financial reporting and credit ratings · 2014. 12. 22. · 4 background on moody’s ratings...

Financial Reporting and Credit Ratings

CARE ConferenceNAPA, CAApril 20, 2007

Greg JonasManaging Director


2

Agenda

Background about credit ratings

Calculation, process, role of financial reporting

Accounting issues and credit ratings

3

Background on Ratings

4

Background on Moody’s ratings

Ratings on $35 trillion of debt outstanding

170,000 corporate, government and structured finance securities

10,000 corporate relationships

100 sovereign nations

Most ratings are freely available

Proprietary research – 2,600 subscriber institutions, 400,000 users

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Corporate

– Financial institutions

– Corporate investment grade

– Corporate high-yield

Municipal

Sovereign

Structured finance

Scope of today’s discussion…

We are Here

We are Here

6

Uses of credit ratings

CreditRatings

BuildingPortfolios Pricing

Contracts

RegulatoryRequirements

Trading

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Benefits of ratings for companies

Market access (gate keeping)

Expands breadth of market

Widens distribution

Improves liquidity

Improves pricing

Helps management with independent, outside perspective on company

Helps management monitor counterparty risk

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Due diligence efficiency

Multiple independent perspectives

Facilitates comparisons

Tool in portfolio management

Enhances secondary market liquidity

Relatively stable over time

Basis for performance benchmarks

Benefits of ratings for investors

9

What does a credit rating mean?

Opinion on expected loss

Expected loss = (Probability of Default) x (Severity of Loss)

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Rating scale

Aaa

Aa(1-3)

A(1–3)

Baa(1-3)

Ba(1-3)

B(1-3)

Caa(1-3)

Ca

C

Minimal credit risk

In default,little prospect of recovery

InvestmentGrade

HighYield

Watch list =under review

Outlook =likely direction

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Historical Rating Distribution

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1919

1924

1929

1934

1939

1944

1949

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

2004

Aaa

Aa

A

Baa

Ba

B

Caa-C

US Non-Financial Corporates

By Issuer Count

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Average Loss and Default Rates

AaaAaABaaBaBCaaCaC

SeniorUnsecured

RatingDefault

Probability1

ExpectedLossRate1

0.002%0.052%0.380%1.32%7.48%19.94%48.27%100%100%

0.001%0.026%0.190%0.66%3.74%9.97%24.13%50%80%

1 4 year time horizon

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Average Cumulative Expected Loss:Senior Unsecured Debt

1 4 7 10 13 16 19

AaaAaABaaBaB0%

10%

20%

30%

Years OutRating

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Assume Moody’s rates a company’s senior unsecured debt “A2, on review for possible downgrade” - What does this mean?

The company’s debt is investment grade

Based on historical averages, investors can expect to lose 0.19% from a portfolio of all debt obligations at this rating over a 4-year period

Based on an average loss in default of 50%, the probability of the debt defaulting is 0.38%

Because debt is on review, it will probably trade as a Baa1 rated debt (2 notch discount)

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Relationship between long-term and CP ratings

Aaa

Aa1Aa2Aa3

A1A2A3

Baa1Baa2Baa3

High Yield

Prime-1

Prime-2

Prime-3

Not prime

Long-Term CP

InvestmentGrade

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Types of high-yield ratings

Company Instruments

Corporate Family Rating

(CFR)Risk of Loss

Speculative Grade Liquidity

(SGL)

Loss Given Default

(LGD)

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Expected loss = (Probability of Default) x (Severity of Loss)

Assumes = Corporate family is a single entity with one class of debt

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Company Instruments


(CFR)Risk of Loss


(SGL)

Loss Given Default

(LGD)

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Instrument ratings

B1

Senior Secured

Subordinated

CorporateFamily Rating Debt Classes

20

0

10

20

30

40

50

6070

80

Bank Loans SeniorSecured

SeniorUnsecured

Subordinated PreferredStock

Defaulted Debt Recovery Rates

%

21

Instrument ratings

B1

Senior Secured

Subordinated


InstrumentRating

Ba2

B2

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Loss Given Default Rating

LGD Assessment Loss Range

LGD1 0% - 10%

LGD2 10% - 30%

LGD3 30% - 50%

LGD4 50% - 70%

LGD5 70% - 90%

LGD6 90% - 100%

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Instrument ratings

B1

Senior Secured

Subordinated


InstrumentRating

Ba2

LGD3

B2

LGD4

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Assume Senior Secured Debt is Rated Ba2, LGD3 (40%) - What does this mean?

