Immersion course at XIMB, Bhubaneswar

Session – I (Aug 7-8, 2009)

Introduction to Credit Ratings

D. Ravishankar
 Bonds outstanding as a % of GDP as on March 2008

70

60
The corporate debt market in India is
50
underdeveloped, amounting to less
Per centage

40
than 5 percent of GDP, compared
30
Government
with over 20 percent of GDP in
20 Private Thailand, Chile and Mexico, and 50-
10 100 percent of GDP in more
0
advanced economies.

Security Type No. of Market Capitalisation % of Total

Securities (Rs. Crore)
Govt. Securities 125 18,08,270 67.75
PSU Bonds 766 1,19,165 4.47
State Loans 1189 3,44,721 12.92
The share of corporate, PSU’s, Banks Treasury Bills 52 1,41,888 5.32
& FI’s constitute only 14% of the Local Bodies 5 423 0.02
Fin Institutions 252 40,861 1.53
overall bond market capitalisation, as
Bank Bonds 427 1,15,146 4.31
of Dec 31’08.. Supranational 1 391 0.01
Bonds
Corporate Bonds 946 98,051 3.67
Total 3,763 26,68,916 100
 Domestic Debt Issue – % of Amount O/S as of June’08 by Issuer Type

in Billion USD
Domestic Debt Sec. Govt FI's Corp Total

USA 6788 15433 2933 25154

UK 910 451 23 1384
Germany 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

• 90% of the domestic debt issues are dominated by the Government issuances
• Reflects the preference for G-Sec amongst investors driven by the regulations on
investment pattern skewed towards G-Sec
 Funding Pattern of Corporate

• 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 for
loans on account of differential treatment as compared to bonds
 Resource Mobilisation in the Private Placement Market

250000

Public Sector -
200000 Non-financial
Rupees Crore

Institutions

150000 Public Sector -

Financial
Institutions
100000

Private Sector -
Non-financial
50000 Institutions

Private Sector -
0 Financial
Institutions

Year

• Corporate bond market is dominated by private placements of bonds...... With issuances

by 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
 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 -1579
2002-03 600 -2353
2003-04 459 -1856
2004-05 613 5194
2005-06 2552 2508
2006-07 3776 16155
2007-08QE 8769 22165

Easy access of the Indian corporate to international funding....... May be facilitated with
the then lower interest rates and access to large sum
 Instrument-wise Share of Securities Traded in WDM Segment of NSE

• G-Sec trading volume is consistently higher, reflecting the scenario in primary market
• Also reflects the availability of efficient market mechanism and information system for
G-Secs
 Trading in Corporate Bonds

30,000 90000

80000
25,000
70000

20,000 60000

Number of Trades
Rupees Crore

50000
15,000 Value of Trades
40000 Volume of Trades

10,000 30000

20000
5,000
10000

0 0

There is a lacklustre trading for corporate bonds except during the last three months may
be due to the bullish interest rate scenario, weak equity market and higher participation
by the FIIs
 Rating Wise Distribution of Corporate Bonds Issued

% of Total Grade AAA AA A BBB Non-Investment

Number 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 0.3
2005-06 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

Very high preference for highly rated bonds (AAA and AA category) driven by restrictions
on investment for most investor classes
 Bonds, 2008 (As reported on FIMMDA)

Rupee Crore

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 0
Aug 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

• Trading concentrated at AAA category indicating low liquidity in other rating categories
• Discourages investors with wider risk appetite (like mutual funds)
 India and EEA Securitisation (% of GDP), 2007

In spite of India being an early entrant in the securitisation market, other countries have
made rapid progress
 Size of Indian Securitisation Market

60000

50000

Rupee Crore
40000 Others
30000 Partial Guarantee
20000 CDO/LSO

10000 MBS
ABS
0

(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 0
Others 50 1000 680 0 0
Total 13930 30810 25640.0 36950 58710

• Growth in the ABS has slowed down during the last one year, will continue on account of slow down
in 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.
 Other Challenges

• Issues with taxation – TDS and Stamp Duty

• High cost of public issuances restricting the initial
participation by wider investor group
• Absence of liquidity enhancing mechanisms – short
sale, repos
• Absence of credit risk hedging techniques – CDS, well
developed interest rate futures/ options
 What is needed for developing the Indian Debt Market?

