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ENRON The Movie

• Hollywood will find a way to make this story an
  entertainment
• But at its core it was a scheme to enrich
  management through a complex web of lies and
  misrepresentations

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WELCOME TO THE REAL WORLD
BEFORE ENRON, ALMOST ALL CREDIT RATERS BELIEVED
THAT

• When you asked management a direct question, you
  would receive a fundamentally honest answer

• Despite the potential conflicts of interest in
  providing both auditing and consulting services,
  accountants recognized that credibility rested on
  confidence in their independence, and acted
  accordingly

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How Well Did The Rating Agencies Handle Enron?
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LONG-TERM DEBT RATING SCALE

• INVESTMENT GRADE
• AAA/Aaa
• AA/Aa
• A/A
• BBB/Baa

• SPECULATIVE GRADE
• BB/Ba
• B/B
• CCC/Caa
• CC/Ca
• C/C
• D

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What the Agencies Did Right!

• For years, Enrons ratings were in the BBB/Baa
  range, only one category above speculative grade
• Met regularly with Enron management to perform
  normal due diligence
• Communicated their credit opinions to the market

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What the Agencies Did Wrong!

• Didnt recognize on a timely basis numerous red
  flags (i.e. extraordinary growth, lack of
  transparency, extreme corporate arrogance,
  inexplicable management changes)
• Were overly concerned about domino effect on
  Enrons liquidity of a decision to downgrade out
  of investment grade
• When they finally acted, it didnt matter!

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After Enron the Agencies Considered Whether to

• Apply a shorter perspective when assigning
  long-term debt ratings (no more rating through
  the cycle)
• Incorporate current market sentiment (i.e. market
  prices) directly into ratings
• Investor reaction was overwhelmingly negative, so
  more subtle changes have been adopted

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Changes in Agency Attitudes Practices

• More intense surveillance, particularly where
  there are liquidity and funding risks
• 1) recognize that changes in banking practices
  have altered liquidity risks
• 2) recognize that share and bond price changes
  can effect liquidity funding risks

(slide 1 of 3)
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Changes in Agency Attitudes Practices

• Ask more questions about ratings equity price
  triggers
  other contingent
  financial
  commitments
• Incorporate assessments
  of corporate governance
  into rating decisions

(slide 2 of 3)
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Changes in Agency Attitudes Practices

• Publish opinions more frequently on individual
  credits of market interest and importance
• Use existing communication tools, including
  CreditWatch Rating Outlooks, more effectively
• Have far less patience, especially when there are
  perceived liquidity funding risks

(slide 3 of 3)
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Implications of Changes for Investors/Lenders

• The number of rating changes may increase
• Individual ratings may change more often
• Greater ratings volatility may cause larger
  swings in regulatory capital, demanding more
  cautious investing/lending approaches

(slide 1 of 2)
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Implications of Changes for Investors/Lenders

• If agencies become more proactive, it may not be
  so easy to anticipate their actions
• If agencies provide more predictive guidance, it
  will be necessary to become more of a student
  of ratings
• If agency research improves, internal credit
  research will have to improve

(Slide 2 of 2)
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Implications of Changes for Borrowers/Counterparti
es

• Need to convince agencies youre not another
  Enron and are deserving of their trust
• Need for greater familiarity with the rating
  process and how different agencies work
• Need to establish and maintain open lines of
  communication with key agency personnel

(slide 1 of 2)
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Implications of Changes for Borrowers/Counterpart
ies

• Need to understand rating criteria being applied
  to your industry and be able to address them when
  you meet the agencies
• Agencies have certain hot buttons - know what
  they are and how to address them
• Managing the rating process will be harder, but
  the benefits of doing so and the penalties for
  not doing so will be greater

(slide 2 of 2)
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A Treasurers Guide to Effective Rating Agency
Relationships
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Keys to Establishing/Reestablishing/ Maintaining
Credibility

• Continuity
• Balance
• Transparency

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Meeting the Rating Agencies

• Annual or semi-annual meetings are main
  communication forums
• Opportunity for company to tell its story and for
  agency to ask its questions
• But also a chance for dialogue and for company to
  question the agency
• Thoughtful and organized presentations establish
  a good framework for discussion

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Credible Written Presentations Will Include
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Credible Written Presentations Will Include

• A clear statement of business purpose and
  objectives
• An analysis of business segments - candid
  evaluation of competitive strengths weaknesses
  - key strategies
• Explanation of financial policies and strategies

(slide 1 of 2)
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Credible Written Presentations Will Include

• A discussion of financial goals and expectations
  1)
  explain key assumptions
  2) build bridges from the past
  3) provide evidence of flexibility contingency
  planning

(slide 2 of 2)
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Successful Meetings Require

• Advance preparation
• Having the right people present
• Expanding on written materials, not reading them
• Answering questions directly or not at all
• Asking questions

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Talking But Not Communicating

• Companys Agenda 1) Earnings growth 2)
  Efforts to enhance shareholder value 3)
  external influences on performance 4)
  belittle competitors 5) success of last financial
  deal

• Raters Agenda 1) financial flexibility
  2) soundness of strategic plan 3)
  take responsibility for performance 4)
  respect competition 5) appropriateness of
  financial policies 6) evidence of
  contingency planning

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Current Rating Agency Hot Buttons

• Corporate Governance
• Triggers Contingent Financial Obligations
• Liquidity Funding Risks

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Corporate Governance

• Ownership Issues 1) transparency
  of ownership 2) owners influence
  
• Relationships with Financial Stakeholders 1)
  shareholder meeting voting procedures 2)
  protection of owners rights

• Information Disclosure Transparency
  1) Quality of disclosure
  2) Timeliness ease of access to
  information 3)
  Independence credibility of auditors
• Board of Directors 1) Structure
  2) Responsibilities 3)
  Effectiveness

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Triggers Other Financial Contingencies

• Rating and equity price triggers
• Operating and synthetic leases
• Explicit and implicit commitments under
  structured financings
• Guarantees/commitments between affiliates
• Make-whole commitments to third parties

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Liquidity Funding Risks

• Internal liquidity
• Quality of external liquidity supports
• Dependence on asset/business unit sales
  to meet maturing debt
• Dependence on refinancing to
  meet maturing debt
• Magnitude and timing of contingent cash demands
  tied to performance triggers

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Final Thoughts

• Enron has severely shaken investor confidence in
  capital markets
• Due to their role, the rating agencies
  reconsidered some long-standing policies
• They concluded that drastic changes were not
  called for and could be even more disruptive
• Still, the formal and informal changes are
  important for all users of ratings to understand

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Roy P. Weinberger Credit Research,
Advisory Consultingsm 1004
Monarch Circle Statesboro, GA, USA 30458
Tel/Fax [phone] rweinberger_at_frontier
net.net