The debt is speculative grade

Based on historical averages, investors can expect to lose 3.7 percent from a portfolio of these debt securities over a 4-year period

If the security defaults, investors can expect to lose about 40% of the principle and accrued interest

The probably that the company will default on this security is about 10%

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Company Instruments


(CFR)Risk of Loss


(SGL)

Loss Given Default

(LGD)

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SGL

SGL 1 SGL 2 SGL 3 SGL 4

Operating cash flow + cash on hand

SufficientSufficient except for extra capex

Breakeven and limited cash

Insufficient

Committed facility

UndrawnNeeded only for extra capex

Reliant and used, but not fully

Needs external sources

CovenantsCompliant with headroom

Compliant Barely compliant

Likely violation

Back door Present Present but impairment Unlikely Little

Assets Unsecured Mostlyunsecured

Mostly secured

Few alternatives

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Rating qualityWhat investors want from ratings

Accurate (relative ranking of credit risk)

Low ratings in advance of default

Stable (few rating reversals)

Don’t incorporate market price information (self-fulfilling, pro-cyclical)

Independent, stabilizing force

Separate point of view from each agency

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Rating qualityKey performance measures

Investment grade defaults

Accuracy measure (90% = average defaulter rating lower than 90% of all issuers)

Stability measure

– # of issuers with rating changes divided by total number of rated issuers

– # of issuers with 3+notch changes divided by total number of rated issuers

Rating reversals

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Ways to assess credit risk

Fundamental approach (e.g. Moody’s credit ratings)

Market implied ratings (e.g. bond or CDS prices)

Mathematical models

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Fundamental ratingsNot quite as accurate but more stable…

Moody’sBond-

ImpliedMDP

1-year accuracy 79 87 76

5-year accuracy 63 66 55

Average rating B2/B3 B3/Caa1 B2

Rating action rate 25 98 76

Large action rate 5 26 32

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Calculation, Process, Role of Financial

Reporting

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Fundamental Analysis: Areas of Analysis

Issue Structure

Company Structure

Operating / Financial Position

Management Quality

Industry / Regulatory Trends

Sovereign / Macro Economic

Fin

an

cial

Rep

ort

ing

Pro

bab

ilityo

f Defa

ult

Severity

of L

oss

33

Rating data flow…

DATABASE

Rating Methodologies Adjustment Worksheets

Company Reports

XYZ Company

Adjusted Financial Statement Data


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Reasons to adjust reported amounts

Apply accounting principles that we believe more faithfully capture underlying economics

Identify and segregate effects of unusual or non-recurring items

Improve comparability by aligning accounting principles

Reflect estimate or assumptions that we believe are more prudent

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Moody’s Standard Adjustments

IFRS Only

Capitalized development costs

Income statement presentation of interest cost related to certain discounted liabilities

U.S. GAAP Only

LIFO Inventories

All Accounting RegimesDefined benefit pension plans

Operating leases

Employee stock compensation

Hybrid securities

Securitizations

Unusual / non-recurring items

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Purpose of U.S. GAAP adjustments

Adjustment Purpose

Pensions Eliminate smoothing

Leases Capitalize operating leases

Capitalized interest Expense capitalized interest

Stock compensation Expense and flag on CFS

Hybrid securities Apply Moody’s framework

Securitizations Treat as securitized borrowings

LIFO Adjust balance sheet to FIFO

Unusual items Highlight core earnings

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Typical timeframe for data

Historical Projected

5 years 3 years

38

…more rating data flow

Industry / Macro Economic Data




Other Company Specific Data


AnalysisAnalysis

Rating Committee Package and

Recommendation


Recommendation

39

Industry methodologies…

Key metrics

Benchmark and rate

Weigh

Indicative Rating

Other qualitative factors

Final rating

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Size, Scale and DiversificationTotal Revenues (20%)Segment Diversification (7.27%)Concentration of customers (7.27%)

Product and Portfolio ProfitabilityR&D as a % of Sales (7.27%)EBIT Margin (7.27%)ROA (7.27%)

Financial PoliciesReliance on acquisitions, share buy-backs and dividends (7.27%)Debt / Book Capitalization (7.27%)Debt / EBITDA (7.27%)

Key metrics – Global Medical Devices Industry

Financial StrengthCFO / Debt (7.27%)Free Cash Flow / Debt (7.27%)EBIT / Interest Expense (7.27%)

Note− Factor weight in parenthesis− Financial metrics in Italics

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Key metrics – Most Commonly Used Moody’s Industry Rating Methodologies *

Metric Category Metric

% of Methodologies

Including Metric

Size Revenue 58%

Profitability EBIT (or EBITA) Margin 38%

Return EBIT (or EBITA) / Avg. Assets 30%

Free Cash Flow / Debt 55%

Retained Cash Flow / Debt 30%

Retained Cash Flow / Net Debt 28%

Coverage EBIT / Interest Expense 45%

Debt / EBITDA 50%

Debt / Capital 40%Leverage

Cash Flow

* To date Moody’s has published 40 industry rating methodologies.