• Widen investor base

• Develop retail interest in bond market
• Abolishing Tax Deducted at Source (TDS) and providing
a level playing field with equity / MF’s
• Introduction of credit derivatives
• Product innovation – Loan trading, Infrastructure
financing through bonds
• Develop market infrastructure and systems
• A concerted efforts among Regulators to overcome any
overlaps
Credit rating – definitions, benefits and methodologies
 Definition of Credit Rating?

A grading of a borrower's ability to meet

financial obligations in a timely manner.

-Ability to pay
- Willingness to pay
 What is a Credit Rating?

• 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 a Credit Rating is Not

• 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
 Benefits of Rating
Benefits of Rating
Investors
Issuers
A simple indicator of credit risk
Improved funding flexibility

Risk premium assessment

Reduce borrowing costs
excellent indicator of a bond's
future credit performance"
More access to capital markets

Portfolio monitoring and

Counter party risk assessment, trade adjustment.
finance, swaps, insurance, etc Benefits
of
Rating Providing underwriting in planning,
pricing and placement of issues.
Investor protection

Marketing - to help sales forces place

Market discipline new issues.

Monitoring counter party risks.

Regulatory Authorities Intermediaries

 Rating Agencies in India

• CRISIL Ltd.
• Credit Analysis & Research Ltd (CARE)
• ICRA Ltd.
• Fitch Rating India Pvt. Ltd
• Brickwork Ratings
 Independence of Rating Agencies

• 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
 SEBI – The Watchdog

• Rating agencies cannot rate debt issued by their promoters

• If promoter is a lending institution, the
Chairperson/Director/employee cannot be the
Chairperson/Director/employee of the rating agency, nor can they
be 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 must
have dual ratings
• Ratings must be released to the public even if it is not accepted, if
the 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 to
prevent insider trading in securities
 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. Structured
finance 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.
 Brickwork Ratings – Overall Process

Pre-Rating Rating Post-Rating

Rating Mandate Consistent Application of

Publication of Ratings
& Agreement Rating Policies

Quality Integrity - Non-Assurance Use of Criteria, Research &

Management Meetings Surveillance
of Particular Rating

Explanation of Critical Policy Quality Assurance by

Rating Committee Withdrawal
and Process to Issuer

Initial Rating Assignment &

Confidentiality Requirements
Appeal Process
 The Transparent Rating Process

Rating Commence Top

Rigorous
Agreement Information Management
evaluation
With the client review Meetings

Assign rating
Rating Publish ratings Ongoing
(option for
committee surveillance
appeal)

25
Brickwork Rating Scale – Long Term Ratings

BEST Safety
AAA+
Excellent Safety
AAA
High Safety
+ AA
AA -
Adequate Safety
Investment A
A -
+
Grades
Moderate safety

+ BBB -
Inadequate Safety
Speculative
+ BB - Grades
Low Safety
+ B -
Very Low Safety
+ C -
Default Grade
D

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

Global Credit Crisis
 What Causes Financial Crises? (A. Puncturing Asset Bubbles)
Cheap Money + Leverage Asset Bubble
Interest Rate (%)

+
Financial Innovation
 What Caused the Current Credit Crisis?
The Conditions for the Current Credit Crisis Emerged in a Number of Ways in 2005–2006:

Cheap Financial Asset

Money Innovation Bubble

Attractive No-doc/low-doc
mortgage “Piggyback” seconds Housing
financing Option ARMs

Collateralized Debt
Fed funds ≤ 3% Current
Obligations (CDOs): Housing
(9/01-6/05)
Structuring/Valuation Credit
Crisis
Collateralized Loan
High-yield rates
Obligations (CLOs): Corporations?
below 8%
Structuring/Valuation
 How Did The Current Credit Crisis Start?
A bubble in … enabled by a loosening … fed mortgages into complex structured
housing prices … of lending standards … transactions, with high-grade ratings …

Housing Mortgages RMBS CDO

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

Senior
AAA

Mezzanine
AA-BB
CDO
Manager
Subprime Mortgage Equity
Borrower Brokers Banks Not Rated

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

When the Music Stopped, Banks & Brokers Retained Hundred of Billions of Senior CDO
Tranches and “Warehoused” Subprime Loans … Leading to Major Writedowns …
1. In 2001, following a massive stock market and capital spending bubble, Federal Reserve
Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began
cutting interest rates down to 1% and kept them at that level until 2004, raising them
slowly 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 were
masking 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 rising
home 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 purchase
homes, so called subprime borrowers, started to default in the U.S., prices having run well
out of their range of affordability.

