Moodys After Enron: Improving the Reliability of Our Bond Ratings

1
Moodys After Enron Improving the Reliability
of Our Bond Ratings

• Christopher Mahoney
• Chairman, Credit Policy Committee
• Moodys Investors Service

2
The Post-Enron Critique

• Ratings lag markets
• Ratings are unreliable
• Large number of investment-grade defaults
• Ratings do not look behind the published numbers
• Excessive rating volatility is causing
  unnecessary bond market turmoil
• Downgrades can be self-fulfilling

3
Rating agencies are in the public spotlight

• Senate hearings
• House investigation
• SEC review of the industry
• Discussions at IOSCO and abroad

4
Ratings Lag Markets
5
Ratings are observed to follow market price
movements

• Yes, that has been empirically observed. But
• Ratings are intended to provide a stable signal
  of fundamentally derived credit risk.
• On the tradeoff between accuracy and stability,
  ratings offer stability.
• Rating signals provide additional information
  outlooks, watchlist, rating history.

6
The Agencies Missed Enron
7
Enron

• The agencies missed Enron.
• Rating agencies provided no warning of the true
  condition of the company before it was revealed
  in October/November.
• Rating agencies maintained investment grade
  ratings until shortly before default.

8
Quote

• Enron changes how citizens look at the safety of
  the markets, the truth of corporate disclosures,
  the dependability of financial statements, the
  validity of analyst recommendations, and the
  reliability of rating agency evaluations.
  (Harvey Pitt)

9
All investor protection safeguards failed

• Management
• Board of directors
• Audit committee
• External auditors
• Underwriters
• Equity analysts
• Rating agencies

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Investment Grade Defaults
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High Level of Investment Grade Defaults

• Definition rated IG within one year of default
• Large number of IGDs
• Very large dollars
• These hurt our reputation.

12
Major Investment Grade Defaults

• WorldCom 26B
• Enron 11B
• Finova 6B
• PGE 6B
• SoCal Edison 5B

13
Investment Grade Defaults (count)
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Investment Grade Defaults ()
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The Investment Grade Default Date
16
Can rating agencies do a better job of investor
protection?
17
What is the proper job of a rating agency?

• Traditional definition securities analysis
  relying primarily upon issuers published
  financials
• Evolving definition inspector/certifier/forensic
  agent analogous to a bank examiner
• Legislators and investors want us to look behind
  the issuers financial accounting in order to
  discover the underlying economic reality.

18
Quote

• Rating agencies have authority over companies
  comparable to the FDA. The FDA doesnt let a drug
  go on the market until theyve gone over all
  sorts of investigations to guarantee its safe.
  Weve asked rating agencies to play a similar
  role with regard to corporations.(Sen.
  Lieberman)

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How can we improve the reliability of ratings?

• Since the Enron catastrophe we have been talking
  to investors about the role of rating agencies in
  the capital market and how we can improve the
  reliability of Moodys ratings.

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What investors want

• Investors view us as their forensic agent in the
  analytical process.
• They expect us to use our power and access on
  their behalf to discover the truth behind the
  numbers.
• One portfolio manager said that he expects us to
  audit the auditors.

21
What investors want

• They want our analysts to have smaller portfolios
  in order for them to devote much more time to
  in-depth forensic analysis, resulting in the
  publication of in-depth research.

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So what is Moodys doing to improve the
reliability of our ratings?
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What we are doing

• Specialist teams
• CCO for CFG
• Portfolio quality monitoring techniques
• Liquidity risk assessments
• Default post-mortems
• Rating trigger survey
• Intensive portfolio reviews
• Smaller analytic portfolios

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Specialist Teams

• We have identified three areas of specialized
  expertise that we believe will require full-time
  nonrating professionals in the future
• Accounting
• Corporate governance
• OBS risk

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Role of Specialists

• Train analysts
• Participate in issuer meetings and rating
  committees
• Write issuer and topical research

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CCO for CFG

• Pam Stumpp charged with oversight of corporate
  credits

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Portfolio Monitoring

• Introduction of quantitative tools for portfolio
  monitoring
• Yield implied ratings
• EDF implied ratings

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Liquidity Risk Assessments

• Intensified focus on issuers alternate liquidity
  in the event of a credit shock
• LRA An opinion of the adequacy of an issuers
  contingent liquidity sources in the event of an
  abrupt loss of market access
• Approximately 400 released since March 200 more
  to be released over next 6 months
• Modifiers to be added by yearend (Excellent,
  Good, Adequate)

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Default Post-Mortems

• Rigorous post-mortem analysis of all
  investment-grade defaulters since Enron
• Peer review
• All Managing Directors in U.S. corporate ratings
  are invited
• Changes in rating policies/practices where
  appropriate

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Rating Trigger Survey

• Systematic identification of rating triggers in
  financial and operating agreements

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Intensive Portfolio Reviews

• Intensive reviews of certain volatile sectors
• Telecom, merchant energy, technology, retail

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Smaller Analyst Portfolios

• We are reducing analyst loads in both high grade
  and spec grade in order to intensify
  surveillance, deepen analysis, and increase
  research coverage
• Issuers will receive greater scrutiny

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Can we spot future Enrons?

• Red flags prior to financial distress
• Aggressive accounting
• Arrogant management
• Negative FCF
• Opaque disclosure
• Complexity
• Serial acquisitions

34
But...

• We cant spot fraud.
• Were not auditors, and even they dont spot it.

35
Rating Volatility
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Investors Hate Volatility

• Rating downgrades cost investors money.
• Investors want stability.
• Once they have purchased a bond, they dont want
  the rating to be downgraded until after they have
  sold it.
• They argue that downgrades become self-fulfilling
  prophecies due to the impact on market access.

