $500 billion a year into the crisis for all global institutions.

11. The Merrill losses were followed by losses at most of the large global financial institutions. Many CEOslost their jobs and the companies were forced to raise capital. By August 2008, the amount raised wasto reach $350 billion.

12. The situation seemed to quiet down in early 2008. However, in March the failures of hedge fundsPeloton and Carlyle Capital put the credit crisis back in full view. Another 2nd period of panic resulted inthe sudden collapse of Bear Stearns, Americas 5th largest investment bank. The Fed organized a

takeover by JP Morgan Chase that was a catastrophic 90% loss for Bears shareholders.

13. Eventually the collapse of Bear Stearns faded and, for the third time, we were lulled into a false senseof security that the worst was over. Nevertheless, writedowns continued unabated as did capital raising.When Lehman Brothers announced a massive $3 billion loss 0n 9 Jun 2008, the crisis came into fullview yet again much as it had when Bear Stearns hedge funds collapsed the previous June.

14. This time, market fears did not recede and the financial markets remained in a constant state of stress.Things started to unravel very quickly. IndyMac, an aggressive mortgage lender, an American version ofNorthern Rock, was taken over by the FDIC. And a panic was on for the third time.

15 Next were the GSEs The end result of the market panic was a questioning of the viability of


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15. Next were the GSEs. The end result of the market panic was a questioning of the viability ofFannie Mae and Freddie Mac, the two largest mortgage lenders in the United States and atthe core of the residential property market. Eventually the U.S. Government was forced totake the two companies into conservatorship.

16. Afterwards, all financial shares generally came under assault. The ones considered the

weakest came under the heaviest selling pressure, resulting in the collapse of LehmanBrothers. Without government support and unable to close a merger in around-the-clocknegotiations at the weekend, the company filed for bankruptcy on Sep. 15.

17. Merrill Lynch, the venerated U.S. investment bank, sensing trouble, sought and receivedcover in a takeover by Bank of America that very same weekend.

18. Financial markets smelled blood after Lehman collapsed. Apparently no company was toobig to fail. So, the assault on financial service companies continued. Eventually, AIG, thelargest insurance company in the world, succumbed to this pressure. The FederalReserve, citing special considerations, bailed out the non-depositary institution.

19. At this stage, we were in free fall and the entire banking system was on the verge of

collapse in the United States. Global shocks had not ended either, as UK institutions wereincreasingly under attack as well, having been damaged by their own property bubble. Atthe urging of the British Prime Minister and the UK regulatory authorities, Lloyds TSB boughtBritains largest mortgage lender HBOS, which was in jeopardy of failing.

20. By this time, the Feds had had enough. The time for ad hoc crisis management was at anend. Hank Paulson moved decisively and put forward his $700 billion bailout plan. It awaitscongressional approval.


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A. Before Congress could approve the Paulson Plan, the credit crisis had moved to Europewhere several banks were nationalized. Markets around the world suffered.

B. Congress eventually approved the Paulson Plan after much debate and initial setbacks.The Plan was augmented to include $100 billion in relief from the Alternative Minimum Taxand offer tax breaks for specific businesses as well. In addition, it raised the limit onfederal bank deposit insurance from $100,000 to $250,000.

C. Meanwhile, turmoil in both the credit markets and the stock markets continued. Europewas still the focus as French President Sarkozy called a European crisis summit toaddress the situation. As the crisis worsened, National governments were forced to react

and Ireland, Greece, Denmark, Austria, and Germany all offered sweeping depositguarantees. Britain partially nationalized its banking system in a 400 Billion bailout of theUKs financial system. Iceland was forced to nationalize its largest banks and teetered on

the verge of bankruptcy as it received financial assistance from Russia in return for a 75-year lease to an Icelandic air base.

D. Central Banks around the world acted in a coordinated fashion, cutting rates and injecting

massive amounts of liquidity into the markets. However, the markets were still unhappyand plunged anew. With the U.S. markets flirting with 2003 lows and financial stocks downby half on the year, U.S. Treasury Secretary Paulson admitted that he might inject capitaldirectly into American banks.


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Thank You

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session i - introduction to credit ratings (aug 7, 2009)

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