6. In February 2007, HSBC issued the first major warning, a harbinger of things to
come, 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 makers
convinced 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
investment funds that people began to panic. If a bank with zero obvious exposure to the
U.S. mortgage sector could have this measure of difficulty, anyone could be hiding untold
losses. This marked the official beginning of the credit crisis. The result was mutual
distrust amongst large banks operating in the global market for interbank loans which
meant credit was hard to come by for many banks.

9. By September, liquidity in the interbank market was so bad that rumors were swirling
about various institutions which received most of their funding in wholesale markets. One
of these was Northern Rock, an aggressive British mortgage lender. The British public
panicked and began lining up to pull their money out of the institution. The Bank of
England 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 the
alphabet soup of mortgage-related derivative assets held by large global banks.
 These instruments are called derivatives because their value is derived from the value in
underlying assets like mortgages. The first wave of mortgage-related losses were concentrated
in these instruments and investing vehicles: RMBSs (Residential Mortgage Backed Securities)
CDOs (Collateralized Debt Obligations), and SIVs (Structured Investment Vehicles) and CDOs
of CDOs. Merrill Lynch was the first to report a large loss, at $5.5 billion on 5 Oct 2007. Only to
come 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 CEOs
lost their jobs and the companies were forced to raise capital. By August 2008, the amount raised was
to reach $350 billion.

12. The situation seemed to quiet down in early 2008. However, in March the failures of hedge funds
Peloton and Carlyle Capital put the credit crisis back in full view. Another 2nd period of panic resulted in
the sudden collapse of Bear Stearns, America’s 5th largest investment bank. The Fed organized a
takeover by JP Morgan Chase that was a catastrophic 90% loss for Bear’s shareholders.

13. Eventually the collapse of Bear Stearns faded and, for the third time, we were lulled into a false sense
of 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 full
view 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 of
Northern 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
Fannie Mae and Freddie Mac, the two largest mortgage lenders in the United States and at
the core of the residential property market. Eventually the U.S. Government was forced to
take 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 Lehman
Brothers. Without government support and unable to close a merger in around-the-clock
negotiations at the weekend, the company filed for bankruptcy on Sep. 15.

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

18. Financial markets smelled blood after Lehman collapsed. Apparently no company was too
big to fail. So, the assault on financial service companies continued. Eventually, AIG, the
largest insurance company in the world, succumbed to this pressure. The Federal
Reserve, 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 were
increasingly under attack as well, having been damaged by their own property bubble. At
the urging of the British Prime Minister and the UK regulatory authorities, Lloyds TSB bought
Britain’s 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 an
end. Hank Paulson moved decisively and put forward his $700 billion bailout plan. It awaits
congressional approval.
A. Before Congress could approve the Paulson Plan, the credit crisis had moved to Europe
where 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 Tax
and offer tax breaks for specific businesses as well. In addition, it raised the limit on
federal bank deposit insurance from $100,000 to $250,000.

C. Meanwhile, turmoil in both the credit markets and the stock markets continued. Europe
was still the focus as French President Sarkozy called a European crisis summit to
address the situation. As the crisis worsened, National governments were forced to react
and Ireland, Greece, Denmark, Austria, and Germany all offered sweeping deposit
guarantees. Britain partially nationalized its banking system in a £400 Billion bailout of the
UK’s 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 unhappy
and plunged anew. With the U.S. markets flirting with 2003 lows and financial stocks down
by half on the year, U.S. Treasury Secretary Paulson admitted that he might inject capital
directly into American banks.
Thank You
dravishankar@hotmail.com