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Key metrics – Global Medical Devices Industry

An example “Rating Grid”…

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Industry methodologies…

Key metrics

Benchmark and rate

Weigh

Indicative Rating

Final rating

Industry structure

Financial policy

Management quality

Contingent liabilities

Aggressive accounting

Weak accounting control

Governance risk

Event risk

Other qualitative factors

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An Example Rating: Stryker Corporation







AnalysisAnalysis


Recommendation


Recommendation

45

An Example Rating: Stryker CorporationAdjusted Financial Statement Data Industry Model Rating Grid

Other Company Specific DataFinancial projections

Strategic plans

Details of significant transactions

Access to management / directors


Other Qualitative ConsiderationsRelatively high degree of exposure to the orthopedics market

Potential litigation stemming from DOJ investigation

Potential for acquisitions in consolidating market place

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An Example Rating: Stryker Corporation


Recommendation


Recommendation

47

Accounting Issues and Credit

Ratings

48

Moody’s Specialist Groups

Group Focus

AccountingCredit-relevant issues related to

financial reporting

GovernanceImpact of governance issues on

credit risk

OBS/StructuredCredit impact of off-balance sheet

structures

Risk ManagementImpact of complex financial

instruments on credit risk

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What do accounting specialists do?

Area of Responsibility

Time Allocation

Help get ratings right 40%

Publish on companies and topics 30%

Train Moody’s analysts 15%

Communicate with outsiders 15%

Are analytical adjustments useful?

Evidence of aggressive accounting?

Evidence of weak reporting control?

Impact of financial reporting meltdown?

The Big Questions

50

Getting ratings right –Evidence of aggressive accounting

MisleadingAccounting

AnalystConcern

GovernanceConcern

Red Flag Metrics

Comment Letters

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=

Category “B1”

weakness

General uncertainty about

company’s reporting2

Rating that does not yet reflect

uncertainty+

Negative rating action

+

2Examples:Delinquent filingsContinuing restatementsAggressive accountingInvestigationsWeak remediation

Getting ratings right –Evidence of weak reporting control

1Pervasive weakness, e.g.:Not enough folksInsufficient skills

Evaluating the impact control weakness on ratings…

52

404 problem #1: reports lag reporting problems

Restatements 38%

None 5%

Both 15%

Adjustments and Other 42%

Types of Financial Reporting Errors Preceding Material Weakness Disclosures

53

404 problem #2: No one is talking about fraud

5%

95%

Fraud-Control Disclosures

No Fraud-Control Disclosures

Percentage of Companies with Material Weaknesses Citing Fraud Controls

54

Getting ratings right -Impact of a meltdown…

Company Rating Before Problem Rating After Problem

Adelphia High Speculative Grade Low Speculative Grade - Rating WithdrawnAIG Highest Investment Grade High Investment GradeCendant High Investment Grade High Speculative GradeComputer Associates Low Investment Grade Speculaltive GradeDelphi High Speculative Grade Low Speculative Grade - Rating WithdrawnDollar General Low Investment Grade High Speculative GradeDuke Energy High Investment Grade Speculaltive GradeDynegy Low Investment Grade Low Speculative GradeEnron High Speculative Grade Low Speculative Grade - Rating WithdrawnGlobal Crossing Speculative Grade Low Speculative Grade - Rating WithdrawnHealthSouth Low Investment Grade Low Speculative Grade - Rating WithdrawnLucent High Investment Grade Low Speculative GradeQwest Low Investment Grade Low Speculative Grade - Rating WithdrawnRiteAid High Speculative Grade Low Speculative GradeSunbeam Speculative Grade Low Speculative Grade - Rating WithdrawnTyco High Investment Grade Speculaltive GradeUnited Rentals High Speculative Grade Speculaltive GradeWaste Management Low Investment Grade High Speculative GradeWorldCom Low Investment Grade Low Speculative Grade - Rating Withdrawn

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Reporting meltdown… factors to consider

Covenant violations?

Will bond holders accelerate?

Is backup liquidity ready and bulletproof?

What will banks do?

Crisis of confidence with customers and vendors?

Management distraction?

Management’s plan to mitigate damage?

Rating impact when we don’t have #’s - basis to continue ratings?

56

Published materials – 2006 examples

Fair Value Option Leveraged leases

Standardadjustments

Volumetric production payments

Short-cutmethod

Pooling adjustmentsat oil and gas companies

Internally funded pension plans

Fair value for servicing assets

Pensions -Phase 1

Expensingstock comp.

404 reporting -Year 2

Backdating

Uncertain taxpositions

Multi-employer pensions

Pension reform

SAB 108

Internalaudit

Events

New Rules

Adjustments

Accounting? Credit Impact? Data?Content

Financial Reporting and Credit Ratings

CARE ConferenceNAPA, CAApril 20, 2007



financial reporting and credit ratings · 2014. 12. 22. · 4 background on moody’s ratings...

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