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What Portfolio Managers Want

• Stable ratings reflecting fundamental credit risk
  which look through the cycle.
• Predictable rating changes with clear signaling
  in advance.
• Smooth transitions without multinotch lurches.
• Time to rebalance portfolios.
• Transparent, replicable methodology.
• Minimal level of crossovers into junk.

38
Recent Investor Feedback

• Moody's has a centrally guided policy to be more
  aggressive in downgrades than before
• that we have thrown out our old one-person
  one-vote system and that all ratings are now
  being assigned by a senior person who is
  determined to take ratings down
• that we have thrown out looking at separate
  markets and if we see a problem in the US it now
  just applies globally
• that we no longer upgrade companies unless of a
  parent change
• that our rating horizon has moved to 12-18 months
  and if we see pressure in that period but a good
  position in 3 years we'll downgrade to be on the
  safe side
• that we react to short-term equity volatility
• that we're determined to be ahead of SP in
  downgrades.

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There is a widespread perception that Moodys is
seeking greater rating volatility that we are
too swift to downgrade, creating unnecessary
market turmoil.
40
Have we changed our rating methodology?

• We have not changed our methodology.
• We are not chasing stock or bond prices, or KMVs
  ratings.
• We believe that ratings should provide a stable
  signal of relative credit risk using the
  traditional techniques of fundamental financial
  analysis.

41
However...

• . Post-Enron we have placed greater emphasis on
  liquidity risk, and on the relationship between
  an issuers free cashflow and its indebtedness.
  We are penalizing negative cashflow (after capex)
  to a greater degree than before. Insofar as a
  troubled issuer has negative proforma free
  cashflow and requires continued access to the
  capital market, we will not necessarily forbear
  in order to help it stay afloat.

42
Have our ratings been more volatile since Enron ?
43
Yes.But this reflects cyclical phenomena, not a
policy change. We are not seeking greater
volatility. We desire rating stability.
44
Is KMV influencing our ratings?

• No.
• Our ratings reflect fundamental credit analysis.
• Our ratings are not a hybrid of fundamentals and
  market-based inputs.
• KMVs ratings are no more admissible as rating
  committee analytical factors than are SPs
  ratings.
• Investors can use Moodys, KMV or both. Neither
  is a hybrid of the other.

45
Rating Volatility vs Competitors of Universe
Rating Changes (2001)
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Rating volatility is increasing---cyclically
47
Ratings and the credit cycle

• While we say that we look through the cycle.
• our rating behavior is actually cyclical.
• Cycles stress our assumptions about how issuers
  will perform through the cycle.
• Most issuers perform as anticipated, but some
  dont and are downgraded.

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Rating Volatility Data
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Frequency of Rating Changes(since 1984)
All Rating Changes
Multi-Notch Rating Changes
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Rating Activity (since 1994)
51
Rating Activity (since 1982)
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Fallen Angels (since 1982)
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Global Fallen Angels (billions debt affected)
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Fallen Angels ()
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Downgrades/Upgrades (ratio)
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Watchlist Activity (since 1994)
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Conclusion

• We are taking steps to improve the reliability of
  our ratings.
• We have not changed our rating methodology.
• We are not seeking greater rating volatility.
• Rating volatility is high, but this is a
  recurring cyclical phenomenon.

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An Addendum The Analytical Lessons of Enron
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Enron SEC Filing, April 22, 2002

• No party should rely on any previously reported
  financial information of the company, nor should
  any reader of this operating report place undue
  reliance upon the information contained herein.

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Analytical Lessons

• Opaque financials should be viewed with extreme
  skepticism, even in the face of apparent success
  and a booming stock price.
• Consider the possibility that even though the
  financials are audited, they may be completely
  misleading or even fraudulent.
• Think forensically what could they be trying to
  hide? How do I know any of what they say is true?
• Discover and understand all off-B/S exposures, no
  matter how innocuous or complex.
• Are all nonrecourse OBS entities really
  nonrecourse?
• Explore covenants for landmines.
• Dig deeply into revenue recognition try to
  distinguish between liberal accrual or MTM
  methodologies and real cash income.

61
Analytical Lessons

• Does the company's cashflow statement show items
  on a gross or net basis?
• If the company doesn't pay taxes but reports big
  profits, why? (The Tax Code is more conservative
  than GAAP.)
• How does the company really make money? Explain a
  representative transaction. Does it make sense?
• If the company is in the trading business, why
  hasn't Wall Street eaten its lunch?
• Does the company have an active independent audit
  committee? Who chairs it? Who's on it? Do they
  have financial backgrounds and do they attend the
  meetings?
• Has anyone suggested that the company plays games
  with its accounting or aggressively manages its
  earnings?

62
Analytical Lessons

• Has it ever had to restate?
• Have you ever caught management in a lie?
• What is management's attitude toward public and
  private disclosure? Is it open-kimono or
  uncooperative?
• Is management hostile toward media or Street
  critics?
• How does the CEO get paid?
• What conflicts of interest are exposed in the
  proxy?
• Has there been material inside selling?
• How much did they pay their accountants for
  consulting last year?
• Is internal audit outsourced and to whom?

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Analytical Lessons

• Is the company highly acquisitive, does it have
  material goodwill, and is it unwilling to share
  details on pre and post-acquisition accounting
  adjustments?
• Is the company reluctant to provide quality
  information on earnings by operating segment?
• Are there material differences between pro forma
  reporting and GAAP earnings?
• The number, complexity and clarity of notes to
  the financial statements
• Begin with the B/S understand every line item
• Probe the assertions in the glossy section of the
  A/R are they true? evidence?